SEC Issues New Rules on Naked Short Sales and Plans Further Actions to Combat Market Abuses
September 18, 2008
On September 17, 2008, the SEC issued new rules to protect investors against “naked” short selling and also announced an intention to take further regulatory and enforcement actions relating to short sales.
The new rules, Rule 204T of Regulation SHO, an amendment to Rule 203(b) of Regulation SHO and Rule 10b-21 under the Securities Exchange Act of 1934, will apply to the securities of all public companies.
Rule 204T: New Close-Out Requirement: The SEC adopted, on an interim basis, Rule 204T, which imposes new requirements for failures to deliver equity securities for clearance and settlement by the settlement date (ordinarily, T+3). If a participant in registered clearing organization does not make the required delivery on settlement date, it must generally close out the position by the opening of business on the next settlement day. However, if the participant can demonstrate on its books and records that the sale resulted from a “long” sale, then it must close out the fail to deliver by the opening of business on the third consecutive business day after it occurred. A failure to deliver securities sold under Rule 144 pursuant to the Securities Act of 1933 which persists for 35 consecutive days after the settlement date must be closed out by the beginning of regular trading hours on the 36th settlement day. If a participant fails to comply with these close-out requirements, then it may not (and any broker-dealer from which it accepts trades for clearance and settlement may not) accept a short sale order in the relevant equity security from another person, or effect a short sale 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. This “pre-borrowing” requirement will remain in effect until the participant closes out the fail to deliver position. Rule 204T, which was adopted pursuant to the SEC’s authority to issue temporary orders in emergency situations, became effective at 12:01 a.m. (Eastern Time) on Thursday, September 18, 2008, and applies to all subsequent fails to deliver.
Rule 204T will present difficult operational issues for broker-dealers, particularly those that are clearing agency participants, and will require the development of new operational practices as well as revisions to existing policies and procedures. The SEC has published on its website informal compliance guidance.
Elimination of Options Market Maker Exception: The SEC amended Rule 203(b)(3) of Regulation SHO (which generally establishes close-out requirements for certain “threshold securities” for which there are persistent failures to deliver at a registered clearing agency) to eliminate the options market maker exception from the close-out requirement of that rule. Options market makers will be required to close out existing fail to deliver positions subject to Rule 203 within 35 consecutive settlement days from the effective date of the amendment. This amendment was also adopted under the SEC’s emergency authority, and has the same time of effectiveness as Rule 204T.
While the amendment does not remove the exemption from Regulation SHO’s affirmative determination requirement for market makers, including option market makers, when they effect short sales in connection with market making activities, failure to perform such an affirmative determination would put those market makers at substantial risk of failing to deliver the securities.
Rule 10b-21 Anti-Fraud Rule: New Rule 10b-21 provides that it will be a “manipulative or deceptive device or contrivance” under Section 10(b) of the Securities Exchange Act of 1934 for any person to deceive a broker-dealer, a clearing organization participant or a purchaser about their intention or ability to deliver securities in time for settlement and then fail to deliver such securities. Rule 10b-21 was effective as of September 17, 2008.
When Rule 10b-21 was originally proposed in March of this year, the SEC indicated that a finding of “scienter” will be required in order to establish a violation.
The SEC also announced that it plans to pursue other initiatives, including the following:
Hedge Fund Short Position Disclosures and Enforcement Investigation: SEC Chairman Cox also announced a plan to propose to the Commission an emergency rule requiring hedge funds and investment managers managing $100 million or more in investments to publicly disclose their short positions. In addition, the SEC’s Director of Enforcement indicated that the SEC will shortly seek information from hedge funds and other large investors regarding past short sale activities in certain securities.
These announcements do not contain details regarding the nature of reporting or the scope of the impending enforcement inquiries.
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The SEC press releases on these initiatives are available at http://www.sec.gov/news/press/2008/2008-204.htm and http://www.sec.gov/news/press/2008/2008-209.htm. As indicated above, the SEC staff and self-regulatory organizations have published a document containing informal guidance to broker-dealers on avoiding failures to deliver, which is available at http://www.sec.gov/about/offices/ocie/shortsaletips.pdf.
If you have any questions regarding this newsflash, please call your Davis Polk contact.