Thank you for the opportunity to testify today.

Manipulative short selling has a long, colorful and disreputable history, going back at least to the seventeenth century, and has been a perennial problem in publicly traded financial markets. Manipulation on the London Stock Exchange caused the British Parliament to go to the extreme of outlawing short selling from 1734 to 1860. "Bear pools" were a notorious feature of the New York Stock Exchange in the 1920s.

Fifteen years ago, in 1991, the House Committee on Government Operations submitted a report which stated that its Subcommittee on Commerce, Consumer and Monetary Affairs had inquired of the SEC in an "attempt to verify company complaints that the SEC often assisted short sellers by investigating companies that the short sellers had identified as targets." The report notes further: "The SEC responded that they did not have the necessary information in their possession to respond to this inquiry."

The disclosures I recommend would give the SEC the necessary information to address this question.

As everyone who is involved in this discussion is quick to say, there is no objection to (and much to be said for) legitimate short selling based on an investment view of asset prices, including, of course, the securities of a specific company. The issue is manipulative short selling. This reflects the unfortunate fact that some market actors succumb to the temptation to make profits on short positions come true, by themselves causing a drop in specific stock prices.

Spreading negative rumors is a centuries-old element of such efforts. The patterns are alleged to include coordinating short sales with lawsuits against the target companies. They certainly do include, as inquired about in the 1991 House report, trying to induce the SEC to initiate investigations, a sure fire way to knock down the price of a stock. It is remarkable that the financial interests involved in such activities currently do not need to be disclosed.

Financial markets with today’s technology reflect an intense network of virtually instantaneous communication. In the midst of this network, the SEC cannot regulate capital markets from an Olympian height. It is itself immersed in the markets as a very powerful source of market-moving events. This effect has been magnified by the post-Enron or Sarbanes-Oxley era. Unavoidably, some market actors draw this conclusion: If I can move the SEC, I can move the market to my personal profit.

In other words, these market actors have unfortunately observed the force of the following logic:

1. Disclosure of an SEC investigation of a company can reliably be expected to depress the price of the company’s stock.
2. If I am short the stock, this is a very profitable event for me.
3. Therefore, if I can induce the SEC to begin an investigation, I will almost certainly make a lot of money.

How should the SEC deal with the fact that other people wish to use it to change the price of certain stocks? And with the fact that since these people have very large financial interests at stake and rightly appreciate the market-moving power of SEC investigations, they will work tirelessly to achieve this?

A Manipulative Short Selling Scenario

With these questions in mind, consider the following scenario.

While establishing a large short position in the stock of a target company, a manipulative group or its representative urges claims of accounting or financial deficiencies as "tips" to the SEC. Let us stipulate that these claims are spurious. Whether or not the claims are spurious, however, the fact that the group is pushing them on the SEC and knowledge of how the SEC staff is reacting constitutes key non-public information, highly relevant to the price of the stock in question.

In our scenario the claims are spurious, so when the SEC staff asks the company about the question, it receives a reasonable explanation. That should close the matter, since there is no real problem. But the group tirelessly continues to press its claims with strident rhetoric and urge an SEC investigation.

Now consider the position of the SEC staff in the post-Enron era. They are well aware that such claims often reflect the financial self-interest of those making them and their intense desire to cause adverse movement in market prices. This is the so-called "short and distort" strategy. But in the post-Enron era, the political and public relations penalty for the SEC staff of missing any problem is great, however low they may view its probability. However, there is no political or public relations penalty on the SEC for imposing great costs and market losses on the shareholders of the target company. None. In this environment, the SEC staff cannot afford to take the personal and bureaucratic risk of not commencing an investigation.

An SEC investigation is therefore begun, and in compliance with the SEC’s own disclosure requirements, is publicly announced by the company. As the manipulative group planned all along, the price of the company’s stock drops. This means that the group has itself caused the realization of handsome profits on its short position by using the SEC’s regulatory structure to manipulate the stock market. The strategy has successfully developed from "short and distort" to "short, distort, and get the SEC to support" the attack.

The public rationale leading to this scenario is the watchword of the Sarbanes-Oxley requirements: disclosure. But the most essential elements underlying this situation--the financial interest of the investor group and its activity with the SEC--are not required to be disclosed at all! Even though the group benefits by causing fear of an SEC investigation among stockholders of the target company, and thereby transfers wealth from them to itself, that critical fact never has to be revealed so the market can weigh its claims accordingly.

A scenario like this is certainly not what the authors of the Sarbanes-Oxley Act had in mind and obviously should not be permitted in well-designed capital markets. Everyone should be able to agree on this point.

However, situations like this are in fact one source of the informal investigations the SEC has in process, at great cost to everyone concerned. Especially great administrative and market costs are imposed on the shareholders of the target companies who are supposedly being "protected," while profits are created for the group with the undisclosed short interests.

A related scenario has become well-publicized through the allegations in the lawsuits brought by Biovail Corp. and Overstock.com Inc. These suits assert that short-selling hedge funds, having conspired with an investment research firm to produce misleading negative research reports, had non-public information of the content and timing of their release. They could then time their market moves to benefit from the market price reaction.

It is well known that short sellers routinely and aggressively push views favorable to their investment positions on journalists, analysts and regulators. "We have had hedge funds twist our arms to write reports in a certain way," said one analyst. But if this morphs into the use of privileged, non-disclosed, market price-moving information, it is a different matter.

As another related example, consider using private knowledge that there will be a lawsuit filed, as discussed in papers published by the Washington Legal Foundation. Use of the non-public information that there is an imminent lawsuit, especially when the short-selling group is itself initiating or arranging the suit to cause the resulting price movement from which it will profit, is self-evidently manipulation. "The failure of the short-seller to disclose the impending suit," Professor Moin Yahya writes, "...is arguably a material omission and constitutes fraud.... No rational investor would ever consent to purchasing stock from someone who was about to sue the company."

Let us return to the scenario of the group selling you stock while doing its utmost in private to cause the SEC to commence an investigation of the company. No rational investor would ever consent to purchase stock from a seller working hard to use the SEC to knock down the price of the stock.

The Answer: Disclosure

The principle of disclosure provides a straightforward way to help address this problem: Require that any party bringing claims of accounting or financial irregularities to the SEC publicly disclose all the short or long financial interests it has or represents in the company involved, and whether it is acting as part of a group. A simple SEC questionnaire could provide this disclosure. Appropriate penalties for failure to disclose would automatically be covered by existing sanctions for making false statements.

Disclosure should be a continuing requirement for all interests acquired or disposed of while any contacts between the group and the SEC continue and/or during the life of the SEC’s inquiry or investigation of the issues raised. This is because ongoing communication with the SEC can allow the group to have trading advantages based on its private knowledge of how the SEC staff is responding and what they are likely to do.

Such a disclosure requirement would reveal how much profit the group has realized while involving the SEC to move market prices. The SEC could then measure this effect.

Any profits derived by effective insider information of coming SEC investigations or actions, should be treated exactly as other profits from trading on insider information.

The good news is that this problem can be addressed with a simple and obviously appropriate requirement. This could be enacted as legislation, adopted as policy by the SEC, or implemented as a required procedure by the SEC staff. I believe that at least one of the three needs to be energetically put in place, as promptly as possible.

Parallel Disclosures of Large Short and Long Positions

While we are about improving disclosures for the benefit of the entire market, the disclosure of large, concentrated short positions should be required in exactly parallel fashion to the existing required disclosures of long positions. The importance, simplicity and fairness of this idea seems obvious to me.

To be specific, Sections 13 (f) and 13 (d) of the Securities Exchange Act of 1934 should be amended to require publicly filed reports of any short positions equivalent in value to the long positions already covered by these statutory provisions, including their coverage of group actions. Disclosure of such short positions will be at least as useful to investors and market participants generally as are the existing disclosures of long positions.

I believe this is a straightforward and essential reform to improve the fairness and transparency of our capital markets.