• SEC Adopts Final Rules Regarding Short Sales
  • October 31, 2008 | Authors: Timothy B. Nagy; Michael D. Wolk
  • Law Firm: Bingham McCutchen LLP - Washington Office
  • On October 14, 2008, the Securities and Exchange Commission adopted (i) an “interim final temporary rule” extending until July 31, 2009, the recently imposed Rule 204T requiring that clearing firms buy or borrow securities to close-out any fail to deliver position in an equity security resulting from a long or a short sale by the beginning of regular trading hours on the next settlement day following the date the fail to deliver position arose; (ii) a final rule eliminating the options market maker exception to the close-out requirement of Regulation SHO; and (iii) an antifraud rule prohibiting misrepresentations by a seller regarding the seller’s ability or intention to deliver securities on time in connection with both long and short sales. The rules are generally consistent with the rules adopted by the SEC pursuant to an emergency order issued on September 17, 2008, as extended on October 1, 2008.1 The following is a brief overview of each of the rules:

    Adoption of Rule 204T as an “Interim Final Temporary Rule” (Release No. 34-58773)  

    The SEC adopted Rule 204T as an interim final temporary rule requiring clearing firms to close-out fail to deliver positions resulting from long or short sales of any equity security by no later than the beginning of regular trading hours on the settlement day after the day the fail to deliver position arose. A participant in a registered clearing agency that does not comply with the 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. The new temporary rule will be in effect until July 31, 2009, unless it is amended or extended.

    Rule 204T operates just as it did under the Emergency Order and the subsequent written guidance issued by the Commission’s staff. Generally, Rule 204T requires that once a clearing firm fails to close-out a fail as required, the clearing firm must notify any broker-dealer from which it receives trades for clearance and settlement that it has a fail to deliver position that has not been closed out and when the position has cleared and settled. Rule 204T permits a clearing firm to allocate a fail to a particular broker-dealer for whom it clears resulting in only such broker-dealer and its customers being subject to the pre-borrow requirement. Rule 204(T) 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.  

    In the Release, the SEC reminded broker-dealers that they should consider having in place policies and procedures to help ensure that delivery is being made by settlement date and stated that it intended to examine broker-dealers’ policies and procedures to determine whether such policies and procedures monitor for delivery by settlement date.

    The SEC has requested comments on a number of aspects of the temporary rule and has indicated that it intends to address such comments in a future release.  

    A copy of Release No. 34-58773 is available at: http://www.sec.gov/rules/final/2008/34-58773.pdf

    Elimination of the Options Market Maker Exception (Release No. 34-58775)    

    Rule 203(b)(3) of Regulation SHO, as originally adopted in 2004, provided an exception to the mandatory close-out requirement for any fail to deliver 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. The Final Rule eliminated the options market maker exception to Regulation SHO’s close-out requirement. The SEC concluded that the elimination of the options market maker exception was appropriate because the market data it analyzed suggested that a significant number of persistent fails to deliver in threshold securities were the result of the options market maker exception.

    The amendments include a one-time 35 consecutive settlement day phase-in period similar to the phase-in period permitted in the Emergency Order. Since the final elimination of the exception was adopted prior to the expiration of the Emergency Order, any fails to deliver in threshold securities that were in the process of being closed out pursuant to the 35 consecutive settlement days phase-in period as set forth in the Emergency Order will not receive any additional time in which to be closed out. 

    The SEC also provided guidance regarding the definition of bona-fide market making for purposes of complying with the market maker exception to the “locate” requirement of Rule 203(b)(1) of Regulation SHO. The SEC advised that the following types of activities would indicate that a market maker is engaged generally in bona-fide market making activities for purposes of claiming the exception to the locate requirement:

    • whether the firm incurs economic or market risk such as putting the firm’s own capital at risk to provide continuous two-sided quotes in markets;
    • taking the other side of trades when there are short-term buy- and sell-side imbalances;
    • attempting to prevent excess volatility;
    • engaging in a pattern of trading that includes both purchases and sales in roughly comparable amounts to provide liquidity; and
    • maintaining continuous quotations that are at or near the market on both sides and that are communicated and represented in a way that makes them widely accessible. 

    Conversely, the following are examples of activities that would not constitute bona-fide market making:

    • trading that is related to speculative selling strategies or investment purposes of the broker-dealer and is disproportionate to the usual market making patterns or practices of the broker-dealer in that security;
    • posting quotations continually at or near the best offer, but not also posting at or near the best bid; and
    • continually executing short sales away from the firm’s posted quotes. 

    None of the above referenced activities are dispositive. Indeed, whether or not a market maker is engaged in bona-fide market making will ultimately depend on the facts and circumstances of the particular activity. 

    A copy of Release No 34-58775 is available at: http://www.sec.gov/rules/final/2008/34-58775.pdf
    “Naked” Short Selling Antifraud Rule (Release No. 34-58774)

    The SEC adopted Rule 10b-21 to target sellers who deceive their broker-dealers or certain other persons about either the seller’s source of borrowable shares (in the case of a short sale) or the seller’s share ownership (in the case of a long sale). A violation of Rule 10b-21 requires that the following three conditions be met: (i) the seller deceives its broker-dealer or certain other persons about its source of borrowable shares or its share ownership; (ii) the seller possesses the requisite intent (i.e., scienter); and (iii) a fail to deliver must actually occur as a result of the subject transaction. Although “naked” short selling as part of a manipulative scheme is already illegal under the general antifraud provisions of the federal securities laws, the SEC believes that a rule further evidencing liability will focus the attention of market participants on such activities. 

    In general, if a seller in good faith relies on a broker-dealer’s “Easy to Borrow” list to satisfy the locate requirement, the seller would not be deceiving the broker-dealer at the time it submits an order to sell a security that it can or intends to deliver securities on the date delivery is due. Rule 10b-21 also imposes liability on a seller who deceives a broker-dealer, participant of a registered clearing agency, or purchaser about its ownership of shares or the deliverable condition of owned shares and fails to deliver securities by settlement date. This requires that sellers and broker-dealers properly consider whether or not an order should be marked as “long.” The SEC indicated that it intended there would be a private right of action for violations of Rule 10b-21. However, the SEC also stated that the rule was not intended to create any liability on the part of broker-dealers handling customer orders beyond that already imposed by Regulation SHO.

    A copy of Release No. 34-58774 is available at: http://www.sec.gov/rules/final/2008/34-58774.pdf


    1 Exchange Act Release No. 58572 (Sept. 17, 2008) (the “Emergency Order”). The rules adopted pursuant to the Emergency Order are due to expire on October 17, 2008. Exchange Act Release No. 58711 (Oct. 1, 2008).