Originally published August 9, 2004
On July 28, 2004, the SEC promulgated its new rules regulating short sales. These rules significantly change the existing regulatory framework. This article summarizes the existing regulation of short sales and the new short sale rules.
Background
Section 10(a) of the Securities Exchange Act of 1934 gives the SEC plenary authority to regulate short sales of securities registered on a national securities exchange (listed securities). Pursuant to this and other authority, the SEC and, with SEC approval, the self-regulatory organizations (SROs) have promulgated several significant rules regulating short sales. One such rule is SEC Rule 10a-1, which generally regulates the price at which short sales may be made. Other rules are NASD Rule 3370 and NYSE Rule 440C.10, which generally require that the selling broker be in a position to complete the short sale transaction before effecting a short sale.
On November 6, 2003, the SEC published for public comment proposed Regulation SHO in the Federal Register. This proposed regulation would, among other things, change the current rules controlling when short sales are permitted and address certain concerns raised by so-called .naked short selling. . that is, selling short without having borrowed the securities to make delivery.
Price Rules
SEC Rule 10a-1 generally provides that a listed security can be sold short only on a plus tick (that is, at a price above the immediately preceding sale price) or a zeroplus tick (that is, at the last sale price if it is higher than the last different price). Similarly, NASD Rule 3350 generally prohibits members from effecting short sales at a price that is at or below the current best bid for transactions in Nasdaq NMS securities made on either SuperMontage or the NASD.s Alternative Display Facility (ADF). Rule 3350 does not apply to Nasdaq SmallCap, OTCBB, or other securities traded over the counter. There is an exemption in the rule for bona fide marketmaking activity.
Through Regulation SHO, the SEC proposed to replace SEC Rule 10a-1 and the SRO rules with proposed Rule 201, which would impose a uniform bid test. Proposed Rule 201 would require that all short sales in exchange-listed and Nasdaq NMS securities be effected at a price at least one cent above the consolidated best bid at the time of execution. Under the proposal, the price at which a short sale could be effected would move contemporaneously with the consolidated best bid.
Locate and Borrowing Rules
One of the reasons that the SEC proposed Regulation SHO was to address growing concerns regarding naked short selling. The SEC recognized that naked short selling can have a number of negative effects on the market, particularly when the seller fails to deliver the securities to the buyer for an extended period of time. When this happens on a broad scale, the failures to deliver can be greater than the total public float. Naked short sellers have more leverage than short sellers who borrow securities prior to selling because they can sell more shares short faster and with lower administrative cost. The SEC pointed out that naked short sellers may use this leverage to engage in trading activities that deliberately depress the price of a security.
The SROs currently regulate whether a short seller must first borrow shares before selling short. NYSE Rule 440C.10 generally provides that no NYSE member should fail to deliver against a short sale on a national securities exchange until diligent efforts have been made to borrow the necessary securities to make delivery. The NYSE comments to this rule state that no short sale order should be accepted or entered unless prior arrangements to borrow the stock have been made or there are other acceptable assurances that delivery can be made on the settlement date. NASD Rule 3370 generally provides that no member may sell a stock short unless it makes an affirmative determination that the member can borrow the shares by the settlement date. The affirmative determination must be annotated in writing. There is an exemption for bona fide market-making activities.
The NASD also has rules addressing failures to deliver. For example, NASD Rule 3210 generally prevents a member from selling a security for its own account or buying a security as a broker for a customer if it has a failure to deliver in that security that is 60 days or older. NASD Rule 11830 imposes mandatory close-out and buy-in requirements in certain circumstances.
Proposed Regulation SHO contained provisions that would change existing short sale regulation significantly. It resulted in part from the SEC.s belief that the SRO requirements have not fully addressed the problems of naked short selling and extended failures to deliver.
One aspect of proposed Regulation SHO was intended to establish a uniform standard specifying the procedures for all short sellers to locate securities for borrowing. Proposed Rule 203 of Regulation SHO would prohibit a broker from executing a short sale order for its own account or the account of another person unless the broker or customer (1) borrowed the security, or entered into an arrangement for the borrowing of the security, or (2) had reasonable grounds to believe that it could borrow the security so that it would be capable of delivering the securities on the date delivery is due. Compliance with this requirement would have to be documented. The SEC proposed an exception for bona fide marketmaking activities.
In order to address concerns regarding naked short selling, the SEC also proposed that when there are failures to deliver at a clearing agency of 10,000 shares or more per security, and the failures to deliver are equal to at least 0.5 percent of the issue.s total shares outstanding, special delivery requirements will apply. For short sales of any security meeting this threshold, the selling broker would be required to deliver the shares no later than two days after the settlement date. If the shares were not delivered by this date, with certain exceptions, then the broker may not execute future short sales in the security for the person who had the failure to deliver. Moreover, the proposed rule required that the broker failing to deliver be referred to the NASD and the applicable examining authority for appropriate action, and that the clearing agency withhold mark-to-market amounts or payments that otherwise would be made to the party failing to deliver. The SEC did not propose an exemption from the delivery requirements for short sales made in connection with market making.
Finally, the SEC proposed various changes to the regulation of long sales. Under current Rule 10a-2, which applies only to securities listed or admitted to unlisted trading privileges on a national exchange, if a sale is marked long, then the broker-dealer must make delivery when due and cannot lend securities to accomplish this. If the broker-dealer does not have the securities, then it must buy the securities for cash unless it knows that the seller either is in the process of forwarding the securities to the broker-dealer or will do so as soon as possible. Two exceptions to this buy-in requirement exist. First, in sales between broker-dealers, loans of stock are permitted in lieu of a buy in. Second, the brokerdealer may borrow shares rather than buy in if, despite the brokerdealer .s efforts to ensure that the sale was long, it was actually short. In proposed Regulation SHO, the SEC proposed to extend the delivery requirements of Rule 10a-2 to all securities, including those traded over the counter. In addition, the SEC proposed to permit loans for failures to deliver in certain limited circumstances.
The SEC received letters from 462 commentators in response to proposed Regulation SHO. After considering the comments, the SEC decided to adopt certain provisions of proposed Regulation SHO, some with modifications, and to defer consideration of other provisions.
Final Regulation SHO
On July 28, 2004, the SEC released final Regulation SHO, consisting of Rules 200, 202T and 203. Consideration of proposed Rule 201, which addresses price tests for short sales, was deferred.
Rule 200 contains various definitional and order marking requirements. Rule 200(a) defines .short sale. as meaning any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller. Rule 200(b)-(f) specifies when a person is deemed to own a security. In a change from the current rules, but in accord with the position taken by the Commission.s staff in a no-action letter, Rule 200(f) allows broker-dealers to aggregate their net position in a security in each independent trading unit, rather than the firm as a whole, if certain requirements are met.
In Rule 200(g), the SEC is imposing order marking requirements on trades in all equity securities, not just listed securities which previously were covered by Rule 10a-1. Rule 200(g) requires that orders be marked long, short, or short-exempt. A sell order can be marked long when the seller owns the security being sold and the security either is in the physical possession or control of the broker-dealer, or it is reasonably expected that the security will be in the physical possession or control of the broker-dealer no later than settlement. All other sell orders must be marked short, unless the seller is relying on an exception to an applicable price test, in which case the sell order should be marked short-exempt. The compliance date for Rule 200 is January 3, 2005.
Rule 202T gives the SEC the authority to designate securities for which, or time periods during which, the short sale price test of Rule 10a-1(a) or the price tests of the SROs will not apply. The purpose of this rule is to give the SEC the ability to evaluate the overall effectiveness of short sale price restrictions.
Finally, Rule 203 provides new uniform borrowing and delivery requirements. For orders marked long, Rule 203(a) generally prohibits a broker-dealer from (1) lending or arranging a loan of any security for delivery to the purchaser.s broker after the sale, or (2) failing to deliver a security on the date delivery is due. Exceptions exist for, among other situations, loans between brokerdealers, and instances where the broker-dealer.s customer fails to deliver promised securities to the broker-dealer.
With respect to short sales, Rule 203(b) prohibits a broker-dealer from accepting a short sale in an equity security from another person, or effecting a short sale in an equity security for its own account, unless the broker-dealer (1) has borrowed the security, or entered into a bona fide arrangement to borrow the security, or (2) has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. The broker-dealer must document compliance with this requirement. Reasonable grounds to believe that the security can be borrowed may be established by reliance on easy-to-borrow lists, as long as the list is less than 24-hours old and securities on the list are readily available so that it is unlikely that failures to deliver will occur. However, if there are repeated failures to deliver securities included on an easy-to-borrow list, reliance on the list would not constitute reasonable grounds. Moreover, the absence of a security on a hard-to-borrow list will not constitute reasonable grounds to believe that the security can be borrowed by the delivery date.
Certain exceptions to the uniform locate requirement exist. For example, a broker-dealer accepting a short sale order from another broker-dealer need not comply with the requirement. This is because the broker-dealer submitting the order is required to fulfill the locate requirement. Of course, this exception would not apply if the accepting broker-dealer has contracted to locate the shares for the submitting broker-dealer. Another exception exists for short sales executed by market makers in connection with bona fide market-making activities. However, this exception would not apply where the market maker enters into an arrangement with another broker-dealer to execute short sales in order to avoid the locate requirement.
Rule 203 also imposes special requirements for trades in threshold securities, which are securities with substantial failures to deliver. Rule 203(c)(6) defines .threshold security. as any equity security for which there is an aggregate failure to deliver position for five consecutive settlement days at a registered clearing agency of 10,000 shares or more that is equal to at least 0.5 percent of the issue.s total shares outstanding, and such security is included on a list disseminated by an SRO. The exchanges and SROs will be responsible for publishing lists of threshold securities. Rule 203(b)(3) generally requires any participant of a registered clearing agency to take action on all failures to deliver in threshold securities ten days after the normal settlement date by closing out the failure to deliver by purchasing securities of like kind and quantity. In addition, until the failure to deliver is closed out, there are restrictions on further short sales in the threshold security by the participant and any broker-dealers for which it clears transactions. There is no exception in the rule for market makers. However, the SEC chose not to adopt other penalties for extended failures to deliver, such as being reported to the applicable examining authority or having mark-to-market benefits withheld.
The compliance date for Rule 203 is January 3, 2005.
Conclusion
Regulation SHO significantly changes how broker-dealers must address short sales. In order to minimize the risk of becoming embroiled in the naked shorting litigation, broker-dealers would be well advised to take all steps necessary to assure compliance with this new rule.
Mr Weiner will be speaking on this and other current securities topics at the upcoming PIPE's Conference in New York on October 14, 2004.
This article is intended to provide information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.
