Short-selling and the uptick rule

The SEC has been holding hearings about reinstating the “uptick rule” for short-selling in the US market, and has come up with a new rule.  The rule-making comes as a reaction to assertions that the Wall Street decline in late 2008 was made worse by speculative short sellers taking advantage of the removal of the uptick rule in 2007.  What are the issues?


A short seller borrows stock from an owner, promising to return it on demand, and  promptly sells it.  The debt to the owner is expressed, not in dollars, but in a specific number of shares of a certain stock.  So at some point, the short seller must buy the stock back in the market and return it.  This can happen because the short seller decides his investment idea has outlived its usefulness, or because the original owner “calls” the stock back to him.

why sell short?

The short seller may think the stock in question will go down, so that he can make money by buying it back at a lower price and then returning it to the original owner.

Or he may have a hedging strategy in mind (this was the original “hedge fund” idea).  If so, he will reinvest the sale proceeds in something else he thinks will do better than the stock he sold short.  He might, for example, short Toyota and go long (i.e., buy) Ford.  In this case, he will make money if Ford goes up more, or down less, than Toyota.  He doesn’t need the stock he’s betting against to be an absolute loser, just a relative one.

Short selling is highly institutionalized on Wall Street.  Many financial firms and most large institutional investors have stock lending departments, which deal with each other to facilitate short selling by locating and arranging for stock to be borrowed and arranging for collateral to be provided.  (As a portfolio manager, I understood why my firm would do stock lending.  It didn’t thrill me, though.  It always irked me on those occasions when, despite their promises to the contrary, the borrower refused to return a stock I wanted to sell.)

Then, of course, there was the incredible disaster at AIG–and apparently other middlemen as well–where that company took the collateral it was holding, typically Treasury bonds, sold it and replaced it with sub-prime mortgage securities so it could earn higher interest income.  After sub-prime mortgage securities tanked, short sellers couldn’t close out their positions because AIG couldn’t give them back their collateral.  AIG needed another $40 billion+ from the government to clean up this mess.  But that’s another story.

the uptick rule

The uptick rule was instituted for exchange-traded stocks by the SEC in 1938, in response to a market swoon in 1937.  The SEC believed the market’s fall was caused, or at least made considerably worse, by rampant speculative short selling.  In response to brokerage industry lobbying, the rule was rescinded in July 2007–just at the beginning of a sharp market contraction made considerably worse, in the view of many, by rampant speculative short selling.

The rule was that you could only sell a stock short on an uptick.  That is to say, you could only sell a stock short either:

–at a price higher than the immediately previous trade, or

–at the same price as the previous trade, if the last price that was different from the previous trade was a lower price.

Put in less precise terms, the rule says that if a stock is declining you can’t hold it down or push the price even lower  by selling it short.  You can only sell short into a rebound (and thereby prevent that rebound from advancing), but if the stock turns lower again, you have to stop selling it short.

Remember, none of this prevents a “natural” seller (someone who owns the stock) from selling.  The uptick rule only applies to short sellers.

the new rule

The SEC has just instituted a new, limited anti-short selling rule.  It applies only to stocks which have fallen by 10% in price during a trading day, and applies only to the remainder of that trading day and the following trading day.

During that time, a stock may only be sold short if the sale price is higher than the highest bid price maintained by any market maker in the stock.  In other words, the short sale trade has to establish an uptick.

The main untested feature of the new rule is that it only kicks in after a stock has fallen by 10%  Before that, it’s a free-for-all.  It may well happen that market makers decide to move the market in a stock that’s being sold short down as fast as possible to the 10% mark, where they receive temporary protection against short sellers.  In my experience, that’s what happens in foreign markets when market makers encounter any sort of concerted selling.

“naked” shorts are much more important, I think

I don’t find anything particularly wrong with short selling–I should mention, though, that I worked on, and later ran, a (very successful) short portfolio in the early Eighties.  I’m also not sure that the uptick rule is a significant issue.

If anything, there may be unintended negative consequences.  My experience outside the US with markets that put arbitrary, or commodity market-like, restrictions on selling is that they end up with declines that are longer in time and deeper in extent than similar markets that don’t have such restrictions.

I think that colorfully named “naked” shorts are a much more significant concern.  More on that topic in my next post.

Transfer pricing–what you need to know about it

What it is

In all but the simplest companies, it often happens that one unit of the firm provides a good or service to another unit, which uses it in a product it sells to the outside world.  In some cases, unit #1 has no customer other than unit #2; likewise, unite #2 may have no other source than the internal one, unit #1.

For management control purposes–figuring out whether the units are earning money or doing a good job in other ways, as well as for other reasons I’ll write about below, companies want to decide a notional price at which unit #1 “sells” its output to unit #1.  That selling price is called the transfer price. The process of figuring out what the price is is transfer pricing.

Three ways companies use transfer pricing–

Management control:

There are lots of ways of figuring out the transfer price, all with their plusses and minuses.

The process can be complicated.  Unit #1, for example, may have external customers as well as internal ones.  Unit #2 may have external sources of supply in addition to the internal one.  However, internal and external customers may have somewhat different requirements, so products available on the open market may not be strictly comparable to the internally produced ones.  So market price may be hard to use.  The competitive situation within an industry may also argue against selling to or buying from certain external parties.  In addition, cost-plus, another common method, may just institutionalize inefficiency.

The process can also be intensely office-political.  This stands to reason, since a dollar of notional profit that goes into the bonus pool of unit #1 is a dollar that stays out of the bonus pool of unit #2, and vice versa.  In well-managed companies, everyone is slightly unhappy and things work out for the best.  In poorly-run firms, internal pricing may reflect the delusions of the chairman or testifies to the infighting skills of the most “profitable” units–an creates horrible distortions that end in ruin.

Tax planning:

Except for the smallest and simplest companies, there’s no reason that different units in the firm have to be in the same tax jurisdiction.  In fact, there may be very good reasons to have them located in different states or different countries.

When I began investing in the Japanese stock market, I soon came across lists of the financial results of foreign brokers located in Tokyo.  Virtually every one was making huge losses.  As I asked around to try to figure out why this should be, I found out that many trading transactions were legally structured to occur in Hong Kong instead of Japan.  Why?  The total tax on profits for a transaction done in Tokyo would be over 50%.  In Hong Kong, the tax would be zero. So Tokyo had the costs of maintaining research, sales, a trading desk and investment banking–and the trades were farmed out to Hong Kong.

At one time, many computer manufacturing operations were set up in Ireland, which offered tax incentives, had a low income tax rate and was inside the EU.  Let’s say you make a PC in Ireland and ship it to the UK (a high tax-rate regime) for sale to a consumer electronics store.  Should you set the transfer price from manufacturing subsidiary to distribution subsidiary high or low?  Obviously, high–unless you had tax loss carryforwards in the UK that you wanted to use up.

You can see the effects of this sort of activity in the low tax rate reported by publicly traded companies with extensive foreign operations.

Twenty years or more ago, investors didn’t like low tax rates.  Theorizing that the phenomenon was only temporary, the custom in the UK was for analysts in their reports to explicitly correct or “normalize” the tax rate to whatever the (higher) norm was for a purely domestic company.  In the US, investors mostly made a mental adjustment and paid a correspondingly low p/e for the stocks of low tax-rate companies.

Today as far as I can see, no one makes this distinction.

There is one hitch to the low tax rate strategy.  For the US, and also typically elsewhere, if the profits held in a low tax-rate regime are repatriated to the home country, they are subject to tax at the full home-country corporate rate.  And unless repatriated, the funds can’t be used to pay dividends.

Foreign exchange controls:

Some countries, developing nations in particular, may regard their holdings of hard foreign currency as a scarce national resource.  So they restrict companies’ ability to convert local currency profits into foreign currency and send them out of the country.

The most straightforward of the ways creative companies try to get around such policies is through transfer pricing.  A foreign company with a subsidiary in a developing economy will typically act as the sole agent for purchases of foreign materials and equipment for its sub, as well as being the distributor of its finished goods abroad.  The parent can aggressively mark up the foreign currency price of the materials supplied to the domestic company.  And the local sub will sell finished goods at very low prices to the parent, so that the lion’s share of profits will be realized in hard currency and outside the developing nation.

gray market trading

Gray market trading (or grey market, in some parts of the world) is unofficial, off-market trading in a security.  It typically occurs with equities either when official trading in the security has been suspended, or, in the case of new securities, during the period between the holder obtaining the right to the security and the time when official trading begins.

The latter case occurs frequently outside the US, where it is customary in many countries that IPOs or shares created through a rights issue do not trade for several days after they are paid for.  An analogue in the US would be “when issued” trading of a new stock created out of an already-existing parent and spun off in the form of a dividend.  In such a case the first day of trading may be a week or so after holders of the parent company stock qualify for the dividend.  The recent spinoff of AOL is an example.

The most important characteristic of gray market trading is that the official means of recording and settling a trade are not available.  In the strictest sense, the transaction cannot be completed until the official books are open, or reopened in the case of a stock suspension.  So although a broker has put together a buyer and seller who have agreed on a price, the arrangement is subject to all parties honoring their word.  Although in practice it’s unlikely, in theory it’s possible that a sharp price movement after that trade has been arranged will cause one party to “break” the trade.  In such a case, there is no practical recourse for the other party.

Because of the portfolio pricing complications that would arise from a broken gray market trade, portfolios that have daily inflows and outflows, like mutual funds, may hesitate to participate in the gray market.