Commentary: Short selling and the uptick rule

Daily Record (Rochester, NY), Jun 24, 2009 by Mitchell Thomas

The market has recovered in a historic manner since the S&P 500's low point of 666 on March 9.

We are currently trading at 943, appreciating 41.5 percent in about three months.

The rebound is a welcome reprieve from the unprecedented selling since the beginning of the year. A factor contributing to the magnitude of the market sell-off was the abolishment of the uptick rule, established by the SEC in 1930 to prevent short sellers' mass wholesale bear raids on individual securities.

Short selling is defined as the selling of a security that is borrowed in the market in the hopes it will be purchased back at a lower price at a later time. The purchased security then is delivered to the one from whom it was borrowed and the position is closed.

To engage in such action, the SEC requires two conditions to be met: A short seller must have an agreement to locate the security being borrowed to provide delivery on the settlement date to the buyer, and the last trade must be higher than the previous execution -- hence the term "uptick."

Prior to Lehman Brothers' demise, 32.8 million shares were sold short and not delivered to buyers on time -- a 5,700 percent increase of undelivered shares versus the previous year's transactions. Sub-sequently, the SEC received thousands of complaints of abusive short selling in the trading of securities during that time frame.

Investigations returned no en-forcement action. The SEC's re- sponse regarding the issue only served to confirm the egregious attitude by its enforcement division. It was not an isolated incident. Bear Stearns experienced trade failures in its stock of 1.2 million shares on March 17, 2008 -- three times the peak of the previous year. Unsubstantiated rumors claim this condition contributed to the collapse of those institutions.

Naked short selling is the equivalent to issuing new shares to the marketplace. The shares are sold, but unaccountable to the legitimate outstanding shares. Such dilution in a negative market environment exasperates an already stressed scenario.

The collapse of Lehman Brothers on Sept. 15, 2008 signaled enough of an alarm at the SEC that, two days later, the practice of shorting financial securities was banned, protecting from further manipulation from short sellers.

The obvious conclusion is that the abolishment of an established, 80-year-old regulation and the elimination of the uptick rule, along with lax enforcement of naked short selling, allowed a critical situation to elevate to a crisis dilemma.

The forefathers of our industry responded to the depression and wisely implemented regulations that stood strong in a variety of environments for decades. The old adage is relative to our current events: If you have not learned from history then you are bound to repeat it, mistakes and all.

The return of the uptick rule and the severe repercussions of violating current regulations only can enhance the order flow and diminish the probability of violent security volatility.

Mitchell Thomas is an international equity analyst, portfolio manager and head trader for Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.