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WASHINGTON -- The Securities and Exchange Commission needs to take further steps to crack down on "naked" short selling, U.S. lawmakers said Wednesday, after government auditors recommended more aggressive action to prevent market manipulation.

In a short sale, traders sell borrowed stock with the expectation they can buy it back later at a lower price. In a naked short sale, traders sell stock they haven't borrowed. Some executives argue naked short selling allows market manipulators to drive down shares artificially.

One idea is to require that traders borrow shares before they try to sell a stock short, known as a preborrow. Last summer, the SEC issued an emergency rule requiring preborrowing for certain financial firms' shares, but the industry said it was too expensive, and the requirement was abandoned.

A bipartisan group of senators said the SEC needs to consider new restrictions to help quell naked short selling. "Unless the SEC can develop an appropriate alternative, a strict preborrow requirement may be the only way to adequately protect shareholders' rights," Sen. Chuck Grassley (R., Iowa) said in a joint release with Sen. Carl Levin (D., Mich.) and Sen. Arlen Specter (D., Penn.).

The statement came after the Government Accountability Office found that SEC regulations issued earlier this decade only temporarily slowed cases of "failure to deliver," which occurs when the seller of a security doesn't deliver the security to the buyer during a required period. These cases can occur for a variety of reasons, including naked short selling.

An SEC spokesman said the SEC appreciates the GAO's recommendations and is focused on short selling, including examining a preborrow requirement.

Several commentators have recommended a more permanent pre-borrow requirement, the GAO said. However, the organization noted that the SEC is more cautious about this.

"SEC staff said that they are continuing to evaluate the appropriateness of a pre-borrow requirement for addressing FTD and market manipulation related to naked short selling," the GAO said.

"However, SEC staff said that the costs of a pre-borrow requirement might outweigh the benefits because FTD represent 0.01 percent of the dollar value of trades, and that a small group of securities (small market capitalization, thinly traded, or illiquid) are likely to be the target of any manipulative scheme," it added.

MarketWatch.com Story

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