Why is Short Selling Legal? A Brief History

Why Is Short Selling Legal?

Short selling is an investment strategy that speculates on the decline in a stock or other securities price. The practice of short selling was one of the central issues studied by Congress before enacting the Securities and Exchange Act in 1934, but Congress made no judgments about its permissibility.

Instead, Congress gave the Securities and Exchange Commission (SEC) broad authority to regulate short sales to prevent abusive practices.

Understanding Why Short Selling Is Legal

During times of market crisis, when stock prices are falling rapidly, regulators have stepped in to either limit or prohibit the use of short selling temporarily until order is restored. 

Restricted securities are those identified by regulators who believe that they may be prone to modern-day bear raids; however, the effectiveness of these measures is an open question among market participants and regulators.

Short Selling Becomes Legitimate

The SEC adopted Rule 10a-1 in 1937, also known as the uptick rule, which stated market participants could legally sell short shares of stock only if it occurred on a price uptick from the previous sale.

Short sales on downticks (with some narrow exceptions) were forbidden. This rule prevented short selling at successively lower prices, a strategy intended to drive a stock price down artificially. The uptick rule allowed unrestricted short selling when the market was moving up, increasing liquidity, and acting as a check on upside price swings.

Despite its new legal status and the apparent benefits of short selling, many policymakers, regulators—and the public—remained suspicious of the practice. Being able to profit from the losses of others in a bear market just seemed unfair and unethical to many people.

As a result, in 1963, Congress ordered the SEC to examine the effect of short selling on subsequent price trends. The study showed that the ratio of short sales to total stock market volume increased in a declining market.

Then, in 1976, a public investigation into short selling was initiated, testing what would happen if rule 10a-1 were revised or eliminated. Stock exchanges and market advocates objected to these proposed changes, and the SEC withdrew its proposals in 1980, leaving the uptick rule in place.

The SEC eventually eliminated the uptick rule in 2007, following a yearslong study that concluded that the regulation did little to curb abusive behavior and had the potential to limit market liquidity.

Many other academic studies of the effectiveness of short-selling bans also determined that banning the practice did not moderate market dynamics. Following the stock market decline and recession of 2008, many called for a greater restriction on short selling, including reinstating the uptick rule.

The “Naked” Short Sale

Though the SEC granted short selling legal status in the 20th century and extended its franchise in the early 21st century, some short-selling practices remain legally questionable.

For example, in a naked short sale, the seller must “locate” shares to sell to avoid “selling shares that have not been affirmatively determined to exist.” In the United States, broker-dealers are required to have reasonable grounds to believe that shares can be borrowed so they can be delivered on time before allowing such a short sale.

Executing a naked short runs the risk that they will not be able to deliver those shares to whomever the receiving party in the short sale. Another prohibited activity is to sell short and then fail to deliver shares at the time of settlement with the intent of driving down an asset’s price.