SEC Amends Order Temporarily Banning Short Sales of Financial Companies to Modify Scope of Covered Securities and Expand Exemption for Derivatives Market Makers
September 22, 2008
On September 21, 2008, the SEC amended its September 18 emergency order banning short selling of publicly traded stocks of specified financial companies to address a range of concerns that were raised by industry participants and issuers.
Specifically, the amended order:
- Modifies the scope of covered securities. The original order applied to publicly traded securities of issuers whose names appeared in an annex to the order. Under the amended order, short sales will apply to “Covered Securities” that are included in lists to be published by the national securities exchanges. The lists can be expected to include securities of domestic and foreign banks, savings associations, broker-dealers, investment advisers and insurance companies and the owners of such entities. The amended order permits the exchanges to exclude from their lists securities of issuers that request that they not be included. The amended order also clarifies that it applies only to publicly traded common equity securities.
- Expands and extends derivatives market making exemption. The amended order will permit, for the life of the order, an exemption for any market maker, including an over-the-counter market maker, that effects a short sale as part of a bona fide market making and hedging activity related directly to bona fide market making in (a) derivative securities based on Covered Securities, or (b) exchange traded funds and exchange traded notes of which Covered Securities are a component. This exemption is subject to a requirement that if a customer or counterparty position in a derivative security based on a Covered Security is established after 12:01 a.m. (Eastern) on September 22, 2008, a market maker is prohibited from effecting a short sale in the Covered Security if the market maker knows that the customer’s or counterparty's transaction will result in the customer or counterparty establishing or increasing an economic net short position (through actual positions, derivatives, or otherwise) in the issued share capital of a firm covered by the order. All market makers relying on this exception to the limitation on short selling must, as soon as operationally practicable, publish a notice regarding this limitation on their Internet website.
- Permits short sales in connection with existing futures contracts. The original order permits short sales that occur as a result of automatic exercise or assignment of an equity option held prior to the effectiveness of the order. The amended order extends this to short sales effected in connection with the settlement of an existing futures contract.
- Allows short sales by writers of call options. To facilitate the ongoing creation of call options, the amended order permits short sales by writers of call options as a result of assignments upon exercise.
- Clarifies that the order does not apply to sales of Covered Securities pursuant to Rule 144 under the Securities Act of 1933.
The amendment is important because it will permit market makers in listed options and OTC market makers in Covered Securities to continue to provide liquidity to the markets during the full term of the order. (The amended order did not alter the provision of the original order which provides exemptions for registered market makers, block positioners, or other market makers obligated to quote in the over-the-counter market that are selling short as part of bona fide market making in a Covered Security.) The other significant aspect of the amended order is that it will result in adjustments to the list of securities subject to the order to accommodate financial institution issuers who felt that they were improperly excluded from the original list, as well as those who do not wish to be included.
The amended order did not go as far as some market participants would have liked in exempting specified types of short sales. In particular, many market participants urged the SEC to adopt a standard that permitted all short sales for hedging purposes so long as the seller was not establishing or increasing its “net short” position.
There are also a number of significant ambiguities. For example, the derivatives market making exemption permits short sales related to bona fide market making activities in “derivative securities” based on Covered Securities. However, it does not make clear whether the term “derivative securities” includes security-based swaps that are not technically “securities.” Although the definitional provisions in the federal securities laws exclude certain security-based swaps from the definition of “securities,” such swaps are taken into account for other purposes. Also, where the amended order refers to “market makers,” it is not clear whether it is intended to include only entities that meet the definition of market maker contained in the Exchange Act, or whether a more liberal interpretation is intended. In addition, market makers are not given guidance concerning how they are to establish that they do not have knowledge of a customer or counterparty’s intention to use a derivative instrument to establish or increase an economic short position.
The term of the order was not altered, and the order expires at 11:59 p.m. (Eastern) on October 2, 2008, unless extended by the SEC.
In a separate action, the SEC amended its order concerning reporting of short sales and short positions by certain institutional investment managers to provide that the filings will initially be non-public, and that the disclosures will only be made publicly available after two weeks.
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The amended order banning short sales in Covered Securities is available at http://sec.gov/rules/other/2008/34-58611.pdf. The SEC’s order amending reporting requirements for institutional investment managers is available at http://sec.gov/rules/other/2008/34-58591a.pdf.
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