Davis Polk & Wardwell Newsflash

SEC Issues Emergency Order Restricting the “Naked” Short Selling of Fannie Mae, Freddie Mac and Certain Other Substantial Financial Firms

July 17, 2008

On July 15, 2008, the SEC issued an emergency order (the “Order”), pursuant to Section 12(k)(2) of the Securities and Exchange Act of 1934, imposing restrictions on effecting “naked” short sales in the securities of 19 substantial financial firms.[1]   The Order prohibits any person from effecting a short sale[2] in a publicly traded security of any of the 19 firms, unless such person or its agent has borrowed or arranged to borrow the security or otherwise has the security available to borrow in its inventory prior to effecting such short sale and delivers the security on settlement date.[3]  The Order will take effect at 12:01 a.m. EDT on Monday, July 21, 2008, and will terminate at 11:59 p.m. EDT on Tuesday, July 29, 2008, unless extended by the SEC.

The Order differs from the current Regulation SHO “locate” requirement in a number of respects.  For example, it does not allow a broker-dealer to effect a short sale for a customer based upon having “reasonable grounds” to believe that the security can be borrowed (such as by consulting an “easy to borrow list”).  It also does not recognize the existing exemptions under Regulation SHO for equity and options market makers, although various exchanges and others have been requesting the SEC to provide some form of relief.  It is likely that the Order will result in slower processing and execution of short sale orders in the affected securities in many instances. 

The SEC has indicated an intention to propose rulemaking to address issues of naked short selling across the entire market. 

If you have any questions regarding this newsflash, please call your Davis Polk & Wardwell contact.

Davis Polk & Wardwell

1. The Order and the list of securities to which it applies may be found at: http://sec.gov/rules/other/2008/34-58166.pdf. The 19 entities included on the list and their ticker symbols are: BNP Paribas Securities Corp. (BNPQF or BNPQY), Bank of America Corporation (BAC), Barclays PLC (BCS), Citigroup Inc. (C), Credit Suisse Group (CS), Daiwa Securities Group Inc. (DSECY), Deutsche Bank Group AG (DB), Allianz SE (AZ), Goldman, Sachs Group Inc (GS), Royal Bank ADS (RBS), HSBC Holdings PLC ADS (HBC and HSI), J. P. Morgan Chase & Co. (JPM), Lehman Brothers Holdings Inc. (LEH), Merrill Lynch & Co., Inc. (MER), Mizuho Financial Group, Inc. (MFG), Morgan Stanley (MS), UBS AG (UBS), Freddie Mac (FRE) and Fannie Mae (FNM).

2. The Order provides that the definition of “short sale” shall be the same definition used in Rule 200(a) of Regulation SHO and the requirements for marking orders “long” or “short” shall be the same as provided in Regulation SHO.

3. The Order applies to short sales to be effected as a result of a put options exercise and to short sales used to hedge.