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Reg. SHO and Biotech


Sometimes people don't let facts get in the way of trades

On January 3rd the new SEC Regulation SHO went into effect. On Friday evening, the NASDAQ exchange posted a list of threshold securities. Unless you've been following the Reg. SHO story, this may not mean a lot to you so we'll recap.

A short sale starts a process some of you may not be familiar with. To short a security, someone must first loan you the stock so you can make the sale. In order to make it easy for short sellers, traditional rules allow a market maker or broker to simply create a share to sell out of thin air under the assumption they will be able to secure a loan of a real share later. In certain heavily shorted stocks, however, the broker or market maker are not able to find a share to borrow in a timely fashion.

Previous SEC rules generally required borrowable shares to be found within 3 days of the short sale. If no shares were to be found, the short sale should be unwound. While this was the rule, few bothered to follow it. In response to complaints from companies, individual investors, and as a result of the SEC's ongoing "research" into the hedge fund industry, the SEC came up with Reg. SHO.

If more than 10,000 shares and at least 0.5% of an outstanding short position in a company has not yet been legitimately borrowed and this condition has been in place for five consecutive trading days, the stock goes on a "Threshold List." If a stock is on Threshold List criteria for thirteen consecutive trading days, then the SEC steps in. The offending market maker who handled the transaction is required to call in the short sale immediately (this creates buying pressure in the stock). In addition, that market maker cannot facilitate a short sale in that security for a period of time unless they first find shares (remember, normal procedure is short first, find shares later). The broker who handled the trade (if any) is subject to the same penalty.

The urban legend is that if a stock appears on the various Threshold Lists, it will rise dramatically because of a "short squeeze." More specifically, the legend states Monday will see huge gains in the stocks listed on NASDAQ's Threshold List due to short covering. While this legend may have enough momentum to actually cause this effect, it won't be due to the SEC stepping in. Remember, the stocks must be on the Threshold List criteria for thirteen consecutive days before action is taken. This means the first mandatory close-outs won't happen until January 28th according to SEC guidance.

While Reg. SHO sounds good, this rule is essentially useless for combating short sale abuses. There are enough exceptions to drive a truck through and the 13-day requirement is excessively long. A stock could conceivably be on the list all month except for one day and nothing will be done about it. It is useful in illuminating existing abuses, so at least some good will come of it.

For those clinging to the urban legend, we thought we'd share the stocks appearing on the published NASDAQ Threshold List that are also in the NASDAQ Biotech Index.

APPX-American Pharma Partners
INGN-Introgen Therapeutics
NFLD-Northfield Labs

Even if the urban legend gets some legs, the effect on biotech is unlikely to be significant because of the small number of biotech stocks on the list. APPX's appearance on the list will certainly cause some interest given the late Friday announcement of approval for Abraxane.

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No positions in stocks mentioned.

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