September 23, 2008
Revenge of the Shorts
Posted by David Zaring

The hedge funds are talking about suing to undo the SEC's ban on shorting until October 2, with an option to extend the ban for 30 days.  My guess is that it is just talk.  Such a suit would be hard to win - at least if it was focused on the initial temporary ban on shorts. The SEC has broad powers to suspend trades for short periods in the way it did here.  The possibly more likely claim would go after the implementation of the short ban.  The commission appears to have delegated who goes on the list of unshortable stocks to the exchanges, who are expanding it willy-nilly.   my quick review of the statute and the (very limited) case law doesn't say much one way or the other about that sort of delegation, but it looks at least a little fishy on a plain text and precedent analysis.

That ban was issued pursuant to the Commission's authority under section 12(k)(2) of the '34 Act:

Emergency orders

  1. The Commission, in an emergency, may by order summarily take such action to alter, supplement, suspend, or impose requirements or restrictions with respect to any matter or action subject to regulation by the Commission or a self-regulatory organization under this title, as the Commission determines is necessary in the public interest and for the protection of investors--
    1. to maintain or restore fair and orderly securities markets (other than markets in exempted securities); or
    2. to ensure prompt, accurate, and safe clearance and settlement of transactions in securities (other than exempted securities).
  2. An order of the Commission under this paragraph (2) shall continue in effect for the period specified by the Commission, and may be extended, except that in no event shall the Commission's action continue in effect for more than 10 business             days, including extensions.....

C. An order of the Commission under this paragraph may be extended to continue in effect for more than 10 business days if, at the time of the extension, the Commission finds that the emergency still exists and determines that the continuation of the order beyond 10 business days is necessary in the public interest and for the protection of investors to attain an objective described in clause (i), (ii), or (iii) of subparagraph (A). In no event shall an order of the Commission under this paragraph continue in effect for more than 30 calendar days.

The SEC's power sure looks broad, broad enough to ban shorting, and the chief limit on them is duration.  The Supreme Court has said that the agency can't use its 12(k) powers over and over again, in seriatim:

"the only question confronting us is whether, even upon a periodic redetermination of “necessity,” the Commission is statutorily authorized to issue a series of summary suspension orders based upon a single set of events or circumstances which threaten an orderly market. This question must, in our opinion, be answered in the negative."

S.E.C. v. Sloan, 436 U.S. 103, 111 (1978), which is probably why subsection C got added to the section in 2004.  But other than Sloan, I've found very little in the way of judicial gloss on the SEC's powers under section 12(k)(2).

The shorts could argue that this isn't an "emergency," which the statute defines as a "major market disturbance" - language broad enough for a court to conclude that the SEC reasonably thought the credit crisis qualified (the statute actually defines the term with some precision, and so I reprint it after the jump, but I don't think it would change the analysis, at least on a first cut).

The shorts might object to the delegation to the exchanges as to who goes on the list.  This seems like their best argument to me: if the SEC gets special emergency powers, and then gives the ability to define the content of those powers to someone else, with no language suggesting that in the statute, isn't that a little strange?  The way for the commission to justify this would be to show that delegations like this one are a common practice of the agency.  And though the SEC has not used section 12(k) often (I think, at least not in this broad way), it may have relied on the exchanges to delist companies that fell below specified SEC criteria, etc.

Finally, the shorts might want to argue that the SEC is using 12(k) in an unprecedented way, and I'm not unsympathetic to these sorts of arguments in other contexts.  But, though I don't claim comprehensive knowledge of this area of the law, the statute is supposed to be invoked in emergencies, it was amended in 2004, so Congress anticipated that the SEC might use it (this isn't the dusting off of Depression era powers for invocation in new and amazingly expansive ways), and so I think this sort of gestalt argument would be difficult to make.

Here's how the 34 Act defines "emergency" and "major market disturbance":

(A) the term “emergency” means--

(i) a major market disturbance characterized by or constituting--

(I) sudden and excessive fluctuations of securities prices generally, or a substantial threat thereof, that threaten fair and orderly markets; or

(II) a substantial disruption of the safe or efficient operation of the national system for clearance and settlement of transactions in securities, or a substantial threat thereof; or

(ii) a major disturbance that substantially disrupts, or threatens to substantially disrupt--

(I) the functioning of securities markets, investment companies, or any other significant portion or segment of the securities markets; or

(II) the transmission or processing of securities transactions

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