The Rule of Law

La connaissance est inutile sans la sagesse et la compréhension.

Recently, I wrote an article about Atlantic Power (AT) and the events surrounding the cut in its dividend and the subsequent (and significant) drop in its stock price. The feedback I received on the article was a mix of:

  • Go get ’em!
  • You should have known better!
  • If you sue the company you will ruin all chances of investors eventually recouping their losses.
  • Filing a complaint with the SEC would be a much better option than filing a suit against the company.

We, as Americans, are very fortunate to live in a country that, for the most part, operates under the Rule of Law. Sadly, however, the past couple of decades have left many wondering if the laws of the land still serve to protect the common person. Since 2007 we have been living with the worst economic crisis since The Great Depression — and, in many ways, it has been worst than The Great Depression. In my own, humble opinion it is a problem that could have been mitigated, if not totally prevented, by simply enforcing laws and policies that were already on the books. In fact (once again, in my humble opinion) one of the events that helped to trigger the 2007-2008 financial crisis was the repeal of the Uptick Rule.

In 1938 (as a result of the stock market crash of 1929, which marked the beginning of The Great Depression) the Securities and Exchange Commission (SEC) enacted the Uptick Rule, which was designed to prevent a similar crash from occurring in the future. The thinking, at the time, was that if regulators could slow the velocity of a decline that was brought-on by fear it would give investors time to think and, ultimately,  allow clearer heads to prevail; and, for all intents and purposes, it worked.

The rule remained in effect until 2007 when the SEC formally eliminated it. Prior to its elimination, the SEC initiated a year long pilot program that was designed to study the effects of the rule on modern-day markets. It had been argued that the rule was outdated and that it was no longer effective. Worst yet,  the rule was deemed to negatively affect liquidity; something which should have been painfully obvious, given that liquidity would be significantly reduced if investors did not feel the overwhelming need to sell their shares during a panic. Nonetheless, the SEC took the bait and launched the pilot.

“In 2004, the Commission initiated a year-long pilot that eliminated short sale price test restrictions from approximately one-third of the largest stocks. The purpose of the pilot was to study how the removal of such short sale price test restrictions impacted the market for those subject securities.

Short sale data was made publicly available during this pilot to allow the public and Commission staff to study the effects of eliminating short sale price test restrictions. Third-party researchers analyzed the publicly available data and presented their findings in a public Roundtable discussion in September 2006. The Commission staff also studied the pilot data extensively and made its findings available in draft form in September 2006, and final form in February 2007.

At the time the SEC acted in 2007, two different types of price tests covered significant numbers of securities. The Nasdaq “bid” test, based on the national best bid, covered approximately 2,900 Nasdaq securities in 2005 (or 44 million short sales). The SEC’s former uptick test (former Rule 10a-1), based on the last sale price, covered approximately 4,000 exchange-listed securities (or 68 million short sales).”[9]


Ultimately, the SEC determined that the Uptick Rule was not needed and formally eliminated it on July 6, 2007.

The SEC eliminated the uptick rule on July 6, 2007.[10] The SEC concluded from the study cited above: “The general consensus from these analyses and the roundtable was that the Commission should remove price test restrictions because they modestly reduce liquidity and do not appear necessary to prevent manipulation. In addition, the empirical evidence did not provide strong support for extending a price test to either small or thinly-traded securities not currently subject to a price test.”[7]Commenting on the scrapping of the uptick rule, The Economist reported that “short-sellers argue [it] was largely symbolic, and it remains in place at only a few of the world’s big stock exchanges.”[11]


Not surprisingly, the news of Uptick Rule’s cessation was not well received by all investors or lawmakers.

On August 27, 2007, the New York Times published an article on Muriel Siebert, former state banking superintendent of New York, “Wall Street veteran and financial sage”, and, in 1967, the first woman to become a member of the New York Stock Exchange. In this article she expressed severe concerns about market volatility: “We’ve never seen volatility like this. We’re watching history being made.” Siebert pointed to the uptick rule, saying, “The S.E.C. took away the short-sale rule and when the markets were falling, institutional investors just pounded stocks because they didn’t need an uptick.”[12]

On March 28, 2008 Jim Cramer of CNBC offered the opinion that the absence of the uptick rule harms the stock market today. He claimed that reintroducing the uptick rule would help stabilize the banking sector.[13]

On July 3, 2008 Wachtell, Lipton, Rosen & Katz, an adviser on mergers and acquisitions, said short-selling was at record levels and asked the SEC to take urgent action and reinstate the 70-year-old uptick rule.[14] On November 20, 2008, they renewed their call stating “Decisive action cannot await … a new S.E.C. Chairman. … There is no tomorrow. The failure to reinstate the Uptick Rule is not acceptable.” [15]

On July 16, 2008, Congressman Gary Ackerman (D-NY), Congresswoman Carolyn Maloney (D-NY) and Congressman Mike Capuano (D-MA) introduced H.R. 6517, “A bill to require the Securities and Exchange Commission to reinstate the uptick rule on short sales of securities.”[16]

On September 18, 2008, presidential candidate and Senator John McCain (R-AZ) said that the SEC allowed short-selling to turn “our markets into a casino.” McCain criticized the SEC and its Chairman for eliminating the uptick rule.[17]

On October 6, 2008, Erik Sirri, director of the Securities and Exchange Commission’s Division of Trading and Markets, said that the SEC is considering bringing back the uptick rule, stating, “It’s something we have talked about and it may be something that we in fact do.”[18]

On October 17, 2008, the New York Stock Exchange reported a survey with 85% of its members being in favor of reinstating the uptick rule with the dominant reason to “help instill market confidence”.[19]

On November 18, 2008, the Wall Street Journal published an opinion editorial by Robert Pozen and Yaneer Bar-Yam describing an analysis of the difference between regulated and unregulated stocks during the SEC pilot program. By using an analysis they claimed to be more comprehensive than the SEC’s original study, they showed that unregulated stocks have lower returns, with a difference that is both statistically and economically significant. They also reported that twice as many stocks had greater than 40% drops in corresponding 12 month periods before and after the repeal.[20] [21]

On January 20, 2009, Ackerman received a letter from Chairman Cox—written the day he left the SEC—in which Cox said he supports the reinstatement of an uptick rule. The letter reads, “I have been interested in proposing an updated uptick rule. However, as you know, the SEC is a commission of five members. Throughout 2008 there was not a majority interested in reconsidering the 2007 decision to repeal the uptick rule, or in proposing some modernized variant of it. I sincerely hope that the commission, in the year ahead, continues to reassess this issue in light of the extraordinary market events of the last several months, with a view to implementing a modernized version of the uptick rule.”[22]

On February 25, 2009, Chairman of the Federal Reserve, Ben Bernanke in testimony before the House Financial Services Committee stated he favored the SEC to examine the restoration of the uptick-rule.[23]

On March 10, 2009, the SEC and Congressman Barney Frank (D-MA), Chairman of the Financial Services Committee announced plans to restore the uptick rule. Frank said he was hopeful that it would be restored within a month.[24][25]


And look at what happened once the rule was removed.

A paper from the New England Complex Systems Institute claims that they have found evidence that suggests the 2008 financial crisis was triggered by a “Bear Raid” market manipulation by short sellers against Citigroup late in 2007. The uptick rule was repealed in July, 2007, and the alleged bear raid took place in November, 2007.[26]


WHOA! Do you mean to say that the second worst financial crisis in the history of our country was brought about by a group of short sellers? Yep — you betcha! Sadly, our equities markets have become the world’s largest gambling casino, and investors/traders a betting against the House — a very large one at that.

When the debate over the elimination of the Uptick Rule was raging, some very savvy traders argued that if they wanted to short a particular security they could do so through the use of derivatives (rather than “shorting” the actually equity (i.e. the company’s stock)). As such, they argued that the Uptick Rule was of little use and that it had little effect on the markets. But, if that were truly the case, then why the lengthy debate to have the Uptick Rule abolished; why not simply leave it on the books? If it were truly ineffective then there would have been no need to have it eliminated. The short sellers, however, had a BIG incentive to have the rule abolished, and they were lucky enough to find a receptive audience within the SEC. So, let’s see what happened next.

On April 8, 2009, the SEC voted to seek public comment on the following proposals to restore a form of the uptick rule.[9]

The SEC disclosed the 273 page text of the proposals on April 17, 2009.[27] The comment period closed on June 19, 2009.

Market-Wide, Permanent Approach:

  • Proposed Modified Uptick Rule: A market-wide short sale price test based on the national best bid (a proposed modified uptick rule).
  • Proposed Uptick Rule: A market-wide short sale price test based on the last sale price or tick (a proposed uptick rule).

Security-Specific, Temporary Approach:

  • Circuit Breaker: A circuit breaker that would either:
    • Ban short selling in a particular security for the remainder of the day if there is a severe decline in price in that security (a proposed circuit breaker halt rule).
    • Impose a short sale price test based on the national best bid in a particular security for the remainder of the day if there is a severe decline in price in that security (a proposed circuit breaker modified uptick rule).
    • Impose a short sale price test based on the last sale price in a particular security for the remainder of the day if there is a severe decline in price in that security (a proposed circuit breaker uptick rule).


Okay, so “circuit breaker[s]” were put in-place in an attempt to ease panic selling, but how often have we seen them used? Personally, I’ve only seen them used twice.

On February 24, 2010 the SEC adopted the alternative uptick rule.[4] The new rule does not apply to all securities. It is triggered when a security’s price decreases by 10% or more from the previous day’s closing price and is effective until the close of the next day.[28]


Please take note of the highlighted sections. Notice how not all securities are affected by the new rule — only those deemed to be “too big” and too important “to fail?” HHHmmm!

AND, yes, certain companies do deserve to be driven out of business — but, for the most part,  “Short Seller Attacks” or “Bear Raids” on stocks are usually used to scare individual investors out of their positions and, thus, allow short sellers to take advantage of the “fear factor.”

Remember this, too; fear is a much more powerful emotion than greed, and there are some very shrewd people who know that fact and take every advantage of it.

Rational thinking is hard to come by when people are running scared out of their minds, but, as investors, let’s look at why it is important to maintain one’s composure:

In 1978, the purpose of the uptick rule was described in a standard text “To correct inequities that occurred on Stock Exchanges prior to 1934, the SEC implemented Rule 10a-1 and 10a-2. It was not unusual in those days to discover groups of speculatorspooling their capital and selling short for the sole purpose of driving down the stock price of a particular security to a level where the stockholders would panic and unload their fully owned shares. This, in turn, caused even greater declines in value.”[8]


In late March of the year 2000, the S&P 500 began showing signs of weakness, and on September 5th of that year, after the “Tech Bubble” finally burst, the S&P 500 began its long decent into the abyss. The market’s rout started showing signs of a bottom some time around early October of 2002. Finally, on March 13th of 2003 the S&P 500 started climbing again. That ascent lasted until early October of 2007 when the housing market started to collapse — and guess what happened next. You got it, another BIG decline in equity prices. Are you beginning to see a pattern here? Let’s put it in a visual context for more clarity.

S&P 500 Bull Run (1990-2000)

1990 Bull Run

S&P 500 Tech. Bubble Crash

2000 Tech Bubble Crash

S&P 500 Housing Market Crash

2007 Housing Market Collapse

When the housing market finally collapsed, the S&P 500 began to tank, in similar fashion to that of the 2000 crash. Which brings us to today — and to my first point.

Above all else, the first thing investors and traders need to remember is this — Don’t Panic!!! Those who sold (as individual investors usually do, at the bottom of a rout) truly took a beating — especially if they “got in” somewhere around the top of either mountain Euphoria or Greed. On the flip side, however, a whole bunch of people truly enjoyed some very nice, long bull runs when they sensed a bottom and jumped-in with both feet. (Remember this important point as well: Whenever a sales transaction is completed, there is someone acting as a wiling buyer;  which is to say, there is someone who believes there is value in that which you are selling. AND, if you panic, you will undoubtedly be offering that buyer the deal of a lifetime!)

My second and final point is this: Sometimes people are wronged and sometimes those wrongs amount to an illegal act. If and when that happens, those people who committed such illegal acts should be prosecuted to the fullest extent of the law. Sadly, however, there are too many individual investors who are afraid to bring suits against companies in which they have invested. It’s as if they feel as though they are suing themselves and “shooting themselves in the foot.” But investing in a company’s securities is a business transaction, plain and simple. It’s not a marriage, and there should be no second chances afforded to people who are willing to take advantage of others for their own, personal gain.

Investing is difficult, but it has been complicated even further by the sheer rigging of the system — in other words, the game is rigged! The SEC is not effective at protecting investors and, in many ways, it is a complicit accomplice to those who seek to bilk investors out of their hard-earned monies (Think: Bernie Madoff & Harry Markopolos). Thus, for those who believe that filing a complaint with the SEC is a far better option than filing a suit against a company in which they have invested — think again.

Many investors are good and decent human beings who truly believe in giving other people second chances whenever they have done something wrong. However, when it comes to one’s retirement monies, or their children’s college funds, or savings for their child’s wedding or…, the stakes are simply too high to entrust an individual, or individuals, who have already demonstrated a willingness to cheat others. So, embrace the laws that were designed to protect the innocent and don’t be afraid to call on someone to enforce those laws when the time arises. It is certainly better to fight to recoup 50 cents on the dollar than it is to allow corporate criminals to get away with their crimes.

In the final analysis, if you are truly uncomfortable with, or discouraged by, the thought of taking legal actions against those who run the companies in which you have invested, then, by all means, do yourself a favor and put you hard-earned investment dollars in the hands of a professional or professionals who will be willing to do so on your behalf. Your investments and, consequently, your future are much too important to allow less scrupulous people to get away with their misdeeds.

Note: All charts courtesy of optionsXpress.

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