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Curbing short-selling is shooting the messenger

Towards the end of February, the Securities and Exchange Commission (SEC) voted, by a 3-to-2 margin, to restrict the “short-selling” of stocks when they are declining rapidly. This is the result of fear on the part of regulators that the process of deleveraging could get out of control. But it only puts off the necessary restructuring, by slowing down the weeding-out of poor performers. 

Most buyers of stocks hope that the stock price rises. Short-sellers, in contrast, essentially bet that a stock will drop in price. Short-selling can be undertaken for purely speculative purposes, or to hedge other investments (“long” positions). Technically, the short-seller borrows shares and sells them with the intention of buying them back later at a cheaper price before returning them to the original lender. If the price indeed has fallen, the short-seller pockets the difference.

There are many critics of short-sellers. They believe that they can spread false rumors about companies, with the aim of driving down the stock. When operating en masse, short-sellers, it is claimed, can cause a market downturn.

In the midst of the financial crisis in 2008, banks suffering from the nosedive in stock prices called on the SEC to act. In response, the SEC introduced a temporary ban on short-selling in certain stocks. In February of this year, the SEC’s limit applies to stocks whose price has fallen at least 10 percent in a day.

It is primarily the weaker-performing companies that complain about short-selling, as they seek protection from the verdict of the market. A prime example is Lehman Brothers. As described in Andrew Ross Sorkin’s Too Big to Fail, CEO Richard Fuld and others in the company continually blamed short-sellers, and demanded that the government curb them. But it was a short-seller, David Einhorn of Greenlight Capital, who first blew the whistle on Lehman, pointing out that its accounting didn’t add up. The recently-published report from Lehman’s bankruptcy examiner, Anton Valukas, detailed the dodgy accounting tricks, and essentially vindicated Einhorn and other critics.

Indeed, it has also become axiomatic that, once a company starts complaining about short-selling, it is a pretty good sign that they are in big trouble. Most recently, Citigroup’s CEO Vikram Pandit has been a vocal critic of short-sellers.

The SEC appears to cave-in to pressure to “do something” and be seen to protect weaker companies and prevent another financial downturn. John Tamny makes a compelling case why the SEC majority’s view is misguided. He argues that short-sellers provide valuable information to the market, by identifying poor-performing companies, and curbing them will have negative effects:

More broadly, the economy itself will suffer for ineffective stewards of capital essentially having their executions delayed. Rather than boosting confidence in either the economy or the stock market, efforts taken by regulators to make that which should be transparent opaque will slow the economy and market healing process that results from poor managers being starved in favor of those who might oversee it more effectively.

I can think of other possible reason why curbs on short-selling do not make sense:

  • They are illogical: there are no comparable restrictions on bets that stock prices will rise
  • Short-selling is a normal part of portfolio management (i.e., used as a hedge)
  • There is no research that proves that short-selling in itself leads to large downturns in the market as a whole
  • The buying and selling associated with short-sellers arguably lowers the difference between the prices at which shares can be bought and sold, and thus frees additional liquidity for the market

What about the argument that false rumors can be spread? For a start, information that is demonstrably false (i.e, a lie) can be addressed by regulators in a targeted way without curbing the entire short-selling mechanism.

Furthermore, let’s assume that there is a sound company that perhaps is undergoing some short-term pain as part of a longer-term strategy, and this company has been unfairly the victim of a campaign by multiple short-sellers. First, it needs to be recognized that the potential for downgrades comes with the territory of seeking capital on public markets: for the benefits of a liquid market, companies subject themselves to the verdict of the market. If companies don’t like harsh verdicts from those at arm's length, they should remain private. Second, this scenario suggests that companies must be transparent and understand that much rides on a convincing story, not just to their boards, but to the market generally. Third, it also suggests that companies must have a capital structure that can withstand occasional storms. And this really gets to a key issue today: the fact that too many companies – especially those in financial services – were over-leveraged, such that they were very vulnerable. Negative assessments from market players caused a chain-reaction, and the interruption of short-term financing.

Curbing short-selling is a displacement activity: it shoots the messenger bearing bad news. It is borne of fear that restructuring could get out of control. But ultimately, placing such curbs is the sign of a capitalism that wants to be protected, rather than live and die by the market.

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