Document Type

Article

Publication Date

2004

Center/Program

Richard Paul Richman Center for Business, Law, and Public Policy

Center/Program

The Charles Evans Gerber Transactional Studies Center

Abstract

In recent years, a speculative bubble in Internet stocks has burst and several "blue chip" firms have failed amidst high profile allegations of corporate misconduct. Why did high-tech start-ups with no earnings attain such lofty valuations? Why didn't sophisticated investors keep prices at saner levels? And why didn't more sophisticated investors look past accounting gimmicks much earlier to uncover problems at Enron and other firms? More generally, why did the mechanisms of market efficiency prove inadequate?1 While there obviously is no single answer to these complex questions, this Article focuses on one piece of the problem: U.S. tax and regulatory rules raise the cost of betting against the market, making it more costly for sophisticated investors to police the markets in this way. A short sale is the standard way to bet that publicly traded stock will decline in value. The seller sells stock that she does not own, hoping to purchase it later for a lower price. To implement this bet, the seller borrows stock (or, to be precise, the seller's broker borrows it).2 Although short sales serve an important function in financial markets, they face legal constraints that do not govern long positions.

While others have criticized these constraints, these commentators have not focused rigorously enough on the precise contours of current law. Some short sale constraints are mischaracterized 3 and others are omitted entirely, such as the higher tax rate on short sales.4 Likewise, the existing literature neglects many strategies that enable well-advised investors to circumvent these constraints. This avoidance probably reduces the impact of short sale constraints on market prices, but contributes to social waste in other ways.

To fill these gaps in the literature, this Article provides a careful look at existing law, drawing on the economics of capital markets and public finance. We offer three conclusions. First, short sales play a valuable role in the financial markets; while there may be plausible reasons to regulate them-most notably, concerns about market manipulation and panics-current law is poorly tailored to these goals. Second, investor self-help can mitigate some of the harm from this poor tailoring, but at a cost. Third, relatively straightforward reforms can eliminate the need for such self-help while accommodating legitimate regulatory goals.

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