On February 25, 2022, the Securities and Exchange Commission proposed rules to enhance the transparency of short positions in equity securities. One proposal would require confidential, monthly reporting of short sellers’ individual positions, which would then be aggregated by security and disclosed to the public. A second proposal would establish a new buy-to-cover order-marking requirement for broker-dealers.
In its proposing release, the SEC explained that the purpose of these rules is to deter manipulative short selling campaigns:
In determining the proposed reporting requirements under Proposed Rule 13f-2 and Proposed Form SHO, the Commission is mindful of concerns that certain short selling activity can be carried out pursuant to potentially abusive or manipulative schemes. For instance, market manipulators may seek to spread false information about an issuer whose stock they sold short in order to profit from a resulting decline in the stock’s price. The Commission has previously noted various other forms of manipulation that can be advanced by short sellers to illegally manipulate stock prices, such as “bear raids.” As discussed below, greater transparency into the activities of Managers holding large short positions in a security could help regulators’ oversight of short selling and deter these and other types of manipulative short selling campaigns potentially by alerting regulators to suspicious activity.
The SEC’s commitment to deterring “short and distort” activity comes two years after I and Professor John C. Coffee, Jr. drafted and, with 10 other securities law experts, signed a rulemaking petition that asked the SEC to improve disclosure around short-selling campaigns. Our petition urged the SEC to impose a duty to update promptly a voluntary short-position disclosure that no longer reflected current holdings or trading intention, and to clarify that rapidly closing a short position after publishing (or commissioning) a report, without having specifically disclosed an intent to do so, could constitute fraudulent scalping in violation of Rule 10b-5.
The SEC’s proposals directly respond to our petition by empowering enforcement staff with the tools to identify manipulative short selling and clarifying, as we requested, that short sellers will be held accountable for deceptive trading practices of the kind identified in our petition. In the SEC’s words:
Some market participants and academics have raised concerns that short selling may in some instances offer the potential for stock price manipulation, including “short and distort” campaigns. In “short and distort” strategies, which are illegal, the goal of manipulators is to first short a stock and then engage in a campaign to spread unverified bad news about the stock with the objective of panicking other investors into selling their stock in order to drive the price down. If a “short and distort” campaign is suspected, then detecting this behavior via the activity and positions data in Proposed Form SHO would be easier than it would be using current data. . . . Consequently, if “short and distort” type behavior were to be suspected, then the Commission would be more likely to identify individuals with large short positions and could thus quickly focus any inquiries on entities in an economic position to potentially profit from manipulation. Then regulators could match buy to cover trading on individual days to statements or other actions of the investor which may indicate that the investor was engaging in such behavior.
The proposal to “match buy to cover” trading to “statements or other actions of the investor” directly addresses the concern identified in our petition, namely that short sellers may falsely state that they are short and give a misleading valuation of a public company while rapidly covering a short position at a share price above that valuation.
As the SEC explains, a central challenge with deterring this behavior is the lack of real-time data on short positions and cover transactions by individual investment managers. These proposals would enhance the data-analysis capabilities of enforcement staff by rapidly identifying instances of manipulative short selling.
The SEC identified additional forms of abusive and manipulative short selling that would be deterred by these proposed rules, including short selling that distorts managers’ choice of projects to pursue and causes contagion effects throughout the financial system. While the SEC acknowledged that data on these forms of manipulation are limited, it said:
should they be suspected, these types of manipulation could better be identified with the positions and activity data. The positions data would allow the Commission to quickly identify individuals with large short positions and then use the activity and CAT data to investigate their trading behavior to look for signs of manipulation. Improved detection capacity may also lead to decreased fraud as would be manipulators choose not to engage in manipulative behavior due to increased fear of detection.
The proposals will be unlikely to chill short selling itself, which has long been shown to improve price accuracy and liquidity in the financial markets. The SEC would only publish aggregated short-position data for each security after a delay, which would ensure that individual short sellers could still accumulate a position without tipping the market. Small short positions would remain exempt from reporting and disclosure. And the proposed rule would pose no additional burden on activist short sellers who already voluntarily announced a short position.
Finally, the SEC’s proposals would also facilitate identifying short squeezes and thereby mitigate price distortions arising from activity in that direction as well. The proposed rule explains that “because short positions often take some time to create, the Commission could have attempted to quickly identify individual short sellers with large short positions in the various meme stocks in January 2021 based on the most recent reports; then the Commission could have used the enhanced CAT data to understand how these short sellers traded during the heightened volatility.” The SEC cited to the recent report by the ad hoc academic committee on the events of GameStop (which I chaired) as an example of the challenges of data availability. These new proposals would go a long way toward ensuring that the SEC has the information and tools necessary to identify and respond to price-distorting activity both by and against short sellers.
This post comes to us from Joshua Mitts, associate professor of law and Milton Handler Fellow at Columbia Law School.