• SEC Outlaws Abusive Naked Short Selling
  • November 10, 2008
  • Law Firm: Blank Rome LLP - Philadelphia Office
  • Introduction

    On October 14, 2008, the Securities and Exchange Commission (the “SEC”) adopted an antifraud rule that addresses abusive “naked” short selling.1 Rule 10b-21 is designed to prevent short sellers, including broker-dealers acting for their own accounts, from deceiving specified persons about their intention or ability to deliver securities in time for settlement and then failing to deliver securities by the settlement date. This rule took effect on October 17, 2008, following the expiration of an emergency order issued by the SEC on September 17, 2008 to address naked short sales.

    Background

    Regulation SHO was originally adopted by the SEC in 2004 to address the problems associated with persistent failures to deliver securities following short sales and potentially abusive “naked” short selling. The SEC defines abusive naked short selling as selling stock that a person does not own, without having the stock available for delivery, and intentionally failing to deliver that stock within the standard three-day settlement cycle. Among other requirements, Rule 203 of Regulation SHO includes a “locate” requirement, under which a broker or dealer may not accept a short-sale order from another person or effect a short sale for its own account unless the executing or introducing broker or dealer:

    • has borrowed the security or entered into a bona fide arrangement to borrow the security, or
    • has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due, which may be based upon reasonable assurances that a customer has identified its own sources of borrowable securities; and
    • has documented compliance with the “locate” requirement.

    This rule addresses concerns that short sellers deliberately misrepresent to broker-dealers that they own or have obtained legitimate sources of securities in order to circumvent the locate requirement. Some short sellers have also misrepresented their sales as long sales in order to circumvent Rule 105 of Regulation M, which prohibits certain short sellers from purchasing securities in a secondary or follow-on offering. The SEC believes that these and other similar abusive “naked” short selling activities can drive down companies’ stock prices, cause irreparable harm to companies’ reputations, severely reduce investor confidence in the market, and manipulate the prices of securities.

    Rule 10b-21

    Rule 10b-21 is an antifraud rule promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”) and designed to address harmful and abusive naked short selling practices. This rule makes it unlawful for any person to submit an order to sell an equity security if such person deceives a broker-dealer, participant of a registered clearing agency, or purchaser regarding its intention or ability to delivery the security on the date delivery is due, and such person fails to deliver the security on or before the date delivery is due. Rule 10b-21 only applies to equity securities and covers situations in which a seller deceives a purchaser about the seller’s intention to deliver securities by the settlement date, its locate source, or its share ownership, and then fails to deliver the securities by the settlement date. Scienter is a necessary element for a violation of this rule. In addition, a violation will only occur if a failure to deliver a security results from a relevant transaction.

    Although abusive short selling practices constituting a manipulative scheme are already illegal under the general antifraud provisions of the federal securities laws, including Rule 10b-5, Rule 10b-21 will focus market attention on these abusive practices and clarify that short sellers who engage in these practices will have Exchange Act liability. The new rule also serves to halt activities that may create failures to deliver, which in turn could mislead the market about an issuer’s securities and negatively impact shareholders by depriving them of ownership benefits, such as voting and lending. In addition, by requiring broker-dealer compliance with the locate requirement of Regulation SHO, this new rule could help reduce both the number of failures to deliver a security, as well as other manipulative schemes involving “naked” short selling.

    While Rule 10b-21 is primarily aimed at curbing abusive short selling practices, a seller can also violate the rule for causing a broker-dealer to mark an order to sell a security “long” if the seller knows or recklessly disregards that it is not “deemed to own” (as defined in Regulation SHO) the security being sold. The seller may also be liable if the seller knows or recklessly disregards that the security is not, or cannot reasonably be expected to be, in the broker-dealer’s possession or control by the date delivery is due, and the seller fails to deliver the security by the settlement date. Broker-dealers face potential liability in similar situations as to “long” transactions in which they act for their own accounts.

    In adopting the rule substantially as proposed, the SEC clarified that Rule 10b-21 does not limit or restrict the applicability of the general antifraud provisions of the federal securities laws. The SEC also noted that a private plaintiff who is able to prove the elements of a 10b-21 violation could properly assert a claim under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. However, the rule does not impose any additional liability or requirements on any person, including broker-dealers, other than as already imposed under the Exchange Act and related rules, including Regulation SHO and the antifraud rules of the federal securities laws.

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    1. Release No. 34-58774 (Oct. 14, 2008).