UPDATE 2-U.S. SEC amends emergency short sale rule

(Adds details on rule change, comment, background, bylines)

By Rachelle Younglai and Doris Frankel

WASHINGTON, July 18 (Reuters) - U.S. securities regulators have modified an emergency rule aimed at curbing manipulative short-selling in 19 major financial firms including Fannie Mae (FNM.N: Quote, Profile, Research, Stock Buzz) and Freddie Mac (FRE.N: Quote, Profile, Research, Stock Buzz).

Facing complaints from financial industry groups and exchanges, the Securities and Exchange Commission provided guidance and said on Friday it was granting market makers relief to help maintain order and liquidity in the markets.

The market makers affected would not have to pre-borrow shares before shorting the stocks, the SEC said.

The emergency rule, which takes effect on Monday and can last up to 30 days, requires a short seller to borrow the securities before executing the sale. It also requires the investor to deliver the securities on the settlement date.

Short selling is a legitimate strategy where the investor arranges to borrow shares they consider overvalued and sell them in hopes of profiting when the price drops. A naked short occurs when an investor sells stock that has not yet been borrowed.

The rule applies only to the stocks of 17 Wall Street firms, primary dealers that have access to the Federal Reserve's discount window, such as Citigroup Inc (C.N: Quote, Profile, Research, Stock Buzz) and Lehman Brothers (LEH.N: Quote, Profile, Research, Stock Buzz). The SEC also included the biggest mortgage finance companies, Fannie and Freddie, after a week when their shares dived on concerns they were undercapitalized.

Wall Street, which was thrown off guard when the SEC announced the emergency rule on Tuesday, quickly applauded the rule modifications and guidance.  Continued...