Short Selling Uptick Rule to Return, But Keep It Simple

By: Frank_Holmes

It looks like an uptick rule for short selling will soon be back in place, but let's hope it's not the version being sought by the Nasdaq and the New York Stock Exchange.

The two exchanges and others are pushing a proposal that is overloaded with conditions that must be met before a particular stock becomes subject to the rule, and even then the rule's reach would be limited.

My question is, “Why make things so complicated?” If Washington 's new leadership is serious about restoring integrity to our capital markets, it will restore the old uptick rule requiring that any short sale of a stock must follow an uptick in the share price.

Adding conditions to the uptick rule creates gray areas that will be open to interpretation and thus open to exploitation. Rogue hedge funds and other market abusers like to operate in the gray areas—we've been warning about their abusive practices for several years.

The uptick rule was created in the 1930s to protect public companies from illegal “bear raid” manipulations—groups of investors working together to make big profits by driving down a stock's price. Insightful research by the Wharton School published last year lays out how these attacks can occur.

A few years ago an SEC study determined the rule was ineffective, but many have suggested this study was flawed because it took place during a rising market with low volatility. Not in doubt, however, is that the removal of the uptick rule in July 2007 was immediately followed by an unprecedented jump in market volatility.

Especially hard hit have been financial stocks, with Bear Stearns and Lehman Brothers among the first to be dragged under by what many market commentators have described as classic “bear raid” manipulations.

Lehman shares, for example, lost 30 percent of their value in the first month after the uptick rule was shelved. In the first 10 trading days of September 2008, Lehman stock fell from over $17 to 15 cents per share, and soon it was gone. It never had a chance once it was attacked by predatory short-sellers taking advantage of the uptick rule's absence. We are fortunate that we don't own any risky derivative securities or have any debt—factors that could have exposed us to the same forces that affected Bear Stearns, Lehman and many others.

The uptick rule is not solely to blame for the stock market's huge drop and it will not cure all of the unscrupulous behavior in our stock markets.

Abusive “naked shorting”—making a short sale with no intention of locating and delivering those shares to the buyer—also should be addressed with stricter rules on both the short seller and the broker executing that sale. The SEC has recognized this as a significant problem in the market, and we have been calling for a remedy since 2007.

While the regulations are being changed, we should also do something about “empty voting”—short sellers borrowing shares of a company involved in an important shareholder vote in order to oppose management's proposals. The game: defeating ballot proposals can undermine confidence in management and drive down the stock price.

And let's not forget the FAS 157 “mark-to-market” rule, which pushed many financial companies to write off many billions of dollars worth of securities. As we've written recently, these wounded companies were easy prey for malevolent short-sellers, who pounded down their stock prices and impaired their ability to raise new capital to rebuild their balance sheets. I believe having the uptick rule in place could have changed how that scenario played out.

Oddly enough, there was no great clamor to get rid of the uptick rule in the first place. Not oddly, those arguing loudest against restoring it are hedge fund managers who have been the main beneficiaries of its absence.

Regulators surely had good intentions when they suspended the uptick rule, but there were unforeseen consequences. Now they should learn from the experience and make appropriate changes before more companies are needlessly destroyed.

Bottom line—bring back the uptick rule as it was prior to July 2007. That's the simple and straightforward solution, not to mention a good first step toward more effective market regulation.

By Frank Holmes, CEO , U.S. Global Investors

Frank Holmes is CEO and chief investment officer at U.S. Global Investors , a Texas-based investment adviser that specializes in natural resources, emerging markets and global infrastructure. The company's 13 mutual funds include the Global Resources Fund (PSPFX) , Gold and Precious Metals Fund (USERX) and Global MegaTrends Fund (MEGAX) .

More timely commentary from Frank Holmes is available in his investment blog, “Frank Talk”: www.usfunds.com/franktalk .

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