Corporate Governance

The SEC, the APA and Naked Short Selling: A Continued Failure to Follow Legal Requirements

By J. Robert Brown

The SEC recently promulgated Rule 10b-21, Exchange Act Release No. 58774 (Oct. 14, 2008), an antifraud rule designed to prevent abusive naked short selling.  Specifically, the Rule makes it a violation for a short seller to deceive a broker about the ability to deliver the shares needed to cover the short position.  If the provision sounds familiar, it is because the Commission had already put the requirement in place pursuant to its emergency authority under Section 12(k)(2) of the Exchange Act.  See Exchange Act Release No. 58572 (Sept. 17, 2008). 

In promulgating the rule, the Commission made it effective immediately.  This almost certainly violates the Administrative Procedures Act or, at least, the spirit behind the Act.  Section 553 (5 USC 553) required that final rules be published "not less than 30 days before its effective date."  There is, however, a "good cause" exception to the requirement.  Specifically, the provision provides that the effective date provision does not apply "as otherwise provided by the agency for good cause found and published with the rule."  In general, the good cause requirement for the effective day period requires a balancing of the government interest involved against the need to prepare for implementation.  For a case examining these requirements, see Riverbend Farms, Inc. v. Madigan, 958 F.2d 1479 (9th Cir. 1992).   Courts have generally construed the good cause requirement narrowly construed.  See Tennessee Gas Pipeline Co. v. FERC, 969 F.2d 1141 (DC Cir. 1992)("Despite the broad nature of this language, our cases make clear that the good cause exception is to be 'narrowly construed and only reluctantly countenanced."). 

In making the rule effective immediately, the release invoked good cause.  The adopting release contained, as it must, the justification used to invoke good cause.

• The Administrative Procedure Act also generally requires that an agency publish an adopted rule in the Federal Register 30 days before it becomes effective.  This requirement,  however, does not apply if the agency finds good cause for making the rule effective sooner. The Commission has determined that the rule should be effective in fewer than 30 days because it addresses illegal conduct that can cause market disruption. In addition, because the rule further evidences conduct that is manipulative and deceptive under existing general antifraud rules, market participants should not need time to adjust systems or procedures to comply with the rule. Therefore, the Commission finds good cause to make the rule effective on October 17, 2008.

In short, there is no explanation other than a generic concern that "illegal conduct that can cause market disruption."   In the field of securities regulation, it is hard to imagine illegal conduct that wouldn't potentially have that affect.  Moreover, in proposing Rule 10b-21 back in March, Exchange Act Release No. 57511 (March 17, 2008), the Commission described the provision as a "narrowly-tailored rule."  In other words, the proposal was narrow and there did not seem to be any rush in implementation. 

While the turmoil in the markets represent an intervening factor, there is no evidence that the turmoil arose out of "abusive naked short selling" and certainly there is no evidence of this provided in the adopting release.  In a section of the release unrelated to the good cause exception, the Commission noted the following:

• We issued the July Emergency Order because we were concerned that false rumors spread by short sellers regarding financial institutions of significance in the U.S. could continue to threaten significant market disruption. As we noted in the July Emergency Order, false rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by “naked” short selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process.

In other words, the turmoil may have been exacerbated by false rumors, which may have led to panic selling.  The panic selling "may" have been exacerbated by naked short selling.  In addition to the series of unsupported suppositions, the Commission did not ever say that the panic may have been exacerbated by "abusive" naked short selling. 

There is little concern over the merits of Rule 10b-21.  The Rule doesn't restrict short sales but requires a certain degree of honesty when they occur.  The provisions are probably already covered by Rule 10b-5.  The objection is over the decision to sidestep the requirements of the Administrative Procedures Act by making a rule effective immediately without having provided an adequate justification.  In fact, had the Commission waited 30 days and met the requirements of the Rule, there would likely have been little or no impact on the markets.

It's a relatively safe violation of the APA.  Subsequent defendants can challenge an action brought by the Commission under the Rule by asserting that it was invalid for violating the requirements of the APA.  But a court is unlikely to strike down a rule just because the Agency declined to wait the requisite 30 days to make it effective.  Moreover, because the Rule was issued at an earlier date through the Agency's emergency authority, defendants will have a hard time arguing that they were unable to adequately prepare for the requirements of the Rule once it was made effective immediately.

The fact that there will likely be no recourse in some ways makes the violation worse.  But this begs the question.  Why did the Agency sidestep the requirements of the APA?  The Commission is still struggling both to overcome bad publicity in connection with its oversight of investment banking firms and to remain relavent in the current turmoil.  Making the Rule effective immediately makes the Commission seem like its involved.  But whatever message the Agency wants to send to the market, it is not an excuse for violating the requirements of the APA.   

Full post as published by The Race to the Bottom on October 22, 2008 (boomark / email).