Short Sellers Squeezed All Around

By TOM MCGINTY and JENNY STRASBURG Securities regulators and some financial firms are making it more difficult for investors to pile on when stocks are falling and further drive down prices. The Securities and Exchange Commission, facing years of criticism, has begun to crimp the ability of traders who bet against stocks to depress prices by selling millions of shares they don't possess, known as naked short selling. And some financial firms have cut back on lending to traders who want to bet against stocks. The result: The number of stocks in which big chunks of shares haven't properly been delivered to investors has plummeted, to a daily average of 79 in the three months ending in March from 529 in the first nine months of 2008, according to an analysis of trading data from major stock exchanges. At issue are short sellers, traders who sell borrowed shares, betting they can replace them later with shares bought at a lower price. Critics say short sellers, with the aid of brokerage firms, cause these delivery failures by shorting stocks without first borrowing shares, as required by securities law. Such activity drives down stocks by adding to the selling pressure. The moves come as the SEC meets Wednesday to discuss further potential restrictions on short sellers. These include reinstating the "uptick rule," which until 2007 had required short sellers to wait for a rise, or uptick, in a stock's price before placing their bet that it would go down. Critics say such trading by short sellers roiled stocks last year by swamping the market with sales that characterized the 2008 market volatility. Amid that turmoil, the SEC closed loopholes that had allowed sold shares to go undelivered. The developments come at a critical time. Stock prices have surged roughly 20% within weeks, despite Monday's decline. Traditionally, short sellers have been an important cog in helping alert investors to warning signs at companies ranging from Enron Corp. to Lehman Brothers Holdings Inc. Some say short-sales restrictions have helped fuel the recent rally. Despite the reductions in delivery failures, critics say the SEC took too long to act forcefully and still hasn't gone far enough because failures still occur. "The majority of these failures-to-deliver are not the result of honest mistakes or bad processing," former SEC commissioner Roel Campos wrote in a letter posted on the SEC's Web site. "Rather, these companies are instead targets of illegal and manipulative trading, with intentional failures-to-deliver used by traders to extract profits as the share price plummets." An SEC spokesman said in an email: "Reducing long-standing failures to deliver has been central to commission actions in this area." The SEC first attempted to address the problem in 2005, with the implementation of Regulation SHO, which mandated "threshold securities" lists, daily compilations by exchanges of stocks that had suffered at least five consecutive days of delivery failures totaling at least 10,000 shares and at least a half a percent of their outstanding shares each day. Once a stock hit the threshold lists, traders were required to close out failed deliveries by the 13th day after the trade. But there were loopholes in the regulation, and there was no requirement to close out delivery failures of securities that weren't on the lists. The threshold lists averaged about 300 securities a day in the first two years after Regulation SHO was instituted. In 2007, the daily average climbed to 414. In the first nine months of 2008, as the markets and banks crumbled, the lists averaged 529 securities. Last summer and fall, the SEC issued emergency orders restricting the short sales of certain financial firms and tightening the requirements for deliveries. Most important, observers say, was a new rule requiring short sellers to close out any delivery failure by the open of trading on the fourth day after the trade. The number of securities on the threshold lists has since plummeted. Pension funds and other institutional investors have curtailed lending stock to short sellers, which also might have contributed to the decline in delivery failures. But stricter SEC delivery requirements may have instilled a new discipline in market participants. In the past, hedge-fund and bank executives said, brokers were quick to tell clients not to worry about finding borrowed shares to sell short, even if there was some risk that they wouldn't be able to find and deliver the stock. Most delivery failures result from honest mistakes by brokers, not intentional misconduct by short sellers, says James Chanos, the short seller who runs Kynikos Associates LP, a New York hedge fund. Mr. Chanos says the view that the SEC is cracking down on short sellers may have boosted investor confidence and helped fuel the current rally. Peter Chepucavage, a former counsel at the SEC who helped draft Regulation SHO, said the initial weakness of the rule and the years it took the SEC to stiffen it can be traced to the lobbying efforts of hedge funds and Wall Street. Brokerage firms "have made huge amounts of money" facilitating short selling, said Mr. Chepucavage, general counsel for Plexus Consulting Group, a Washington firm that advises nonprofit firms and broker-dealers. "They want and have argued strenuously for flexibility." Write to Tom McGinty at tom.mcginty@wsj.com and Jenny Strasburg at jenny.strasburg@wsj.com