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: Hedge funds sue SEC over new short selling rules in wake of meme stock mania

A consortium of groups representing the hedge fund industry and other investment companies sued the U.S. Securities and Exchange Commission Tuesday over new rules that require them to disclose information related to securities short sales and lending.

A short sale is a securities transaction whereby an investor borrows shares of a company and then sells those shares on the open market, expecting the price to fall. The investor will profit if he can repurchase those shares at a lower price and repay the loan.

Read more: Why naked short selling has suddenly become a hot topic

The lawsuit claims that the rules will discourage short selling because they would reveal confidential information about trading strategies and enable market participants to imitate or trade against funds deploying a short-selling strategy.

“The rules will impair market efficiency and price discovery and harm market participants and investors,” said Jack Inglis, CEO of the Alternative Investment Management Association, one of the groups suing the SEC, along with the National Association of Private Fund Managers and the Managed Funds Association.

The SEC approved two rules in October, one requiring certain fund managers to report their short sales to the SEC within 14 days on the end of the month. The agency would then aggregate and publish the data on a delayed basis, keeping the fund manager information confidential.

The second rule requires that financial companies that facilitate securities loans disclose information about those transactions to the Financial Industry Regulatory Authority, a self-regulatory organization overseen by the SEC, on a daily basis.

The lawsuit argues that the two rules take a “fundamentally contradictory approach” because one rule acknowledges that “frequent, detailed disclosures about short sale activity” can be harmful to markets while the other requires “daily public disclosure of individual transaction information” that can be used to learn which funds hold a particular short position.

The lack of transparency regarding short selling was a major force in the meme-stock craze of 2021 that saw shares of GamesStop Corp. GME, +0.94% and AMC Entertainment Holdings Inc. AMC, -3.87% soar and become detached from fundamentals of company performance.

Traders at the time focused on data showing that GameStop was being heavily shorted by institutional investors. At its peak 140% of all outstanding shares of the company were shorted, leading to accusations of illegal “naked” short selling, whereby a broker lends out shares of a company that it doesn’t own.

Short selling specialist Moshe Hurwitz told MarketWatch in January that while naked short selling is mostly banned in the U.S. some brokers skirt the rules that are meant to prevent them from lending out shares they don’t have because the securities lending business is lucrative.

The issue of naked short selling also made headlines earlier this year after several small-cap companies raised concerns that their share prices were being artificially suppressed by illegal trading activity.

Read more: Small-cap companies are going after naked short sellers in growing numbers: ‘It’s the biggest risk to the health of today’s public markets’

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