Not-So-Free Market: Group of Large Hedge Funds Expected to Sue FSA Over Short-Selling Ban

Thanks to Bryan Carter and the Tuscan Group for passing along this article on the litigation expected to arise from the U.K. regulator’s decision to ban short-selling for financial company stocks.

On September 18, England’s Financial Services Authority (FSA) announced that it would impose a temporary ban on the short-selling of shares in all financial companies, a drastic maneuver that wreaked havoc on hedge funds and other investment groups that rely on the mechanism to balance, or “hedge,” their investments. The SEC, after claiming that it would not follow suit, enacted a similar ban the following day on hundreds of stocks, only some of them primarily financial companies.

Short-selling is ostensibly a bet that a company’s stock will decline, effectuated by borrowing the stock and selling it at the current price, and then repaying or “covering” the debt by buying back the stock at a later date (and presumably a lower price). Short-selling is not illegal, though it is illegal to spread false rumors to engender the decline in a stock price. Yet, the practice has been blamed for the recent downward spiral of many banking institutions (rather than their years of unchecked lending to people who could not afford mortgages, of course).

Short-selling is not used solely to bet against stocks, however, and is often used by funds for a variety of risk-management strategies. These funds were forced to immediately cover their positions upon the news of the ban. As expected, this, along with the Treasury and Fed’s contemporaneous announcement of a bailout plan, drove up the prices of many of these stocks, and regulators were able to extol the market’s glowing response to their plan.

But, what happened to the idea of a free market, where investors’ perceptions of the stock are allowed to determine its actual value? If investors are restricted from betting against stocks, this uptick in value is artificial and essentially illusory. This will undermine both confidence and liquidity (thereby increasing volatility) in the markets and many investors will move their money out of the U.S. and U.K. markets and into more predictable markets. It has already resulted in a “bloodbath” on Wall St. for many investors and funds who thought they knew the rules to the game, and protests came immediately from many market players.

The powerful backlash from this ban has already prompted the SEC to back off of its initially inflexible position and ease short-selling restrictions on “market makers,” while at the same time adding additional companies to the banned list that seem tenuously related (if at all) to banking (like IBM, see here). It will be interesting to see whether this backlash and resulting retreat will obviate the need for litigation, or whether funds will press ahead, both in the U.K. and the U.S., to recover their losses or object to the unprecedented restrictions that have suddenly been placed on their freedom of trade. We will monitor these developments closely.

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