Regulation SHO. On June 23, 2004, the Securities and Exchange Commission ("SEC") adopted new Regulation SHO under the Securities Exchange Act of 1934 (the "Act") and amended several rules that relate to the short selling of securities.1 Regulation SHO is intended to curtail increased instances of abusive "naked" short selling, (i.e., selling short without borrowing the necessary securities to make delivery), particularly in thinly capitalized stocks that might be more prone to manipulation. Specifically, Regulation SHO requires short sellers in all equity securities to locate those securities before selling, and also imposes additional delivery requirements on broker-dealers for securities in which a substantial number of failures to deliver have occurred. Regulation SHO also includes a temporary rule that establishes procedures by which the SEC may temporarily suspend the operation of the current "tick" test and any short sale price test of any exchange or national securities association, for specified securities. As described in more detail below, pursuant to this temporary rule, the SEC issued an order on July 28, 2004 that will suspend such price tests for a group of close to a thousand securities.2

Short Selling. Though short selling can serve useful market purposes (e.g., market liquidity and pricing efficiency), abusive short selling may be used to illegally manipulate stock prices, especially in thinly-capitalized securities trading over-the-counter. Naked short selling sometimes results in a "fail to deliver" by the seller to the buyer which, in turn, can have negative effects on the market, particularly when the fails to deliver persist for an extended period of time and result in a significantly large unfulfilled delivery obligation at the clearing agency where trades are settled. Unrestricted short selling can exacerbate a declining market in a security by increasing pressure from the sell-side, eliminating bids, and causing a further reduction in the price of a security by creating an appearance that the security price is falling for fundamental reasons. Regulation SHO was adopted to protect issuers and investors from these negative consequences of abusive short selling.

"Threshold Securities" and Close-Out Requirement. Rule 203 of Regulation SHO imposes requirements targeted at securities where there is evidence of significant settlement failures (i.e., certain designated "threshold securities"). Rule 203 incorporates the NASD Rule 11830 definition of "threshold security" which defines this term to mean an equity security (1) for which there is an aggregate fail to deliver position for five consecutive settlement days at a registered clearing agency of 10,000 shares or more per security; (2) where the level of fails is equal to at least one half of one percent of the issuer's total shares outstanding; and (3) the security is included on a list published by an SRO.3 With limited exception, Rule 203 requires a participant of a registered clearing agency that has a fail to deliver position in threshold securities that persists for ten consecutive days after the normal settlement date (i.e., 13 consecutive settlement days), to take action to close out the extended fail to deliver position by purchasing securities of like kind and quality. Until the position is closed out, the participant, and any broker-dealer for which it clears transactions, may not effect further short sales in the particular threshold security without borrowing or entering into a bona fide arrangement to borrow the security. Rule 203 will become effective 30 days after its publication in the Federal Register and has a compliance date of January 3, 2005, to permit firms to make programming and procedural adjustments.

Uniform "Locate" Rule. Rule 203 of Regulation SHO enhances "locate" and delivery requirements by incorporating a uniform locate rule applicable to short sales in all equity securities, wherever they are traded. Rule 203 prohibits a broker-dealer from executing a short sale order for its own account or the account of another person, unless the brokerdealer: (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. Though Rule 203 supersedes current comparable SRO rules4, it incorporates the requirement that the "locate" be made and annotated in writing prior to effecting any short sale, regardless of whether the seller’s short position may be closed out by purchasing securities the same day. Generally, the requirements of Rule 203 reflect current industry practice, but the SEC believes that adopting Rule 203 is desirable in order to establish a uniform standard specifying the procedures for all markets.

Exceptions to Locate Requirement. Rule 203 of Regulation SHO includes a limited number of exceptions from its locate requirement, including an exception for short sales by market makers (including specialist and option market makers) in connection with bona-fide market making, even when effecting short sales in threshold securities.5 This exception is based on the premise that a narrow exception for market makers and specialists engaged in bona fide market making activities is necessary due to their potential need to facilitate customer orders in a fast moving market without possible delays associated with complying with Rule 203. Further, the SEC reasoned that most specialists and market makers seek a net "flat" position in a security at the end of each day and often "offset" short sales with purchases such that they are not required to make delivery under the security settlement system. Market makers will not be excepted from the requirements to close out fails to deliver in threshold securities that remain for thirteen consecutive settlement days.

Regulation SHO does not incorporate an exception from the locate and delivery requirements of Rule 203 for short sales that result in bona-fide fully hedged or arbitraged positions previously allowed under NASD Rule 3370. Regulation SHO also does not include an exception from the locate requirements for transactions in exchange traded funds.

Order-Marking Requirements. Rule 200(g) of Regulation SHO adopts new order-marking requirements. The new marking requirements apply to all equity securities, not just exchange-listed securities and differentiate between "long," "short," and "short exempt" orders for all exchange-listed and over-the-counter equity securities. The new marking requirements will eliminate the prior discrepancy between how Rule 3b-3 under the Act defined a short sale and the marking provisions previously found in Rule 10a-1. In addition, the new marking requirements should facilitate the surveillance and monitoring of compliance with Rule 10a-1.

The former marking requirements contained in Rule 10a-1 provided that a broker-dealer could only mark an order to sell a security "long" if the security is carried in the account for which the sale is to be effected, or the broker-dealer is informed that the seller owns the security to be sold, and will deliver the security to the account for which the sale is effected as soon as possible without undue inconvenience or expense.

Under Rule 200(g), an 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 or dealer no later than settlement. The SEC added the language "reasonably expected" because it acknowledged that it may be difficult for a person to know with certainty at the time of sale that a security will be in the possession or control of the broker-dealer prior to settlement. However, if a person owns the security sold and does not reasonably believe that the security will be in the possession or control of the broker-dealer prior to settlement, the sale should be marked "short." The sale could be marked "short exempt" if the seller is entitled to rely on an exception from the tick test of Rule 10a-1, or the price test of an exchange or national securities association. Rule 200 will become effective 30 days after publication in the Federal Register.

Pilot Program and Temporary Suspension of "Tick" Test. Rule 202T of Regulation SHO establishes procedures to allow the SEC to temporarily suspend the trading restrictions of the current "tick" test in Rule 10a-1 under the Act,6 and any short sale price test of any exchange or national securities association, for specified liquid securities. Utilizing these procedures, on July 28, 2004, the SEC issued an order that suspends on a pilot basis for a one-year period the tick test provision of Rule 10a-1(a), and any short sale price test of any exchange or national securities association, for: (1) short sales in approximately one-third of stocks in the Russell 3000 index; (2) short sales executed in any security included in the Russell 1000 index after 4:15 p.m. Eastern and the open of the consolidated tape the following day, and (3) short sales in any security not included in (1) and (2) between the close of the consolidated tape and the open of the consolidated tape the following day. The pilot suspends only the operation of the tick test, while the other requirements of Regulation SHO, including the order-marking, locate and close-out requirements, remain in effect.

The pilot will allow the SEC to review the effects of relatively unrestricted short selling on, among other things, market volatility, price efficiency, and liquidity. The SEC anticipates that the data derived from the pilot will assist in its consideration of alternatives for regulating short sales in actively-traded securities which may include actions such as: (i) eliminating a SEC-mandated price test for an appropriate group of securities (which may be all securities), (ii) adopting a uniform bid test, and any exceptions with the possibility of extending a uniform bid test to smaller securities for which there currently is no price test, or (iii) leaving in place the current price tests.

The pilot will commence on January 3, 2005 to permit broker-dealers and self-regulatory organizations to make the necessary programming adjustments.

Proposed Uniform Bid Test. In light of the substantial programming changes that could be incurred in going forward with its previous proposal to replace the "tick" test of Rule 10a-1 with a new uniform bid test,7 the SEC deferred consideration of this issue until after the conclusion of the pilot established by Rule 202T. Therefore, Rule 10a-1 and all other SRO price tests are still effective in their current form for securities not included in the pilot.

Ownership. Unconditional Contracts to Purchase Securities. Rule 200(b) of Regulation SHO incorporates the current definition of unconditional contract found in Rule 3b-3(b) without amending the rule to require the specification of a fixed price and amount of securities to be purchased in order for a person to claim ownership of the securities underlying the contract as the SEC had proposed. However, the SEC will continue to consider whether any future changes to the unconditional contract provision are appropriate, and may revisit its decision upon termination of the pilot to be implemented pursuant to Rule 202T.

Ownership of Securities Underlying Securities Futures Products. Rule 200(b) of Regulation SHO also includes language consistent with existing SEC guidance concerning the manner in which Rule 3b-3 addresses instances where a person owns a derivative instrument that entitles the person to acquire securities underlying the instrument (e.g., options, rights, warrants, convertibles, and security futures). Rule 200(b) provides that a person holding a long security futures position is not considered to own the underlying security until the security future stops trading and the person has received notice that the position will be physically settled and is irrevocably bound to receive the underlying security. The SEC has stated that the termination of trading is the moment at which an open position in a security future, either a long or short position, can no longer be closed or liquidated either by buying or selling an opposite position. At that point, the person obligated to deliver would be considered short, and a person entitled to acquire the securities would be considered long.

Aggregation. Rule 200(f) of Regulation SHO incorporates aggregation unit netting because the SEC believes that such netting allows aggregation units at multi-service broker-dealers to pursue different trading strategies, as well as provide liquidity to the market, without the restrictions of firm-wide netting.8 Rule 200(f) permits trading unit aggregation if a registered broker-dealer meets the following requirements: (1) the broker or dealer has a written plan of organization that identifies each aggregation unit, specifies the trading objective of each, and supports its independent identity; (independence of the units would be evidenced by factors such as: separate management structures, location, business purpose, and profit and loss treatment), (2) each aggregation unit within the firm continuously determines, on a realtime basis, its net position for every security that it trades, (3) all traders in an aggregation unit pursue only the trading objectives or strategies of that aggregation unit; and (4) individual traders are assigned to only one aggregation unit at a time.

Block Positioners and Liquidation of Index Arbitrage Positions. Rule 200(d) of Regulation SHO incorporates the block positioner exception currently found in Rule 10a-1(e)(13) under the Act. A broker-dealer that engages in blockpositioning will continue to be able to disregard economically neutral bona-fide arbitrage, risk arbitrage, and bona-fide hedge positions involving short stock components in determining its net position in the block-positioned security. Rule 200(e) of Regulation SHO provides a limited exception for unwinding index arbitrage positions by relaxing the requirement that a person selling a security aggregate all of the person's positions in that security to determine whether he or she has a net long position.

Long Sales. Subject to limited exception, Rule 203(a) of Regulation SHO requires that if a broker-dealer knows or should know that a sale of an equity security is marked long, the broker-dealer must make delivery when due and cannot use borrowed securities to do so. This delivery obligation does not apply in three circumstances: (1) the loan of a security through the medium of a loan to another broker or dealer; (2) where the broker or dealer knows or has been reasonably informed by the seller that the seller owns the security and will deliver it to the broker or dealer prior to the scheduled settlement of the transaction and the seller fails to make such delivery; or (3) where an exchange or securities association finds, prior to the loan or arrangement to loan any security for delivery, or failure to deliver, that the sale resulted from a good-faith mistake, the broker-dealer exercised due diligence, and either that requiring a buy-in would result in undue hardship or that the sale had been effected at a permissible price.

Rule 105 of Regulation M. The Regulation SHO adopting release also contained amendments to Rule 105 of Regulation M (which relates to short selling prior to a public offering) that eliminate the shelf offering exception. The amendment applies to short sales effected within five days prior to the pricing of a shelf offering. These short sales may not be covered with offering securities purchased from an underwriter or other broker-dealer participating in the offering. Additionally, the SEC enumerated a non-exhaustive list of transactions that would be considered sham transactions designed to evade Rule 105 and advised that such transactions if used as part of a fraudulent or manipulative scheme, may violate the federal anti-fraud and anti-manipulation securities laws. The Rule 105 amendments will be effective 30 days after publication in the Federal Register.

Conclusion. In adopting Regulation SHO, the SEC revised its regulatory framework regarding short selling primarily to enhance the efficiency of the national clearance and settlement system and to protect investors and issuers from abusive short selling tactics that are intended to manipulate the market. Regulation SHO also provides a comprehensive structure designed to modernize short sale rules and establish a uniform regulatory standard. Additionally, the SEC plans to use the information collected in connection with the pilot program to apply future regulation to areas where regulation is most needed and away from areas where regulation is not necessary or practical in light of actual market operation.

Footnotes

1. The rules were proposed by the SEC on October 29, 2003 (See Release No. 34-48709). The adopted final rules (See Release No. 34-50103) and the proposed rules are available on the SEC.s website at: http://www.sec.gov/rules/other/34-50104.htm.

2. The order (See Release No. 34-50104) is available on the SEC.s website at: http://www.sec.gov/rules/other/34-50104.htm.

3. For example, if an issuer had 1,000,000 shares outstanding, one-half of one percent (.005) would be 5,000 shares. An aggregate fail to deliver position at a clearing agency of 10,000 shares or more would thus exceed the specified level of fails. If an issuer had 10,000,000 shares outstanding, one-half of one percent would be 50,000 shares. An aggregate fail to deliver position at a clearing agency of 50,000 shares or greater would exceed the specified level of fails.

4. NYSE Rule 440C.10 states that no NYSE member or member organization should .fail to deliver. against a short sale of a security on a national securities exchange until a diligent effort has been made by such member or member organization to borrow the necessary securities to make delivery. NASD Rule 3370 generally provides that no member, or person associated with a member, shall effect a short sale for a customer or for its own account unless the member makes an .affirmative determination. that the member can borrow the securities or otherwise provide for delivery of the securities by settlement date.

5. Other exceptions to the locate requirement are applicable to: (i) registered broker-dealers that receive short sale orders from other registered broker-dealers and, (ii) under limited circumstances, to situations where a broker-dealer effects a sale on behalf of a customer that is deemed to own the security, but will not be expected to have physical possession or control of the broker-dealer by the settlement date.

6. Rule 10a-1(a)(1) provides that, subject to certain exceptions, a listed security may be sold short: (a) at a price above the price at which the immediately preceding sale was effected (plus tick), or (b) at the last sale price if it is higher than the last different price (zero-plus tick) (commonly referred to as the .tick. test). In 1994, the SEC granted temporary approval to the NASD to apply its own short sale rule to Nasdaq National Market System (NMS) securities. NASD Rule 3350 prohibits short sales by NASD members in Nasdaq NMS Securities at or below the current best (inside) bid when that bid is lower than the previous best (inside) bid (commonly referred to as the .bid. test).

7. This rule change was proposed by the SEC on October 29, 2003. See supra note 1.

8. Rule 3b-3 requires a seller of an equity security subject to Rule 10a-1 to aggregate all of its positions in that security in order to determine whether the seller has a .net long position. in the security.

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