On July 27, 2009, the Securities and Exchange Commission (“SEC”) adopted final Rule 204 of Regulation SHO (“Rule 204” or the “final rule”) under the Securities Exchange Act of 1934, making permanent, with minor changes, the firm delivery and close-out requirements for sales of equity securities contained in temporary Rule 204T of Regulation SHO (“temporary Rule 204T” or the “temporary rule”). Among the minor changes, the final rule provides broker-dealers with some limited increased flexibility by allowing them to close out fails by either borrowing or purchasing securities in certain situations where the temporary rule required purchases, and expanding the class of securities eligible for a 35-day close-out period to include certain securities the seller is deemed to own.
The rule is part of the SEC’s efforts to curtail potential “naked” short selling abuses and reduce fails to deliver. Rule 204 will become effective on July 31, 2009, upon the expiration of temporary Rule 204T.
In its press release regarding Rule 204, the SEC also indicated that it will not renew temporary Rule 10a-3T (Form SH), which is set to expire on August 1, 2009. Under this temporary rule, which has been in effect since September 2008, institutional investment managers have been required to report their short positions. In lieu of renewing temporary Rule 10a-3T, the SEC announced a joint effort with self-regulatory organizations (“SROs”) aimed at increasing public availability of short sale data by providing short sale volume and transaction data on SRO websites. Details regarding the program have not yet been announced, although it appears that the intent is not to publicly identify individual short sellers or position holders.
The SEC is also planning to hold a roundtable to discuss other potential reforms affecting securities lending and short sale markets. The SEC release did not address pending proposals to reinstate a short sale price test.
Final Rule 204
Temporary Rule 204T was originally adopted as part of an SEC emergency order in September 2008 as a measure to limit abusive “naked” short selling of equity securities. The rule aimed to close out fails to deliver, which could allow naked short sale positions to persist. The SEC believes the temporary rule was a success and credits it for a subsequent 56.6% decline in average daily fails.
Final Rule 204 contains the same basic provisions as temporary Rule 204T:
- Accelerated Close-Outs. Participants of registered clearing agencies must deliver equity securities to the clearing agency for a long or short sale by the settlement date. If a participant has a fail to deliver position at the clearing agency relating to a short sale, the participant must immediately close out the position by either borrowing or purchasing the shares before the beginning of trading hours on the first settlement day after the settlement date. Fails relating to long sales or bona fide market making activity have two additional settlement days before they must be closed out, but under the temporary rule, such fails to deliver must be closed out by a purchase of the relevant security and not by stock borrows. The temporary rule contained an exception that extends the close-out date for fails of Rule 144 securities. As discussed below, the exception is expanded in the final rule to include certain additional securities.
- Pre-Borrow Penalty. If a participant fails to close out an open fail by the deadline, the participant and any broker-dealer from which it receives trades for clearance and settlement become subject to a penalty (the “Pre-Borrow Penalty”) requiring them to first borrow or enter into an arrangement to borrow the security before accepting any short sales orders or effecting short sales for its own account in the security. The Pre-Borrow Penalty remains in effect until the open fail is closed out by purchasing (not borrowing) the securities.
- Pre-Fail Credit. A broker-dealer can avoid the close-out requirement or Pre-Borrow Penalty by purchasing enough shares to offset its fail, subject to certain conditions, including the amount and timing of the purchase (“Pre-Fail Credit”).
- Allocations and Certifications. The temporary rule contained exceptions for broker-dealers and market makers who certify that they have not incurred fails in respect of the relevant securities, for market makers who demonstrate that they do not have open short positions at the time of additional short sales and for participants who “reasonably allocate” a portion of a fail to deliver position to another broker-dealer for whom it clears trades.
The SEC adopted the following minor modifications in the final rule:
- Flexibility to Purchase or Borrow. The final rule adds flexibility by allowing borrowing to close out long fails, market maker fails or for Pre-Fail Credit. As noted above, in these cases the temporary rule only allowed purchases.
- Pre-Fail Credit Conditions Relaxed. Unlike the temporary rule, which conditions the availability of Pre-Fail Credit on the broker-dealer acquiring an amount of securities equal to the amount of the open short position in the security, the final rule provides that only the amount of the fail to deliver position at the registered clearing agency must be purchased or borrowed.
- Additional Securities Eligible for Extended Close-Out Period. The final rule expands the category of securities that qualify for an extended close-out period from only Rule 144 securities to other securities that the seller is “deemed to own” and intends to deliver, such as securities not yet received after exercising an option or warrant. The final rule also reduces the close-out timeframe for these securities from the 36th consecutive settlement day to the 35th calendar day following the settlement date.
- Market Maker Exception from Pre-Borrow Penalty Removed. The final rule removes the temporary rule’s exception from the Pre-Borrow Penalty for market makers that do not have an open short position in the security. The SEC explained that the exception is unnecessary because a market maker, like any broker-dealer, can be relieved of the Pre-Borrow Penalty by certifying that it is not responsible for the fail.
The final rule also added a new subsection to reemphasize the SEC’s concerns regarding attempts to evade the requirements of Rule 204 through sham close-outs. New Rule 204(f) specifies that the purchase or borrow of securities will not qualify as a close-out if the participant knows or has reason to know the securities will not actually be delivered in settlement. The adopting release also reinforced the importance of good record keeping and compliance procedures, and indicates the SEC’s intent to examine firms for compliance. Additionally, because Rule 204 applies to all equity securities, it effectively eliminates (but does not actually remove) the close-out requirements for “threshold” securities under Rule 203(b)(3) of Regulation SHO.
Despite these modifications, the final rule remains stringent. The SEC did not accept a number of commenters’ suggested changes that would have eased the operational burden of the rule, including extending the close-out date further, or simply allowing the close-out to be completed by the end of the day on which a close-out is required. The SEC emphasized that while many comments had merit, given the success of the temporary rule and the fact that participants have already adjusted to it, the SEC was not prepared to relax its requirements. Although the SEC had requested comment on whether to extend Rule 204 to include debt securities, it determined not to do so. However, the adopting release noted that the status of certain (unspecified) securities as debt or equity may be unclear, and that the SEC would evaluate the application of Rule 204 (and other provisions of Regulation SHO) to such instruments on a case-by-case basis.
Expiration of Rule 10a-3T and Form SH
The SEC also announced that it would allow temporary Rule 10a-3T and Form SH to expire, relieving institutional investment managers of a significant compliance burden. Temporary Rule 10a-3T currently requires certain institutional investment managers to provide a weekly report of their short sales and short positions on Form SH.
SROs and SEC to Publish Short Sale Data
In connection with the expiration of temporary Rule 10a-3T, the SEC announced that it is working with SROs to make more short sale volume and transaction data publicly available. According to the SEC, in the next few weeks SROs will begin publishing on their websites aggregate daily short selling volume in individual equity securities and one-month-delayed information regarding individual short sale transactions in exchange-listed equity securities. The SEC will also begin reporting on its website twice monthly fail to deliver data for all equity securities.
The SEC has not yet released details on these initiatives, but it appears that the data will be derived from short and long sale designations on trade reports, and from fails data furnished by the National Securities Clearing Corporation. The delayed transaction data is intended to provide the same information that was made publicly available during the pilot period before the short sale price test was eliminated in 2007. It is not intended to publicly identify investors or their specific holdings.
Public Roundtable on Securities Lending and Short Sales
The SEC announced its plan to hold a public roundtable on September 30, 2009 to solicit public comment on a variety of other potentially controversial matters relating to securities lending and short sales.
Among other measures, at the roundtable the SEC will consider whether to require the addition of a short sale indicator to the “tapes” that report transactions in exchange-listed securities – which may present technological challenges and be of limited utility on a trade-by-trade basis; whether to require public disclosure of large individual short positions – which institutions will likely resist for fear of tipping their hand; and whether to institute pre-borrowing or enhanced “locate” requirements on short sellers – which many argue would reduce liquidity and increase borrowing costs.
Proposed Short Sale Price Test Restrictions
The SEC did not take any action in this release with respect to the proposed price tests restricting short sales. As we discussed in our May 4, 2009 client memorandum Short Sale Proposals: Key Questions, the SEC has proposed for comment a number of different iterations of the tick test. The SEC is expected to act on these proposals in the near future