Regulatory Reform, the SEC, and the Violation of the Administrative Procedures Act

In an effort to get in the game, the SEC announced new rules (effective on Thursday) designed to restrict naked short selling. According to the SEC press release, the rules would requre:

• that short sellers and their broker-dealers deliver securities by the close of business on the settlement date (three days after the sale transaction date, or T+3) and imposing penalties for failure to do so.

In the case of violations, the new rules provide that:

• any broker-dealer acting on the short seller’s behalf will be prohibited from further short sales in the same security unless the shares are not only located but also pre-borrowed. The prohibition on the broker-dealer’s activity applies not only to short sales for the particular naked short seller, but to all short sales for any customer.

In addition, the agency adopted Rule 10b-21 that would short sellers falsely representing that they have borrowed the shares required to be delivered at settlement.

The Commission noted that the rules, although effective immediately, would be subject to a 30 day comment period and, obliquely that the agency "expects to follow further rulemaking procedures at the expiration of the comment period."

Now, there may be a sense of panic at the SEC over the need to get involved, but panic is not one of the justifications for avoiding the requirements of the Administrative Procedures Act with respect to the adoption of new rules. Section 553 of the APA requires agencies to propose rules, provide an opportunity for comment, and wait at least 30 days before they become effective. The provision has a "good cause" exception from these requirements. Good cause requires a showing that notice and comment was "impracticable, unnecessary, or contrary to the public interest." The SEC must invoke good cause in the adopting release.

The implementation of these rules reflects panic at the SEC, but are they so immediately necessary that they must be implemented without notice and comment? The agency allowed the earlier emergency rules to expire (the rules that regulated short selling in the stocks of 19 financial companies) without the apparent need to adopt interim rules. In other words, only a week ago, there appeared be no reason why the rules needed to be rushed. While there is no doubt that the turmoil in the markets has increased, the case has not been made that the turmoil resulted from short selling. In other words, the existence of turmoil cannot be used as an excuse to adopt a rule that will likely have little affect on the current crisis.

Finally, notice and comment is not a mere formality. It is necessary to make sure, in particular, that those who are affected by the rules can weigh in and suggest changes or alternatives. By simply imposing, the SEC has not obtained the necessary feedback that might have enabled it to take a more nuanced approach.