WASHINGTON (CN) – After months of industry and consumer input, the Securities Exchange Commission has adopted a new rule aimed at restricting short-selling of stock when there is sharp downturn in its price.
Rule 201, also known as the “alternative uptick rule,” will limit trades of stock when the price of drops by more than 10 percent in one day. After that, short-selling would only be allowed if the price is above the current national best bid.
In a short sell, an investor borrows stock from its owner, sells it, buys it back and returns it to its owner at a lower price in the same trading session. The investor pockets the difference.
While many market analysts and economists faulted short selling for the decline on stocks of major financial firms, SEC Chairman Mary Schapiro said, “Short selling can play an important and constructive role in the markets, such as by providing market liquidity and pricing efficiency.”
In 1938, the SEC enacted Rule 10a-1, known as the “uptick rule” which prohibited investors from short selling stock unless the sale price of the security had gone up.
The rule remained in effect until 2007, when the SEC removed price test restrictions on short selling, believing, at the time, that short selling could help prevent price bubbles by deflating prices when they rose too high, too fast.
However, the SEC reversed course as wide-spread market volatility from 2007 through 2009 led to an erosion of investor confidence. The SEC banned “naked shorting,” where the investor selling stock, hoping to buy it back, did not actually have sufficient capital reserves to buy stock if its price did not fall.
Short-sellers were required to either post bonds equal to the value of the stock at the price they borrowed it or to make good on the delivery of the security of short sale within 24 hours.
The SEC’s efforts did not succeed in restoring investor confidence and the Obama administration decided to reintroduce a price test restriction on short sales.
Rule 201 also mandates that once a circuit breaker has been triggered, the alternative uptick rule applies to short sale orders in that security for the remainder of the trading session as well as the next trading session.
All stocks listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market, are covered by Rule 201. Trading centers must develop and enforce rules officials say are designed to prevent the execution or display of a prohibited short sale.