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SECFileNo. S7-08-09 ,ilrNI il 20|]0
NIBBLING AT THE EDGES-REGULATION OF SHORT STOCK BORROWING AND RESTORATION OF AN UPTICKRULE
DouglasM. Branson"
Short selling is a meanswhereby an investor seeksto capitalizeon her mental fix that a particularcompany's shares, an entire industry'sshares,or most sharesin the market,will go down,ratherthan up, in price.r Temporarily, at least,a short selleris a bear,betting thatprices will go down,ratherthan a bull, who believesthatprices will rise.
Tradersand veteraninvestors know well the mechanicsof a typical short sale. First, the
investorborrowsshares,often from a broker dealerwho, underthe terms ofthe standard
customer'sagreement,2has the powerto hlpothecate sharesin margin accounts.rSecond,the
-W. EdwardSell Chairin BusinessLaw,University of Pittsburgh.The author wishesto thankMichaelEsler,John Stephens andKim Buckley,Portland, Oregon, for introducinghim to cerlainofthe issuesinthis articlerelating to theregulation of shortselling. Theviewsexpressed in the article remain,as ever,those of the author.
'See,e.g.,Securities and ExchangeCommission(SEC),Divisionof MarketRegulation, KeyPoints About RegulationS11O1(Apr.11,2005)(footnoteomitted):
A shortsale is generallythe saleof a stockyou do not own (orthatyou will bonow for delivery). Shortsellersbelievethe price of the stockwill fall, or areseekingtohedgeagainst price volatilityin securitiesthatthey own'
Ifthe priceofa stockdrops,short sellers buy the stockat the lowerprice andmake a profit. Ifthe priceofthe stockrises, short sellers will incura loss.
2SeeNationalFinancialServices,LLC, SupplementalApplication for MarginAccount Privileges,Notefollowing $20,at 4 (uppercase in original): "YOU AREHEREBY AUTHORISEDTO LEND,HYPOTHECATE,ORREHYPOTHECATESEPARATELYOR WITH THE PROPERTYOF OTHERS,EITHERTO YOURSELFOR TO OTHERS,ANY PROPERTYYOU MAY BE CARRYING FOR ME ON MARGIN " Nowherein the tvpical marginagreementdoesthe broker-dealerdrive hometo the customerthat, pursuantto the clause, thebroker may lendher sharesto shortsellers, therebypossiblycontributingto decreasesin the priceofthe stockbut regulatorsconsiderthepresentdisclosureto be adequate.See, e.g', Janes W. Christian,RobertShapiro& John-PaulWhalen, Naked Short Selling: How Exposedare shoftseller sellsthe borrowedsharesin the market. Third, sometimelater, the short seller
"covers,"buying replacementsharesin the market, hopefully now at a lower price, retuming the sharesto the account from w-hich she had borrowed them in the frrst place. Her profit is the differentialbetweentheproceedsrealized when sheborrowed sharesand sold them, and the price
(hopefully lower) at which shecovered, lesstransaction costs (for example,commissionsand possibly interestpaid to the personfrom whom sheborrowed the shares,if shareswere no1 availablein margin accounts).
Short selling hasalwaysbeen subjectto varying opinions as to its worth. Many corporate
CEOs,someof whom whose stockhasbeen subjectto extensiveshort selling, want the
Securitiesand ExchangeCommission (SEC)or the Congressto regulatethe practice extensively.aFrom time to time, governmentshave banned short selling.5 The Malaysian
Investors?,43Hous. L. REV.1033, 1057 & n.I83 (2006).
rln margin trading, an investor usesthe sharesto be purchasedas collateralfor the funds bonowed to buy the shares. The FederalReserve sets the amorurt(e.g., 40% of the securities value) aspayment shemust make from her own resources(the margin), while the SEC enforces the FederalReserve's regulations as to broker-dealerloans and maintenanceofthe margin thereafter @egulation T), the Comptroller of the Currency as to bank loans (Regulation U), and the FederalReserve as to other lenders(RegulationG). SecuritiesExchange Act of 1934 $ 7, 15 U.S.C. $ 78(g). Seea/so JeNresCox, RoBERTHILLMAN & DoNALDLANGEvooRr, SECURITIES REGULATToN1071-73(5th ed. 2006). If the investor purchasessecuritieswith funds borrowed using other collateral,for instance,the equity in her house,margin trading regulationsdo not apply. Margin transactionsthen are equivalentto money purchasemortgagesin the commercial world in which the item purchased(e.g, an automobile)will be the collateralfor the loan usedto purchaseit.
oSee,e.g., Staff, Nasf,, Brutish and Shorl, TIG EcoNo],{sr, June21,2008,at (actionsby MNBA, Inc., and other largepublic compa:ries).
tSee,e.g.,Kara Scannell,SEC Moves to Curb Short Selling,W*t-Sr. J., July 16,2008, at A-1 (bansby British Houseof Commonsin 1733,following the South SeaBubble, and by the New York statelegislature in 1792);James S. Chanos,Sftorl,Sellers Keep the Market Honest, WALL Sr. J., 5ept.22,2008, at A-23 (banby Englishgovemmentin 1630sfollowing tulipmania govemmentonce advocatedcriminal penaltiesfor short selling, including caning(lasheswith a whip) for the trader.6
At the other extreme, free marketershave arguedfor few restrictions on short selling, tendingtoward none.t Short selling hasbeenan arrow in many traders'quivers,including some famousones.SNo seriousstudent of securitiesregulationadvocateseithera ban on short selling or severerestdctions. All concedethat shortselling,althoughhistoricallyequivalentto 4o/oof total shareslisted on the New York StockExchange(NYSE),' servesvaluable purposes. is in the mainstream,andshouldnot go away.
Yet today, in contlastto yearspast, massive amounts of short selling takesplace,by the
7,000or so hedgeftrndsin existence,by exchangetradedfunds (ETFs) whoseprimary bailiwick
is short selling, and by investment company (mutual) funds who market their sharesby promotion
collapsein the Netherlands).Suchproposalsresurface from time-to-time. SeeMark Wolski, SouthDakotans Reject Proposal to Ban Short SalesofStock,4O BNA Fed. Sec.Reg. & L. Rep. 1854(November10,2008)(43%"for," 57o/o"against").
6Scawrcll,supranote 5. ln 1932,Representative Adolph Sabathwanted to ban short selling,termingit'1he greatestevil that has beenpermitted or sanctionedby the Govemment." Hearings on H.R. 4, 4604, 4638& 4639, House Committeeon the Judiciary, 72d Cong., lst Sess.,pt. l, at7 (1932).
'See,e.g., Kevin A. Crisp, Giving Investors Short Shrift: How Short Sale Constraints DecreaseMarket Efficiency and a ModestProposal for Letting More Shorts Go Naked,S J. Bus. & SEc.L. 135 Q008); JonathanR. Macey, Mark Mitchell & JeffreyNetter, Reslrictionson Short Sales: An Analysis of the Uptick Rule and lts Role in View of the October, 1987 Stock Market Crash,74 CorNELL L. REV.799 (1989); Michael R. Powers,David M. Schizer& Martin Shubik, Market Bubblesand WastefulAvoidance: Tax and Regulatory Constraintson Short Sales,57 N.Y.U.TAXL. REY.233(2004).
ssee,e.g.,AucE SCFIRoEDE&TI{E SNowBArr: WennrN BUTFETAND THE BusINEss oF LrFE19(2008) ("Short sellingis normally risky: you are betting againstthe long term ffend of the market," but Buffett indicates he has sold short many times)' 'Chanos, supra note 5. at A-23. of their strongbiases in favorof shorting.loToday's volume of shortselling dwarfsthevolume whichexistedin theeras in whichthe SECand stock exchanges adopted cunentregulations, or I deletedotherlong existingrules, such asthe uptick rule.r Everyoneagreesthatshortselling, as we now know it, is a contributorto the volatilitywhich exists in themarkets. The Dow Jonesor S
& P 500averages cangodown2-3tt/oinnotaday, not evenan aftemoon,but in 30 minutesof trading. Somethinghas changedradically.
OnApril 10,2009,theSECpromulgatedfor commenta 273 pageconcept-likerelease, puttingforth 2 basicapproaches.2 variationsofeach ofthose approaches, and countlesspossible refinementsofthose approachesandtheir variations,regardingfurther regulationof short
se11ing.12On May 5, the SECheld a roundtablein Washington,D.C. on whetherthe SECshould imposeany ofthe proposedor anyother restrictionsonshortselling.rr
'0Forexample,Momingstar,Inc.,nowtracks159 mutual funds specializing in short selling.See Kara Scannell& Tom Lauricella,SEC To ExtendShort Selling B4n, WALL ST. J., July20,2008, at C-1 (featuring, interalia,FederatedInvestors,lnc.'s PrudentBear Funds); EleanorLaise, Sftort Sale Ban Is Hitting MutualFunds, War-r- Sr. J., Sept.24,2008, at C-3 (use by ETFsof derivativesto imitateshort selling).
lrshortinterestequaled18 trillion shareson theNYSE at theend ofJune, 2008, up from 9 trillion plussharesin January,2007. Scannell& Lawicell4supranote 10,at A-13 (graph).In 1987there were 3.98 billion sharessoldshorton theNYSE andin 1986there were 3.11 billion shares.New YoRKSrocK EXCHANGE,NYSE FAcrBooK (1988). Thus,short selling increased roughly600 fold between1986 and 2008.
t2AmendmentstoRegulationSHO,SEC Release No. 34-59748(April 10, 2009)(hereinaftercitedas"SECReformProposals").SeealsoKaraScannell, Wrangling Ahead on Short-SalePlarns,Wall St.J., April 9, 2009,at C-1 ("commentsfrom two Republican commissionerssignaledtusslingahead");JesseWestbrook,,SEClYeighs New Ruleson Short Se/iing,Pittsburgh Post-Gazette, April 9,2009,at C-4.
13See,e.g.,SEC AnnouncesRoundtable to DiscussProposalsto CurbShortSales,4l BNA Fed.Sec. Reg. & L. Rep.753(April 27,2009). Thequestionsareshould we do somethingabout out-sizedmarketgyrations?If so,what?
Howmuchof the"whaf' relatesto shortselling?
Therestrictions, or "reforms,"advocatedfor shortselling include:
1. An outight ban on short selling.
2. Apartial ban,as to critical stocks(issues) and,/orfor periodsof time,which
was attemptedin late Summer,2008,as to the stocksof financial firms.
J. A strengthenedprohibition on "nakedshort selling," that is, selling the
stock in the market before bonowing it, with the trader delaying the
delivery ofthe stockthat was supposedto have beenborrowed, or never
deliveringit at all.
A Regtlation of stock borrowing programs inwhich broker dealersand otier
marketparticipantsseekto borrow sharesfrom individuals holding long
positions,in the main to lend to erstwhile short sellers.raIn recentyears,
those short sellershave faced increasedefforts to enforceregulations
againstnakedshort selling, making stock borrowing imperative.
'oBrokersrepresentingshortsellers may attempt to borrowstock from otherbrokers,as well asfrom individuals.The olher brokers remove the stockfrom marginaccountsthat their customersmaintainwith them. Theintermediary among brokersis the StockBorrow Program runbyDepositoryTrustClearing Corporation (DTCC), whichoperates through its subsidiaries DepositoryTrustCompany (DTC) andthe National Securities Clearing Corporation(NSCC). See,e.g., Christian,supra note 2, at 1042& 1053-55;SEC Short Selling Concept Release, SEC ExchangeAt ReleaseNo. 42,037(Oct.28, 1999).In its vault,DTC holdscertificates representingover 97o/o of publiccompanyshares in circulation.NSCC clears99Yoof thetrades whichtake place, amountingto 4.5 trillion sharesper dayand 1.5quadrillion sharesperyear. Christianat 1086. Eachday DTCC promulgates an Easyto Borrowlist ofcompanieswhose sharesarereadily available through the StockBonow Program.The emphasis in this articlers on borrowingstock direct$ ftom investorsrather than through the DTCC program, whichresults in anotherset of allegedabuses that are beyond the scopeofthis article.See, e.g., Christian, suDronote 2. at \070-7I. 5. Recognitionof now ubiquitous,andvital to muchshort selling, s/ocft
borrowingprogramsas investmentcontrqcts. Stockbonowingprograms
wouldhencebe securities,which must be registered orhavean exemption
fromregistrationandthe offer ofparticipationwould have to be
accompaniedby full disclosure.
b. Restorationof theuptick rule, SECRule 10a-1,which the SEC
implementedin 1938,and repealedin July 2007,15in modemizedform (for
example,appiicabletoNASDAQandother OTC stocksaswell asNYSE
stocks(NationalMarketSystems,orNMS, stocks)and in decimalized
form).'oTherule mandatedthattrader could sell short only at a priceone
eighthhigher thanthe previoustrade(anuptick). Altematively, a short
couldsellborrowed shares atapriceequalto the lastsale if theprice of that
lasttrade exceeded the previoussalesprice("azeroplusuptick"). In April,
2009,oneof severalproposed rules,which the Commissionspromulgated
for comment,would by-andJargereplicatetheuptickrule.r7
'17 C.F.R.$ 240.1Oa-l(1988).Repealwasby meansofSEC ReleaseNo.34-55970 (hne28,2007).
tuManymore corporationsare moving sharelistings from the NYSE to the Nasdaqthan in thepast. From 2000-2007,144 Nasdaqcompanies moved listings to the NYSE while only 20 moved the other way. In 2008, however,companies with marketcapitalizationsof $80billion moved to the Nasdaqwhile only $8 billion moved the other way,to the NYSE. SerenaNg, NasdaqPulls Harder for Listing Swilc&es,WALL Sr. J., Feb.26,2009, at C-1. Sharetrading convertedto decimalizationin 2004 while previously,and in the heydayofthe uptick rule, tradingwasin fractions(l/8,ll4, etc.)ofa dollar.
ITSECReformproposalsat 69-85. Thisarticleis aboutnumbers 4, 5 and6, stockborrowing programs (assubjectto SEC regulation,or asinvestment contracts), restorationin someform ofan uptickrule,and approaches andvariationsto thoseapproaches, to whichnew SECChair Mary Shapirois openl8and for which certainmembersof Congresshavecalled. It is not aboutseverely hamstringing, or banning re altogether,shortselling.
Further,this articleis aboutthe SEC'slatest proposals, whichnecessitateaddingnumbers
7. 8 and 9. andwhich include further:
7. A Modified Uptick Rule, which would bebasedupon the national bestbid price,as
produced by the securities information processorunder the National Market
System'sconsolidatedinformationprocessingsystem,ratherthan upon the
previoussalesprice.2oThe NMS systemwill yield a nationalbest bid pricedespite
trading having occurred in several disparate and geographically remote markets.
8. A Circuit Breaker Halt Rule, which would prohibit, for the remainderof the
trading day, any personfrom selling short a secuity following a 10% decline in
that day's price for that security.2l
9. A Circuit Breaker Modified Uptick Rule purstant to which a severedecline in a
particularsecurity'spricewould trigger applicationofa temporaryshort saleprice
18.SeeYin Wilczek, Shapiro Directs Trading & Markets Division to Review Uptick Rule, NRSROPay Models, 4l BNA FBD.SEc. REc. & L .REP.247 (Feb.16,2009).
t\4alini Manickav asagatn,Ackerman Urges SEC's New Leader to Act on Uptick Rule, Citing Cox'sSupport,41 BNA Feo. SEc.REG. & L. REP.198 (Feb.9,2009).
20SECReformProposals at 3 &29-69.
21[d. at4 &89-99. test(uptickor modifieduptick test) for that security,rather than halting short
sellingaltogether.22
To usea sportsmetaphor, althoughshortsellingshould co-exist with otherfoms of trading,and do soon a levelplaying field,levelplayingfields have boundaries. Therules should prohibithits out of bounds(offthe playingfield), but nothingmore. This articleis abouthits out ofboundsor, aboutestablishing wherethe boundaries arein the first place'
PROPOSEDAND HALF-HEARTED"REFORMS''
A. IYhy We Want Short Selling
"We needthe shortsin the market for balanceso that we don't have bubbles," says
(former)SEC ChairmanChristopher Cox.2r Short sellers' transactionshelp bring pricesinto line with levels supportedby a corporateissuer's andthemarket's fundamentals(revenues, costs,
profits, competitiveoutlook,growth rate,and so on). Short salesdamp down irrational
exuberancsthrough their downward effect on securitiesprices.
Short selling facilitates many trading strategies. Arbitrage attempts to profit by taking
advantageofprice disparities in different markets or between comparable items with different
names,sometimes in the samemarket. Index arbitrage,for example,exploits differencesin the
priceof stock indexesand the basketof stocksupon which the index basesitse1f.2a Convertible
arbitrage notes small differences between the prices of convertible bonds and the common stocks
221d.at4 &99-104.
23Quotedin Chanos, supra note 5 .
2aSee, e.g., Macey et al., supra note 7, at 809. into whichthey are convertible.25These and othertrading strategiesuse short selling to createo( to unwindpositions.
Traderswho wish to lock in a proflt but not realizea gainuntil they haveheld a assetfor 1 year,andtherefore will payonly the 15"/otax rateapplicable to capitalgains, ratherthan higher rates(33%or 35Yo)applicableto ordinaryincome, often sell shortthe samenumber of sharesas theyhold. Knownas"goingshortagainst the box," from thedayswheninvestors kept share certificatesin safetydeposit boxes, the strategydictates thattie investorunwind the short positionsafterthe required year haspassed.26
Overallthemost laudatory aspect of shortselling is asa mechanismof informational efficiency.Short selling tendsto helpprices movepromptlyin thecorrectdirectionandto the correctextent, or magnitude.It therebyenhances confidence in the market,as fewerinvestorsbuy or sellatpricesnot in accordwith underlyingeconomicrealities.Inotherwords, there are fewer surprises.
Statisticson shortinterest in variousstocks,whichisregularlypublishedandwidely followed, also sendwhat financeprofessional term "noisy signals": increasingshortinterest figuresinform other traders, who arenot shortsellersthemselves,thata well informedsegment of themarkets ha^staken progressivelydimmerviewof a particularstockor industry.27They thus maynotsellshort but theymay reduce or eliminatetheir long positions.
B. WhySomeRestrictions on Short SellingMay Be in Order.
2sSee,e.g.,Powerset al.,supranote7,at237.
26Described in, interalia,Powerset a1.,supranote 7, at 239&n.20.
21hd. at 243. Effortstantamountto at leasta partialban nonethelesssurface from time to time,
Grandstandingfor corporationsand investors(alsovoters)back home,several senators and congressmensaytheywantlegislation forcing hedge fundsto registerwith theSEC,disclosing theirnading strategies,such as aggressive shorl selling,and who theirinvestorsate.28Wealthy investorswoulddesert hedge funds in drovesif funds' shortselling strategies became public knowledgeasdid investors'identities. Short selling, especially of well-knownstocks or ofthe sharesof hometowncompanies,hasnever been popular.2n Suchlegislation would not banshort sellingaltogether but wouldconstitute painting bull's-eyeson hedgefunds' andinvestors' backs, whichisprobablythelegislators'objective.
Onthe otherhand, some restrictionsmay bein orderbecausethe factualpremises of laissezfaire advocateshave been wrong. "Only for thinly tradedstocksis therea remote possibilityof manipulativeshort sellersstampedingthepricedown," asserts Yale law professor 'bear JonathanMacey.'u"It is unlikelyin today'shighly developedmarketthat raids'could seriouslydisruptthe workings of themarket. Bear raidsare most likelyto be a problemfor OTC firms," concludesProfessor Macey. Of course,in a bearraid, groups of traderssell short a corporation'sstock,pursuantto an expressor tacit agreementamong the traders. The further hope
?8,SeeJennyStrasburg, LegislatorsSeek Hedge-FundDisclosure,Wl'rt Sr.J.,Feb. 2, 2009,at C-2. Seea/so StephenJoyce, New Rulesfor HedgeFundsLikely,AnalystsSay, Due to SystemicRiskProposal, 4l BNA FrD.SEc.REc.L. & REP.13 I (Jan.26,2009).
2eShort-sellershavebeen described as"evil people":"theyhaverobbed us of our money andtlrey must be stopped."Reportedin Nick Evans,Don't Shootthe Short Sellers,33 ELRoMoNEy20(2002).JapaneseFinanceMinisterMaajuroShiokawa opined that"[s]hort sellersaremean-spirited sorts benton makingmoney by gettingajumpon otherinvestors." 13 AsrAMor'{EY 1 Q002). 3oMacey et a1.,supra note7, at 817.
10 is that the group'sshortsellingwill depressthe marketpriceenoughto trigger stop loss orders personswhich long positionshave placedseveralpointsbeneaththe currentmarket price. Price declinesof anymagnitudewill also trigger sell ordersby institutionalholderswho adhereto programmed trading strategiesoften automatically generatedby computers. Such further sales
will increase,becoming a cascadeand thena tonent, which will depressa stock's market price further,increasingthe short sellers' profits.
Thesepremises (that bearraidsonly affect thinly tradedsharesin OTC markets)are
wrong. Bear raids are difficult to detectbut we now have evidence that they have occurred in
several"large cap" companies,suchas Morgan Stanleyor Long Term Capital Management.rl
Bearraids in suchlarge companiesaffect not only investorsin thosecompanies. Raids in those
stocksreceive wide publicity, impugning market confidence over a front much broader than in the caseof smaller,somewhat obscure OTC companies.r2
31See,e.g., SusanPulliam, Liz Rappaport,Aaron Luchetti, JennyStrasburg& Tom McGinty, Anatorny of the Morgan Stanley Panic-Trading Records Tell Tale of How Rivals Bearish BetsPounded Stock in September,W*t-ST. J., Nov. 24,2008, at A-1, chroniclesa bear raid on a high visibility large cap stock. Morgan Stanley(MS), which hadjust announced quarterlyprofits exceedingall forecasts,saw its stock price dechne24o/oin a single day. Short interestshot up to 9 times normal, althoughtraders also usedderivatives, including credit default swaps,to make bearishbets on the stock. While lateranalysisrevealed no expressagreements, consciousparallelismandherd mentalitiesby a number of major tradersoccuned. Citigroup, Menill Lynch (thenindependent),DeutscheBank, UBS, Royal Bank of Canad4 and Swiss Re, amongothers, sold MS short in greatquantities. Falserumors, that DeutscheBank had pulleda $25billion line of credit, or that Morgan Stanleywould enterbankruptcy, accompanied and causedsomeof the further short selling. Among hedgefunds, King StreetCapital Management, LLC, Owl Creek AssetManagement,LLC, and Third Point, LLC, engagedin short selling of MS. The Morgan Stanleyaffair, as well as other instances,discredits the conclusionthat bear raidsand short selling cannotaffect a largecap companyand its stock.
t'See,e.g.,John R. Emshwiller, "NakedShorting" Lurks in Refco'sPast, WALL Sr. J., Oct.25. 2005.at C-3.
t1 Freemarket advocates have lost sightofthe greatergoal, which is overallmarket efficiency. In tum, a marketis efficient if largenumbers of buyerand sellersare in that market.
Largenumbers ofbuyers andsellerswill be in the marketif the spreadbetween bid andasked pricesis smalland transactions costs arelow. As the gapbetweenbid andask priceswidens, pricecontinuitydisappears, volatility increases,prices gyrations occur, and roller coasterprice changesand stomachchuming price dropscauseerstwhiletraders to retreatfrom the markets.
It is manifesterror to equateinformational fficiency with marketfficiency overall,as mostacademic writers do. In an efficientmarket, there will be fewersurprises. Prices will move promptlyin the correctdirection and toward a new equilibrium.There will be a sizeabledegree of informationalefficiency. But therealso will beprice continuity.Prices will moveto new highs,or to newlows, in, for lackof betterwords, aa orderlyand stately fashion. Fewer investors will berepelled by activityin market.The two goals,informationalefficiencyandprice continuity,work at crosspurposes,but bothare necessaryprerequisites foroverallmarket efficiency.r3
Academiccommentary flatly assertsthat investors' trading, including short selling, should
"movepricesgzr ickly to theireqilibrium level."raAnother concludes that "[]egal rulesshould
3tSee,e.g.,Douglas M. Branson,SecuritiesRegulationAfier Enteringthe Competitive Era: TheSecurities Industry, SECPolicy, and the Individual Investor, T5 Nw. U. L. REV.857, 896-97(1980)('A healthymarket is onenot characterizedby roller-coastergy'rations which frightenparticipantsaway");Solomon,The Impact of the EmergingSystemon SecuritiesTrading and theEconomy, inWALL STREETrN TRANstrloN 111, at 130-31(H. Manne& E. Solomon eds.,1974) (same). Seadha fucHARDR. WEsr& SEHAM. Tnruc,TIm EcoNoMIcsoF rm STocKMARKET 5-8 (1974) (price continuity as symptomaticof an efficient market);Bru, E. ScHrrLTZ,TrG SncururrEsMemBr ANDHow IT WopJ raMaceyet af.. supra nole 7- al821 . 12 nurturethe dynamicprocesses that developand incorporateinformation into marketprices.' . . Ourlaw shouldrecognize the legitimate-indeed,necessary-role of shortsales."r5 Speedisn't everything. To the extentthat they nibble aroundthe edges,and contributeto pricecontinuityandto investorconfidence,somerestrictionson shortselling arein order. That hasbeen heresy to sayfor the last25yearsbut the eventsof 2008-publicizedbear raids on well- knownstocks, huge waves ofshort sellingby someinvestors,wholesaleretreatsfrom the markets by others,and aprecipitousfall in theDow Jones(13,000 to below7,000 in 6 months)and other marketaverages----callfor re-examinationof whathas become the received wisdom.r6 Informationaleffi ciencyuber allesmay not be the correctmantra. C. Is ContinuedVigilance Against "Distort andShort" BearRaids and Similar Tactics Sufficient? Shortsellersmay attemptto manipulatethe marketby spreadingdisparagingrumors abouta particularcompany.Simultaneously the rumor'sauthor, or herconfederates, sell short, hopingto profitbythepricedecreasetherumor causes. Crroups oftradersmayengage in concertedactionof the samesort, labeled "distort and short" campaigns.3T These gpes ofcases surfacefrom time to time. 35Powers et a1.,suprd note7 , at270. 36BetweenJuly,2008,andMarch,2009,the Dow JonesIndustrial Average lost 50%of itsvalueandthe S & P 500Index lost 54%. SECReform Proposals at 24. ttSECChairChristopher Cox perceivesdistortand short campaigns as having "drastic consequences,"leadingtheCommissionstaffto targetthem for specialenforcement efforts. ,See Cox, l(hat theSEC Really Did on ShortSelling, WALL Sr. J., htly 24,2008,at A-15. Earlierthe SEChad issued 50 subpoenastohedgefunds suspected of spreadingfalse rumors about companiesand stocks. Scannell& Lauicella, supra note 10, at A- 13. 13 The occasionalrevelation ofthese sortsof manipulation,alongwith the evidentpotential for many more, combined with the difficulty of detection, gives impetus to advocatesof additional regulation of short selling. By conffast, those who support unfettered short selling point out that vigilanceby the self regulatoryorganizations(SROs,such as stock exchanges)and the SEC will leadto criminal andcivil actionsunder,for example,sEC Rule i 0b-5.38The goal,of course,is a sufficientnumberofprosecutionsto deterthe practice,not aszerodefectapproachwhich would adverselyaffect legitimate short sales D. Regulation SHO and the Campaign Against Naked Short Selling' As with the condemnationof "distort and short' manipulations,manymarketpafticipants condemnthe practiceof nakedshort selling.3eIn theory, if short sellersdo not haveto, or simply do not, deliver shareswhich they have purported to sell, short interest in a stock can exceed the total number of sharesoutstanding. On a morerealisticscale,without the constraintof having to deliver shareswithin 3 days afterselling them (T+3), shortintelestiI1a stock canmount rapidly, exertingexcessivedownward pressure on a stock'sprice. Combinedwith broadcastof false rumors,or an organizeddistort andshort campaign,naked short selling canpush a stock's price so far down that theprice level hasno connectionwith underlying economicrealities. In the view of Russo,74 F3rd "Two casesinvolving manipulativeshortsellingschemesare SEC v. 1383,1392(2dCir. 1996),and SECv. Gardiner,48 SECDocket9121(SDNY 1991)' 21, 2006, "See, e.g.,Liz Moyer, Crying Foul in Shoft Selling,Forbescom, June http://w.w.w.forbes.cornl2006/06/20/naked-short-selling-overstock.html;Karl Thiel, TheNaked Trith About Short Selling,Trs MoTLEYFooL, Mar. 24,2005 ('Naked short sellerssell sharesof stock they haven't borrowed, have no intention of borrowing, and that may not exist"). Prolongedfails to deliver resultingfrom nakedshortselling may reachhigh levels. The amount of fails may exceedthe numberof sharesin the public float ofthe security,resulting in great numbers of phantom shares. SeeChistian, supra note 2, atl045-46. t4 nearlyevery market participant,naked short selling, like the spreadof false rumors,is a "hit out of bounds,"notconsideredto bewithin the boundariesmarking the levelplaying freld.ao Buthow to policeit? TheSEC adopted RegulationSHOin August,2004, to takeeffect in January,2005.41Theregulationforbidsa broker-dealerfrom acceptinga shortsale order unless the would-beshort sellerhas already borrowed the shareshe proposesto sell,or hasidentified the shareshe intendsto bonow (the"locate" requirement).4Z As to widelytraded shares, the trader, or his broker,can usually frnd them in the firm's own accountsor on the DepositoryTrustClearing Corporation's(DTCC's)Easyto Bonow list, whichin normaltimes would satis$the locate requirement.a3 After thetrade (sale ofthe shares),RegulationSHO reduces the durationfor whichfailures to deliverare permittedto remainopen. Broker-dealersmust close out fail-to-deliverpositions in "thresholdsecurities"thathave persisted for 13settlement days (the"closeout"requirement").aa Closeoutmeansthatthe broker essentially will haveto cover"open fails," thatis, buy in the requisitenumberof shares,closing out the shortposition. The SEC,or the applicableSRO, amy ouCf. Crisp,supra note7 , at 145. arRegulationSHO,SEC Release No. 34-50,103(Aug. 6, 2004). ttA shortsellermust possess "reasonablegroundsto believethat the securitymay be borrowedso that it canbe deliveredon the datedelivery is due,"that is, by the closeof the third businessdayafter the trader purportedto sellstock (T+3). SECRule 203(b)(1)(ii), 17 C.F.R. $ 240.203(bxlXiD(2006)."Thislocatemust be madeand documented prior to effoctingthe shortsale." SECDivision of MarketRegulation, Key PointsAbout Regulation SHO at 2 (Apr.11,2005). o3Thatis, sadsrythe locaterequirement, absent actual knowledge by the brokerthat there havebeen repeated fails to deliver in the particularstock. SeeChristian, supra note2, at 1070-71. onRegulationSHORule203(B); Key PointsaboutRegulationSHOat 3. 15 alsoinstitute disciplinary actions against licensedprofessionals, most particularlythe broker dealer,lor violatingRegulation SHO.{5 A securityis a thresholdsecurity i{ over any running 5 day period, fails to deliver equaled or exceeded10,000 sharesand.5%of the issuingcompany'soutstanding shares,whichisan SEC reportingcompany.a6 A broker-dealercaffrot acceptfrom anytrader an orderto sellshorta thresholdsecuriryif thetrader has an open position (unfilled)in thatsecurily.aT For 2 years followingRegulationSHO'sadoption, the threshold list on averagecontained 300names, averaged414stocksin theflrstninemonths of2008, andpeakedat 529stocks as naked short sellingof banksand other financial stocks crescendoed.as E. July2008Modification of SH0's Applicationto CertainFinanciql Stocks. It is commonlystated thatthe SECinstituted a "ban" ot a "curb" onshort sales. It did no suchthing,at leastat flrst. Instead,on July 15,2008, the SECannounced that, effective July 21, otSee,e.g., StephenJoyce, ATYSER Imposes Largest Regulation SHO Fine in Case h*olving DeutschSecurities,40BNA Fed.Sec. Reg. & L. Rep.1486 (September 22, 2008X$575,000for failureby 5 tradingdesks to closepositionsaftershortsellersfailedto produceborrowedsecuritiesin 13days). ft1d.Thevarious selfregulatoryorganizations (SROs),suchasstock exchanges and the Nasdaq,areto disseminatedaily lists of threshcldsecurities which, inter alia, theypublishon their websites.Id. at 4. Apptoximately16,200corporations (the numberfluctuates daily) file periodicreports with the SEC. SeeAnruun Prsro & DoucLASBRANSoN, UNDERSTANDING CoRpoRArELAw150 & n.19(2ded.2004). 47Atthe time of SHO'sadoption,Wall Streetspokespersons expressed concem thatthe existenceofa list ("ThresholdSecurities")andthe presence ofissuingcorporations' names onit would result in lessshortselling, in turn permittinghigherpricesto persist. ,SeeHenry Sender, NewRules Put theSqueeze onthe Sftartr,Werr,Sr.I., I'arl'27,2006,at C-5. Theconcems nevetmateialized. See Floyd Nonts, A NewSECRule Fails to RaiseStock Prices,andSome AreAngry,N.Y. Tnvms, Feb. 18,2005, at C-l. a8TomMcGinty& JennyStrasberg,Short Sellers Squeezed on All Sides,Wall St.J., April 7.2009.atC-t. 16 andwith licenseto continuefor up to 30 days,theSECwouldsuspendthelocateprongof in RegulationsHo, asto 19ofthe mostwidely traded financial stocks.would-be short sellers thosestockswould eitherhaveto haveborrowed the sharestheyproposedto sell short,or havea formal agreementfrom a lenderto providethe requisiteshares to theshortselleron or before closingofa trade(T+3).aeThepricesof financialstocks had declined greatly.The SECthought thatahighlevel of shortsales had contributedto the decline,or to thesteepnessof its slope.The SECthoughtfurther thata greatnumberof thosesales had beennaked short sales. So the Commissionengagedin technicalbelt tightening'50 on September18,2009,the SECextendedtheT+3 mandate,requiring a// openshort positionsto be closedout by the fourth day after thetrade. The numberof stockson lhe theshold listsoonthereafter dropped well below200,averaging ?9 in thefirstquarterof2009.5r criticismof the sEC'seffortswasnearlyuniversal. Professorowen Lamont,formerlyof Yale,termedit a"silly butharmlesseffort."52Presidentof the ManagedFundsAssociation, the hedgefundindustrygoup, termedthe SEC',sactions "aberrant"and'\/vithoutprecedent."sron oeSECExchangeat ReleaseNo. 58166(July 15,2008). Seealso SEC PressRelease 2008-143,SECEnhancesInvestorProtectionsAgainstNaked short Selling (announcing emergencyrule making). "An arrangementto bonow requires more than a reasonablegrounds to believe that the security may be trorrowed. An arrangementto borrow meansa bona frde agreementto borrow the security such that the security being borrowed is set aside at the time of the arrangement. . . ." SEC Division of Trading and Markets, GuidanceRegarding the Commission'sEmergencyOrderConcemingShortSellingat I (July 18'2008)' toSee,e.g.,RobertCpan & Antony Curie, ClumsySEC Atives Late, WALL ST' J', July 19,2008,at B-16 (a "technicality,""actuallyonly [to] clari$ a grayarea"). stMcGinty& Strasberg,supra note48. 52Scannell& Lauricella,supra nole10, at A-13' 53ts l'7 fear that with nakedshort the othersideofthe issue,the American BankersAssociationexpressed banks not coveredby the selling curtailed for the largest banks, short sellerswould focus on the and startling. Price new SECrules.raTherule's effect,althoughshortJived,was immediate 14'5%o(Frcddie increasesin the financial stocksrangedfrom a highs of 89.5% (FannieMae), 25.27o.55Short interest Mac) and4g.4%(Bank of America) to a meanof 25.6% attda mediartof in Freddie in someof those stockshad beenhi gh: t4.22% in FannieMae sharesand12.81% prices Mac. Relievedof nakedshortsellingand its downwardpressureon price' the share rebounded. of course, an afgument may be made that curtailment of naked short sales merely prolonged the inevitable: Lehman Brothers shares,in which short interest had tsen to 72.57o/o' The samemay rebounded44.6%. Lehman Brothers, of course,enteredbankruptcy in september. be said of Fannie Mae and Freddie Mac: although they reboundedtemporarily, their shares eventuallybecameworthlessaswell. 'l he counterargument is that informationalefficiencyis not everything. Relievedofnaked (zero' shortselling,seffects,Lehman's,Fannie'sandFreddie'ssharepricesmovedto equilibrium or nearzero) in a moreorderlyfashionand investors' confidencewas(slightly) lessshaken. Nonetheless,on July 29,the SEC announcedcontinuation of temporaryrules to the maximum extentallowedfor, 30 days,that is, until August 14, 2008'56 saScannell.SEC Short-SateRule Gets Negative Reviews, W.{LL ST.J.,July19,2008,at B-1. "1d lTable;. tUSECpressRelease2008-155, SEC Extends Order Limiting NakedShortSelling (July29,2008);Scamell& Lauricella,supranote10' l8 F. SECSeptember,2008 ExpansionofRestrictionson ShortSelling. Manyat the SECbelievedthatshort selling hadcontributed to, inter alia,thecollapses of BearSteamsCos.andLehmanBrothersInc. So,in September,the SECwentbackto the drawing boards.TheCommissionadoptedseveraltemporaryruies: . The SECincreased penaltiesfor shortsellers who rely on thelocate requirement andthen fail to deliveron T+3. After anysuch failure to deliver,the SECwill barthe broker-dealer from executinganyshortsaleunless the traderactually hasborrowedthe sharesbefore placingthe order(thehard delivery requirement,to expireAugust l, 2009.1.57 . The SEC definedas misleadingand persefraudulent for any traderto misleada broker- dealerthat the traderhas located shares to borrowwhen he hasn'l.tt . TheSECbanned, temporarily,all shortselling in financialstocks.se Thenewrules,announcedonSeptember17and18, went into effectat 12:01AM on September1860andquicklyexpanded thereafter. 5?SECExchangeAct ReleaseNo. 58572(Sept. 17,2008)(adoptingtemporaryRegulation SHORule 204T and Rule 10b-21).See qlso SECPressReleaseNo. 2008-204,SEC IssuesNew Rulesto ProtectInvestors AgainstNaked Short SellingAbuses(Sept.17,2008) 58sEC Rule I0b-21,17C.F.R. $ 10b-21(Sept.2I,2008) ("It shallalsoconstitute a 'manipulative or deceptivedeviceor contrivance'. . . for anyperson to submitan orderto sellan equitysecurity ifsuch persondeceives a broker-dealer,aparticipant ofa registeredclearing agency,ot a purchaseraboutits intention or ability to deliver thesecurityon or beforethe settlementdate, and suchperson fails to deliver the securityon or beforethe settlementdate"). 5eSECExchangeAct Release58592(Sept.18,2008) (Emergency OrderPursuantto Sectionl2(k)(2) ofthe SecuritiesExchangeAct of 1934). 60KaraScannell,SECIssuesShort-SellingRulesin Bid to StopManipulation,WeLl St. J.,Sept.18,2008,at .4-6. 19 Thehard delivery requirement wasthoughtespeciallyto be efficacious'Open fails declinedfiom an averageof 1.1billion sharesperday, before therule,to anaverage of58? million sharesper day,afterthe SEChad adopted the provision.6l Effective Monday, September22, the SEC adoptedatemporaryrule requiringhigher volumeshortsellers, such as hedge funds and other money managers,to disclosetheir short positionsonthe Mondaysfollowing their trades.62The SECalso added 71 stocksto itslistof750 in whichthe Commissionhad prohibitedshortselling, including sharesof GeneralMotors,Credit SuisseFirstBoston, American Express, Moody's, and Legg Mason, the brokeragefirm. The latter trend (additionof stocksto the list) continued,with the SEC addingto thelist anyretail or industrialcorporation which had a financialsubsidiary, including CVS,Ford, United Healthcare,lBM, Zale(ewelers), andSears.63 Regulators around the world, alsofaced with the g1'rationsofa world crisis,enacted short selling bans in theirowncountries.oo Criticismmixedwith bits of empathyfortheSEC."It looksiike wehavea bunchof amateus[at the SEC] who don't know what they aredoing . . . [b]anningshort selling showsthe desperationof theregulators,"saidProfessorJamesAngelatGeorgetownUniversity.TheSEC "'SECReformProposal at23 &n.81. 62SEC ExchangeAct ReleaseNo. 58591A(Sept. 21,2008).SeealsoSECDivision of CorporateFinance,Divisionof InvestmentManagement,andDivision of Tradingand Markets, GuidanceRegardingtheCommission'sEmergencyOrderConceming Disclosureof Short Selling(Sept.24,2008);KaraScannell, SEC Revises "Short" RulesAlready, WALL Sr. J., Sept.23,2008, at A-3. 63KaraScannell& SerenaNg,.SZC'sBanon ShortSellingIs Castinga Veryl{ide Net, WALLSr. J.,Sept. 26, 2008, atC-3. uoSee,e.g.,Scannell,SfrorrSale Ban Spreads Aroundthe llorld,W,qu,St. J., Sept.22, 2008,at C-l (Australia,UK, Taiwan,Netherlands); Staff, Korea Tightenslts Rules,WALL Sr. J., Sept.25, 2008, at C-2. 20 justdecidedthat..weneededatime-out[but][t]herearealotofusouttherewhoarewondering rails ' ' ' said ProfessorCharles what the SEC was thinking' whether they have gone of the "' a SwissProfessor (Ibis), finding that Jonesat Columbia.6s"Stop the folly. Endthe ban," opined the umbrella'"" stocks on the ban list reactedmore slowly than stocks outside point' which wasto causeshares Ofcourse,ProfessorIbis mayhavemissedthewhole there are those who believe that prices to react in a more orderly and slower fashion' Again' informationalefficiencyis not the sole objectiveof regulalors' Nonetheless,theshortsellingbanexpitedonOctoberlT'2008'6?Aroundtheworld'other In thefinal analysis'onemay regulatorsfollowed, allowing banson shortsellingto lapse'68 Industrialaverageslipped questionwhethertheU.S. banaccomplishedarything. The Dow Jones below3,000inJanuary200g,theworstJanuatyonrecord.Perhapsroiledbytwbulentprices,and to desseltthe markets,pushing certainlyadverselyaffectedby falling prices,investors continued t}reDow Jonesaveragetoward 6,000' 65Scannell,SEC Refises"Short" RulesAlreaSt, supranote50' A-25. 6IbiS,SholtingFingncialStoct3ShouldResume,WALL ST.J', Sept'29, 2008'at terminate"at 67SeeSECExchangeAct ReleaseNo. 58723(Oct.2,2008) (extended banto theearlierof(i)threebusiness ShortSellingin DaysGoneby and Abolition of theRule. Torelieshthe reader's recoliection, theuptick rule existedfrom 1938unt1l2007 . Therule limited a would-beshort sellerto selling shortonly following a transactionat a pricegleaterthan theprevioustransaction(uptick), or onestepremoved (zero plus tick). In announcingrecision of therule,theSECpointedto thetransparency and the intense surveillance oftoday's markets, which makemarket manipulation usingrumorsand shortsales easier to detectand therefore less likely to occur. Thebrake of the uptickrule, which would slowtheprogress of anybear raid or shortsellingcampaign, including manipulative ones, wasno longerneeded.6e The SECalso relied on its ownempidcalstudy of the effectsof theuptickrule. From May 2,2005,until July3, 200'1,theSECsuspendedthe uptickru1efor 1,000stocks.70 The result of the"pilot program"wasa conclusionthatthe presence or absenceofan uptickrule hadno effecton thevolume or characterof shortselling. A pilot programstock, freeof theuptick rule constrain,experiencedno volumeof shortselling greateror lessthan comparable stocksubject to 6e,SeeSECReleaseNo. 34-55970(June 28,2007). 70SECReleaseNo.34-50204(July28, 2004)(initiatingpilotstudy). 22 the uptick rule.Tr Using the datathe SEC's studyhad generated,researchersat major universities backedtlte SEC 's conclusions.T2The uptick rule was gone. But not without misgivings. Membersof Congressintroduced a bill which would have reinstatedthe uptick rule, extendingits applicationbeyond NYSE to many over-the-counter stocks,as statutoryrequirement.T3 B. Reactionsto Abolition. Whenthe llall StreetJournal publishedan editorial on thequestionofrestoring the rule, letters to the editor, or at least the published ones, ran 5 to 1 in favor of restoring the rule or somethingcomparable. "[T]he absenceof the rule has createdselling cascadesin certainstocks. I have shortedstocks my whole career,but this selling is crazy," concludedonetraderin Decembet, 2008.74"We don't needthat meaninglessrule to be restored. We needa new rule . . . that is unambiguousand impossibleto manipulate. No stock can be sold short unlessit is sold at a price abovevesterdav's close."75 "See,e.g.,SEC Reform Proposals at 14:the SEC'sOffice of EconomicAnalysis (OEA) "[did not frnd] a significantdi{fience in shortinterestpositionsbetweenthosesecuritiessubject to a shortsale price testversus thse secuities that were not subjectto sucha test..." (footnore omitted). TzSeeLyrnBai, The Uptick Rule of Short SaleRegulation-Can It Alleviate the DownwardPressure From NegativeEarnings Shocfs? (Llniversityof CincinnatiCollege ofLaw WorkingPaper Series, 2007), available a/ h@://ssm.com/abstract:956106;Karl Diether,1/'s SHOTime! Short-SalePrice-Testsand MarketQuality(OhioStateUniversity Fisher College of BusinessWorkingPaperSeries,2007), available at http'./lssm.conrlabstract=910614;JulieWu, ShortSellingamdthe Informational ElficiencyofPrlces(Jniversityof GeorgiaWorking Paper Series,2008),available at http://ssm.com/abstracr:9726230. t'H.R.6517,11Oth Cong., 1st Sess. (2008). taletterftom JonGroveman, Lettersto theEditor, Walr Sr. J.,Dec. 15,2008, at A-18. Tsletterfrom JonR. Alden.lrtters to theEditor. W.t I-l Sr. J..Dec. 15.2008. at A-18. than giving lip The lone dissenter weighed in in favor of infomational efficiency rather price goesto its service, or otherwise, to any notion of price continuity: "The faster the [share] properlevel[assistedbyshortselling]thefewerinnocentvictimswillbuyonthewaydown.The 'restore' agony,and .confidence,thattheuptick rule would is nothingbut a prolongationof the anotherform of manipulation."t6 authoredby Much of this dustup was most immediately precipitated by an op-ed column critical of charles Schwab,founder of the eponymousonline brokeragefirm. He was exceedingly the SEC'sabolition of therule: [T]heSECrepealedtheuptickruleafterabriefstudy.Manipulativeshortsellers couldn'tbelievetheirluck. TheSEC'sstudytookplaceduringaperiodof low volatilityand overall risingstock prices in 2005throughpartof2007 anddidn't anticipatethe ljnd of marketwe areexperiencing today. Welive in an environmentwhere200point dropsor moreintheDowJonesIndustrial Average areincreasinglycommon' wherea stocklosing20%,307oor evenmorein a singleday barelywarrantsa secondglanceat theticker. Ironically,it wasjust this sortof volatilitythatinspired the regulatorsin the 1930sto implementthe uptickrule in the first place' Without this mechanism,short sellershavebeenhavinga freldday, betting heavilyon Tt lowerpricesandtriggeredpanickedinvestorsto selleven more tuletter from S.PaulPosner,Lettersto the Editof, WALL ST.J., Dec. 15, 2008' at A-18. 7?CharlesR. Schwab,Restorethe UptickRule,RestoreConfidence,W Att Sr' J', Dec' 9' 2008.at A-17. 24 Mr. Schwabintimates that the SECshould havestudied the uptick rule in generallydownmarkets aswell in morebullish times,as it did in 2006-2007 ' In a risingmarket, buyers are plentiful. Certainoftheir purchasesproduceupticks. For the shortseller, then, in a bullishmarket an uptick is not hardto find. Onthe otherhand, in a marketwhich is flat, or frendingdownward, buyers are more scarce.Therewill moredownticks. An uptickwill beharder to find. Thepresence of anuptick rule will delay,or in someinstances forestall altogether,putativeshortsellers.In termsofthe SEC'sstudy, in a downstock market,stocks subjectto theuptick rule would experienceless short sellingthanwould comparable stocksto whichthe rule did not apply. Thatwould be trueeven thoughin a generallyrisingmarket the presenceor absenceof anuptick rule would make no difference.Ts At a minimum, then,the SEC shouldconduct additional studies which might illustratethe differingeffects ofthe uptickrule, and variants thereof, in differingsorts of markets.A separate questionis whetherthe SECshould re-instate, temporarilyat least,some version of anuptick rule, or somesimilar brake or checkon stomachchurning roller coastervolatility, and the shortselling which contributesto it. C. Proposals:CircuitBreakersor SalePrice Restrictions? The SECfirst proposesa"modifieduptickrule," basedupon the national best bid pricein aparticular"covered"security,Tefollowed by aproposalfor"proposeduptick ruIe," which would '"See,e.g.,JeffD. Opdyke,Uptick Rule Gets Debate Arnid Turmoil,WALL Sr.J., Dec.24,2008,at C-l ("CharlesWhitehead, a securitiesJawprofessor atBostonUniversity, notesthat the SEC studyoccuned during a generallyrising market. Whenthe marketis declining,anuptick rule wouldat leastabate the relentless downward pressure. . . ."). TeSECReform Proposalat3 &29-69. 25 bebaseduponthe lastsale price, as of old.80Generically, theSECstaffrefers to theseproposals as"price restriction rules" or "ShortSalePrice Restrictions." A bestbid, of course,isthehighest price any bonafide investoris willing to pay,while the bestasked would be the lowestprice at whichanerstwhileselleris willing to accept.EtThe short sale price restriction proposals are discussedbelow. CoveredsecuritieswouldbeNational Market SysGm ('{MS) securities(e.g.,NYSE, AMEX,Nasdaqandactively traded other OTC). TheCommission invites commentaryon extensionof whaleverrulesareadopted to stockslisted on the OTCElectronicBulletin Board and thelike, becausein thosemarketsmany small("microcap")issuers believe theirsha.resare "particularlywlnerableto abusiveshort se1ling."82 Thegreatwatershedamongproposalsis betweenshort sale price restrictions,asjust outlined,and "proposed circuitbreaker rules." The SEComits to tell its readerswhata circuit breakeris, althoughmost interestedcommentators will havefamiliarity with thedevice and its use in financialregulation.s3Thecircuit breaker proposals divideinto 2 basicvariants: the "Proposed 8old.^t 69-96. 81Thedifference between the bid and the ask is referred to as the spread. t'Id. at 31. 83For the uninitiated,a cirouit breaker(fusesin days-gone-by)is an electricaldevice which opens an electrical circuit when the electricity flowing through the circuit is too great or at too great a rate. By popping open, the breaker preventsdamageto appliances on the circuit or, indeed, an electrical fire. The homeowner must then manually reset the circuit breaker (or replacethe blown fuse) so that the circuit is again complete,allowing electricityto flow to appliances,light fixtures, etc. 26 declineof circuit BreakerHaltRule,"s4andthe"Proposed circuit BreakerPriceTestRule'"85A 10%in theday'spriceofa particularsecuriqrwould"pop" the circuitbreaker asto the security'E6 short The effect of apop would differ betweenthe2 proposedrules. with thehalt rule, no more oron sellingcouldoccurthatday. Withthepricerestrictionrule,only shortselling on anuptick' trading a modified uptick (nationalbest bid priceor better),couldbedonefor the remainderof the day. TheSECrepeatedlystatesits policy goal: to attemptto pfevent"potentially abusiveor used manipulativeshortselling,from beingusedas atool to drivedowna marketand from being and to accelerateadeclining market...[b]y seekingto advancethesegoals,the proposed [rules theirvariantslmighthelp restore investorconfidence."8? when it fashionedproposedcircuit breakerrules,however,the SECstaff seemsto haveforgotten what the policy goalofthe exercise is. Simplyput,thecircuitbreakerproposalsconsistof closingthe bamdoorafter the horseis gone. By thetime a security'sprice had declined10Yo, manyindividual investorswould be consideringselling, or at leastbetakingnote of thevolatility in theparticular stock. Shortselling couldresumethenextmoming.If shortselling resumed and 107odeclines occurredon successive,or nearlysuccessive days, evenmoredamageto investors'psyches'would occur. Evendeclinesof 5-6-70%on successivedays,whichwouldnot triggereither circuitbreaker 84SECReform Proposalat 89-99. ttld. at99-104. 86TheCommissionbelievesthat a 10%decline "would be anappropriatelevel at which to triggera circuit breaker,"SECReformProposalat 90' stSECReformProposalat65. Seealsoid at30,'72. 27 proposed,canhavean adverseeffect onirvestorattitudes. If thosedeclinesoccur over spectrums of the market,even thoughoverall the marketis up,the type damagewe wish to lessenwill take place. But we may not be ableto do anlthing aboutthe latter. Regulationcannot, andshouldnot, stuntmarket forces. It can only smooththeir effect. Circuit breakerrules conjureup visions of jarringjolts in pricemovements. The aim is totakeout, or reduce,the jolt in thepricebefore,and not after,it occurs.Circuit breakerswould only do the latter. D. Uptickor ModifiedUptick? The SECrelease, itsdedicationofvariouspagearnountsto variousproposals, andits juxtapositionofthe variousproposedrulesseem strongly to indicatetheSEC'spredispositionto a modifieduptickru1e.88 This seemingthumb on the scale,however, makessense. A rule baseduponthe lastsale, asan uptick rulewouldbe, and as SEC Rule 10a-1was beforerepeal,isoutmoded.Since1975, we havebeen moving toward a NationalMarket System (NMS).tt NMSdoesnot contemplateonemarket, or theconsolidationof variousdisparate markets.Instead,the National Market Systemcontemplates promoting and makingmore visible 88Forexample,the SECputsthe uptick rule proposalafter the modified uptick rule discussion,when, in the ordinary courseof things,the old ru1e,with which readerswould most be familiar, would come first. SeeSEC Reform Proposal.at 69-96 (old rule) & at29-69 (modifieduptick rule discussionfirst). The SEC devotesfar more pages,40,to the modified rule, as comparedto the updatedversion ofthe old rule, 16, althoughmuch ofthe 40 page discussionis of exemptionswhich would apply to both rules. The Commissionthen sticksthe proposedcircuit breakerrules way in the back. SeeSEC Reform Proposalat 89-99(Circuit BreakerHalt Rule) & 99-104 (Circuit BreakerModifred Uptick Rule). 8eSeegenerallyDouglasM. Branson,sapra note 33, at 871-876. SecuritiesExchange Act $11A.,15 U.S.C. $78k(A), addedby the SecuritiesAct Amendmentsof 1975,describes the ingredients of the National Markel System. Seealso Jonathan Macey & David Haddock, Shirkingat theSEC: TheFailure of theNational Market System,1985U. ilI. L. Rev. 315, 321 330. 28 the pricesand other terms of trade various markets(say,NYSE, Nasdaq,Midwest Stock Exchange,Pacific Stock Exchange, Instinet, etc,) offer as to a particular stock. The first stepin that processis consolidationof hading information. All marketparticipants,no matter wherethey trade, must report their tradesto the securities information processorfor the particular security.e0 Seemingly,suchconsolidatedreportingaids implementationof a short selling uptick rule basedupon the last salebut it doesnot. Tradesget repofied out of sequence'Information processorspublish tradesin "reportingsequence,not trade sequence."erMarket participants reporttheir trades,as the law requires,but delaysmay occur. Trading takesplace at different prices in "multiple, dispersed,and diversemmkets."e2 More often than not, the purportedlast sale price is not lhe true last saleprice. The National Associationof SecuritiesDealers (NASD) implementeda modified uptick rule in 1994,applicable to a portion ofthe Nasdaqlist, which was in effectfor over 10years.e3 The restrictionon short selling was"modified," becausethe NASD basedtheprohibition of the nationalbestbid ratherthan the last saleprice. The NASD experience,as well as its own observations,inform the SEC'spreferencefor a bestbid basedshort selling restriction. "The nationalbest bid would have advantagesovera test basedupon the last sale [andwould be] a more accuratereflection of current prices for a security than the last sale prices due to delays that canoccur in the reporting of last saleinformation."ea e0SeeBranson,suprarrote33, at 873& n.99; e'SECReformProposalat 42. e2 Id. at38. 9TNASD Rule3350, discussed SEC ReformProposalat7. e4SEC ReformProposalat 6. ?o Securitiesinformationprocessorsalreadycollect,calculateand disseminatethe national andenforce bidprice. under theSEC'sproposedrule, "a tradingcentershallestablish, maintain sale policiesandproceduresreasonabledesignedtopreventthe execution or displayof a short bid" price orderin a coveredsecurityata downbid price." Therule would furtherdefine "down asa "pricethat is lessthanthecurrentnationalbestbid price'"ej Participants? E. PoliciesandProcedures for TrLdingcentersor Flat ProhibitionsonMarket ln framingits proposals,andruleswhich would implementthem,theSECseemsto favor than short anapproachwhichwouldput the onusof complianceonindustryprofessionalsrather sellersthemselves.TheSECprefersabranchof the "modifreduptick rulewhichwouldrequire tradingcentersto havepoliciesandproceduresreasonably designed to preventtheexecutionor displayof shortsales at impermissibleprices."e6Tradingcenterscouldrejectanimpermissibly pricedshort sale or requirethatit bere-priced andre-submitted.eTTrading centers'procedures wouldhaveto requirethat thetradingcentermonitor,ona real time basis,thenationalbid price andto conductcontinuous surveillance of shortselling'e8 The,.old"upticktestput the onusof complianceonthe trader(short seller)herself- The purposeof therule is to retardor stopaltogether the activitiesofabusiveandmanipulativeshorts sellers,whouseshortsellingasa tool to acceleratea decliningmarket. Ifthat is so,keep theonus e5SECRule 201(b)(1)(proposed),discussedSECRefotm Proposalat 29' e6SEC Reform Proposalat 28. elId. at36. eEId. ^t3'7. 30 of complianceon the would-beprime movers,the short sellersthemselves, rather on trading centerswho may or may not be innocentbystanders, depending upon the case. Thosewho render substantial assistanceto another who violates the law (the primary violator), and who do so possessedof the requisitestate of mind (knowingly, or at least consciouslyunmindful ofthe effect their conductmay have on others),are aidersand abettors. In Central Bank of Denver v. First Interstate Bank,eethe Supreme Court struck down aiding and abettingcauses of action under the federal securitieslaws.ro0 Two yearslater, however,the Private SecuritiesLitigation Refom Act (PSLRA) addedsection 20(f) to the SecuritiesExchange Act, permitting the SEC enforcement actions against collateral participants who aid and abet an 101 illegal securitiestransaction, at least if they did so knowingly. By its regulation,the SEC couldput the onusof compliancewith themodified short salerule on short sellersthemselves, whereit belongs,leaving the prolonged failure to adoptpolicies andprocedures,or to enforce those they have adopted, to aiding and abetting enforcement actions against the trading centers who have assistedshort sellersin violating the short saleprice restrictions. II. REGULATORYREFORM: DEFININGSECURITYTO INCLUDE STOCK BORROWINGPROGRAMS, OR DISCPLININGINTERMEDIARIES WHO FACILITATE STOCKBORROWING WHEN THEY FAIL TO MAKE REQUIRED DISCLOSURES A. StockBorrowins. .511U.S.164i1994\. lmTheCourtreiterateditspositionin StoneridgeInvestmentPartnersLLC v. Scientific Atlanta,Inc.,128 S. Ct. 761 (2008). 'o'15u.s.c.g78u(t)(1996). JI The most dillicult thing to find, accordingto experiencedregistered representatives, is stock for a short sellercustomer to borrow.l0' Or, at leastthat is true for thestockof mid capand small cap companies. Somesuchissuesare not eligible collateralfor margin,borrowing'r0' Traditionally, too, holders of such sharestend not to keep them in margin accounts. Ifthe shares were in margin accounts,asmanyofthe sharesofhousehold namestocks are, brokers(registered representatives)could engineerthe loan of them to short sellers. The margin accountholder would neverknow that her sharestemporarily had beenin anotherset ofhands.l0a In 2004,as aforesaid,r0rthe SECadoptedRegulationSHO, which cracksdown on naked short selling, making it all the more imperative for shorts to borrow, or at least locate, stock. In July, 2008, and againin September,2008, in large part,the SEC suspendedthe locatealtemative under RegulationSHO . 106 All of theserecent developments put greatly addedpressureon short sellersactually to bonow stock and to do sopromptly,that is, beforethey se1lshort. There have alwaysbeeninstitutional investorswho hold long positionsin certain stocks, who will make certain ofthose sharesavailable to brokers,who in nrm will engineerloansto to'See,e.g.,Key PointsAbout Regulation SHO, supra note 42, at 2 ('[M]arket-makers who sell shortthinly traded,illiquid stock in responseto customerdemand may encounter difficulty in obtainingsecurities when the time for deliveryarrives"); Christian,supranote2, at 1059("Oftensharesof smallcompanies . . . arehardto find becausefor.rnders andother initial investorshold mostof the sharesin restrictedform," or at leastin cashrather thanmargin accountssothatbroker-dealers cannot bonow the shareswithout the owner's express consent). rorSomesecuritiesof smallercompanies maynot bein marginaccounts becausethey are not eligiblecollateral for marginborrowing. t* Seesupranote2 & accompanyingtext. tosseesupranotes41-48 & accompanyingtext. 1o6See supranotes49-5 & accompanyingtext. )L I shortsellers.r07Theinstitution receives a negotiatedfee,often consisting ofan abovemarket rate of interestand the right to call thestockback on specifiednotice, or at the end ofeach month. Brokering suchtransactions, marketprofessionalsoperatefirms that facilitate the lending and borrowingof stock."Locatestock.com"isaweb siteone suchprofessionaloperates'r08Backon theborrowingside,market participants other than shortsellers also haveneeds to bonow stock. For example,an over-the-countertrader mayfind its inventoryinsufficient to fill an order it has taken. The tradermay borrow shareswith which to fill the orderuntil suchtime asthe tradercan buyin additionalinventory elsewhere.loe B. Borrowing Stockfrom Individual lwestors and RisksPandemicto Such Ventures. The truth, though,is that stockbonowing efforts aim themselvesmostly at individual investors.All of thelargefinancial frms haveformal stockborrowing departrnents whose principalrole is to locateand facilitate the lendingof shares.They promise abovemarketrates of interestto individualinvestors who will maketheirstockavailable. Whatis not disclosedto the lenderis thatall, or mostall, ofthoseshares are lentto hedge fundsandother aggressiveshort sellerswhose interestsareantitheticalto the lender. The lender wishesto seethe sharesincreasein value,or at leasttrade sideways.Thestockbonowingshort to'See,e.g.,Scannell& Lawicella,supranote 10,at C-3 ("Manyfund companies,such as Vanguard,lendout someof the stocksand bonds in theirportfolios in exchangefor a fee."). r0sRandallSmith,JennyStrasburg& KaraScannell, Sft ort-Selling Rules LoomforFirms, WALLST.J.,July 17,2008,ar C-I, C-2("bigfundsgetpreferential access to borrowscarce shares";LocateStock.com"helps hedge funds andsmall brokerages locate hard-to-borrow shares"). 'onSee,e.g.,NATToNALSEctrRrrrEs CLEARTNG CoRp., RULESAND PROCEDURES 13(2008). JJ a sellelnotonlywantstoseethestockdecreaseinpricebutmayalsobeaparticipantinaconcerted elforttoput downwardpressure onprice' Stockborrowingremainsunregulated.Individualinvestorsaskedtoparticipateinstock notreceiverisk factortlpe borrowingprogramsreceivelittle or no disclosure.Theycertainlydo disclosure,oftenseeninprospectusesandprivateplacementmemoranda.Riskfactordisclosure wouldbringhomgtostocklendersthedistinctpossibilityofdevelopmentsadversetotheir canreduce the value interests,namely,that short sellingandbearraidswhichthey arefacilitating to hold, aswell as of their sharessignificantlyin a matterof days. Thesharesthat theycontinue intermediary'may the sharesthe shortsellereventuallyretumsto them,via the stockborrowing pigeons be wortha fractionof their originalvalue.Manyof them(individualinvestors)are waitingtobeplucked. go If stocklenders (investors)sufferdamagesandcomplain,theircomplaints to unknown' arbitration,in whichopinions are seldompublishedandtheoutcomesof mostcases or NYSE panels Since1987,all customer-brokerdisputes have goneto arbifiation,firstbyNASD (FINRA) panelsof of arbitrators,andthen by FinancialInstitutionsRegulatoryAuthority we do not arbitrators,after theNASD andNYSEdisputeresolutionmechanismsmerged.noSo with claimsthat know if, asprivate attomeysgeneral, stock lendersin any numberhave succeeded ttolnShearson/ArnericanExpress, Inc. v. McMahon,482U.S. 220(19&'1),andagainm 477(1989)'the Supreme RorlriquezdeQuijasv. Shearson/AmericanExpress. Inc.,490IJ.S. of Courtfuldthatan arbitrationclause in a customeragreement constitutedmerelya choice ovemrled forumratherthananillicit waiverofthe securitieslaws'protections'TheCourtthus Wilkov'Swan,435IJ.S.427(1953),whichheldthatanagreementtoarbitrateviolatedthe all securitieslaws'anti-waiverprovisionsandwasthereforevoid. sincethattime,virtually go customerdisputes,employmentdisputes,and othersecuritiescasesaswell, to arbitration panelsratherthan courts. 34 stockborrowingprogramparticipationsare securitiesand, Iirrthermore,securitiesas to which disclosureaccompanyingtheir offer is insufficient or misleading. C. ProposedRegulation. Thepoint of this subsectionis that anotherregulationsomewhat peripheral to short selling maybeneeded.That regulationis SEC regulationof stock bonowing programs. The commission should adopt regulations making clear that the offer of participation in such a programis a security,which shouldbe registeredor have an exemptionfrom regulation. As the offer ofa security,the offer ofany suchparticipation should be accompaniedby a formal disclosure documentwhich brings home to investors the risks they ale undertaking by lending their stock, andthe precise nature oftheir withdrawal rights, or the lack thereof. D. Disciplining Brokers and Other Market Participants. On the regulatoryftont, an altemativewould be for the SEC to add to its list ofprohibited broker-dealerpractices(the SEC Rule 15c series)the offer ofparticipation in a stock lending programwithout certainspecified disclosure to theputativelender.rtr The SEC has long required broker-dealersto have in their possessioncertainbasicinformation about lesswell-known corporationsand their securitiesbefore thosebroker-dealers can facilitate trading in those securities.The regulationrequires that "the broker or dealer. . . make reasonablyavailable," the specifiedinformation"upon the requestofany personexpressinganinterestin a proposed 'rrSecurities ExchangeAct of 193a$ 1s(cXlXA),78U.S.C. $ p(cXl)(a),provides that 'No brokerdealershallmake use of themails or anymeans or instrumentalityof interstate commerceto effect any transactionin, or to induceor attemptto inducethe purchase,or saleof, any security. . . by meansof any manipulative,deceptive,or other fraudulentdeviceor contrivance."Pusuantto authoritygranted in the section,the SEChas adopted a numberof rulesto "define,andprescribe,meansreasonablydesignedto prevent,suchacts and practices as arefraudulent,deceptive,or manipulative."1d $ l5(cX2XD). 35 transactionin the securitywith suchbroker or dealer."l12Requiring that brokers possessce(ain information,whichmust be disclosedto investorswith or beforethe offer of participationin a stockborrowing program,bearsa strongresemblance to whatis knownas 15c-2-ll disclosure. IV. APPLICATIONOF EXISTINGLAW: STOCKBORROWING PROGRAMS AS INVESTMENTCONTRACTS A. InvestrnentContract. SECv. W.J.Howey Co.1t3 involvedNorthem tourists who bargedover a seriesof lakesand riversfrom Jacksonville,Florida, to Howey'sinland resort, Howey in theHills' Whenthey came down from their hotel rooms,the tourists sawadvertisements offering rows of orangegroves. With thepurchaseof a fee simpleon whichwas located a rowof trees,the purchasercouldalso buy a servicecontract: Howey-in-the Hill's employeeswould pruneandspray the trees, pick the fruit, packit, andmarket it. Under the arangement,puchasers hadno rights to specificfruit (that is, from their trees),limited rights of entry,and arightonlyto receivealimitedquantityof fruit at holidaytime. TheSECchallengedHoweyCo. in court,in oneofthe first casesunder the still relatively newSecuritiesAct of 1933.Howeydefended, inter alia, on groundsthathe wasoffering a saleof realestate, not a security,and a servicecontract, also not a security.The SECresponded,and the SupremeCourtagreed, with thenotion that Howey Co. offeredthe two itemsas a package, Securitieslawjudgesitems as they are offered, not ashow they may eventually be sold.lla rr2SEC Regulation15c2-11(a)(5),17C.F.R. $ 15c2-12(a)(5). "'328U.S.293(1946\. rra"The SecuritiesAct prohibitsthe offer aswell asthe saleofunregistered, non-exempt securities.Henceit is enoughthe respondents merely offertheessentialelements of an 36 I I Soconstituted, the packagefell within the catchallcontained in the statute'sdefinition ofa security.While enumeratingspecifically 24 or soother items ("any note,stock,treasury stock, securityfuture, bond, debenture, evidenceofindebtedness. . . " andsoon),thestatutory definitionincludes "investment conttact."l15Bonowing fromstateblue sky law jurisprudence,in Howey,Mr.JusticeMurphy defined investment contractas"a contract,transactionor scheme wherebyapersoninvestshis moneyin a commonenterpriseand is ledto expectprofitssolely from theefforts ofthe promoteror a third party."rr6Thetest, which has remainedthe lodestar for 65yearsandcounting, has 4 elements:(1) aninvestment ofmoney; (2)in a commonenterprise: (3)with theexpectation ofprofits; (4)solelyfiom the effortsof others. B. Investmentof Money. In a stockborrowing program, the offeree investor fumishes money's worth rather than moneyitself, namely, shares of commonstockin a publiclyheldcorporation. Cases have long heldthat contribution of itemsreadily convertible into moneyis equivalentto thecontribution of moneyitself.rrT investmentcontract."SEC v. W.J.Howey Co., 328 U.S. at 300-01(footnote omitted).In the caseatbar(Howey),85Voof thelandpurchasersoptedfor thepackage (realestateplusa services contractOratherthan the real estatealone. Id. at 295. rbsecurities Act of 1933$ 2(a)(1),77U.S.C. $ 77(b)(a)(1). "u328u.s. ar298-99. 1t7See, e.g.,Inre TradeParbrers, Inc. InvestorsLitigation,2008 WL 3992168,at 5 (W.D. Mich.)("Thetestto establishthe existenceofan investmentcontractrequires (1)aninvestment in moneyor money'sworth," quoting Howellv. Ballard,801 P.2d 127 , 128(Okla.App. 1990) (viaticalsettlements);Battig v. Simon,237F. Supp.2dlI39,1148 (D.Or.2001)("Oregon appliesthe [investmentcontract]definition o$lined, in Securitiesand ExchangeCommission v. Howey.... Therelevant factors are: (1)aninvestment of money(or money'sworth)"). 37 C. CommonEnterprise. 1. Commonality. This is the shorthand term used for this lynchpin element of the definition.rlt The saleof recreationalreal estate(say, a ski resort condominium)illustrates how, in many ventures,each investor's fortunesare tied both to the overall successofthe venture, including that ofthe promoter(verticalcommonality),and to fellow investors' fortunesas well (horizontal commonality). In typical recreationalreal estatesales, an exclusiverental agent requirementties the investor's fate to that of the promoter,or its affiliate, whose future may rise or fall dependingupon the level ofrentals. A rental pool feature,in which all investors'units' rents go into a single ILnd, ties every investor's fate to the fatesofother investors,supplying horizontal commonalityas well. In that manner,an item ordinarily real estate(a ski condominium)by virtual of collateralarrangements (exclusiveagentrequirement, rental pool) becomesan investmentcontract and thereforea security.lle 2. HorizontalCommonality. The most restrictive of courtshold that horizontal commonalitymust be presentand it, and only it, satisfiesthe common enterpriseelement of investmentcontract.r20 The presenceof multiple investorsmay not in itself suffice. \n Minarik v. ttsSee,e-g.,Susan S. McDonald, Toward ConsistentInvestor Protection Under the Securities Ldws: The Solution to the Conflict Among the Circuits Regarding the So-called "Commonality" RequirementJbr an "InvestmentContract,32 SEcuRtrIEsREc. L. REV.68 (2004);RodneyL . Moore, Defining an "InvestmentContract " : The CommonalityRequirement of the Howey fesr,43 WAsH.&LEEL.REv. 1057(1986).Seealso Mark K. Monaghan,An UncommonStateof Coffision: The CommonEnterprise Element of InvestmentContract Analysis,63FoRDHAML. REV.2135(1995). 1t'SeeSECReleaseNo. 33-5347(Jer:... 4,1973) (SECcondominiumrelease, outlining collateralarrangements which may convertrecreational real estateinterests into investment contmcts). r20Ofcourts coming down firmly on the issues,the Sixth and the Seventh Circuits require horizontal commonality exclusively. See,e.g., SEC v. SG Ltd., 265 F.3d 42, 50 (lst Cir. 2001) 38 M-SCommodities,Inc.,t2rthe SeventhCircuit affirmeda findingof no horizontalcommonality becauseprofitabilityofthe plaintiff s accountwas not influencedby theprofitabilityorlossof othersimilar accountsthe samebroker managed. Theparadigrnfor horizontalcommonality is onein which investors' contributions,aswell asretumsor lossesarepooled,asin the ski condominiumhlpothetical above.r22 3. VerticalCommonalitv. At otherend of the spectrum,vertical commonalityistheleast demandinginterpretationof Howey'scommon enterpriserequirement.Verticalcommonality requiresaninvestor to allegeand prove thatherretums are dependent upon the promoter's expertiseor efforts,or both. For example,in .SECv.Payphones,Iec.,r23purchasers were dependentuponthe promoters' abilif andefforts in choosingthemodelandlocation for pay telephones.Furtherreturns may alsobe dependentupon tlle promoterattractingar ever expandingcircleof investors.All the investormust do is fumishthe money and sign acontract. 4. SnictVertical Commonality. Strict vertical commonality requiresmore, namely that, theinvestor'sfortunesbe"interwovenwith anddependent upon the effortsand success ofthose (surveyingcircuitcourts of appeal). t2t457F.2d274(7thCir. 1972)(Stevens, J.)(discretionarytradingaccountsin commoditiesfutures found not to be investrnentcontractsbecause no horizontalcommonality). "tSee,e.g.,SEC v. Infinity GroupCo., 212F.3d 180,187-88 (3d Cir. 2000)(investors promiseddifferentretums, ranging ftom l38o/oto 181%,in "AssetEnhancementProgram"but promoterpooledinvestors'contributions, "to createhighly-leveraged investment powerthat wouldyieldhigh ratesof retum,"resulting in a findingof horizontalcommonality). Other cases requiringa showingof horizontalcommonality include SECv. Life Partners,Inc., 87 F.3d 536, 543(D.C.Cir. 1996);Wals v. FoxHills Dev.Corp.,24 F.3d 1016, 1018 (7thCir.1994);Revakv. SECRealtyCorp., 18 F.3d 81, 87 (2d Cir. 1994);and Curran v. Merrill Lynch,Pierce, Fenner & Smith,[nc.,622F.2d216,22&224 (6thCir. 1980),af'd,456 U.S.353(1982). '"408F.3d727,732 (1lth cir.2005). 39 I seekingtheinvestment or of thirdparties."l2aSEC v. KoscotInterplanatory,lzc.,r25 began with the saleofvarious levels of participation,with everygreater amountsof overridecommissions, in thepyramidsales of self-improvementcombinedwith cosmeticssales programs.The investor producedthenew prospectswhile thepromoter's salesstaffclosed the deals. Horizontal commonalitywaslackingbut thatwas not determinative."[T]hat an investor'sretumis independentof thatof otherinvestors is not decisive.[T]he requisitecommonalif is evidenced bythe factthat the fortunesofall investorsareinextricably tied to the effrcacyofthe Koscot meetingsandguidelineson recruitingprospects and consrunmating a sale.''r26 5. OffersRatherThan Sales. Participationin stockborrowing programs maymeasure up asinvestment contracts,and thereforesecwities,injurisdictionsin whichcourts require vertical commonalitybut perhapsappearto fall shortin jurisdictionsin which judgeshaveheld that only horizontalcommonality will suffice. An investorwho contributesher sharesto anintermediary, to be lent out to a shortseller, may not haveher shares,and thus her fortunes,tied to the fortunes of other contributorsto the program. Horizontal commonalityis lacking. Whetheran investment contractispresentornot maydepend on tracing,which may be difficult to do,tztand be determinableonlv a case-bv-casebasis. ttoSECv. SGLtd., 265F.3d42,49 (lst Cir.2001) (virtual stockexchange membership program,on whichinvestors bought and sold shares of i 1 virnralcompanies, nevertheless found alsoto evincehorizontalcommonality). '2'497F.2d 473,479 (5th cir. 1974). 12649'iF.zd 479. 127See PeterOh, Tracing,80TuL. L. REv.849 (2006). 40 r : A first principleof securitiesregulations, however,is thatjudges,practitioners,and regulators will judge items on the basis of how they are offered rather than how they eventually may be sold. At his resorthotel, William Howey and his companyoffered orangetrees and service contracts as a package, even though, at the end of the day, a persistentpurchasercould buy thereal estateonly.128 In the very first case under the Securities Act, SEC v. C. M. Joiner Leasing Corp.,t2ethe promoters attempted to escapethe statutory definition, which lists only "fractional undivided interestsin oil, gasor mineral rights" amongthe items enumerated,by selling dividedinterestsin oil and gasleases(for example,the Southeasteighth of the Southwestquarter section)' The courts,though,judgedtheitems as to how they were offered,interests in land expertly selected undertheguidanceof a promoterin the vicinity of where thepromoterwould drill a test well, ratherthan how it eventuallymay havebeen sold (asan interestin real estate). The leaseholds, divided interestsin oil andgasleases,while falling out ofthe list of more specific items in the statute,came back within the definition of a security, by means of the investment contract catchall andjudgments made as to how the items were offered rather than how they might have been sold.l3o lttSee,e.g.,supra note 114' r']"320 u.s.344(1943). r3oMr.JusticeJackson noted that: Had the offer mailedby defendantsomitted the economicinducements of the proposedandpromisedexplorationwell it would have beenquite a different proposition[e.g , only the offer of interestsin real properfy]. Purchaserswould have beenleft to their own devicesfor realizing upon their rights. . . . The exploration enterprisewas woven into these leaseholds . . . . 320 U.S. at 348. Stocklendershereperceivetheir economicplospects (a loan of stock at favorablerates)to be enhancedby the prospectof co-mingling their stockwith the stock of 4l The offer ofparticipation in stock bonowing programsalwaysincorporatesa right of the intermediary to combine the sharesan investor contributes with the shareswhich other investors contribute. Yet the ultimate loan of the securities may end up strictly as a passthrough,with a singleinvestor'sshareslent out to a single short seller. No commingling occurs;horizontal commonality appearsto be lacking. But we judge items are to how they are offered (reserving the right to commingle),not as to how they are sold. Parlicipationsin stock borrowing programsthus satisfu even the strictest interpretation of the common enterprise requirement central to investment conkact analysis. D. Expectationof Profits. In SEC v. Edwards,t3t10,000personsinvested$300million in a payphonesale-and leasebackarrangement.Promotersoffered a saleofthe payphonefor $7,000,a 5 year leaseback, andpalrnentto the investor of a fixed l4%oannual retum. The promoterdefendedan SEC complaint on the groundsthat the drangements were not investment confiacts, and tlerefore not securities.The arrangementswere not investmentcontracts because the expectationswere not of profits from the efforts of a promoter or third party. Rather, as a matter of contract, the retum was due becauseofthe contractualprovisionandwas due in any case. Thepromoter of a stock bonowing schemewould make a similar argument. The above- market rate of interest the intermediary (a broker-dealer frm) paysto the stock lender (an investor) may be due in any event, as a matter ofthe contract, rather than ofthe successor failue of the ultimate borrower of tle shares. othersifnecessary to make a loan. rrr54ou.s.389(2005). A' a Ms. JusticeO'Connor had no dif{icultyrejecting such an argument. In investmentcontract analysiscasessuch as Howey, [W]ewerespeaking of theprofitsthatinvestorsseekon their investment,not the profits of tlle schemein whichthey invest. We usedprofits in the senseof income orretum.... Thereis no reasonto distinguishbetween promisesoffixed retumsand promisesofvariableretums. . . . In bothcases, the investingpublic sattractedby representationsof investment income ' . . .li2 "[A] promiseof a fixed retum,"asherein the caseof stockborrowing progams, "doesnot precludea schemefrom beingan investrnent contract,"she concluded.rrs E. SolelyFrom the Efforts of Others. Herethe investormakes hercontribution(theloanof stock)and does nothing further. The return,if any,comes necessarily from the effortsofothers, namely, successful effort ofthe broker- dealerfirm or other intermediary,to lend the shares,either aloneor in combinationwith other lenders'shares,to a shortseller, andto receivetherefor interest payments, aportionof whichit passesthroughto the stocklender. Evenifthe stockbonowing program'sprovisionsrequiredstock lenders to performsome acts,which they usually do not, the critical inquiry is "whetherthe efforts madeby thoseother that theinvestorare the undeniablysignificant ones,those managerial efforts which affect the failure t32ld.at394. JusticeO'Connor observedthat"[n]o distinctionbetweenfixed andvariable retumswas drawn in the blue skylaw casesthat the Howey courrused," citing PeopIe v. W4tite, 124CaL App. 548,550-51, 12 P.2d 1078, 1079 (1932), utd Stevensv. LibertyPacking Corp., 1I 1N.J. Eq. 61,62-63, I 61A. 193,193-94(1932).540U.S. at 395. '33540u.s. 396. 43 or successof the enterprise."l3aIn thepyramid saleof self-improvementprograms ("DareTo Be Great"),upper level membersreceived commissions and override commissionson lower level members successin attracting prospectsto meetings. But the court found that the efforts ofthe Dare To Be Great staff in making presentationsand procuring investors' signatureson purchase contractshad been"the undeniablysignificantones."r35 F . Stock Borrowing Programs as In|estment Contracts and Therefore Securities. Under the foregoing analysis, with or without SEC regulation, stock borrowing plograms aresecurities,the offer of which must be accompaniedby full and fair discloswe' At least one case has so held. In Hughes v. Dempsey-Tegeler & Co.,t36a brokerage firm requestedthe loan by an investor of his portfolio of municpal bonds,along with an agreementto subordinatehis interest in the bonds to that of the firm. In that way, "the firm could utilize them [thebonds] as additional capital in meetingthe Exchange'snet capital requirements"applicable to '\,vhich brokeragefirms. In retum, the firm promised the lender an above market rate of interest would realizean additional incometo Hughesfrom the secwities in the amount of $30,000.00." The district court found the arrangement(loan of securites and subordinalion agleentptoviding for payment of interest) to be an investment contract under the 'F1ov;eyanalysis 'toSECv. GlennW. TumerEnterprises,Inc.,474F.2d 476,482 (fth Cir.),cert. denied, 414U.S.821 0973). t354'74F.2dat 482. 13611973 TransferBinderlCCH Sec. L. Rep.$ 94,133(C.D.Cal.1973), alf'd,534F.2d 156(r976 44 No court,however,has so held recently and probably neverwill, assuch claims by stock lendersdisappear behind the veil of arbitration,which shieldsfrom view the outcomesof customer-broker-dealerdisputes. CONCLUSION TheseareMain Streetversus Wall Streetissues.rsT On WallStreet,brokerage firms and otherfinancialintermediaries wish to be freeofthe yokeofregulationon asmany fronts as possible.To requireof themprospectustypedisclosure regarding stockborrowing plans would be onerous,severely crimping the reachof suchprograms andthe amountof stock investors would lendand short sellerscould borrow. Regulationandprobablyrestrictionof stock bonowing would occur at a time when SECinitiatives(RegulationSHO enforcement)make the abilityto borrowstock of vastlyincreased importanceto shortsellers. Because naked short sellingwill not betolerated,as it wasin thepast,theabilityto borrowstock becomes extremely urgent. On Main Street,stock lenderstend to be much different than marketprofessionals and stockborrowers. Market professionals(tradersat Vanguard,T. RowePrice,or a hedgefund, for example)make judicious loansof stock from time to time, aftercarefulcalculations of the likely retums,weighed against the probabiliqzand magnitudeof downwardmovement in the stock's shareprice.In nonfinancial circles, however, brokeragefirmsandother intermediaries ask r37AnissueI haveraised before in conjunctionwithrevisionsof corporatelaw. '!ee DouglasM. Branson,Recent Changes to theModel Business Corporation Act: DeathKnells for Main StreetContoration Law.72 NEB.L. REV.258 (1993). 45 I I individualinvestorsto lendstock, with little or no disclosureofthe principaluseto which such sharesof stockwill beput-loans to short sellersand bearraid participants-and how antithetical to stocklenders' interests the activities of typicalborrowers are. Theoutcomesfor investors, almostall of whichare bad, should be setforth in plain,readableform("plainEnglish,"in a risk factorstatement).Cunently, individual investorsarepigeonswaitingtobepluckedby Wall Streetsharpies. Restorationof an uptick rule, or comprehensivere-examinationof it, is anotherWall StreetversusMain Streetissue. For years,fiee marketers,hedge fundmanagers,andfrequent shortsellershaveheaped scom uponthe uptickrule. Shortselling promotes informational efficiency,theycontend. Anything which standsin the way of shortselling, such as a salesprice restrictionof somekind, is outmoded,and inimicalto accomplishmentof whatthey regard as markete{ficiency. As the latePaul Harvey would say, however, that is only "halfof the story." Wall Street tradershavean entirely different mental fix thando Main Street,hinterland investors.Traders' time horizonsgenerallyare a few hours,or a few days;theh expectationsas to pricea few cents, albeitovera largeblock ofshares.To them,aquarteror three-eightspoint ($.25or $.375) surpriseoccasionedby an information asymmetry,exaggerated by a lack of an optimal amountof shortselling,eatsconsiderably into, or eliminatesaltogether, prospectsfor profitsofcents per share. TheMain Streetinvestor has a 3 year,5 year,or 10year timehorizon.Herprofit expectationsarequitedifferentas well: a 20 point,25point,or 30 point($20, $25, or $30)gain ratherthan a dollar or centsper share.A quarterpoint differential,contributedto by a lack of uninhibitedshoftselling is of no momentto her,as it mightbe to themarket professional. 46 Moreover,pricecontinuityin the markets,aidedby implementationof an uptick or similar rule, has a significant effect on keeping individual and long term investors in the markets over the mediumandlong terms. My surmiseis that, in its proposals,the SEC favors Wall Streetrather than Main Street, perhapsbecauserank-and-fileinvestorshave few if any advocates,or knowledgeableadvocates, while hedgefrrndsand financial firms flood the sEC with comments,and sophisticatedones at that,which opposespecificproposalsand any regulationat all.l3BFor example,in abolishingthe old uptick rule, in 2007 the SEC gaveas a principal reasonthe disintegratingeffect myriad exceptionswere having on the basicuptick rule.r3eNonetheless, in its newestproposals the SEC beginswith the exceptions ftom the old rule intact and goes from there. In addition to mmking tickets.,long"or "short," asRegulationSHOrequiresthem to do, registeredrepresentatives (brokers)can label a seeminglyinfinite varietyoftrades not bound by the uptick or similar rule, .,short marking tickets exempt."raOTo paraphraseShakespeare'sl1amlet, the ban's the thing. The 1t9See,e.g.,McGinty& JennyStrasberg, supranote 48, atC-3:"the initial weaknessof [RegulationSHO]andthe yearsit took the SECto stiffen it can be tracedto the lobbyingefforts of hedgefunds and Watl Street"(comment of PeterChepucavage, former SECattomey who helpeddraft SHO). t3eSee,e.g.,SEC Reform Proposalsat 72 (somanyexemptions under old SECRule 10a-1 that confusionand "anunlevelplayingfreld" resulted,necessitating abolitionofthe rule). raoFromtheget-go,the SECproposed9 exemptionsfrom theproposedmodifieduptick rule. SeeSEC Reform Proposalsat 44-62: (I) Broker-DealerExemption(whendueto, e.g ' "bid flickering"executionpricebecomesadownbid priceeventhoughpriceat time of submission wasnot); (2) Seller'sDelayin Delivery(e.g., becauseofneedto removeRule 144re-sale restrictions);(3)old Lot Transactions;(4) DomesticArbitrage;(5) IntemationalArbitrage; (6) Over-AllotmentsandLay-OffSales (a.g, by underwritingparticipants in a publicoffering);(7) RisklessPrincipalTransactions:8) Transactionson a Volume-WeightedAverage Price(VWAP) Basis.The 9'h wouldbe an exemptionfor afterhours short selling, when securities information processorswouldno longerbe calculatingand disseminating a national best bidprice. SEC ReformProposals at 67. Theold ruleflatlyprohibitedshortsalesunlessthe lastsale had been an 47 emphasisshouldbe on a salesprice restrictionon shortsales, its possibleeffectson helping restoreameasureofpricecontinuity,and its possibledeleteriouseffectsoninformational efficiency. That is whereemphasis should first be put, with exceptionsto be evolvedas time goes by andas the industrypetitions for them.larAll theexemptions seemsto indicatenot only a lingeringobeisanceto the industrybut thatthe SECdoes not reallyhave it heartin anyof this.ra2 Theconflictinggoalsa salesprice or otherrestriction of shortselling would serve, namely, pricecontinuityand overall marketeffrciency, versus informational efficiency, seem mutually exclusive.Nonetheless,a basketof the two, ratherthan one or the other,is necessary.What precisemixtureseemsutilitarian,producingthegreatestgoodfor thegreatestnumber, is a thomy questionwhichonly the SECcan attempt to answer.What is clearis how, overthe years, commentators,market professionals,and even to someextent regulatorssuchasthe SEC, have shownlittle regardfor theMain Streetview ofissuessuch as short selling, the uptick rule, and stockborrowins. uptick. Therewas no exceptionfor after hourstrading. Theproposedrule seemsa roadmapfor evasionofthepricerestrictionrule,albeit probably only a low volumeevasion. ratontop of thefirst 9 exemptions,supra rroIe 140, theSEClayers proposals for 4 more in its discussionof theproposed uptickrule, which followsdiscussionofthe proposedmodified uptickrule. See,e.g.., SEC Reform Proposals at71. Theyare: (1) Enor in MarkingShort Sale; (1l) ElectronicTrading Systems; (12) TradeThroughs; and (13)Facilitationof CustomerBuy Orders.1d. at 77-84. ra?Forinstance,earlyon in its 273pagerelease, the Commissionlamentsthat "[w]e recognizethatthe proposedshort sale price restrictionswouldresult in increasedcosts to shorl selling.... [R]equiringall shortsales to be executedabove tirebestbid ... in adecliningmarkot mayslowdownthe speedofexecutions andimposeadditionalcostson marketparticipants ...." SECReform Proposals at10. Thatis preciselypoint of thewhole exercise,to slowdownthe speedof executionand to depriveshort sellers of someof their outsizedprofits,ifnot to impose addedcostson them. TheSEC is to actin thepublicinterestand for theprotection of investors, not as an auxiliary for the industry,for hedgefunds, or for theshort selling community. 48