The Securities and Exchange Commission published Regulation SHO on July 28. The new regulation represents probably the most significant change to short sale regulation since the SEC first adopted the short sale rule 10a-1 under the Securities Exchange Act of 1934 (the Exchange Act). Since its enactment, Rule 10a-1 has imposed a tick test, generally requiring short sales in securities listed or traded on a national securities exchange to be effected at a price above the last sale price or equal to the last sale price if such a last sale price is above the next preceding different sale price. With respect to Nasdaq National Market securities, the National Association of Securities Dealers imposes a bid test pursuant to NASD Rule 3350, adopted in 1994, generally prohibiting NASD members from effecting short sales in such securities for their own accounts or for the accounts of customers at or below the current best (inside) bid when the current (inside) bid is below the preceding best (inside) bid in such a security.
Regulation SHO relaxes some of the current restrictions on effecting short sales, notably by removing the tick and bid test restrictions for a subset of actively-traded securities and for after-hours short sales of other securities. Regulation SHO also imposes some new restrictions, including a uniform locate requirement for short sales in all equity securities and an additional close-out requirement on designated threshold securities with substantial settlement failures. The SEC also concurrently published amendments to Rule 105 of Regulation M, which generally prohibits covering short sales effected immediately prior to the pricing of an offering with securities received in the offering. The amended rule provisions became effective Sept. 5, although the provisions of Regulation SHO will have a later compliance date of Jan. 3. The key provisions of the new rules are highlighted below.
Pilot Program Suspending A Price Test For Specified Securities
As amended, Regulation SHO includes a pilot program suspending the tick and bid tests for one-third of the securities included in the Russell 3000 index (Pilot). Concurrently with the adopting release, the SEC published an order identifying the specific securities for which the price test will be suspended on a one-year pilot basis, which can be found on the SEC's web site. The SEC's order also suspends the operation of the tick test for short sales in all securities included in the Russell 1000 index that are effected between 4:15 p.m. EST and 8:00 a.m. EST the following day and for short sales in all other equity securities effected after the close of the consolidated tape, i.e., between 8:00 p.m. EST and 8:00 a.m. EST the following day. The bid test already does not operate outside regular trading hours (currently 9:30 a.m.4:00 p.m. EST). The SEC noted that the SROs will actively monitor trading in the Pilot securities to identify any abusive short selling.
Uniform Locate Requirement
As adopted, Rule 203(b) of Regulation SHO supplants existing SRO rules (e.g., NASD Rule 3370 and NYSE Rule 440C) and creates a uniform SEC rule requiring a broker-dealer, prior to effecting a short sale in any equity security, to locate securities available for borrowing. Specifically, the rule prohibits a broker-dealer from accepting a short sale order in any equity security from another person, or effecting a short sale order for the broker-dealer's own account, unless the broker-dealer has: (i) borrowed the security, or entered into an arrangement to borrow the security; or (ii) has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the settlement date. The broker-dealer must make and document the locate prior to effecting a short sale, regardless of whether the seller's short position may be closed out by purchasing securities the same day.
The SEC provides guidance in the Release on the manner in which broker-dealers may satisfy the reasonable grounds requirement of Rule 203(b), noting in particular that, absent countervailing factors, broker-dealers can rely on easy-to-borrow lists, provided the information used to generate such lists is less than 24 hours old and the securities included on the list are so readily available that it is unlikely the seller will fail to deliver securities on the settlement date. In contrast to the current provisions of NASD Rule 3370, however, the Release states that the mere fact that a security does not appear on a hard-to-borrow list will not satisfy the reasonable grounds requirement of Regulation SHO. The Release further notes that a broker-dealer may rely on a customer's assurance that the customer received a locate from another identified source (e.g., a prime broker), provided the broker-dealer: (i) documents the source of the locate cited by the customer and (ii) is able to demonstrate that prior assurances from such a customer resulted in timely deliveries to settle the customer's transactions.
There are several exceptions to the locate requirement. Consistent with the current SRO rules, Regulation SHO includes an exception for short sales by market makers in connection with bona-fide market making activities. The SEC provides guidance in the Release on trading activity that it believes does not constitute bona-fide market making, to include speculative selling strategies that are disproportionate to the broker-dealer's usual market making patterns or practices; activity whereby the market maker posts continually at or near the best offer but not also at or near the best bid; and arrangements between a market maker and a customer to use the market maker's exception to avoid compliance with the locate requirement.
Regulation SHO also includes an exception from the locate requirement in which a broker-dealer effects a sale on behalf of a customer who owns a security that is not reasonably expected to be available for delivery on settlement date. This could include sales of formerly restricted stock that may not be deliverable on settlement date due to processing to remove the restricted legend or when a convertible security, option, or warrant has been tendered for conversion or exchange. Delivery should be made 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 must either borrow securities or close out the open position by purchasing securities of like kind and quantity.
The SEC did not incorporate into Regulation SHO the current exception in NASD Rule 3370 for short sales that result in bona-fide hedged or arbitraged positions, nor did it include an exception for transactions in exchange-traded funds. Instead of granting blanket exceptions for such activities, interested parties will need to petition the Division of Market Regulation for specific exemptive relief.
This week's Learning Curve was written by David Katz, partner, and Kevin Campion, associate, at Sidley Austin Brown & Wood.
