The SEC Acts on Short-and-Distort Petition

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.