The SEC has recently proposed two approaches to restricting short selling. Each of the two proposals could potentially be applied in a variety of ways, but the two broad approaches are as follows:

(1) a new uptick rule that prohibits a short sale for all securities at a price below either the last sale price or the last best bid; or

(2) a “circuit breaker” rule that bans short selling for a particular security if there has recently been a severe decline in price.

A successful short sale occurs when an investor borrows a security, sells it at a high price, and then buys it later at a lower price and delivers the security back to the original security lender. If the investor correctly predicts that a decrease in the price will occur, the investor earns the difference between the sale price and the subsequent purchase price (minus the cost of borrowing the security).

The SEC release for the proposed short sale rules explains the many benefits of short sales, not the least of which is pricing efficiency. The ability to short a stock keeps the price of the stock honest because it affords investors a way to make money if the price becomes inflated. At the same time the SEC worries that short selling is used to manipulate the markets in a “bear raid” by investors spreading false rumors about a stock or taking large short positions to encourage speculation that the stock price will decrease. Some commentators claim this can create a cycle of declining value and confidence in a particular security.

The SEC rule proposals are an attempt to weigh the benefits of short selling against the supposed costs. The problem is that manipulating the markets through short selling is already illegal and a new rule cannot make the practice more illegal than it already is. Just as the SEC doesn’t prohibit taking a long position as a way to combat market manipulation that causes a stock price to rise (pump and dump for example), it seems just as troublesome to prohibit short selling as a way to combat market manipulation that causes a stock price to fall. This is especially true given the benefits that the SEC agrees short selling provides.

At some point false negative rumors and incorrect speculation about a stock prove false. The goal of a short seller spreading false rumors is to get out of the security before this occurs, but enforcement is a better way to discourage this behavior than prohibiting short selling.

The SEC is accepting comments until June 19, 2009, and so far approximately 100 comment letters have been published on the SEC’s website.