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SEC Proposes New Rule Requiring Increased Disclosure of Short Sale Information

In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which required the SEC “to prescribe rules to make certain short sale data publicly available no less than monthly.”[1]  On February 25, 2022, the SEC acted to implement that directive by unanimously proposing Proposed Rule 13f-2, its plan to “broaden the scope of short-sale released data available to the investing public and to regulators” by requiring certain institutional investment managers to disclose substantial short positions to the SEC for its subsequent disclosure to the public in aggregated form.[2] 

In this post, we explain the basics of a short sale, summarize the SEC’s Proposed Rule 13f-2, and discuss the potential benefits and costs of this rule.[3]

Background: The Short on Shorts

“Short selling is a widely used market practice, which allows investors to profit if an asset declines in value or to hedge risk.”[4]  “Where the traditional investor seeks to profit by trading a stock the value of which he expects to rise, the short seller seeks to profit by trading stocks which he expects to decline in value.”[5]  To do this, he generally borrows shares, sells them, and then returns the shares he borrows at a date in the future.[6]  To return these shares, he must buy new ones, which he can do at a lower cost if the price of the share has declined, “pocket[ing] the difference” between the price of the share when he borrowed it and when he purchased it.[7]  For example, say an investor shorts a stock at 50 cents and the share price falls to 40 cents before he must return the shares he borrowed: he keeps ten cents per share as profit (minus costs).[8] 

The upsides of short selling are profound—shorting allows traditional “long” investors to hedge downside risk and incentivizes market research by allowing investors to profit from uncovering unflattering information about a security.  So too is the potential for abuse.  “For instance, market manipulators may seek to spread false information about an issuer whose stock they sold short in order to profit from a resulting decline in the stock’s price.”[9]  Proposed Rule 13f-2 represents the SEC’s effort to balance the benefits of short selling against the risks it poses to issuers and investors. 

What the Proposed Rule Requires:

Under the SEC’s proposed rule, institutional investment managers (“managers”) who meet minimum reporting thresholds are required to file a Proposed Form SHO with the SEC within 14 days of the end of a calendar month in which the reporting thresholds are met.[10]  The Proposed Form SHO will disclose the manager’s name and businesses information, the month for which it is reporting, its gross short positions for the month at issue, and information about any daily trading activity that affected the manager’s gross short position during the reporting period.[11]  The SEC will then use the data reported on the forms to publish aggregated information for each security for which a form is filed.[12]

The rule would cover managers who hold “a short position of at least $10 million or the equivalent of 2.5 percent or more of the total shares outstanding, or who hold, in an equity security of a non-reporting issuer, a short position of at least $500,000.”[13] 

Potential Benefits and Costs:

The SEC hopes its proposed rule will help investors in at least two ways.  First, the rule is “designed to provide greater transparency through the publication of short sale related data to investors and other market participants.”[14]  In theory, providing the public with more information about short positions will “promote greater risk management among market participants, and may facilitate capital formation to the extent that greater transparency bolsters confidence in the markets.”[15]  Second, the SEC hopes that requiring managers to file Proposed Form SHO will “bolster its oversight of short selling,” potentially discouraging manipulative or abusive uses of short selling.[16]

The SEC acknowledges that its proposed rule will come with costs as well as benefits, starting with the compliance cost to managers of capturing and reporting the information required by the proposed rule, which, the SEC estimates, could cost managers a collective 54 to 156 million dollars per year.[17]  The SEC also fears that its proposed rule could disincentives short-selling, depriving the market of the benefits the strategy offers.  Proposed Rule 13f-2 could discourage short selling by facilitating copycat trading: when investors learn that a peer is short Stock A, they may deduce the strategy that led that investor to their short position, potentially reducing the incentive for would-be short sellers to conduct the market research needed to profitably short a security.[18] Furthermore, particularly following the recent events surrounding GameStop, the SEC worries that releasing even aggregated information about short-sellers could enable “motivated market participants” to identify individual investors, and that “the threat of this additional exposure to retaliation may disincentivize short selling.”[19]  For instance, issuers and other investors could retaliate against individual short sellers by suing them, forwarding information about them to regulators, or else by orchestrating short squeezes.[20]  

In weighing these potential benefits and costs, it’s helpful to recall that the SEC was directed by Congress to implement some scheme for the disclosure of information on short sales.  It was not free to merely leave it up to FINRA or other entities to supply the market with data on shorts. 

Next Steps and Conclusion:

Proposed Rule 13f-2 is not yet law.  The SEC has solicited comments on its proposal and any party wishing to comment should do so on or before April 26, 2022 or 30 days after the proposed rule is published in the Federal Register, whichever is later.[21]  Should it be adopted, the rule will hopefully benefit issuers and investors alike, even if, as the SEC acknowledges, these benefits come at some cost.  

[1] Short Position and Short Activity Reporting by Institutional Investment Managers, (Release No. 34-94313; File No. S7-08-22), Feb. 25, 2022 (“Proposed Rule”) at 7–8.  

[2] See Chair Gary Gensler, Statement on Rules to Increase Transparency of Short Sale Activity, Feb. 25, 2022 (“Statement of Chair Gensler”). 

[3] On the same day it announced its proposed Rule 13f-2, the SEC also proposed amendments to the Consolidated Audit Trail and to Regulation SHO.  Id.  These proposals are beyond the scope of this post. 

[4] Proposed Rule at 107.

[5] Zlotnick v. Tie Commc’ns, 836 F.2d 818, 820 (3rd Cir. 1988). 

[6] Id. 

[7] Id. 

[8] Sullivan & Long v. Scattered Corp., 47 F.3d 857, 858 (7th Cir. 1995) (Posner, C.J.). 

[9] Proposed Rule at 13. 

[10] Id. at 18.

[11] Id. at 27–32; see also id. at 216–217 (sample of Proposed Form SHO). 

[12] Id. at 18–19.  The SEC hopes to publish this information by the end of the month following a reporting month, such that forms filed for March will feed into reports published by the end of April.  Id.

[13] Supra, Statement of Chair Gensler.

[14] Proposed Rule at 1.

[15] Id. at 8.

[16] Id. at 11, 13.  

[17] Id. at 148. 

[18] Id. at 10 (“[R]equiring disclosure of short positions could facilitate copycat trading that, in turn, could limit the profit an investor may earn using strategies developed in connection with its marketplace information gathering efforts.”).  

[19] See id. at 140.

[20] Id. at 140–41.  In extreme situations, short sellers might face even more threatening forms of retaliation for their positions.  According to the SEC, the CEO of Melvin Capital LP—the investment fund targeted for its short position in GameStop in 2021—received threats of physical harm once his short positions became publicly known.  Id. at 141 n.279. 

[21] Id. at 1.