The U.S. Securities and Exchange Commission issued an emergency order effective today that places additional limitations on manipulative short-selling (often referred to as “naked” short selling). This follows the SEC’s emergency order issued in July that attempted to limit short selling in the securities of sixteen specified issuers. As described more completely below, the order penalizes broker-dealers that have a fail to deliver position at a registered clearing agency in any equity security, eliminates the options market maker exception from Regulation SHO’s close-out requirement, and adopts a new anti-fraud rule aimed at persons who deceive their brokerage firm about their ability to deliver securities for settlement.
The SEC’s emergency order raises a number of operational issues that have not yet been resolved. It is our understanding that the SEC has been asked a number of questions by the industry and that additional guidance will be forthcoming. We will update this Client Alert to provide any additional information from the SEC.
Close-Out Requirement, Penalties, and Mandatory Pre-Borrow
In an attempt to rein in “naked” short selling, the Commission has adopted, on a temporary basis, Rule 204T to Regulation SHO, which provides that:
- clearing agency members are required to deliver all securities involved in a short sale by the close of business on the settlement date;
- clearing agency members are required to close out any fail to deliver position at the clearing agency no later than one business day following the settlement date; and
- if a fail to deliver position is not closed out, the clearing agency member and any broker-dealer from whom it receives trades must pre-borrow securities before effecting short sales until the fail is resolved.
Fails resulting from long sales are afforded two additional days before they are required to be closed out; importantly, this additional time period is available only where the participant is able to “demonstrate on its books and records that such fail to deliver position resulted from a long sale.” Fails resulting from sales of securities pursuant to Rule 144 under the Securities Act of 1933 are afforded 35 additional days before they are required to be closed out.
Rule 204T applies only to fails to deliver resulting from trades that occur on or after September 18, 2008. Accordingly, existing fails to deliver must be closed out pursuant to Rule 203(b)(3) of Regulation SHO.
Elimination of Exemption for Options Market Makers
The SEC used its emergency powers to amend Rule 203(b)(3) of Regulation SHO. The amendment to Rule 203(b)(3) eliminated the options market maker exemption from the requirement to close out fails in threshold securities, making it harder for options market makers to hedge their positions when they sell put contracts.
Short Selling Anti-Fraud Rule
The SEC adopted a new anti-fraud rule -- Rule 10b-21 under the Exchange Act. New Rule 10b-21 makes it clear that that it is a “manipulative or deceptive device or contrivance” -- as that term is used in Section 10(b) of the Exchange Act -- to submit an order to sell a security while at the same time deceiving a broker-dealer or purchaser about the seller’s ability or intention to deliver the securities at settlement and the seller fails to deliver the securities.
While the new measures implemented today by the SEC to combat “naked” short selling do not require firms to pre-borrow prior to effecting short sales, many firms will likely tighten their procedures around short selling to avoid the cost associated with closing out a position. As a result, reliance on easy to borrow lists to locate securities may become a thing of the past. In addition, firms may ban short selling in securities which have typically been hard to borrow out of fear that they will be unable to obtain the securities in time to settle the trades.
The new measures are effective until October 1, 2008 unless the SEC takes action to extend them. We think that it is likely that the SEC will extend the effective period for the new measures and will ultimately make them permanent in their current or a modified form after receiving comments from the public.
Please contact any of the following if you have any questions regarding Regulation SHO or the SEC’s new short selling rules.