History of the Short Sale Rules

By: Carmen Lelli

As recent as 2021, there was a large controversy over short selling in Gamestop, where a group of retail investors were claiming that the big players on Wall Street were short selling in order to keep the price of Gamestop and other stocks down at certain levels, and the retail investors created a short squeeze by buying shares and pushing the price of the stock upward. Short selling is not a new practice and those activities are heavily regulated nowadays. But where did the Short Sale Rules come from? What was the reason Short Sale Rules were implemented in the first place? So let’s go back in time. Well, we all remember the Stock Market Crash of 1929. During that period of time, there weren’t any safeguards in place to prevent market abuse, and regardless of that, approximately 10 percent of households in America were invested in stocks as if they were betting on horses at the racetrack. Today approximately 50% are invested in stocks, likely because of 401K’s and other retirement vehicles. What people were seeing during that period of time was that stocks seemed to go up higher and higher and higher. Most people had no expectation that the market would ever decline.?

In 1929, Wall Street bankers were abusing the markets by manipulating stocks. Manipulation was done in a couple of different ways. One way was to have a number of bankers in a group that would pick a particular stock and begin buying that stock into position. As they were building their positions, they would pay financial journalists to publish favorable stories about the subject stock. The bankers would also trade shares among themselves in order to make it appear that there was a growing interest in the subject stock. Today, this is called “Painting the Tape”. This would draw the attention of the investing public.?

As people saw this activity in the markets, they would begin buying these stocks themselves. This was also a time of “Buy now and pay later”. Credit was a big player in the economy as companies that sold household appliances, automobiles, furniture and other goods would offer a line of credit to people where they can put down a certain amount to purchase an item and pay the rest off over time with monthly or weekly payments. The banks were also providing loans to the investing public in order to provide a means for the people to be able to take advantage of the rising markets by offering margin, or in other words a loan to invest with. Once again this was a continuation of the “Buy now pay later” idea that dominated the economy at the time. An investor was able to put down $1000, and receive $10,000 worth of buying power from the bank. Margin at this time was only 10%.?

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As the interest of the investing public in the markets grew, and grew and when a particular stock was the subject of manipulation, more and more investors would jump in on the opportunity, because they saw that the price of the subject stock was continually rising. The stock would continuously rise because more and more people would be buying into it. Once the stock reached a certain level, the bankers would start selling the shares they had previously purchased to the investing public that was still buying.?

Then was another opportunity for the bankers to profit even more by taking advantage of the declining price of the subject stock. They would then have the ability to start selling the stock short because they knew what would eventually occur. At this time there was no regulation in place that governed the way Short Selling was to occur in the marketplace, and these bankers were able to sell stocks Short simply by selling right into the market because there were no pricing restrictions. Additionally, since the bankers had ceased their buying of the stock, there weren’t many buyers left in the marketplace that would continue to buy the stock and/or support it. This resulted in the price of the stock beginning to decline. As the subject stock’s price would decrease, all of the investors that had borrowed money from the banks to purchase the stock would receive what is known as a “Margin Call”. This meant that the investors would have to deposit more money in their accounts in order to cover the loan deficiency and hold their shares, or they would be forced to sell their shares off and close their positions.?

Most people at the time were not able to continue depositing money in order to hold their shares, so most sold their shares to close out their holdings. As this happened the price of the stock would decline even further and as this continued, “Stop” orders that were active in the marketplace would be triggered. A “Stop” is an order to Sell at a triggering price that is below the price at which a particular stock was trading. This order was used as a safety measure by investors, traders and bankers to limit losses in the markets. So as the price of a particular stock would drop to the triggering price of the “Stop” order, the stop order would be activated and executed against the market of the stock and the investor who placed that order would sell their shares at that price level.?

When all of this activity occurred, the entire market sold off so quickly during this time that many investors had lost everything. They lost their savings, their homes, any plans for vacations were cancelled, college for their children was no longer achievable and some even took their own lives. Following the stock market crash of 1929, the United States experienced what is known as “The Great Depression”. A large part of the population was unemployed. Many had little to no food for their families. This led to the introduction of the Securities and Exchange Acts of 1933 and 1934. Why are there two Exchange Acts? The Exchange Acts were really only one piece of legislation. There are two titled Exchange Acts because President Franklin Delano Roosevelt, who took office on March 4th 1933, only managed to finish part of the Act by the end of 1933. President Roosevelt decided to sign off on the portion that he completed that year to make it law. He then continued to finish reviewing the legislation in 1934.

Franklin Delano Roosevelt

Source: www.biography.com

The Securities and Exchange Commission implemented the “Uptick Rule” in 1938 after it was introduced in the Securities and Exchange Act of 1934 which President Roosevelt eventually signed into law. The uptick rule required that all Short Sales take place at a price which was pegged to the last sale of a stock, when the last sale was at a “Plustick” or a “Zero Plus Tick”. A plus tick was a last sale price that was higher than the previous last sale. A zero plus tick was a last sale price that was equal to the previous last sale when the previous last sale was at an uptick. In other words, the uptick rule prohibited Short Sales from occurring at prices that were lower than a last sale that was a plustick or a zero plus tick. This eliminated the possibility for short sales to be used as a means of manipulating a stock price downward or for causing sharp and fast price drops in stocks caused by strategists trying to take advantage of a falling market.

Source: www.reisster.nl

The uptick rule was in effect from 1938 to 2007. In 2007 the Securities and Exchange Commission eliminated the uptick rule and from 2007 to 2010 short sales were permitted to occur on any price movement without restrictions.

After a period of time where there were no pricing restrictions on short sales between 2007 and 2010, the Securities and Exchange Commission adopted a new alternative pricing restriction rule on short sales. This new regulation was called Regulation Short Sale or as is commonly known “Reg SHO”. Reg SHO is covered under Commission Regs Part 242.200, 201, 203 and 204. The new pricing restriction is covered specifically under 201 (Circuit Breaker). Rule 201 requires that exchanges have in place a circuit breaker. This circuit breaker is basically the onset of a pricing restriction on short sales. Reg SHO only applies to NMS Stocks which are defined under Commission Rule Part 242.600 (NMS security designation and definitions). When the price of a NMS stock declines 10% from the previous day’s closing price on the stock’s primary listing exchange, a circuit breaker is triggered, for which, the exchange must disseminate to the financial industry that a “Price Test” is in effect for the underlying stock. This price test will remain in effect for the remainder of that business day and also for the following business day.

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While a price test is in effect in a NMS stock, short sales are prohibited from taking place at a price that is equal to or lower than the inside national best bid. This required broker dealers, trading firms and Exchanges to implement policies, procedures and mechanisms to prevent the execution or display of limit orders in the marketplace at prices equal to or lower than the inside national best bid.

So what is the difference between the prior uptick rule and the current price test under Reg SHO? Under the prior uptick rule, the short sale price was compared to the last sale of the underlying stock. Under Reg SHO, the price test requires a comparison between the short sale price and the inside national best bid and only applies during the period that a price test is in effect. Does the difference between the two make much difference? Not really. Each, on its own merit, prevents bad actors from manipulating the price of a stock downward for the purpose of making a profit from illegal activities. Regardless of the regulations however, there are still bad actors that will try to get away with stock manipulation and other illegal activities. The regulators do surveill for suspicious activities and investigate as warranted. The probability of being caught engaging in such activities is very high and extremely risky. Those caught in these activities face very harsh fines, the loss of their industry licenses and possibly imprisonment depending on the severity.?

Source: www.refinery29.com

Remember, over time many things change, and so does regulation. Will the short sale rules change again in the future? Possibly. Regulators are always reviewing statistics, evaluating the effectiveness of current regulations and examining the effects that certain events have on the financial markets. As discoveries are made and the need for better mechanisms to protect financial markets come to realization, regulators always consider the possibility of making changes to current regulations, introducing new regulations in addition to what may currently exist, or seek to replace a current regulation with something they feel will work better. Regulators generally seek the opinions of industry professionals regarding how they feel the regulation may work in real time, and what challenges they feel may be brought about by the proposed new regulations or changes. Overall and most importantly, regulators are always looking out for the best interests of public investors. Something that was not done so much during the 1920’s however, as we can see, things do change over time and will always continue to change.

Other Sources: U.S. Securities and Exchange Commission, Speed Trader, Investopedia, FIDC.gov