[Federal Register: August 14, 2007 (Volume 72, Number 156)]
[Rules and Regulations]
[Page 45543-45557]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr14au07-21]
[[Page 45543]]
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Part III
Securities and Exchange Commission
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17 CFR Part 242
Amendments to Regulation SHO; Final Rule and Proposed Rule
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 242
[Release No. 34-56212; File No. S7-12-06]
RIN 3235-AJ57
Amendments to Regulation SHO
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
adopting amendments to Regulation SHO under the Securities Exchange Act
of 1934 (``Exchange Act''). The amendments are intended to further
reduce the number of persistent fails to deliver in certain equity
securities by eliminating the grandfather provision of Regulation SHO.
In addition, we are amending the close-out requirement of Regulation
SHO for certain securities that a seller is ``deemed to own.'' The
amendments also update the market decline limitation referenced in
Regulation SHO.
DATES: Effective Date: October 15, 2007.
FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Associate
Director, Josephine J. Tao, Assistant Director, Victoria L. Crane,
Branch Chief, Elizabeth A. Sandoe, Branch Chief, Joan M. Collopy,
Special Counsel, and Lillian S. Hagen, Special Counsel, Office of
Trading Practices and Processing, Division of Market Regulation, at
(202) 551-5720, at the Securities and Exchange Commission, 100 F
Street, NE., Washington, DC 20549-6628.
SUPPLEMENTARY INFORMATION: We are amending Rules 200 and 203 of
Regulation SHO [17 CFR 242.200 and 242.203] under the Exchange Act.
I. Introduction
Regulation SHO, which became fully effective on January 3, 2005,
sets forth the regulatory framework governing short sales.\1\ Among
other things, Regulation SHO imposes a close-out requirement to address
persistent failures to deliver stock on trade settlement date \2\ and
to target potentially abusive ``naked'' short selling \3\ in certain
equity securities.\4\ While the majority of trades settle on time,\5\
Regulation SHO is intended to address those situations where the level
of fails to deliver for the particular stock is so substantial that it
might impact the market for that security.\6\ Although high fails
levels exist only for a small percentage of issuers,\7\ we are
concerned that large and persistent fails to deliver may have a
negative effect on the market in these securities. For example, large
and persistent fails to deliver may deprive shareholders of the
benefits of ownership, such as voting and lending. In addition, where a
seller of securities fails to deliver securities on trade settlement
date, in effect the seller unilaterally converts a securities contract
(which should settle within the standard 3-day settlement period) into
an undated futures-type contract, to which the buyer may not have
agreed, or that may have been priced differently. Moreover, sellers
that fail to deliver securities on trade settlement date may enjoy
fewer restrictions than if they were required to deliver the securities
within a reasonable period of time, and such sellers may attempt to use
this additional freedom to engage in trading activities that
deliberately and improperly depress the price of a security.
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\1\ 17 CFR 242.200. See also Exchange Act Release No. 50103
(July 28, 2004), 69 FR 48008 (Aug. 6, 2004) (``Adopting Release''),
available at http://www.sec.gov/rules/final/34-50103.htm. For more
information on Regulation SHO, see ``Frequently Asked Questions''
and ``Key Points about Regulation SHO,'' available at http://www.sec.gov/spotlight/shortsales.htm
.
A short sale is the sale of a security that the seller does not
own or any sale that is consummated by the delivery of a security
borrowed by, or for the account of, the seller. In order to deliver
the security to the purchaser, the short seller may borrow the
security, typically from a broker-dealer or an institutional
investor. The short seller later closes out the position by
purchasing equivalent securities on the open market, or by using an
equivalent security it already owns, and returning the security to
the lender. In general, short selling is used to profit from an
expected downward price movement, to provide liquidity in response
to unanticipated demand, or to hedge the risk of a long position in
the same security or in a related security.
\2\ Generally, investors must complete or settle their security
transactions within three business days. This settlement cycle is
known as T+3 (or ``trade date plus three days''). T+3 means that
when the investor purchases a security, the purchaser's payment must
be received by its brokerage firm no later than three business days
after the trade is executed. When the investor sells a security, the
seller must deliver its securities, in certificated or electronic
form, to its brokerage firm no later than three business days after
the sale. The three-day settlement period applies to most security
transactions, including stocks, bonds, municipal securities, mutual
funds traded through a brokerage firm, and limited partnerships that
trade on an exchange. Government securities and stock options settle
on the next business day following the trade. Because the Commission
recognized that there are many legitimate reasons why broker-dealers
may not be able to deliver securities on settlement date, it adopted
Rule 15c6-1, which prohibits broker-dealers from effecting or
entering into a contract for the purchase or sale of a security that
provides for payment of funds and delivery of securities later than
the third business day after the date of the contract unless
otherwise expressly agreed to by the parties at the time of the
transaction. 17 CFR 240.15c6-1. However, failure to deliver
securities on T+3 does not violate the rule.
\3\ We have previously noted that abusive ``naked'' short
selling, while not defined in the federal securities laws, generally
refers to selling short without having stock available for delivery
and intentionally failing to deliver stock within the standard three
day settlement cycle. See Exchange Act Release No. 54154 (July 14,
2006), 71 FR 41710 (July 21, 2006) (``Proposing Release'').
\4\ In 2003, the Commission settled a case against certain
parties relating to allegations of manipulative short selling in the
stock of Sedona Corporation. The Commission alleged that the
defendants profited from engaging in massive naked short selling
that flooded the market with Sedona stock, and depressed its price.
See Rhino Advisors, Inc. & Thomas Badian, Lit. Rel. No. 18003 (Feb.
27, 2003); see also, SEC v. Rhino Advisors, Inc. & Thomas Badian,
Civ. Action No. 03 civ 1310 (RO) (S.D.N.Y.). See also, Exchange Act
Release No. 48709 (Oct. 28, 2003), 68 FR 62972, 62975 (Nov. 6, 2003)
(``2003 Proposing Release'') (describing the alleged activity in the
case involving stock of Sedona Corporation); Adopting Release, 69 FR
at 48016, n.76.
\5\ According to the National Securities Clearing Corporation
(``NSCC''), 99% (by dollar value) of all trades settle on time.
Thus, on an average day, approximately 1% (by dollar value) of all
trades, including equity, debt, and municipal securities fail to
settle. The vast majority of these fails are closed out within five
days after T+3.
\6\ These fails to deliver may result from either short or long
sales of stock. There may be many reasons for a fail to deliver. For
example, human or mechanical errors or processing delays can result
from transferring securities in physical certificate rather than
book-entry form, thus causing a failure to deliver on a long sale
within the normal three-day settlement period. Also, broker-dealers
that make a market in a security (``market makers'') and who sell
short thinly-traded, illiquid stock in response to customer demand
may encounter difficulty in obtaining securities when the time for
delivery arrives.
\7\ The average daily number of securities on the threshold list
in March 2007 was approximately 311 securities, which comprised
0.39% of all equity securities, including those that are not covered
by Regulation SHO. Regulation SHO's current close-out requirement
applies to any equity security of an issuer that is registered under
Section 12 of the Exchange Act, or that is required to file reports
pursuant to Section 15(d) of the Exchange Act. NASD Rule 3210, which
became effective on July 3, 2006, applies the Regulation SHO close-
out framework to non-reporting equity securities with aggregate
fails to deliver equal to, or greater than, 10,000 shares and that
have a last reported sale price during normal trading hours that
would value the aggregate fail to deliver position at $50,000 or
greater for five consecutive settlement days. See Exchange Act
Release No. 53596 (April 4, 2006), 71 FR 18392 (April 11, 2006) (SR-
NASD-2004-044). Consistent with the amendment to eliminate the
grandfather provision of Regulation SHO, we anticipate the NASD
would propose similar amendments to NASD Rule 3210.
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In addition, many issuers and investors continue to express
concerns about extended fails to deliver in connection with ``naked''
short selling.\8
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To the extent that large and persistent fails to deliver might be
indicative of manipulative ``naked'' short selling, which could be used
as a tool to drive down a company's stock price, fails to deliver may
undermine the confidence of investors.\9\ These investors, in turn, may
be reluctant to commit capital to an issuer they believe to be subject
to such manipulative conduct.\10\ In addition, issuers may believe that
they have suffered unwarranted reputational damage due to investors'
negative perceptions regarding large and persistent fails to
deliver.\11\ Any unwarranted reputational damage caused by large and
persistent fails to deliver might have an adverse impact on the
security's price.\12---------------------------------------------------------------------------
\8\ See, e.g., comment letter from Patrick M. Byrne, Chairman
and Chief Executive Officer, Overstock.com, Inc., dated Sept. 11,
2006 (``Overstock''); comment letter from Daniel Behrendt, Chief
Financial Officer, and Douglas Klint, General Counsel, Taser
International, dated Sept. 18, 2006 (``Taser''); comment letter from
John Royce, dated April 30, 2007; comment letter from Michael Read,
dated April 29, 2007; comment letter from Robert DeVivo, dated April
26, 2007; comment letter from Ahmed Akhtar, dated April 26, 2007.
\9\ See, e.g., comment letter from Mary Helburn, Executive
Director, National Coalition Against Naked Shorting, dated Sept. 30,
2006 (``NCANS''); comment letter from Richard Blumenthal, Attorney
General, State of Connecticut, dated Sept. 19, 2006 (``State of
Connecticut'') (discussing the impact of fails to deliver on
investor confidence).
\10\ See, e.g., comment letter from Congressman Tom Feeney,
Florida, U.S. House of Representatives, dated Sept. 25, 2006
(``Feeney'') (expressing concern about potential ``naked'' short
selling on capital formation, claiming that ``naked'' short selling
causes a drop in an issuer's stock price and may limit the issuer's
ability to access the capital markets); comment letter from Zix
Corporation, dated Sept. 19, 2006 (``Zix'') (stating that ``[m]any
investors attribute the Company's frequent re-appearances on the
Regulation SHO list to manipulative short selling and frequently
demand that the Company ``do something'' about the perceived
manipulative short selling. This perception that manipulative short
selling of the Company's securities is continually occurring has
undermined the confidence of many of the Company's investors in the
integrity of the market for the Company's securities'').
\11\ Due, in part, to such concerns, issuers have taken actions
to attempt to make transfer of their securities ``custody only,''
thus preventing transfer of their stock to or from securities
intermediaries such as the Depository Trust Company (``DTC'') or
broker-dealers. A number of issuers have attempted to withdraw their
issued securities on deposit at DTC, which makes the securities
ineligible for book-entry transfer at a securities depository. We
note, however, that in 2003 the Commission approved a DTC rule
change clarifying that its rules provide that only its participants
may withdraw securities from their accounts at DTC, and establishing
a procedure to process issuer withdrawal requests. See Exchange Act
Release No. 47978 (June 4, 2003), 68 FR 35037 (June 11, 2003).
\12\ See also, Proposing Release, 71 FR at 41712 (discussing the
potential impact of large and persistent fails to deliver on the
market). See also, 2003 Proposing Release, 68 FR at 62975
(discussing the potential impact of ``naked'' short selling on the
market).
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The close-out requirement, which is contained in Rule 203(b)(3) of
Regulation SHO, applies only to securities in which a substantial
amount of fails to deliver have occurred (also known as ``threshold
securities'').\13\ As adopted in August 2004, Rule 203(b)(3) of
Regulation SHO included two exceptions to the mandatory close-out
requirement. The first was the ``grandfather'' provision, which
excepted fails to deliver established prior to a security becoming a
threshold security; \14\ and the second was the ``options market maker
exception,'' which excepted fails to deliver in threshold securities
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.\15---------------------------------------------------------------------------
\13\ A threshold security is defined in Rule 203(c)(6) of
Regulation SHO as any equity security of an issuer that is
registered pursuant to section 12 of the Exchange Act (15 U.S.C.
78l) or for which the issuer is required to file reports pursuant to
section 15(d) of the Exchange Act (15 U.S.C. 78o(d)) for which there
is an aggregate fail to deliver position for five consecutive
settlement days at a registered clearing agency of 10,000 shares or
more, and that is equal to at least 0.5% of the issue's total shares
outstanding; and is included on a list (``threshold securities
list'') disseminated to its members by a self-regulatory
organization (``SRO''). See 17 CFR 242.203(c)(6). Each SRO is
responsible for providing the threshold securities list for those
securities for which the SRO is the primary market.
\14\ The ``grandfathered'' status applied in two situations: (1)
to fail positions occurring before January 3, 2005, Regulation SHO's
effective date; and (2) to fail positions that were established on
or after January 3, 2005 but prior to the security appearing on a
threshold securities list. See 17 CFR 242.203(b)(3)(i).
\15\ 17 CFR 242.203(b)(3)(ii).
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At the time of Regulation SHO's adoption, the Commission stated
that it would monitor the operation of Regulation SHO, particularly
whether grandfathered fail to deliver positions were being cleared up
under the existing delivery and settlement requirements or whether any
further regulatory action with respect to the close-out provisions of
Regulation SHO was warranted.\16\ In addition, with respect to the
options market maker exception, the Commission noted that it would take
into consideration any indications that this provision was operating
significantly differently from the Commission's original
expectations.\17---------------------------------------------------------------------------
\16\ See Adopting Release, 69 FR at 48018.
\17\ See id. at 48019.
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Since Regulation SHO's effective date in January 2005, the
Commission's staff (``Staff'') and the SROs have been examining firms
for compliance with Regulation SHO, including the close-out provisions.
We have received preliminary data that indicates that Regulation SHO
appears to be significantly reducing fails to deliver without
disruption to the market.\18\ However, despite this positive impact, we
continue to observe a small number of threshold securities with
substantial and persistent fail to deliver positions that are not being
closed out under existing delivery and settlement requirements.
Allowing these persistent fails to deliver to continue indefinitely may
lead to greater uncertainty about the fulfillment of the settlement
obligation.\19\ While some delays in closing out may be understandable
and necessary, a seller should deliver shares to close out its sale
within a reasonable time period.
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\18\ For example, in comparing a period prior to the effective
date of the current rule (April 1, 2004 to December 31, 2004) to a
period following the effective date of the current rule (January 1,
2005 to March 31, 2007) for all stocks with aggregate fails to
deliver of 10,000 shares or more as reported by NSCC:
The average daily aggregate fails to deliver declined
by 29.5%;
The average daily number of securities with aggregate
fails to deliver of at least 10,000 shares declined by 5.8%;
The average daily number of fails to deliver declined
by 15.1%;
The average age of a fail to deliver position declined
by 25.5%;
The average daily number of threshold securities
declined by 39.0%; and
The average daily fails to deliver of threshold
securities declined by 52.9%.
See also, supra n. 7.
\19\ See Adopting Release, 69 FR at 48016-48017; see also, 2003
Proposing Release, 68 FR at 62977-62978 (discussing the Commission's
belief that the delivery requirements of proposed Regulation SHO
would protect and enhance the operation, integrity and stability of
the markets and the clearance and settlement system, and protect
buyers of securities by curtailing ``naked'' short selling).
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Based, in part, on the results of examinations conducted by the
Staff and SROs, as well as our desire to reduce large and persistent
fails to deliver, on July 14, 2006, we proposed revisions to Regulation
SHO that would modify Rule 203(b)(3) by eliminating the grandfather
provision and narrowing the options market maker exception.\20\ The
proposed amendments were intended to reduce the number of persistent
fails to deliver attributable primarily to the grandfather provision
and, secondarily, to reliance on the options market maker exception.
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\20\ See Proposing Release, 71 FR 41710.
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The proposals were based, in part, on data collected by the
National Association of Securities Dealers, Inc. (``NASD''), as well as
concerns about the persistence of certain securities on the threshold
securities lists.\21\ However, in response to commenters' concerns
regarding the public availability of data relied on by the Commission,
on March 26, 2007 we re-opened the comment period to the Proposing
Release for thirty days to provide the public with an opportunity to
comment on a summary of the NASD's findings that the NASD had submitted
to the public file on March 12, 2007. In addition, the notice regarding
the re-opening of the
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comment period directed the public's attention to brief summaries of
data collected by the Commission's Office of Compliance Inspections and
Examinations and the New York Stock Exchange LLC (``NYSE'').\22---------------------------------------------------------------------------
\21\ See Proposing Release, 71 FR at 41712.
\22\ See Exchange Act Release No. 55520 (March 26, 2007), 72 FR
15079 (March 30, 2007) (``Regulation SHO Re-Opening Release''). We
received a number of comment letters in response to the Regulation
SHO Re-Opening Release, most of which urged the Commission to take
action on the proposed amendments to eliminate the grandfather
provision and narrow the options market maker exception. Comment
letters, including the comments of the NASD, are available on the
Commission's Internet Web Site at http://www.sec.gov/comments/s7-12-06/s71206.shtml.
See also, Memorandum from the Commission's Office
of Economic Analysis regarding Fails to Deliver Pre- and Post-
Regulation SHO (dated August 21, 2006), which is available on the
Commission's Internet Web Site at http://www.sec.gov/spotlight/failstodeliver082106.pdf
.
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The proposals included a 35 settlement day phase-in period
following the effective date of the amendment intended to provide
additional time to begin closing out certain previously-excepted fails
to deliver. In addition, the proposals included an amendment to update
the market decline limitation referenced in Rule 200(e)(3) of
Regulation SHO.\23\ The Commission also included in the Proposing
Release a number of requests for comment, including whether the
Commission should amend Regulation SHO to extend the close-out
requirement to 35 consecutive settlement days for fails to deliver
resulting from sales of threshold securities pursuant to Rule 144 of
the Securities Act of 1933 (the ``Securities Act'').\24---------------------------------------------------------------------------
\23\ 17 CFR 242.200(e)(3).
\24\ 17 CFR 230.144.
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We received over 1,000 comment letters in response to the Proposing
Release.\25\ As discussed below, after considering the comments
received and the purposes underlying Regulation SHO, we are adopting
the amendments to the grandfather provision and the market decline
limitation, with some modifications to refine provisions and address
commenters' concerns. However, in a separate companion release, we are
re-proposing amendments to the options market maker exception.\26\ In
addition, we are adopting amendments to the close-out requirement of
Regulation SHO for fails to deliver resulting from sales of threshold
securities pursuant to Rule 144 of the Securities Act.
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\25\ The comment letters are available on the Commission's
Internet Web Site at http://www.sec.gov/comments/s7-12-06/s71206.shtml
.
\26\ See Exchange Act Release No. 56213 (Aug. 7, 2007)
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II. Overview of Regulation SHO
A. Rule 203(b)(3)'s Close-out Requirement
One of Regulation SHO's primary goals is to reduce fails to deliver
in those securities with a substantial amount of fails to deliver by
imposing additional delivery requirements on those securities.\27\ We
believe that additional delivery requirements help protect and enhance
the operation, integrity and stability of the markets, as well as
reduce short selling abuses.
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\27\ See Adopting Release, 69 FR at 48009.
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Regulation SHO requires certain persistent fail to deliver
positions to be closed out. Specifically, Rule 203(b)(3)'s close-out
requirement provides that a participant of a clearing agency registered
with the Commission \28\ must take immediate action to close out a fail
to deliver position in a threshold security in the Continuous Net
Settlement (``CNS'') \29\ system that has persisted for 13 consecutive
settlement days by purchasing securities of like kind and quantity.\30\
In addition, if the failure to deliver has persisted for 13 consecutive
settlement days, Rule 203(b)(3)(iii) of Regulation SHO, as originally
adopted, prohibits the participant, and any broker-dealer for which it
clears transactions, including market makers, from accepting any short
sale orders or effecting further short sales in the particular
threshold security without borrowing, or entering into a bona-fide
arrangement to borrow, the security until the participant closes out
the fail to deliver position by purchasing securities of like kind and
quantity.\31---------------------------------------------------------------------------
\28\ For purposes of Regulation SHO, the term ``participant''
has the same meaning as in section 3(a)(24) of the Exchange Act. See
15 U.S.C. 78c(a)(24). The term ``registered clearing agency'' means
a clearing agency, as defined in section 3(a)(23) of the Exchange
Act, that is registered as such pursuant to section 17A of the
Exchange Act. See 15 U.S.C. 78c(a)(23)(A), 78q-1 and 15 U.S.C. 78q-
1(b), respectively. See also, Adopting Release, 69 FR at 48031. As
of May 2007, approximately 90% of participants of the NSCC, the
primary registered clearing agency responsible for clearing U.S.
transactions, were registered as broker-dealers. Those participants
not registered as broker-dealers include such entities as banks,
U.S.-registered exchanges, and clearing agencies. Although these
entities are participants of a registered clearing agency, generally
these entities do not engage in the types of activities that would
implicate the close-out requirements of Regulation SHO. Such
activities of these entities include creating and redeeming Exchange
Traded Funds, trading in municipal securities, and using NSCC's
Envelope Settlement Service or Inter-city Envelope Settlement
Service. These activities rarely lead to fails to deliver and, if
fails to deliver do occur, they are small in number and are usually
closed out within a day. Thus, such fails to deliver would not
trigger the close-out provisions of Regulation SHO.
\29\ The majority of equity trades in the United States are
cleared and settled through systems administered by clearing
agencies registered with the Commission. The NSCC clears and settles
the majority of equity securities trades conducted on the exchanges
and over the counter. NSCC clears and settles trades through the CNS
system, which nets the securities delivery and payment obligations
of all of its members. NSCC notifies its members of their securities
delivery and payment obligations daily. In addition, NSCC guarantees
the completion of all transactions and interposes itself as the
contraparty to both sides of the transaction. While NSCC's rules do
not authorize it to require member firms to close out or otherwise
resolve fails to deliver, NSCC reports to the SROs those securities
with fails to deliver of 10,000 shares or more. The SROs use NSCC
fails data to determine which securities are threshold securities
for purposes of Regulation SHO.
\30\ 17 CFR 242.203(b)(3).
\31\ 17 CFR 242.203(b)(3)(iii). It is possible under Regulation
SHO that the close out by the participant of a registered clearing
agency may result in a failure to deliver position at another
participant if the counterparty from which the participant purchases
securities fails to deliver. However, Regulation SHO prohibits a
participant of a registered clearing agency from engaging in ``sham
close outs'' by entering into an arrangement with a counterparty to
purchase securities for purposes of closing out a failure to deliver
position and the purchaser knows or has reason to know that the
counterparty will not deliver the securities, which thus creates
another fail to deliver position. 17 CFR 242.203(b)(3)(v); see also,
Adopting Release, 69 FR at 48018 n.96. In addition, we note that
borrowing securities, or otherwise entering into an agreement with
another person to create the appearance of a purchase would not
satisfy the close-out requirement of Regulation SHO. For example,
the purchase of paired positions of stock and options that are
designed to create the appearance of a bona fide purchase of
securities but that are nothing more than a temporary stock lending
arrangement would not satisfy Regulation SHO's close-out
requirement.
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B. Grandfathering Under Regulation SHO
As originally adopted, Rule 203(b)(3)'s close-out requirement did
not apply to positions that were established prior to the security
becoming a threshold security.\32\ This is known as grandfathering.
Grandfathered positions included those that existed prior to the
January 3, 2005 effective date of Regulation SHO, and to positions
established prior to a security becoming a threshold security.\33\
Regulation SHO's grandfathering provision was adopted because the
Commission was concerned about creating volatility through short
squeezes \34\ if large pre-existing fail to deliver positions had to be
closed out
[[Page 45547]]
quickly after a security became a threshold security.
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\32\ 17 CFR 242.203(b)(3)(i).
\33\ See Adopting Release, 69 FR at 48018. However, any new
fails to deliver in a security on a threshold securities list are
subject to the mandatory close-out provisions of Rule 203(b)(3) of
Regulation SHO.
\34\ The term short squeeze refers to the pressure on short
sellers to cover their positions as a result of sharp price
increases or difficulty in borrowing the security the sellers are
short. The rush by short sellers to cover produces additional upward
pressure on the price of the stock, which then can cause an even
greater squeeze. Although some short squeezes may occur naturally in
the market, a scheme to manipulate the price or availability of
stock in order to cause a short squeeze is illegal.
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C. Regulation SHO's Options Market Maker Exception
In addition, Regulation SHO's options market maker exception
excepts from the close-out requirement of Rule 203(b)(3) any fail to
deliver position in a threshold security that is attributed to short
sales by a registered options market maker, if and to the extent that
the short sales are effected by the registered options market maker to
establish or maintain a hedge on options positions that were created
before the security became a threshold security.\35\ The options market
maker exception was created to address concerns regarding liquidity and
the pricing of options. The exception does not require that such fails
be closed out.
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\35\ 17 CFR 242.203(b)(3)(ii).
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III. Discussion of Amendments to Regulation SHO
A. Grandfather Provision
1. Proposal
To further Regulation SHO's goal of reducing persistent fails to
deliver, the Commission proposed to eliminate the grandfather provision
in Rule 203(b)(3)(i) of Regulation SHO.\36\ In particular, the proposed
amendment would require that any previously-grandfathered fails to
deliver in a security that is on a threshold list on the effective date
of the amendment be closed out within 35 consecutive settlement days
\37\ of the effective date of the amendment. In addition, similar to
the pre-borrow requirement in Rule 203(b)(3)(iii) of Regulation SHO, as
originally adopted, if the fail to deliver position has persisted for
35 consecutive settlement days from the effective date of the
amendment, the proposal would prohibit a participant, and any broker-
dealer for which it clears transactions, including market makers, from
accepting any short sale orders or effecting further short sales in the
particular threshold security without borrowing, or entering into a
bona-fide arrangement to borrow, the security until the participant
closes out the entire fail to deliver position by purchasing securities
of like kind and quantity.
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\36\ See Proposing Release, 71 FR 41710.
\37\ The Commission chose 35 settlement days because 35 days is
used in the current rule (although for a different purpose) and to
allow participants additional time to close out their previously-
grandfathered fails to deliver, given that some participants may
have large previously-excepted fails to deliver with respect to a
number of securities.
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However, if a security becomes a threshold security after the
effective date of the amendment, any fails to deliver in that security
that occurred prior to the security becoming a threshold security would
be subject to Rule 203(b)(3)'s mandatory 13 consecutive settlement day
close-out requirement, similar to any other fail to deliver position in
a threshold security.
2. Comments
We received a large number of comment letters regarding the
proposal to eliminate the grandfather provision. The comments were from
numerous entities, including issuers, retail investors, broker-dealers,
SROs, associations, members of Congress, and other elected officials.
Commenters expressed both support \38\ and opposition \39\ to the
proposal to eliminate the grandfather provision.
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\38\ See, e.g., comment letter from Overstock, supra note 8;
comment letter from Taser, supra note 8; comment letter from Barry
McCarthy, Chief Financial Officer, Netflix, Inc., dated Sept. 19,
2006; comment letter from Glenn W. Rollins, President, Orkin, Inc.,
dated Aug. 29, 2006; comment letter from Zix, supra note 10; comment
letter from Joseph P. Borg, Esq., President, North American
Securities Administrators Association, Inc., dated Oct. 4, 2006
(``NASAA''); comment letter from Paul Rivett, Vice President,
Fairfax Financial Holdings, Ltd., Sept. 19, 2006; comment letter
from State of Connecticut, supra note 9; comment letter from John G.
Gaine, President, MFA, dated Sept. 19, 2006 (``MFA''); comment
letter from James J. Angel, PhD., Associate Professor of Finance,
McDonough School of Business, Georgetown University, dated July 18,
2006 (``Angel''); comment letter from NCANS, supra note 9; comment
letter from Simon Lorne, Chief Legal Officer, and Martin Schwartz,
Chief Compliance Officer, Millennium Partners, LP, dated Oct. 10,
2006; comment letter from David C. Chavern, Capital Markets Program,
U.S. Chamber of Commerce, dated Sept. 13, 2006; comment letter from
Jeffrey D. Stacey, Managing Director, Jeffrey D. Stacey Associates,
Ltd., dated Sept. 19, 2006; comment letter from Congressman Rodney
Alexander--Louisiana, U.S. House of Representatives, dated July 28,
2006; comment letter from Senator Orin Hatch--Utah, U.S. Senate,
dated Sept. 19, 2006; comment letter from Feeney, supra note 10;
comment letter from Congressman Virgil Goode, Jr.--Virginia, U.S.
House of Representatives, dated Sept. 13, 2006; comment letter from
Congresswoman Sue Kelly--New York, U.S. House of Representatives,
dated Sept. 19, 2006; letter from Congressman Jim Ryun--Kansas, U.S.
House of Representatives, dated Sept. 18, 2006; comment letter from
Congressman Jim Matheson--Utah, U.S. House of Representatives, dated
Sept. 19, 2006; comment letter from Governor Jon M. Huntsman,
Governor of Utah, dated Sept. 8, 2006; comment letter from Mark L.
Shurtleff, Attorney General for the State of Utah, dated Sept. 18,
2006; and comment letter from Wayne Klein, Director, Division of
Securities, State of Utah, dated Sept. 13, 2006 (``Utah Division of
Securities'').
\39\ See, e.g., comment letter from Ira D. Hammerman, Senior
Vice President and General Counsel, Securities Industry Association,
dated Sept. 19, 2006 (``SIA''); comment letter from Keith F.
Higgins, Chair, Committee on Federal Regulation of Securities,
American Bar Association Section of Business Law, dated Sept. 27,
2006 (``ABA''); comment letter from Edward J. Joyce, President and
Chief Operating Officer, Chicago Board Options Exchange, dated Oct.
11, 2006 (``CBOE''); comment letter from Gerard S. Citera, Executive
Director, U.S. Equities, UBS Securities LLC, dated Sept. 22, 2006
(``UBS''); comment letter from Leonard J. Amoruso, Senior Managing
Director and Chief Compliance Officer, Knight Capital Group, Inc.,
dated Sept. 20, 2006 (``Knight'').
---------------------------------------------------------------------------
Some of the commenters that supported eliminating the grandfather
provision stated that the proposal would restore investor confidence
and that it would not cause excessive volatility.\40\ For example, one
commenter stated that elimination of the grandfather provision should
not cause excessive volatility because, according to the commenter, the
Depository Trust & Clearing Corporation (``DTCC'') and market
participants have said that fails to deliver are a small problem.\41\
Another commenter stated that the Commission's concern over potential
short squeezes is ``misplaced,'' as this is a risk short sellers assume
when they sell short.\42\ Many commenters supported the proposed 35-day
phase-in period for certain previously-grandfathered fails to deliver;
\43\ although some commenters stated their belief that a phase-in
period was unnecessary.\44---------------------------------------------------------------------------
\40\ See comment letters from MFA, supra note 38; NCANS, supra
note 9; State of Connecticut, supra note 9.
\41\ See comment letter from NCANS, supra note 9.
\42\ See comment letter from H. Glenn Bagwell, Jr., Esq., Sept.
19, 2006.
\43\ See, e.g., comment letters from NCANS, supra note 9; Taser,
supra note 8; Overstock, supra note 8.
\44\ See, e.g., comment letters from NASAA, supra note 38; Utah
Division of Securities, supra note 38; Zix, supra note 10.
---------------------------------------------------------------------------
Commenters opposing the elimination of the grandfather provision
did so for various reasons. For example, one commenter stated that
elimination of the grandfather provision could adversely impact stock
liquidity and borrowing, increasing costs to investors.\45\ Another
commenter stated its belief that eliminating the grandfather provision
would lead to increased volatility and short squeezes as individuals
attempt to close out positions.\46\ This commenter also stated that
eliminating the grandfather provision would negatively impact bona fide
market making and the ability of market makers to provide liquidity,
which would lead to less liquidity, greater volatility, and widening of
spreads.\47\ According to this commenter, the proposal could also lead
to upward price manipulation, causing investors to purchase shares at
inflated prices.\48\ Another commenter maintained that eliminating the
grandfather provision
[[Page 45548]]
would cause substantial market disruption by increasing significantly
the number of buy-ins in the market without sufficiently targeting the
abusive ``naked'' short sellers.\49---------------------------------------------------------------------------
\45\ See comment letter from CBOE, supra note 39.
\46\ See comment letter from Knight, supra note 39.
\47\ See id.
\48\ See id.
\49\ See comment letter from UBS, supra note 39.
---------------------------------------------------------------------------
Some commenters stated that the proposal is an overly broad means
of addressing the issue of substantial, persistent fails to deliver
that may occur in only a small subset of threshold securities and that,
in fact, the available data shows that the proposal is not
necessary.\50\ These commenters also stated their belief that a more
targeted approach, such as tracking actual ``naked'' short sales, would
be a more appropriate method of addressing the issue of fails to
deliver. Another commenter stated that the Commission had not explained
the need for the proposal and had not provided substantial evidence
showing that persistent fails to deliver are primarily attributable to
the grandfather provision.\51\ However, as discussed in more detail
below, even those commenters opposing the elimination of the
grandfather provision suggested alternative proposals to elimination
for the Commission to consider. For example, one commenter suggested
allowing for a period longer than 13 consecutive settlement days within
which to close out all fails to deliver currently excepted from the
close-out requirement due to the grandfather provision.\52---------------------------------------------------------------------------
\50\ See, e.g., comment letter from Knight, supra note 39.
\51\ See comment letter from ABA, supra note 39; see also, supra
note 22 (discussing the Regulation SHO Re-Opening Release).
\52\ See, e.g., comment letters from CBOE, supra note 39; SIA,
supra note 39; Knight, supra note 39; UBS, supra note 39. See also,
Section III.A.3., discussing these alternative proposals.
---------------------------------------------------------------------------
3. Adoption
After careful consideration of the comments, we are adopting the
amendment to eliminate the grandfather provision as proposed. As
adopted, the amendment eliminates the grandfather provision from
Regulation SHO and amends Rule 203 to require that all fails to deliver
in threshold securities be closed out within either 13 consecutive
settlement days or, in the case of a previously-grandfathered fail to
deliver position in a security that is a threshold security on the
effective date of the amendment, 35 consecutive settlement days from
the effective date of the amendment.\53---------------------------------------------------------------------------
\53\ In addition, similar to the proposed amendment and Rule
203(b)(3)(iii) of Regulation SHO, as originally adopted, if the fail
to deliver position persists for 35 consecutive settlement days from
the effective date of the amendment, the amendment will prohibit a
participant, and any broker-dealer for which it clears transactions,
including market makers, from accepting any short sale orders or
effecting further short sales in the particular threshold security
without borrowing, or entering into a bona-fide arrangement to
borrow, the security until the participant closes out the entire
fail to deliver position by purchasing securities of like kind and
quantity. For those fails to deliver not subject to the 35
consecutive settlement day phase-in period, Rule 203(b)(3)(iii) of
Regulation SHO, as originally adopted, will apply to fail to deliver
positions in threshold securities that persist beyond the 13
consecutive settlement day mandatory close-out requirement.
---------------------------------------------------------------------------
For the reasons discussed above and in the Proposing Release, we
believe that no fail to deliver position should be left open
indefinitely. While some delays in closing out may be understandable
and necessary, a seller should deliver shares to close out a sale
within a reasonable time period. Thus, we believe the adoption of the
amendment as proposed is warranted and strikes the appropriate balance
between reducing large and persistent fails to deliver in threshold
securities and still providing participants flexibility and advance
notice to close out the originally grandfathered fails to deliver.
While the amendments may have some potential impact on liquidity, we
believe the advance notice and flexibility provided by the amendments
will limit any impact on liquidity of requiring market participants to
close out such previously-grandfathered fails to deliver.
Commenters opposing the elimination of the grandfather provision
contended that elimination of the grandfather provision could lead to
increased volatility, a reduction in liquidity, and short squeezes in
these securities as individuals attempt to close out positions.
Although we recognize that elimination of the grandfather provision
could have these potential effects, we believe the benefits of
requiring that fails to deliver not be allowed to continue indefinitely
justify these potential effects. In addition, we believe that such
effects, if any, would be minimal.
First, we believe that the potential effects, if any, of
eliminating the grandfather provision will be minimal because the
number of securities that will be impacted by elimination of the
grandfather provision will be relatively small. Regulation SHO's close-
out requirement is narrowly tailored in that it targets only those
securities where the level of fails to deliver is high (0.5% of total
shares outstanding and 10,000 shares or more) for a continuous period
(five consecutive settlement days).\54\ Requiring close out only for
securities with large and persistent fails to deliver limits the
overall market impact. Moreover, the amendment only impacts those fails
to deliver in threshold securities that were created before the
security became a threshold security. Because the current grandfather
provision has a limited application, the overall impact of its removal
on liquidity, volatility, and short squeezes, is expected to be
minimal, if any.
---------------------------------------------------------------------------
\54\ See supra note 7 (discussing the number of threshold
securities as of March 31, 2007).
---------------------------------------------------------------------------
Second, to the extent that the amendment could result in a decrease
in liquidity, increased volatility, or short squeezes, we believe that
any such potential effects will likely be mitigated by the fact that
even though fails to deliver that were previously-grandfathered from
the close-out requirement of Regulation SHO will no longer be permitted
to continue indefinitely, such fails to deliver will not have to be
closed out immediately, or even within the standard 3-day settlement
period. Instead, under Rule 203(b)(3)'s mandatory close-out
requirement, both new and previously-grandfathered fails to deliver in
threshold securities will have 13 consecutive settlement days within
which to be closed out.
Third, as noted above, the grandfather provision excepts from Rule
203(b)(3)'s mandatory 13 consecutive settlement day close-out
requirement only those fails to deliver created before the security
became a threshold security. Thus, it does not apply to fails to
deliver created after the security became a threshold security. In
examining the application of the current mandatory close-out
requirement of Regulation SHO for all non-grandfathered fail to deliver
positions, we have not become aware of any evidence that the current
close-out requirement for non-grandfathered fails to deliver in
threshold securities has negatively impacted liquidity or volatility in
these securities, or resulted in short squeezes.
Fourth, to the extent that elimination of the grandfather provision
results in decreased liquidity, or increased volatility in certain
securities, or results in short squeezes, we believe that these
potential effects are justified by the benefits of requiring that fails
to deliver in all threshold securities be closed out within specific
time-frames rather than being allowed to continue indefinitely. As
discussed above, large and persistent fails to deliver can deprive
shareholders of the benefits of ownership, such as voting and lending.
They can also be indicative of potentially manipulative conduct, such
as abusive ``naked'' short selling. The deprivation of the benefits of
ownership, as well as the perception that abusive ``naked'' short
selling is
[[Page 45549]]
occurring in certain securities can undermine the confidence of
investors. These investors, in turn, may be reluctant to commit capital
to an issuer they believe to be subject to manipulative conduct.
In the Proposing Release, we sought comment on whether the proposed
amendments would promote capital formation, including whether the
proposed increased short sale restrictions would affect investors'
decisions to invest in certain equity securities. Some commenters
expressed concern about ``naked'' short selling causing a drop in an
issuer's stock price, which may limit an issuer's ability to access the
capital markets.\55\ We believe that by requiring that all fails to
deliver in threshold securities be closed out within specific time-
frames rather than allowing some to continue indefinitely, there will
likely be a decrease in the number of threshold securities with
persistent and high levels of fails to deliver. If persistence on the
threshold securities lists leads to an unwarranted decline in investor
confidence about the security, the amendments are expected to improve
investor confidence about the security. We also believe that the
amendments will lead to greater certainty in the settlement of
securities which should strengthen investor confidence in the
settlement process.
---------------------------------------------------------------------------
\55\ See, e.g., comment letter from Feeney, supra note 10.
---------------------------------------------------------------------------
Alternative Proposals
Some commenters suggested alternative close-out requirements to the
proposed amendment to eliminate the grandfather provision of Regulation
SHO. For example, one commenter suggested that all fails to deliver in
threshold securities, whether or not grandfathered, be closed out
within 20 consecutive settlement days.\56\ Although 20 consecutive
settlement days would provide a uniform close-out requirement, we
believe that it would be unwise to extend the close-out requirement to
20 consecutive settlement days because the current industry practice is
to close out non-grandfathered fails to deliver in threshold securities
within 13 consecutive settlement days and, for the most part, firms
appear to be complying with this requirement. Also, it would extend the
time in which a fail to deliver position would be permitted to persist,
which is contrary to our goal of further reducing fails to deliver in
threshold securities within a reasonable period of time. In addition,
the current close-out requirement has led to a significant reduction in
fails to deliver in threshold securities and, therefore, we do not
believe it is appropriate to extend the close-out requirement beyond 13
consecutive settlement days.\57---------------------------------------------------------------------------
\56\ See comment letter from SIA, supra note 39.
\57\ See, e.g., supra note 18 (providing data regarding the
impact of Regulation SHO since adoption).
---------------------------------------------------------------------------
As another alternative to the proposed amendment, this commenter
also recommended that the Commission require that all fails to deliver
that exist prior to the security becoming a threshold security be
closed out within 35 consecutive settlement days.\58\ Under this
alternative, all new fail to deliver positions in threshold securities
would be subject to the current 13 consecutive settlement day close out
requirement; however, it would allow all fails to deliver that occur
prior to the security becoming a threshold security to be closed out
within 35 consecutive settlement days. We believe that this two-track
approach to the close out requirement of Regulation SHO would be
difficult to apply and monitor for compliance.
---------------------------------------------------------------------------
\58\ See comment letter from SIA, supra note 39.
---------------------------------------------------------------------------
Another option suggested by commenters was to modify the proposal
to have it address only threshold securities that have a high level of
persistent fails to deliver, rather than all threshold securities.
Under this alternative, a previously-grandfathered fail to deliver
position in a threshold security would only become subject to the
mandatory close-out requirement if the threshold security has a
substantial number of fails to deliver and consistently remains on the
threshold list for an extended period of time. The number of securities
that are threshold securities is already a small number of securities.
For example, in March 2007, the average daily number of securities on
the threshold list was approximately 311 securities, which comprised
0.39% of all equity securities, and 2.33% of those securities subject
to Regulation SHO. The number of threshold securities with a high level
of persistent fails to deliver would be an even smaller number. Thus,
we do not believe that this alternative would effectively achieve the
Commission's goal of further reducing fails to deliver in all threshold
securities.
B. Options Market Maker Exception
The Commission proposed amendments to the options market maker
exception contained in Regulation SHO to limit the duration of the
exception.\59\ Based on comments to the proposed amendments, we have
determined at this time to re-propose amendments to the options market
maker exception that would eliminate the exception.\60\ In addition, in
the re-proposal we request comment regarding specific alternatives to
eliminating the options market maker exception that would require fails
to deliver in threshold securities underlying options to be closed out
within specific time-frames. We look forward to receiving comments
regarding these proposed amendments to the options market maker
exception.
---------------------------------------------------------------------------
\59\ See Proposing Release, 71 FR 41710.
\60\ See Exchange Act Release No. 56213 (Aug. 7, 2007).
---------------------------------------------------------------------------
C. Amendments to Rule 200(e)
1. Proposal
Regulation SHO currently provides a limited exception from the
requirement that a person selling a security aggregate all of the
person's positions in that security to determine whether the seller has
a net long position. This provision, which is contained in Rule 200(e)
of Regulation SHO, allows broker-dealers to liquidate (or unwind)
certain existing index arbitrage positions involving long baskets of
stocks and short index futures or options without aggregating short
stock positions in other proprietary accounts if, and to the extent
that, those short stock positions are fully hedged.\61\ The current
exception, however, does not apply if the sale occurs during a period
commencing at a time when the Dow Jones Industrial Average (``DJIA'')
has declined below its closing value on the previous trading day by at
least two percent and terminating upon the establishment of the closing
value of the DJIA on the next succeeding trading day.\62\ If a market
decline triggers the
[[Page 45550]]
application of Rule 200(e)(3), a broker-dealer must aggregate all of
its positions in that security to determine whether the seller has a
net long position.\63---------------------------------------------------------------------------
\61\ To qualify for the exception under Rule 200(e), the
liquidation of the index arbitrage position must relate to a
securities index that is the subject of a financial futures contract
(or options on such futures) traded on a contract market, or a
standardized options contract, notwithstanding that such person may
not have a net long position in that security. 17 CFR 242.200(e).
\62\ Specifically, the exception under Rule 200(e) is limited to
the following conditions: (1) The index arbitrage position involves
a long basket of stock and one or more short index futures traded on
a board of trade or one or more standardized options contracts; (2)
such person's net short position is solely the result of one or more
short positions created and maintained in the course of bona-fide
arbitrage, risk arbitrage, or bona-fide hedge activities; and (3)
the sale does not occur during a period commencing at the time that
the DJIA has declined below its closing value on the previous day by
at least two percent and terminating upon the establishment of the
closing value of the DJIA on the next succeeding trading day. Id.
The two percent market decline restriction was included in Rule
200(e)(3) so that the market could avoid incremental temporary order
imbalances during volatile trading days. Regulation SHO Adopting
Release, 69 FR at 48011. The two percent market decline restriction
limits temporary order imbalances at the close of trading on a
volatile trading day and at the opening of trading on the following
day, since trading activity at these times may have a substantial
effect on the market's short-term direction. The two percent
safeguard also provides consistency within the equities markets. Id.
\63\ See 17 CFR 242.200(e)(3); Regulation SHO Adopting Release,
69 FR at 48012.
---------------------------------------------------------------------------
The reference to the DJIA in the Commission's rule was based in
part on NYSE Rule 80A (Index Arbitrage Trading Restrictions).\64\
However, on August 24, 2005, the Commission approved an amendment to
NYSE Rule 80A to use the NYSE Composite Index (``NYA'') to calculate
limitations on index arbitrage trading as provided in the rule instead
of the DJIA.\65\ As noted in the Commission's approval order, according
to the NYSE, the NYA is a better reflection of market activity with
respect to the S&P 500 and, therefore, is a better indicator as to when
the restrictions on index arbitrage trading provided by NYSE Rule 80A
should be triggered.\66---------------------------------------------------------------------------
\64\ See 2003 Proposing Release, 68 FR at 62994-62995
(discussing proposed Rule 200 regarding netting and the liquidation
of index arbitrage activities and changes to the language of the
rule text to keep the language consistent with the language in NYSE
Rule 80A).
\65\ See Exchange Act Release No. 52328 (Aug. 24, 2005), 70 FR
51398 (Aug. 30, 2005).
\66\ See id.
---------------------------------------------------------------------------
In addition, NYSE Rule 80A provides that the two percent limitation
in that rule must be calculated at the beginning of each quarter and
shall be two percent, rounded down to the nearest 10 points, of the
average closing value of the NYA for the last month of the previous
quarter.\67\ As adopted, Rule 200(e)(3) of Regulation SHO did not refer
to the basis for determining the two percent limitation in the rule.
---------------------------------------------------------------------------
\67\ See id. See also, NYSE Rule 80A (Supplementary Material
.10).
---------------------------------------------------------------------------
Because the Commission approved the change to NYSE Rule 80A to
reference the NYA rather than the DJIA and because we believe that this
is an appropriate index to reference for purposes of Rule 200(e)(3) of
Regulation SHO, the Commission proposed to amend Rule 200(e)(3) to: (i)
Reference the NYA instead of the DJIA; and (ii) add language to clarify
that the two percent limitation is to be calculated in accordance with
NYSE Rule 80A. The proposed amendments are intended to maintain
consistency with NYSE Rule 80A so that market participants need refer
to only one index in connection with restrictions regarding index
arbitrage trading.
2. Comments
The Commission received four comment letters addressing the
proposed amendment to Rule 200(e) of Regulation SHO. Three of the four
commenters supported the proposed amendment. While one of these
commenters supported the amendment as proposed,\68\ the other two
commenters suggested revisions that would make the provision more
consistent with NYSE Rule 80A by providing that the restriction be
terminated at the end of the trading day rather than upon the
establishment of the closing value of the NYA on the next succeeding
trading day, as provided in the current rule.\69\ One commenter
suggested that the Commission examine whether to retain Rule 200(e) at
all.\70---------------------------------------------------------------------------
\68\ See, e.g., comment letter from UBS, supra note 39.
\69\ See comment letters from SIA, supra note 39; CBOE, supra
note 39.
\70\ See comment letter from Angel, supra note 38 (stating that
in today's fast markets, there are better ways of managing
volatility than ``kludges'' like Rule 200(e) and other circuit
breakers).
---------------------------------------------------------------------------
3. Adoption
After considering the above comments, we are amending Rule
200(e)(3) of Regulation SHO to: (i) Reference the NYA instead of the
DJIA; (ii) add language to clarify how the two percent limitation is to
be calculated for purposes of the market decline limitation; and (iii)
provide that the market decline limitation will remain in effect for
the remainder of the trading day. As adopted, Rule 200(e) will
reference the NYA instead of the DJIA. In the Proposing Release, we
proposed that Rule 200(e)(3) of Regulation SHO state that the two
percent be calculated pursuant to NYSE Rule 80A. We have determined,
however, that it is more appropriate to describe in the rule text how
the two percent must be calculated rather than referring to NYSE Rule
80A. Thus, the amendments provide that the two percent limitation is to
be calculated at the beginning of each quarter and shall be two
percent, rounded down to the nearest 10 points, of the average closing
value of the NYA for the last month of the previous quarter. In
response to commenter concerns regarding maintaining consistency with
NYSE Rule 80A, we are also amending Rule 200(e) to provide that the
market decline limitation will terminate at the end of the trading day
rather than upon the establishment of the closing value of the NYA on
the next succeeding trading day.
D. Amendments to Rule 203 for Sales of Securities Pursuant to Rule 144
1. Proposal
In the Proposing Release we asked whether we should amend Rule 203
to extend the close-out requirement from 13 to 35 consecutive
settlement days for fails to deliver resulting from sales of threshold
securities pursuant to Rule 144 of the Securities Act. Currently,
Regulation SHO provides for an exception from the locate requirement of
Rule 203(b)(1) for situations where a broker-dealer effects a short
sale on behalf of a customer that is deemed to own the security
pursuant to Rule 200, although, through no fault of the customer or
broker-dealer, it is not reasonably expected that the security will be
in the physical possession or control of the broker-dealer by
settlement date and, therefore, is a ``short'' sale under the marking
requirements of Rule 200(g).\71\ Rule 203(b)(2)(ii) of Regulation SHO
provides that in such circumstances, delivery must be made on the sale
as soon as all restrictions on delivery have been removed, and in any
event no later than 35 days after trade date, at which time the broker-
dealer that sold on behalf of the person must either borrow securities
or close out the open position by purchasing securities of like kind
and quantity.\72\ If the security is a threshold security, however, any
fails to deliver in the security must be closed out in accordance with
the requirements of Rule 203(b)(3) of Regulation SHO, i.e., within 13
consecutive settlement days.\73---------------------------------------------------------------------------
\71\ Pursuant to Rule 200(g)(2) of Regulation SHO, as adopted in
August 2004, generally these sales were marked ``short exempt.'' See
Adopting Release, 69 FR at 48030-48031; but cf Exchange Act Release
No. 55970 (June 28, 2007), 72 FR 36348 (July 3, 2007) (removing the
``short exempt'' marking requirement).
\72\ See 17 CFR 242.203(b)(2)(ii). In the Adopting Release, the
Commission stated that it believed that 35 calendar days is a
reasonable outer limit to allow for restrictions on a security to be
removed if ownership is certain. In addition, the Commission noted
that Section 220.8(b)(2) of Regulation T of the Federal Reserve
Board allows 35 calendar days to pay for securities delivered
against payment if the delivery delay is due to the mechanics of the
transactions. See Adopting Release, 69 FR at 48015, n.72.
\73\ See 17 CFR 242.203(b)(3).
---------------------------------------------------------------------------
2. Comments
The majority of commenters who responded to this request for
comment supported extending the close-out requirement to 35 consecutive
settlement days for fails to deliver resulting from sales of threshold
[[Page 45551]]
securities pursuant to Rule 144 of the Securities Act.\74---------------------------------------------------------------------------
\74\ A few commenters, namely NASAA and some retail investors,
opposed allowing additional time for delivery of these types of
threshold securities. See, e.g., comment letter from NASAA, supra
note 38.
---------------------------------------------------------------------------
Commenters that supported extending the close-out requirement for
fails to deliver resulting from sales of threshold securities pursuant
to Rule 144 of the Securities Act stated that these are legitimate long
sale transactions that fail to settle within the normal 3-day
settlement cycle only because of the time necessary to transfer the
securities.\75\ One commenter stated that the current requirement in
Regulation SHO to close out all fails in threshold securities that
remain for 13 consecutive settlement days, including fails resulting
from sales of securities which the seller owns, has imposed serious
unintended consequences on clearing firms and the broker-dealer and
non-broker-dealer customers for which they clear.\76\ Another commenter
noted that these types of transactions do not reflect any of the
abusive short sale transactions targeted by Regulation SHO since the
seller has an ownership position in the security being sold and,
therefore, no incentive to depress the price of the security.\77\ In
addition, commenters noted that clearing firms may have to effect buy-
ins even though the security will be available for delivery as soon as
the restrictions on sale have been removed.\78\ Another commenter
stated that it believes that all sellers who actually own a security
and are permitted a maximum of 35 days after trade date to deliver such
securities to their broker-dealer in accordance with Rule 203(b)(2)(ii)
of Regulation SHO, not just owners of securities eligible for resale
under Rule 144, should be free from the risk of being bought in.\79---------------------------------------------------------------------------
\75\ See, e.g., comment letters from UBS, supra note 39; Knight,
supra note 39.
\76\ For example, one commenter noted that firms have discovered
in numerous instances that their CNS fail positions in threshold
securities are attributable to situations where sales are effected
pursuant to Rule 144 of the Securities Act; however, due to delays
in getting the restricted legend removed from the certificates (or
other such delays outside the seller's control), such shares are not
available for a period of time after settlement date. See comment
letter from SIA, supra note 39.
\77\ See comment letter from UBS, supra note 39.
\78\ See comment letter from SIA, supra note 39.
\79\ See comment letter from ABA, supra note 39.
---------------------------------------------------------------------------
However, some commenters opposed allowing a longer period for
closing out fails to deliver in threshold securities sold pursuant to
Rule 144 of the Securities Act. These commenters stated their belief
that legended shares should not be sold until the legend has been
removed.\80\ Commenters also stated that, because sellers are free to
borrow shares to deliver while they await receipt of their securities
from the transfer agent, any additional time for delivery is
unnecessary.\81\ One commenter stated that given that ``most 144
sellers are insiders who have received their stocks at very low
prices,'' it is ``both fair and in the interests of ensuring market
integrity and confidence to expect them to bear the cost of borrowing
shares until delivery of unrestricted stock.'' \82\ Another commenter
stated that the exception allows Rule 144 shares to be used as
collateral for delivery failures, and stated that any errors,
difficulties, inconveniences and expense in having restrictions lifted
should be borne by the owner of the restricted securities.\83---------------------------------------------------------------------------
\80\ See, e.g., comment letters from NASAA, supra note 38;
NCANS, supra note 9.
\81\ See comment letters from Utah Division of Securities, supra
note 38; NASAA, supra note 38.
\82\ Comment letter from NASAA, supra note 38.
\83\ See comment letter from Thomas Vallarino, dated May 5,
2007.
---------------------------------------------------------------------------
3. Adoption
While commenters raise valid concerns, we believe that adopting the
amendments is justified by the benefit of permitting the orderly
settlement of fails to deliver resulting from sales of threshold
securities pursuant to Rule 144 of the Securities Act without causing
market disruption due to unnecessary purchasing activity (particularly
if the purchases are for a sizeable amount). Thus, we are amending Rule
203 of Regulation SHO to extend the close-out requirement from 13 to 35
consecutive settlement days for fails to deliver resulting from sales
of threshold securities pursuant to Rule 144 of the Securities Act.
In addition, because we are extending the close-out requirement for
fails to deliver resulting from sales of threshold securities pursuant
to Rule 144, we are also extending the pre-borrow requirement of Rule
203(b)(3)(iii) of Regulation SHO, as originally adopted, for these
fails to deliver. Thus, if the fail to deliver position persists for 35
consecutive settlement days, the amendment will prohibit a participant
of a registered clearing agency, and any broker-dealer for which it
clears transactions, including market makers, from accepting any short
sale orders or effecting further short sales in the particular
threshold security without borrowing, or entering into a bona-fide
arrangement to borrow, the security until the participant closes out
the entire fail to deliver position by purchasing securities of like
kind and quantity.
Securities sold pursuant to Rule 144 of the Securities Act are
formerly restricted securities that a seller is ``deemed to own,'' as
defined by Rule 200(a) of Regulation SHO. The securities, however, may
not be capable of being delivered on the settlement date due to
processing delays related to removal of the restricted legend and,
therefore, sales of these securities frequently result in fails to
deliver. Following our review of the comment letters, and based on our
understanding of industry practices, we understand that such processing
delays, which are often out of the seller's and broker-dealer's
control, frequently result in delivery taking longer than 13
consecutive settlement days. We believe, however, that 35 consecutive
settlement days will provide sufficient time for delivery of these
securities.
We believe that extending the current close-out requirement to 35
consecutive settlement days for fails to deliver resulting from sales
of these securities will permit the orderly settlement of such sales
without the risk of causing market disruption due to unnecessary
purchasing activity (particularly if the purchases are for sizable
quantities of stock). Because the security sold will be received as
soon as all processing delays have been removed, this additional time
will allow participants to close out fails to deliver resulting from
the sale of the security with the security sold, rather than having to
close out such fail to deliver position by purchasing securities in the
market.
Although this amendment will allow fails to deliver resulting from
sales of threshold securities pursuant to Rule 144 of the Securities
Act 35 rather than 13 consecutive settlement days in which to be closed
out, these fails to deliver must be closed out within 35 consecutive
settlement days and, therefore, these fails to deliver cannot continue
indefinitely. Thus, we believe that this amendment is consistent with
our goal of further reducing fails to deliver in threshold securities,
while balancing the concerns associated with closing out fails to
deliver resulting from sales of threshold securities pursuant to Rule
144 of the Securities Act.
IV. Paperwork Reduction Act
The amendments to Regulation SHO will not impose a new ``collection
of information'' within the meaning of the Paperwork Reduction Act of
1995 (``PRA'').\84---------------------------------------------------------------------------
\84\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------
[[Page 45552]]
V. Cost-Benefit Analysis
We are sensitive to the costs and benefits of our rules and we have
considered the costs and the benefits of the amendments to Regulation
SHO. In order to assist us in evaluating the costs and benefits, in the
Proposing Release, we encouraged commenters to discuss any costs or
benefits that the amendments might impose. In particular, we requested
comment on the potential costs for any modifications to both computer
systems and surveillance mechanisms and for information gathering,
management, and recordkeeping systems or procedures, as well as any
potential benefits resulting from the proposals for registrants,
issuers, investors, brokers or dealers, other securities industry
professionals, regulators, and other market participants. Commenters
were encouraged to provide analysis and data to support their views on
the costs and benefits associated with the proposed amendments to
Regulation SHO. We did not receive any comments providing specific cost
or benefit estimates.
A. Amendments to Rule 203(b)(3)'s Delivery Requirements
1. Amendment to Rule 203(b)(3)(i)'s Grandfather Provision
a. Benefits
As adopted, the amendment eliminates the grandfather provision from
Regulation SHO and amends Rule 203 to require that all fails to deliver
be closed out within either 13 consecutive settlement days or, in the
case of a previously-grandfathered fails to deliver in a security that
is on the threshold list on the effective date of the amendment, 35
consecutive settlement days from the effective date of the
amendment.\85---------------------------------------------------------------------------
\85\ In addition, similar to the pre-borrow requirement in Rule
203(b)(3)(iii) of Regulation SHO, as originally adopted, if the fail
to deliver position persists for 35 consecutive settlement days from
the effective date of the amendment, the amendment will prohibit a
participant of a registered clearing agency, and any broker-dealer
for which it clears transactions, including market makers, from
accepting any short sale orders or effecting further short sales in
the particular threshold security without borrowing, or entering
into a bona-fide arrangement to borrow, the security until the
participant closes out the entire fail to deliver position by
purchasing securities of like kind and quantity.
---------------------------------------------------------------------------
We believe the amendment strikes the appropriate balance between
reducing fails to deliver in threshold securities from persisting for
extended periods of time and still providing participants flexibility
and advance notice to close out the previously-grandfathered fails to
deliver. While some delays in closing out may be understandable and
necessary, a seller should deliver shares to the buyer within a
reasonable time period. Although high fails levels exist only for a
small percentage of issuers,\86\ we are concerned that persistent fails
to deliver may have a negative effect on the market in these
securities. For example, persistent fails to deliver may deprive
shareholders of the benefits of ownership, such as voting and lending.
In addition, where a seller of securities fails to deliver securities
on trade settlement date, in effect the seller unilaterally converts a
securities contract (which should settle within the standard 3-day
settlement period) into an undated futures-type contract, to which the
buyer may not have agreed, or that may have been priced differently.
Moreover, sellers that fail to deliver securities on trade settlement
date may enjoy fewer restrictions than if they were required to deliver
the securities within a reasonable period of time, and such sellers may
use this additional freedom to engage in trading activities that
deliberately and improperly depress the price of a security.
---------------------------------------------------------------------------
\86\ See supra note 7.
---------------------------------------------------------------------------
We believe the amendment will benefit investors by facilitating the
receipt of shares so that more investors receive the benefits
associated with share ownership. The amendment may enhance investor
confidence as they make investment decisions by providing investors
with greater assurance that securities will be delivered as expected.
An increase in investor confidence in the market may facilitate
investment.
We believe the amendment will also benefit issuers. A high level of
persistent fails to deliver in a security may be perceived by potential
investors negatively and may affect their decision about making a
capital commitment.\87\ Some issuers may believe they have endured
unwarranted reputational damage due to investors' negative perceptions
regarding a security having a large fail to deliver position and
becoming a threshold security.\88\ Thus, issuers may believe that
elimination of the grandfather provision will restore their good name.
Some issuers may also believe that large and persistent fails to
deliver indicate that they have been the target of potentially
manipulative conduct as a result of ``naked'' short sales.\89\ Thus,
elimination of the grandfather provision may decrease the possibility
of artificial market influences and, therefore, may contribute to price
efficiency.
---------------------------------------------------------------------------
\87\ See, e.g., comment letter from Feeney, supra note 10.
\88\ See, e.g., comment letter from Zix, supra note 10.
\89\ See, e.g., comment letters from Feeney, supra note 10; Zix,
supra note 10.
---------------------------------------------------------------------------
We believe the 35 day phase-in period will reduce disruption to the
market and foster greater market stability because it gives
participants a sufficient length of time to effect purchases to close
out grandfathered positions in an orderly manner, particularly since
participants could have begun to close out grandfathered positions
anytime before the 35 day phase-in period was adopted. Some of the
commenters that supported eliminating the grandfather provision stated
that the 35 day phase-in proposal would restore investor confidence and
would not cause excessive volatility.\90---------------------------------------------------------------------------
\90\ See comment letters from MFA, supra note 38; NCANS, supra
note 9; State of Connecticut, supra note 9.
---------------------------------------------------------------------------
b. Costs
In order to comply with Regulation SHO when it became effective in
January 2005, market participants needed to modify their recordkeeping,
systems, and surveillance mechanisms. In addition, market participants
should have retained and trained the necessary personnel to ensure
compliance with the rule. Thus, the infrastructure necessary to comply
with the amendments is likely already in place. As such, any additional
changes to the infrastructure will likely be minimal. In the Proposing
Release, we requested specific comment on the system changes to
computer hardware and software, or surveillance costs that might be
necessary to comply with this rule. One investor, in his comment
letter, stated that elimination of the grandfather provision will not
increase costs for surveillance and compliance but, instead, will
actually reduce costs because firms will no longer have to identify and
track which fails to deliver are grandfathered and which are not.\91---------------------------------------------------------------------------
\91\ See comment letter from David Patch, dated July 22, 2006.
---------------------------------------------------------------------------
We also requested comment regarding the economic costs of
eliminating the grandfather provision and how this would affect the
liquidity of equity securities. One commenter contended that
elimination of the grandfather provision could adversely impact stock
liquidity and borrowing, increasing costs to investors.\92\ Another
commenter stated its belief that eliminating the grandfather provision
would lead to increased volatility and short squeezes as individuals
attempted to close out positions.\93\ This commenter also stated that
eliminating the grandfather provision would negatively impact bona
[[Page 45553]]
fide market making and the ability of market makers to provide
liquidity, which would lead to less liquidity, greater volatility, and
widening of spreads.\94\ Another commenter stated that eliminating the
grandfather provision would cause substantial market disruption by
increasing significantly the number of buy-ins in the market without
sufficiently targeting the abusive ``naked'' short sellers.\95---------------------------------------------------------------------------
\92\ See, e.g., comment letter from CBOE, supra note 39.
\93\ See comment letter from Knight, supra note 39.
\94\ See id. According to this commenter, the proposal could
also lead to upward price manipulation, causing investors to
purchase shares at inflated prices.
\95\ See comment letter from UBS, supra note 39.
---------------------------------------------------------------------------
There could be some risk of market disruption in requiring market
participants to close out grandfathered fails to deliver. However, we
believe that any market disruption, including increased volatility,
reduction in liquidity and potential short squeezes are justified by
the benefits of reducing the number of persistent fails to deliver. In
addition, we believe that such effects, if any, will be minimal.
First, we believe that these potential effects, if any, of
eliminating the grandfather provision will be minimal because the
number of securities that will be impacted by elimination of the
grandfather provision will be relatively small. Regulation SHO's close-
out requirement is narrowly tailored in that it targets only those
securities where the level of fails to deliver is high (0.5% of total
shares outstanding and 10,000 shares or more) for a continuous period
(five consecutive settlement days).\96\ Requiring close out only for
securities with large and persistent fails to deliver limits the
overall market impact. Moreover, the amendment only impacts those fails
to deliver in threshold securities that were created before the
security became a threshold security. Because the current grandfather
provision has a limited application, the overall impact of its removal
on liquidity, volatility, and short squeezes, is expected to be
relatively small.
---------------------------------------------------------------------------
\96\ See supra note 7 (discussing the number of threshold
securities as of March 31, 2007).
---------------------------------------------------------------------------
Second, to the extent that the amendment could result in a decrease
in liquidity, increased volatility, or short squeezes, we believe that
any such potential effects will likely be mitigated by the fact that
even though fails to deliver that were previously-grandfathered from
the close-out requirement of Regulation SHO will not be permitted to
continue indefinitely, such fails to deliver will not have to be closed
out immediately, or even within the standard 3-day settlement period.
Instead, under Rule 203(b)(3)'s mandatory close-out requirement, both
new and previously-grandfathered fails to deliver in threshold
securities will have 13 consecutive settlement days within which to be
closed out.
Third, as noted above, the grandfather provision excepts from Rule
203(b)(3)'s mandatory 13 consecutive settlement day close-out
requirement only those fails to deliver created before the security
became a threshold security. Thus, it does not apply to fails to
deliver created after the security became a threshold security. In
examining the application of the current mandatory close-out
requirement of Regulation SHO for all non-grandfathered fail to deliver
positions, we have not become aware of any evidence that the current
close-out requirement for non-grandfathered fails to deliver in
threshold securities has negatively impacted liquidity or volatility in
these securities, or resulted in short squeezes.
Fourth, to the extent that elimination of the grandfather provision
results in decreased liquidity, or increased volatility in certain
securities, or results in short squeezes, we believe that these
potential effects are justified by the benefits of requiring that fails
to deliver in all threshold securities be closed out within specific
time-frames rather than being allowed to continue indefinitely. As
discussed above, large and persistent fails to deliver can deprive
shareholders of the benefits of ownership, such as voting and lending.
They can also be indicative of potentially manipulative conduct, such
as abusive ``naked'' short selling. The deprivation of the benefits of
ownership, as well as the perception that abusive ``naked'' short
selling is occurring in certain securities can undermine the confidence
of investors. These investors, in turn, may be reluctant to commit
capital to an issuer they believe to be subject to manipulative
conduct.
2. Amendments to Rule 203 for Sales of Securities Pursuant to Rule 144
a. Benefits
The amendments to Rule 203 will extend the close out requirement
from 13 to 35 consecutive settlement days for fails to deliver
resulting from sales of threshold securities pursuant to Rule 144 of
the Securities Act. In addition, because we are extending the close-out
requirement for fails to deliver resulting from sales of threshold
securities pursuant to Rule 144, we are also extending the pre-borrow
requirement of Rule 203(b)(3)(iii) of Regulation SHO, as originally
adopted, for these fails to deliver. Thus, if the fail to deliver
position persists for 35 consecutive settlement days, the amendment
will prohibit a participant of a registered clearing agency, and any
broker-dealer for which it clears transactions, including market
makers, from accepting any short sale orders or effecting further short
sales in the particular threshold security without borrowing, or
entering into a bona-fide arrangement to borrow, the security until the
participant closes out the entire fail to deliver position by
purchasing securities of like kind and quantity.
Securities sold pursuant to Securities Act Rule 144 are formerly
restricted securities that a seller is ``deemed to own'' as defined by
Rule 200(a) of Regulation SHO. The securities, however, may not be
capable of being delivered on the settlement date due to processing
delays related to removal of the restricted legend. We understand,
however, that such processing delays, which are out of the seller's and
broker-dealer's control, frequently result in delivery taking longer
than 13 consecutive settlement days.\97---------------------------------------------------------------------------
\97\ See, e.g., comment letter from SIA, supra note 39.
---------------------------------------------------------------------------
We believe that extending the current close-out requirement to 35
consecutive settlement days for fails to deliver resulting from sales
of threshold securities pursuant to Rule 144 of the Securities Act will
permit the orderly settlement of such sales without the risk of causing
market disruption due to unnecessary purchasing activity (particularly
if the purchases are for sizable quantities of stock). Because the
security sold will be received as soon as all processing delays have
been removed, this additional time will allow participants to close out
fails to deliver resulting from the sale of the security with the
security sold, rather than having to close out such fail to deliver
position by purchasing securities in the market. Thus, the amendments
will reduce costs to participants and, in turn, investors.
Although this amendment will allow fails to deliver resulting from
sales of threshold securities pursuant to Rule 144 of the Securities
Act 35 rather than 13 consecutive settlement days in which to be closed
out, these fails to deliver must be closed out within 35 consecutive
settlement days and, therefore, these fails to deliver cannot continue
indefinitely. Thus, we believe that this amendment is consistent with
our goal of further reducing fails to deliver in threshold securities,
while balancing the concerns associated with closing out fails to
deliver in threshold securities pursuant to Securities Act Rule 144.
[[Page 45554]]
b. Costs
We do not believe these amendments will impose any significant
burden or cost on market participants. As discussed in more detail
above, we believe that extending the current close-out requirement from
13 to 35 consecutive settlement days for fails to deliver resulting
from the sale of a threshold security pursuant to Rule 144 of the
Securities Act is expected to reduce costs by allowing participants of
a registered clearing agency with a fail to deliver position additional
time for delivery of these securities beyond the current 13 consecutive
settlement day close-out requirement of Rule 203(b)(3) of Regulation
SHO.
Participants may incur, however, some added costs for minor changes
to their current systems to reflect the extended close-out requirement.
We believe any added costs are justified by the benefits of extending
the close-out requirement for these securities.
3. Amendments to Rule 200(e)(3)
a. Benefits
The amendments to the market decline limitation in Rule 200(e) of
Regulation SHO will reference the NYA rather than the DJIA. The
previous reference in Rule 200(e)(3) to the DJIA was based in part on
NYSE Rule 80A (Index Arbitrage Trading Restrictions). However, as
discussed above, because the Commission approved an amendment to NYSE
Rule 80A to use the NYA to calculate limitations on index arbitrage
trading as provided in the rule instead of the DJIA,\98\ and because we
believe that this is an appropriate index to reference for purposes of
Rule 200(e)(3) of Regulation SHO, we are amending Rule 200(e)(3) to
reference the NYA instead of the DJIA.
---------------------------------------------------------------------------
\98\ See 70 FR 51398.
---------------------------------------------------------------------------
In addition, the amendments provide that the two percent limitation
is to be calculated at the beginning of each quarter and shall be two
percent, rounded down to the nearest 10 points, of the average closing
value of the NYA for the last month of the previous quarter.\99\ In
addition, Rule 200(e), as amended, will provide that the market decline
limitation will terminate at the end of the trading day rather than
upon the establishment of the closing value of the NYA on the next
succeeding trading day. These amendments are intended to maintain
consistency with NYSE Rule 80A so that market participants need refer
to only one index in connection with restrictions regarding index
arbitrage trading.
---------------------------------------------------------------------------
\99\ This amendment provides consistency with how the two
percent value is calculated pursuant to NYSE Rule 80A. See NYSE Rule
80A (Supplementary Material .10).
---------------------------------------------------------------------------
b. Costs
As discussed above, the reference in Rule 200(e)(3) of Regulation
SHO to the DJIA was based, in part, on the reference in NYSE Rule 80A
to the DJIA.\100\ Following the Commission's approval of the amendment
to NYSE Rule 80A to reference the NYA rather than the DJIA, market
participants engaged in index arbitrage trading needed to reference the
NYA for purposes of complying with NYSE Rule 80, and the DJIA for
purposes of complying with Rule 200(e)(3) of Regulation SHO. By
amending Rule 200(e)(3) to reference the NYA rather than the DJIA,
market participants engaged in index arbitrage trading will need to
reference only one index with respect to restrictions on such trading.
Thus, we believe the amendments will not impose any significant costs
or burdens on market participants.
---------------------------------------------------------------------------
\100\ See 2003 Proposing Release, 68 FR at 62994-62995
(discussing proposed Rule 200 regarding netting and the liquidation
of index arbitrage activities and changes to the language of the
rule text to keep the language consistent with the language in NYSE
Rule 80A).
---------------------------------------------------------------------------
VI. Consideration of Burden on Competition and Promotion of Efficiency,
Competition, and Capital Formation
Section 3(f) of the Exchange Act requires the Commission, whenever
it engages in rulemaking and is required to consider or determine
whether an action is necessary or appropriate in the public interest,
to consider whether the action will promote efficiency, competition,
and capital formation.\101\ In addition, Section 23(a)(2) of the
Exchange Act requires the Commission, when making rules under the
Exchange Act, to consider the impact such rules would have on
competition.\102\ Exchange Act Section 23(a)(2) prohibits the
Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act. In the Proposing Release, we solicited comment on
whether the proposed amendments are expected to promote efficiency,
competition, and capital formation.
---------------------------------------------------------------------------
\101\ 15 U.S.C. 78c(f).
\102\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
We believe the amendments will have minimal impact on the promotion
of price efficiency. In the Proposing Release we sought comment on
whether the proposals promote price efficiency, including whether the
proposals might impact liquidity and the potential for manipulative
short squeezes. One commenter stated that the Commission's concern over
potential short squeezes is ``misplaced,'' as this is a risk short
sellers assume when they sell short.\103\ Another commenter maintained
that elimination of the grandfather provision should not cause
excessive volatility because, according to the commenter, DTCC and
market participants have said that fails to deliver are a small
problem.\104\ However, one commenter stated its belief that elimination
of the grandfather provision could adversely impact stock liquidity and
borrowing, increasing costs to investors.\105\ Another commenter stated
its belief that eliminating the grandfather provision would lead to
increased volatility and short squeezes as individuals attempted to
close out positions.\106\ This commenter also stated that eliminating
the grandfather provision would negatively impact bona fide market
making and the ability of market makers to provide liquidity, which
would lead to less liquidity, greater volatility, and widening of
spreads.\107\ Another commenter stated that eliminating the grandfather
provision would cause substantial market disruption by increasing
significantly the number of buy-ins in the market without sufficiently
targeting the abusive ``naked'' short sellers.\108---------------------------------------------------------------------------
\103\ See comment letter from H. Glenn Bagwell, Jr., supra note
42.
\104\ See comment letter from NCANS, supra note 9.
\105\ See comment letter from CBOE, supra note 39.
\106\ See comment letter from Knight, supra note 39.
\107\ See id. According to this commenter, the proposal could
also lead to upward price manipulation, causing investors to
purchase shares at inflated prices.
\108\ See comment letter from UBS, supra note 39.
---------------------------------------------------------------------------
We believe 13 consecutive settlement days will be a sufficient
amount of time in which to close out fail to deliver positions even in
hard to borrow securities and will likely limit the potential for short
squeezes, increased volatility, or reduction in liquidity. In addition,
these amendments will impact only threshold securities, which comprise
a small subset of all equity securities trading in the market. For
example, in March 2007, the average daily number of securities on the
threshold list was approximately 311 securities, which comprised 0.39%
of all equity securities, and 2.33% of those securities subject to
Regulation SHO. Thus, we believe that the overall market impact of the
amendments will be minimal, if any.
We also believe the 35 day phase-in period for previously-
grandfathered fail
[[Page 45555]]
to deliver positions will not result in market disruption because it
allows participants of a registered clearing agency an extended period
of time in which to effect purchases to close out previously-
grandfathered fail to deliver positions as of the effective date of the
amendment, particularly because these participants could have begun to
close out previously-grandfathered fail to deliver positions before
adoption of the 35 day phase-in period.
In addition, we believe that the amendments will have minimal
impact on the promotion of capital formation. Large and persistent
fails to deliver can deprive shareholders of the benefits of ownership,
such as voting and lending. They can also be indicative of potentially
manipulative conduct, such as abusive ``naked'' short selling. The
deprivation of the benefits of ownership, as well as the perception
that abusive ``naked'' short selling is occurring in certain
securities, can undermine the confidence of investors. These investors,
in turn, may be reluctant to commit capital to an issuer they believe
to be subject to such manipulative conduct. In the Proposing Release,
we sought comment on whether the proposed amendments would promote
capital formation, including whether the proposed increased short sale
restrictions would affect investors' decisions to invest in certain
equity securities. Commenters expressed concern about the potential
impact of ``naked'' short selling on capital formation claiming that
``naked'' short selling causes a drop in an issuer's stock price that
may limit the issuer's ability to access the capital markets.\109\
Another commenter submitted a theoretical economic study concluding
that ``naked'' short selling is economically similar to other
shorting.\110---------------------------------------------------------------------------
\109\ See, e.g., comment letter from Feeney, supra note 10.
\110\ See comment letter from J.B. Heaton, Bartlit Beck Herman
Palenchar & Scott LLP, dated May 1, 2007.
---------------------------------------------------------------------------
By requiring that all fails to deliver in threshold securities be
closed out within specific time-frames rather than allowing them to
continue indefinitely, we believe that there will be a decrease in the
number of threshold securities with persistent and high levels of fails
to deliver. If persistence on a threshold securities list leads to an
unwarranted decline in investor confidence about the security, the
amendments are expected to improve investor confidence about the
security. We also believe that the proposed amendments will lead to
greater certainty in the settlement of securities, which should
strengthen investor confidence in the settlement process.
We also believe the amendments will not impose any burden on
competition not necessary or appropriate in furtherance of the Exchange
Act. By eliminating the grandfather provision and extending the close
out requirement from 13 to 35 consecutive settlement days for fails to
deliver resulting from sales of threshold securities pursuant to Rule
144 of the Securities Act, we believe the amendments to Regulation SHO
will promote competition by requiring similarly situated participants
to close out fails to deliver in threshold securities within the same
time-frame or, in the case of threshold securities sold pursuant to
Rule 144 of the Securities Act, it will provide the same additional
time-frame within which to close out fails to deliver resulting from
sales of these securities. The amendments also will promote competition
by maintaining consistency with NYSE Rule 80A so that broker-dealers
can refer to the same index with respect to restrictions regarding
index arbitrage trading. Thus, we believe that the amendments will
improve the functioning of the capital markets and, thereby, will
enhance investor confidence in the markets.
VII. Final Regulatory Flexibility Analysis
The Commission has prepared a Final Regulatory Flexibility Analysis
(``FRFA''), in accordance with the provisions of the Regulatory
Flexibility Act (``RFA''),\111\ regarding the amendments to Regulation
SHO, Rules 200 and 203, under the Exchange Act. An Initial Regulatory
Flexibility Analysis (``IRFA'') was prepared in accordance with the RFA
and was included in the Proposing Release. We solicited comments on the
IRFA.
---------------------------------------------------------------------------
\111\ 5 U.S.C. 604.
---------------------------------------------------------------------------
A. Reasons for and Objectives of the Amendments
We are adopting revisions to Rules 200 and 203 of Regulation SHO.
The amendments to Rule 203(b)(3) of Regulation SHO are designed to
further reduce the number of persistent fails to deliver in threshold
securities by eliminating the grandfather provision. We are concerned
that persistent, large fail positions may have a negative effect on the
market in these securities. For example, although high fails levels
exist only for a small percentage of issuers, they may impede the
orderly functioning of the market for such issuers, particularly
issuers of less liquid securities. A significant level of fails to
deliver in a security may have adverse consequences for shareholders
who may be relying on delivery of those shares for voting and lending
purposes, or may otherwise affect an investor's decision to invest in
that particular security. In addition, a seller that fails to deliver
securities on trade settlement date effectively unilaterally converts a
securities contract into an undated futures-type contract, to which the
buyer might not have agreed, or that would have been priced
differently.
To allow participants sufficient time to comply with the new close-
out requirements, we are including a 35 settlement day phase-in period
following the effective date of the amendment. The phase-in period is
intended to provide participants with flexibility and advance notice to
begin closing out previously-grandfathered fail to deliver positions.
The amendment to extend the close out requirement from 13 to 35
consecutive settlement days for fails to deliver resulting from sales
of threshold securities pursuant to Rule 144 of the Securities Act also
is intended to provide participants with flexibility by allowing
additional time for delivery of these securities, thereby also
permitting the orderly settlement of such sales. The amendment to
update the market decline limitation referenced in Rule 200(e)(3) is
intended to maintain consistency with NYSE Rule 80A, and to provide for
an appropriate and consistent protective measure.
B. Significant Issues Raised by Public Comment
The IRFA appeared in the Proposing Release. We requested comment on
any aspect of the IRFA. In particular, we requested comment on: (i) The
number of small entities that would be affected by the amendments; and
(ii) the existence or nature of the potential impact of the amendments
on small entities. We requested that the comments specify costs of
compliance with the amendments, and suggest alternatives that would
accomplish the objectives of the amendments. We did not receive any
comments that responded specifically to this request. One investor, in
his comment letter, however, stated that elimination of the grandfather
provision would not increase costs for surveillance and compliance but,
instead, will actually reduce costs because firms would no longer have
to identify and track which
[[Page 45556]]
fails to deliver are grandfathered and which are not.\112---------------------------------------------------------------------------
\112\ See comment letter from David Patch, supra note 91.
---------------------------------------------------------------------------
C. Small Entities Subject to the Amendments
The entities covered by these amendments will include small
entities that are participants of a registered clearing agency, and
small broker-dealers for which the participant clears trades or for
which it is responsible for settlement. In addition, the entities
covered by these amendments will include small entities that are market
participants that effect sales subject to the requirements of
Regulation SHO. Although it is impossible to quantify every type of
small entity covered by these amendments, Paragraph (c)(1) of Rule 0-10
under the Exchange Act \113\ states that the term ``small business'' or
``small organization,'' when referring to a broker-dealer, means a
broker or dealer that had total capital (net worth plus subordinated
liabilities) of less than $500,000 on the date in the prior fiscal year
as of which its audited financial statements were prepared pursuant to
Sec. 240.17a-5(d); and is not affiliated with any person (other than a
natural person) that is not a small business or small organization. We
estimate that as of 2006 there were approximately 894 broker-dealers
that qualified as small entities as defined above.\114---------------------------------------------------------------------------
\113\ 17 CFR 240.0-10(c)(1).
\114\ These numbers are based on the Commission's Office of
Economic Analysis's review of 2006 FOCUS Report filings reflecting
registered broker dealers. This number does not include broker-
dealers that are delinquent on FOCUS Report filings.
---------------------------------------------------------------------------
As noted above, the entities covered by these amendments will
include small entities that are participants of a registered clearing
agency. As of May 2007, approximately 90% of participants of the NSCC,
the primary registered clearing agency responsible for clearing U.S.
transactions, were registered as broker-dealers. Participants not
registered as broker-dealers include such entities as banks, U.S.-
registered exchanges, and clearing agencies. Although these entities
are participants of a registered clearing agency, generally these
entities do not engage in the types of activities that would implicate
the close-out requirements of Regulation SHO. Such activities of these
entities include creating and redeeming Exchange Traded Funds, trading
in municipal securities, and using NSCC's Envelope Settlement Service
or Inter-city Envelope Settlement Service. These activities rarely lead
to fails to deliver and, if fails to deliver do occur, they are small
in number and are usually cleaned up within a day. Thus, such fails to
deliver would not trigger the close-out provisions of Regulation SHO.
The federal securities laws do not define what is a ``small
business'' or ``small organization'' when referring to a bank. The
Small Business Administration regulations define ``small entities'' to
include banks and savings associations with total assets of $165
million or less.\115\ As of May, 2007 no bank that was a participant of
the NSCC was a small entity because none met this criteria.
---------------------------------------------------------------------------
\115\ See 13 CFR 121.201.
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Paragraph (e) of Rule 0-10 under the Exchange Act \116\ states that
the term ``small business'' or ``small organization,'' when referring
to an exchange, means any exchange that: (1) Has been exempted from the
reporting requirements of Rule 11Aa3-1 under the Exchange Act; and (2)
is not affiliated with any person (other than a natural person) that is
not a small business or small organization, as defined by Rule 0-10. No
U.S. registered exchange is a small entity because none meets these
criteria. There is one national securities association (NASD) that is
subject to these amendments. NASD is not a small entity as defined by
13 CFR 121.201.
---------------------------------------------------------------------------
\116\ 17 CFR 240.0-10(e).
---------------------------------------------------------------------------
Paragraph (d) of Rule 0-10 under the Exchange Act \117\ states that
the term ``small business'' or ``small organization,'' when referring
to a clearing agency, means a clearing agency that: (1) Compared,
cleared and settled less than $500 million in securities transactions
during the preceding fiscal year (or in the time that it has been in
business, if shorter); (2) had less than $200 million in funds and
securities in its custody or control at all times during the preceding
fiscal year (or in the time that it has been in business, if shorter);
and (3) is not affiliated with any person (other than a natural person)
that is not a small business or small organization as defined by Rule
0-10. No clearing agency that is subject to the requirements of
Regulation SHO is a small entity because none meets these criteria.
---------------------------------------------------------------------------
\117\ 17 CFR 240.0-10(d).
---------------------------------------------------------------------------
D. Reporting, Recordkeeping, and Other Compliance Requirements
The amendments may impose some new or additional reporting,
recordkeeping, or compliance costs on small entities that are
participants of a clearing agency registered with the Commission.\118\
In order to comply with Regulation SHO when it became effective in
January 2005, small entities needed to modify their systems and
surveillance mechanisms. Thus, we believe that the infrastructure
necessary to comply with the amendments regarding elimination of the
grandfather provision is likely already in place. Any additional
changes to the infrastructure are expected to be minimal. We do not
believe, at this time, that any specialized professional skills will be
necessary to comply with these new requirements.
---------------------------------------------------------------------------
\118\ See discussions above in Section VII.C. and note 28,
regarding participants of a registered clearing agency that are
broker-dealers as opposed to non broker-dealers.
---------------------------------------------------------------------------
E. Agency Action To Minimize Effect on Small Entities
The RFA directs the Commission to consider significant alternatives
that would accomplish the stated objectives, while minimizing any
significant adverse impact on small entities. In connection with the
proposals, the Commission considered the following alternatives: (a)
Establishment of differing compliance or reporting requirements or
timetables that take into account the resources available to small
entities; (b) clarification, consolidation, or simplification of
compliance and reporting requirements under the rule for small
entities; (c) use of performance rather than design standards; and (d)
an exemption from coverage of the rule, or any part thereof, for small
entities.
The primary goal of the new amendments is to reduce the number of
persistent fails to deliver in threshold securities. As such, we
believe that imposing different compliance requirements, and possibly a
different timetable for implementing compliance requirements, for small
entities will undermine the goal of reducing fails to deliver. In
addition, we have concluded similarly that it is not consistent with
the primary goal of the new amendments to further clarify, consolidate
or simplify the new amendments for small entities. The Commission also
believes that it is inconsistent with the purposes of the Exchange Act
to use performance standards to specify different requirements for
small entities or to exempt small entities from having to comply with
the amended rules.
VIII. Statutory Authority
Pursuant to the Exchange Act and, particularly, Sections 2, 3(b),
9(h), 10(a), 11A, 15, 17(a), 17A, 23(a) thereof, 15 U.S.C. 78b, 78c(b),
78i(h), 78j, 78k-1, 78o, 78q(a), 78q-1, 78w(a), the
[[Page 45557]]
Commission is adopting amendments to Sec. Sec. 242.200 and 242.203.
Text of the Final Amendments to Regulation SHO
List of Subjects in 17 CFR Part 242
Brokers, Fraud, Reporting and recordkeeping requirements,
Securities.
0
For the reasons set out in the preamble, Title 17, Chapter II, Part
242, of the Code of Federal Regulations is amended as follows.
PART 242--REGULATIONS M, SHO, ATS, AC, AND NMS, AND CUSTOMER MARGIN
REQUIREMENTS FOR SECURITY FUTURES
0
1. The authority citation for part 242 continues to read as follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g),
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and
80a-37.
0
2. Section 242.200 is amended by revising paragraph (e)(3) to read as
follows:
Sec. 242.200 Definition of ``short sale'' and marking requirements.
* * * * *
(e) * * *
(3) The sale does not occur during a period commencing at the time
that the NYSE Composite Index has declined by two percent or more from
its closing value on the previous day and terminating upon the end of
the trading day. The two percent shall be calculated at the beginning
of each calendar quarter and shall be two percent, rounded down to the
nearest 10 points, of the average closing value of the NYSE Composite
Index for the last month of the previous quarter.
* * * * *
0
3. Section 242.203 is amended by:
0
a. Revising paragraph (b)(3)(i);
0
b. Redesignating paragraphs (b)(3)(ii), (b)(3)(iii), (b)(3)(iv) and
(b)(3)(v) as paragraphs (b)(3)(iii), (b)(3)(iv), (b)(3)(vi) and
(b)(3)(vii), respectively; and
0
c. Adding new paragraphs (b)(3)(ii) and (b)(3)(v).
The additions and revision read as follows:
Sec. 242.203 Borrowing and delivery requirements.
* * * * *
(b) * * *
(3) * * *
(i) Provided, however, that a participant of a registered clearing
agency that has a fail to deliver position at a registered clearing
agency in a threshold security on the effective date of this amendment
and which, prior to the effective date of this amendment, had been
previously grandfathered from the close-out requirement in this
paragraph (b)(3) (i.e., because the participant of a registered
clearing agency had a fail to deliver position at a registered clearing
agency on the settlement day preceding the day that the security became
a threshold security), shall close out that fail to deliver position
within thirty-five consecutive settlement days of the effective date of
this amendment by purchasing securities of like kind and quantity;
(ii) Provided, however, that if a participant of a registered
clearing agency has a fail to deliver position at a registered clearing
agency in a threshold security that was sold pursuant to Sec. 230.144
of this chapter for thirty-five consecutive settlement days, the
participant shall immediately thereafter close out the fail to deliver
position in the security by purchasing securities of like kind and
quantity;
* * * * *
(v) If a participant of a registered clearing agency entitled to
rely on the thirty-five consecutive settlement day close out
requirement contained in paragraphs (b)(3)(i) or (b)(3)(ii) of this
section has a fail to deliver position at a registered clearing agency
in the threshold security for thirty-five consecutive settlement days,
the participant and any broker or dealer for which it clears
transactions, including any market maker, that would otherwise be
entitled to rely on the exception provided in paragraph (b)(2)(iii) of
this section, may not accept a short sale order in the threshold
security from another person, or effect a short sale in the threshold
security for its own account, without borrowing the security or
entering into a bona-fide arrangement to borrow the security, until the
participant closes out the fail to deliver position by purchasing
securities of like kind and quantity;
* * * * *
By the Commission.
Dated: August 7, 2007.
Nancy M. Morris,
Secretary.
[FR Doc. E7-15708 Filed 8-13-07; 8:45 am]
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