Punishing Short-Sellers

If you're a CEO and you're upset that your stock is going down, never, ever, blame short sellers for your woes. No one will sympathise, and the financial press will have a field day tearing you apart. (See, as a prime example, Overstock CEO Patrick Byrne.)

Generally, short-sellers are an important part of any efficient market, and regulators should embrace them rather than punishing them. So what is the SEC doing fining UK hedge fund GLG Partners $3.2 million over illegal short-selling? (Reader Matthew Tubin sent me the link and asked what the difference is between legal and illegal short-selling.)

The SEC has a huge set of rules regulating short-selling. It's called Regulation SHO, and you're more than welcome to read all 30,000 words of it here. Most short selling is allowed, but some short-selling is not allowed, and if you're an active trader in the markets it definitely behooves you to know the difference. In the specific case of Rule 105, which GLG is accused of violating, you can't short a stock into a public offering, and then cover your short with shares you receive in that offering.

Can you short a stock into an offering, buy stock in the offering, and then unwind both positions in the market at the market price? I have no idea: you'd have to ask a lawyer about that one. But what does seem clear is that participants in the market need to have a very detailed knowledge of the arcana of Regulation SHO: I do believe GLG when it says that "it did not understand the rule".

In general, time and money spent worrying about compliance is wasted time and money: it's an inefficiency in the market. And rules against short selling in general don't seem to really help market efficiency and transparency very much – if anything, quite the opposite. So while I have little sympathy for GLG – they're certainly big enough to know what they're doing – I also wonder whether this kind of fine serves any useful purpose.