THE LONG AND SHORT OF IT: THE SECURITIES AND EXCHANGE COMMISSION SHOULD REINSTATE A PRICE RESTRICTION TEST TO REGULATE SHORT SELLING

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1 THE LONG AND SHORT OF IT: THE SECURITIES AND EXCHANGE COMMISSION SHOULD REINSTATE A PRICE RESTRICTION TEST TO REGULATE SHORT SELLING I. INTRODUCTION After the 1937 market break, the Securities and Exchange Commission ("SEC") adopted a rule involving short sale price restrictions to restrict short selling. 1 The rule was known as the uptick rule and it prevented a security from being sold short unless one of the following exceptions was met. 2 First, the SEC allowed a security to be sold short if the short sale was at a price higher than the immediately preceding sale price of the security. 3 Second, the SEC allowed the short sale of a security when the short sale was at the same price as the last sale price so long as the last sale price was greater than the last different price of the security. 4 After the implementation of the uptick rule, the SEC left the chief provisions of the rule fundamentally unchanged for virtually seventy years. 5 However, in mid 2007, the SEC eliminated the uptick rule altogether and prohibited any self-regulatory organization from implementing any type of short sale price test. 6 Since the elimination of the uptick rule, the financial markets experienced extreme turbulence due to turmoil in the financial sector as well as severe volatility and sharp declines in securities prices. 7 In 2008 and early 2009, significant financial institutions experienced sizeable reductions in the value of their securities. 8 Volatility and steep changes in the prices of securities scarred the status of the markets subsequent to the elimination of the uptick rule. 9 Although the SEC did not recognize any empirical data that the elimination of the uptick rule increased the volatility of the markets, many investors and 1. Amendments to Regulation SHO, 74 Fed. Reg. 18,042, 18,044 (proposed April 20, 2009) (to be codified at 17 C.F.R. pt. 242). 2. Amendments to Regulation SHO, 74 Fed. Reg. at 18,044, 18,044 n.25. The uptick rule provided that "a listed security could be sold short (i) at a price above the price at which the immediately preceding sale was effected (plus tick), or (ii) at the last sale price if it was higher than the last different price (zero plus tick)." Id. at 18,044 n Id. at 18,044 n Id. 5. Id. at 18, Id. at 18, Id. at 18, Id. 9. See infra notes and accompanying text.

2 CREIGHTON LAW REVIEW [Vol. 43 other members of the public associated the recent volatility of the markets along with sharp declines in security prices and the loss of investor confidence with the removal of the uptick rule. 10 This Note analyzes the effects of the SEC's elimination of all short sale price test restrictions, particularly the uptick rule." First, this Note discusses the definition of a short sale. 12 Next, this Note examines the SEC's history of regulating short sales. 13 This Note will also discuss recent market volatility along with international views on short selling. 14 Primarily, this Note advances the argument that the SEC should reinstate a price test restriction through a modified uptick rule along with a circuit breaker halt rule to prevent abusive short selling and to restore investor confidence in the markets. 15 In support of this argument, this Note analyzes market volatility subsequent to the elimination of the uptick rule, the electronic trend of today's markets, potential benefits of short selling, the SEC's justification for the removal of the uptick rule, and the SEC's role in the regulation of short selling. 16 II. BACKGROUND A. DEFINITION OF A SHORT SALE A short sale occurs when a seller sells a security that the seller does not own and has to borrow to make delivery.' 7 In a short sale transaction, a short seller will sell a security that the seller does not own, borrow the security from a broker to meet the delivery obligation after selling the security, and then purchase an equivalent security to return to the broker that lent the security to the short seller.'1 A brokerage firm generally will loan the short seller the stock from either the firm's inventory, the margin account of other firm clients, or a different lender. 19 The short seller will be responsible for interest charged by the brokerage firm on the lent stock. 20 The securities that 10. Amendments to Regulation SHO, 74 Fed. Reg. at 18, See infra notes and accompanying text. 12. See infra notes and accompanying text. 13. See infra notes and accompanying text. 14. See infra notes and accompanying text. 15. See infra notes and accompanying text. 16. See infra notes and accompanying text. 17. BLACK'S LAw DICTIONARY (8th Edition 2004), sale. 18. Whistler Investments, Inc. v. Depository Trust & Clearing Corp., 539 F.3d 1159, 1162 (9th Cir. 2008). 19. Division of Market Regulation: Key Points About Regulation SHO, (last visited June 22, 2009). 20. Id.

3 2010] THE LONG AND SHORT OF IT 595 the short seller will return to the lender are typically purchased on the open market. 21 A seller commonly will make a short sale if the seller anticipates the particular security's price to decline. 2 2 The short seller will realize a profit if the security's price declines in the time between the sale and the purchase. 2 3 However, if the price of the stock increases, the short seller will not produce a profit but instead will incur a loss. 24 As an illustration, consider an investor that anticipated a decrease in the stock price of Corporation A. 25 If Corporation A's stock was trading at $60 per share, the investor would have borrowed shares of Corporation A stock at $60 per share and then sold the shares without delay in a short sale. 26 If Corporation A's stock subsequently decreased to $40 per share, the investor would have profited if the investor later bought shares on the open market to replace the borrowed shares. 27 On the other hand, if Corporation A's stock subsequently increased, the investor would have incurred a loss rather than produced a profit. 28 For example, if Corporation A's stock subsequently increased to $80 per share, the investor would have lost $20 per share if the investor bought shares on the open market to replace the borrowed shares. 2 9 In contrast to a short sale, a "naked" short sale occurs when the seller does not borrow and does not arrange to borrow securities. 30 As the seller does not borrow or arrange to borrow the securities, the seller will fail to deliver the securities to the purchaser when the delivery of the securities is due. 3 1 The seller may intentionally fail to deliver securities to manipulate the price of a security or a seller may intentionally fail to deliver securities to avoid the borrowing costs that are associated with short sales Amendments to Regulation SHO, 74 Fed. Reg. 18,042, 18,044 (proposed April 20, 2009) (to be codified at 17 C.F.R. pt. 242). 22. BLACK'S LAW DICTIONARY (8th Edition 2004), sale. 23. Whistler Investments, 539 F.3d at 1162 (9th Cir. 2008). 24. Division of Market Regulation, supra note Id. 26. Id. 27. Id. In this case, the investor will profit $20 a share (minus transaction costs such as commissions and fees). Id. 28. Id. Since a stock has the potential to rise indefinitely, shorting a stock opens the possibility of unlimited losses to an investor. Id 29. Id. 30. "Naked" Short Selling Antifraud Rule, 73 Fed. Reg. 61,666, 61,667 (October 17, 2008) (to be codified at 17 C.F.R. pt. 240). 31. "Naked" Short Selling Antifraud Rule, 73 Fed. Reg. at 61,667. "Generally, investors settle or complete security transactions within three business days", thus the security is generally due within the standard three-day settlement period. Id. at 61,667 n.7. 32, Id. at 61,667.

4 CREIGHTON LAW REVIEW [Vol. 43 B. HISTORY OF SEC REGULATION OF SHORT SALES 1. Regulation of Short Sales from 1938 to 2007 The Securities Exchange Act of 1934 ("Exchange Act") 3 3 gave the Securities and Exchange Commission ("SEC") authority to regulate short sales. 3 4 The Exchange Act limits the SEC's authority to regulate short sales to only those securities registered on a national securities exchange. 35 The SEC's authority is comprised of the power to prescribe rules and regulations that are necessary or appropriate for the protection of investors or in the public interest. 36 In 1938, the SEC utilized its authority and adopted a rule to restrict short selling, known as the uptick rule. 37 The SEC adopted the uptick rule following an investigation on concentrated short selling effects that the SEC conducted throughout the market break of The uptick rule provided that a seller could short sell a listed security at a price higher than the price of the sale preceding the last sale price, known as a plus tick, or a seller could short sell a security at the last sale price, but only if it was higher than the last different price of the security, known as a zero plus tick. 3 9 For almost seventy years, the central provisions of the uptick rule remained largely undisturbed; however, in response to changes in the securities markets, the SEC did add exceptions to the uptick rule and granted relief from the rule's restrictions. 40 In July 2004, the SEC studied the effectiveness of short sale price tests by creating a one-year pilot ("pilot program") that temporarily suspended the uptick rule for short sales of certain securities. 4 1 The SEC established the pilot program to determine whether changes to the uptick rule were appropriate at the time of the program and whether changes would further the purposes of the short sale price test regulation. 4 2 The pilot program studied changes as to whether U.S.C.A. 78j (2000). 34. Amendments to Regulation SHO, 74 Fed. Reg. 18,042, 18,044 (proposed April 20, 2009) (to be codified at 17 C.F.R. pt. 242) U.S.C.A. 78j(a)(1) (2000). 36. Id. 37. Amendments to Regulation SHO, 74 Fed. Reg. at 18, Id. The study was conducted from September 7-13, 1937, and from October 18-23, Id. at 18,044 n Id. at 18,044 n.25. A listed security could be sold short "(i) at a price above the price at which the immediately preceding sale was effected (plus tick), or (ii) at the last sale price if it was higher than the last different price (zero plus tick)." This rule was subject to certain exceptions. Id. 40. Id. at 18,044. The central provisions of the uptick rule remained unchanged from 1938 to Id. 41. Id. at 18,045. The SEC also suspended any price test of any exchange or national securities association for the chosen securities. Id. 42. Id.

5 2010] THE LONG AND SHORT OF IT the SEC should remove the uptick rule, or if the uptick rule was to remain in action, whether the rule should apply to additional securities. 4 3 To analyze the changes, the SEC examined the influence of price tests on market quality, any price changes that could be caused by short selling, the costs associated with the use of price tests, and short positions established through alternative means. 44 The SEC selected securities to be used in the pilot program to represent the Russell 3000 index as a whole. 4 5 The chosen securities represented various levels of liquidity to allow the SEC to examine the difference between price tests on securities with minimal liquidity and those with significant liquidity. 46 The remaining securities in the Russell 3000 index not chosen in the group of pilot stocks, which were similar to the stocks in the pilot group, served as a control group. 4 7 Securities that were not subject to a price test at the time of the pilot program were excluded from both the group of securities selected for the pilot group and the remaining securities in the control group. 48 The SEC's Office of Economic Analysis ("OEA") gathered and analyzed the data during the pilot program. 4 9 The OEA compiled a summary report on the pilot program, which it provided to the public. 50 At the time the OEA set forth the summary report, the OEA explained that it found little empirical justification for sustaining short sale price test restrictions including the uptick rule. 5 1 The OEA found that the short sale price tests did not have a sizeable impact on daily volatility, little evidence existed that the restrictions altered a security's price, removal of the restriction did not affect realized liquidity levels, and price tests operated as a restraint on short selling activity Order Suspending the Operation of Short Sale Price Provisions for Designated Securities and Time Periods, 69 Fed. Reg. 48,032, 48,032 (July 28, 2004). 44. Order Suspending the Operation of Short Sale Price Provisions for Designated Securities and Time Periods, 69 Fed. Reg. at 48, Id. at 48,032 n.8. "The Russell 3000 index is specifically composed of 49.9 percent NYSE listed securities, 2.2 percent Amex listed securities, 47.9 percent Nasdaq NNM securities, 63 percent with associated options, and 3.4 percent with associated single stock futures." Id. 46. Id. at 48, Id. The control group was specifically composed of"49.9 percent NYSE listed securities, 2.2 percent Amex listed securities, 47.9 percent Nasdaq securities, 62.7 percent with associated options, and 3.7 percent with associated single stock futures." Id. at 48,032 n Id. at 48,032 n.9. The securities excluded included securities that were not exchange-listed or Nasdaq NNM. Id. 49. Amendments to Regulation SHO, 74 Fed. Reg. 18,042, 18,045 (proposed April 20, 2009) (to be codified at 17 C.F.R. pt. 242). 50. Amendments to Regulation SHO, 74 Fed. Reg. at 18,045. Known as "OEA Staffs Summary Pilot Report". Id. 51. Id. 52. Id.

6 CREIGHTON LAW REVIEW [Vol. 43 In December 2006, the SEC proposed to eliminate the uptick rule to provide that short sales in any security would not be limited by a price test. 5 3 After receiving public comments, which largely supported the removal of price test restrictions, the SEC eliminated the former uptick rule and added a rule that prohibited any self-regulatory organization ("SRO") from holding a short sale price test. 5 4 This rule became effective July 3, The SEC noted that it believed that the elimination of the uptick rule and the addition of the new rule would offer an increased consistency and uniformity to short selling regulation and enhance equality for market participants Criticism of the SEC's Pilot Program In November 2008, the New England Complex Systems Institute ("Institute") found that the Securities and Exchange Commission's ("SEC") Office of Economic Analysis ("OEA") incorrectly analyzed the one-year pilot ("pilot program") prior to eliminating the uptick rule. 5 7 The Institute found that the SEC's pilot program actually showed that the uptick rule had an economically and statistically significant impact on markets, which was consistent with the market conditions subsequent to the elimination of the uptick rule. 58 As illustrated below, the Institute's findings suggested that the historical stability of the markets may have been in part due to the uptick rule. 59 The primary results of the pilot program showed a cumulative sixmonth return difference between unregulated and regulated stocks of percent in New York Stock Exchange ("NYSE") securities, and a percent difference in Nasdaq Stock Market ("NASDAQ") securities. 60 The OEA disregarded the two percent difference in returns on securities as statistically insignificant in relation to the standard deviation of the securities during the pilot program. 6 1 However, the Institute found that the two percent difference was economically im- 53. Amendments to Regulation SHO, 74 Fed. Reg. at 18,046; see also Amendments to Regulation SHO and Rule 10a-1, 71 Fed. Reg. 75,068, 75,074 (proposed December 13, 2006) (to be codified at 17 C.F.R. pt. 240, 242). 54. Id. Comments were received from individual traders, academics, broker-dealers, SROs, and trade associations. Id. 55. Id. 56. Regulation SHO and Rule 10a-1, 72 Fed. Reg. 36,348, 36,352 n.61 (July 3, 2007) (to be codified at 17 C.F.R. pt. 240, 242). 57. Dion Harmon & Yaneer Bar-Yam, Technical Report on SEC Uptick Repeal Pilot, New England Complex Systems Institute, November 2008 at 1 (Research was performed by the New England Complex Systems Institute). 58. Id. 59. Id. at Id. 61. Robert C. Pozen & Yaneer Bar-Yam, There's a Better Way to Prevent 'Bear Raids', WALL ST. J., November 18, 2008 at A19.

7 2010] THE LONG AND SHORT OF IT portant and represented a significant decline in return on investment. 62 Since World War II, stocks generally appreciated from six percent to seven percent annually in United States markets. 6 3 If the pilot program results were extended to one year, two-thirds of the average return for securities would be eliminated given that securities would have approximately a 4.8 percent reduction, resulting in securities appreciating only 1.2 percent to 2.2 percent each year. 6 4 The Institute commented that this difference could be expected to cause investor behavior to dramatically change and distort the risks and rewards of the stock market in comparison to other investment options. 6 5 The Institute also analyzed securities that experienced large declines in a single day. 6 6 The study found that securities after the repeal of the uptick rule showed drops that were more dramatic in their value than securities before the elimination of the uptick rule. 67 The sudden and extreme decreases in value for securities in a single day served as an illustration of bear raids. 68 Bear raids will occur when short sellers drive down a security's price to create an imbalance of sell-side interest. 69 These unregulated short sales can worsen a declining market for a security by ousting bids, escalating pressure from the sell side, and causing further reductions in the price of the security. 70 A bear raid can create the guise that the security price is declining for genuine reasons, rather than other factors such as short selling. 7 1 An analysis of large declines in a single day of securities experiencing an over forty percent drop in their value showed a statistically significant increase after the elimination of the uptick rule. 7 2 Further, in the period studied prior to the elimination of the uptick rule, no securities experienced a greater than seventy percent drop in 62. Dion Harmon & Yaneer Bar-Yam, Technical Report on SEC Uptick Repeal Pilot, New England Complex Systems Institute, November 2008 at Id. 64. Id. (4.8 percent figure comes from doubling the 2.38 percent decrease in NYSE securities during the pilot program). 65. Id. 66. Id. at Id. at Id. at Amendments to Regulation SHO, 74 Fed. Reg. 18,042, 18,044 (proposed April 20, 2009) (to be codified at 17 C.F.R. pt. 242). 70. Amendments to Regulation SHO, 74 Fed. Reg. at 18, Id. 72. Dion Harmon & Yaneer Bar-Yam, Technical Report on SEC Uptick Repeal Pilot, New England Complex Systems Institute, November 2008 at 2-3. The periods studied were the 12 months following March 31, 2000, for securities prior to the elimination of the uptick rule and the 12 months following September 30, 2007, for securities after the elimination of the uptick rule. Id. at 3.

8 CREIGHTON LAW REVIEW [Vol. 43 value. 73 However, seven securities experienced such a drop in the period studied after the elimination of the uptick rule. 7 4 Moreover, for twelve-month periods beginning in July 1999 through October 2008, forty-five securities experienced a drop in value greater than forty percent in the most recent period while the greatest number of drops in value for a security in one day greater than forty percent in all other intervals was twenty-seven securities. 7 5 In addition to reanalyzing data collected by the pilot program, leaders of MFS Investment Management and the Institute have scrutinized the pilot program itself. 7 6 The pilot program only compared the returns on pilot securities for six-months but was intended to be the foundation for a decision whether or not to eliminate a rule that was in effect for seventy years. 7 7 Additionally, the pilot program occurred when the elimination of the uptick rule could not be stress tested. 78 In 2005, when the SEC conducted the comparison of returns on securities for the pilot program, stock prices rose with low volatility. 79 In analyzing the results of the pilot program, the OEA found that little empirical justification existed to maintain short sale price test restrictions (i.e., uptick rule) at that time, noting that the uptick rule did not appear to have a substantial impact on the daily volatility of actively traded securities. 8 0 However, Dennis Nixon, Chief Executive Officer and Chairman of International Bancshares Corporation, pointed out that since the OEA report found little empirical justification to continue the uptick rule, it also would have found little to no justification for eliminating the uptick rule Id. at Id. 75. Id. 76. See Robert C. Pozen & Yaneer Bar-Yam, There's a Better Way to Prevent 'Bear Raids', WALL ST. J., November 18, 2008, at A19 (criticizing length of pilot program and timing of pilot program). 77. Robert C. Pozen & Yaneer Bar-Yam, There's a Better Way to Prevent 'Bear Raids', WALL ST. J., November 18, 2008, at A19. The pilot program went on for over a year, but in the OEA's analysis of the program, the returns of securities were included for only 6 months in Table 9 of the report. Office of Economic Analysis U.S. Securities and Exchange Commission, Economic Analysis of the Short Sale Price Restrictions Under the Regulation SHO Pilot, September 14, 2006, Table 9, available at sec.gov/about/economiclshopilot09l5o6/draftreg-sho-pilotreport.pdf. 78. Robert C. Pozen & Yaneer Bar-Yam, There's a Better Way to Prevent 'Bear Raids', WALL ST. J., November 18, 2008, at A Id. 80. Amendments to Regulation SHO, 74 Fed. Reg. 18,042, 18,045 (proposed April 20, 2009) (to be codified at 17 C.F.R. pt. 242). 81. Letter from Dennis Nixon, Chief Executive Officer and Chairman, International Bancshares Corporation, to The Honorable Mary L. Schapiro, Chairman, Securities and Exchange Commission, et al. (June 9, 2009) (on file with author), available at /comments/s /s pdf.

9 2010] THE LONG AND SHORT OF IT 3. SEC's Actions After the Repeal of the Uptick Rule In response to increased market volatility subsequent to the elimination of the uptick rule, the Securities and Exchange Commission ("SEC") took action to address concerns about the impact that short selling may have had in connection with the disturbance and price fluctuations in the market. 8 2 The SEC issued an emergency order on July 15, 2008, that established borrowing and delivery conditions on short sales of select financial institutions' equity securities. 8 3 In the SEC's notice regarding the emergency order, the SEC stressed that confidence in our markets can be lost through false rumors. 8 4 The loss of such confidence can lead to panic selling that can be intensified through naked short selling and can be further worsened if significant financial institutions are involved. 8 5 The SEC's market concerns expanded and no longer included only financial institutions. 8 6 In response to these concerns, the SEC issued an emergency order on September 17, 2008, that established increased delivery requirements on sales of all equity securities, not only financial institution securities. 8 7 As the SEC had further concerns for financial institution securities with regard to prices impacted by short selling, the SEC issued another emergency order on September 18, 2008, that prohibited short selling of select financial institution securities traded publicly. 8 8 The SEC noted that the loss of confidence in our markets can lead to panic selling that can be intensified through naked short selling and can be further worsened if major financial institutions are involved. 8 9 The SEC eventually adopted Rule 204T 90 in October 2008, which enhanced close-out requirements of Regulation SH0 9 1 as set forth in 82. Amendments to Regulation SHO, 74 Fed. Reg. at 18, Id. at 18,047. The emergency order was issued pursuant to Section 12(k)(2) of the Exchange Act. Id. 84. Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments, 73 Fed. Reg. 42,379, 42,379 (July 15, 2008). 85. Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments, 73 Fed. Reg. at 42, Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments, 73 Fed. Reg. 54,875, 54,875 (September 17, 2008). 87. Amendments to Regulation SHO, 74 Fed. Reg. at 18, This included all equity securities under Rule 204T of Regulation SHO. Id. at 18, Amendments to Regulation SHO, 74 Fed. Reg. at 18, Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments, 73 Fed. Reg. at 42, FR 61,678 (Oct. 17, 2008) C.F.R (2005).

10 CREIGHTON LAW REVIEW [Vol. 43 the September emergency order and also eliminated Regulation SHO's grandfather and options market maker exceptions. 9 2 Also in 2008, the SEC proposed and later adopted a "naked" short selling anti-fraud rule. 9 3 The SEC intended the "naked" short selling antifraud rule to target short sellers that deceive others in relation to their intention or capability to deliver securities for settlement and those that are unsuccessful in delivering securities by the settlement date. 94 This rule makes it unlawful for a person to sell an equity security if that person both deceives the purchaser in regards to that person's intention or capability to deliver the security on time for settlement, and that person does fail to deliver the security on time for settlement. 9 5 The SEC recognized that investor confidence was still a concern and the rapid and sharp declines in security prices created apprehension in regards to markets despite the SEC's previous actions. 96 In response to this concern, the SEC continued to examine actions it could consider due to the extreme market conditions and deterioration of investor confidence. 9 7 The SEC proposed amending Regulation SHO through the addition of a short sale price test or the addition of a circuit breaker rule. 98 The SEC set forth four basic options: a modified uptick rule, a proposed uptick rule, a circuit breaker halt rule, or a circuit breaker price test rule. 99 The proposed modified uptick rule is a type of short sale price test This rule would require a trading center to have policies and procedures designed to prevent the trading center from carrying out or showing any short sale order at a price that is lower than the national best bid. 1 1 The best bid is the highest bid quoted for a particular 92. Amendments to Regulation SHO, 74 Fed. Reg. at 18,048. See Amendments to Regulation SHO, 72 Fed. Reg (August 14, 2007); and Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments, 73 Fed. Reg. 54,875 (September 23, 2008). 93. Amendments to Regulation SHO, 74 Fed. Reg. at 18, "Naked" Short Selling Antifraud Rule, 73 Fed. Reg. 61,666, 61, (October 17, 2008) (to be codified at 17 C.F.R. pt. 240). 95. Id. at 61,671. The purchaser can also include a broker-dealer or participant of a registered clearing agency. Id. 96. Amendments to Regulation SHO, 74 Fed. Reg. at 18, Id. 98. Id. at 18, Id. Another option offered by the SEC is a combination of a price test rule and a circuit breaker rule. Id Id. at 18, Id. The rule would also require the trading center to have "policies and procedures designed to prevent it from executing or displaying a short sale order unless the order is priced above the current national best bid in the event that the current national best bid is below the last differently priced national best bid." Id.

11 2010] THE LONG AND SHORT OF IT stock This is determined among all bids offered by competing market makers The implementation of the proposed modified uptick rule may further help prevent short sellers from forcing the market down and may help prevent short sales from being used to quicken a declining market. 104 Another alternative offered by the SEC is a modified version of the previous uptick rule, known as the proposed uptick rule.' 0 5 Opposed to the national best bid being used as a reference point for the modified uptick rule, the last sale price of the certain security would be used as the reference point for short sale orders for the proposed uptick rule.' 0 6 Under the proposed uptick rule, a short sale order could not be made below the last sale price of the particular security that is being sold short.' 0 7 The only instance where short sale orders may be made at the last sale price is if the last sale price is above the last different price of the particular security; in all other instances, short sale orders must be made above the last sale price.' 0 8 Another option the SEC provided is a circuit breaker halt rule, which could be implemented in the alternative or in addition to the proposed price test restrictions The circuit breaker halt rule would prohibit the selling short of an individual equity security when a severe price decline in a specific security triggers the circuit breaker. 110 The prohibition would be in effect wherever the security is traded and would only be in effect while the circuit breaker is in force."' Thus, the prohibition is not as broad as a market-wide trading halt Under the proposal, the SEC suggested a ten percent decline in a particular security's price as an appropriate level to trigger the circuit breaker halt rule partly because it was consistent with the current self-regulatory organization ("SRO") Circuit Breakers An additional alternative circuit breaker rule offered by the SEC is the circuit breaker price test rule The circuit breaker price test rule would impose short sale price restrictions for a particular security 102. Investopedia.com, Best Bid, (last visited January 31, 2010) Id Amendments to Regulation SHO, 74 Fed. Reg. at 18, Id. at 18, Id Id Id Id. at 18, Id. at 18, Id Id Id. The ten percent decline would be measured from the prior day's closing price of the particular security. Id Id. at 18,065.

12 CREIGHTON LAW REVIEW [Vol. 43 when the circuit breaker triggers a severe price decline in the specific security. 115 The short sale price restrictions would be imposed for the particular security wherever it is traded and would be in effect for the remainder of the trading day Like the circuit breaker halt rule, the circuit breaker price test rule would be triggered by a ten percent decline of an individual equity security. 117 If imposed, the circuit breaker price test rule would be implemented instead of a permanent, market-wide price test restriction. 118 The SEC has recognized that short selling provides both market liquidity and pricing efficiency to markets Short sales may offset temporary imbalances for specific securities and reduce the risk of artificially high prices because of temporary imbalances in buying and selling interest, which shows that short sales contribute to market liquidity. 120 Short selling transactions inform the market of how investors perceive the future of a security involved in a transaction A short seller predicts that the price of a security will fall and the purchaser of the short sale predicts that the security will rise Price tests, including the price tests proposed by the SEC, are generally not designed to eliminate short selling, but rather to moderate and mitigate the consequences of short selling. 123 The proposed modified uptick rule, for example, is intended to allow relatively unrestricted short selling in an advancing market. 124 C. THE FINANCIAL MARKETS HAVE BEEN EXTREMELY VOLATILE DUE To RAPID AND STEEP PRICE DECLINES IN SECURITIES AFTER THE ELIMINATION OF THE UPTICK RULE Shortly after the elimination of the uptick rule, the financial markets experienced extreme turbulence due to turmoil in the financial sector and severe volatility and sharp declines in securities prices Id. at 18, Id. at 18, Id. at 18,069. The ten percent decline would be measured from the prior day's closing price of the particular security. Id Id Id. at 18, Id Id Id Compare Letter from Michael R. McAlevey, Vice President & Chief Corporate, Securities & Finance Counsel, General Electric Company, to Elizabeth M. Murphy, Secretary, Securities & Exchange Commission (June 18, 2009) (on file with author), available at ("Price tests have never been designed to eliminate short selling, but instead to moderate and mitigate the effects of the practice."), with Amendments to Regulation SHO, 74 Fed. Reg. at 18,050 (proposed modified uptick rule is type of short sale price test) Amendments to Regulation SHO, 74 Fed. Reg. at 18, Id. at 18,048.

13 20101 THE LONG AND SHORT OF IT For instance, the Dow Jones Industrial Average ("DJIA") lost approximately fifty percent of its value between July 2007 and March Similarly, between July 2007 and March 2009, the Standard and Poor's 500 Index ("S&P 500") fell approximately fifty-four percent, greatly reducing its value The financial sector was one of the most noticeable areas experiencing severe market decline and volatility after the elimination of the uptick rule. 128 Financial institutions depended on short-term liquidity causing the institutions to be more vulnerable to bear raids, sudden price declines, and high volatility. 129 In 2008 and early 2009, significant financial institutions experienced sizeable reductions in the value of their securities. 130 For instance, the stock price of one major financial institution fell approximately $48 per share when it decreased from approximately $49 per share in July 2007, to just above/below $1 per share in March During the same time period, another significant financial institution's stock price decreased in value approximately $46 per share, amounting to a value of only $3 per share in March Further, the federal government seized several major banks in The federal government seized the banks for reasons such as insufficient assets to pay obligations and demands of depositors and a determination that the bank was in an unsafe or unsound condition to transact business Overall in 2008, a total of twenty-six banks failed As of August 21, 2009, the Federal Deposit Insurance Corporation ("FDIC") reported seventy-seven bank failures In stark contrast, the FDIC reported only three bank failures in 2007, none in 2006 and 2005, four in 2004, and three in In fact, the largest number of bank failures reported by 126. Id. The DJIA closed at 13,577 on July 3, 2007, and fell 6,541 for a close of 6,726 on March 3, Id Id. The S&P 500 closed at on July 3, 2007, and fell for a close of on March 3, Id See infra notes and accompanying text Letter from Michael R. McAlevey, Vice President and Chief Corporate Securities & Finance Counsel, General Electric Company, to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission (June 18, 2009) (on file with author), available at / /comments /s /s7o pdf Amendments to Regulation SHO, 74 Fed. Reg. at 18, Id Id. The stock price declined from around $49 per share in July 2007 to $3 per share in March Id Id Office of Thrift Supervisions, Receivership of a Federal Saving Association, Sept. 5, 2008, (last visited September 14, 2009) FDIC: Failed Bank List, html (last visited Aug. 21, 2009) FDIC: Failed Bank List, supra note Id.

14 CREIGHTON LAW REVIEW [Vol. 43 the FDIC before 2008 was eleven in The drastic change in numbers of failed banks in recent history paints a vivid picture of the recent dramatic change in market conditions Many investors and other members of the public associated the recent volatility of the markets along with sharp declines in security prices and the loss of investor confidence with the removal of the uptick rule. 140 The Securities and Exchange Commission ("SEC") received thousands of comments associated with the removal of the uptick rule and the reinstatement of some form of price restriction test or other regulation of short sales For example, in March 2009, the Nasdaq Stock Exchange ("NASDAQ"), the New York Stock Exchange ("NYSE"), and the Better Alternative Trading System ("BATS") Exchange (collectively, the "Exchanges") sent a letter to the SEC sup Id Compare FDIC: Failed Bank List, supra note 135 (zero bank failures in 2005), with FDIC: Failed Bank List, supra note 135 (seventy-seven bank failures as of August 21, 2009) See, e.g., Letter from Samuel E. Wynegar, Investor, to Securities and Exchange Commission (May 27, 2009) (on file with author), available at comments/s /s htm ("[Ellimination of the uptick rule has caused great harm to our financial markets."); Letter from Barbara Meinwald, to Securities and Exchange Commission (May 27, 2009) (on file with author), available at gov/commentsls /s htm (re-enactment and enforcement of the uptick rule will prevent the free fall of financial stocks from happening again); Letter from Thomas P. Brownbridge to Securities and Exchange Commission (May 29, 2009) (on file with author), available at httpj/ (rescinding the uptick rule contributed to economic chaos) See, e.g., Letter from Kimberly Unger, Esq. Executive Director, The Security Traders Association of New York, Inc., to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission (June 18, 2009) (on file with author), available at (implementation of modified uptick rule will result in loss of liquidity in markets); Letter from Jeffrey D. Morgan, President & CEO, National Investor Relations Institute, to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission (May 29, 2009) (on file with author), available at (during times of volatility circuit breaker will ensure equity prices are not manipulated); Letter from Renald C. Long, Director, Regulatory Affairs, Wells Fargo Advisors, to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission (Sept. 17, 2009) (on file with author), available at (implementation of rule regulating short selling will help interested public feel that action is being taken to regulate short sales); Letter from Sarah A. Miller, Senior Vice President Center for Securities, Trust and Investments, American Bankers Association to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission (July 1, 2009) (on file with author), available at (reinstating uptick rule in some format will restore investor confidence); Letter from Michael R. McAlevey, Vice President & Chief Corporate, Securities & Finance Counsel, General Electric Company, to Elizabeth M. Murphy, Secretary, Securities & Exchange Commission, supra note 129 (national best bid better in electronic trading environment); Letter from Howard Meyerson, General Counsel, Liquidnet, to Securities & Exchange Commission (June 18, 2009) (on file with author), available at httpj/ s /s pdf (best bid gives more accurate portrayal of current market conditions).

15 2010] THE LONG AND SHORT OF IT porting the reinstatement of a rule to slow short selling The letter proposed a modified version of the uptick rule referred to as a modified uptick rule and a circuit breaker rule. 143 In the letter, the Exchanges stated that abusive short selling harms companies listed on the Exchanges and investors. 144 Further, the Exchanges noted that abusive short selling destroys confidence in United States markets In a memorandum to clients on November 20, 2008, the prominent law firm Wachtell, Lipton, Rosen & Katz ("firm"), which had numerous Fortune 500 companies as clients, criticized the SEC for failing to reinstate the uptick rule The firm stated that the SEC must take action in its leadership role to restore investor confidence in our markets. 147 The firm also stated that the SEC's failure to reinstate the uptick rule was unacceptable. 148 Also, in a comment to the SEC supporting the proposed modified uptick rule and a circuit breaker rule, International Bancshares Corporation ("IBC"), a $12.4 billion financial holding company, faulted steep price declines and severe volatility in certain financial stocks in part to short sellers. 149 IBC stated that investor confidence had been eroded and actions of short sellers disrupted the stability and integrity of the financial system.150 IBC also added that short sellers created a gambling environment similar to that of Las Vegas and provided little to no benefit to the market IBC further reported that in the short period from February 13, 2009 to March 31, 2009, its stock decreased percent due to an increase of 188 percent in short interest, exhibiting the economic harm experienced by IBC subsequent to the elimination of the uptick rule Peter Barnes, SEC Considers Changes to Short-Selling Rules, entrepreneur.com/foxbusiness/370.html (last visited August 22, 2009) Ray Pellecchia, Exchanges File Joint Proposal to SEC for Modified Uptick Rule and Circuit Breaker, php (last visited August 22, 2009) Id Id Edward D. Herlihy & Theodore A. Levine, N. Y. TIMEs DEALBOOK, Wachtell Lipton Calls for Return of Uptick Rule, wachtell-lipton-calls-for-return-of-uptick-rule/ (last visited August 22, 2009) Id Id Letter from Dennis Nixon, Chief Executive Officer and Chairman, International Bancshares Corporation, to The Honorable Mary L. Schapiro, Chairman, Securities and Exchange Commission, et al. supra note Id Id Id.

16 608 CREIGHTON LAW REVIEW [Vol. 43 D. TODAY'S ELECTRONIC TRADING ENVIRONMENT Today's trading environment relies heavily on electronic trading, which is becoming increasingly rapid Communications at physical locations used to be the only way to trade financial instruments Technology has since replaced physical interaction in the trading of securities Today, most stock exchanges in the world have adopted electronic trading. 156 Even though the New York Stock Exchange ("NYSE") presently utilizes physical trading, it has introduced systems that allow investors to make use of electronic trading. 157 Security transactions are generally reported in a small window, which is usually within ninety seconds Trade reporting can occur in different trading centers. 159 Rather than trade sequence, trades are published in reporting sequence. 160 As trades are published in reporting sequence, transactions can be reported in out-of-sequence reports Surprisingly, transactions that are completed and reported automatically can also be out of sequence if the transactions took place in different trading centers. 162 In contrast to transactions, changes in the national best bid are sequenced using all trading centers.1 63 As the electronic trading platforms' price was determined without regard to the last sale price, the former uptick rule required several exceptions for use of systems utilizing electronic trading platforms See Letter from Michael R. McAlevey, Vice President & Chief Corporate, Securities & Finance Counsel, General Electric Company, to Elizabeth M. Murphy, Secretary, Securities & Exchange Commission, supra note 129 (electronic trading environment is becoming increasingly rapid) Terrence Hendershott, Electronic Trading in Financial Markets, available at Id Id. Stock exchanges including London, Tokyo, and Frankfurt have all moved to electronic trading. Id Id Amendments to Regulation SHO, 74 Fed. Reg. at 18, Id. at 18,053. Multiple trading centers can report trades in the same stock. Id Id Id Id. ("For example, trade reporting for covered securities can involve multiple trading centers reporting trades in the same stock from different locations using different means of reporting.") Id See Letter from Michael R. McAlevey, Vice President & Chief Corporate, Securities & Finance Counsel, General Electric Company, to Elizabeth M. Murphy, Secretary, Securities & Exchange Commission, supra note 129 ("Because this bid-offer spreadbased price is determined without regard to (and me be less than) the last sale price, the Original Uptick rule required numerous exceptions for such systems.").

17 20101 THE LONG AND SHORT OF IT E. INTERNATIONAL REGULATION OF SHORT SELLING In 2009, the International Organization of Securities Commissions's ("IOSCO") Technical Committee ("Committee") published a report that contains standards for effective regulation of short selling. 165 The Committee set up the Task Force on Short Selling because of the recent financial crisis to unify various regulatory approaches for the effective regulation of short selling.166 The Committee recommended four principles for effective regulation of short selling. 167 The first principle called for controlling the stability of financial markets through appropriate controls on short selling that minimize potential risks that could disturb the efficient functioning of the markets. 168 The second principle recommended a reporting regime for short selling that gave the market or market authorities timely information The third principle suggested an effective compliance system along with an effective enforcement system for successful regulation of short selling. 170 The fourth and final principle recommended proper exceptions for some categories of transactions to promote an efficient market. 171 The Committee's first principle called for controlling the stability of financial markets through appropriate controls on short selling that minimize potential risks that could disturb the efficient functioning of the markets The Committee suggested different tools to exercise control over short sales such as price restriction rules and pre-borrowing requirements The Committee recognized that not all measures to regulate short sales will work in all jurisdictions universally, so the 165. IOSCO Publishes Principles For the Effective Regulation of Short Selling, &vname=srlrnotallissues&fn= &jd=AOB8X3N6U9&split=O (last visited June 25, 2009) Technical Committee of the International Organization of Securities Commissions, Regulation of Short Selling, June 2009, at 4. The principles were developed by the Task Force on Short Selling following consultation with regulators and market participants from around the world who were generally supportive of the proposals. Id Id Id. at 6. "Short selling should be subject to appropriate controls to reduce or minimi[zle the potential risks that could affect the orderly and efficient functioning and stability of financial markets." Id Id. "Short selling should be subject to a reporting regime that provides timely information to the market or to market authorities." Id Id. "Short selling should be subject to an effective compliance and enforcement system." Id Id. "Short selling regulation should allow appropriate exceptions for certain types of transactions for efficient market functioning and development." Id Technical Committee of the International Organization of Securities Commissions, Regulation of Short Selling, June 2009, at 6. "Short selling should be subject to appropriate controls to reduce or minimi[zle the potential risks that could affect the orderly and efficient functioning and stability of financial markets." Id Id. at 7.

18 CREIGHTON LAW REVIEW [Vol. 43 Committee suggested using a tool that was workable with local market conditions and any market infrastructure that was already in place The Securities and Exchange Commission's ("SEC") former uptick rule was a form of a price restriction rule The Committee's next principle recommended a reporting regime for short selling that would give the market or market authorities timely information The Committee believed that more transparent short sale information would support market efficiency.' This 7 7 principle required that, to create a strong reporting regime for short selling, market authorities must consider what information must be reported, the trigger level for information to be reported, the frequency of the reports, the person or agency responsible for reporting the information, and the recipients of the reported information. 178 The Committee recognized that to be effective, the appropriate trigger level of reporting and frequency of reports could not be set too high as to not capture information on short positions but also could not be too low or too frequent as to be overly burdensome for those responsible 79 for reporting the information.' Further, this principle required the timing of the reports must be done as soon as practicable, as recommended by the Committee, for the reporting of short sales to be effective. 180 The third principle recommended by the Committee suggested an effective compliance system along with an effective enforcement system for successful regulation of short selling.' 8 ' The Committee suggested that an enforcement system is crucial for ensuring compliance of a stringent regulatory system.' 8 2 The Committee suggested a strong deterrent effect for control measures and recognized some jurisdictions using a financial penalty to discourage breaches of settlement rules Monitoring and surveillance could assist in detecting any potential abusive short sales through the reporting of short posi Id. at See Technical Committee of the International Organization of Securities Commissions, Regulation of Short Selling, June 2009, at 6 n. 7 (stating "[i]n the United States, the price restriction rules were removed in July 2007) Technical Committee of the International Organization of Securities Commissions, Regulation of Short Selling, June 2009, at 6. "Short selling should be subject to a reporting regime that provides timely information to the market or to market authorities." Id Id. at Id. at Id. at Id Id. at 6. "Short selling should be subject to an effective compliance and enforcement system." Id Id. at Id.

19 20101 THE LONG AND SHORT OF IT tions. 184 This principle suggested, to enforce securities regulation, the regulator hold comprehensive investigation, inspection, and surveillance powers The final principle recommended by the Committee suggested proper exceptions for some categories of transactions to promote an efficient market.' 8 6 The Committee recognized that when regulation is developed for short sales, along with being effective to deter abusive short sales, the regulation should capture any potential benefits associated with short selling This principle suggested that any short sales regulation should not restrain legitimate short selling activities such as bona fide hedging, arbitrage, and market making, which mainly provide benefits to the markets The Committee encouraged that legitimate short selling activities should be reported to market authorities but did not necessarily encourage that these activities be reported to the public. 8 9 Finally, the Committee stressed that any exceptions made to a short sale regulation should be clearly defined to prevent any potential abuses of the exception. 190 The Committee had two chief objectives in recommending a regulatory framework for short selling The first was to reduce volatility in the financial markets and the second was to lessen any possible hindering effect that abusive short selling can have on financial markets without causing an undue impact on security transactions The Committee reasoned that a more consistent and reliable international regulatory method to short selling could result if market authorities follow the Committee's four principles. 9 3 Under the Committee's reasoning, creating a more consistent approach to international regulation of short selling would simplify the compliance process, especially for those market participants that operate in markets in different jurisdictions Id. at Id. at Id. at 6. "Short selling regulation should allow appropriate exceptions for certain types of transactions for efficient market functioning and development." Id Id. at Id Id. at Id Id. at Id Id Id.

20 CREIGHTON LAW REVIEW [Vol. 43 F. RECENT UNITED STATES COURT OF APPEALS DECISIONS DEALING WITH SHORT SELLING 1. Pet Quarters, Inc. v. Depository Trust & Clearing Corp.: The Eighth Circuit Found a Favorable Ruling for Corporation and Shareholders Would Pose an Obstacle to the Congressional Objectives in Section 17A In Pet Quarters, Inc. v. Depository Trust & Clearing Corp.,195 the United States Court of Appeals for the Eighth Circuit found that the claims brought by a corporation and shareholders came from activities that conformed to Securities and Exchange Commission's ("SEC") approved rules and that a favorable ruling on any of the claims would conflict with federal law In Pet Quarters, Pet Quarters and its shareholders, brought an action in the Circuit Court of Pulaski County, Arkansas, Sixth Division against Depository Trust and Clearing Corporation and its subsidiaries, Depository Trust Company ("DTC") and National Securities Clearance Corporation ("NSCC") (collectively, the "defendants"), alleging that the program used by the defendants permitted naked short selling and put Pet Quarters out of business by driving down the market price for its shares On the basis of federal preemption, the defendants removed the suit to federal court. 198 The United States District Court for the Eastern District of Arkansas dismissed Pet Quarters's complaint with prejudice because the sixteen state law claims were preempted due to claims that attacked a SEC approved program and elements of that program.199 Pet Quarters appealed to the Eighth Circuit challenging the district court's failure to remand the case to state court Key in the Eighth Circuit's analysis was determining whether plaintiff Pet Quarters's claims directly conflicted with SEC approved rules In two of Pet Quarters's claims, Pet Quarters alleged that one of the clearing agencies sold and delivered borrowed shares, characterizing a sale transaction The Eighth Circuit found that these claims conflicted with the SEC approved rules because the SEC characterizes transactions as loaning and borrowing and a determination otherwise F.3d 772 (8th Cir. 2009) Pet Quarters, Inc. v. Depository Trust & Clearing Corp., 559 F.3d 772, 782 (8th Cir. 2009) Pet Quarters, 559 F.3d at Id Id. at Id Pet Quarters, 559 F.3d at Id. at