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The Securities and Exchange Commission voted last week to adopt a new rule to place certain restrictions on short-selling when a stock is experiencing downward price pressure. The measure is intended to promote market stability and preserve investor confidence, but commissioners were divided in their voting. This alternative uptick rule is designed to restrict short selling from further driving down the price of a stock that has dropped more than 10 percent in one day. It will enable long sellers to stand in the front of the line and sell their shares before any short sellers once the circuit breaker is triggered.

“The rule is designed to preserve investor confidence and promote market efficiency, recognizing short selling can potentially have both a beneficial and a harmful impact on the market”, - said SEC Chairman Mary L. Schapiro in a statement. – “It is important for the Commission and the markets to have in place a measure that creates certainty about how trading restrictions will operate during periods of stress and volatility”.

However, another commissioner, Troy Paredes, voted against the rule, as did another Republican commissioner, Kathleen Casey. “The essential rationale behind the rule is that the short sale restriction, if implemented, will bolster investor confidence”, - said Paredes. – “This claim is rooted in conjecture and is too speculative to form a properly cognizable basis for adopting the alternative uptick rule. Indeed, a more thorough analysis indicates that the rule amendments are just as likely, if not more so, to erode investor confidence instead of boosting it”.

Short selling involves the selling of a security that an investor does not own or has borrowed. When shorting a stock, the investor expects that he or she can buy back the stock at a later date for a lower price than it was sold for. Rather than buying low and selling high, the investor is hoping to sell high and then buy low. Short selling can serve useful market purposes, including providing market liquidity and pricing efficiency. However, it also may be used improperly to drive down the price of a security or to accelerate a declining market in a security.

The alternative uptick rule (Rule 201) approved by the SEC imposes restrictions on short selling only when a stock has triggered a circuit breaker by experiencing a price decline of at least 10 percent in one day. At that point, short selling would be permitted if the price of the security is above the current national best bid. Rule 201 includes the following features:

• Short Sale-Related Circuit Breaker: The circuit breaker would be triggered for a security any day in which the price declines by 10 percent or more from the prior day`s closing price.
• Duration of Price Test Restriction: Once the circuit breaker has been triggered, the alternative uptick rule would apply to short sale orders in that security for the remainder of the day as well as the following day.
• Securities Covered by Price Test Restriction: The rule generally applies to all equity securities that are listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market.
• Implementation: The rule requires trading centers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the execution or display of a prohibited short sale.

The SEC voted 3-2 to pass the rules last Wednesday, shortly before voting on a statement and work on International Financial Reporting Standards.

Marty Lax, a managing director at RSM McGladrey and a partner in McGladrey & Pullen in New York City, believes the new rule was a good decision for the SEC. “The rule is fair”, - he said. - “It allows people who trade to sell short, but within certain limits. What they were striving for was the institution of a circuit breaker that would be trigged anytime the price of a stock dropped 10 percent in one day, so there would be a cessation of short selling. That was one of the main controversies, that people would continually put pressure on the market by short selling”.