• SEC, Fed and Others Take Action to Stem Market Turmoil
  • October 9, 2008 | Author: Mitchell S. Ames
  • Law Firm: Pepper Hamilton LLP - New York Office
  • The week of September 15, 2008 saw the Securities and Exchange Commission, the Federal Reserve Board, the Treasury Department and the UK Financial Services Authority all take significant action to stop the hemorrhaging in U.S. and other financial markets. Much of this action was designed to stop the short-selling pressure that arguably was a major factor in the bankruptcy of Lehman Brothers Holdings (and threatened Goldman Sachs and Morgan Stanley), the government takeover of AIG, the quick sale of Merrill Lynch to Bank of America, and a two-day drop in the Dow of 1,000 points. How did short-selling pressure cause such turmoil? Do you know the regulatory actions taken? Do you have the information you need to protect your interests in light of these developments?

    How Did It Happen?

    Although experts may agree that a “crisis in confidence,” depressed asset values due to the subprime fiasco and worldwide economic conditions throughout 2008 contributed greatly to the sudden illiquidity of our financial institutions, our government has focused on the lack of regulation over short sales as a major cause of last week’s market turmoil, and stricter regulation of these sales as a principal component of the cure. CalPERS apparently agrees with this view, as it announced on September 18, 2008 that it would temporarily pull back shares of Goldman Sachs, Morgan Stanley, State Street and Wachovia from its securities lending program to help mitigate the adverse short-selling impact on these institutions. On the same day, New York State’s pension funds announced a similar pullback from loaning shares of 19 banks and brokerages.

    The practice of “naked” short sales (selling stock without first borrowing or arranging to borrow the shares) can result in the seller’s failure to deliver the shares within the standard three-day settlement period (known as a “fail to deliver”). Although not illegal per se, it is prohibited for any person to engage in a series of transactions to create actual or apparent active trading in a security or to depress the price of a security for the purpose of inducing the purchase or sale of the security by others. Thus, short sales effected to manipulate the price of a stock are illegal. But it is not just naked short sales that the regulators targeted – it is all short sales, particularly in the securities of financial institutions.

    With other factors, such as the continuing credit crunch, significantly depressed equity trading volumes, widening fixed-income credit spreads, declining asset values, rising inflation amid slowing economic growth (due to increased production costs), and challenged consumer spending (due to declining home values, rising unemployment and higher commodity prices), how are short sales to blame for the week’s sudden collapse?

    Intense short-sale activity in a compressed time period, coupled with the already depressed asset values of subprime mortgages and derivatives, caused sharp drops in the stock prices of financial institutions. These drops reduced market capitalization and debt-to-equity ratios. In addition, thinly traded inventory such as subprime mortgages lost further value, and revenues from financial products and brokerage sales declined. The combination of these factors caused significant downward pressure on financial asset prices, and caused an urgent need to de-leverage. Financial institutions rely on short-term credit, particularly repurchase agreements, to create liquidity for their businesses. But the falling value of the assets pledged in these arrangements created an adverse impact on overnight borrowing. This in turn caused “crisis” sales of stock, and further reductions in market cap, debt-to-equity ratios and revenue. This vicious downward spiral had a material adverse impact on liquidity, resulting in ratings downgrades, speculation in credit default swaps (as ratings drop, speculators bet on default), forced sales of bonds held by institutional investors, increased borrowing costs and even the unavailability of credit on customary terms.

    Regulatory Actions Taken

    Significant regulatory action was taken to curb abusive short selling prior to the week of September 15, 2008:

    • January 3, 2005 – SEC adopts Reg SHO principally to establish uniform locate and close-out requirements to address problems associated with “fails to deliver,” but grandfathers pre-Reg SHO short sales (www.sec.gov/spotlight/keyregshoissues.htm)
    • October 15, 2007 – SEC releases final rules amending Reg SHO and removes the grandfather provision – at the time, naked short sales were permitted if the brokerage reasonably believed that the sale would be covered by settlement (www.sec.gov/rules/final/2007/34-56212.pdf)
    • March 17, 2008 – SEC proposes new short sale anti-fraud Rule 10b-21 under the 1934 Act to curb deceptive short sale practices (www.sec.gov/rules/proposed/2008/34-57511.pdf)
    • July 3, 2007 – SEC removes Rule 10a-1 under the 1934 Act (the “uptick rule”) and adds Rule 201 to Reg SHO principally to provide that no price test, including a price test by an SRO (self-regulatory organization), shall apply to short selling in any security (www.sec.gov/rules/final/2007/34-55970.pdf)
    • July 21, 2008 – SEC takes temporary emergency action announced July 15, 2008 to prohibit naked short sales of 19 financial institutions and GSEs (government-sponsored entities) to limit market volatility in Fannie MAE and Freddie MAC (www.sec.gov/rules/other/2008/34-58166.pdf)
    • July 29, 2008 – Emergency action effective July 21, 2008, expires

    Swift and strong regulatory action was taken last week and is being taken this week by various government agencies to stem market turmoil:


    • September 18, 2008 – SEC issues emergency order adopting temporary rules (effective through October 2, 2008, but subject to extension necessary in the public interest not to exceed 30 calendar days) to combat the adverse effects of naked short sales (www.sec.gov/rules/other/2008/34-58572.pdf)
      • SEC adopts Rule 204T requiring sellers and broker-dealers to deliver securities for settlement of new short- or long-equity trades by the settlement date, requiring such trades to be closed out by the next settlement day and imposing penalties on broker-dealers for failure to deliver by such date, excepting Rule 144 fails to deliver from being closed out by the settlement date until 35 consecutive settlement days since the settlement date, and in either case, prohibiting all naked short sales orders in those equities if the orders are not closed out
      • SEC amends Rule 203(b)(3) of Reg SHO to eliminate the options market-maker exception from Reg SHO’s close-out requirements for threshold securities
      • SEC adopts Rule 10b-21 to explicitly prohibit fraudulent short-selling transactions by sellers who deceptively misrepresent their intention or ability to deliver securities by the settlement date and thereafter fail to deliver such securities
    • September 19, 2008 – SEC issues additional temporary emergency orders to combat market turmoil resulting from short sales (effective through October 2, 2008, but subject to extension necessary in the public interest not to exceed 30 calendar days)
      • SEC temporarily prohibits all short selling of publicly traded securities of select “Included Financial Firms,” with narrow exceptions for short sales by certain bona fide market makers and certain short selling as a result of automatic exercise of equity options held prior to the order upon expiration of the options (www.sec.gov/rules/other/2008/34-58592.pdf)
      • SEC requires institutional investment managers exercising investment discretion over accounts holding certain Section 13(f) securities to report short sale positions by filing a report on Form SH, unless the position (i) constitutes less than 0.25 percent of the issuer’s most recently reported (to the SEC) outstanding securities, and (ii) has a fair market value of less than $1 million (www.sec.gov/rules/other/2008/34-58591.pdf)
      • SEC amends the timing and volume conditions of Rule 10b-18 under the 1934 Act to address sudden and unexplained stock price declines by providing additional flexibility for issuer repurchases to increase liquidity during times of market volatility (www.sec.gov/rules/other/2008/34-58588.pdf)
    • September 22, 2008 – SEC amendments to its September 18, 2008 and September 19, 2008 temporary emergency orders released the prior day are effective
      • SEC requires institutional money managers to report any new short selling in all equities, except options, on new Form SH and revises the form and its instructions (www.sec.gov/rules/other/2008/34-58591a.pdf)
      • SEC adopts technical amendments to its September 19, 2008 temporary emergency order, keeping in place the original exception for short selling related directly to bona fide market making in derivatives of an Included Financial Firm, but requiring that market makers may not sell short any new position if they know that a customer or counterparty is increasing an economic net short position in the shares of an Included Financial Firm (www.sec.gov/rules/other/2008/34-58611.pdf)

    Fed and Treasury Department

      • September 17, 2008 – Fed and Treasury Department initiate the Supplementary Financing Program consisting of Treasury bills to provide cash for use in Fed liquidity initiatives (www.treasury.gov/press/releases/hp1144.htm)
      • September 19, 2008 – Fed approves interim rules to provide liquidity to financial markets by extending loans to banking institutions to finance purchases of high-quality asset-backed commercial paper (ABCP) from money market mutual funds (www.federalreserve.gov/newsevents/press/monetary/20080919c.htm)
      • September 21, 2008 – Fed approves applications by Goldman Sachs and Morgan Stanley to become bank holding companies (pending a statutory five-day antitrust waiting period), thereby providing Fed credit support against all types of collateral to the U.S. and London broker-dealer subsidiaries of these companies and the London broker-dealer subsidiary of Merrill Lynch (www.federalreserve.gov/newsevents/press/bcreg/20080921a.htm)

    UK Financial Services Authority

      • September 18, 2008 – FSA adopts new provisions to the Code of Market Conduct temporarily banning all short selling of securities in financial institutions and requiring daily disclosure of net short positions in excess of 0.25 percent of ordinary share capital of financial institutions held at market close the previous day (www.fsa.gov.uk/pages/Library/Communication/PR/2008/103.shtml; www.fsa.gov.uk/pages/Library/Communication/PR/2008/102.shtml)

    As of the date of this article, the President and his advisors have proposed that Congress establish a $700 billion dollar trust to purchase, at market rates, the subprime and other faltering mortgage loans held by US financial institutions. The loans presumably would be held until saleable. Although the details are not yet available, the Associated Press announced today that Representative Barney Frank (D-MA), the House Financial Services Committee Chairman, says the Bush administration has agreed to include mortgage aid and strong congressional oversight in the bailout plan.

    What is next? Will the “uptick” rule be reinstated? Some experts argue that it is the only definite obstacle to the potential material adverse impact that rapid-fire short selling can have on a company (by virtue of requiring any short sale to occur only (i) at a price above the price at which the immediately preceding sale was effected (known as a “plus-tick”) or (ii) at the last sale price if it is higher than the last different price (known as a “zero plus-tick”)).

    Do You Have the Information You Need to Protect Your Interests?

    The directors and officers of financial institutions in sale or distressed mode will need to scrutinize their fiduciary duty obligations (and how they shift as insolvency approaches), other rules regarding self-interest, and public disclosure obligations. They also will need to understand pre-emptive and defensive action available to protect against often inevitable class actions and government investigations. Financial institutions also will want to take pre-emptive action against possible SEC fines similar to those levied last year against Goldman Sachs, Piper Jaffray and others for their alleged failure to ensure that clients could cover naked short sales.

    Prime brokers and lenders of Lehman Brothers need to understand and analyze the bankruptcy stay, their termination rights, collateral use rights, their swap, hedging, guaranty, custody and other safe-keeping arrangements (and replacements for them), and more. In addition, prime brokers and clearinghouses will want to take pre-emptive action in anticipation of lawsuits similar to those brought (yet in many cases, dismissed) against the Depository Trust and Clearing Corporation as “keeper” of the system in which naked short selling occurs.

    Broker-dealers and investment advisers can expect a wave of customer arbitrations as investors look for someone to blame for their losses. This type of turmoil also may give rise to disputes between broker-dealers and other financial services firms, such as wrap-fee sub-advisers or clearing firms. Broker-dealers also might find themselves in the cross hairs of shareholder class actions if they served as part of an offering syndicate. And, of course, there is always the very real possibility of an inquiry by the SEC or FINRA. Just because the firms did nothing wrong is no reason for them to be confident they will not get sued. When the market goes up, everyone’s a genius; when it goes down, surely it must be fraud.

    Hedge funds, broker-dealers and others will need to understand and comply with the new rules curtailing naked short sales, prohibiting short sales of financial institutions and requiring short-sale reporting. They also may expect SEC action of the type taken in the Blackstone acquisition of Alliance Data Systems in April 2008 regarding false rumors, and state attorney general action, as recently announced by New York State Attorney General Andrew Cuomo with regard to the numerous complaints of rumor-mongering by short sellers.

    Institutional investors will want to examine their investments, especially the activities of alternative investments, their role in influencing market movements (and possible culpability), fiduciary obligations to plan participants under ERISA, and their reporting obligations to the PBGC.