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Requirements For Short Sales In Threshold Securities - Part II

Last week's article gave a general introduction into Regulation SHO and looked at a pilot program suspending a price test for specified securities and the uniform locate requirement.

Last week's article gave a general introduction into Regulation SHO and looked at a pilot program suspending a price test for specified securities and the uniform locate requirement.

Rule 203 of Regulation SHO includes additional requirements targeted at designated threshold securities that have substantial settlement failures, (i.e., equity securities of reporting companies with aggregate fails of 10,000 shares or more that are also equal to at least 0.5% of the issuer's total shares outstanding). A list of such threshold securities will be calculated and disseminated daily by the SRO on which the security is listed or for which the SRO bears primary surveillance responsibility. The Securities and Exchange Commission estimates in the Release that approximately 4% of all equity securities will meet this threshold.

Rule 203(b)(3) requires a participant of a registered clearing agency (e.g., generally clearing brokers) to close out any fail to deliver position in a threshold security (whether caused by a long or short sale) that has remained for 13 consecutive settlement days, namely by purchasing securities of like kind and quantity. In order to be deemed to have met such a close-out requirement, the rule requires the participant must not know or have reason to know the counterparty from whom the participant purchases securities will not deliver the securities, i.e., a participant may not enter into an arrangement with a counterparty to evade the rule by simply transferring the fail position to that party. The rule also includes self-executing restrictions that are triggered if the participant does not take action to close out the open fail to deliver position. Specifically, Rule 203(b)(3)(iii) states any such participant, and any broker-dealer for which it clears transactions (including any market maker), shall be prohibited from effecting further short sales in the particular threshold security without first borrowing or arranging to borrow the security (as opposed to only obtaining a locate). If a participant is able to identify the specific account(s) for which it clears that contributed to the fail to deliver position, the pre-borrow restriction should only apply to such account(s). Rule 203(b)(3) appears to override the ability of a broker-dealer, pursuant to Rule 15c3-3(n) under the Exchange Act, to seek an extension from its designated examining authority from the requirement of 15c3-3(m) to close out a customer long sale in which the customer has not delivered the securities sold within at least 13 consecutive settlement days.

While the SEC chose to provide an exception from the locate requirement for short sales effected in connection with bona-fide market making, it did not provide a similar exception from the close-out requirement for threshold securities. The rule makes clear, however, the close-out requirement of Rule 203(b)(3) does not apply to fail to deliver positions established prior to the particular security becoming a threshold security (i.e., it only applies to new fail to deliver positions that remain for 13 consecutive settlement days). In addition, the rule specifies the close-out requirement does not apply to any fail to deliver position that is attributable to an options market maker, to the extent such options market maker is effecting short sales to establish or maintain a hedge on options positions that were created before the security became a threshold security.  

Delivery Requirements For Long Sales

New Rule 203(a) of Regulation SHO largely incorporates the provisions of former Rule 10a-2 under the Exchange Act and extends these requirements to all equity securities, as opposed to only exchange-listed securities. As adopted, the rule prohibits a broker-dealer from failing to deliver, or lending securities to prevent a fail to deliver, on a sale that is marked long. This restriction does not apply in several circumstances, including when the broker-dealer knows or has been reasonably informed the seller owns the security and will deliver the security prior to settlement, but such delivery does not occur. The Release emphasizes, however, it may be unreasonable for a broker-dealer to treat a sale as long when the same customer has repeatedly failed to deliver the security by settlement date.  

Rule 200--Ownership Definition & Aggregation; New Marking Requirements

Rule 200 of Regulation SHO replaces current Rule 3b-3 under the Exchange Act, with some modifications. In particular, the marking requirements of Rule 10a-1 (i.e., the requirement all sales be marked long, or short), have been moved into new Rule 200, extended to all equity securities and slightly altered. Specifically, new Rule 200(g) specifies an order can only be marked long when the seller owns the security being sold and the security either is in the physical possession or control of the broker-dealer or it is reasonably expected the security will be in the physical possession or control of the broker-dealer prior to settlement. This requirement is more stringent than the former language of Rule 10a-1(d) and will result in certain sales previously marked long to be treated as short sales. Rule 200(g) specifies short sales are subject to an exception from the tick or bid tests should be marked Short exempt, to include short sales of all Pilot securities.

Rule 200 also incorporates former Rule 3b-3's definition of a short sale, as well as the general standards for determining whether a seller is deemed to own a particular security. While this generally still necessitates aggregating a seller's positions in the security across all accounts, Rule 200 also codifies, with some modifications, a prior SEC no-action position allowing broker-dealers to aggregate their positions within defined trading units rather than on a firm-wide basis. As adopted, Rule 200(f) permits trading unit aggregation if a broker-dealer meets certain requirements that are generally designed to maintain the independence of the trading units and limit potential abuses caused by the units coordinating trading strategies. Although some commentators had advocated the concept of aggregation unit netting be expanded to include unregistered entities, such as hedge funds, the SEC declined to take this position.

Rule 105 Of Regulation M--Short Sales
In Connection With A Public Offering

The SEC published concurrently with Regulation SHO an amendment to Rule 105 of Regulation M, which generally prohibits the covering of short sales effected within a five-day period prior to pricing with offering securities purchased from an underwriter or broker-dealer participating in the offering. The amendment eliminates the current exception from the rule for shelf offerings, based on the SEC's belief that shelf offerings have become more commonplace and investors today have increased notice of a shelf offering before it occurs.

The Release also provides interpretive guidance concerning certain sham transactions the SEC believes may be structured to give the appearance that pre-pricing short sales are being covered with shares purchased in the open market, as opposed to shares received in the offering. The Release provides examples of what it would consider sham transactions, including covering short sales effected in the pre-pricing restricted period through a series of wash sales (i.e., by selling the offering shares received in the open market and contemporaneously purchasing an equivalent number of shares, which are then used to cover the short sales).

The elimination of the shelf exception became effective on Sept. 5 and the interpretive guidance became effective in August.  

This week's Learning Curve was written by David Katz, partner, and Kevin Campion, associate, at Sidley Austin Brown & Wood.

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