[Federal Register Volume 73, Number 202 (Friday, October 17, 2008)]
[Rules and Regulations]
[Pages 61706-61731]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-24785]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 242
[Release No. 34-58773; File No. S7-30-08]
RIN 3235-AK22
Amendments to Regulation SHO
AGENCY: Securities and Exchange Commission.
ACTION: Interim final temporary rule; request for comments.
-----------------------------------------------------------------------
SUMMARY: The Securities and Exchange Commission (``Commission'') is
adopting an interim final temporary rule under the Securities Exchange
Act of 1934 (``Exchange Act'') to address abusive ``naked'' short
selling in all equity securities by requiring that participants of a
clearing agency registered with the Commission deliver securities by
settlement date, or if the participants have not delivered shares by
settlement date, immediately purchase or borrow securities to close out
the fail to deliver position by no later than the beginning of regular
trading hours on the settlement day following the day the participant
incurred the fail to deliver position. Failure to comply with the
close-out requirement of the temporary rule is a violation of the
temporary rule. In addition, a participant that does not comply with
this close-out requirement, and any broker-dealer from which it
receives trades for clearance and settlement, will not be able to short
sell the security either for itself or for the account of another,
unless it has previously arranged to borrow or borrowed the security,
until the fail to deliver position is closed out.
DATES: Effective Date: October 17, 2008 until July 31, 2009. Comment
Date: Comments should be received on or before December 16, 2008.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/final.shtml); or
Send an e-mail to [email protected]. Please include
File Number S7-30-08 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Florence E. Harmon,
Acting Secretary, Securities and Exchange Commission, 100 F Street,
NE., Washington, DC 20549-1090.
All submissions should refer to File Number S7-30-08. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/final.shtml).
[[Page 61707]]
Comments are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549 on official business days between the hours of 10 a.m. and 3 p.m.
All comments received will be posted without change; we do not edit
personal identifying information from submissions. You should submit
only information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Associate
Director, Josephine J. Tao, Assistant Director, Victoria L. Crane,
Branch Chief, Joan M. Collopy, Special Counsel, Christina M. Adams and
Matthew Sparkes, Staff Attorneys, Office of Trading Practices and
Processing, Division of Trading and Markets, at (202) 551-5720, at the
Commission, 100 F Street, NE., Washington, DC 20549-6628.
SUPPLEMENTARY INFORMATION: We are adopting temporary Rule 204T of
Regulation SHO [17 CFR 242.204T] as an interim final temporary rule. We
are soliciting comments on all aspects of the rule. We will carefully
consider the comments that we receive and intend to respond to them in
a subsequent release.
I. Introduction
Recently, we have become concerned that there is a substantial
threat of sudden and excessive fluctuations of securities prices and
disruption in the functioning of the securities markets that could
threaten fair and orderly markets. These concerns with respect to
financial institutions are evidenced by our recent publication of
emergency orders under section 12(k) of the Exchange Act in July (the
``July Emergency Order'') \1\ and September of this year (the ``Short
Sale Ban Emergency Order'').\2\ In these orders we noted our concerns
about the possible use of unfounded rumors regarding the stability of
financial institutions by short sellers for the purpose of manipulating
the prices of securities issued by the financial institutions to
increase profits through ``naked'' short selling.\3\
---------------------------------------------------------------------------
\1\ See Exchange Act Release No. 58166 (July 15, 2008), 73 FR
42379 (July 21, 2008) (imposing borrowing and delivery requirements
on short sales of the equity securities of certain financial
institutions).
\2\ See Exchange Act Release No. 58592 (Sept. 18, 2008), 73 FR
55169 (Sept. 24, 2008) (temporarily prohibiting short selling in the
publicly traded securities of certain financial institutions); see
also Exchange Act Release No. 58611 (Sept. 21, 2008), 73 FR 55556
(Sept. 25, 2008) (amending the Short Sale Ban Emergency Order).
\3\ ''Naked'' short selling generally refers to selling short
without having borrowed the securities to make delivery. See
Exchange Act Release No. 50103 (July 28, 2004), 69 FR 48008, 48009
n.10 (Aug. 6, 2004) (``2004 Regulation SHO Adopting Release''); see
also Commission press release, dated July 13, 2008, announcing that
the Commission's Office of Compliance Inspections and Examinations,
as well as the Financial Industry Regulatory Authority (``FINRA'')
and New York Stock Exchange Regulation, Inc., (``NYSE'') will
immediately conduct examinations aimed at the prevention of the
intentional spreading of false information intended to manipulate
securities prices. See http://www.sec.gov/news/press/2008/2008-140.htm. In addition, in April of this year, the Commission charged
Paul S. Berliner, a trader, with securities fraud and market
manipulation for intentionally disseminating a false rumor
concerning The Blackstone Group's acquisition of Alliance Data
Systems Corp (``ADS''). The Commission alleged that this false rumor
caused the price of ADS stock to plummet, and that Berliner profited
by short selling ADS stock and covering those sales as the false
rumor caused the price of ADS stock to fall. See http://www.sec.gov/litigation/litreleases/2008/lr20537.htm.
---------------------------------------------------------------------------
Our concerns, however, are not limited to just the financial
institutions that were the subject of the July Emergency Order and the
Short Sale Ban Emergency Order. Given the importance of confidence in
our financial markets as a whole, we have become concerned about sudden
and unexplained declines in the prices of equity securities generally.
Such price declines can give rise to questions about the underlying
financial condition of an institution, which in turn can create a
crisis of confidence even without a fundamental underlying basis. This
crisis of confidence can impair the liquidity and ultimate viability of
an institution, with potentially broad market consequences. These
concerns resulted in our issuance on September 17 of this year of an
emergency order under section 12(k) of the Exchange Act (the
``September Emergency Order'').\4\ Pursuant to that emergency order we
imposed enhanced delivery requirements on sales of all equity
securities by adding and making immediately effective a temporary rule
to Regulation SHO, Rule 204T.\5\
---------------------------------------------------------------------------
\4\ See Exchange Act Release No. 58572 (Sept. 17, 2008), 73 FR
54875 (Sept. 23, 2008).
\5\ See id. The September Emergency Order also made immediately
effective amendments to Rule 203(b)(3) of Regulation SHO that
eliminate the options market maker exception from Regulation SHO's
close-out requirement. It also made immediately effective Rule 10b-
21, a ``naked'' short selling antifraud rule.
---------------------------------------------------------------------------
To further our goal of preventing substantial disruption in the
securities markets, we are adopting Rule 204T as an interim final
temporary rule, with some modifications to address operational and
technical concerns resulting from the requirements of the temporary
rule as adopted in the September Emergency Order. We intend that the
temporary rule will address potentially abusive ``naked'' short selling
by requiring that securities be purchased or borrowed to close out any
fail to deliver position in an equity security by no later than the
beginning of regular trading hours on the settlement day following the
date on which the fail to deliver position occurred. This temporary
rule should provide a powerful disincentive to those who might
otherwise engage in potentially abusive ``naked'' short selling.
II. Background
Short selling involves a sale of a security that the seller does
not own or a sale which is consummated by the delivery of a security
borrowed by, or for the account of, the seller.\6\ Short sales normally
are settled by the delivery of a security borrowed by or on behalf of
the seller. In a ``naked'' short sale, however, the short seller does
not borrow securities in time to make delivery to the buyer within the
standard three-day settlement period.\7\ As a result, the seller fails
to deliver securities to the buyer when delivery is due (known as a
``fail'' or ``fail to deliver'').\8\ Sellers sometimes intentionally
fail to deliver securities as part of a scheme to manipulate the price
of a security,\9\ or possibly to avoid
[[Page 61708]]
borrowing costs associated with short sales, especially when the costs
of borrowing stock are high.
---------------------------------------------------------------------------
\6\ 17 CFR 242.200(a).
\7\ See 2004 Regulation SHO Adopting Release, 69 FR at 48009
n.10.
\8\ Generally, investors complete or settle their security
transactions within three settlement days. This settlement cycle is
known as T+3 (or ``trade date plus three days''). T+3 means that
when a trade occurs, the participants to the trade deliver and pay
for the security at a clearing agency three settlement days after
the trade is executed so the brokerage firm can exchange those funds
for the securities on that third settlement day. The three-day
settlement period applies to most security transactions, including
stocks, bonds, municipal securities, mutual funds traded through a
brokerage firm, and limited partnerships that trade on an exchange.
Government securities and stock options settle on the next
settlement day following the trade (or T+1). In addition, Rule 15c6-
1 prohibits broker-dealers from effecting or entering into a
contract for the purchase or sale of a security that provides for
payment of funds and delivery of securities later than the third
business day after the date of the contract unless otherwise
expressly agreed to by the parties at the time of the transaction.
17 CFR 240.15c6-1; Exchange Act Release No. 33023 (Oct. 7, 1993), 58
FR 52891 (Oct. 13, 1993). However, failure to deliver securities on
T+3 does not violate Rule 15c6-1; see also Exchange Act Release No.
56212 (Aug. 7, 2007), 72 FR 45544, n. 2 (Aug. 14, 2007) (``2007
Regulation SHO Final Amendments'').
\9\ In 2003, the Commission settled a case against certain
parties relating to allegations of manipulative short selling in the
stock of a corporation. The Commission alleged that the defendants
profited from engaging in massive ``naked'' short selling that
flooded the market with the stock, and depressed its price. See
Rhino Advisors, Inc. and Thomas Badian, Lit. Rel. No. 18003 (Feb.
27, 2003); see also SEC v. Rhino Advisors, Inc. and Thomas Badian,
Civ. Action No. 03 civ 1310 (RO) (S.D.N.Y); see also Exchange Act
Release No. 48709 (Oct. 28, 2003), 68 FR 62972, 62975 (Nov. 6, 2003)
(``2003 Regulation SHO Proposing Release'') (describing the alleged
activity in the case involving stock of Sedona Corporation); 2004
Regulation SHO Adopting Release, 69 FR at 48016, n.76.
---------------------------------------------------------------------------
Although the majority of trades settle within the standard three-
day settlement cycle (``T+3''),\10\ we adopted Regulation SHO \11\ on
July 28, 2004, in part to address problems associated with persistent
fails to deliver securities and potentially abusive ``naked'' short
selling. For example, Regulation SHO requires broker-dealers to
``locate'' securities that the broker-dealer reasonably believes can be
delivered within the standard three-day settlement period.\12\
---------------------------------------------------------------------------
\10\ According to the National Securities Clearing Corporation
(``NSCC''), 99% (by dollar value) of all trades settle within T+3.
Thus, on an average day, approximately 1% (by dollar value) of all
trades, including equity, debt, and municipal securities fail to
settle on time.
\11\ 17 CFR 242.200. Regulation SHO became effective on January
3, 2005.
\12\ 17 CFR 242.203(b)(1). Rule 203(b)(1) of Regulation SHO
requires that, ``A broker or dealer may not accept a short sale
order in an equity security from another person, or effect a short
sale in an equity security for its own account, unless the broker or
dealer has: (i) Borrowed the security, or entered into a bona-fide
arrangement to borrow the security; or (ii) Reasonable grounds to
believe that the security can be borrowed so that it can be
delivered on the date delivery is due; and (iii) Documented
compliance with this paragraph (b)(1).'' This is known as the
``locate'' requirement. Market makers engaged in bona fide market
making in the security at the time they effect the short sale are
excepted from this requirement.
---------------------------------------------------------------------------
Another requirement of Regulation SHO aimed at potentially abusive
``naked'' short selling and reducing fails to deliver in certain equity
securities is the rule's ``close-out'' requirement. Specifically, Rule
203(b)(3) requires participants \13\ of a registered clearing
agency,\14\ which includes broker-dealers, to purchase shares to close
out fails to deliver in securities with large and persistent fails to
deliver, i.e., ``threshold securities.'' \15\ Until the position is
closed out, the participant responsible for the fail to deliver
position and any broker-dealer from which it receives trades for
clearance and settlement may not effect further short sales in that
threshold security without first borrowing or arranging to borrow the
securities.\16\
---------------------------------------------------------------------------
\13\ For purposes of Regulation SHO, the term ``participant''
has the same meaning as in section 3(a)(24) of the Exchange Act. See
15 U.S.C. 78c(a)(24).
\14\ The term ``registered clearing agency'' means a clearing
agency, as defined in Section 3(a)(23)(A) of the Exchange Act, that
is registered as such pursuant to Section 17A of the Exchange Act.
See 15 U.S.C. 78c(a)(23)(A) and 78q-1, respectively; see also 2004
Regulation SHO Adopting Release, 69 FR at 48031. The majority of
equity trades in the United States are cleared and settled through
systems administered by clearing agencies registered with the
Commission. The National Securities Clearing Corporation (``NSCC'')
clears and settles the majority of equity securities trades
conducted on the exchanges and in the over-the-counter market. NSCC
clears and settles trades through the Continuous Net Settlement
(``CNS'') system, which nets the securities delivery and payment
obligations of all of its members. NSCC notifies its members of
their securities delivery and payment obligations daily. In
addition, NSCC guarantees the completion of all transactions and
interposes itself as the contraparty to both sides of the
transaction.
\15\ Rule 203(c)(6) of Regulation SHO defines a ``threshold
security'' as any equity security of an issuer that is registered
pursuant to Section 12 of the Exchange Act (15 U.S.C. 78l) or for
which the issuer is required to file reports pursuant to Section
15(d) of the Exchange Act (15 U.S.C. 78o(d)) 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, and
that is equal to at least 0.5% of the issue's total shares
outstanding; and is included on a list disseminated to its members
by a self-regulatory organization (``SRO''). See 17 CFR
242.203(c)(6).
\16\ See 17 CFR 242.203(b)(3)(iv).
---------------------------------------------------------------------------
As adopted, Regulation SHO included two major exceptions to the
close-out requirement: The ``grandfather'' provision and the ``options
market maker'' exception. The ``grandfather'' provision had provided
that fails to deliver established prior to a security becoming a
threshold security did not have to be closed out in accordance with
Regulation SHO's thirteen consecutive settlement day close-out
requirement.
Due to our concerns about the potentially negative market impact of
large and persistent fails to deliver, and the fact that we continued
to observe threshold securities with fail to deliver positions that are
not being closed out under existing delivery and settlement
requirements, effective on October 15, 2007, we adopted an amendment to
Regulation SHO that eliminated the ``grandfather'' exception to
Regulation SHO's close-out requirement.\17\
---------------------------------------------------------------------------
\17\ See 2007 Regulation SHO Final Amendments, 72 FR 45544. This
amendment also contained a one-time phase-in period that provided
that previously-grandfathered fails to deliver in a security that
was a threshold security on the effective date of the amendment must
be closed out within 35 consecutive settlement days from the
effective date of the amendment. The phase-in period ended on
December 5, 2007.
---------------------------------------------------------------------------
The options market maker exception excepted any fail to deliver
position in a threshold security resulting from short sales effected by
a registered options market maker to establish or maintain a hedge on
options positions that were created before the underlying security
became a threshold security. On September 17, 2008, as part of the
September Emergency Order, we adopted and made immediately effective an
amendment to Rule 203(b)(3) of Regulation SHO to eliminate the options
market maker exception to the rule's close-out requirement.\18\
Following the issuance of the September Emergency Order, we adopted
amendments making permanent the elimination of the options market maker
exception.\19\ As we discussed in the 2008 Regulation SHO Final
Amendments, we believe it was appropriate to eliminate the options
market maker exception in part because substantial levels of fails to
deliver continue to persist in threshold securities and it appears that
a significant number of these fails to deliver are as a result of the
options market maker exception.\20\
---------------------------------------------------------------------------
\18\ See September Emergency Order, supra note 4.
\19\ See Exchange Act Release No. 58775 (Oct. 14, 2008)
(adopting final amendments to Rule 203(b)(3) of Regulation SHO to
eliminate the options market maker exception from the rule's close-
out requirement) (``2008 Regulation SHO Final Amendments''); see
also Exchange Act Release No. 56213 (Aug. 7, 2007), 72 FR 45558
(Aug. 14. 2007) (``2007 Regulation SHO Proposed Amendments);
Exchange Act Release No. 54154 (July 14, 2006), 71 FR 41710 (July
21, 2006) (``2006 Regulation SHO Proposed Amendments''); Exchange
Act Release No. 58107 (July 7, 2008), 73 FR 40201 (July 14, 2008)
(``2008 Regulation SHO Re-Opening Release'').
\20\ See 2008 Regulation SHO Final Amendments, supra note 19;
see also 2008 Regulation SHO Re-Opening Release, 73 FR 40201.
---------------------------------------------------------------------------
In addition to the actions we have taken aimed at reducing fails to
deliver and addressing potentially abusive ``naked'' short selling in
threshold securities, we have also taken action targeting potentially
abusive ``naked'' short selling in both threshold and non-threshold
securities. For example, in the September Emergency Order we adopted
and made immediately effective a ``naked'' short selling anti-fraud
rule, Rule 10b-21, aimed at sellers, including broker-dealers acting
for their own accounts, who deceive certain specified persons about
their intention or ability to deliver securities in time for settlement
and that fail to deliver securities by settlement date.\21\ Following
the issuance of the September Emergency Order, we adopted final
amendments making Rule 10b-21 permanent.\22\
---------------------------------------------------------------------------
\21\ See September Emergency Order, supra note 4.
\22\ See Exchange Act Release No. 58774 (Oct. 14, 2008) (``Anti-
Fraud Rule Adopting Release''); see also Exchange Act Release No.
57511 (March 17, 2008), 73 FR 15376 (March 21, 2008) (``Anti-Fraud
Rule Proposing Release'').
---------------------------------------------------------------------------
Also, as mentioned above, in the July Emergency Order and the Short
Sale Ban Emergency Order, we took emergency action targeting ``naked''
short selling in the securities of certain financial firms that
included non-threshold securities. Specifically, on July 15, 2008, we
published the July
[[Page 61709]]
Emergency Order \23\ that temporarily imposed enhanced requirements on
short sales in the publicly traded securities of certain substantial
financial firms. The July Emergency Order required that, in connection
with transactions in the publicly traded securities of the substantial
financial firms identified in Appendix A to the Emergency Order
(``Appendix A Securities''), no person could effect a short sale in the
Appendix A Securities using the means or instrumentalities of
interstate commerce unless such person or its agent had borrowed, or
arranged to borrow, the security or otherwise had the security
available to borrow in its inventory, prior to effecting such short
sale. The July Emergency Order also required that the short seller
deliver the security on settlement date, prohibiting any fails to
deliver in the Appendix A Securities.\24\
---------------------------------------------------------------------------
\23\ See supra note 1.
\24\ See id.
---------------------------------------------------------------------------
We issued the July Emergency Order because we were concerned that
false rumors regarding financial institutions of significance in the
U.S. may have fueled market volatility in the securities of some of
these institutions. As we noted in the July Emergency Order, false
rumors can lead to a loss of confidence in our markets. Such loss of
confidence can lead to panic selling, which may be further exacerbated
by ``naked'' short selling. As a result, the prices of securities may
artificially and unnecessarily decline below the price level that would
have resulted from the normal price discovery process. If significant
financial institutions are involved, this chain of events can threaten
disruption of our markets.\25\
---------------------------------------------------------------------------
\25\ We delayed the effective date of the July Emergency Order
to July 21, 2008 to create the opportunity to address, and to allow
sufficient time for market participants to make, adjustments to
their operations to implement the enhanced requirements. Moreover,
in addressing anticipated operational accommodations necessary for
implementation of the July Emergency Order, we issued an amendment
to the July Emergency Order on July 18, 2008. See Exchange Act
Release No. 58190 (July 18, 2008) (excepting from the July Emergency
Order bona fide market makers, short sales in Appendix A Securities
sold pursuant to Rule 144 of the Securities Act of 1933, and certain
short sales by underwriters, or members of a syndicate or group
participating in distributions of Appendix A Securities).
---------------------------------------------------------------------------
On July 29, 2008, we extended the July Emergency Order after
carefully reevaluating the current state of the markets in consultation
with officials of the Board of Governors of the Federal Reserve System,
the Department of the Treasury, and the Federal Reserve Bank of New
York and remaining concerned about the ongoing threat of market
disruption and effects on investor confidence.\26\ Pursuant to the
extension, the July Emergency Order terminated at 11:59 p.m. EDT on
August 12, 2008.
---------------------------------------------------------------------------
\26\ See Exchange Act Release No. 58248 (July 29, 2008), 73 FR
45257 (Aug. 4, 2008).
---------------------------------------------------------------------------
Due to our continued concerns regarding recent market conditions
and that short selling in the securities of a wider range of financial
institutions than those subject to the July Emergency Order may be
causing sudden and excessive fluctuations of the prices of such
securities that could threaten fair and orderly markets, on September
18, 2008, we issued the Short Sale Ban Emergency Order.\27\ The Short
Sale Ban Emergency Order temporarily prohibited any person from
effecting a short sale in the publicly traded securities of certain
financial institutions. On October 2, 2008, we extended the Short Sale
Ban Emergency Order due to our continued concerns regarding the ongoing
threat of market disruption and investor confidence in the financial
markets.\28\ Pursuant to the extension, the Short Sale Ban Emergency
Order terminated at 11:59 p.m. EDT on October 8, 2008.
---------------------------------------------------------------------------
\27\ See supra note 2.
\28\ See Exchange Act Release No. 58723 (Oct. 2, 2008) (stating
that the Short Sale Ban Emergency Order would terminate the earlier
of (i) three business days from the President's signing of the
Emergency Economic Stabilization Act of 2008 (H.R. 1424), or (ii)
11:59 p.m. E.D.T. on Friday, October 17, 2008).
---------------------------------------------------------------------------
Our concerns are no longer limited to just the financial
institutions that were the subject of the July Emergency Order and the
Short Sale Ban Emergency Order. Given the importance of confidence in
our financial markets as a whole, we have become concerned about sudden
and unexplained declines in the prices of equity securities generally.
These concerns resulted in our adopting and making immediately
effective in the September Emergency Order the enhanced delivery
requirements contained in temporary Rule 204T.\29\ For the reasons
explained in detail herein, today we are adopting the temporary rule as
set forth in the September Emergency Order, with modifications to
address technical and operational concerns resulting from the
requirements of the temporary rule.
---------------------------------------------------------------------------
\29\ See September Emergency Order, supra note 4.
---------------------------------------------------------------------------
III. Concerns About ``Naked'' Short Selling
We have been concerned about ``naked'' short selling and, in
particular, abusive ``naked'' short selling, for some time. As
discussed above, such concerns were a primary reason for our adoption
of Regulation SHO in 2004, the elimination of the ``grandfather'' and
options market maker exceptions to Regulation SHO's close-out
requirement, the adoption of a ``naked'' short selling antifraud rule,
and our recent issuance of the July Emergency Order, Short Sale Ban
Emergency Order, and the September Emergency Order.
Despite these Commission actions, due to our continuing concerns
about the potential impact of ``naked'' short selling on the weakened
financial markets, we believe it is necessary to immediately adopt as
an interim final temporary rule, temporary rule 204T, with some
modifications to address technical and operational concerns resulting
from the rule's requirements as set forth in the September Emergency
Order. We believe that adoption of temporary rule 204T as an interim
final temporary rule is necessary to further address abusive ``naked''
short selling and, therefore, fails to deliver resulting from such
short sales, in all equity securities. As we have stated on several
prior occasions, we believe that all sellers of securities should
promptly deliver, or arrange for delivery of, securities to the
respective buyer and all buyers of securities have a right to expect
prompt delivery of securities purchased.\30\ In addition, as we have
stated on several prior occasions, we are concerned about the negative
effect that fails to deliver may have on the markets and
shareholders.\31\
---------------------------------------------------------------------------
\30\ See, e.g., Anti-Fraud Rule Proposing Release, 73 FR at
15376.
\31\ See, e.g., 2007 Regulation SHO Final Amendments, 72 FR at
45544; 2006 Regulation SHO Proposed Amendments, 71 FR at 41712; 2007
Regulation SHO Proposed Amendments, 72 FR at 45558-45559; Anti-Fraud
Rule Proposing Release, 73 FR at 15378.
---------------------------------------------------------------------------
For example, large and persistent fails to deliver may deprive
shareholders of the benefits of ownership, such as voting and
lending.\32\ In addition, where a seller of securities fails to deliver
securities on settlement date, in effect the seller unilaterally
converts a securities contract (which is expected to settle within the
standard three-day settlement period) into an undated futures-type
contract, to which the buyer might not have agreed, or that might have
been priced differently.\33\ Moreover, sellers that fail to deliver
securities on settlement date may attempt to use this additional
freedom to engage in trading activities to improperly depress the price
of a security. For example, by not borrowing securities and, therefore,
not making delivery within the standard three-day settlement period,
the seller does not incur the costs of borrowing.
---------------------------------------------------------------------------
\32\ See id.
\33\ See id.
---------------------------------------------------------------------------
[[Page 61710]]
In addition, issuers and investors have repeatedly expressed
concerns about fails to deliver in connection with manipulative
``naked'' short selling. For example, in response to proposed
amendments to Regulation SHO in 2006 \34\ designed to further reduce
the number of persistent fails to deliver in certain equity securities
by eliminating Regulation SHO's ``grandfather'' exception, and limiting
the duration of the rule's options market maker exception, we received
a number of comments that expressed concerns about ``naked'' short
selling and extended delivery failures.\35\ Commenters continued to
express these concerns in response to proposed amendments to eliminate
the options market maker exception to the close-out requirement of
Regulation SHO in 2007.\36\
---------------------------------------------------------------------------
\34\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
\35\ See, e.g., letter from Patrick M. Byrne, Chairman and Chief
Executive Officer, Overstock.com, Inc., dated Sept. 11, 2006; letter
from Daniel Behrendt, Chief Financial Officer, and Douglas Klint,
General Counsel, TASER International, dated Sept. 18, 2006; letter
from John Royce, dated April 30, 2007; letter from Michael Read,
dated April 29, 2007; letter from Robert DeVivo, dated April 26,
2007; letter from Ahmed Akhtar, dated April 26, 2007.
\36\ See, e.g., letter from Jack M. Wedam, dated Oct. 16, 2007;
letter from Michael J. Ryan, Executive Director and Senior Vice
President, Center for Capital Markets Competitiveness, U.S. Chamber
of Commerce, dated Sept. 13, 2007 (``U.S. Chamber of Commerce'');
letter from Robert W. Raybould, CEO Enteleke Capital Corp., dated
Sept. 12, 2007 (``Raybould''); letter from Mary Helburn, Executive
Director, National Coalition Against Naked Shorting, dated Sept. 11,
2007 (``NCANS'').
---------------------------------------------------------------------------
To the extent that fails to deliver might be part of manipulative
``naked'' short selling, which could be used as a tool to drive down a
company's stock price,\37\ such fails to deliver may undermine the
confidence of investors.\38\ These investors, in turn, may be reluctant
to commit capital to an issuer they believe to be subject to such
manipulative conduct.\39\ In addition, issuers may believe that they
have suffered unwarranted reputational damage due to investors'
negative perceptions regarding fails to deliver in the issuer's
security.\40\ Unwarranted reputational damage caused by fails to
deliver might have an adverse impact on the security's price.\41\
---------------------------------------------------------------------------
\37\ See supra note 9 (discussing a case in which we alleged
that the defendants profited from engaging in massive ``naked''
short selling that flooded the market with the company's stock, and
depressed its price); see also S.E.C. v. Gardiner, 48 S.E.C. Docket
811, No. 91 Civ. 2091 (S.D.N.Y. March 27, 1991) (alleged
manipulation by sales representative by directing or inducing
customers to sell stock short in order to depress its price); U.S.
v. Russo, 74 F.3d 1383, 1392 (2d Cir. 1996) (short sales were
sufficiently connected to the manipulation scheme as to constitute a
violation of Exchange Act Section 10(b) and Rule 10b-5).
\38\ In response to the 2007 Regulation SHO Proposed Amendments,
we received comment letters discussing the impact of fails to
deliver on investor confidence. See, e.g., letter from NCANS.
Commenters expressed similar concerns in response to the 2006
Regulation SHO Proposed Amendments. See, e.g., letter from Mary
Helburn, Executive Director, National Coalition Against Naked
Shorting, dated Sept. 30, 2006 (``NCANS (2006)''); letter from
Richard Blumenthal, Attorney General, State of Connecticut, dated
Sept. 19, 2006 (``Blumenthal'').
\39\ In response to the 2007 Regulation SHO Proposed Amendments,
we received comment letters expressing concern about the impact of
potential ``naked'' short selling on capital formation, claiming
that ``naked'' short selling causes a drop in an issuer's stock
price and may limit the issuer's ability to access the capital
markets. See, e.g., letter from Robert K. Lifton, Chairman and CEO,
Medis Technologies, Inc., dated Sept. 12, 2007 (``Medis''); letter
from NCANS. Commenters expressed similar concerns in response to the
2006 Regulation SHO Proposed Amendments. See, e.g., letter from
Congressman Tom Feeney--Florida, U.S. House of Representatives,
dated Sept. 25, 2006 (``Feeney''); see also letter from Zix
Corporation, dated Sept. 19, 2006 (``Zix'') (stating that ``[m]any
investors attribute the Company's frequent re-appearances on the
Regulation SHO list to manipulative short selling and frequently
demand that the Company ``do something'' about the perceived
manipulative short selling. This perception that manipulative short
selling of the Company's securities is continually occurring has
undermined the confidence of many of the Company's investors in the
integrity of the market for the Company's securities.'').
\40\ Due in part to such concerns, some issuers have taken
actions to attempt to make transfer of their securities ``custody
only,'' (i.e., certificating the securities and prohibiting
ownership by a securities intermediary) thus preventing transfer of
their stock to or from securities intermediaries such as the
Depository Trust Company (``DTC'') or broker-dealers. See Exchange
Act Release No. 48709 (Oct. 28, 2003), 68 FR 62972, at 62975 (Nov.
6, 2003). Some issuers have attempted to withdraw their issued
securities on deposit at DTC in order to make the securities
ineligible for book-entry transfer at a securities depository. See
id. Withdrawing securities from DTC or requiring custody-only
transfers would undermine the goal of a national clearance and
settlement system designed to reduce the physical movement of
certificates in the trading markets. See id. We note, however, that
in 2003 the Commission approved a DTC rule change clarifying that
its rules provide that only its participants may withdraw securities
from their accounts at DTC, and establishing a procedure to process
issuer withdrawal requests. See Exchange Act Release No. 47978 (June
4, 2003), 68 FR 35037 (June 11, 2003).
\41\ See 2006 Regulation SHO Proposed Amendments, 71 FR at
41712; 2007 Regulation SHO Amendments, 72 FR at 45544; 2007
Regulation SHO Proposed Amendments, 72 FR at 45558-45559; Anti-Fraud
Rule Proposing Release, 73 FR at 15378 (providing additional
discussion of the impact of fails to deliver on the market); see
also Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR 62972,
62975 (Nov. 6, 2003) (discussing the impact of ``naked'' short
selling on the market).
---------------------------------------------------------------------------
IV. Discussion of Temporary Rule 204T
A. Rule 204T's Close-Out Requirement
In these unusual and extraordinary times and in an effort to
prevent substantial disruption to the securities markets, we have
concluded that it is necessary to immediately adopt as an interim final
temporary rule, temporary rule Rule 204T, with some modifications to
address technical and operational concerns resulting from the rule's
requirements as set forth in the September Emergency Order. We believe
that adoption of the temporary rule will substantially restrict the
practice of potentially abusive ``naked'' short selling in all equity
securities by strengthening the delivery requirements for such
securities.\42\
---------------------------------------------------------------------------
\42\ As noted above, in a ``naked'' short sale, the short seller
does not borrow or arrange to borrow securities in time to make
delivery to the buyer within the standard three-day settlement
period. As a result, the seller fails to deliver securities to the
buyer when delivery is due. See supra note 7 and supporting text.
---------------------------------------------------------------------------
Specifically, temporary Rule 204T(a) provides that a participant of
a registered clearing agency must deliver securities to a registered
clearing agency for clearance and settlement on a long or short sale in
any equity security by settlement date, or if a participant of a
registered clearing agency has a fail to deliver position at a
registered clearing agency in any equity security for a long or short
sale transaction in that equity security, the participant shall, by no
later than the beginning of regular trading hours \43\ on the
settlement day \44\ following the settlement date, immediately close
out the fail to deliver position by borrowing or purchasing securities
of like kind and quantity.\45\
---------------------------------------------------------------------------
\43\ ``Regular trading hours'' has the same meaning as in Rule
600(b)(64) of Regulation NMS. Rule 600(b)(64) provides that
``Regular trading hours means the time between 9:30 a.m. and 4 p.m.
Eastern Time, or such other time as is set forth in the procedures
established pursuant to Sec. 242.605(a)(2).''
\44\ The term ``settlement day'' is defined in Rule 203(c)(5) of
Regulation SHO as: ``* * * any business day on which deliveries of
securities and payments of money may be made through the facilities
of a registered clearing agency.'' 17 CFR 242.203(c)(5).
\45\ See temporary Rule 204T(a).
---------------------------------------------------------------------------
Temporary Rule 204T(a)'s close-out requirement requires a
participant of a registered clearing agency that has a fail to deliver
position at a registered clearing agency on the settlement date for a
transaction to immediately borrow or purchase securities to close out
the amount of the fail to deliver position by no later than the
beginning of regular trading hours on the settlement day following the
settlement date (the ``Close-Out Date''). This close-out requirement
requires that the participant take affirmative action to purchase or
borrow securities. Thus, a participant may not offset the amount of its
settlement date fail to deliver position with shares that the
participant receives or will receive on the Close-Out
[[Page 61711]]
Date.\46\ To meet its close-out obligation a participant also must be
able to demonstrate on its books and records that on the Close-Out Date
it purchased or borrowed shares in the full quantity of its settlement
date fail to deliver position and, therefore, that the participant has
a net flat or net long position on its books and records in that equity
security on the Close-Out Date.
---------------------------------------------------------------------------
\46\ In determining its close-out obligation, a participant may
rely on its net delivery obligation as reflected in its notification
from NSCC regarding its securities delivery and payment obligations,
provided such notification is received prior to the beginning of
regular trading hours on the Close-Out Date.
---------------------------------------------------------------------------
The temporary rule defines a ``settlement date'' as ``the business
day on which delivery of a security and payment of money is to be made
through the facilities of a registered clearing agency in connection
with the sale of a security.'' \47\ This definition is consistent with
Rule 15c6-1 that prohibits broker-dealers from effecting or entering
into a contract for the purchase or sale of a security that provides
for payment of funds and delivery of securities later than the third
business day after the date of the contract unless otherwise expressly
agreed to by the parties at the time of the transaction.\48\
---------------------------------------------------------------------------
\47\ See temporary Rule 204T(f)(1).
\48\ See 17 CFR 240.15c6-1.
---------------------------------------------------------------------------
Because most transactions settle by T+3 and because delivery on all
sales should be made by settlement date, participants should consider
having in place policies and procedures to help ensure that delivery is
being made by settlement date. We intend to examine participants'
policies and procedures to determine whether such policies and
procedures monitor for delivery by settlement date.\49\
---------------------------------------------------------------------------
\49\ Of course, broker-dealers must comply with any applicable
SRO policies and procedures requirements. For example, NASD Rule
3010 contains, among other things, written procedures requirements
for member firms.
---------------------------------------------------------------------------
Similar to the existing close-out requirement of Rule 203(b)(3) of
Regulation SHO, the temporary rule is based on a participant's fail to
deliver position at a registered clearing agency. As noted above, the
NSCC clears and settles the majority of equity securities trades
conducted on the exchanges and in the over-the-counter markets. NSCC
clears and settles trades through the CNS system, which nets the
securities delivery and payment obligations of all of its members. NSCC
notifies its members of their securities delivery and payment
obligations daily. Because the temporary rule is based on a
participant's fail to deliver position at a registered clearing agency,
the temporary rule is consistent with current settlement practices and
procedures and with the Regulation SHO framework regarding delivery of
securities.\50\
---------------------------------------------------------------------------
\50\ See 17 CFR 242.203(b)(3) (Regulation SHO's close-out
requirement). Consistent with current industry practice under
Regulation SHO, with respect to a net syndicate short position
created in connection with a distribution of a security that is part
of a fail to deliver position at a registered clearing agency, the
requirements of temporary Rule 204T shall not apply provided action
is taken to close out the net syndicate short position by no later
than the beginning of regular trading hours on the thirtieth day
after commencement of sales in the distribution. See e.g., Exchange
Act Release No. 58190 (July 18, 2008) (amending the July Emergency
Order to provide an exception from its requirements for fails to
deliver in connection with syndicate offerings).
---------------------------------------------------------------------------
In addition, similar to Rule 203(b)(3)(vi) of Regulation SHO, the
temporary rule provides that a participant may reasonably allocate its
responsibility to close out a fail to deliver position to another
broker-dealer from which the participant receives trades for clearance
or settlement.\51\ Specifically, temporary Rule 204T(d) provides that
if a participant of a registered clearing agency reasonably allocates a
portion of a fail to deliver position to another registered broker or
dealer for which it clears trades or from which it receives trades for
settlement, based on such broker's or dealer's short position, the
provisions of Rule 204T(a) and (b) relating to such fail to deliver
position shall apply to such registered broker or dealer that was
allocated the fail to deliver position, and not to the participant.\52\
---------------------------------------------------------------------------
\51\ See 17 CFR 242.203(b)(3)(vi). Rule 203(b)(3)(vi) provides
that ``[i]f a participant of a registered clearing agency reasonably
allocates a portion of a fail to deliver position to another
registered broker or dealer for which it clears trades or for which
it is responsible for settlement, based on such broker or dealer's
short position, then the provisions of this paragraph (b)(3)
relating to such fail to deliver position shall apply to the portion
of such registered broker or dealer that was allocated the fail to
deliver position, and not to the participant.''
\52\ See temporary Rule 204T(d).
---------------------------------------------------------------------------
Thus, participants that are able to identify the accounts of
broker-dealers for which they clear or from which they receive trades
for settlement, could allocate the responsibility to close out the fail
to deliver position to the particular broker-dealer account(s) whose
trading activities have caused the fail to deliver position provided
the allocation is reasonable (e.g., the allocation must be timely).
Absent such identification, however, the participant would remain
subject to the close-out requirement.
Unlike Rule 203(b)(3)(vi) of Regulation SHO, temporary Rule 204T(d)
imposes an additional notification requirement on a broker-dealer that
has been allocated responsibility for complying with the rule's
requirements. Specifically, temporary Rule 204T(d) provides that a
broker or dealer that has been allocated a portion of a fail to deliver
position that does not comply with the provisions of temporary Rule
204T(a) must immediately notify the participant that it has become
subject to the borrowing requirements of temporary Rule 204T(b).\53\ We
are adopting this notification requirement so that participants will
know when a broker-dealer for which they clear and settle trades has
become subject to the temporary rule's borrowing requirements.
---------------------------------------------------------------------------
\53\ See id.
---------------------------------------------------------------------------
The temporary rule also differs from the current close-out
requirement of Regulation SHO in that it applies to fails to deliver in
all equity securities rather than only to those securities with a large
and persistent level of fails to deliver, i.e., threshold securities. A
primary purpose of the temporary rule is to prevent the use of
``naked'' short selling as part of a manipulative scheme. To achieve
this purpose, the rule must apply to all equity securities, regardless
of the level or persistence of any fails to deliver in such securities.
In addition, as discussed above, we believe that all sellers of
securities should promptly deliver, or arrange for delivery of,
securities to the respective buyer and all buyers of securities have a
right to expect prompt delivery of securities purchased. We believe
this should be the case for sales in all equity securities and are
adopting this temporary rule to further that goal.
Regulation SHO, as adopted in 2004, was a first step in trying to
reduce persistent fails to deliver and address abusive ``naked'' short
selling. In Regulation SHO, we took a targeted approach, imposing
additional delivery requirements on securities with a substantial and
persistent amount of fails to deliver. As we stated in the 2004
Regulation SHO Adopting Release, we took this targeted approach at that
time in an effort not to burden the vast majority of securities where
there are not similar concerns regarding settlement.\54\ In addition,
Regulation SHO's close-out requirement was adopted to address potential
abuses that may occur with large, extended fails to deliver.\55\ We
also noted in the 2004 Regulation SHO Adopting Release, however, that
we would pay close attention to the operation and efficacy of
[[Page 61712]]
the provisions we were adopting at that time and would consider whether
any further action was warranted.\56\
---------------------------------------------------------------------------
\54\ See 2004 Regulation SHO Adopting Release, 69 FR at 48016.
\55\ See id. at 48017.
\56\ See id. at 48018.
---------------------------------------------------------------------------
Because of continued concerns about the potentially negative market
impact of fails to deliver, and the fact that through our monitoring of
the efficacy of Regulation SHO's close-out requirement we continued to
observe threshold securities with fail to deliver positions that are
not being closed out under existing delivery and settlement
requirements, we eliminated the ``grandfather'' and options market
maker exceptions to Regulation SHO's close-out requirements.\57\
---------------------------------------------------------------------------
\57\ On June 13, 2007, we adopted amendments to eliminate the
``grandfather'' exception to Regulation SHO's close-out requirement.
On September 17, 2008, in the September Emergency Order, we adopted
amendments to eliminate the options market maker exception, which
amendments were subsequently made permanent. See supra notes 17, 18
and 19.
---------------------------------------------------------------------------
However, we are concerned that Regulation SHO's current provisions
have not gone far enough in reducing fails to deliver and addressing
potentially abusive ``naked'' short selling.\58\ More is needed to
reduce fails to deliver and to address potentially abusive ``naked''
short selling, especially in light of the current instability and lack
of investor confidence in the financial markets.\59\ In addition,
because Regulation SHO's close-out requirement applies only to
threshold securities, fails to deliver in non-threshold securities
never have to be closed out.\60\ We believe that adoption of temporary
rule 204T as an interim final temporary rule is necessary to curtail
fails to deliver in both threshold and non-threshold securities to
further address abusive ``naked'' short selling in such securities.
---------------------------------------------------------------------------
\58\ See, e.g., 2007 Regulation SHO Final Amendments, 72 FR
45544 (eliminating the ``grandfather'' exception to Regulation SHO's
close-out requirement due to our observing continued fails to
deliver in threshold securities); 2008 Regulation SHO Final
Amendments, supra note 19 (eliminating the options market maker
exception to Regulation SHO's close-out requirement due to
substantial levels of fails to deliver continuing to persist in
optionable threshold securities).
\59\ See, e.g., letter from Leland Chan, General Counsel,
California Bankers Association, dated Aug. 21, 2008; letter from
Eric C. Jensen, Esq., Cooley Godward Kronish L.P., dated Aug. 21,
2008; letter from Steven B. Boehm and Cynthia M. Krus, Sutherland
Asbill Brennan LLP, dated July 31, 2008; letter from James J. Angel,
Professor of Finance, Georgetown University, McDonough School of
Business, dated Aug. 20, 2008; letter from Tuan Nguyen, dated Aug.
8, 2008.
\60\ OEA estimates that fails to deliver in non-threshold
securities averaged approximately 624 million shares or $4.6 billion
in value per day from January to July 2008. These fails account for
approximately 54.5% (56.6%) of all fail to deliver shares (by dollar
value).
---------------------------------------------------------------------------
As discussed above, due to our concerns about potentially abusive
``naked'' short selling in certain non-threshold securities, we
recently issued the July Emergency Order to temporarily impose enhanced
requirements on short sales in the Appendix A Securities. Following our
issuance of the July Emergency Order, we issued the Short Sale Ban
Emergency Order in which we took the additional step of prohibiting
short selling in the securities of a wider range of financial
institutions than those subject to the July Emergency Order. In
addition, we issued the September Emergency Order which, in part,
imposed enhanced delivery requirements for transactions in all equity
securities and made effective immediately a ``naked'' short selling
antifraud rule. We took these emergency actions because we were
concerned about panic selling in securities due to a loss of confidence
that could be further exacerbated by ``naked'' short selling.
Following the issuance of the July Emergency Order, members of the
public have repeatedly expressed their concerns about a loss of
confidence in the financial markets.\61\ In addition, since the
termination of the July Emergency Order and the issuance of the Short
Sale Ban Emergency Order and the September Emergency Order, we have
continued our evaluation of the markets and our discussions with the
Federal Reserve, Treasury, and the Federal Reserve Bank of New York
regarding the state of the financial markets. In light of these
processes, we have determined that we must take action to adopt as an
interim final temporary rule, temporary Rule 204T, to substantially
restrict ``naked'' short selling in all equity securities. As with the
July Emergency Order, the Short Sale Ban Emergency Order, and the
September Emergency Order, we are adopting this temporary rule as a
preventative step to help restore market confidence.
---------------------------------------------------------------------------
\61\ See, e.g., letter from Tom Donohue, President, U.S. Chamber
of Commerce, dated July 15, 2008; letter from Ron Heller, dated July
21, 2008; letter from Ronald L. Rourk, dated July 21, 2008; letter
from Wayne Jett, Managing Principal and Chief Economist at Classical
Capital, LLC, dated July 24, 2008; letter from Edward Herlilhy and
Theodore Levine, Wachtell, Lipton, Rosen and Katz, LLP, dated Sept.
16, 2008; letter from Sen. Hillary Rodham Clinton, dated Sept. 17,
2008; letter from Representative D. Burton, dated Sept. 18, 2008;
letter from Elliott Bossen, Chief Investment Officer at Silverback
Asset Management, dated Sept. 24, 2008.
---------------------------------------------------------------------------
In addition to applying the temporary rule to fails to deliver in
all equity securities, rather than just threshold securities, the
temporary rule also differs from the close-out requirement of Rule
203(b)(3) of Regulation SHO in that it shortens the close-out period
for such fails to deliver.\62\ For the reasons discussed below, rather
than requiring close out of a fail to deliver position within thirteen
consecutive settlement days (or 10 days after settlement date),
temporary Rule 204T requires a participant to immediately purchase or
borrow shares to close out a fail to deliver position by no later than
the beginning of regular trading hours on the settlement day following
the day on which the fail to deliver position occurs.
---------------------------------------------------------------------------
\62\ Rule 203(b)(3) of Regulation SHO provides: ``If a
participant of a registered clearing agency has a fail to deliver
position at a registered clearing agency in a threshold security for
thirteen consecutive settlement days, the participant shall
immediately thereafter close out the fail to deliver position by
purchasing securities of like kind and quantity.'' See 17 CFR
242.203(b)(3).
---------------------------------------------------------------------------
As noted above, trades in most securities generally settle within a
three-day settlement cycle, known as T+3 (or ``trade date plus three
days''). T+3 means that when a trade occurs, the participants to the
trade are expected to deliver and pay for the security at a clearing
agency three settlement days after the trade is executed so the
brokerage firm can exchange those funds for the securities on that
third business day. The three-day settlement period applies to most
security transactions, including stocks, bonds, municipal securities,
mutual funds traded through a brokerage firm, and limited partnerships
that trade on an exchange. Government securities and stock options
typically settle on the next business day following the trade (or
T+1).\63\ We believe that delivery on all sales should be made by
settlement date and, therefore, in temporary Rule 204T we are requiring
that fails to deliver in all equity securities be closed out by no
later than the beginning of regular trading hours on the Close-Out
Date.
---------------------------------------------------------------------------
\63\ See supra note 8.
---------------------------------------------------------------------------
In the 2004 Regulation SHO Adopting Release we stated we were
adopting a thirteen consecutive settlement day close-out requirement in
part because the close-out requirement applied to fails to deliver
resulting from long and short sales in threshold securities, and
extending the time period to ten days after settlement date for a
transaction would make the close-out requirement consistent with Rule
15c3-3(m).\64\ In addition, we noted in that release that ten days
after settlement was also the timeframe used at that time in NASD Rule
11830.\65\ We also acknowledged that a shorter timeframe, such as two
days after settlement, may capture many
[[Page 61713]]
instances of ordinary course settlement delays.\66\
---------------------------------------------------------------------------
\64\ See 17 CFR 240.15c3-3(m).
\65\ See 2004 Regulation SHO Adopting Release, 69 FR at 48017,
n.93.
\66\ See id.
---------------------------------------------------------------------------
In addition, we have stated previously that the vast majority of
fails to deliver are closed out within five days after T+3.\67\ In
addition, a recent analysis by our Office of Economic Analysis found
that more than half of all fails to deliver and more than 70% of all
fail to deliver positions are closed out within two settlement days
after T+3.\68\ Although this information shows that delivery is being
made, it demonstrates that often delivery is not being made until
several days following the standard three-day settlement cycle. In
addition, the current close-out requirement for threshold securities
under Regulation SHO and the lack of any close-out requirement for non-
threshold securities under Regulation SHO enables fails to deliver to
persist for many days beyond settlement date. We believe that allowing
fails to deliver to extend out beyond settlement date for a transaction
is too long.
---------------------------------------------------------------------------
\67\ See, e.g., 2007 Regulation SHO Final Amendments, 72 FR at
45544, n.5.
\68\ OEA's analysis examined the period from January to July
2008 and used the age of the fail to deliver position as reported by
the NSCC. The NSCC data included only securities with at least
10,000 shares in fails to deliver. We note that these numbers
included securities that were not subject to the close-out
requirement in Rule 203(b)(3) of Regulation SHO, which applies only
to ``threshold securities'' as defined in Rule 203(c)(6) of
Regulation SHO.
---------------------------------------------------------------------------
We have continuously monitored the extent of fails to deliver and
abusive ``naked'' short selling in the markets. We believe that
allowing fails to deliver in all equity securities to persist for
thirteen consecutive settlement days (10 days after settlement date) if
such securities are threshold securities, or indefinitely if such
securities are not threshold securities, is too long. As discussed
above, fails to deliver may be indicative of a scheme to manipulate the
price of a security. In addition, we are concerned about the negative
effect that fails to deliver and potentially abusive ``naked'' short
selling may have on the market and the broader economy, including on
investor confidence. Temporary Rule 204T addresses these concerns by
requiring a participant to immediately close out a fail to deliver
position by purchasing or borrowing securities by no later than the
beginning of regular trading hours on the Close-Out Date.
We believe we should act to require earlier close out so that more
sales settle by settlement date. Indeed, we believe that delivery on
all sales should be made by settlement date. As we discuss above, and
as we have stated on several prior occasions, we believe that all
sellers of securities should promptly deliver, or arrange for delivery
of, securities to the respective buyer and all buyers of securities
have a right to expect prompt delivery of securities purchased.\69\
Although the temporary rule's close-out requirement may capture some
instances of ordinary course settlement delays, we believe that the
temporary rule's close-out requirement is necessary to help ensure that
fails to deliver in all equity securities settle by settlement date. In
addition, as discussed above, due to our belief that delivery should be
made by settlement date, participants should consider having policies
and procedures in place to monitor for the delivery of securities by
settlement date.
---------------------------------------------------------------------------
\69\ See supra note 30.
---------------------------------------------------------------------------
We understand, however, that fails to deliver may occur from long
sales within the first two settlement days after settlement date for
legitimate reasons. For example, human or mechanical errors or
processing delays can result from transferring securities in custodial
or other form rather than book-entry form, thereby causing a fail to
deliver on a long sale within the normal three-day settlement period.
Thus, temporary Rule 204T(a)(1) includes an exception from the
temporary rule's close-out requirement for fail to deliver positions
resulting from long sales of all equity securities. Specifically,
temporary Rule 204T(a)(1) provides that if a participant of a
registered clearing agency has a fail to deliver position at a
registered clearing agency in any equity security and the participant
can demonstrate on its books and records that such fail to deliver
position resulted from a long sale, the participant shall by no later
than the beginning of regular trading hours on the third consecutive
settlement day following the settlement date, immediately close out the
fail to deliver position by purchasing securities of like kind and
quantity.\70\
---------------------------------------------------------------------------
\70\ See temporary Rule 204T(a)(1). We note that if a person
that has loaned a security to another person sells the security and
a bona fide recall of the security is initiated within two business
days after trade date, the person that has loaned the security will
be ``deemed to own'' the security for purposes of Rule 200(g)(1) of
Regulation SHO, and such sale will not be treated as a short sale
for purposes of temporary Rule 204T. In addition, a broker-dealer
may mark such orders as ``long'' sales provided such marking is also
in compliance with Rule 200(c) of Regulation SHO. Thus, the close-
out requirement of temporary Rule 204T(a)(1) applies to sales of
such securities.
---------------------------------------------------------------------------
B. Borrowing Requirements
If a participant does not purchase or borrow shares, as applicable,
to close out a fail to deliver position in accordance with temporary
Rule 204T, the participant violates the close-out requirement of the
temporary rule. In addition, the temporary rule imposes on the
participant for its own trades and on all broker-dealers from which
that participant receives trades for clearance and settlement
(including introducing and executing brokers), a requirement to borrow
or arrange to borrow securities prior to accepting or effecting further
short sales in that security.
Specifically, temporary Rule 204T(b) provides that the participant
and any broker or dealer from which it receives trades for clearance
and settlement, including any market maker that is otherwise entitled
to rely on the exception provided in Rule 203(b)(2)(iii) of Regulation
SHO,\71\ may not accept a short sale order in an equity security from
another person, or effect a short sale order in such equity security
for its own account, to the extent that the broker or dealer submits
its short sales to that participant for clearance and settlement,
without first borrowing the security, or entering into a bona-fide
arrangement to borrow the security, until the participant closes out
the fail to deliver position by purchasing securities of like kind and
quantity and that purchase has cleared and settled at a registered
clearing agency.\72\
---------------------------------------------------------------------------
\71\ See 17 CFR 242.203(b)(2)(iii) (providing an exception from
Regulation SHO's ``locate'' requirement for short sales effected by
a market maker in connection with bona fide market making activities
in the securities for which the exception is claimed).
\72\ See temporary Rule 204T(b).
---------------------------------------------------------------------------
The borrow requirements of temporary Rule 204T(b) are consistent
with the requirements of Rule 203(b)(3)(iv) of Regulation SHO for a
participant that has not closed out a fail to deliver position in a
threshold security that has persisted for thirteen consecutive
settlement days.\73\ Similar to Regulation SHO, the temporary rule is
aimed at addressing potentially abusive ``naked'' short selling. To
that end, we believe it is appropriate to include in the temporary rule
borrow requirements for broker-dealers,
[[Page 61714]]
including participants, that sell short a security that has a fail to
deliver position that has not been closed out in accordance with the
requirements of the temporary rule. We believe that the borrow
requirements of temporary Rule 204T(b) will further our goal of
limiting fails to deliver and addressing abusive ``naked'' short
selling by promoting the prompt and accurate clearance and settlement
of securities transactions. By requiring that participants and broker-
dealers from which they receive trades for clearance and settlement
borrow or arrange to borrow securities prior to accepting or effecting
short sales in the security that has a fail to deliver position that
has not been closed out, the temporary rule will help to ensure that
shares will be available for delivery on the short sale by settlement
date and, thereby, help to avoid additional fails to deliver occurring
in the security.
---------------------------------------------------------------------------
\73\ See 17 CFR 242.203(b)(3)(iv). Rule 203(b)(3)(iv) of
Regulation SHO provides that ``[i]f a participant of a registered
clearing agency has a fail to deliver position at a registered
clearing agency in a threshold security for thirteen consecutive
settlement days, the participant and any broker or dealer for which
it clears transactions, including any market maker that would
otherwise be entitled to rely on the exception provided in paragraph
(b)(2)(iii) of this section, many not accept a short sale order in
the threshold security from another person, or effect a short sale
in the threshold security for its own account, without borrowing the
security or entering into a bona fide arrangement to borrow the
security, until the participant closes out the fail to deliver
position by purchasing securities of like kind and quantity.''
---------------------------------------------------------------------------
Unlike the borrow requirements of Rule 203(b)(3)(iv) of Regulation
SHO, however, the borrow requirements of the temporary rule specify
that participants must notify all broker-dealers from which they
receive trades for clearance and settlement that a fail to deliver
position has not been closed out in accordance with temporary Rule
204T. Specifically, temporary Rule 204T(c) provides that the
participant must notify any broker or dealer from which it receives
trades for clearance and settlement, including any market maker that is
otherwise entitled to rely on the exception provided in Rule
203(b)(2)(iii) of Regulation SHO,\74\ (a) that the participant has a
fail to deliver position in an equity security at a registered clearing
agency that has not been closed out in accordance with the requirements
of temporary Rule 204T, and (b) when the purchase that the participant
has made to close out the fail to deliver position has cleared and
settled at a registered clearing agency.\75\
---------------------------------------------------------------------------
\74\ See 17 CFR 203(b)(2)(iii) (providing for an exception from
the ``locate'' requirement for market makers engaged in bona fide
market making in that security at the time of the short sale).
\75\ See temporary Rule 204T(c).
---------------------------------------------------------------------------
We are including this notification requirement in temporary Rule
204T(c) so that all broker-dealers that submit trades for clearance and
settlement to a participant that has a fail to deliver position in a
security that has not been closed out in accordance with temporary Rule
204T will be on notice that short sales in that security to be cleared
or settled through that participant will be subject to the borrow
requirements of temporary Rule 204T(b) until the fail to deliver
position has been closed out.
The temporary rule, however, includes an exception from the
borrowing requirements for any broker-dealer that can demonstrate that
it was not responsible for any part of the fail to deliver position of
the participant. Specifically, temporary Rule 204T(b)(1) provides that
a broker or dealer shall not be subject to the requirements of
temporary Rule 204T(b) if the broker or dealer timely certifies to the
participant that it has not incurred a fail to deliver position on
settlement date for a long or short sale in an equity security for
which the participant has a fail to deliver position at a registered
clearing agency or that the broker or dealer is in compliance with the
requirements of temporary Rule 204T(e).\76\ We have included this
exception because we do not believe that a broker-dealer should be
subject to the borrowing requirements of the temporary rule if the
broker-dealer can demonstrate that it did not incur a fail to deliver
position in the security on settlement date.
---------------------------------------------------------------------------
\76\ See temporary Rule 204T(b)(1). Temporary Rule 204T(e) is
discussed in detail below in Section IV.C.
---------------------------------------------------------------------------
In addition, as noted above, the temporary rule provides that a
participant may reasonably allocate (e.g., the allocation must be
timely) its responsibility to close out a fail to deliver position to
another broker-dealer for which the participant clears or from which
the participant receives trades for settlement. Thus, to the extent
that the participant can identify the broker-dealer(s) that have
contributed to the fail to deliver position, and the participant has
reasonably allocated the close-out obligation to the broker-dealer(s),
the requirement to borrow or arrange to borrow prior to effecting
further short sales in that security will apply to only those
particular broker-dealer(s).
C. Pre-Fail Credit
To avoid the borrow or arrangement to borrow requirement of
temporary Rule 204T(a), a participant could close-out the fail by
borrowing and delivering securities sufficient to close-out the fail to
deliver position prior to the beginning of regular trading hours on the
Close-Out Date. If, however, the participant does not succeed in
eliminating the fail to deliver position the participant can only close
out that position by immediately borrowing or purchasing securities to
close out the fail to deliver position by no later than the beginning
of regular trading hours on the Close-Out Date in accordance with
temporary Rule 204T.
To encourage close outs of fail to deliver positions prior to the
Close-Out Date, similar to the September Emergency Order,\77\ temporary
Rule 204T(e) provides that a broker-dealer can satisfy the temporary
rule's close-out requirement by purchasing securities in accordance
with the conditions of that provision (i.e., broker-dealers will
receive ``pre-fail credit'' for the purchase). Specifically, temporary
Rule 204T(e) provides that even if a participant of a registered
clearing agency has not closed out a fail to deliver position at a
registered clearing agency in accordance with temporary Rule 204T(a),
or has not allocated a fail to deliver position to a broker or dealer
in accordance with temporary Rule 204T(d), a broker or dealer shall not
be subject to the requirements of paragraphs (a) or (b) of the
temporary rule if the broker or dealer purchases securities prior to
the beginning of regular trading hours on the Close-Out Date for a long
or short sale to close out an open short position, and if:
---------------------------------------------------------------------------
\77\ See Exchange Act Release No. 58711 (Oct. 1, 2008) (stating
that in connection with extending the September Emergency Order, the
Commission incorporates and adopts the Division of Trading and
Markets: Guidance Regarding the Commission's Emergency Order
Concerning Rules to Protect Investors Against ``Naked'' Short
Selling Abuses and the Division of Trading and Markets Guidance
Regarding Sale of Loaned but Recalled Securities).
---------------------------------------------------------------------------
(1) The purchase is bona fide;
(2) The purchase is executed on, or after, trade date but by no
later than the end of regular trading hours on settlement date for the
transaction;
(3) The purchase is of a quantity of securities sufficient to cover
the entire amount of the open short position; and
(4) The broker or dealer can demonstrate that it has a net long
position or net flat position on its books and records on the
settlement day for which the broker or dealer is seeking to demonstrate
that it has purchased shares to close out its open short position.
To receive pre-fail credit under temporary Rule 204T(e), the
purchase must be ``bona fide.'' Thus, where a broker-dealer enters into
an arrangement with another person to purchase securities, and the
broker-dealer knows or has reason to know that the other person will
not deliver securities in settlement of the transaction, the purchase
will not be considered to be ``bona fide.'' \78\ In addition, the
purchase
[[Page 61715]]
must be of a quantity of securities sufficient to cover the entire
amount of the open short position.\79\
---------------------------------------------------------------------------
\78\ See 17 CFR 203(b)(3)(vii) (discussing bona fide purchases
for purposes of Regulation SHO). It is possible under Regulation SHO
that a close out by a participant of a registered clearing agency
may result in a fail to deliver position at another participant if
the counterparty from which the participant purchases securities
fails to deliver. However, Regulation SHO prohibits a participant of
a registered clearing agency, or a broker-dealer for which it clears
transactions, from engaging in ``sham close outs'' by entering into
an arrangement with a counterparty to purchase securities for
purposes of closing out a fail to deliver position and the purchaser
knows or has reason to know that the counterparty will not deliver
the securities, and which thus creates another fail to deliver
position. See id. at (b)(3)(vii); 2004 Regulation SHO Adopting
Release, 69 FR at 48018 n.96. In addition, we note that borrowing
securities, or otherwise entering into an arrangement with another
person to create the appearance of a purchase would not satisfy the
close-out requirement of Regulation SHO. For example, the purchase
of paired positions of stock and options that are designed to create
the appearance of a bona fide purchase of securities but that are
nothing more than a temporary stock lending arrangement would not
satisfy Regulation SHO's close-out requirement.
\79\ See temporary Rule 204T(e)(3).
---------------------------------------------------------------------------
Temporary Rule 204T(e) also requires that to receive pre-fail
credit, the purchase must be executed on, or after, trade date but by
no later than the end of regular trading hours on the settlement date
of the transaction that resulted in the fail to deliver position at a
registered clearing agency.\80\ The purpose of this provision is to
encourage broker-dealers to close out fail to deliver positions prior
to the beginning of regular trading hours on the Close-Out Date.
---------------------------------------------------------------------------
\80\ See temporary Rule 204T(e)(2).
---------------------------------------------------------------------------
In addition, to help ensure that broker-dealers purchase sufficient
shares to close out their fail to deliver positions, temporary Rule
204T(e) requires that the broker-dealer claiming pre-fail credit be net
long or net flat on the settlement day on which the broker-dealer is
claiming pre-fail credit.\81\ In addition, the temporary Rule 204T(e)
requires that the broker-dealer be able to demonstrate that it has
complied with this requirement.\82\ This requirement will enable the
Commission and SROs to monitor more effectively whether or not a
broker-dealer has complied with the requirements of temporary Rule
204T(e).
---------------------------------------------------------------------------
\81\ See temporary Rule 204T(e)(4).
\82\ See id.
---------------------------------------------------------------------------
D. Market Makers
To allow market makers to facilitate customer orders in a fast
moving market, similar to the September Emergency Order,\83\ temporary
rule includes a limited exception from the rule's close-out and
borrowing requirements for fails to deliver attributable to bona fide
market making activities by registered market makers, options market
makers, or other market makers obligated to quote in the over-the-
counter market. Specifically, temporary Rule 204T(a)(3) provides that
if a participant of a registered clearing agency has a fail to deliver
position at a registered clearing agency in any equity security that is
attributable to bona fide market making activities by a registered
market maker, options market maker, or other market maker obligated to
quote in the over-the-counter market (individually a ``Market Maker,''
collectively ``Market Makers''), the participant shall by no later than
the beginning of regular trading hours on the third consecutive
settlement day following the settlement date, immediately close out the
fail to deliver position by purchasing securities of like kind and
quantity.\84\
---------------------------------------------------------------------------
\83\ See supra note 77.
\84\ See temporary Rule 204T(a)(3). Unlike the September
Emergency Order, however, the temporary rule does not require a
Market Maker to which a fail to deliver position at a registered
clearing agency is attributable to attest in writing to the market
on which it is registered that the fail to deliver position at issue
was established solely for the purpose of meeting its bona fide
market making obligations and the steps the Market Maker has taken
in an effort to deliver securities to its registered clearing
agency. We believe the costs of such a requirement would outweigh
the benefits. We note, however, that as with any exception, a
broker-dealer would have to evidence eligibility for, and compliance
with, the requirements of the exception.
---------------------------------------------------------------------------
In addition, similar to the September Emergency Order,\85\ the
temporary rule excepts Market Makers from the borrowing requirements of
temporary Rule 204T(b) if the Market Maker can demonstrate that it does
not have an open fail to deliver position at the time of any additional
short sales. The borrowing requirements of the temporary rule apply to
all broker-dealers from which a participant of a registered clearing
agency receives trades for clearance and settlement. To allow Market
Makers to facilitate customer orders, we do not believe that a Market
Maker should be subject to the temporary rule's borrowing requirements
if the Market Maker does not have an open fail to deliver at the time
of any additional short sales.
---------------------------------------------------------------------------
\85\ See supra note 77.
---------------------------------------------------------------------------
E. Sales Pursuant to Rule 144
The temporary rule includes an exception for sales of all equity
securities pursuant to Rule 144 under the Securities Act of 1933
(``Securities Act'').\86\ Specifically, temporary Rule 204T(a)(2)
provides that if a participant of a registered clearing agency has a
fail to deliver position at a registered clearing agency in an equity
security sold pursuant to Rule 144 for thirty-five consecutive
settlement days after the settlement date for a sale in that equity
security, the participant shall, by no later than the beginning of
regular trading hours on the thirty-sixth consecutive settlement day
following the settlement date for the transaction, immediately close
out the fail to deliver position by purchasing securities of like kind
and quantity.\87\
---------------------------------------------------------------------------
\86\ See 17 CFR 230.144.
\87\ See temporary Rule 204T(a)(2).
---------------------------------------------------------------------------
Regulation SHO provides an exception from the ``locate''
requirement of Rule 203(b)(1) for situations where a broker-dealer
effects a short sale on behalf of a customer that is deemed to own the
security pursuant to Rule 200 of Regulation SHO, although, through no
fault of the customer or broker-dealer, it is not reasonably expected
that the security will be in the physical possession or control of the
broker-dealer by settlement date and, therefore, is a ``short'' sale
under the marking requirements of Rule 200(g).\88\ Rule 203(b)(2)(ii)
of Regulation SHO provides that in such circumstances, delivery must be
made on the sale as soon as all restrictions on delivery have been
removed, and in any event no later than 35 days after trade date, at
which time the broker-dealer that sold on behalf of the person must
either borrow securities or close out the open position by purchasing
securities of like kind and quantity.\89\ In addition, recently we
adopted amendments to the close-out requirement of Regulation SHO to
allow fails to deliver resulting from sales of threshold securities
pursuant to Rule 144 to be closed out within 35 rather than 13
consecutive settlement days.\90\
---------------------------------------------------------------------------
\88\ Pursuant to Rule 200(g)(2) of Regulation SHO, as adopted in
August 2004, generally these sales were marked ``short exempt.'' See
2004 Regulation SHO Adopting Release, 69 FR at 48030-48031; but cf.
Exchange Act Release No. 55970 (June 28, 2007), 72 FR 36348 (July 3,
2007) (removing the ``short exempt'' marking requirement).
\89\ See 17 CFR 242.203(b)(2)(ii). In the 2004 Regulation SHO
Adopting Release, the Commission stated that it believed that 35
calendar days is a reasonable outer limit to allow for restrictions
on a security to be removed if ownership is certain. In addition,
the Commission noted that Section 220.8(b)(2) of Regulation T of the
Federal Reserve Board allows 35 calendar days to pay for securities
delivered against payment if the delivery delay is due to the
mechanics of the transactions. See 2004 Regulation SHO Adopting
Release, 69 FR at 48015, n.72.
\90\ See 2007 Regulation SHO Final Amendments, 72 FR at 45550-
45551.
---------------------------------------------------------------------------
Securities sold pursuant to Rule 144 under the Securities Act are
formerly restricted securities that a seller is ``deemed to own,'' as
defined by Rule 200(a) of Regulation SHO.\91\ The securities, however,
may not be capable of being delivered on the settlement date due to
processing delays related to removal of the restricted legend and,
therefore, sales of these securities frequently result in fails to
deliver.
[[Page 61716]]
Consistent with our statements in connection with our recent amendments
to Regulation SHO in connection with closing out fails to deliver in
threshold securities sold pursuant to Rule 144, we believe that a
close-out requirement of 35 consecutive settlement days from settlement
date for fails to deliver resulting from sales of all equity securities
sold pursuant to Rule 144, will permit the orderly settlement of such
sales without the risk of causing market disruption due to unnecessary
purchasing activity (particularly if the purchases are for sizable
quantities of stock). Because the security being sold will be received
as soon as all processing delays have been removed, this additional
time will allow participants to close out fails to deliver resulting
from the sale of the security with the security sold, rather than
having to close out such fail to deliver position by purchasing
securities in the market.\92\
---------------------------------------------------------------------------
\91\ See 17 CFR 242.200(a).
\92\ We understand that sellers that own restricted equity
securities that wish to sell pursuant to an effective resale
registration statement under Rule 415 under the Securities Act
experience similar types of potential settlement delays as sales of
securities pursuant to Rule 144 under the Securities Act. Thus,
fails to deliver in such securities may be closed out in accordance
with temporary Rule 204T(a)(2) if the fails to deliver resulted from
sales of securities that were outstanding at the time they were sold
and the sale occurred after a registration has become effective. In
addition, we understand that sales pursuant to broker-assisted
cashless exercises of compensatory options to purchase a company's
stock, may result in potential settlement delays and, therefore,
fails to deliver. Such fails to deliver may be closed out in
accordance with temporary Rule 204T(a)(2).
---------------------------------------------------------------------------
If, however, a fail to deliver position resulting from the sale of
an equity security pursuant to Rule 144 is not closed out in accordance
with temporary Rule 204T(a)(2), the borrowing requirements of temporary
Rule 204T(b) will apply. Thus, if a participant does not close out a
fail to deliver position at a registered clearing agency in accordance
with temporary Rule 204T(a)(2), the temporary rule prohibits the
participant, and any broker-dealer from which it receives trades for
clearance and settlement, including market makers, from accepting any
short sale orders or effecting further short sales in the particular
security without borrowing, or entering into a bona-fide arrangement to
borrow, the security until the participant closes out the entire fail
to deliver position by purchasing securities of like kind and quantity
and that purchase has cleared and settled at a registered clearing
agency.\93\
---------------------------------------------------------------------------
\93\ See temporary Rule 204T(b).
---------------------------------------------------------------------------
V. Other Matters
The Administrative Procedure Act generally requires an agency to
publish notice of a proposed rulemaking in the Federal Register.\94\
This requirement does not apply, however, if the agency ``for good
cause finds * * * that notice and public procedure are impracticable,
unnecessary, or contrary to the public interest.'' \95\ Further, the
Administrative Procedure Act also generally requires that an agency
publish an adopted rule in the Federal Register 30 days before it
becomes effective.\96\ This requirement, however, does not apply if the
agency finds good cause for making the rule effective sooner.\97\
---------------------------------------------------------------------------
\94\ See 5 U.S.C. Sec. 553(b).
\95\ Id.
\96\ See 5 U.S.C. Sec. 553(d).
\97\ Id.
---------------------------------------------------------------------------
For the reasons discussed throughout this release, we believe that
we have good cause to act immediately to adopt this rule on an interim
final temporary basis. The September Emergency Order, in which we
adopted and made immediately effective temporary Rule 204T expires at
11:59 p.m. EDT on October 17, 2008. As discussed throughout this
release, we have determined it is necessary to act immediately and
adopt this rule on an interim final temporary basis so that temporary
rule 204T remains in effect in the form set forth herein following the
expiration of the September Emergency Order.
This temporary rule takes effect on October 17, 2008. For the
reasons discussed above, we have acted on an interim final temporary
basis. We emphasize that we are requesting comments on the temporary
rule and will carefully consider the comments we receive and respond to
them in a subsequent release. Moreover, this is a temporary rule, and
will expire on July 31, 2009. Setting a termination date for the rule
will necessitate further Commission action no later than the end of
that period if the Commission intends to continue the same, or similar,
requirements contained in the temporary rule.
The sunset provision will enable the Commission to assess the
operation of the temporary rule and intervening developments, including
a restoration of stability to the financial markets, as well as public
comments, and consider whether to continue the rule with or without
modification or not at all.
We find that there is good cause to have the temporary rule take
effect on October 17, 2008 and that notice and public procedure in
advance of effectiveness of the rule are impracticable, unnecessary,
and contrary to the public interest.\98\
---------------------------------------------------------------------------
\98\ This finding also satisfies the requirements of 5 U.S.C.
808(2), allowing the rules to become immediately effective
notwithstanding the requirements of 5 U.S.C. 801 (if a Federal
agency finds that notice and public comment are ``impractical,
unnecessary, or contrary to the public interest,'' a rule ``shall
take effect at such time as the Federal agency promulgating the rule
determines.'').
---------------------------------------------------------------------------
VI. Request for Comment
We are requesting comments from all members of the public. We will
carefully consider the comments that we receive and intend to respond
to them in a subsequent release. We seek comment generally on all
aspects of the temporary rule. In addition, we seek comment on the
following:
[cir] The temporary rule requires participants to immediately close
out a fail to deliver position by no later than the beginning of
regular trading hours on the Close-Out Date. Should we narrow the
close-out requirement further? Should we allow a longer or shorter
period of time within which to close out a fail to deliver position?
What would be the justifications for allowing a shorter or longer
close-out period?
[cir] Are there any operational or compliance issues related to
complying with the requirement in temporary Rule 204T(a) to immediately
purchase or borrow securities ``by no later than the beginning of
regular trading hours''? Should we allow a participant to take steps to
purchase or borrow securities after the beginning of regular trading
hours on the Close-Out Date to satisfy temporary Rule 204T(a)? If so,
how much time after the beginning of regular trading hours should we
provide? For example, should we allow trading during an opening auction
that commences after the beginning of regular trading hours or should
we provide until noon? Alternatively, should we allow participants to
purchase or borrow securities at any time on the Close-Out Date to
satisfy the temporary rule's close-out requirement? What would be the
costs and benefits of allowing additional time beyond the beginning of
regular trading hours on the Close-Out Date for the participant to
purchase or borrow securities to close out a fail to deliver position?
[cir] Temporary Rule 204T(f)(1) defines ``settlement date'' as
``the business day on which delivery of a security and payment of money
is to be made through the facilities of a registered clearing agency in
connection with the sale of a security.'' Is this an appropriate
definition of ``settlement date''?
[cir] Due to our expectation that delivery of securities on all
sales should be made
[[Page 61717]]
by settlement date, we state in the release that participants should
consider having in place policies and procedures to monitor for the
delivery of securities by settlement date. Should we adopt a rule
requiring that participants have in place such policies and procedures?
[cir] Should a de minimus amount of fails to deliver be excepted
from the close-out requirements of the temporary rule? If so, what
should be the de minimus amount?
[cir] Should the temporary rule be expanded to apply to debt as
well as equity securities? Please explain.
[cir] The temporary rule requires that a participant purchase
securities by no later than the beginning of regular trading hours on
the third settlement day after the settlement date for a fail to
deliver position resulting from a long sale transaction. What are the
costs associated with purchasing versus borrowing securities to close
out a fail to deliver position? Should we permit participants to close
out a fail to deliver position for long sale transactions by borrowing
as well as purchasing securities? Please explain.
[cir] The temporary rule allows a participant to close out a fail
to deliver position attributable to bona fide market making activity by
a registered market maker, options market maker, or other market maker
obligated to quote in the over-the-counter market by purchasing
securities of like kind and quantity by no later than the beginning of
regular trading hours on the third settlement day after the settlement
date. Should this close-out period be a shorter or longer time-frame?
Please explain. What would be the costs and benefits of a longer or
shorter close-out period for such fails to deliver?
[cir] The temporary rule does not include a complete exception from
its close-out requirement for options market makers with fails to
deliver resulting from short sales effected to establish or maintain a
hedge on options positions. We seek comment regarding the impact of the
temporary rule on options market makers that are subject to the close-
out requirement of the temporary rule. For example, we seek comment
regarding the impact of the temporary rule, if any, on liquidity,
spread widths, and quote depth in the securities that are subject to
the temporary rule.
[cir] The temporary rule allows a participant to close out a fail
to deliver position resulting from a sale of an equity security
pursuant to Rule 144 of the Securities Act by no later than the
beginning of regular trading hours on the thirty-sixth consecutive
settlement day after the settlement date. Are there other types of
sales that encounter settlement delays due to processing requirements
similar to sales of Rule 144 securities that should have an exception
from the close-out requirements of temporary Rule 204T(a)? Please
explain.
[cir] What impact will the temporary rule have on borrowing costs?
Please explain. What impact will the temporary rule have on legitimate
short selling and market efficiency?
[cir] An arrangement to borrow means a bona fide agreement to
borrow the security such that the security being borrowed is set aside
at the time of the arrangement solely for the person requesting the
security. Should we define ``arrangement to borrow'' as requiring a
contract between the broker-dealer and the lending source?
[cir] Should temporary Rule 204T(b) require that participants and
broker-dealers from which participants receive trades for clearance and
settlement borrow securities prior to effecting further short sales,
rather than allowing for either an arrangement to borrow or a borrow?
If a fail to deliver position has not been closed out in accordance
with temporary Rule 204T, should we prohibit the participant, and any
broker-dealer from which it receives trades for clearance and
settlement, from effecting any further short sales until the fail to
deliver position has been closed out?
[cir] If a participant becomes subject to the requirements of
temporary Rule 204T(b), the participant will be required to borrow or
arrange to borrow securities prior to settlement at a registered
clearing agency of the purchase to close out the fail to deliver
position. What are the costs associated with this requirement?
[cir] Temporary Rule 204T(c) imposes a notification requirement on
participants. Will such a notification requirement impose operational
or systems costs on participants? What types of communication
mechanisms will participants use to comply with this requirement of the
temporary rule? What will be the costs and benefits of this
notification requirement?
[cir] The temporary rule allows a broker-dealer to obtain pre-fail
credit if it purchases securities in accordance with the conditions
specified in temporary Rule 204T(e). Are there any operational or
compliance concerns associated with the conditions of temporary Rule
204T(e)? To what extent, if any, will temporary Rule 204T(e) encourage
broker-dealers to close out a fail to deliver position prior to the
Close-Out Date?
[cir] The temporary rule does not propose amendments to the
``locate'' requirement of Rule 203(b)(1) of Regulation SHO. In addition
to the temporary rule, should we also require that broker-dealers
arrange to borrow, or borrow, equity securities prior to effecting
short sales in those equity securities? How would this impact the
liquidity and availability of such equity securities overall? How would
this affect lending rates for such equity securities?
[cir] The temporary rule imposes a close-out requirement on fails
to deliver for all equity securities. Due to this hard delivery
requirement is it necessary to retain the ``locate'' requirement of
Regulation SHO for short sales? What are the benefits of continuing to
require that broker-dealers have a reasonable grounds to believe that a
security can be borrowed so that it can be delivered by settlement date
if a participant is required to immediately close out a fail to deliver
position by no later than the beginning of regular trading hours on the
Close-Out Date?
[cir] The temporary rule does not allow any exceptions for fails to
deliver due to mechanical aspects of corporate events, such as equity
offers, including initial public offerings (``IPOs''),\99\ and tender
offers. Will the temporary rule cause any disruption to these corporate
events? For example, will the temporary rule interfere with the ability
of underwriters to provide price support? Would any disruption warrant
an exception for certain corporate events? If so, should the exception
focus on particular corporate events and why? How much time is needed
for securities subject to such corporate events to be delivered? Would
providing exceptions for such securities create opportunities for price
manipulation?
---------------------------------------------------------------------------
\99\ See Amy Edwards and Kathleen Weiss Hanley, Short Selling in
Initial Public Offerings (2008) http://ssrn.com/abstract=981242
showing that fails to deliver in IPOs are not from ``naked'' short
selling but instead seem to be related to fails to deliver resulting
from long sales that result from underwriter price support. The
aggregate fails to deliver in these stocks seem to persist for the
typical price support period. Thus, the temporary rule's close-out
requirement could apply to a high proportion of such fails to
deliver, potentially as much as 2.5% of the shares offered on
average. Edwards and Hanley believe that such a result could have a
substantial impact on the aftermarket of IPOs.
---------------------------------------------------------------------------
VII. Paperwork Reduction Act
A. Background
Temporary Rule 204T contains ``collection of information''
requirements within the meaning of the Paperwork Reduction Act of 1995
(``Paperwork Reduction Act'').\100\ We submitted these requirements to
the
[[Page 61718]]
Office of Management and Budget (``OMB'') for review and approval in
accordance with 44 U.S.C. 3507(j) and 5 CFR 1320.13. Separately, we
have submitted the collection of information to OMB for review and
approval in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The
OMB has approved the collection of information on an emergency basis
with an expiration date of April 30, 2009. An agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information unless it displays a currently valid OMB control number.
The title for the collection of information is: ``Temporary Rule 204T''
and the OMB control number for the collection of information is 3235-
0647.
---------------------------------------------------------------------------
\100\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------
Temporary Rule 204T will substantially restrict the practice of
``naked'' short selling in all equity securities by strengthening the
delivery requirements for such securities.\101\ Temporary Rule 204T(a)
amends Regulation SHO to require that participants of a clearing agency
registered with the Commission deliver securities by settlement date,
or if the participants have not delivered shares by settlement date,
the participants must, by no later than the beginning of regular
trading hours on the settlement day following the settlement date (the
``Close-Out Date''), immediately close out the fail to deliver position
by borrowing or purchasing securities of like kind and quantity.
---------------------------------------------------------------------------
\101\ As noted above, in a ``naked'' short sale, the short
seller does not borrow or arrange to borrow securities in time to
make delivery to the buyer within the standard three-day settlement
period. As a result, the seller fails to deliver securities to the
buyer when delivery is due.
---------------------------------------------------------------------------
A participant that does not comply with the temporary rule's close-
out requirements will have violated temporary Rule 204T. In addition,
the participant and any broker-dealer from which it receives trades for
clearance and settlement, will not be able to short sell the security
either for itself or for the account of another, unless it has
previously arranged to borrow or has borrowed the security, until the
participant closes out the fail to deliver position by purchasing
securities of like kind and quantity and that purchase has cleared and
settled at a registered clearing agency.\102\
---------------------------------------------------------------------------
\102\ See temporary Rule 204T(b).
---------------------------------------------------------------------------
Several provisions under temporary Rule 204T will impose a new
``collection of information'' within the meaning of the Paperwork
Reduction Act. These collections of information are mandatory for
broker-dealers relying on the rule. The information collected will be
retained and/or provided to other entities pursuant to the specific
rule provisions and will be available to the Commission and SRO
examiners upon request. The information collected will aid the
Commission and SROs in monitoring compliance with the rule's
requirements.
1. Allocation Notification Requirement
Similar to Rule 203(b)(3)(vi) of Regulation SHO, temporary Rule
204T(d) provides that a participant may reasonably allocate its
responsibility to close out a fail to deliver position to another
broker-dealer for which the participant clears or from which the
participant receives trades for settlement.\103\ Unlike Rule
203(b)(3)(vi) of Regulation SHO, however, temporary Rule 204T(d)
imposes an additional notification requirement on a broker-dealer that
has been allocated responsibility for complying with the rule's
requirements (the ``allocation notification requirement'').\104\
---------------------------------------------------------------------------
\103\ See 17 CFR 242.203(b)(3)(vi). Rule 203(b)(3)(vi) provides
that ``[i]f a participant of a registered clearing agency reasonably
allocates a portion of a fail to deliver position to another
registered broker or dealer for which it clears trades or for which
it is responsible for settlement, based on such broker or dealer's
short position, then the provisions of this paragraph (b)(3)
relating to such fail to deliver position shall apply to the portion
of such registered broker or dealer that was allocated the fail to
deliver position, and not to the participant.''
\104\ See temporary Rule 204T(d).
---------------------------------------------------------------------------
Specifically, temporary Rule 204T(d) provides that a broker or
dealer that has been allocated a portion of a fail to deliver position
that does not comply with the provisions of temporary Rule 204T(a) must
immediately notify the participant that it has become subject to the
borrowing requirements of temporary Rule 204T(b).\105\ This allocation
notification requirement is designed to help ensure that participants
that receive trades for clearance and settlement from broker-dealers
will be on notice that the broker-dealer is subject to the borrow
requirements of temporary Rule 204T(b) until the fail to deliver
position has been closed out.
---------------------------------------------------------------------------
\105\ See id.
---------------------------------------------------------------------------
Such notification will require a broker-dealer to determine that it
has a fail to deliver that does not comply with the provisions of
temporary Rule 204T(a) and, therefore, has become subject to the
requirements of temporary Rule 204T(b). After making such
determination, the temporary rule requires that the broker-dealer
notify such participant regarding this information.
We estimate that such procedures will take a broker-dealer no more
than approximately 0.16 hours (10 minutes) to complete. We base this
estimate in part on the fact that, in accordance with Rule
203(b)(3)(vi) of Regulation SHO, participants are permitted to allocate
responsibility to close out a portion of a fail to deliver position to
a broker-dealer that is responsible for the fail to deliver position;
the fact that most broker-dealers already have the necessary
communication mechanisms in place and are already familiar with
notification processes and procedures to comply with the borrowing
requirements of Rule 203(b)(3)(iv) of Regulation SHO for threshold
securities; and the fact that broker-dealers will be able to continue
to use the same communication mechanisms, processes and procedures to
comply with the notification requirement of temporary Rule 204T(b). On
average, participants estimate that currently it takes approximately
0.16 hours (10 minutes) to notify broker-dealers pursuant to Rule
203(b)(3)(iv) of Regulation SHO.\106\
---------------------------------------------------------------------------
\106\ We base this estimate on information provided to our staff
by three small, three medium, and three large registered clearing
agency participants.
---------------------------------------------------------------------------
If a broker-dealer has been allocated a portion of a fail to
deliver position in an equity security and after the beginning of
regular trading hours on the Close-Out Date, the broker-dealer has to
determine whether or not that portion of the fail to deliver position
was not closed out in accordance with temporary Rule 204T(a), we
estimate that a broker-dealer will have to make such determination with
respect to approximately 1.76 equity securities per day.\107\
---------------------------------------------------------------------------
\107\ OEA estimates that there are approximately 9,809 fail to
deliver positions per settlement day. Across 5,561 broker-dealers,
the number of securities per broker-dealer per day is approximately
1.76 equity securities. During the period from January to July 2008,
approximately 4,321 new fail to deliver positions occurred per day.
The NSCC data for this period includes only securities with at least
10,000 shares in fails to deliver. To account for securities with
fails to deliver below 10,000 shares, the figure is multiplied by a
factor of 2.27. The factor is estimated from a more complete data
set obtained from NSCC during the period from September 16, 2008 to
September 22, 2008. It should be noted that these numbers include
securities that were not subject to the close-out requirement of
Rule 203(b)(3) of Regulation SHO.
---------------------------------------------------------------------------
As of December 31, 2007, there were 5,561 registered broker-
dealers. Each of these broker-dealers could clear trades through a
participant of a registered clearing agency and, therefore, become
subject to the notification requirements of temporary Rule 204T(b). We
estimate a total of 2,466,415 notifications in accordance with
temporary Rule 204T(b) across all broker-dealers (that were allocated
responsibility to close out a fail to deliver position) per year
[[Page 61719]]
(5,561 broker-dealers notifying participants once per day \108\ on 1.76
securities, multiplied by 252 trading days in a year). The total
estimated annual burden hours per year will be approximately 394,626
burden hours (2,466,415 multiplied by 0.16 hours/notification). We
estimate that the paperwork compliance for the allocation notification
requirement for each broker-dealer will be approximately 71.0 burden
hours per year.
---------------------------------------------------------------------------
\108\ Because failure to comply with the close-out requirements
of temporary Rule 204T(a) is a violation of the temporary rule, we
believe that a broker-dealer would make the notification to a
participant that it is subject to the borrowing requirements of
temporary Rule 204T(b) at most once per day.
---------------------------------------------------------------------------
2. Demonstration Requirement for Fails To Deliver on Long Sales
Temporary Rule 204T(a)(1) includes an exception from temporary
rule's close-out requirement for fail to deliver positions resulting
from long sales of all equity securities. Under this exception, if a
participant has a fail to deliver position at a registered clearing
agency in an equity security and can demonstrate on its books and
records that such fail to deliver position resulted from a long sale
(the ``demonstration requirement for fails to deliver on long sales''),
such participant will have until no later than the beginning of regular
trading hours on the third consecutive settlement day following the
settlement date to immediately close out the fail to deliver position
by purchasing securities of like kind and quantity.\109\
---------------------------------------------------------------------------
\109\ See temporary Rule 204T(a)(1).
---------------------------------------------------------------------------
This provision allows a participant an additional two settlement
days in which to close out the fail to deliver position that resulted
from a long sale, provided that the participant's books and records
reflect the fact that the fail to deliver resulted from a long
sale.\110\
---------------------------------------------------------------------------
\110\ See id.
---------------------------------------------------------------------------
The demonstration requirement will require a participant of a
registered clearing agency to determine whether it has a fail to
deliver position at a registered clearing agency in an equity security
that resulted from a long sale. After making such determination, the
temporary rule requires that the participant demonstrate or reflect
this information in its books and records. We estimate that such
procedures will take a participant of a registered clearing agency no
more than approximately 0.16 hours (10 minutes) to complete.
We base this estimate on the fact that, to comply with Regulation
SHO's marking requirements, broker-dealers are already required to
ascertain whether a customer is ``deemed to own'' the securities being
sold before marking a sell order ``long'' and, if the securities are
not in the broker-dealer's physical possession or control, whether the
broker-dealer reasonably expects that the shares will be in the broker-
dealer's physical possession or control by settlement date.\111\ This
reasonableness determination includes consideration of whether or not a
prior sale resulted in a fail to deliver position. In addition, broker-
dealers already must comply with the documentation requirement
contained in the ``locate'' requirement of Rule 203(b)(1) of Regulation
SHO. Participants will be able to use similar mechanisms, processes and
procedures to demonstrate compliance with the temporary rule's close-
out requirement for fails to deliver resulting from long sales as they
use for compliance with the current requirements of Regulation SHO.
---------------------------------------------------------------------------
\111\ See 17 CFR 242.200(g)(1).
---------------------------------------------------------------------------
If a participant of a registered clearing agency has a fail to
deliver position in an equity security at a registered clearing agency
and determined that such fail to deliver position resulted from a long
sale, we estimate that a participant of a registered clearing agency
will have to make such determination with respect to approximately 34
securities per day.\112\
---------------------------------------------------------------------------
\112\ OEA estimates approximately 68% of trades are long sales
and applies this percentage to the number of fail to deliver
positions per day. 68% of 50 securities per day is 34 securities per
day. The 68% figure is estimated as 100% minus the proportion of
short sale trades found in the Regulation SHO Pilot Study. See
http://www.sec.gov/news/studies/2007/regshopilot020607.pdf.
---------------------------------------------------------------------------
As of July 31, 2008, there were 197 participants of NSCC, the
primary registered clearing agency responsible for clearing U.S.
transactions that were registered as broker-dealers. We estimate a
total of 1,687,896 demonstrations in accordance with temporary Rule
204T(a)(1) across all participants per year (197 participants checking
for compliance once per day on 34 securities, multiplied by 252 trading
days in a year). The total approximate estimated annual burden hour per
year will be approximately 270,063 burden hours (1,687,896 multiplied
by 0.16 hours/documentation). We estimate that the paperwork burden for
the temporary demonstration provision for each participant will be
approximately 1,371 burden hours per year.
3. Pre-Borrow Notification Requirement
The borrowing requirements of temporary Rule 204T(b) are similar to
the requirements of Rule 203(b)(3)(iv) of Regulation SHO for a
participant that has failed to close out a fail to deliver position in
a threshold security that has persisted for thirteen consecutive
settlement days.\113\ Unlike the current borrow requirements of Rule
203(b)(3)(iv) of Regulation SHO, however, temporary Rule 204T(c)
specifies that participants must notify all broker-dealers from which
they receive trades for clearance and settlement that a fail to deliver
position has not been closed out in accordance with temporary Rule
204T(a) (the ``pre-borrow notification requirement'').
---------------------------------------------------------------------------
\113\ See 17 CFR 242.203(b)(3)(iv). Rule 203(b)(3)(iv) of
Regulation SHO provides that ``[i]f a participant of a registered
clearing agency has a fail to deliver position at a registered
clearing agency in a threshold security for thirteen consecutive
settlement days, the participant and any broker or dealer for which
it clears transactions, including any market maker that would
otherwise be entitled to rely on the exception provided in paragraph
(b)(2)(iii) of this section, may not accept a short sale order in
the threshold security from another person, or effect a short sale
in the threshold security for its own account, without borrowing the
security or entering into a bona fide arrangement to borrow the
security, until the participant closes out the fail to deliver
position by purchasing securities of like kind and quantity.''
---------------------------------------------------------------------------
Specifically, temporary Rule 204T(c) provides that the participant
must notify any broker or dealer from which it receives trades for
clearance and settlement, including any market maker that would
otherwise be entitled to rely on the exception provided in Rule
203(b)(2)(iii) of Regulation SHO,\114\ (1) that the participant has a
fail to deliver position in an equity security at a registered clearing
agency that has not been closed out in accordance with the requirements
of temporary Rule 204T(a), and (2) when the purchase that the
participant has made to close out the fail to deliver position has
cleared and settled at a registered clearing agency.\115\
---------------------------------------------------------------------------
\114\ See 17 CFR 203(b)(2)(iii) (providing for an exception from
the ``locate'' requirement for market makers engaged in bona fide
market making in that security at the time of the short sale).
\115\ See temporary Rule 204T(c).
---------------------------------------------------------------------------
The notification requirement will involve a participant of a
registered clearing agency determining whether it has a fail to deliver
position in an equity security at a registered clearing agency that has
not been closed out in accordance with the requirements of temporary
Rule 204T(a), and when the purchase that the participant has made to
close out the fail to deliver position has cleared and settled at a
registered clearing agency. After making such determinations, the
temporary rule requires that the participant notify such broker-dealer
regarding this information.
We estimate that such procedures will take a participant of a
registered clearing
[[Page 61720]]
agency no more than approximately 0.16 hours (10 minutes) to
complete.\116\ We base this estimate in part on the fact that most
participants already notify broker-dealers for which they receive
orders for clearance and settlement that the participant has a fail to
deliver position in a threshold security that has not been closed out
in order to comply with the borrow requirements of Rule 203(b)(3)(iv)
of Regulation SHO for threshold securities; the fact that most
participants already have the necessary communication mechanisms in
place and are already familiar with notification processes and
procedures to comply with the borrow requirements of Rule 203(b)(3)(iv)
of Regulation SHO for threshold securities; and the fact that
participants will be able to continue to use the same communication
mechanisms, processes and procedures to notify any broker-dealers from
which they receive trades for clearance and settlement of the
information required by the temporary rule's notification requirement
as they use for compliance with Regulation SHO.
---------------------------------------------------------------------------
\116\ We base this estimate on information provided to our staff
by three small, three medium, and three large registered clearing
agency participants.
---------------------------------------------------------------------------
If a participant of a registered clearing agency has a fail to
deliver position in an equity security and after the beginning of
regular trading hours on the Close-Out Date (or, in the case of a fail
to deliver that resulted from a long sale, on the third consecutive
settlement day following the settlement date), the participant has to
determine whether or not the fail to deliver position was closed out in
accordance with temporary Rule 204T(a), we estimate that a participant
of a registered clearing agency will have to make such determination
with respect to approximately 50 equity securities per day.\117\
---------------------------------------------------------------------------
\117\ OEA estimates that there are approximately 9,809 fail to
deliver positions per day. Across 197 broker-dealer participants of
the NSCC, the number of securities per participant per day is
approximately 50 equity securities. During the period from January
to July 2008, approximately 4,321 new fail to deliver positions
occurred per day. The NSCC data for this period includes only
securities with at least 10,000 shares in fails to deliver. To
account for securities with fails to deliver below 10,000 shares,
the figure is grossed-up by a factor of 2.27. The factor is
estimated from a more complete data set obtained from NSCC during
the period from September 16, 2008 to September 22, 2008. It should
be noted that these numbers include securities that were not subject
to the close-out requirement of Rule 203(b)(3) of Regulation SHO.
---------------------------------------------------------------------------
As of July 31, 2008, there were 197 participants of NSCC, the
primary registered clearing agency responsible for clearing U.S.
transactions that were registered as broker-dealers.\118\ We estimate a
total of 2,482,200 notifications in accordance with temporary Rule
204T(c) across all participants per year (197 participants notifying
broker-dealers once per day on 50 securities, multiplied by 252 trading
days in a year). The total estimated annual burden hours per year will
be approximately 397,152 burden hours (2,482,200 @ 0.16 hours/
documentation). We estimate that the paperwork burden for the
notification requirement for each participant will be approximately
2,016 burden hours per year.
---------------------------------------------------------------------------
\118\ Those participants not registered as broker-dealers
include such entities as banks, U.S.-registered exchanges, and
clearing agencies. Although these entities are participants of a
registered clearing agency, generally these entities do not engage
in the types of activities that will implicate the close-out
requirements of the temporary rule. Such activities of these
entities include creating and redeeming Exchange Traded Funds,
trading in municipal securities, and using NSCC's Envelope
Settlement Service or Inter-city Envelope Settlement Service. These
activities rarely lead to fails to deliver and, if fails to deliver
do occur, they are small in number and are usually closed out within
a day. Thus, such fails to deliver will not trigger the close-out
requirement of the temporary rule.
---------------------------------------------------------------------------
4. Certification Requirement
The temporary rule includes an exception from the borrowing
requirements for any broker-dealer that can demonstrate that it was not
responsible for any part of the fail to deliver position of the
participant. Specifically, temporary Rule 204T(b)(1) provides that a
broker or dealer shall not be subject to the requirements of temporary
Rule 204T(b) if the broker or dealer timely certifies to the
participant that it has not incurred a fail to deliver position on
settlement date for a long or short sale in an equity security for
which the participant has a fail to deliver position at a registered
clearing agency or that the broker or dealer is in compliance with the
requirements of temporary Rule 204T(e) (the ``certification
requirement'').\119\
---------------------------------------------------------------------------
\119\ See temporary Rule 204T(b)(1).
---------------------------------------------------------------------------
This certification requirement will allow a broker-dealer to avoid
being subject to the temporary rule's borrowing requirements if it can
demonstrate that it did not incur a fail to deliver position in the
security on settlement date. Also, by requiring the broker-dealer to
demonstrate that it was not responsible for any part of the fail to
deliver position of the participant, the information collected will
help ensure that broker-dealers are complying with the requirements of
the temporary rule.
This certification requirement will require a broker-dealer to
determine that it has not incurred a fail to deliver position on
settlement date in an equity security for which the participant has a
fail to deliver position at a registered clearing agency or that the
broker-dealer is in compliance with the requirements set forth in the
Pre-Fail Credit provision of temporary Rule 204T(e). After making such
determinations, the broker-dealer will have to certify this information
to the participant. We estimate that such procedures will take a
broker-dealer no more than approximately 0.16 hours (10 minutes) to
complete.
We base this estimate, in part, on the fact that, to comply with
the close-out requirements of Rule 203(b) of Regulation SHO, current
industry practice for some participants that are registered broker-
dealers is to document purchases made on settlement days 11, 12, and 13
to demonstrate that such participants do not have a close-out
obligation under Regulation SHO. On average, participants informed us
that such documentation takes approximately 0.16 hours (10
minutes).\120\
---------------------------------------------------------------------------
\120\ We base this estimate on information provided to our staff
by three small, three medium, and three large registered clearing
agency participants.
---------------------------------------------------------------------------
If the broker-dealer determines that it has not incurred a fail to
deliver position on settlement date in an equity security for which the
participant has a fail to deliver position at a registered clearing
agency or has purchased securities in accordance with the conditions
specified in temporary Rule 204T(e), we estimate that a broker-dealer
will have to make such determinations with respect to approximately
1.76 securities per day. As of December 31, 2007, there were 5,561
registered broker-dealers. Each of these broker-dealers may clear
trades through a participant of a registered clearing agency. We
estimate that on average, a broker-dealer will have to certify to the
participant that it has not incurred a fail to deliver position on
settlement date in an equity security for which the participant has a
fail to deliver position at a registered clearing agency or,
alternatively, that it is in compliance with the requirements set forth
in the Pre-Fail Credit provision of the temporary Rule 204T(e),
2,466,415 times per year (5,561 broker-dealers certifying once per day
on 1.76 securities, multiplied by 252 trading days in a year). The
total approximate estimated annual burden hour per year will be
approximately 394,626 burden hours (2,466,415 multiplied by 0.16 hours/
certification). We estimate that the paperwork burden for the
certification provision for each broker-
[[Page 61721]]
dealer will be approximately 71.0 burden hours per year.
5. Pre-Fail Credit Demonstration Requirement
To encourage close outs of fail to deliver positions prior to the
Close-Out Date, temporary Rule 204T(e) provides that a broker-dealer
can satisfy the temporary rule's close-out requirement by purchasing
securities in accordance with the conditions of that provision (i.e.,
broker-dealers will receive ``pre-fail credit'' for the purchase),
including a condition that the broker-dealer demonstrate that it has a
net long position or net flat position on its books and records on the
settlement day for which the broker or dealer is claiming credit (the
``Pre-Fail Credit demonstration requirement'').
Temporary Rule 204T(e) provides that even if a participant of a
registered clearing agency has not closed out a fail to deliver
position at a registered clearing agency in accordance with temporary
Rule 204T(a), or has not allocated a fail to deliver position to a
broker-dealer in accordance with temporary Rule 204T(d), a broker or
dealer may receive credit for purchasing securities prior to the
beginning of regular trading hours on the Close-Out Date if, among
other things, the purchase is executed on, or after, trade date but by
no later than the end of regular trading hours on settlement date and
the broker or dealer can demonstrate that it has a net long position or
net flat position on its books and records on the settlement day for
which the broker or dealer is claiming credit.\121\
---------------------------------------------------------------------------
\121\ See temporary Rule 204T(e).
---------------------------------------------------------------------------
The Pre-Fail Credit provision is intended to encourage broker-
dealers to close out fail to deliver positions prior to the beginning
of regular trading hours on the Close-Out Date. By requiring, among
other things, that the broker-dealer demonstrate that it has a net long
position or net flat position on its books and records on the
settlement day for which the broker-dealer is claiming credit, the
information collected will help ensure that broker-dealers purchase
sufficient shares to close out their fail to deliver position prior to
the beginning of regular trading hours on the Close-Out Date.
Such demonstration requirement will require a broker-dealer that
purchased securities in accordance with the conditions specified in
temporary Rule 204T(e) to determine that it has a net long position or
net flat position on the settlement day for which the broker-dealer is
claiming credit. After making such determination, the temporary rule
requires that the broker-dealer demonstrate such information on its
books and records. We estimate that such procedures will take a broker-
dealer no more than approximately 0.16 hours (10 minutes) to complete.
We base this estimate on the fact that, to comply with the close-
out requirement of Rule 203(b)(3) of Regulation SHO, current industry
practice for some participants that are registered broker-dealers is to
document purchases made on settlement days 11, 12, and 13 to
demonstrate that such participants do not have a close-out obligation
under Regulation SHO. On average, participants informed us that such
documentation takes approximately 0.16 hours (10 minutes).\122\
---------------------------------------------------------------------------
\122\ We base this estimate on information provided to our staff
by three small, three medium, and three large registered clearing
agency participants.
---------------------------------------------------------------------------
If a broker-dealer purchased securities in accordance with the
conditions specified in temporary Rule 204T(e) and determined that it
has a net long position or net flat position on the settlement day for
which the broker-dealer is claiming credit, we estimate that a broker-
dealer will have to make such determination with respect to
approximately 1.76 securities per day.\123\
---------------------------------------------------------------------------
\123\ See supra, note 107.
---------------------------------------------------------------------------
As of December 31, 2007, there were 5,561 registered broker-
dealers. We estimate that on average, a broker-dealer will have to
demonstrate in its books and records that it has a net long position or
net flat position on the settlement day for which the broker-dealer is
claiming credit, 2,466,415 times per year (5,561 broker-dealers
checking for compliance once per day on 1.76 securities, multiplied by
252 trading days in a year). The total approximate estimated annual
burden hour per year will be approximately 394,626 burden hours
(2,466,415 multiplied by 0.16 hours/demonstration). We estimate that
the paperwork burden for the temporary Pre-Fail Credit provision for
each broker-dealer will be approximately 71.0 burden hours per year.
6. Market Maker Demonstration Requirement
To allow market makers to facilitate customer orders in a fast
moving market, the temporary rule includes a limited exception from the
rule's close-out requirement for fails to deliver attributable to bona
fide market making activities by registered market makers, options
market makers, or other market makers obligated to quote in the over-
the-counter market (collectively, ``Market Makers''). Under this
exception, a participant must close out the fail to deliver position
attributable to a Market Maker by no later than the beginning of
regular trading hours on the morning of the third settlement day after
the settlement date for the transaction that resulted in the fail to
deliver position. The borrowing requirements of the temporary rule do
not apply to Market Makers provided the Market Maker can demonstrate
that it does not have an open fail to deliver position at the time of
any additional short sales (the ``Market Maker demonstration
requirement'').
By requiring a Market Maker to demonstrate that it does not have an
open fail to deliver position at the time of any additional short sales
and, thus, avoid being subject to the temporary rule's pre-borrow
requirements, the information collected will help ensure that Market
Makers are complying with the requirements of temporary Rule
204T(b)(2).
This requirement will require a Market Maker to determine whether
it has an open fail to deliver position at the time of any additional
short sales in the particular equity security in which there is a fail
to deliver position at a registered clearing agency. After making such
a determination, the temporary rule requires that the Market Maker
demonstrate that it does not have an open fail to deliver position in
that equity security. We estimate that such procedures will take a
Market Maker no more than approximately 0.16 hours (10 minutes) to
complete.\124\
---------------------------------------------------------------------------
\124\ We base this estimate on information provided to our staff
by three large, three medium, and three small firms that engage in
market making activities currently complying with temporary Rule
204T, pursuant to the September Emergency Order, which has similar
requirements to temporary Rule 204(T)(b)(2) of this release.
---------------------------------------------------------------------------
If a participant of a registered clearing agency has a fail to
deliver position in an equity security at a registered clearing agency
that is attributable to a Market Maker and the Market Maker, in seeking
to avoid the borrowing requirements of temporary Rule 204T(b), has
determined that it does not have an open fail to deliver position, we
estimate that such Market Maker will have to make such determination
with respect to approximately 15 securities per day.\125\
---------------------------------------------------------------------------
\125\ OEA estimates that there are approximately 9,809 fail to
deliver positions per day. An upper bound on the number of fail to
deliver positions per day due to market makers is 9,809. Across 656
market makers, the number of securities per market maker per day is
approximately 15 equity securities. During the period from January
to July 2008, approximately 4,321 new fail to deliver positions
occurred per day. The NSCC data for this period includes only
securities with at least 10,000 shares in fails to deliver. To
account for securities with fails to deliver below 10,000 shares,
the figure is grossed-up by a factor of 2.27. The factor is
estimated from a more complete data set obtained from NSCC during
the period from September 16, 2008 to September 22, 2008. It should
be noted that these numbers include securities that were not subject
to the close-out requirement of Rule 203(b)(3) of Regulation SHO.
---------------------------------------------------------------------------
[[Page 61722]]
As of December 31, 2007, there were 656 Market Makers.\126\ We
estimate a total of 2,479,680 written demonstrations in accordance with
temporary Rule 204T(b)(1) across all Market Makers per year (656 Market
Makers demonstrating once per day on 15 securities, multiplied by 252
trading days in a year). The total estimated annual burden hour per
year will be approximately 396,749 burden hours (2,479,680 multiplied
by 0.16 hours/demonstration). We estimate that the paperwork burden for
the Market Maker demonstration requirements for each Market Maker will
be approximately 604.8 burden hours per year.
---------------------------------------------------------------------------
\126\ These numbers are based on OEA's review of 2007 FOCUS
Report filings reflecting registered broker-dealers. This number
does not include broker-dealers that are delinquent on FOCUS Report
filings.
---------------------------------------------------------------------------
B. Request for Comment
We invite comment on these estimates and assumptions. Pursuant to
44 U.S.C. 3506(c)(2)(B), we request comment in order to: (a) Evaluate
whether the collection of information is necessary for the proper
performance of our functions, including whether the information will
have practical utility; (b) evaluate the accuracy of our estimate of
the burden of the collection of information; (c) determine whether
there are ways to enhance the quality, utility and clarity of the
information to be collected; and (d) evaluate whether there are ways to
minimize the burden of the collection of information on those who
respond, including through the use of automated collection techniques
or other forms of information technology.
Persons submitting comments on the collection of information
requirements should direct them to the Office of Management and Budget,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Washington, DC 20503, and
should also send a copy of their comments to Florence E. Harmon, Acting
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090, with reference to File No. S7-30-08.
Requests for materials submitted to OMB by the Commission with regard
to this collection of information should be in writing, with reference
to File No. S7-30-08, and be submitted to the Securities and Exchange
Commission, Records Management, Office of Filings and Information
Services, 100 F Street, NE., Washington, DC 20549-1090. As OMB is
required to make a decision concerning the collections of information
between 30 and 60 days after publication, a comment to OMB is best
assured of having its full effect if OMB receives it within 30 days of
publication.
VIII. Cost-Benefit Analysis
A. Summary
The Commission is sensitive to the costs and benefits of its rules.
Commenters should provide analysis and data to support their views on
the costs and benefits associated with the temporary rule.
We are adopting, as an interim final temporary rule, Rule 204T,
under the Exchange Act. The temporary rule is intended to address
abusive ``naked'' short selling in all equity securities by requiring
that participants of a registered clearing agency deliver securities by
settlement date, or if the participants have not delivered shares by
settlement date, the participants must, by no later than the beginning
of regular trading hours on the Close-Out Date, immediately close out
the fail to deliver position by borrowing or purchasing securities of
like kind and quantity.
If a participant does not purchase or borrow shares, as applicable,
to close out a fail to deliver position in accordance with temporary
Rule 204T(a), the participant will have violated the temporary rule. In
addition, the temporary rule imposes on the participant for its own
trades and on all broker-dealers from which that participant receives
trades for clearance and settlement (including introducing and
executing brokers), a requirement to borrow or arrange to borrow
securities prior to accepting or effecting further short sales in that
security.\127\
---------------------------------------------------------------------------
\127\ See temporary Rule 204T(b).
---------------------------------------------------------------------------
To the extent that a participant becomes subject to the borrowing
requirements of temporary Rule 204T(b), a broker-dealer that clears
through the participant can avoid being subject to the borrowing
requirements of temporary Rule 204T(b) if the broker-dealer can
demonstrate that it was not responsible for any part of the fail to
deliver position of the participant. Moreover, to allow Market Makers
to facilitate customer orders in a fast moving market without possible
delays associated with complying with the pre-borrow penalty provision
of temporary Rule 204T(b), the borrowing requirements of the temporary
rule do not apply to Market Makers provided the Market Maker can show
that it does not have an open fail to deliver position at the time of
any additional short sales.\128\
---------------------------------------------------------------------------
\128\ See temporary Rule 204T(b)(2).
---------------------------------------------------------------------------
Similar to Rule 203(b)(3)(vi) of Regulation SHO, temporary Rule
204(d) provides that a participant may reasonably allocate its
responsibility to close out a fail to deliver position to another
broker-dealer for which the participant clears trades, or from which it
receives trades for settlement.\129\ Unlike Rule 203(b)(3)(vi) of
Regulation SHO, however, temporary Rule 204T(d) imposes a notification
requirement on a broker-dealer that has been allocated responsibility
for complying with the rule's requirements.\130\
---------------------------------------------------------------------------
\129\ See 17 CFR 242.203(b)(3)(vi). Rule 203(b)(3)(vi) provides
that ``[i]f a participant of a registered clearing agency reasonably
allocates a portion of a fail to deliver position to another
registered broker or dealer for which it clears trades or for which
it is responsible for settlement, based on such broker or dealer's
short position, then the provisions of this paragraph (b)(3)
relating to such fail to deliver position shall apply to the portion
of such registered broker or dealer that was allocated the fail to
deliver position, and not to the participant.''
\130\ See temporary Rule 204T(d).
---------------------------------------------------------------------------
In addition, the temporary rule provides that if a participant has
a fail to deliver position at registered clearing agency in an equity
security and can demonstrate on its books and records that such fail to
deliver position resulted from a long sale, such participant has until
no later than the beginning of regular trading hours on the third
consecutive settlement day following the settlement date to immediately
close out the fail to deliver position by purchasing securities of like
kind and quantity.
The temporary rule also extends the close-out requirement for fails
to deliver attributable to bona fide market making activities by Market
Makers by requiring a participant to close out the fail to deliver
position attributable to a Market Maker by no later than the beginning
of regular trading hours on the third settlement day after the
settlement date for the transaction that resulted in the fail to
deliver position.
In addition, consistent with Rule 203(b)(3)(ii) of Regulation SHO,
the temporary rule includes an exception for sales of securities
pursuant to Rule 144 of the Securities Act.\131\
[[Page 61723]]
Specifically, temporary Rule 204T(a)(2) provides that if a participant
of a registered clearing agency has a fail to deliver position at a
registered clearing agency in any equity security sold pursuant to Rule
144 for thirty-five consecutive settlement days after the settlement
date for a sale in that equity security, the participant shall, by no
later than the beginning of regular trading hours on the thirty-sixth
consecutive settlement day following the settlement date for the
transaction, immediately close out the fail to deliver position by
purchasing securities of like kind and quantity.\132\
---------------------------------------------------------------------------
\131\ See 17 CFR 242.203(b)(3)(ii).
\132\ See temporary Rule 204T(a)(2).
---------------------------------------------------------------------------
If, however, a fail to deliver position resulting from the sale of
an equity security pursuant to Rule 144 is not closed out in accordance
with temporary Rule 204T(a)(2), the participant is subject to the
borrow requirements in temporary Rule 204T(b). Thus, if the fail to
deliver position persists beyond thirty-five consecutive settlement
days, the temporary rule prohibits a participant of a registered
clearing agency, and any broker-dealer from which it receives trades
for clearance and settlement, from accepting any short sale orders or
effecting further short sales in the particular security without
borrowing, or entering into a bona-fide arrangement to borrow, the
security until the participant closes out the entire fail to deliver
position by purchasing securities of like kind and quantity and that
purchase has cleared and settled at a registered clearing agency.\133\
---------------------------------------------------------------------------
\133\ See temporary Rule 204T(b).
---------------------------------------------------------------------------
Although we recognize the temporary rule may impose increased
borrowing costs to assure settlement in accordance with the
requirements of the temporary rule, which may increase the costs of
legitimate short selling, we believe that the requirements of the
temporary rule are necessary to achieve our goal of further reducing
fails to deliver and addressing abusive ``naked'' short selling.
B. Benefits
The temporary rule will substantially restrict the practice of
``naked'' short selling in all equity securities by strengthening the
delivery requirements for such securities. By requiring that
participants of a registered clearing agency deliver securities by
settlement date, or if the participants have not delivered shares by
settlement date, immediately close out the fail to deliver position by
borrowing or purchasing securities of like kind and quantity, the
temporary rule also furthers our goals of limiting fails to deliver and
helping to reduce the possibility that abusive ``naked'' short selling
may contribute to disruption in the securities markets. This, in turn,
will help to ensure that investors remain confident that trading can be
conducted without the influence of illegal manipulation. The temporary
rule also furthers the goals of helping to maintain fair and orderly
markets against the threat of sudden and excessive fluctuations of
securities prices and substantial disruption in the functioning of the
securities markets. The temporary rule also promotes the prompt and
accurate clearance and settlement of transactions in equity securities.
In addition, the temporary rule will help to further reduce the
number of fails to deliver. These fails may create a misleading
impression of the market for these securities. Large and persistent
fails to deliver may have a negative effect on shareholders,
potentially depriving them of the benefits of ownership, such as voting
and lending. Thus, by facilitating the prompt receipt of shares, the
temporary rule will help enable investors to receive the benefits
associated with share ownership.
Persistent fails to deliver in a security may also be perceived by
potential investors negatively and may affect their decision about
making a capital commitment. Thus, by providing greater assurance that
securities will be delivered and, thereby, alleviating investor
apprehension as they make investment decisions, the temporary rule will
benefit issuers in that an increase in investor confidence in the
market for their securities will facilitate investment in their
securities.
1. Close-Out Requirements
By requiring that participants of a registered clearing agency
deliver securities by settlement date, or if the participants have not
delivered shares by settlement date, immediately close out the fail to
deliver position by borrowing or purchasing securities of like kind and
quantity, the temporary rule will help restore, maintain, and enhance
investor confidence in the securities markets. It will also help reduce
manipulative schemes involving ``naked'' short selling in equity
securities. Sellers that fail to deliver securities on settlement date
may enjoy fewer restrictions than if they were required to deliver the
securities within a reasonable period of time, and such sellers may
attempt to use this additional freedom to engage in trading activities
that deliberately depress the price of a security. Thus, the temporary
rule's close-out requirements are expected to remove a potential means
of manipulation, thereby decreasing the possibility of artificial
market influences and contributing to price efficiency.
Under temporary Rule 204T(a)(1), a participant that has a fail to
deliver position at a registered clearing agency in an equity security
and can demonstrate on its books and records that such fail to deliver
position resulted from a long sale, will have until no later than the
beginning of regular trading hours on the third consecutive settlement
day following the settlement date to immediately close out the fail to
deliver position by purchasing securities of like kind and quantity.
This provision allows participants an additional two settlement days to
close out fail to deliver positions that result from long sales,
provided that the participant's books and records reflect the fact that
the fail to deliver resulted from a long sale.\134\ We believe this
exception to temporary Rule 204T(a)'s close-out requirement benefits
participants because the two additional days to close-out these fail to
deliver positions may reduce close-out costs for such participants.
---------------------------------------------------------------------------
\134\ See temporary Rule 204T(a)(1).
---------------------------------------------------------------------------
The temporary rule also extends temporary Rule 204T(a)'s close-out
requirement for fails to deliver attributable to bona fide market
making activities by Market Makers by requiring a participant to close
out the fail to deliver position attributable to a Market Maker by no
later than the beginning of regular trading hours on the third
settlement day after the settlement date. We believe this exception to
temporary Rule 204T(a)'s close-out requirement benefits participants
because the two additional days to close-out these fail to deliver
positions may reduce close-out costs for such participants.
Similar to Rule 203(b)(3)(vi) of Regulation SHO, temporary Rule
204(d) allows a participant to reasonably allocate its responsibility
to close out a fail to deliver position to another broker-dealer for
which the participant clears trades, or from which it receives trades
for settlement. This allocation provision benefits participants because
if a participant can identify the accounts of broker-dealers for which
they clear or from which they receive trades for settlement, the
participant can allocate the responsibility to close out the fail to
deliver position to the particular broker-dealer account(s) whose
trading activities caused the fail to deliver position provided the
allocation is reasonable and, therefore, the allocated broker-dealer
rather than the participant
[[Page 61724]]
will incur any costs associated with the temporary rule's close-out
requirement.
In addition, temporary Rule 204T(d) imposes a notification
requirement on a broker-dealer that has been allocated responsibility
for complying with the rule's requirements. Thus, under the temporary
rule's allocation provision, if the broker-dealer does not comply with
the provisions of temporary Rule 204T(a), it must immediately notify
the participant that it has become subject to the borrowing
requirements of temporary Rule 204T(b).\135\ This allocation
notification requirement is intended to let participants know when a
broker-dealer from which the participant receives trades for clearance
and settlement has become subject to the temporary rule's borrowing
requirements. The notification requirement furthers the Commission's
goals of limiting fails to deliver and addressing abusive ``naked''
short selling by promoting the prompt and accurate clearance and
settlement of transactions involving equity securities. The
notification requirement will also help ensure that participants that
receive trades for clearance and settlement from broker-dealers will be
on notice that the broker-dealer is subject to the borrow requirements
of temporary Rule 204T(b) until the fail to deliver position has been
closed out.
---------------------------------------------------------------------------
\135\ See temporary Rule 204T(d).
---------------------------------------------------------------------------
Moreover, under the temporary rule's Pre-Fail Credit provision, a
broker or dealer may receive credit for purchasing securities prior to
the beginning of regular trading hours on the Close-Out Date if, among
other things, the purchase is executed on, or after, trade date but by
no later than the end of regular trading hours on settlement date and
the broker or dealer can demonstrate that it has a net long position or
net flat position on its books and records on the settlement day for
which the broker or dealer is claiming credit. The Pre-Fail Credit
provision is intended to encourage earlier close out of fails to
deliver in all equity securities and, therefore, to the extent used
could result in a reduction of persistent fails to deliver.
2. Borrowing Requirements
The borrowing requirements of temporary Rule 204T(b) are similar to
the requirements of Rule 203(b)(3)(iv) of Regulation SHO for a
participant that has not closed out a fail to deliver position in a
threshold security that has persisted for thirteen consecutive
settlement days.\136\ Similar to Regulation SHO, the temporary rule is
aimed in part at addressing potentially abusive ``naked'' short selling
in equity securities. To that end, we believe it is appropriate to
include in the temporary rule borrowing requirements for broker-
dealers, including participants, that sell short a security that has a
fail to deliver position that has not been closed out in accordance
with the requirements of the temporary rule. We believe that the
borrowing requirements of temporary Rule 204T(b) will further our goal
of limiting fails to deliver and addressing abusive ``naked'' short
selling by promoting the prompt and accurate clearance and settlement
of transactions in equity securities. By requiring that participants
and broker-dealers from which they receive trades for clearance and
settlement borrow or arrange to borrow securities prior to accepting or
effecting short sales in the security that has a fail to deliver
position that has not been closed out, the temporary rule will help to
ensure that shares will be available for delivery on the short sale by
settlement date and, thereby, help to avoid additional fails to deliver
occurring in the security.
---------------------------------------------------------------------------
\136\ See 17 CFR 242.203(b)(3)(iv).
---------------------------------------------------------------------------
Unlike the current borrow requirements of Rule 203(b)(3)(iv) of
Regulation SHO, however, the borrow requirements of the temporary rule
specify that participants must notify all broker-dealers from which
they receive trades for clearance and settlement that a fail to deliver
position in an equity security has not been closed out in accordance
with temporary Rule 204T(a).\137\ This notification requirement in
temporary Rule 204T(c) is intended to ensure that all broker-dealers
that submit trades for clearance and settlement to a participant that
has a fail to deliver position in an equity security that has not been
closed out in accordance with temporary Rule 204T(a) are on notice that
all short sales in that security will be subject to the borrowing
requirements of temporary Rule 204T(b) until the fail to deliver
position has been closed out.
---------------------------------------------------------------------------
\137\ See temporary Rule 204T(c).
---------------------------------------------------------------------------
However, if a participant becomes subject to the borrowing
requirements of temporary Rule 204T(b) because it did not close out a
fail to deliver position by no later than the beginning of regular
trading hours on the settlement date for the transaction, a broker-
dealer that clears through the participant will not also be subject to
the borrowing requirements of temporary Rule 204T(b) if the broker-
dealer can demonstrate that it was not responsible for any part of the
fail to deliver position of the participant.\138\ This exception allows
a broker-dealer to avoid being subject to the borrowing requirements of
the temporary rule if the broker-dealer can demonstrate that it did not
incur a fail to deliver position in the security on settlement date.
---------------------------------------------------------------------------
\138\ See temporary Rule 204T(b)(1).
---------------------------------------------------------------------------
Moreover, the borrowing requirements of the temporary rule will not
apply to Market Makers, provided that the Market Maker can show that it
does not have an open fail to deliver position at the time of any
additional short sales.\139\ This provision is intended to allow Market
Makers to facilitate customer orders in a fast moving market without
possible delays associated with complying with the pre-borrow penalty
provision of temporary Rule 204T(b).
---------------------------------------------------------------------------
\139\ See temporary Rule 204T(b)(2).
---------------------------------------------------------------------------
3. Sales of Securities Pursuant to Rule 144
Securities sold pursuant to Rule 144 of the Securities Act are
formerly restricted securities that a seller is ``deemed to own,'' as
defined by Rule 200(a) of Regulation SHO.\140\ The securities, however,
may not be capable of being delivered on the settlement date due to
processing delays related to removal of the restricted legend and,
therefore, sales of these securities frequently result in fails to
deliver. Consistent with our statements in connection with our recent
amendments to Regulation SHO in connection with closing out fails to
deliver in threshold securities sold pursuant to Rule 144,\141\ we
believe that a close-out requirement of thirty-five consecutive
settlement days from settlement date for fails to deliver resulting
from sales of equity securities sold pursuant to Rule 144, will permit
the orderly settlement of such sales without the risk of causing market
disruption due to unnecessary purchasing activity (particularly if the
purchases are for sizable quantities of stock). Because the Rule 144
security sold will be received as soon as all processing delays have
been removed, this additional time will allow participants to close out
fails to deliver resulting from the sale of the security with the
security sold, rather than having to close out such fail to deliver
position by purchasing securities in the market. Thus, the amendments
will
[[Page 61725]]
reduce costs to participants and, in turn, investors.
---------------------------------------------------------------------------
\140\ See 17 CFR 242.200(a).
\141\ As mentioned above, we recently adopted amendments to the
close-out requirement of Regulation SHO to allow fails to deliver
resulting from sales of threshold securities pursuant to Rule 144 to
be closed out within 35 rather 13 consecutive settlement days. See
2007 Regulation SHO Final Amendments, 72 FR at 45550-45551.
---------------------------------------------------------------------------
Although the temporary rule allows fails to deliver resulting from
sales of equity securities sold pursuant to Rule 144 of the Securities
Act thirty-five consecutive settlement days after the settlement date
before a participant must take action to close out the fail to deliver
position, these fails to deliver must be closed out by no later than
the beginning of regular trading hours on the thirty-sixth settlement
day and, therefore, these fails to deliver cannot continue
indefinitely. Thus, we believe that the temporary rule is consistent
with our goal of further reducing fails to deliver in equity
securities, while balancing the concerns associated with closing out
fails to deliver resulting from sales of securities pursuant to Rule
144 of the Securities Act.
C. Costs
We recognize that the temporary rule may result in increased short
selling costs for participants that may impact legitimate short selling
activities; however, we believe such costs will be limited. For
example, it might result in participants incurring borrowing costs
where they borrow securities to close out a fail to deliver position
that might have been closed out soon thereafter with shares received
from the customer. Such actions might result in added demand in the
lending market which in turn might exert upward pressure on securities
lending rates, potentially making short selling more expensive for all
market participants. For example, it is estimated that about $700
billion in U.S. equity securities are lent out per year. Preliminary
input from industry participants suggests that lending rates increased
significantly after the September Emergency Order for stocks not
covered by the ban on short selling. While results from the period
after the September Emergency Order may be confounded by the unusual
circumstances of the continued credit crisis, an increase of 10 basis
points in lending rates would result in an annual cost increase to
securities borrowers of $700 million and the new revenue for securities
lenders increasing by the corresponding amount of $700 million.
Therefore, if lending increased by 10 basis points, the annual impact
on the securities lending market would be about $1,400 million (or
$1,050 million for nine months).
To the extent that the requirements of the temporary rule will
result in increased costs to short selling in equity securities, it may
lessen some of the benefits of legitimate short selling and, thereby,
result in a reduction in short selling generally. Such a reduction may
lead to a decrease in market efficiency and price discovery, less
protection against upward stock price manipulations, a less efficient
allocation of capital, an increase in trading costs, and a decrease in
liquidity. We also recognize that requiring that participants purchase
securities to close out fails to deliver in equity securities in
accordance with the temporary rule, may potentially impact the
willingness of participants to provide liquidity.
As a likely result of the temporary rule as contained in the
September Emergency Order, bid-ask spreads on equity securities have
increased. Preliminary input from industry participants suggests that
bid-ask spreads have increased after the September Emergency Order for
stocks not covered by the ban on short selling. While results from the
period after the September Emergency Order may be confounded by the
unusual circumstances of the continued credit crisis, an increase of 1
basis point in bid-ask spreads would result in an annual cost to
investors of about $6,048 million. To calculate the annual cost, we
assume that 12 billion shares trade on a daily basis. At an average
share price of approximately $20, this constitutes $240 billion in
dollar volume per day. Based on this total, an increase in transaction
costs of one basis point would result in a daily increase in realized
transaction costs of approximately $24 million a day. At this rate,
investors would experience increased total transaction costs of over
$100 million within the first five trading days of the rule or about
$6,048 million annually ($24 million times 252 trading days) (or $4,536
million for nine months).
We believe, however, that strengthening rules against potentially
abusive ``naked'' short selling will provide increased confidence in
the securities markets. Thus, although we recognize that the temporary
rule may result in increased short selling costs, we believe such costs
are justified by the fact that the temporary rule may help restore,
maintain, and enhance investor confidence in the markets by preventing
potentially abusive ``naked'' short selling.
1. Close-Out Requirements
We also recognize that requiring that participants purchase
securities to close-out fails to deliver in any equity security in
accordance with the temporary rule, may potentially impact the
willingness of participants to provide liquidity. However, we believe
that any such potential effect will be minimal because participants
will still have some flexibility by having two additional settlement
days in which to purchase securities to close-out their fail to deliver
positions that either result from long sales or are attributable to
bona fide market making activities by Market Makers.
In addition, we recognize that the temporary rule's close-out
requirement may result in some additional costs for participants of a
registered clearing agency in terms of systems and surveillance
modifications, as well as changes to processes and procedures. However,
we believe any additional costs incurred in implementing temporary Rule
204T's close-out requirement in terms of these modifications will be
minimal. The close-out requirement of the temporary rule is consistent
with the current settlement practices and procedures and with the
close-out requirement of Regulation SHO. For example, because most
transactions settle by T+3, participants should already have in place
policies and procedures to help ensure that delivery is being made by
settlement date. Nevertheless, participants will incur costs for each
close-out and these costs could accumulate to significant amounts over
time and across participants.
Moreover, similar to the existing close-out requirement of Rule
203(b)(3) of Regulation SHO, the temporary rule is based on a
participant's fail to deliver position at a registered clearing agency.
As noted above, the NSCC clears and settles the majority of equity
securities trades conducted on the exchanges and in the over-the-
counter markets. The NSCC clears and settles trades through the CNS
system, which nets the securities delivery and payment obligations of
all of its members. The NSCC notifies its members of their securities
delivery and payment obligations daily. Thus, because the temporary
rule is based on a participant's fail to deliver position at a
registered clearing agency, it is consistent with current settlement
practices and procedures and with the Regulation SHO framework
regarding delivery of securities.\142\ As such, we anticipate that most
participants will already have systems, processes and procedures in
place in order to comply with the temporary rule's close-out
requirements and, therefore, that any additional implementation costs
associated with the temporary rule will be minimal.
---------------------------------------------------------------------------
\142\ See 17 CFR 242.203(b)(3).
---------------------------------------------------------------------------
In addition, to comply with Regulation SHO's close-out requirement
[[Page 61726]]
when it became effective in January 2005, participants needed to modify
their recordkeeping systems and surveillance mechanisms. Participants
also should have retained and trained the necessary personnel to ensure
compliance with the rule's close-out requirements. Thus, most of the
infrastructure necessary to comply with the temporary rule's close-out
requirement should already be in place. Thus, we believe that any
changes to personnel, computer hardware and software, recordkeeping or
surveillance costs will be minimal.
We recognize that the requirements of temporary Rule 204T(a)(1) may
also impose additional costs on participants of a registered clearing
agency. As discussed above, under temporary Rule 204T(a)(1), a
participant of a registered clearing agency that has a fail to deliver
position at a registered clearing agency in an equity security and can
demonstrate on its books and records that the fail to deliver position
resulted from a long sale, will have until no later than the beginning
of regular trading hours on the third consecutive settlement day
following the settlement date to immediately close out the fail to
deliver position by purchasing securities of like kind and quantity.
Thus, to qualify for this additional time to close out a fail to
deliver position, the temporary rule requires the participant to
demonstrate on their books and records that the fail to deliver
position resulted from a long sale.
This demonstration requirement may result in participants incurring
costs related to personnel, recordkeeping, systems, and surveillance
mechanisms. For example, as discussed in detail in section VII above,
for purposes of the Paperwork Reduction Act, we estimate that it will
take each participant of a registered clearing agency no more than
approximately 0.16 hours (10 minutes) to comply with the demonstration
requirement of the temporary Rule 204T(a)(1). In addition, we estimate
that the total annual hour burden per year for each participant subject
to the documentation requirement will be 1,371 hours.
The allocation notification requirement of temporary Rule 204T(d)
will impose costs on broker-dealers that have been allocated
responsibility for the close-out requirement under the temporary rule.
As discussed above, temporary Rule 204T(d) requires a broker or dealer
that has been allocated a portion of a fail to deliver position that
has not complied with the close-out provisions under the temporary rule
to notify the participant that it has become subject to the borrowing
requirements of temporary Rule 204T(b). This notification requirement
may result in broker-dealers incurring costs related to personnel,
recordkeeping, systems, and surveillance mechanisms. For example, as
discussed in detail in section VII, above, for purposes of the
Paperwork Reduction Act, we estimate that it will take each broker-
dealer no more than approximately 0.16 hours (10 minutes) to comply
with the notification requirements of temporary Rule 204T(d). In
addition, we estimate that the total annual hour burden per year for
each broker-dealer subject to the notification requirement will be 71.0
hours.
We also recognize that the requirements of temporary Rule 204T(e)
may impose additional costs on broker-dealers. As discussed above,
temporary Rule 204T(e) allows a broker-dealer to obtain pre-fail credit
if it purchases securities in accordance with the conditions specified
in the temporary rule. To receive pre-fail credit, the temporary rule
requires, among other things, that a broker-dealer demonstrate that it
has a net long position or net flat position on its books and records
on the settlement day for which the broker or dealer is claiming
credit.
This demonstration requirement may result in participants incurring
costs related to personnel, recordkeeping, systems, and surveillance
mechanisms. For example, as discussed in detail in section VII above,
for purposes of the Paperwork Reduction Act, we estimate that it will
take each broker-dealer no more than approximately 0.16 hours (10
minutes) to comply with the demonstration requirements of the temporary
rule. In addition, we estimate that the total annual hour burden per
year for each broker-dealer subject to the demonstration requirement
will be 71.0 hours.
2. Borrowing Requirements
We believe that temporary Rule 204T's borrow requirements for fail
to deliver positions that are not closed out in accordance with the
temporary rule will result in limited, if any, implementation costs to
participants of a registered clearing agency, and broker-dealers from
which they receive trades for clearance and settlement. These entities
must already comply with the borrow requirements of Rule 203(b)(3)(iv)
of Regulation SHO if a fail to deliver position has not been closed out
in accordance with Regulation SHO's mandatory close-out requirement.
Accordingly, these entities should already have in place the personnel,
recordkeeping, systems, and surveillance mechanisms necessary to comply
with the temporary rule's borrow requirements. Nevertheless, we
recognize that each pre-borrow will impose costs on participants,
broker-dealers, and investors and these costs can accumulate to
significant amounts if the borrow requirement is imposed often.
The pre-borrow notification requirement of temporary Rule 204T(c)
will impose costs on participants of a registered clearing agency.
Temporary Rule 204T(c) requires a participant to notify any broker or
dealer from which it receives trades for clearance and settlement,
including any market maker that would otherwise be entitled to rely on
the exception provided in Rule 203(b)(2)(iii) of Regulation SHO,\143\
(1) that the participant has a fail to deliver position in an equity
security at a registered clearing agency that has not been closed out
in accordance with the requirements of temporary Rule 204T(a), and (2)
when the purchase that the participant has made to close out the fail
to deliver position has cleared and settled at a registered clearing
agency.\144\ This notification requirement may result in participants
incurring costs related to personnel, recordkeeping, systems, and
surveillance mechanisms. For example, as discussed in detail in section
VII, above, for purposes of the Paperwork Reduction Act, we estimate
that it will take each participant of a registered clearing agency no
more than approximately 0.16 hours (10 minutes) to comply with the pre-
borrow notification requirements of temporary Rule 204T(b). In
addition, we estimate that the total annual hour burden per year for
each participant subject to the notification requirement will be 2,016
hours.
---------------------------------------------------------------------------
\143\ See 17 CFR 203(b)(2)(iii) (providing for an exception from
the ``locate'' requirement for market makers engaged in bona fide
market making in that security at the time of the short sale).
\144\ See temporary Rule 204T(c).
---------------------------------------------------------------------------
Moreover, we believe any additional costs incurred in connection
with the borrowing requirements of temporary Rule 204T(b) will be
limited by the fact that if a participant becomes subject to the
borrowing requirements of temporary Rule 204T(b), a broker-dealer that
clears through the participant will not also be subject to the
borrowing requirements of temporary Rule 204T(b) if the broker-dealer
can demonstrate that it was not responsible for any part of the fail to
deliver position of the participant. This provision allows a broker-
dealer to avoid the costs of being subject to the temporary rule's
borrowing requirements, provided that the broker-dealer can demonstrate
that it
[[Page 61727]]
did not incur a fail to deliver position in the security on settlement
date.
The certification requirement of temporary Rule 204T(b)(1) may
impose some costs on broker-dealers having to demonstrate that it was
not responsible for any part of the fail to deliver position of the
participant. As discussed above, temporary Rule 204T(b)(1) requires the
broker-dealer to timely certify to the participant that it has not
incurred a fail to deliver position on settlement date in an equity
security for which the participant has a fail to deliver position at a
registered clearing agency or the broker-dealer is in compliance with
the requirements set forth in the temporary rule's Pre-Fail Credit
provision. This certification requirement may result in broker-dealers
incurring costs related to personnel, recordkeeping, systems, and
surveillance mechanisms. For example, as discussed in detail in section
VII, above, for purposes of the Paperwork Reduction Act, we estimate
that it will take each broker-dealer no more than approximately 0.16
hours (10 minutes) to comply with the certification requirement of
temporary Rule 204T(b)(1). In addition, we estimate that the total
annual hour burden per year for each broker-dealer subject to the
certification requirement will be 71.0 hours.
Any potential additional costs associated with the temporary
borrowing requirements will be limited by the fact that the temporary
rule's borrowing requirements will not apply to Market Makers, provided
that the Market Maker can demonstrate that it does not have an open
fail to deliver position at the time of any additional short sales.
This allows Market Makers to facilitate customer orders in a fast
moving market without possible delays and added costs associated with
complying with the pre-borrow penalty provision of temporary Rule
204T(b).
The demonstration requirement of temporary Rule 204T(b)(2) may
impose costs on Market Makers. This demonstration requirement may
result in Market Makers incurring costs related to personnel,
recordkeeping, systems, and surveillance mechanisms. For example, as
discussed in detail in section VII, above, for purposes of the
Paperwork Reduction Act, we estimate that it will take each Market
Maker no more than approximately 0.16 hours (10 minutes) to comply with
the demonstration requirement of temporary Rule 204T(b)(2). In
addition, we estimate that the total annual hour burden per year for
each Market Maker subject to this demonstration requirement will be
604.8 hours.
3. Sales of Securities Pursuant to Rule 144
Consistent with our statements in connection with our recent
amendments to Regulation SHO in connection with closing out fails to
deliver in threshold securities sold pursuant to Rule 144,\145\ we do
not believe the temporary rule's close-out requirement will impose any
significant burden or cost on market participants. We believe that a
close-out requirement of thirty-five consecutive settlement days from
settlement date for fails to deliver resulting from sales of equity
securities sold pursuant to Rule 144 will reduce costs by allowing
participants of a registered clearing agency with a fail to deliver
position additional time for delivery of these securities.
---------------------------------------------------------------------------
\145\ See 2007 Regulation SHO Final Amendments, 72 FR at 45550-
45551.
---------------------------------------------------------------------------
Participants may incur, however, some added costs for minor changes
to their current systems to reflect the application of the temporary
rule's close-out requirement to fails to deliver resulting from sales
of all equity securities, rather than just threshold securities, sold
pursuant to Rule 144 of the Securities Act.
D. Request for Comment
The Commission is sensitive to the costs and benefits of the
temporary rule, and encourages commenters to discuss any additional
costs or benefits beyond those discussed herein, as well as any
reduction in costs. Commenters should provide analysis and data to
support their views of the costs and benefits associated with the
temporary rule.
What, if any, additional benefits are involved in
complying with the temporary rule? Should the temporary rule be
modified in any way to increase the benefits of the temporary rule? If
so, how?
What, if any, additional costs are involved in complying
with the temporary rule? What are the types of costs, and what are the
amounts? Should the temporary rule be modified in any way to mitigate
costs? If so, how?
The temporary rule requires that participants of a
registered clearing agency deliver securities by settlement date, or if
the participants have not delivered shares by settlement date, borrow
or purchase securities to close out the fail to deliver position by no
later than the beginning of regular trading hours on the settlement day
following the day the participant incurred the fail to deliver
position. What are the costs and benefits associated with purchasing
versus borrowing securities to close out a fail to deliver position?
What impact will the temporary rule have on borrowing
costs? Please explain. What effect will the temporary rule have on the
availability of equity securities for lending and borrowing?
The temporary rule will allow a participant that has a
fail to deliver position at a registered clearing agency in an equity
security and can demonstrate that such fail to deliver position
resulted from a long sale, two additional settlement days in which to
close out that fail to deliver position by purchasing securities of
like kind and quantity. What costs and benefits are associated with the
long sale documentation requirement? Are there any operational or
compliance concerns associated with this provision of the temporary
rule?
The temporary rule will allow a participant of a
registered clearing agency two additional settlement days to close out
any fail to deliver positions attributable to a Market Maker. What are
the costs and benefits of allowing this additional time to close-out
fails to deliver attributable to Market Makers? Are there any
operational or compliance concerns associated with this provision of
the temporary rule?
Will the temporary rule create any additional
implementation or operational costs associated with systems (including
computer hardware and software), surveillance, procedural,
recordkeeping, or personnel modifications?
To comply with the temporary rule, will broker-dealers be
required to purchase new systems or implement changes to existing
systems? Will changes to existing systems be significant? What are the
costs and benefits associated with acquiring new systems or making
changes to existing systems? What, if any, changes will need to be made
to existing records? What are the costs and benefits associated with
any changes?
Will there be any increases in staffing and associated
overhead costs? What are the costs and benefits associated with hiring
new staff or retraining existing staff? Will other resources need to be
re-dedicated to comply with the temporary rule?
How much, if any, will the temporary rule affect
compliance costs for small, medium, and large broker-dealers (e.g.,
personnel or system changes)? We seek comment on the costs of
compliance that may arise.
We solicit comment on whether the costs will be incurred
on a one-time or ongoing basis, as well as cost estimates. In addition,
we seek comment as to
[[Page 61728]]
whether the temporary rule will decrease any costs for any market
participants. We seek comment about any other costs and cost reductions
associated with the temporary rule.
We recognize that the temporary rule may increase the
costs of legitimate short selling and lessen some of the benefits of
legitimate short selling, which, in turn, could result in a reduction
of short selling. To what extent, if any, will the temporary rule
impact legitimate short selling and market efficiency?
The temporary rule does not allow any exceptions for fails
to deliver due to mechanical aspects of corporate events, such as
equity offers, including initial public offerings, and tender offers.
Will the temporary rule cause any disruption to these corporate events?
Can the costs of any disruption be quantified?
What, if any, additional costs are involved in complying
with the borrowing requirements under temporary Rule 204T(b)? What are
the types of costs, and what are the amounts? Should the temporary rule
be modified in any way to mitigate costs? If so, how? Are there any
operational or compliance concerns associated with the borrowing
requirements under temporary Rule 204T(b)?
The temporary rule will allow a broker-dealer that clears
through a participant that becomes subject to the borrowing
requirements of temporary Rule 204T(b) to avoid being subject to the
temporary rule's borrowing requirements if the broker-dealer can
demonstrate that it was not responsible for any part of the fail to
deliver position of the participant. What costs and benefits are
associated with the certification requirement? Are there any
operational or compliance concerns associated with this provision of
the temporary rule?
Temporary Rule 204T(c) imposes a pre-borrow notification
requirement on participants. Will such a notification requirement
impose operational or systems costs on participants? What types of
communication mechanisms do participants use to comply with this
requirement of the temporary rule? What are the costs and benefits of
this notification requirement?
What, if any, additional costs are associated with
extending the close-out requirement for Rule 144 securities? What are
the types of costs, and what are the amounts? Who bears these costs?
Should the exception be modified in any way to mitigate costs? If so,
how?
Please identify any other costs, including reductions in
costs, associated with sales of Rule 144 restricted securities not
already discussed.
IX. Consideration of Burden on Competition and Promotion of Efficiency,
Competition, and Capital Formation
Section 3(f) of the Exchange Act requires the Commission, whenever
it engages in rulemaking and whenever it is required to consider or
determine if an action is necessary or appropriate in the public
interest, to consider whether the action would promote efficiency,
competition, and capital formation.\146 \In addition, section 23(a)(2)
of the Exchange Act requires the Commission, when adopting rules under
the Exchange Act, to consider the impact such rules would have on
competition.\147\ Exchange Act section 23(a)(2) prohibits the
Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.
---------------------------------------------------------------------------
\146\ 15 U.S.C. 78c(f).
\147\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
We believe the temporary rule will have minimal impact on the
promotion of efficiency. The temporary rule is intended to further
reduce fails to deliver and address abusive ``naked'' short selling in
equity securities by requiring that participants of a registered
clearing agency deliver securities by settlement date, or if the
participants have not delivered shares by settlement date, the
participants must, by no later than the beginning of regular trading
hours on the Close-Out Date, immediately close out the fail to deliver
position by borrowing or purchasing securities of like kind and
quantity. A participant that does not comply with this close-out
requirement, and any broker-dealer from which it receives trades for
clearance and settlement, will not be able to short sell the security
either for itself or for the account of another, unless it has first
arranged to borrow the security, until the fail to deliver position is
closed out.
The temporary rule is designed to ensure that buyers of equity
securities receive delivery of their shares, thereby helping to reduce
persistent fails to deliver, which may have a negative effect on the
securities markets and investors and also may be used to facilitate
some manipulative strategies. By requiring that participants of a
registered clearing agency deliver securities by settlement date and to
the extent that participants have not delivered shares by settlement
date, borrow or purchase securities to close out the fail to deliver
position by no later than the beginning of regular trading hours on the
Close-Out Date, the temporary rule will promote the prompt clearance
and settlement of securities transactions. By doing so, the temporary
rule will further our goals of helping to eliminate any possibility
that abusive ``naked'' short selling, as well as persistent fails to
deliver, will contribute to the disruption of markets in equity
securities and, thereby, will help ensure that investors remain
confident that trading can be conducted without the illegal influence
of manipulation. A loss of confidence in the market for these
securities can lead to panic selling, which may be further exacerbated
by potentially abusive ``naked'' short selling. As a result, prices of
these securities may artificially and unnecessarily decline below the
price level that would have resulted from the normal price discovery
process, threatening the disruption of the markets for these
securities. We seek comment regarding whether the temporary rule may
adversely impact liquidity, disrupt markets, or unnecessarily increase
risks or costs to participants of a registered clearing agency.
In addition, we believe that the temporary rule will have minimal
impact on the promotion of capital formation. Issuers and investors
have repeatedly expressed concerns about fails to deliver in connection
with manipulative ``naked'' short selling.\148\ The perception that
abusive ``naked'' short selling is occurring in securities could
undermine the confidence of investors. These investors, in turn, may be
reluctant to commit capital to an issuer they believe to be subject to
such manipulative conduct.\149\ To the extent that ``naked'' short
selling and fails to deliver result in an unwarranted decline in
investor confidence about a security, the temporary rule will improve
investor confidence about the security. In addition, the temporary rule
may lead to a greater certainty in the settlement of these securities
which should
[[Page 61729]]
strengthen investor confidence in the settlement process.
---------------------------------------------------------------------------
\148\ See, e.g., 2008 Regulation SHO Final Amendments, supra
note 19.
\149\ In connection with prior proposed amendments to Regulation
SHO aimed at reducing fails to deliver and addressing potentially
abusive ``naked'' short selling, such as the 2007 Regulation SHO
Proposed Amendments, we sought comment on whether such proposed
amendments would promote capital formation, including whether the
proposed increased short sale restrictions would affect investors'
decisions to invest in certain equity securities. In response,
commenters expressed concern about the potential impact of ``naked''
short selling on capital formation claiming that ``naked'' short
selling causes a drop in an issuer's stock price that may limit the
issuer's ability to access the capital markets. See, e.g., letter
from Robert K. Lifton, Chairman and CEO, Medis Technologies, Inc.,
dated Sept. 12, 2007; letter from NCANS.
---------------------------------------------------------------------------
We also believe that the temporary rule will not impose any burden
on competition not necessary or appropriate in furtherance of the
purposes of the Exchange Act. By requiring that participants of a
registered clearing agency deliver securities by settlement date, and
to the extent that participants have not delivered shares by settlement
date, borrow or purchase securities to close out the fail to deliver
position by no later than the beginning of regular trading hours on the
Close-Out Date, we believe the temporary rule will promote competition
by requiring similarly situated participants of a registered clearing
agency, including broker-dealers from which they receive trades for
clearance and settlement, to close out fail to deliver positions in any
equity securities within similar time-frames. Moreover, the
requirements of the temporary rule will help to eliminate any
possibility that abusive ``naked'' short selling may contribute to the
disruption of markets in equity securities and, therefore, will help
ensure that all investors remain confident that trading in these
securities can be conducted without the influence of illegal
manipulation. We also believe that the temporary rule will promote
competition by protecting and enhancing the operation, integrity, and
stability of the markets. At the same time, the temporary rule will
help to maintain fair and orderly markets without unduly restricting
legitimate short selling.
In addition, by providing a close-out requirement of 35 consecutive
settlement days from settlement date for fails to deliver resulting
from sales of equity securities sold pursuant to Rule 144 of the
Securities Act, we believe the temporary rule will promote competition
by requiring similarly situated participants to close out fail to
deliver positions in any equity securities resulting from sales of Rule
144 securities within the same time-frame.
Similarly, an extended close-out requirement for fails to deliver
resulting from long sales that are attributable to a Market Maker, will
promote competition by requiring similarly situated participants to
close out these fail to deliver positions within the same time-frame.
We request comment on whether the temporary rule is likely to
promote efficiency, capital formation, and competition.
X. Final Regulatory Flexibility Analysis
The Final Regulatory Flexibility Analysis (``FRFA'') has been
prepared in accordance with 5 U.S.C. 604. This FRFA relates to the
amendments that add temporary Rule 204T to Regulation SHO, which we are
adopting in this release.\150\
---------------------------------------------------------------------------
\150\ Although the requirements of the Regulatory Flexibility
Act are not applicable to rules adopted under the Administrative
Procedure Act's ``good cause'' exception, see 5 U.S.C. 601(2)
(defining ``rule'' and notice requirements under the Administrative
Procedures Act), we nevertheless prepared a FRFA.
---------------------------------------------------------------------------
A. Need for and Objectives of the Rule
Sections I through VI of this release describe the reasons for and
objectives of temporary Rule 204T. As we discuss in detail above, we
have become concerned that there is a substantial threat of sudden and
excessive fluctuations of securities prices and disruption in the
functioning of the securities markets that could threaten fair and
orderly markets.
B. Small Entities Affected by the Rule
The entities covered by the temporary rule will include small
entities that are participants of a registered clearing agency and
small broker-dealers from which participants receive trades for
clearance and settlement. In addition, the entities covered by the
temporary rule will include small entities that are market participants
that effect sales subject to the requirements of Regulation SHO.
Although it is impossible to quantify every type of small entity
covered by the temporary rule, Paragraph (c)(1) of Rule 0-10 under the
Exchange Act \151\ states that the term ``small business'' or ``small
organization,'' when referring to a broker-dealer, means a broker or
dealer that had total capital (net worth plus subordinated liabilities)
of less than $500,000 on the date in the prior fiscal year as of which
its audited financial statements were prepared pursuant to Sec.
240.17a-5(d); and is not affiliated with any person (other than a
natural person) that is not a small business or small organization. We
estimate that as of 2007 there were approximately 896 broker-dealers
that qualified as small entities as defined above.\152\
---------------------------------------------------------------------------
\151\ 17 CFR 240.0-10(c)(1).
\152\ These numbers are based on OEA's review of 2007 FOCUS
Report filings reflecting registered broker-dealers. This number
does not include broker-dealers that are delinquent on FOCUS Report
filings.
---------------------------------------------------------------------------
As noted above, the entities covered by the temporary rule will
include small entities that are participants of a registered clearing
agency. As of July 31, 2008, approximately 91% of participants of the
NSCC, the primary registered clearing agency responsible for clearing
U.S. transactions, were registered as broker-dealers. Participants not
registered as broker-dealers include such entities as banks, U.S.-
registered exchanges, and clearing agencies. Although these entities
are participants of a registered clearing agency, generally these
entities do not engage in the types of activities that would implicate
the close-out requirements of Regulation SHO. Such activities of these
entities include creating and redeeming Exchange Traded Funds, trading
in municipal securities, and using NSCC's Envelope Settlement Service
or Inter-city Envelope Settlement Service. These activities rarely lead
to fails to deliver and, if fails to deliver do occur, they are small
in number and are usually cleaned up within a day. Thus, such fails to
deliver would not trigger the close-out provisions of Regulation SHO.
The federal securities laws do not define what is a ``small
business'' or ``small organization'' when referring to a bank. The
Small Business Administration regulations define ``small entities'' to
include banks and savings associations with total assets of $165
million or less.\153\ As of July 31, 2008, no bank that was a
participant of the NSCC was a small entity because none met these
criteria.
---------------------------------------------------------------------------
\153\ See 13 CFR 121.201.
---------------------------------------------------------------------------
Paragraph (e) of Rule 0-10 under the Exchange Act \154\ states that
the term ``small business'' or ``small organization,'' when referring
to an exchange, means any exchange that: (1) Has been exempted from the
reporting requirements of Rule 11Aa3-1 under the Exchange Act; and (2)
is not affiliated with any person (other than a natural person) that is
not a small business or small organization, as defined by Rule 0-10. No
U.S. registered exchange is a small entity because none meets these
criteria.
---------------------------------------------------------------------------
\154\ 17 CFR 240.0-10(e).
---------------------------------------------------------------------------
Paragraph (d) of Rule 0-10 under the Exchange Act \155\ states that
the term ``small business'' or ``small organization,'' when referring
to a clearing agency, means a clearing agency that: (1) Compared,
cleared and settled less than $500 million in securities transactions
during the preceding fiscal year (or in the time that it has been in
business, if shorter); (2) had less than $200 million in funds and
securities in its custody or control at all times during the preceding
fiscal year (or in the time that it has been in business, if shorter);
and (3) is not affiliated with any person (other than a
[[Page 61730]]
natural person) that is not a small business or small organization as
defined by Rule 0-10. No clearing agency that is subject to the
requirements of Regulation SHO is a small entity because none meets
these criteria.
---------------------------------------------------------------------------
\155\ 17 CFR 240.0-10(d).
---------------------------------------------------------------------------
C. Projected Reporting, Recordkeeping and Other Compliance Requirements
The temporary rule may impose some new or additional reporting,
recordkeeping, or compliance costs on small entities that are
participants of a clearing agency registered with the Commission and
small broker-dealers from which the participant receives trades for
clearance and settlement. We do not believe, at this time, that any
specialized professional skills will be necessary to comply with the
temporary rule.
D. Agency Action To Minimize Effect on Small Entities
As required by the Regulatory Flexibility Act, we have considered
alternatives that would accomplish our stated objectives, while
minimizing any significant adverse impact on small entities. Temporary
Rule 204T should not adversely affect small entities because it imposes
minimal new reporting, recordkeeping, or compliance requirements.
Moreover, it is not appropriate to develop separate requirements for
small entities because we think all small entities that are broker-
dealers should be subject to the enhanced delivery requirements imposed
by the temporary rule.
E. Duplicative, Overlapping, or Conflicting Federal Rules
The Commission believes that there are no rules that duplicate,
overlap, or conflict with temporary Rule 204T. The Commission has
designed the temporary rule so that it is consistent with the close-out
requirements of Rule 203(b)(3) of Regulation SHO.
F. Significant Alternatives
The Regulatory Flexibility Act directs us to consider significant
alternatives that would accomplish our stated objective, while
minimizing any significant adverse impact on small entities.\156\ In
connection with the temporary rule, we considered the following
alternatives: (1) Establishing different compliance or reporting
standards or timetable that take into account the resources available
to small entities; (2) clarifying, consolidating, or simplifying
compliance requirements under the rule for small entities; (3) using
performance rather than design standards; and (4) exempting small
entities from coverage of the rule, or any part of the rule.
---------------------------------------------------------------------------
\156\ See 5 U.S.C. 603(c).
---------------------------------------------------------------------------
The temporary rule furthers the Commission's stated goal of helping
to eliminate any possibility that abusive ``naked'' short selling may
contribute to the substantial disruption in the securities markets and,
therefore, to help ensure that investors remain confident that trading
in equity securities can be conducted without the illegal influence of
manipulation. The temporary rule also furthers the goals of helping to
maintain fair and orderly markets against the threat of sudden and
excessive fluctuations of securities prices generally and disruption in
the functioning of the securities markets.
The temporary rule should not adversely affect small entities
because the rule may impose only minimal new compliance requirements.
Moreover, it is not appropriate to develop different compliance
requirements for small entities with respect to the temporary rule
because we think all entities, including small entities, should be
subject to the requirements of the temporary rule. We believe that
imposing different compliance requirements, and possibly a different
timetable for implementing compliance requirements, for small entities
would undermine the Commission's goal of addressing abusive ``naked''
short selling. We have concluded similarly that it is not consistent
with the goal of the temporary rule to further clarify, consolidate or
simplify the temporary rule for small entities. The Commission also
believes that it is inconsistent with the purposes of the Exchange Act
to use performance standards to specify different requirements for
small entities or to exempt small entities from having to comply with
the temporary rule.
G. General Request for Comments
We solicit written comments regarding our analysis. We request
comment on whether the temporary rule will have any effects that we
have not discussed. We request that commenters describe the nature of
any impact on small entities and provide empirical data to support the
extent of the impact.
XI. Statutory Authority
Pursuant to the Exchange Act and, particularly, Sections 2, 3(b),
6, 9(h), 10, 11A, 15, 15A, 17, 17A, 19 and 23(a) thereof, 15 U.S.C.
78b, 78c(b), 78f, 78i(h), 78j, 78k-1, 78o, 78o-3, 78q, 78q-1, 78s and
78w(a), the Commission is adopting, as an interim final temporary rule,
Rule 204T, amendments to Regulation SHO.
XII. Text of the Amendments to Regulation SHO
List of Subjects in 17 CFR Part 242
Brokers, Fraud, Reporting and recordkeeping requirements,
Securities.
0
For the reasons set out in the preamble, Title 17, Chapter II, Part
242, of the Code of Federal Regulations is amended as follows.
PART 242--REGULATIONS M, SHO, ATS, AC, AND NMS, AND CUSTOMER MARGIN
REQUIREMENTS FOR SECURITY FUTURES
0
1. The authority citation for part 242 continues to read as follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g),
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and
80a-37.
0
2. Section 242.204T is added to read as follows:
Sec. 242.204T Short sales.
(a) A participant of a registered clearing agency must deliver
securities to a registered clearing agency for clearance and settlement
on a long or short sale in any equity security by settlement date, or
if a participant of a registered clearing agency has a fail to deliver
position at a registered clearing agency in any equity security for a
long or short sale transaction in that equity security, the participant
shall, by no later than the beginning of regular trading hours on the
settlement day following the settlement date, immediately close out its
fail to deliver position by borrowing or purchasing securities of like
kind and quantity; Provided, however:
(1) If a participant of a registered clearing agency has a fail to
deliver position at a registered clearing agency in any equity security
and the participant can demonstrate on its books and records that such
fail to deliver position resulted from a long sale, the participant
shall by no later than the beginning of regular trading hours on the
third consecutive settlement day following the settlement date,
immediately close out the fail to deliver position by purchasing
securities of like kind and quantity;
(2) If a participant of a registered clearing agency has a fail to
deliver position at a registered clearing agency in any equity security
sold pursuant to Sec. 230.144 of this chapter for thirty-five
consecutive settlement days after the settlement date for a sale in
that equity security, the participant shall, by no later than the
beginning of regular trading hours on the thirty-sixth
[[Page 61731]]
consecutive settlement day following the settlement date for the
transaction, immediately close out the fail to deliver position by
purchasing securities of like kind and quantity; or
(3) If a participant of a registered clearing agency has a fail to
deliver position at a registered clearing agency in any equity security
that is attributable to bona fide market making activities by a
registered market maker, options market maker, or other market maker
obligated to quote in the over-the-counter market (individually a
``Market Maker,'' collectively ``Market Makers''), the participant
shall by no later than the beginning of regular trading hours on the
third consecutive settlement day following the settlement date,
immediately close out the fail to deliver position by purchasing
securities of like kind and quantity.
(b) If a participant of a registered clearing agency has a fail to
deliver position in any equity security at a registered clearing agency
and does not close out such fail to deliver position in accordance with
the requirements of paragraph (a) of this section, the participant and
any broker or dealer from which it receives trades for clearance and
settlement, including any market maker that would otherwise be entitled
to rely on the exception provided in Sec. 242.203(b)(2)(iii), may not
accept a short sale order in the equity security from another person,
or effect a short sale in the equity security for its own account, to
the extent that the broker or dealer submits its short sales to that
participant for clearance and settlement, without first borrowing the
security, or entering into a bona fide arrangement to borrow the
security, until the participant closes out the fail to deliver position
by purchasing securities of like kind and quantity and that purchase
has cleared and settled at a registered clearing agency; Provided,
however:
(1) A broker or dealer shall not be subject to the requirements of
paragraph (b) of this section if the broker or dealer timely certifies
to the participant of a registered clearing agency that it has not
incurred a fail to deliver position on settlement date for a long or
short sale in an equity security for which the participant has a fail
to deliver position at a registered clearing agency or that the broker
or dealer is in compliance with paragraph (e) of this section.
(2) The requirements of paragraph (b) of this section shall not
apply to Market Makers provided the Market Maker can demonstrate that
it does not have an open short position in the equity security at the
time of any additional short sales.
(c) The participant must notify any broker or dealer from which it
receives trades for clearance and settlement, including any market
maker that would otherwise be entitled to rely on the exception
provided in Sec. 242.203(b)(2)(iii):
(1) That the participant has a fail to deliver position in an
equity security at a registered clearing agency that has not been
closed out in accordance with the requirements of paragraph (a) of this
section; and
(2) When the purchase that the participant has made to close out
the fail to deliver position has cleared and settled at a registered
clearing agency.
(d) If a participant of a registered clearing agency reasonably
allocates a portion of a fail to deliver position to another registered
broker or dealer for which it clears trades or from which it receives
trades for settlement, based on such broker's or dealer's short
position, the provisions of paragraphs (a) and (b) of this section
relating to such fail to deliver position shall apply to such
registered broker or dealer that was allocated the fail to deliver
position, and not to the participant. A broker or dealer that has been
allocated a portion of a fail to deliver position that does not comply
with the provisions of paragraph (a) of this section must immediately
notify the participant that it has become subject to the requirements
of paragraph (b) of this section.
(e) Even if a participant of a registered clearing agency has not
closed out a fail to deliver position at a registered clearing agency
in accordance with paragraph (a) of this section, or has not allocated
a fail to deliver position to a broker or dealer in accordance with
paragraph (d) of this section, a broker or dealer shall not be subject
to the requirements of paragraph (a) or (b) of this section if the
broker or dealer purchases securities prior to the beginning of regular
trading hours on the settlement day after the settlement date for a
long or short sale to close out an open short position, and if:
(1) The purchase is bona fide;
(2) The purchase is executed on, or after, trade date but by no
later than the end of regular trading hours on settlement date for the
transaction;
(3) The purchase is of a quantity of securities sufficient to cover
the entire amount of the open short position; and
(4) The broker or dealer can demonstrate that it has a net long
position or net flat position on its books and records on the
settlement day for which the broker or dealer is seeking to demonstrate
that it has purchased shares to close out its open short position.
(f) Definitions. (1) For purposes of this section, the term
settlement date shall mean the business day on which delivery of a
security and payment of money is to be made through the facilities of a
registered clearing agency in connection with the sale of a security.
(2) For purposes of this section, the term regular trading hours
has the same meaning as in Rule 600(b)(64) of Regulation NMS (17 CFR
242.600(b)(64)).
(g) This temporary section will expire and no longer be effective
on July 31, 2009.
By the Commission.
Dated: October 14, 2008.
Florence E. Harmon,
Acting Secretary.
[FR Doc. E8-24785 Filed 10-16-08; 8:45 am]
BILLING CODE 8011-01-P