On August 7, 2007, the Securities and Exchange Commission (the "SEC" or the "Commission") published final amendments to Regulation SHO under the Securities Exchange Act of 1934 (the "Exchange Act") ( Amendments to Regulation SHO , Exchange Act Release No. 56212 (Aug. 7, 2007), 72 FR 45544 (Aug. 14, 2007)). Regulation SHO substantially increased the requirements to locate and deliver securities in the settlement of short sales. The amendments eliminate a "grandfather" exception to the "close-out" requirements contained in Regulation SHO, extend the current close-out requirement of 13 consecutive settlement days for sales of Rule 144 threshold securities to 35 settlement days and make technical changes related to New York Stock Exchange ("NYSE") Rule 80A. The adopted amendments became effective on October 15, 2007.
In a separate release, the Commission re-proposed for comment amendments to Regulation SHO that would eliminate the exception to the close-out requirements for options market maker hedging activities and proposed for comment a requirement that broker-dealers document the location of securities subject to a long sale ( Amendments to Regulation SHO , Exchange Act Release No. 56213 (Aug. 7, 2007), 72 FR 45558 (Aug. 14, 2007)). The comment period on the re-proposed and proposed amendments closed on September 13, 2007.
Before the recent amendments, Rule 203(b)(3) contained two main exceptions to the close-out requirements. Under the first exception, contained in Rule 203(b)(3)(i) and commonly referred to as the "grandfather" provision, any fail to deliver position established before the security became a threshold security1was not subject to the close-out requirement. The Commission adopted this exception because it was concerned that closing out large, pre-existing fail to deliver positions would create volatility in the subject security.
The second exception, the "options market maker" exception, is still in effect and provides that any fail to deliver position in a threshold security resulting from short sales by a registered options market maker effected to hedge options positions created before the underlying security becomes a threshold security are not subject to the close-out requirement.2Fails to deliver in threshold securities not effected to hedge pre-existing positions, and that remain open for 13 consecutive settlement days, are subject to mandatory close out, unless the grandfather provision applies.
Grandfather exception eliminated. The SEC has amended Rule 203(b)(3)(i) to eliminate the grandfather provision. According to the Commission, the level of fails to deliver has declined since implementation of Regulation SHO, but SEC and self-regulatory organization ("SRO") examinations have indicated that persistent fails to deliver may be attributable to the grandfather and the options market maker exceptions. Elimination of the grandfather provision is intended to reduce those persistent fails to deliver. Under the amended rule, all fail to deliver positions in threshold securities, including those that existed before the security became a threshold security, except as discussed below, will be required to be closed out within 13 consecutive settlement days, with the exception of previously grandfathered positions. The amendment includes a 35 consecutive settlement day phase-in period to allow market participants time to comply with the new close-out requirements. The phase-in period began on October 15, 2007 and ends on December 3, 2007.
Rule 144 sales. The Commission adopted an amendment to Rule 203(b)(3)(ii) of Regulation SHO with respect to sales of securities subject to Rule 144 of the Securities Act of 1933. Sales of restricted securities made pursuant to Rule 144 often cannot be settled by delivery of the securities for practical reasons and, therefore, must be settled with borrowed securities. In such cases, Regulation SHO treats the sales as short sales because Rule 200(g)(1) does not permit a broker-dealer to mark an order to sell as "long" unless the seller is deemed to own the security and the broker-dealer either (i) has physical possession or control over the security to be delivered or (ii) reasonably expects that it will have physical possession or control of the security by no later than settlement of the transaction. The amendment extends to 35 consecutive settlement days the current close-out requirement of 13 consecutive settlement days for Rule 144 threshold securities. After 35 days, the broker-dealer must take steps to purchase the security to close out the fail position. The Commission also amended Rule 203(b)(3)(iii) to extend the preborrow requirement. Until the broker-dealer closes out the entire fail to deliver position, the broker-dealer and any broker-dealer for which it clears transactions, including market makers, may not accept any short sale orders or effect further short sales in the threshold security without borrowing, or entering into a bona-fide arrangement to borrow the security.
Technical amendment. Finally, the SEC adopted a technical amendment to Rule 200(e)(3) of Regulation SHO that relates to index arbitrage trading activity. The amendment updates the market decline limitation contained in the rule by referencing the NYSE Composite Index instead of the Dow Jones Industrial Average, and by adding language to clarify how the two percent market decline limitation is to be calculated in accordance with NYSE Rule 80A (Rule 80A places certain restrictions on index arbitrage orders to sell any component of the S&P 500 Stock Price Index). The technical amendment is intended to maintain consistency with NYSE Rule 80A.
Re-proposed And Proposed Amendments
Options market maker exception. Last year, the Commission proposed an amendment (the "2006 Proposal") to Regulation SHO that would have narrowed the options market maker exception under Rule 203(b)(3)(ii) of the Exchange Act ( Amendments to Regulation SHO , Exchange Act Release No. 54154 (July 14, 2006), 71 FR 41710 (July 21, 2006)). The 2006 Proposal would have permitted an options market maker to keep open a fail to deliver position in a threshold security that resulted from a short sale to hedge an options position created before the underlying security became a threshold security, if the options position had not expired or been liquidated. Once the underlying security became a threshold security and the options position being hedged had expired or been liquidated, however, the 2006 Proposal would have required the fail to deliver position to be closed out within 13 consecutive settlement days from the date that the security became a threshold security or the options position expired or was liquidated, whichever was later. According to the Commission, preliminary data indicated that Regulation SHO's close-out requirement appears to have reduced fails to deliver without market disruptions, but that a small number of threshold securities with substantial and persistent fail to deliver positions remains and appears to be related to the options market maker exception.
Given the substantial and persistent fail to deliver positions, the Commission has re-proposed an amendment to Rule 203(b)(3)(ii) that would eliminate the options market maker exception entirely. Options market makers would have a 35 consecutive settlement day phase-in period under amended Rule 203(b)(3)(iii) from the effective date of the amendment to close out a previously excepted fail to deliver position in a threshold security. If a fail to deliver position in a threshold security persisted for 35 consecutive settlement days from the effective date of the amendment, the amendment would prohibit a participant, and any broker-dealer for which it clears transactions, including market makers, from accepting any short sale order or effecting further short sales in the threshold security without borrowing, or entering into a bona fide arrangement to borrow, the security until the participant closed out the entire fail position by purchasing securities of a like kind and quantity. For any security that became a threshold security after the effective date of the amendment, any fails to deliver that result or resulted from a short sale effected by an options market maker to establish or maintain a hedge on an options position created before the security became a threshold security would be subject to the 13 consecutive settlement day close-out requirement of Rule 203(b)(3).
The Commission also proposed two alternatives to the elimination of the options market maker exception, each of which would be subject to a 35 consecutive settlement day phase-in period similar to the one for the proposed elimination of the options market maker exception. Under Alternative 1, a fail to deliver in a threshold security that resulted from a short sale by an options market maker to establish or maintain a hedge on any options series within a portfolio created before the security became a threshold security, and that remained open for 35 consecutive settlement days from the date the security became a threshold security, would be subject to mandatory closeout. Alternative 2 would require the options market maker to close out any fail to deliver in a threshold security that remained open for 35 consecutive settlement days from the date on which the security became a threshold security, or that persisted for 13 consecutive settlement days after the expiration or liquidation of the related options position, whichever is shorter. After the expiration of the 35 or 13 consecutive settlement day period, any additional fails to deliver would be subject to the 13 consecutive settlement day close-out requirement.
Documentation for long sales. The Commission also is proposing to amend the long sale marking provisions of Rule 200(g) of Regulation SHO. The proposed amendment to Rule 200(g)(2) would require broker-dealers to document the location of a security related to a sale marked long and, in doing so, determine if the customer is deemed to own the security within the meaning of Rule 200(g)(1). If the broker-dealer could not document the location of a security related to an order marked long, the broker-dealer would be required to mark the sale short.
Broker-dealers and their customers who use broker-dealer electronic systems to engage in short selling should consider what effect elimination of Regulation SHO's grandfather provision will have on their operations, and also should update their policies and procedures accordingly. The policies and procedures should include a method to track securities that become threshold securities and the steps that should be taken to close out fails to deliver on short positions in threshold securities in a timely manner. The policies and procedures also should reflect the changes to the close-out requirements applicable to Rule 144 securities.
The proposed elimination of the current options market maker exception would prevent options market makers from selling short threshold securities as a hedge to their options positions if the options market maker is subject to a requirement to close out a fail to deliver position and the options market maker is unable to borrow or arrange to borrow the threshold security underlying the option.
Broker-dealers should consider the potential operational changes that would be necessary to document the location of securities related to a sale marked long under the proposed amendment to Rule 200(g) of Regulation SHO.
The amendments to Regulation SHO demonstrate that it is necessary to have effective procedures for determining if a sale is a short sale. This determination is necessary for a number of SEC provisions, including: Regulation SHO, to perform a locate and to mark an order properly; Rule 105 of Regulation M, to determine if a person is subject to the prohibitions of that rule; and Rules 17a-3 and 17a-4 under the Exchange Act, which require accurate recordkeeping regarding orders. Whether a sale is a short sale also is relevant to: SRO order and trade reporting rules (for example, OATS); SRO short position reporting requirements; and margin rules. Also, the SEC and the SROs will continue to monitor short selling activity for indications of market manipulation, so proper identification of short sales will continue to be important.
1 Rule 203(c)(6) of Regulation SHO, 17 C.F.R.242.203(b)(3)(i), defines a "threshold security" as an equity security for which there is an aggregate fail to deliver position for five consecutive settlement days at a registered clearing agency, as that term is defined in Rule 203(c)(3), of 10,000 shares or more that equals at least 0.5% of the issuer's total shares outstanding and is included on a list disseminated by a self-regulatory organization ("SRO").
2 Rule 203(b)(3)(ii) of Regulation SHO, 17 C.F.R.242.203(b)(3)(ii).
Roger D. Blanc is a Partner in the Financial Institutions Regulatory Group of Willkie Farr & Gallagher LLP in the New York office. Larry E. Bergmann is Special Counsel in the Regulatory Group and Matthew B. Comstock is an Associate in the Regulatory Group, both in Willkie Farr's Washington, DC office.