Proposed Amendments- Short Sales
The Commission believes that these SRO requirements have not fully addressed the problems of naked short selling and extended fails to deliver. We believe it would be beneficial to establish a uniform standard specifying the procedures for all short sellers to locate securities for borrowing.45 This would further the goals of regulatory simplification and avoidance of regulatory arbitrage, as well as address some areas not currently covered. We are therefore proposing to incorporate in proposed Regulation SHO a uniform "locate" rule applicable to all equity securities, wherever they are traded.46 Proposed Rule 203 would prohibit a broker-dealer from executing a short sale order for its own account or the account of another person, unless the broker-dealer, or the person for whose account the short sale is executed (1) borrowed the security, or entered into an arrangement for the borrowing of the security, or (2) had reasonable grounds to believe that it could borrow the security so that it would be capable of delivering the securities on the date delivery is due.47 Consistent with the current SRO requirements, the proposed rule would require that the locate be made and annotated in writing prior to effecting any short sale, regardless of the fact that the seller's short position may be closed out by purchasing securities the same day.48 The Commission is proposing an exception from these requirements for short sales executed by specialists or market makers but only in connection with bona-fide market making activities.49 We believe a narrow exception for market makers and specialists engaged in bona fide market making activities is necessary because they may need to facilitate customer orders in a fast moving market without possible delays associated with complying with the proposed "locate" rule. Moreover, we believe that most specialists and market makers seek a net "flat" position in a security at the end of each day and often "offset" short sales with purchases such that they are not required to make delivery under the security settlement system.
As an additional safeguard against some of the problems associated with naked short selling, we are proposing a delivery requirement targeted at securities where there is evidence of significant settlement failures. We are incorporating the same threshold currently used in NASD Rule 11830,50 i.e., any security where there are fails to deliver at a clearing agency registered with the Commission of 10,000 shares or more per security, and that is equal to at least one-half of one percent of the issue's total shares outstanding.51 We are incorporating this standard into proposed Rule 203 because we believe that the levels set in NASD Rule 11830 characterize situations where the ratio of unfulfilled delivery obligations at the clearing agency where trades are settled represents a significant number of shares relative to the company's total shares outstanding, thus requiring remedial action designed to address potential negative effects. The proposed rule would specify that for short sales of any security meeting this threshold, the selling broker-dealer must deliver the security no later than two days after the settlement date.52 We believe a two-day grace period is appropriate to allow for transfer delays or delays due to a variety of circumstances that prevent timely delivery.53 If for any reason such security was not delivered within two days after the settlement date, the rule would restrict the broker-dealer, including market makers, from executing future short sales in such security for the person for whose account the failure to deliver occurred unless the broker-dealer or the person for whose account the short sale is executed borrowed the security, or entered into a bona fide arrangement to borrow the security, prior to executing the short sale and delivered on settlement date. This restriction would be in effect for a period of 90 calendar days.54 In addition, the rule would require the rules of the registered clearing agency that processed the transaction to include the following provisions: (A) A broker or dealer failing to deliver such securities shall be referred to the NASD and the designated examining authority for such broker-dealer for appropriate action;55 and (B) The registered clearing agency shall withhold a benefit of any mark-to-market amounts or payments that otherwise would be made to the party failing to deliver,56 and take other appropriate action, including assessing appropriate charges against the party failing to deliver. Both of these requirements should assist the Commission in preventing abuses and promote the prompt and accurate clearance and settlement of securities transactions.
These proposed requirements in Rule 203 would differ from the current SRO rules in several respects. First, the proposals require action two days after settlement, as opposed to the current ten days after settlement provided in Rule 11830.57 Further, the mandatory close-out provision in NASD Rule 11830 currently only applies to Nasdaq securities. We believe that securities with lower market capitalization may be more susceptible to abuse, and therefore believe that these additional delivery requirements should be extended to all equity securities registered under Section 12 of the Exchange Act. Finally, although market makers engaged in bona fide market making are currently exempted from NASD Rule 11830, we believe that extended failures to deliver appear characteristic of an investment or trading strategy, rather than being related to market making. We believe it is questionable whether a market maker carrying a short position in a heavily shorted security for an extended period of time is in fact engaged in providing liquidity for customers, or rather is engaged in a speculative trading strategy. Therefore, we are not proposing an exception from these additional delivery requirements for short sales in connection with market making.
In our view, these delivery requirements would protect and enhance the operation, integrity and stability of the markets and the clearance and settlement system. In particular, we believe that they will protect buyers of securities by substantially curtailing naked short selling. We request comment on the extent to which the proposed rules will achieve these objectives.
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