Proposed New SEC Rule a Likely Tool for Increased Enforcement Against Short Sellers
On February 25, 2022, the Securities and Exchange Commission issued a new Proposed Rule 13f-2 requiring institutional money managers to file with the SEC, on a monthly basis, certain short sale related data. A short sale is a transaction in which the seller does not actually own the stock that is being sold but borrows it from the broker-dealer through which they are placing the sell order. Some finance experts praise short selling as essential for correcting pricing of stocks inflated by hype or fraud, but the practice has also been heavily criticized by retail investors, public-company managers, and sometimes regulators, as artificially lowering stock prices, creating market instability, and as a tool to engage in abusive trading practices.
Under Proposed Rule 13f-2, managers would be required to report on a monthly basis — for equity securities in which the manager holds certain minimum short positions — the manager’s end of month gross short position and certain daily short-selling activity affecting the growth short position. The minimum thresholds under the proposed rule are as follows:
For equity securities of reporting company issuers in which the manager meets or exceeds either (1) a gross short position with a value of $10 million or more at the close of any settlement date during the calendar month; or (2) a monthly average gross short position as a percentage of shares outstanding in the equity security of 2.5% or more; and
For any equity security of an issuer that is not a reporting company issuer in which the manager meets or exceeds a gross short position of $500,000 or more at the close of any settlement date during the calendar month.
Under Proposed Rule 13f-2, the SEC will make available to the public, on a monthly basis, aggregated data across all managers with short positions in these equity securities. The data includes (1) the aggregated gross short position for each equity across all reporting managers at the close of the last settlement date of the calendar month; and (2) for each reported settlement date during the calendar month reporting period, the net activity in the reported security as aggregated across all reporting managers.
While some of this data is already currently publicly available from FINRA and several stock exchanges (mostly for a fee), the data to be collected under Proposed Rule 13f-2 is more comprehensive, would be more readily accessible to investors, and easier for the SEC to use in performing quantitative analysis.
From an enforcement perspective, the submissions required by Proposed Rule 13f-2 will be used by the SEC to more efficiently police fraud related to short selling activity. In its justification for Proposed Rule 13f-2, the SEC emphasized that data collected under the new rule could help detect and deter fraud. The SEC highlighted the rule’s usefulness in detecting “short and distort” campaigns. These are instances in which an investor shorts a stock and then engages in a campaign to spread unverified bad news about the stock with the objective of panicking other investors into selling their stock to drive the price down. “Short and distort” campaigns are more likely to occur in stocks with lower market capitalizations, therefore it is likely that an individual or entity engaging in such a practice would be required to report their short activity pursuant to the new Proposed Rule 13f-2.
While not specifically described in the proposed rulemaking, the Department of Justice is also reportedly conducting a wide-ranging investigation into short “spoofing” — whereby heavy volumes of sell orders are sent to exchanges and then cancelled within fractions of a second as a way of manipulating the stock price — and short “scalping,” in which activist short sellers cash out their positions without disclosing it. Information to be collected under Proposed Rule 13f-2 will likely be used by the SEC’s Division of Enforcement to detect this and other sorts of conduct and bring enforcement actions.
The SEC has noted that publicly releasing aggregated information about large short positions under the proposed rule may, in some instances, increase the risk of trading behavior harmful to short sellers, namely by enabling traders to create a “short squeeze.” A short squeeze is a large, short-term spike in a stock’s share price that occurs when a large number of short sellers are forced to buy shares to exit their positions. As the SEC notes, if market participants can ascertain which short positions belong to only one manager — something the SEC estimates may occur in as many as 32% of the stocks for which there would be reporting under Proposed Rule 13f-2 — traders may seek to orchestrate a short squeeze targeting that particular manager. It was widely reported, for example, that coordinated trading activity in GameStop securities (NYSE: GME) in January 2021 was intended to and did cause a short squeeze, inflicting painful losses on hedge funds that had taken large short positions in the stock.
But the SEC has also suggested that data available under the new rule would allow it to better protect managers from the harm of a short squeeze. Indeed, an SEC report issued in October 2021 examining the January 2021 trading activity in GME, and the meme stock phenomenon more generally, concluded that improved reporting of short sales would allow regulators to better track the interplay between shorting and price dynamics and guard against short squeezes.
In addition to Proposed Rule 13f-2, the SEC also voted to add to its primary short selling regulation a provision requiring broker-dealers to mark a purchase order as “buy to cover” if the purchaser has any short position in the same security at the time the purchase order is entered — information the SEC says will “especially useful to the Commission in reconstructing significant market events and identifying potentially abusive trading practices including short squeezes.”
While SEC Chair Gary Gensler touted Proposed Rule 13f-2 as a means to “make aggregate data about large short positions available to the public for individual equity securities” and “provide the public and market participants with more visibility,” the proposed rule will also add to the SEC’s enforcement arsenal in targeting short sale activity the Commission sees as harmful to the markets.