Short-Sale Restrictions (Dissent)
by Commissioner Kathleen L. Casey
U.S. Securities and Exchange Commission
February 24, 2010
“When I voted to support the Commission’s proposing release last April, I noted that I was hopeful that the comments and empirical data and analysis we solicited would help answer the threshold question of whether there was any basis to support the view that the repeal of the uptick rule was somehow responsible or contributed to the turbulent and volatile market conditions we experienced most acutely in 2008.
Indeed, getting a firm answer to that question seemed essential, since it was the concern that repeal of the uptick rule had undermined investor confidence that was driving the Commission to revisit the issue.
The release before the Commission today answers this threshold question…in the negative. The release states clearly that there was no evidence that the repeal of the uptick rule contributed to the steep declines in stocks and increased market volatility.
It states: “[W]e are not aware. . . of any empirical evidence that the elimination of short sale price tests contributed to the increased volatility in the U.S. markets.” Moreover, in considering whether there was credible data and analysis offered to question the efficacy of the Pilot Study which supported the repeal of the uptick rule, the release concludes: “[N]one of the empirical studies have given us reason to question the rigor or validity of the Pilot results.” Furthermore, analysis by the Commission’s Office of Economic Analysis (now the Division of Risk, Strategy and Financial Innovation) and corroborating studies found that short volume was a small percentage of overall trading, that price pressures on financial stocks came from long selling and not short selling, and that short selling more generally tends to be contrarian in that it increases in a rising rather a declining market.
Nevertheless, the release recommends adoption of short sale restrictions in the name of achieving investor protection anyway.
In support of the new rule, the release goes on to note that, despite these findings and the targeted measures that have already been taken to combat abusive and manipulative short selling, “questions and concerns” about short selling persist and therefore “we remain concerned that excessive downward price pressure on individual securities accompanied by the fear of unconstrained short selling can undermine investor confidence in our markets generally.”
“Investor confidence” for purposes of the discussion in the release is limited to investor trust in the fairness of the financial markets. But, as we now know, downward price pressure during the 2008 financial crisis was driven largely by long selling, and the Commission has taken action to limit and punish abusive and manipulative short selling, which is already illegal. One can establish a clear nexus between Commission efforts to rein in manipulative activities and investor confidence in our markets. However, it unclear how efforts to limit legitimate short selling, which the release acknowledges plays a vital role in enhancing market efficiency and price discovery, somehow will promote investor confidence.
The release makes little effort to substantiate this potential beneficial outcome other than to offer a rationale and a statement of belief. The argument seems to be that, when the circuit breaker in a particular stock is triggered, it will allow long sellers to sell first in a declining market, which will help facilitate and maintain stability in the markets and help them run efficiently, and also shore up investor confidence by signaling to the market that a security’s continued price decline is more likely due to long selling and the fundamentals of the issuer, rather than other factors. But this is pure conjecture; there is no data or evidence offered to support the view that price declines, brought on by any type of selling, long or short, is a problem that can be cured by prohibiting short selling below the national best bid in particular stocks that have suffered intraday declines, or that investor confidence will be shored up by such a rule.
More fundamentally, the release appears to be suggest that short selling vis-a-vis long selling is less legitimate or even illegitimate and should be restricted if it results in price declines. As previously noted, this actually runs contrary to what we know to be true of the important and valuable role short selling plays in our market and distracts our efforts from properly addressing abusive and manipulative short selling which can harm our markets.
The focus of the Commission should be on rulemaking that furthers the mission of the agency: to protect investors, maintain fair, orderly and efficient markets, and promote capital formation.
In the 330 pages of the rule release, there is no evidence that this proposed rule advances any of these goals, even the inchoate promise of the “promotion of investor confidence.” Of the 90 pages of cost-benefit analysis-80 pages of which are dedicated to the costs-even the roughly ten pages dedicated to the “benefits” focus largely on how the proposals the staff recommends are less intrusive and disruptive to the markets than the alternatives. While I applaud the staff for recommending potential changes that seek to impose the least cost to market participants and does the least damage and disruption to the markets, this is not the standard by which we craft rules. Cost-benefit analysis presupposes that a proposed rulemaking has benefits; if we cannot identify with specificity truly anticipated benefits from a proposed rule, we should resist the urge to act merely to say we have acted, and then choose the most palatable of the unsavory options.
Indeed the strongest case for this rule is that it may mollify those who have been clamoring for reinstatement of the uptick rule and show that we have responded to their concerns.
This alone presumably may provide comfort and confidence to those investors and issuers who are convinced of the deleterious effects that repeal of the uptick rule had on our markets. But this is regulation by placebo; we are hopeful that the pill we’ve just had the patient take, although lacking potency, will convince him that everything is all right.
Maybe the rule will have this effect, and if so then the additional restrictions that are being placed on legitimate short selling, and the additional costs that will be imposed on our markets, will be viewed by many as worth the effort. But, we have to do better than “maybe” it seems to me. Investors expect greater confidence and certainty in the soundness of our judgments. And it couldn’t be more critical, where as here, market quality will be affected, and the compliance costs-which are often underestimated when we adopt rules-are already estimated to be in the billions.
Moreover, I have no confidence that the proposed rule will have the intended effect. For some, the uptick rule has taken on talismanic properties or urban myth status and they will be satisfied with nothing less than full reinstatement of the old rule as a cure, I, therefore, predict that today’s rule will be criticized as insufficient. What’s more, as soon as our equity markets experience real volatility again, which they will at some point, the Commission will be criticized for not having taken more aggressive action, including full reinstatement of the old Rule 10a-1, which they will argue would have prevented such volatility.
Far from ending the inquiry and allowing the Commission to move on to other critical issues for investors and our markets, I believe the clamor for full repeal will continue to be a distraction for the Commission.
The surest way we can improve investor confidence is by reinforcing our credibility as a vigorous and expert regulator, and we can do that by guaranteeing to the public that our rulemaking is in furtherance of the agency’s mission and is sound, thorough, well-reasoned and undergirded by rigorous empirical analysis.
I am deeply concerned that that, by falling short of that standard in this instance, we signal to the public that we are guided less by empirical analysis and more by public relations.
While I certainly understand the temptation to proceed for these reasons in this case, if for no other reason than to try and put the issue behind us, I believe that it will not have its intended effect in the short run and will undermine our credibility in the long run.
In my opening statement in support of the proposing release, I listed six principles that would guide my decision whether to support adoption of some sort of short sale restriction:
1. The regulatory purpose should be properly defined.
2. Empirical evidence must guide the regulatory decision.
3. Regulators must consider the potential for unintended consequences.
4. The benefits of the regulation must exceed the costs.
5. Regulators must, to the greatest extent possible, provide certainty to market participants.
6. The opportunity costs of a particular regulatory approach need to be assessed.
For the reasons I have discussed, I believe that, despite the best efforts of the staff, the rule the staff recommends the Commission adopt today fails these principles.
The regulatory purpose hasn’t been clearly defined, and to the extent that it has, the proposed solution has not been guided by empirical data or evidence, but rather runs contrary to it.
The staff clearly has spent time considering the consequences of the rule, but we do not fully appreciate its impact, particularly in the options and OTC derivatives markets. The ephemeral, and at best arguable, benefits are more than outweighed by the tangible costs the rule would impose. And, although the staff strove to provide some certainty to market participants, ultimately, because this rule lacks a firm foundation and ignores the prevailing evidence and economic data and analysis that would argue against its adoption, it actually undermines regulatory certainty. If market participants have no reason to believe that Commission action will be governed by rigorous empiricism, and instead that policy will be made on an ad hoc basis governed by unknown — indeed unknowable — standards, it is impossible, despite best efforts of the staff, to provide that regulatory certainty that is essential for efficient functioning of markets.
Lastly, I remain concerned that our focus here has real opportunity costs, both for the commission and our markets, and will distract us from higher and better uses of our resources. I believe that continued focus on deterring manipulative short selling, through regulatory improvements and enhanced surveillance and enforcement, would focus the agency more squarely on activities that I think we all agree undermine faith in our capital markets.
By addressing legal and legitimate short selling in this rule, without evidence that it poses a real problem, we risk confusing the public about what are and are not real threats to the vitality and integrity of our markets.