3rd UPDATE: SEC's Cox: Limits On Shorting Fannie, Freddie

(Updated to note rule takes effect on Monday, and comment from US Chamber of Commerce.)

By Judith Burns

Of DOW JONES NEWSWIRES

WASHINGTON -(Dow Jones)- U.S. securities regulators are putting new restrictions in place to prevent short-selling abuses involving shares of Wall Street's primary dealers and Fannie Mae (FNM) and Freddie Mac (FRE), the federally backed housing-finance giants.

Securities and Exchange Commission Chairman Christopher Cox told the Senate Banking Committee on Tuesday that the SEC will require short-sellers to pre- borrow shares before engaging in short sales of Fannie Mae or Freddie Mac.

The same restrictions - which will be required under a 30-day emergency order to be issued later Tuesday - will apply to other significant financial entities such as primary dealers, including Goldman Sachs Group Inc. (GS), Lehman Brothers Holdings Inc. (LEH), Merrill Lynch & Co. (MER) and Morgan Stanley (MS). SEC officials said the restrictions could be extended for a longer period, or to other stocks as well.

The restrictions will take effect starting at 12:01 a.m. Eastern time on Monday.

Short sellers borrow shares for sale in hopes of replacing the shares later at a lower price. The practice is legal and produces profits when stock prices decline. "Naked" short sellers don't borrow shares in advance of short sales, a practice that critics say can have punishing effects on a stock's price.

The SEC has taken a number of steps recently to loosen some short-selling restrictions while imposing new rules to combat abusive "naked" short selling. It eliminated Depression-era limits on short sales in mid-2007 and required exchanges to do the same, scrapping the "tick test" approach that barred short sales as a stock price ticked down. The move came after a multi-year experiment that lifted short-sale restrictions on selected stocks.

Some critics think the SEC erred. Wachtell, Lipton, Rosen & Katz, a prominent New York law firm with large corporate clients, recently urged the SEC to revisit the matter and consider reinstating the tick test.

Federal Reserve Board Chairman Ben Bernanke, testifying to the Senate panel along with Cox, told lawmakers that "some limits on short-selling are probably appropriate." Cox said the SEC is "very open" to using some type of price test, other than a tick test, "for circumstances like those that we find ourselves now in."

U.S. Chamber of Commerce President and Chief Executive Thomas Donohue applauded the SEC's action in a letter to Cox late Tuesday.

"While legitimate short selling plays a critical role in our capital markets, we must crack down on fraudulent actors who give this important tool a bad name, " Donohue wrote. He urged the SEC to move forward with rules to counter abusive naked short selling.

The emergency order surprised some. Regulation SHO, a package of SEC rules to crack down on naked short selling, requires locating shares for borrowing before short sales. Under Regulation SHO, the extra step of actually borrowing the shares in advance of short sales - as the emergency order is expected to require - is limited to certain hard-to-borrow stocks with persistent delivery failures.

"It's kind of surprising to me," said Larry Bergmann, a former SEC official, now special counsel with the law firm of Willkie, Farr & Gallagher, in Washington, D.C. "It seems to suggest Regulation SHO doesn't work."

Limiting the emergency order to shares of Fannie Mae, Freddie Mac and Wall Street firms makes it appear as if regulators are "protecting these securities from being battered" by short selling, Bergmann added.

Bergmann warned that a requirement to pre-borrow shares could "greatly complicate or interfere with the efficiency of short selling," and, if it is extended to all stocks, "it would be a very different market from what we have now."

Susan Grafton, an attorney at the law firm of Gibson, Dunn & Crutcher, said people are trying to understand what stocks would be covered by the emergency order and how quickly it will kick in.

"The devil's in the details," said Grafton. "We need to see the order."

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