A dark day for short sellers

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The Securities and Exchange Commission is proposing significant restrictions on legitimate forms of short selling, which is likely to elicit a heated response from hedge funds, investment banks, and mutual funds, all of which use shorting as a tool to build value in their portfolios.

The legitimacy of the practice of short selling is based on the fact that it is the most direct and functional way to bet that an individual stock will fall. The practice requires the buyer to borrow stock from another party, which includes taking the financial risk if the stock rises.

There are prohibitions, however, against the form of short selling know as naked shorting, which involves gambling that a stock will drop, but without borrowing the shares. This can cause an imbalance in the trading of a stock, particularly if its volume is low.

One of the two most prominent of the SEC's proposed restrictions is that shorting could only be done on the "up-bid" in a stock. In theory, that should keep shorts from repeatedly hitting the downward trades in a stock. The other new rule would suspend all short selling if a stock fell by more than 10 percent in one trading day.

According to Reuters, now that the SEC staff has made its recommendations, "the full commission is expected to debate the issue shortly and vote on whether to propose the recommendations later today."

The proposed restrictions contain several flaws, but the most obvious and egregious is that short sellers would be unable to get into stocks that have released very bad news. A company that announces that it might declare Chapter 11 could be protected if its stock fell 10 percent. It's hard to explain why legitimate traders shouldn't be able to make money on that.

Douglas A. McIntyre is an editor at 24/7 Wall St.

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