Regulation SHO replaces Rules 3b-3 and 10a-2, as well as certain self-regulatory organization (“SRO”) rules governing short sales, and modifies Rule 10a-1. Specifically, Rule Regulation SHO requires short sellers in all equity securities to locate securities to borrow before selling, and also imposes strict delivery requirements in order to settle short sales. The regulation further includes a temporary rule that establishes procedures by which the SEC may temporarily suspend, on a pilot basis, the current “tick” test and the short sale price test of any exchange or national securities association for specified securities. Regulation SHO also defines ownership of securities, permits the establishment of aggregation units (thereby avoiding firm-wide determination of net long and short positions) subject to certain requirements, and requires broker-dealers to mark sales in all equity securities “long,” “short,” or “short exempt.” Finally, the SEC voted to eliminate the shelf offering exception in Rule 105 of Regulation M under Regulation SHO, thereby prohibiting short sales covered by securities offered off the shelf.
The SEC deferred consideration of the additional proposal that would have replaced the current “tick” test with a new uniform bid test allowing short sales to be effected at a price one cent above the consolidated best bid. This uniform test was to apply to exchange-listed securities and Nasdaq National Market System Securities (“NMS Securities”), wherever traded. The SEC has decided to reconsider this proposal after the completion of a pilot program established by Regulation SHO Rule 202T.
Rules 200 to 203 of Regulation SHO will become effective 30 days after publication in the Federal Register, with a compliance date of January 3, 2005. The amendments to Rule 105 of Regulation M will be effective 30 days after publication in the Federal Register.
Pilot Program
As part of its review of current short sale regulation, the SEC adopted a modified version of proposed Rule 202T. As adopted, Rule 202T is a temporary exemption from Rule 202 of Regulation SHO that suspends, on a one-year pilot basis, any short sale price test for such securities and for such time as deemed appropriate and necessary by the SEC. The purpose of this pilot program is to enable the SEC to study the effects of unrestricted short selling on, among other things, market volatility, price efficiency, and liquidity. The pilot program would commence by separate Order of the SEC and continue only as long as necessary to allow the SEC to collect sufficient data. The Order establishing any such pilot program would identify the pilot stocks and the methodology that would be used in selecting pilot and control group stocks.
By separate Order, the SEC is creating a pilot program that applies to a subset of securities from a broad-based index. The Order establishing the pilot program can be found at: http://www.sec.qov/rules/other/34-50104.htm (the “Pilot Order”). This separate pilot program is intended to target the assessment of the efficacy of a price test for short sales. This also allows the SEC to obtain empirical data to assess whether short sale regulation should be removed, in part or whole, for actively traded securities. Further, Rule 202T specifically prohibits the SROs from employing a price test for short sales in securities that are selected for a pilot program during its operation. This is because allowing SRO price tests to continue to apply to securities subject to a pilot would be inconsistent with and detrimental to the goals of Rule 202T.
Deferral of Uniform Price Test
Current short sale regulation applies different price tests to securities trading in different markets. The SEC had proposed to replace the tick test in Rule 10a-1 with Rule 201, which would have provided for a uniform price test that uses the consolidated best bid as the reference point for permissible short sales. Proposed Rule 201 would have essentially prohibited the short selling of listed and NMS Securities at a price less than one cent above the consolidated best bid for that security. However, the SEC decided not to adopt Rule 201 at the present time. Instead, it chose to defer consideration of the proposed uniform bid test until after a pilot program, pursuant to Rule 202T, is concluded.
Definition of a Short Sale
Former Rule 3b-3 under the Exchange Act is now incorporated in the new Rule 200 of Regulation SHO. The new Rule continues to define the term “short sale” as any 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. The new Rule also retains former Rule 3b-3’s definition of ownership for purposes of Rule 10a-1, including instances in which a person has purchased or entered into an “unconditional contract” to purchase the securities.
The SEC initially proposed to amend the definition of “unconditional contract” to specify an irrevocable price and amount of securities to be purchased, and to provide for present delivery. The SEC was concerned that a purchaser that considers itself “long” under a contract with an unspecified price and amount may have an incentive to sell the securities prior to the close of trading, thereby depressing the closing price. The SEC decided not to incorporate this change in light of its preservation of the current price test during the application of Rule 202T’s pilot program.
Notably, Rule 200(g) requires that sell orders in all equity securities be appropriately marked “long,” “short,” or “short exempt.” Further, the SEC decided to amend former Rule 3b-3 to permit broker-dealers to calculate net positions in a particular security within defined trading aggregation units, subject to certain conditions (as opposed to firm-wide). Rule 200(f) allows trading unit aggregation if the following requirements are met: (1) the broker-dealer has a written plan of organization that identifies each aggregation unit, specifies its trading objective(s), and supports its independent identity; (2) each aggregation unit within the firm determines at the time of each sale its net position for every security that it trades; (3) all traders in an aggregation unit pursue only the trading objectives or strategy(ies) of that aggregation unit; and (4) individual traders are assigned to only one aggregation unit at any time.
The SEC also codified in Rule 200 prior interpretations related to security futures products, and the unwinding of certain index arbitrage positions. The exception for unwinding index arbitrage positions is limited to the following situations: (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 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 during which the DJIA has not declined by two percent or more from its closing value on the previous day.
Short Sales - Uniform Locate and Delivery Rule
In an effort to safeguard against the practice of “naked short selling,”[1] the SEC has adopted a uniform standard specifying procedures for all short sellers to locate securities for borrowing. Specifically, Rule 203 under Regulation SHO prohibits a broker-dealer from executing a short sale order for its own account or the account of another person, unless the broker-dealer, or the person for whose account the short sale is executed, (1) borrowed the security or entered into an arrangement for the borrowing of the security, or (2) had reasonable grounds to believe that it could borrow the security such that it would be capable of delivering the securities on the settlement date.[2] Consistent with current SRO requirements, Rule 203 mandates that the “locate” be made and annotated in writing prior to effecting any short sale, regardless of whether the seller’s short position will be closed out by purchasing securities the same day. The rule places the onus to execute on the broker-dealer effecting the sale. The SEC exempts from Rule 203 short sales executed by broker-dealers accepting a short sale order from other registered broker-dealers, specialists or market makers in connection with bona fide market making activities.[3] In order to satisfy the “reasonable grounds” determination in Rule 203, the broker-dealer must have relied on an “Easy to Borrow” list that is less than 24 hours old and lists securities that are readily available and unlikely to result in a fail-to-deliver.
In addition, SEC has adopted a delivery requirement targeted at securities where there is evidence of significant settlement failures. The SEC incorporated into Rule 203 the threshold currently used in NASD Rule 11830 (i.e., any security where there are fails-to-deliver at a registered clearing agency of 10,000 shares or more per security which is equal to at least one half of one percent of the issuer’s total shares outstanding). The rule stipulates that for short sales of any security meeting this threshold, the selling broker-dealer must take action to close out all fails-to-deliver ten days after the normal settlement date, i.e., after thirteen consecutive settlement days, by purchasing securities of like kind and quantity. The close out requirements of Rule 203 do not apply to fail-to-deliver positions established prior to the security meeting the threshold. There is no exception for short sales made in connection with market making and, unlike existing SRO rules, these additional delivery requirements apply to all equity securities registered under the Exchange Act (not just Nasdaq securities).
Long Sales
Rule 203(a) of Regulation SHO incorporates the provisions of current Rule 10a-2. Rule 203(a) requires that if a broker-dealer knows or should know that a security is marked long, it must make delivery when due and cannot borrow securities to do so. If the broker-dealer does not have the securities, it must make delivery with securities purchased for cash (effect a “buy-in”), unless it knows that the seller is in the process of forwarding the securities to the broker-dealer or will do so as soon as possible without undue inconvenience or expense. Broker-dealers are excused from the buy-in requirement in three situations: (1) in sales between broker-dealers, securities may be loaned to settle; (2) where, despite the broker-dealer’s best efforts to ensure the sale was long, it was in actuality short; or (3) where an exchange or securities association finds, that prior to loaning any security for delivery or fail-to-deliver, the sale was a good faith mistake, the broker-dealer exercised due diligence, and either the buy-in requirement would have resulted in undue hardship or the sale was at a permissible price. Regulation SHO extends the delivery requirements of former Rule 10a-2 to all securities, including those traded OTC.
After-Hours Trading
Although the Nasdaq bid test currently applies only during regular trading hours, the SEC interprets the tick test as applying to all trades whenever they occur. Rule 202T establishes a procedure that allows the SEC to suspend on a pilot basis the tick test of Rule 10a-1 (a) and any short sale price test after-hours as deemed appropriate or necessary and consistent with the protection of investors. Specifically, the Pilot Order suspends the short sale price test in after hours trading for 32 specific securities included in the Russell 3000 Index, and for all securities after 8:00 p.m. and before 8:00 a.m. when the consolidated tape is not operating.
Hedging Transactions
Currently, short sales related to hedging transactions are treated the same under Rule 10a-1 as any other short sales. This is because former Rule 3b-3 takes only equity positions into account, and does not consider derivative positions related to these equity positions. Some market participants have recommended that bona fide hedging transactions should be exempted from short sale regulation because such transactions pose little threat of manipulation as gains from short hedging positions are offset by losses in a related security (i.e., they are economically neutral positions). The SEC has decided not to include an exception for hedging short sales in Regulation SHO, believing it unnecessary because the pilot program would offer enough flexibility in effecting short sales for bona fide hedging purposes. “Bona fide” hedging and arbitrage can also be difficult to ascertain; therefore, a blanket exception may potentially harm issuers and shareholders. Instead, the SEC will address this situation through the exemptive process.
Rule 105 of Regulation M - Short Sales in Connection with a Public Offering
Rule 105 of Regulation M prohibits a short seller from covering short sales with offered securities purchased from an underwriter, broker or dealer participating in the offering if the short sale occurred within five business days before pricing of the offered securities. Rule 105 of Regulation M applies to offerings of securities for cash pursuant to a registration statement filed under the Securities Act of 1933. There is an exception under the Rule for shelf offerings filed under Rule 415 and offerings not conducted on a firm commitment basis. The Rule prohibits the conduct irrespective of the short seller’s intent in effecting the short sale.
The SEC decided to remove the current shelf offering exemption in Rule 105 of Regulation M. The rationale is that if an individual with notice of a shelf offering takedown sells short during the five days prior to pricing, and covers his short sale with shelf offering securities, his action may cause the same downward price pressure that happens with pre-pricing short sales in connection with non-shelf offerings. Essentially, this transaction has the same manipulative potential and effect on the offering price that Rule 105 was meant to prevent. The amendment provides that shelf offering prices will be based upon market prices that are not artificially influenced, and therefore is beneficial to both issuers and investors.
The SEC also provides interpretive guidance to address “sham transactions” that have been structured to falsely give the appearance that the pre-pricing short sales have been covered using shares purchased in the open market, when in fact offering shares have been used to cover the short sales in violation of Rule 105.
Conclusion
After remaining largely unchanged for over 60 years, the SEC believes that the short sale rule has become increasingly susceptible to abuse and is inconsistent with market developments. In addition to the traditional objectives of short sale regulation, the SEC believes that implementation of the Regulation SHO short sale rules will reduce market volatility and market manipulation and thereby promote capital formation by increasing issuer and investor confidence in the markets.
[1] Naked short selling is selling short without borrowing the necessary securities to make delivery, thus potentially resulting in “fail-to-deliver” securities to the buyer. Naked short selling can have a number of negative effects on the market, particularly when the fails -to-deliver persist for an extended period of time and resulting in a significantly large, unfulfilled delivery obligation at the clearing agency where trades are settled.
[2] Rule 203 is not limited by its terms to registered broker-dealers. It is interpreted by the SEC as applying to foreign brokers or dealers effecting short sales in U.S. markets.
[3] Bona fide market making activities exclude activity that is related to speculative selling strategies or investment decisions of the broker-dealer or associated person and is disproportionate to the usual market making patterns or practices of the broker-dealer in that security.
This article was originally published in the March 2005, Vol 23, Minnesota State Bar Association's Issue of Business Law News.