On July 12, 2006, the Securities and Exchange Commission proposed amendments to Regulation SHO governing short sales. The comment period extends until September 19, 2006. The proposing release (34-54154) explains that the "proposed amendments are intended to further reduce the number of persistent fails to deliver in certain equity securities, by eliminating the grandfather provision, and narrowing the options market maker exception."
Regulation SHO became effective January 3, 2005. The regulation was implemented after several years of public debate and was designed to impose a new regulatory framework for short sales, focusing on failures to deliver and abusive naked short-selling. A failure to deliver occurs when a seller does not deliver the securities by the settlement date, generally T+3 (trade date plus three days). The SEC has expressed concern that large and persistent failures to deliver, which can arise either from a short sale or a long sale, can deprive shareholders of ownership benefits, such as voting and lending, and may be indicative of manipulative activities to artificially lower an issuer’s stock price. The SEC has, however, recognized that there may be legitimate reasons for a failure to deliver, and that naked short selling itself may, in certain instances, positively contribute to market liquidity.
Among other things, Regulation SHO requires that a broker-dealer not accept a short sale order in an equity security, or effect a short sale in such a security for its own account, unless the broker or dealer had reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. This "locate" must be made and documented prior to effecting the short sale.
As currently contained in Rule 203(b)(3) of Regulation SHO, if a registered clearing agency participant, or any broker-dealer for which it clears transactions, has failed to deliver certain securities known as "threshold" securities for 13 consecutive settlement days, the participant must close out the fail to deliver position by purchasing securities of like kind and quantity. A "threshold security" is defined in the Regulation as an equity security of an issuer required to register under Section 12 and file reports pursuant to Section 15(d) of the Exchange Act, for which the levels of fails is very high (at least 10,000 shares and 0.5% of the total outstanding), for a continuous period of five consecutive settlement days, and is included on a list disseminated to its members by an SRO.
The exceptions to Rule 203(b)(3) include a grandfather provision (excepting fails occurring before the effective date of the Regulation and fails for securities before the securities appeared on the threshold list) and an option maker exception (excepting fails in a threshold security resulting from short sales by a registered options market maker to establish or maintain a hedge on option positions created before the underlying security became a threshold security). The proposed amendment is principally designed to eliminate the grandfather exception and narrow the options market maker exception. In addition, the proposed amendment includes a technical amendment that would update the market decline limitation referenced in Regulation.
The grandfather exception was adopted because the SEC was concerned about creating volatility through short squeezes arising from a need to close out large pre-existing positions quickly after a security became a threshold security. The SEC’s experience since the adoption of Regulation SHO, as well as input from the SROs and others, suggests that, although fails to deliver have declined, persistent fails may be principally attributable to the grandfather exception.
To eliminate the grandfather exception, the proposed amendment would require,upon its adoption by the SEC, any previously grandfathered fail to deliver position to be closed out within 35 days of the settlement date. For any security that becomes a threshold security after the effective date, a fail to deliver would be subject to the Regulation’s mandatory 13-day close-out requirements.
The option market maker exception was intended to address concerns about liquidity and the pricing of options. Under the proposed amendment registered option market makers would be able to keep open fail positions in threshold securities being used to hedge open option positions if an option that was created before the underlying security became a threshold security had not expired or been liquidated. Once the underlying security became a threshold security and the specific option position has expired or been liquidated, the fails would be subject to the 13 day close-out requirement.
In his remarks at the Commission’s open meeting on July 12 on the amendments, Chairman Cox encouraged comments, not only on the proposed amendments, but more broadly, stating: "Once published, the public and the industry will have the opportunity to comment on the specific Regulation SHO proposals, as well as provide us with any alternative approaches. We also will be seeking comment about other ways to modify Regulation SHO." Chairman Cox indicated that the Commission would consider all comments and accompanying data "in determining whether any modifications to the proposals are necessary."
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