SEC May Require Disclosure of Hedge Funds Short-Sale Positions

Date: Thursday, September 18, 2008
Author: Jesse Westbrook, Bloomberg.com

The U.S. Securities and Exchange Commission may require hedge funds to disclose their short-sale positions and plans to subpoena the funds' communication records in an effort to stem turmoil in stock markets.

Hedge funds and investors managing more than $100 million in securities would be ``required to promptly begin public reporting of their daily short positions,'' Chairman Christopher Cox said in a statement late yesterday. The agency will obtain ``disclosure from significant hedge funds'' regarding ``past trading positions in specific securities,'' Cox said.

Lawmakers including U.S. Senate Banking Committee Chairman Christopher Dodd and executives such as Morgan Stanley Chief Executive Officer John Mack say short sellers may have contributed to the market crisis by spreading false information and using abusive tactics to attack companies. Hedge funds argue that poor business strategies are to blame, not short sellers.

``A lot of hedge funds don't like being forced to disclose their long portfolios, so they're really not going to like this,'' said Sean O'Malley, a former SEC lawyer and now a partner at Goodwin Procter LLP in New York. ``There is going to be some push back from hedge funds, but they may not get any sympathy in the current market environment.''

The five SEC commissioners must approve the rule, which would be adopted on an emergency basis, for it to become binding. Hedge funds, which are private pools of capital whose managers participate substantially from any profits on invested money, prefer to keep their positions secret to prevent other traders from stealing their strategies.

Subpoenas

The SEC didn't say whether the rule would apply only to common shares or whether it would effect options and other securities holdings. SEC spokesman John Nester didn't return an e-mail seeking comment.

The agency's plan to subpoena communication records will mark the second time the regulator has sent information requests to hedge funds in three months. In July, the SEC subpoenaed hedge-fund managers and Wall Street's biggest firms seeking evidence they were manipulating shares of financial companies.

The Financial Services Authority in the U.K. required hedge funds and other speculators to reveal short positions in June equaling 0.25 percent or more of a company's shares during rights offering.

Short sellers try to profit by betting stock prices will fall. In a traditional short sale, traders borrow shares from their broker that they then sell. If the price drops, they buy back the stock, return it to their broker and pocket the difference.

Tougher Rules

The SEC earlier yesterday stiffened rules against so-called naked shorting by adopting two regulations that pressure traders and brokers to actually deliver borrowed shares to buyers. A third rule makes it a securities fraud when sellers deceive brokers about delivering borrowed shares to buyers.

The SEC is targeting naked selling, in which traders never borrow shares from their brokers, amid concern investors are using such abusive tactics to flood markets with sell orders and drive down stock prices.

``Naked short-selling has become the scapegoat, but the fundamentals of how these businesses were run is what caused these issues,'' said Stephen Ehrlich, CEO of New York-based Lightspeed Professional Trading LLC, which makes trading systems for hedge funds and professional traders. ``The problems roiling the market and financial stocks are not going to change with less short-selling.''

Morgan Stanley, the second largest U.S. securities firm, tumbled the most ever in New York trading yesterday after a government rescue of American International Group Inc. failed to ease the credit crisis. In a memo to employees, Mack, 63, said the management committee is ``taking every step possible to stop this irresponsible action in the market.''

Morgan Stanley

``There is no rational basis for the movements in our stock,'' wrote Mack, who added that he contacted Cox and Treasury Secretary Henry Paulson. ``We're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down.''

Morgan Stanley and Goldman Sachs Group Inc., both based in New York, are seeking to avoid runs on their shares that helped trigger emergency sales of Merrill Lynch & Co. and Bear Stearns Cos., and the Sept. 15 bankruptcy of Lehman Brothers Holdings Inc.

Democratic New York Senators Hillary Clinton and Charles Schumer urged the SEC yesterday to impose a temporary ban on short-selling of all financial stocks, saying it would ``help restore a measure of stability to our financial markets.''

In July, the SEC instituted an ``emergency'' order that restricted short-selling in Lehman, Fannie Mae, Freddie Mac and 16 securities firms. The order, which expired last month, required investors betting on a decline in stock prices to arrange to borrow shares before completing a short sale.

To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net.