The SEC, the Ban on Short Sales, and A Vote of No Confidence in the Efficient Market: An Unprecedented and Possibly Unauthorized Action
J. Robert Brown
1 Comment
The Commission has, for the next ten days, banned short sales, an extraordinary intervention by the government into the financial markets. The step impairs liquidity and represents a bureaucratic decision to interfere with the efficient market theory.
It is, therefore, worth taking a look at the statutory authority for the move. According to the adopting release, the SEC exercised its authority under Section 12(k)(2) of the Exchange Act. See 15 USCS § 78l(k)(2). As the agency described:
- the Commission is exercising its powers under Section 12(k)(2) of the Act. Pursuant to Section 12(k)(2), in appropriate circumstances the Commission may issue summarily an order to alter, supplement, suspend, or impose requirements or restrictions with respect to matters or actions subject to regulation by the Commission if the Commission determines such an order is necessary in the public interest and for the protection of investors to maintain or restore fair and orderly securities markets.
There are several things that are problematic about the SEC's actions. First, the authority is historically unprecedented. Section 12(k) has only been used only two other times and both times in a very discrete manner. It was used back in July to restrict short sales in a specified list of financial institutions. See Exchange Act Release No. 58166 (July 15, 2008). But that order only applied to 19 firms, not the 799 firms in the latest efforts, and was only designed to restrict naked short sales, not all short sale. The other instance was in a post-9/11 environment when the Commission allowed Amex specialists to also serve as floor brokers. See Exchange Act Release No. 44797 (Sept. 16, 2001)("Amex specialists shall be temporarily exempt from Section 11(a) solely for effecting transactions when acting as floor brokers for Amex orders on the floor of the NYSE for accounts in which they have investment discretion").
Second, while the provision gives the agency the authority to address any matter subject to the SEC's regulation, it is unclear that this would apply to a type of transaction. Thus, there is little doubt that the SEC can use the authority to affect the behavior of market makers or brokers or stop trading. But the ban on short sales by the SEC prohibits "all persons" from engaging in the sales. Is it really the case that the provision is broad enough to prohibit certain types of sales practices among private individuals?
Third, Section 12 provides that an order can be challenged in court but only as "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law." Arbitrary and capricious is a term of art that generally means there's an inadequate explanation in the record to support the decision. While the case can presumably be made that there is a crisis in the market, the record supporting the Commission's decision is entirely devoid of any evidence that the crisis is a consequence of short selling. The existence of a crisis, in other words, doesn't justify any response.
Barney Frank has indicated that he will look into whether the Fed, an independent agency, ought to be able to buy 80% of AIG (and rely on a fund of $800 billion to potentially make other purchases) without some oversight. He also ought to look into whether the SEC's authority under Section 12(k)(2) is so broad (and not subject to oversight) that it can interfere in the markets in such a substantial and unprecedented way without oversight.
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Reader Comments (1)
As the former Assistant Director of Enforcement at the SEC, I applaud the SEC's recent ruling. I realize this could seem counter-intuitive to my fellow free market proponents, but consider this: short-selling does not necessarily go against free market principles, but short-selling fueled by rumors, which in these days can be easily inflated via electronic syndication, does. Therefore, the vehicle of short-selling has been driven improperly and has, in fact, been a significant contributor to the recent downward spiral of U.S. financial institutions. It's high time somebody does something about it and I'm proud to see that the SEC is the first to put its proverbial "foot" down. This is what I've been saying all along: We need more 'CEO type' leadership from our federal institutions, and by that I mean that we need more innovative leadership willing to come to the table to find a way to go beyond the initial individual efforts to pump funds into the system.
Most banks are now having trouble raising new capital from investors, a key step to maintaining solvency when loan losses are rising. To add to this crisis, a weak economy is adding to loan defaults due to the enormous loan activity during the recent housing boom. This crisis may dwarf what happened in the early 1990's when savings and loans were also under-capitalized and the federal government had to bail out these private institutions.
Important issues need to be raised, such as what is the true size of potential losses on sub-prime mortgages and other loans. Some estimates put the total at about $1 trillion. Questions need to be asked about the next big unknown -- the large investment banks, are they too big to fail? The failure of Bear Stearns, Lehman Brothers has raised the question of whether US regulators now consider the largest investment banks at risk. Who could be next and are there systems in place to address the failure of a major investment bank? These large institutions play a much larger role than ever before in our financial system by issuing securities, packaging mortgage and credit-card loans, and other financial packages. The preparation for this can only come through a high level management team that can offer the leadership that is currently lacking within our federal institutions.
We must also ask what level of taxpayer dollars may or may not be needed before the crisis is over. The Federal Reserve has been loaning banks money with the expectation of repayment, taking collateral as a way to protect itself. There is discussion of creating another Resolution Trust Corporation, but we don't really know the extent to which this will continue. So, we must hope that a new and focused leadership will drive trust in the system and begin to define the limits of exposure for all of us. I am suggesting that we look at creating three fundamental strategies/approaches in order to restore confidence, build greater strength in the market and propel new growth. They are:
- Federal Economic Task Force: Rather than having all the various financial regulators, such as the Federal Reserve, SEC, Treasury and others all acting individually, we need to pull together all these organizations and have them act in unison, much the way President Franklin Roosevelt unified or created these organizations to dig out of the depression of the 1930's.
- Transparency: We still need to know the real depth of this crisis, who is at risk, and where the next big problem may be, and the public must be educated as to the risks.
- Leadership: Lastly, we need new fresh leadership. We must look beyond the ranks of the financial industry and the traditional economic advisory panels to find new ideas and individuals willing to make hard decisions.
These are elements of a transition towards solving this deepening crisis and defining how our financial markets will and must be structured in the future. We cannot afford business as usual, we need to act now.
Michael F. Perlis
Partner
Stroock & Stroock & Lavan, LLP