US Securities and Exchange Commission (SEC) chairman Christopher Cox surprised investors on Tuesday with a plan to curb illegal short selling in 19 major financial company shares, including embattled mortgage giants Fannie Mae and Freddie Mac.

Short sellers were widely blamed for bringing down the stock price of Bear Stearns in March, which in turn hastened the brokerage's demise. The jump in the number of shorted shares of Fannie Mae, Freddie Mac and investment bank Lehman Brothers has triggered accusations that short sellers are now trying to drive these companies into ruin.

The SEC suspects that some short sellers are ganging up on these stocks, engaging in naked shorting while spreading rumours that the companies are in dire straits.

In a short sale, a trader borrows stock, usually from a brokerage's inventory, and sells it, expecting the price to decline. If the bet is correct, the trader can buy new shares later at a lower price, repay the borrowed stock and pocket the difference between the sale price and the repurchase price.

Shorting is legal, unless traders are ordering stock sales without having arranged to borrow actual shares - 'naked' shorting, which is illegal. But the rule against such stock plays has not been much enforced.

The SEC's new plan is a crackdown on naked shorting amid what has been a severe hammering of the shares - to the point where investors are beginning to question the firms' survival.

Beginning on Monday, the SEC will require that 'any one effecting a short sale in these securities arrange beforehand to borrow the securities and deliver them at settlement'. The emergency rule will be in effect through July 29, but it may be extended until Aug 21, the SEC said.

Mr Cox said the agency eventually expected to cover the entire stock market with the new rule.

For the 19 stocks on the list, the change means that brokerages will no longer be able to take a short seller's word that he actually has borrowed the shares he wants sold.

And that, in turn, could curb situations in which multiple short sellers are expecting to borrow the same shares for sale - similar, say, to five different people putting the same car up for sale, knowing that only one of them can deliver the vehicle.

With the US financial system under enormous strain, regulators are facing pressure to show that they are on top of the situation. On Sunday, the SEC announced an immediate probe of rumour-mongering intended to manipulate share prices.

Yesterday, reports said the commission had subpoenaed Wall Street firms, including Deutsche Bank, Goldman Sachs and Merrill Lynch, and more than 50 hedge fund advisers, as it investigated suspected manipulation of Lehman and Bear shares.

Veteran short sellers say regulators are looking for scapegoats for the problems that financial companies have brought on themselves.

Legitimate short sellers bet against companies whose shares they believe are overvalued. Short sellers find out things that companies often prefer their shareholders do not know.

For the long-term health of the market, 'you don't want to restrict people's ability to invest on negative information', warns Professor Jill Fisch, a securities law professor at Fordham University.

Professor John Coffee, a securities-law professor at Columbia Law School, said the risk the SEC faced in targeting illegal short selling was that the move could appear to be panic-driven, which might heighten investors' concerns that the market decline was spiralling out of control.

LOS ANGELES TIMES