• New Short Sale Restrictions Take Effect Today
  • September 25, 2008 | Author: Brandon Becker
  • Law Firm: Wilmer Cutler Pickering Hale and Dorr LLP - Washington Office
  • On September 17, 2008, the Securities and Exchange Commission ("SEC" or "Commission") promulgated rules on an emergency basis that are intended to significantly reduce the possibility of naked short selling disrupting the functioning of the securities markets. Unlike the emergency order issued in July, which was limited to the securities of certain financial firms, the new rules apply to all equity securities traded in the United States. While the SEC currently does not impose limitations on "synthetic" short positions established via options or other derivatives, the new rules are expected to have ripple effects on a wide range of financial instruments, given the importance of the cash markets in the overall price discovery process.

    Specifically, the new SEC rules impose the following restrictions on short selling:

    1. Temporary Rule 204T under Regulation SHO. Enhanced delivery requirements are imposed on sales of equity securities that occur on or after September 18, 2008, at 12:01 a.m. In particular, clearing firms must settle sales of equity securities that clear through a registered clearing agency by delivering shares by the close of business on settlement date (generally T+3). In the event of a failure to deliver, the fail must be closed out by the clearing firm no later than the beginning of trading on the day after settlement date (generally T+4) through a purchase or borrow of securities of like kind or quantity. The rule allows the clearing firm until the beginning of trading on T+6 to effect a close-out in connection with a failure to deliver if it can demonstrate that the failure to deliver resulted from a long sale. If any fail is not closed out within the specified period, the clearing firm and any introducing broker from which it receives trades for clearance and settlement will be prohibited from effecting any short sales in the security for any customer or proprietary account unless the security is pre-borrowed. This pre-borrow requirement remains in effect until the fail is resolved through settled purchases.
    2. Amended Rule 203(b)(3) of Regulation SHO. The exemption from the close-out requirement for options market makers that sell short to hedge options positions established before the securities became threshold securities is eliminated. Going forward, options market makers will be treated in the same way as other market participants. For positions existing on September 17, 2008, in connection with which an options market maker previously had been relying on the exemption (e.g., positions that, as of September 17, 2008, had aged beyond day 13 in reliance on the exemption), the Commission will allow 35 days to effect close-outs.
    3. Rule 10b-21 under the Securities Exchange Act. If a person fails to deliver a security by settlement date and such person misrepresented its intention or ability to deliver the security on or before settlement date, that activity will be deemed fraudulent.

    New Rules 204T and 10b-21, as well as the amendment to Rule 203(b)(3) of Regulation SHO, took effect as of 12:01 a.m. (EDT) on September 18, 2008, and apply to fails to deliver resulting from trades that occur on or after trade date September 18, 2008. Fails that occurred prior to the effectiveness of the Order continue to be governed by Rule 203(b)(3) of Regulation SHO. The Emergency Order will expire at 11:59 p.m. (EDT) on October 1, 2008, unless further extended by the Commission.

    The Commission and other regulators also published tips to help broker-dealers avoid failures to deliver, including suggestions such as obtaining pre-borrows. In addition, in a press release issued on September 17, 2008, SEC Chairman Christopher Cox suggested that the Commission also may promulgate an emergency disclosure rule that would require entities with more than $100 million invested in securities (e.g., hedge funds and other large investors) to disclose their short positions on a daily basis.

    In light of the new and proposed rules, clearing firms will need to implement enhanced operational procedures regarding the trade settlement process. Clients of clearing firms should be in contact with those firms to assess how their trading practices will be affected.