Thank you for that warm welcome. It is a pleasure to be speaking here this morning at the Security Traders Association 13th Annual Washington Conference. Since its inception, the Security Traders Association has been at the forefront representing the interests of security traders and advocating for more effective securities markets that serve our shared economic goals.
Before I begin my remarks, I must remind you that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
Two years ago, the SEC repealed the so-called "uptick" rule designed to restrict short selling. The Commission's decision was grounded in its best assessment of the available empirical research. Careful empirical analysis by SEC economists and outside academics had found that short sale price tests do not effectively serve their intended purposes, but do impose costs on markets.1 Before deciding to repeal the "uptick" rule, the SEC had conducted a pilot program that allowed for detailed economic study of the effects of the rule's repeal. The SEC had run a real-life experiment to ascertain the impact of the rule change. Rarely, if ever, does the agency have the benefit of such results before changing its rules.
An important question before the SEC today is whether or not the agency's decision to repeal the "uptick" rule in 2007 left a gap in our regulatory regime governing short selling that should be filled. I want to spend my time this morning speaking to this question. One point at the outset should be emphasized: Whatever the SEC ultimately decides to do concerning the "uptick" rule, our decision must be the product of our independent expert judgment.
Notwithstanding the SEC's recent 2007 decision to repeal the "uptick" rule, last month, in April, the current Commission voted to propose two categories of short sale restrictions: a short sale price test and a circuit breaker. The price test approach includes two options: a modified uptick rule (based on the national best bid) and an uptick rule (based on the last sale price). The circuit breaker could take one of three forms: a circuit breaker that triggers a short selling halt; a circuit breaker that triggers the proposed modified uptick rule; or a circuit breaker that triggers the proposed uptick rule. In all, there are five identified alternatives. I look forward to continuing to consider the comments we receive on the proposal. Just yesterday the Commission held a very informative roundtable on the topic.
Much attention has focused on concerns with short selling, but it is equally important to emphasize the benefits of short selling. Short selling makes significant contributions to the effective operation of securities markets, benefitting all market participants and the economy overall. Short selling contributes to liquidity, capital formation, and more efficiently allocated risk. Short selling can buttress buying by allowing investors going long to hedge their positions; and short selling can encourage market participation by leading to improved price discovery. Short selling helps ensure that securities prices are not systematically biased higher than the fundamentals warrant, as could be the case if prices did not reflect the less optimistic views of short sellers. Price discovery matters because investors would be less willing to invest if the contrarian views of short sellers were not fully incorporated into securities prices. Furthermore, when price discovery is compromised, we run the risk that our securities markets allocate capital inefficiently.
Nothing is perfect. For example, there is the potential for short selling to be used in abusive or manipulative ways; and selling pressure spurred by fear and uncertainty may contribute to the mispricing of securities or destabilization of markets. However worrisome these or other short-selling concerns may be in isolation, as a matter of policymaking, they must be assessed in comparison to the benefits of short selling to appreciate the tradeoffs of imposing a short sale restriction. Regulating short selling may come at the cost of losing the benefits of short selling I mentioned a moment ago. In addition, concerns about short selling need to be considered against the backdrop of the existing regulatory regime governing short selling. It is not as if short selling is unregulated. To the contrary, just last year, the SEC took a number of important steps to enhance the regulation of short selling.
First, the Commission adopted on an emergency basis and then as an interim final temporary rule an amendment to Regulation SHO imposing penalties if a short seller does not deliver the securities within three days after the sale transaction date.2 This hard close-out requirement is directed at curbing "naked" short selling.
Second, the Commission eliminated the options market maker exception from the Regulation SHO close-out requirement.3 This broad exception had worked to undercut Regulation SHO's purpose of curbing "naked" shorting.
Third, the SEC adopted Rule 10b-21, an antifraud rule clarifying that a short seller is subject to liability for fraud for deceiving certain persons as to the short seller's intent or ability to deliver securities by the settlement date.4 Rule 10b-21 gives additional bite to Regulation SHO's "locate" requirement and otherwise curtails fails to deliver.
Fourth, the Commission adopted temporary disclosure requirements for short sales by certain investment managers.5 These disclosures, which are provided to the Commission on a nonpublic basis, are intended to provide the SEC with useful information to assist in monitoring short sale positions.
In addition to all of this is Rule 10b-5 under the '34 Act. As a general antifraud provision under the federal securities laws, Rule 10b-5 broadly regulates manipulation and deception, including a short seller's spreading of false rumors in an attempt to drive down a stock. Fraudulent rumor mongering has long been prohibited.
Many have viewed "naked" short selling as a particular abuse for regulators to target, while otherwise allowing non-"naked" short selling to occur. It is important to recognize an empirical study by the SEC's Office of Economic Analysis showing that fails to deliver have decreased significantly since the Commission's 2008 regulatory improvements.6 These findings should allay concerns over "naked" short selling. Furthermore, it is worth clarifying that, whatever value one may find in an "uptick" rule, such a price test restriction is not intended to curb "naked" shorting. One should not blame the repeal of the "uptick" rule for "naked" short selling.
Given the reaches of the current regulatory regime governing short selling and the benefits that flow from short selling, the challenge is to balance the incremental costs and benefits of imposing another regulatory burden. Comments we receive on the proposal that are supported by rigorous analysis and, when available, empirical data will be especially informative.
In light of the financial market turmoil we have struggled through, including the precipitous drop in stock prices and increased volatility that have characterized our markets, it is appropriate for the SEC to consider whether to reinstitute a short sale restriction. However, it is not self-evident that the economic findings that supported the agency's decision to repeal the "uptick" rule in 2007 do not continue to hold in the current economic and financial climate. Further, I am presently unaware of any empirically-demonstrated link between recent market conditions and the repeal of the "uptick" rule, and it is important to distinguish correlation from causation. It is worth acknowledging a recent study by SEC economists indicating that selling pressure in September 2008, an especially tumultuous time for the markets, primarily came from "long sellers," as compared to short sellers.7 It also is worth observing that financial sector stocks continued to fall during the September 2008 short sale ban.
I recognize that investor confidence contributes to the effective functioning of our securities markets. The need to bolster investor confidence, which has deteriorated in the current economic climate, is one of the central rationales offered for implementing a short sale restriction, be it a price test or a circuit breaker.
But one needs to be cautious about asserting investor confidence as a basis for adopting a short sale restriction. First, investor confidence is difficult to measure. It is easy to conflate a lack of investor confidence with a pessimistic view of the markets that is based on the fundamentals. Second, investor confidence is about investor psychology; and human psychology is difficult to predict. How investors will respond to the implementation of a new short sale restriction is uncertain. It is possible that the decision to implement a short sale restriction actually could erode investor confidence over the longer term, even if investors initially welcome the new restriction.
For example, imagine that the earlier economic studies prove out and a new price test, once implemented, fails to serve its stated goals. Notwithstanding that the markets have performed well in recent weeks, another market downturn is possible. Even if the markets as a whole do not decline, an important company could experience a steep and rapid price drop. If this were to occur, the lack of the "uptick" rule could not be blamed for the decline. Without the lack of the "uptick" rule to blame, investors may become more concerned about the real economy's weakness or other strains on the financial system. Investor confidence could erode if events were to unfold this way. Not only may investors become increasingly concerned about current macroeconomic conditions, but investors may wonder why the Commission adopted a price test in the first place if it was ineffectual.
There is a second scenario whereby adopting a short sale restriction could undercut investor confidence. As I discussed, short selling is essential to the dynamics of price discovery and market efficiency. Because of short selling, investors can be confident that securities prices reflect a range of perspectives — optimistic, pessimistic, and everything in between. If contrarian views are not fully incorporated, investors are unable to rely on market prices as reflecting the overall assessment of the markets as to what a company is "worth." Consequently, an unduly burdensome short sale restriction that undercuts the accurate pricing of securities risks eroding investor confidence.
Under the best of circumstances, we should have realistic — by which I mean modest — expectations for how much investor confidence may rise if the Commission adopts a short sale restriction. There is reason to believe that the perceived investor confidence deficit is primarily attributable to the recession and other stresses burdening the economy, as opposed to the lack of an "uptick" rule. Accordingly, the upside of an investor confidence boost from reinstituting a short sale restriction presumably is limited.
A separate concern is the potential for "ratcheting." If a short sale restriction, once implemented, does not serve its intended goals, will there be a temptation to ratchet up the restriction to make it more stringent? My concern is rooted in much of what I have already expressed this morning — namely, the possibility that a short sale restriction can disrupt market efficiency and other dimensions of market quality, potentially doing more harm than good. Assume, for example, that the markets suffer a considerable decline or the stock price of a high-profile enterprise quickly falls while a short sale price test is in place. It is worth recalling that financial sector stocks dropped sharply during the short sale ban in September 2008. One could imagine a call for a more restrictive price test if the one that is implemented appears not to work. The particular trouble is that as a price test becomes more restrictive, market operations are more severely disrupted. With a relatively small increase of the required increment to execute a short sale, a short sale price test can turn into a short sale ban, in effect.8 If a short sale restriction is implemented, we need to guard against its becoming exceedingly restrictive and costly to our markets.
Given that what I have said so far generally applies to both a short sale price test and a circuit breaker approach, let me draw one distinction, although there are others. To the extent a short sale restriction is costly, a possible benefit of a circuit breaker is that the restriction does not burden short selling until there is at least some indication — in the form of a steep and quick price drop — of a potential concern. A circuit breaker can be conceived of as an attempt to avoid the over-inclusiveness of having a short sale restriction in place at all times.
One offsetting consideration is the possibility of a so-called "magnet effect," whereby a circuit breaker becomes a self-fulfilling prophecy by accelerating selling pressure when a company's stock price approaches the trigger point. Another risk is that a circuit breaker, when triggered, could have an adverse psychological impact on the markets by making the company's stock price decline that much more salient.
It is important for us to recognize that no alternative is without its risks. We at the Commission must appreciate the range of potential outcomes associated with each of the proposed alternatives, as well as the option of not implementing a short sale restriction. If the SEC does put a restriction in place, fashioning the right set of exclusions will be key to mitigating any undesirable consequences that flow from the rule.
I look forward to continuing to consider all the comments the SEC receives in the area of short selling.
Let me conclude by broadening out my discussion. In light of the recent serious strains on the financial system and overall economy, many have been calling for regulatory "gaps" to be closed. I do not think that this is the right way to frame the issue. The word "gap" has taken on a negative meaning in this context, connoting that there is an inherent flaw in the regulatory regime. Calling something a "gap" should not distract from a rigorous analysis of the pros and cons of a regulatory initiative.9 Indeed, I began my remarks today by suggesting that the repeal of the "uptick" rule left a "gap." But that did not get me very far in the analysis.
We need to recognize that many "gaps" are purposeful, reflecting an informed determination that the net consequence of adding the missing piece is adverse to the interests of investors and our economy generally. The federal securities laws are replete with well-reasoned and important exclusions that should not be unwound. It is entirely appropriate for enterprises to organize their affairs to take advantage of the exclusions provided to them.
More importantly, a dynamic economy that robustly grows over time requires a financial system that allows for private-sector innovation and entrepreneurism that is unburdened by undue government restrictions. Some regulations may make good sense precisely because flexibility is built into the regulatory regime to allow enterprises to take a different path. For example, the demands of the Investment Company Act are reasonable and appropriate, in part because not every fund is subject to them. Hedge funds, private equity funds, and venture capital funds, for instance, are permitted to structure themselves to take advantage of certain valid exclusions that were explicitly included in the Act. To deny such private pools of capital the current investment flexibility they have would be costly. Such funds are central to promoting market efficiency and capital formation and allow investors the chance to participate in a host of investment opportunities. I am concerned that features of the regulatory regime that allow for optionality, flexibility, and ultimately innovation and growth are included among the "gaps" that some advocate should be closed.
As we consider the parameters of regulatory reform, it is essential that we do not overreact to the recent hardships. Without question, some change is needed; but so is caution. Even in the aftermath of the financial crisis, it is possible that regulation can go too far, particularly if the regulatory calculus overemphasizes "tail events" or so-called "black swans" and underestimates the cost of regulating to avoid them. We have to recognize that even if there is a market breakdown, it remains possible for the government's response to do more harm than good. Just as there are market failures, there are government failures. The identification of a market failure should begin the analysis, not end it.
It has been a pleasure speaking to you this morning. Thank you.
1 See http://sec.gov/news/studies/2007/regshopilot020607.pdf.
2 See http://www.sec.gov/rules/final/2008/34-58773.pdf.
3 See http://www.sec.gov/rules/final/2008/34-58775.pdf.
4 See http://www.sec.gov/rules/final/2008/34-58774.pdf.
5 See http://www.sec.gov/rules/final/2008/34-58785.pdf.
6 See http://sec.gov/comments/s7-30-08/s73008-107.pdf.
7 See http://sec.gov/comments/s7-08-09/s70809-369.pdf.
8 See http://sec.gov/comments/s7-08-09/s70809-368.pdf.
9 See generally Remarks by Commissioner Troy A. Paredes at "The SEC Speaks in 2009" (Feb. 6, 2009), available at http://www.sec.gov/news/speech/2009/spch020609tap.htm.