Confusion Reins At The SEC

SEC Chairman Christopher Cox announced before the Senate Banking Committee on Tuesday that he was invoking emergency powers to ban naked shorting of Freddie Mac and Fannie May, along with a number of other primary broker banks.

When a stock is sold short, the seller borrows the shares from his broker and then immediately sells them, hoping to buy them back later at a lower price and return them to his broker. At a minimum, the broker of a short seller has to at least locate the shares to be borrowed. Naked short selling means that shares are sold without borrowing or even locating the shares. This allows large traders such as hedge funds to lean into stocks and push them down by selling lots and lots of shares they don't have.

So it naked short selling illegal or not? On CNBC yesterday afternoon Commissioner Cox told Erin Burnett that naked short selling was not illegal. This answer clearly surprised the seasoned CNBC journalist. But in today's New York Times, Cox is quoted as saying on a conference call with reporters, “A run on the bank that can take hold quickly would likely be turbocharged by illegal naked short selling.”

Market maven and CNBC personality Jim Cramer appeared just after Commissioner Cox and actually read from the SEC's own regulations spelling out that naked shorting is clearly banned. Mr. Cramer was incredulous that Commissioner Cox would think he needed to take emergency action for something he could, and should have been doing, all along.

There are a few exceptions regarding market makers, but for the broad trading community, naked shorting is prohibited. In fact, Mr. Cramer, who ran a successful hedge fund for years, said that if a short seller does not deliver the shares for settlement, he risks having his broker unwinds the trade with the short seller taking a big hit.

Why all the confusion? Let's face it, the SEC has never been an organization that inspires confidence with their vigilance and competence. They have been asleep at the wheel again and again, most recently during the collapse of Bear Sterns. Perhaps the invocation of "emergency powers" is an attempt to divert attention from the fact that the SEC's lax attitude toward oversight has once again caused damage. The bottom line is that Commissioner Cox's lack of clarity and lack of understanding of his own organization's regulations does not inspire confidence.