United States: UPDATE: SEC Issues New Rules to Combat Naked Short Selling Abuses

Originally published September 18, 2008

Keywords: Exchange Act Rule, SEC, new rules, combat, naked selling, abuses, emergency order, Regulation SHO, tick test

We are writing to update our client alert issued yesterday, September 17, 2008. The prior client alert was based on a press release issued by the Securities and Exchange Commission, which took additional steps after the close of US markets.

On September 17th, the Securities and Exchange Commission (SEC) issued an emergency order (Emergency Order) under Section 12(k)(2) of the Securities Exchange Act of 1934 (Exchange Act) adopting three new rules designed to combat "naked" short selling (i.e., a short sale where seller does not actually borrow the stock and fails to deliver it in time for settlement).¹

These rules apply to the equity securities of all public companies and were effective at 12:01 a.m. ET on Thursday, September 18, 2008.

First, the SEC adopted temporary Rule 204T under Regulation SHO. Rule 204T requires a participant of a registered clearing agency (e.g., NSCC) to deliver equity securities to the clearing agency for clearance and settlement of long or short sales in any equity security by the settlement date of those sales (e.g., three days after the sale or T+3). If a participant fails to "close out" a short sale in an equity security, the participant, and any broker-dealer from which the participant receives trades for clearance and settlement, will be prohibited from accepting or effecting further short sale orders in the same security from any person for clearance and settlement by the participant without first locating and entering into a bona fide arrangement to borrow the shares required to settle such short sales. This pre-borrow penalty provision will remain in effect until the participant closes out the fail to deliver position. Rule 204T is immediately effective but applies only to fails to deliver resulting from trades that occur after the issuance of the Emergency Order.

Second, the SEC approved amendments to Rule 203(b)(3) of Regulation SHO that eliminate the options market maker exception from the close-out requirements in Regulation SHO. This change is immediately effective and applies to fails to deliver that occurred prior to the issuance of the Emergency Order.

Third, the SEC adopted Exchange Act Rule 10b-21, which was proposed earlier this spring.² Rule 10b-21 provides that it constitutes a "manipulative or deceptive device or contrivance" as used under Section 10(b) of the Exchange Act for any short seller, including a broker-dealer acting for its own account, to deceive others (e.g., broker-dealers, participants of a registered clearing agency, or purchasers) about the seller's intention or ability to deliver equity securities sold short in time for settlement, and to subsequently fail to deliver those securities on or before the date delivery is due. Rule 10b-21 is effective immediately.

With many commenters suggesting that the SEC should consider reinstating the "tick test" (or adopt other restrictive measures), it will be interesting to see if the SEC views today's actions as final solutions or the first steps towards additional rule-making efforts.

Footnotes

^{1. See Securities Exchange Act Release No. 58,572 (Sept. 17, 2008) (not yet published in Federal Register) available at http://www.sec.gov/rules/other/2008/34-58572.pdf.}

^{2. See Securities Exchange Act Release No. 57,511 (Mar. 17, 2008), 73 Fed. Reg. 15,376 (Mar. 21, 2008) available at http://www.sec.gov/rules/proposed/2008/34-57511fr.pdf.}

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