# Amendments to Regulation SHO

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URL: https://www.frixlaw.com/law-library/documents/fr%3AE7-15709

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** August 14, 2007
- **Citation:** 72 FR 45558

## Text

SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 242
[Release No. 34-56213; File No. S7-19-07]
RIN 3235-AJ57
Amendments to Regulation SHO

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is re-proposing amendments to Regulation SHO under the Securities Exchange Act of 1934 (“Exchange Act”). The proposed amendments are intended to further reduce the number of persistent fails to deliver in certain equity securities by eliminating the options market maker exception. In addition, we are requesting comment regarding specific alternatives to our proposal to eliminate the options market maker exception.

We are also proposing an amendment to the long sale marking provisions of Regulation SHO that would require that brokers and dealers marking a sale as “long” document the present location of the securities being sold.

DATES:

Comments should be received on or before September 13, 2007.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's Internet comment form (
http://www.sec.gov/rules/proposed.shtml
); or

• Send an e-mail to
rule-comments@sec.gov
. Please include File Number S7-19-07 on the subject line; or

• Use the Federal eRulemaking Portal (
http://www.regulations.gov
). Follow the instructions for submitting comments.

Paper Comments

• Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549.

All submissions should refer to File Number S7-19-07. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (
http://www.sec.gov/rules/proposed.shtml
). Comments are also available for public inspection and copying in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

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:

The Commission is requesting public comment on proposed amendments to 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 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 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 might not have agreed, or that might have been priced differently. Moreover, sellers that fail to deliver securities on 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 are designed to improperly depress the price of a security.

1
17 CFR 242.200.
See also
Securities 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
.

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 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
Securities Exchange Act Release No. 54154 (July 14, 2006), 71 FR 41710 (July 21, 2006) (“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. and Thomas Badian,
Lit. Rel. No. 18003 (Feb. 27, 2003);
see also, SEC
v.
Rhino Advisors, Inc. and Thomas Badian,
Civ. Action No. 03 civ 1310 (RO) (S.D.N.Y).
See also,
Securities 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 a threshold list (as defined
infra
note 13) 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.

In addition, many issuers and investors continue to express concerns about extended fails to deliver in connection with “naked” short selling.
8

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, such 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 in the issuer's security.
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.
, letter from Patrick M. Byrne, Chairman and Chief Executive Officer, Overstock.com, Inc., dated Sept. 11, 2006 (“Overstock”); letter from Daniel Behrendt, Chief Financial Officer, and Douglas Klint, General Counsel, TASER International, dated Sept. 18, 2006 (“TASER”); letter from John Royce, dated April 30, 2007; letter from Michael Read, dated April 29, 2007; letter from Robert DeVivo, dated April 26, 2007; letter from Ahmed Akhtar, dated April 26, 2007.

9

See, e.g.
, letter from Mary Helburn, Executive Director, National Coalition Against Naked Shorting, dated Sept. 30, 2006 (“NCANS”); 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.
, letter from Congressman Tom Feeney—Florida, U.S. House of Representatives, dated Sept. 25, 2006 (“Feeney”) (expressing concern about the impact of 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); 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
Securities Exchange Act Release No. 47978 (June 4, 2003), 68 FR 35037 (June 11, 2003).

12

See also
2006 Proposing Release, 71 FR at 41712 (discussing the impact of large and persistent fails to deliver on the market).
See also
2003 Proposing Release, 68 FR at 62975 (discussing the impact of “naked” short selling on the market).

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

The second was the “options market maker exception,” which excepted any fail to deliver in a threshold security 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) as any equity security of an issuer that is registered pursuant to section 12 of the Exchange Act (15 U.S.C. 78
l
) 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)): (i) 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 (ii) that 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

See
Adopting Release, 69 FR at 48031. The “grandfathered” status applied in two situations: (i) to fail to deliver positions occurring before January 3, 2005, Regulation SHO's effective date; and (ii) to fail to deliver positions that were established on or after January 3, 2005 but prior to the security appearing on a threshold securities list.

15

See
Adopting Release, 69 FR at 48031.

At the time of Regulation SHO's adoption, the Commission stated that it would monitor the operation of Regulation SHO to determine whether grandfathered fail to deliver positions were being cleared up under the existing delivery and settlement guidelines 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 id.
at 48018.

17

See id.
at 48019.

Based, in part, on the results of examinations conducted by the Commission's staff and the SROs since Regulation SHO's adoption, as well as the persistence of certain securities on threshold securities lists, on July 14, 2006, the Commission published proposed amendments to Regulation SHO,
18

which were intended to reduce the number of persistent fails to deliver in certain equity securities by eliminating the grandfather provision and narrowing the options market maker exception contained in that rule. In addition, in March 2007, the Commission re-opened the comment period to the 2006 Proposing Release for thirty days to provide the public with an opportunity to comment on a summary of the National Association of Securities Dealers, Inc.'s (“NASD's”) analysis that the NASD had submitted to the public file on March 12, 2007. In addition, the notice regarding the re-opening of the comment period directed the public's attention to summaries of data collected by the Commission's Office of Compliance Inspections and Examinations and the New York Stock Exchange LLC (“NYSE”).
19

18

See
2006 Proposing Release, 71 FR 41719.

19
In formulating its proposal to eliminate the grandfather provision and narrow the options market maker exception of Regulation SHO, the Commission relied in part on data collected by the NASD. In response to commenters' concerns regarding the public availability of data relied on by the Commission, we re-opened the comment period to the 2006 Proposing Release for thirty days to provide the public with an opportunity to comment on a summary of the NASD's analysis that the NASD had submitted to the public file on March 12, 2007.
See
Securities Exchange Act Release No. 55520 (March 26, 2007), 72 FR 15079 (March 30, 2007) (“Regulation SHO Re-Opening Release”).

On June 13, 2007, in a companion rule to this proposal, after careful consideration of public comments, we approved the adoption of the amendment, as proposed, to eliminate the grandfather provision of Regulation

SHO.
20

With respect to the options market maker exception, however, in response to comments to the 2006 Proposing Release, we are re-proposing amendments to the current options market maker exception that would eliminate the exception.

20

See
Securities Exchange Act Release No. 56212 (Aug. 7, 2007).

We are concerned that persistent fails to deliver will continue in certain equity securities unless the options market maker exception is eliminated entirely. Thus, as discussed more fully below, our proposal would modify Rule 203(b)(3) by eliminating the exception. In addition, we are requesting comment regarding 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 are also proposing an amendment to the long sale marking provisions of Rule 200(g)(1) of Regulation SHO that would require that brokers and dealers marking a sale as “long” document the present location of the securities.

II. Background

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 participants of a registered clearing agency with fails to deliver in these securities.
21

As discussed above, 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.

Thus, Rule 203(b)(3)'s close-out requirement requires a participant of a clearing agency registered with the Commission
22

to take immediate action to close out a fail to deliver position in a threshold security in the Continuous Net Settlement (“CNS”)
23

system that has persisted for 13 consecutive settlement days by purchasing securities of like kind and quantity.
24

In addition, if the failure to deliver has persisted for 13 consecutive settlement days, Rule 203(b)(3)(iv) 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.
25

21

See
Adopting Release, 69 FR at 48009.

22
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.

23
The majority of equity trades in the United States are cleared and settled through systems administered by clearing agencies registered with the Commission. The National Securities Clearing Corporation (“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.

24
17 CFR 242.203(b)(3).

25

Id.
at (b)(3)(iv). It is possible under Regulation SHO that a close out by a participant of a registered clearing agency may result in a fail 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, or a broker-dealer for which it clears transactions, from engaging in “sham close outs” by entering into an arrangement with a counterparty to purchase securities for purposes of closing out a fail to deliver position and the purchaser knows or has reason to know that the counterparty will not deliver the securities, and which thus creates another fail to deliver position.
See id.
at (b)(3)(vii); Adopting Release, 69 FR at 48018 n.96. In addition, we note that borrowing securities, or otherwise entering into an arrangement 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.

B. Regulation SHO's Options Market Maker Exception

1. Current Options Market Maker Exception

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.
26

The options market maker exception was created to address concerns regarding liquidity and the pricing of options.
27

The exception does not require that such fails to deliver be closed out.

26
17 CFR 242.203(b)(3)(iii).

27
In response to the proposal to adopt Regulation SHO and the Commission's determination at that time not to provide an exception for market makers, including options market makers, from the delivery requirements of proposed Regulation SHO, the Commission received letters that stated that the effect of not including such an exception would be to cease altogether options trading in securities that are difficult to borrow, as it was argued that no options market makers would make markets without the ability to hedge by selling short the underlying security. In addition, one commenter stated that the heightened delivery requirements of proposed Regulation SHO for threshold securities could drain liquidity in other securities where there is no current indication of significant settlement failures. The commenter believed that, while a blanket exception would be preferable, at a minimum the implementation of any such provision should not apply to market maker positions acquired prior to the effective date of the rule, and likewise should not apply to any short position acquired prior to the time that the subject security meets the designated threshold. See Adopting Release, 69 FR at 48019 (discussing the comment letters received in response to the delivery requirements of proposed Regulation SHO). In part, in response to these comments, we adopted a limited options market maker exception to the close-out requirement of Regulation SHO. As discussed in more detail in this release and, in particular, in Section II.B.3. below, we no longer believe that the current options market maker exception is necessary.

Since Regulation SHO's effective date in January, 2005, the 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.
28

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.

28
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
note 7.

Based on the examinations and our discussions with the SROs and market participants, we believe that these persistent fail to deliver positions may be attributable, in part, to reliance on the options market maker exception.
29

Accordingly, on July 14, 2006, the Commission published the 2006 Proposing Release that included proposed amendments to limit the duration of the options market maker exception.
30

29
As noted in the 2006 Proposing Release and the Regulation SHO Re-Opening Release, we believe that the persistent fails to deliver may be attributable primarily to the grandfather provision and, secondarily, to reliance on the options market maker exception.
See
2006 Proposing Release, 71 FR at 41712; Regulation SHO Re-Opening Release, 72 FR at 15079 (providing a summary of data received from certain SROs regarding reasons for the extended fails to deliver).

30

See
2006 Proposing Release, 71 FR at 41722.

The Commission, in the 2006 Proposing Release, proposed that for securities that are threshold securities on the effective date of the amendment, any previously excepted fail to deliver position in the threshold security that resulted from short sales effected by a registered options market maker to establish or maintain a hedge on an options position that existed before the security became a threshold security, but that has expired or been liquidated on or before the effective date of the amendment, would be required to be closed out within 35 consecutive settlement days of the effective date of the amendment. In addition, if the fail to deliver position persisted for 35 consecutive settlement days, the proposal would have prohibited 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 closed out the entire fail to deliver position by purchasing securities of like kind and quantity.

If the security became a threshold security after the effective date of the amendment, all fail to deliver positions in the security that result or resulted from short sales effected by a registered options market maker to establish or maintain a hedge on an options position that existed before the security became a threshold security would have to be closed out within 13 consecutive settlement days of the security becoming a threshold security or of the expiration or liquidation of the options position, whichever was later. In addition, if the fail to deliver position persisted for 13 consecutive settlement days from the date on which the security became a threshold security or the options position had expired or was liquidated, whichever was later, the proposal would have prohibited 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 closed out the entire fail to deliver position by purchasing securities of like kind and quantity.

Thus, under the 2006 Proposing Release, registered options market makers would still have been able to continue to keep open fail to deliver positions in threshold securities that resulted from short sales to hedge an options position created prior to the time the underlying security became a threshold security, provided the options position had not expired or been liquidated. Once the underlying security became a threshold security and the specific options position being hedged had expired or been liquidated, however, such fails to deliver would have been subject to a 13 consecutive settlement day close-out requirement.

2. Comments to the 2006 Proposing Release

We received a number of comment letters on the proposed narrowing of the options market maker exception from a variety of entities including options market makers, SROs, associations, issuers, an academic, and individual retail investors.
31

31

See
,
e.g.
, letter from Overstock,
supra
note 8; letter from NCANS,
supra
note 9; letter from Joseph P. Borg, Esq., President, North American Securities Administrators Association, Inc., dated Oct. 4, 2006 (“NASAA”); letter from TASER,
supra
note 8; letter from James J. Angel, PhD, CFA, dated July 18, 2006 (“Angel”); letter from Margaret Wiermanski, Chief Operations Officer and Matthew Abraham, Compliance Officer, CTC LLC, dated Sept. 28, 2006 (“CTC LLC”); letter from Timothy D. Lobach, Keystone Trading Partners, dated Sept. 19, 2006 (“Keystone”); letter from Steve Keltz, General Counsel, Citigroup Derivatives Markets, Inc., dated Sept. 29, 2006 (“Citigroup”); letter from Robert Bellick, Managing Director, Chris Gust, Managing Director, and Megan Flaherty, Director of Compliance and Chief Legal Counsel, Wolverine Trading LLC, dated Sept. 25, 2006 (“Wolverine”); letter from Edward J. Joyce, President and Chief Operating Officer, Chicago Board Options Exchange, dated October 11, 2006 (“CBOE”); letter from The American Stock Exchange, Boston Options Exchange, Chicago Board Options Exchange, International Securities Exchange, NYSE/Arca, The Options Clearing Corporation, Philadelphia Stock Exchange, dated Sept. 22, 2006 (“Options Exchanges”); letter from Ira D. Hammerman, Senior Vice President and General Counsel, Securities Industry Association, dated Sept. 19, 2006 (“SIA”); letter from Keith F. Higgins, Chair, Committee on Federal Regulation of Securities, American Bar Association Section of Business Law, dated Sept. 27, 2006 (“ABA”); letter from Gerard S. Citera, Executive Director, U.S. Equities, UBS Securities LLC, dated Sept. 22, 2006 (“UBS”).

Several commenters supported the proposal to narrow the options market maker exception. For example, one commenter stated that 13 consecutive settlement days was more than a sufficient amount of time in which to close out a fail to deliver position relating to an options position.
32

Another commenter stated that it believes the current “exemption can be exploited to manipulate prices downward by manipulators buying large numbers of put options in already heavily-shorted securities.”
33

Some of these commenters recommended that the Commission eliminate the options market maker exception altogether,
34

or, reduce the close-out requirement to five consecutive settlement days.
35

In addition, commenters that supported the proposal to narrow the options market maker exception also urged the Commission to enhance the documentation requirements for establishing eligibility for the exception.
36

32

See
letter from Overstock,
supra
note 8.

33

See
letter from NCANS,
supra
note 9.

34

See
,
e.g.
,
id.

35

See
letter from NASAA,
supra
note 31.

36

See
,
e.g.
,
id.
; TASER,
supra
note 8.

Commenters who opposed the proposal to narrow the options market maker exception stated that the proposed amendments would disrupt the markets because they would not provide sufficient flexibility to permit efficient hedging by options market makers, would unnecessarily increase risks and costs to hedge, and would adversely impact liquidity and result in higher costs to customers.
37

These commenters stated that they believe the proposed amendments would likely

discourage options market makers from making markets in illiquid securities since the risk associated in maintaining the hedges in these option positions would be too great.
38

Moreover, these commenters claimed that the reluctance of options market makers to make markets in threshold securities would result in wider spreads in such securities to account for the increased costs of hedging, to the detriment of investors.
39

37

See
,
e.g.
, letter from CBOE,
supra
note 31.

38

See

id.

39

See
letter from Citigroup,
supra
note 31.

Many of the commenters who opposed the proposal to narrow the options market maker exception argued that the requirement that fail to deliver positions be closed out upon liquidation or expiration of a specifically hedged options position was impracticable, given that the industry practice is to use hedges to manage risk of an entire inventory, not just a specific options position.
40

These commenters noted that options market makers typically facilitate an investor's rolling of an existing options position to either a different strike price within the same expiration month or to a future month as expiration approaches, and retain the short position to hedge the new options position.
41

These commenters argued that the amendment would require the options market maker to buy in the short position and/or pre-borrow to maintain a hedge, even though the overall position may have changed very little from a risk perspective, which, they argued, could potentially be a costly and time consuming measure.
42

40
For example, CBOE stated that options market makers hedge on a class basis and, therefore, as options positions are rolled to forward months, the options market maker may need to maintain the hedge. Thus, the stock position would need to be maintained not because it hedges a particular series, but because it maintains a delta of an overall position.
See
letter from CBOE,
supra
note 31.
See
,
also
, letters from CTC LLC,
supra
note 31; Citigroup,
supra
note 31; Wolverine,
supra
note 31.

41

See
,
e.g.
, letters from Citigroup,
supra
note 31; Wolverine,
supra
note 31; Options Exchanges,
supra
note 31.

42

See
,
e.g.
, letters from Wolverine,
supra
note 31; Citigroup,
supra
note 31.

Commenters who opposed the proposed amendments to the options market maker exception favored maintaining the current exception, which they believe is already narrowly tailored.
43

For example, one commenter stated that it believes the current exception preserves the integrity of legitimate hedging practices and prevents manipulative short squeezes.
44

Another commenter stated that the current exception enables it to better service market participants by allowing it to continuously quote and disseminate bids and offers even where it may be difficult to borrow certain stock.
45

Another commenter stated that it is unaware of any statistics establishing that fails to deliver attributable to legitimate options market making activity are correlated to abusive short selling practices, and cautioned that “the possible detrimental effects on options markets in threshold securities should first be quantified to guard against an unanticipated, significant peril to another facet of the capital markets.”
46

43

See

id.

44

See
letter from Keystone,
supra
note 31.

45

See
letter from Citigroup,
supra
note 31.

46

See
letter from CTC LLC,
supra
note 31. Statistical evidence of options market maker failing practices can be found in
Failure is an Option: Impediments to Short Selling and Options Prices
by Evans, Geczy, Musto, and Reed, forthcoming in the
Review of Financial Studies.

See

http://finance.wharton.upenn.edu/~musto/papers/egmr.pdf.

3. Response to Comments to the 2006 Proposing Release

We proposed to narrow the options market maker exception in Regulation SHO because we are concerned about large and persistent fails to deliver in threshold securities attributable, in part, to the options market maker exception, and our concerns that such fails to deliver might have a negative effect on the market in these securities.
47

47

See
2006 Proposing Release, 71 FR at 41711-41712;
see also
, Regulation SHO Re-Opening Release, 72 FR 15079-15080.
See also
, discussion above in Section I. Introduction.

Regulation SHO's options market maker exception does not require fails to deliver to be closed out if they resulted from short sales effected by registered options market makers to establish or maintain a hedge on options positions established before the underlying security became a threshold security. For the reasons discussed below, although we recognize commenters' concerns that a mandatory close-out requirement for fails to deliver in threshold securities underlying options positions could potentially impact options market makers' willingness to provide liquidity in threshold securities, make it more costly for options market makers to accommodate customer buy orders, or result in wider bid-ask spreads or less depth, we believe that such an impact, if any, would be minimal.

First, we believe that the potential effects, if any, of a mandatory close-out requirement would be minimal because the number of securities that would be impacted by a mandatory close-out requirement would 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).
48

Requiring close-out only for securities with large and persistent fails to deliver limits the overall market impact. In addition, as noted by one commenter, a small number of securities that meet the definition of a “threshold security” have listed options, and those securities form a very small percentage of all securities that have options traded on them.
49

Moreover, the current options market maker exception only excepts from Regulation SHO's mandatory 13 consecutive settlement day close-out requirement those fail to deliver positions that result from short sales effected by registered options market makers to establish or maintain a hedge on options positions established
before
the underlying security became a threshold security. Thus, it does not apply to fails to deliver resulting from short sales effected to establish or maintain a hedge on options positions established
after
the underlying security became a threshold security. Because the current options market maker exception has a very limited application, the overall impact of its removal on liquidity, hedging costs, spreads, and depth, should be relatively small.

48

See

supra
note 7 (discussing the number of threshold securities as of March 31, 2007).

49

See
letter from Options Exchanges,
supra
note 31 (noting that as of the date of the 2006 Proposing Release, approximately 84 of the approximately 300 threshold securities had options traded on them). This commenter also noted that “options on a number of these threshold securities are very actively traded as are the securities themselves. Among the actively traded threshold securities with active options trading are iShares Russell 2000 ETF, Avanir Pharmaceuticals, Krispy Kreme Donuts, Martha Stewart Living Omnimedia, Mittal Steel, Navarre Corp., and Novastar Financial.”
See id.

Second, to the extent that a mandatory close-out requirement could potentially impact options market makers' willingness to provide liquidity in threshold securities, make it more costly for options market makers to accommodate customer buy orders, or result in wider bid-ask spreads or less depth, we believe that any such potential effects would likely be mitigated by the fact that even though fails to deliver that were previously-excepted from the close-out requirement of Regulation SHO would not be permitted to continue indefinitely, such fails to deliver would not have to be closed out immediately, or even within the standard 3-day settlement period. Instead, under a mandatory close-out requirement, such as that imposed

currently by the 13 consecutive settlement day requirement of Rule 203(b)(3) of Regulation SHO, fails to deliver in threshold securities would have an extended period of time within which to be closed out. An extended close-out requirement would provide options market makers with some flexibility in conducting their hedging activities in that it would allow them to not buy-in a fail to deliver position or pre-borrow to maintain a hedge for the time that the fail to deliver position can remain open.

Third, as noted above, Regulation SHO's current options market maker exception is limited to only those fail to deliver positions that result from short sales effected by registered options market makers to establish or maintain a hedge on options positions established
before
the underlying security became a threshold security. Thus, it does not apply to fails to deliver resulting from short sales effected to establish or maintain a hedge on options positions established
after
the underlying security became a threshold security. In examining the application of the current mandatory close-out requirement of Regulation SHO for all non-excepted fail to deliver positions, we have not become aware of any evidence that the current close-out requirement for non-excepted fails to deliver in threshold securities has impacted options market makers' willingness to provide liquidity in threshold securities, made it more costly for options market makers to accommodate customer orders, or resulted in wider bid-ask spreads or less depth.

Similarly, all fails to deliver in threshold securities resulting from long or short sales of securities in the equities markets must be closed out in accordance with Regulation SHO's mandatory 13 consecutive settlement day close-out requirement, and we are not aware that such a requirement has impacted the willingness of market makers to make markets in securities subject to the close-out requirement, or led to decreased liquidity, wider spreads, or less depth in these securities. Thus, we believe that the impact of requiring that fails to deliver in threshold securities resulting from short sales to hedge options positions created before the security became a threshold security be closed out would similarly be minimal, if any.

Fourth, to the extent that a mandatory close-out requirement for all fails to deliver resulting from hedging activity in the options markets could potentially impact liquidity, hedging costs, depth, or spreads, or impact the willingness of options market makers to make markets in certain securities, we believe that such effects are justified by our belief, as discussed in more detail below, that fails to deliver resulting from hedging activities by options market makers should be treated similarly to fails to deliver resulting from sales in the equities markets so that market participants trading threshold securities in the options markets do not receive an advantage over those trading such securities in the equities markets.

Fifth, to the extent that a mandatory close-out requirement for all fails to deliver resulting from hedging activity in the options markets could potentially impact liquidity, hedging costs, depth, or spreads, or impact the willingness of options market makers to make a market in certain securities, 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.

In the 2006 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 “naked” short selling causing a drop in an issuer's stock price and that it may limit an issuer's ability to access the capital markets.
50

We believe that, by requiring that all fails to deliver in threshold securities be closed out within specific time-frames rather than allowing them to continue indefinitely, there would 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 proposed amendments should improve investor confidence about the security. We also believe that the proposed amendments should lead to greater certainty in the settlement of securities which should strengthen investor confidence in the settlement process. The reduction in fails to deliver and the resulting reduction in the number of securities on the threshold securities lists could result in increased investor confidence, and the promotion of price efficiency and capital formation.

50

See, e.g.
, letter from Feeney,
supra
note 10.

Due to our concerns about the potentially negative market impact of large and persistent fails to deliver, and the fact that we continue to observe a small number of threshold securities with fail to deliver positions that are not being closed out under existing delivery and settlement requirements, we adopted amendments to eliminate Regulation SHO's grandfather provision that allowed fails to deliver resulting from long or short sales of equity securities to persist indefinitely if the fails to deliver occurred prior to the security becoming a threshold security.
51

We believe that once a security becomes a threshold security, fails to deliver in that security must be closed out, regardless of whether or not the fails to deliver resulted from sales of the security in connection with the options or equities markets.

51

See
Securities Exchange Act Release No. 56212 (Aug. 7, 2007);
see also
, 2006 Proposing Release, 71 FR at 41711-41712.

Moreover, we believe that fails to deliver resulting from hedging activities by options market makers should be treated similarly to fails to deliver resulting from sales in the equities markets so that market participants trading threshold securities in the options markets do not receive an advantage over those trading such securities in the equities markets. We are also concerned that the current options market maker exception might allow for a regulatory arbitrage not permitted in the equities markets. For example, an options market maker who sells short to hedge put options purchased by a market participant unable to locate shares for a short sale in accordance with Rule 203(b)(2) of Regulation SHO may not have to close out any fails to deliver that result from such short sales under the current options market maker exception. The ability of options market makers to sell short and never have to close out a resulting fail to deliver position, provided the short sale was effected to hedge options positions created before the security became a threshold security, runs counter to the goal of similar treatment for fails to deliver resulting from sales of securities in the options and equities markets, because

no such ability is available in the equity markets.
52

52

See
Securities Exchange Act Release No. 56212 (Aug. 7, 2007).

Although commenters who opposed the proposed amendments to the options market maker exception favored maintaining Regulation SHO's current options market maker exception, it has become apparent to us during the comment process that the language of the current exception is being interpreted more broadly than the Commission intended, such that the exception seems to be operating significantly differently from our original expectations.
53

Thus, we are concerned that options market makers are claiming the exception even where options positions are created
after
the underlying security becomes a threshold security. For example, options market makers' practice of “rolling” positions from one expiration month to the next potentially allows these options market makers to not close out fail to deliver positions as required by the close-out requirements of Regulation SHO. According to commenters, when the options that allow an options market maker to be exempt from the close-out requirement expire or are closed out, investors on the opposite side may roll their long put or short call positions to a new expiration month.
54

It appears that options market makers are not treating the rolling of options positions to a new expiration month as creating new options positions for purposes of the current options market maker exception even though the current options position typically is closed out and the same position is opened in the next expiration month.
55

53
The Commission noted in the Adopting Release that it would monitor the operation of Regulation SHO and, in so doing, would take into consideration any indications that the options market maker exception was operating significantly differently from the Commission's original expectations.
See
Adopting Release, 69 FR at 48018-48019.

54

See, e.g.
, letters from ABA,
supra
note 31; Wolverine,
supra
note 31.

55

See, e.g.
, letter from Wolverine,
supra
note 31.

Thus, options market makers providing liquidity to customers who are “rolling” positions from one expiration month to the next appear to use the original short sale to maintain the hedge on these new options positions, rather than closing out that original short sale and any fails to deliver that resulted from the short sale and establishing a new hedge. Regulation SHO's current options market maker exception provides that a fail to deliver position does not have to be closed out if it results from a short sale effected to establish or maintain a hedge on options positions created before the underlying security became a threshold security. Options market makers also may not be closing out fails to deliver that result from short sales effected to maintain or establish a hedge on options positions created
after
the underlying security became a threshold security. Such conduct would not be in compliance with the current options market maker exception and would allow options market makers to avoid improperly Regulation SHO's close-out requirement.
56

56
In addition, we are concerned that options market makers may not have systems in place to determine whether or not fails to deliver resulted from short sales effected to establish or maintain a hedge on options positions created before or after the underlying security became a threshold security, and, therefore, may not be complying with the requirements of the current exception.

In addition, as a practical matter, we note that the cost of maintaining a fail to deliver position may change over time and, in particular, when a security becomes a threshold security. Thus, if options market makers, in accommodating their customers' rolling of options positions from one expiration month to the next, use the original short sale to maintain the hedge on these new options positions rather than closing out that short sale and any fails to deliver that resulted from the short sale and establishing a new hedge, any additional cost of maintaining a fail to deliver in the underlying security would not be properly transferred to the options positions.

Despite our concerns noted above regarding the application of Regulation SHO's current options market maker exception, we credit commenters' statements that the amendments proposed in 2006 to narrow the current options market maker exception would be costly and difficult to implement, or even possibly unworkable, because they do not reflect how options market makers hedge their options positions. According to commenters, options market makers usually hedge their options positions on a portfolio basis.
57

Thus, an options market maker typically does not assign a particular short or long position to a particular options position as would be required if the Commission were to adopt the 2006 amendments, as proposed. Only one commenter asked that the Commission be sensitive to the time necessary to make systems changes to track the requirements of the proposed amendments.
58

Most commenters simply stated that the amendments proposed in 2006 would be difficult and costly to implement or possibly unworkable.

57

See, e.g.
, letters from CBOE,
supra
note 31; Options Exchanges,
supra
note 31; Wolverine,
supra
note 31; UBS,
supra
note 31; Angel,
supra
note 31.

58

See
letter from UBS,
supra
note 31.

Based on commenters' concerns that they would be unable to comply with the amendments to the options market maker exception as proposed in the 2006 Proposing Release, and statements indicating that options market makers might be violating the current exception, we have determined to re-propose amendments to the options market maker exception.

III. Proposed Amendments to the Options Market Maker Exception

A. Elimination of the Options Market Maker Exception

We propose to eliminate the options market maker exception in Rule 203(b)(3) of Regulation SHO. In particular, the proposed amendment would require that any previously excepted fail to deliver position in a threshold security on the effective date of the amendment, including any adjustments to that fail to deliver position, be closed out within 35 consecutive settlement days
59

of the effective date of the amendment. This 35 consecutive settlement day requirement would be a one-time phase-in period. Thus, after 35 consecutive settlement days from the effective date of the amendment this phase-in period would expire and any additional fails to deliver in the threshold security would be subject to the current mandatory 13 consecutive settlement day close-out requirement of Rule 203(b)(3) of Regulation SHO.
60

59
If the security is a threshold security on the effective date of the amendment, participants of a registered clearing agency would have to close out that position within 35 consecutive settlement days, regardless of whether the security becomes a non-threshold security after the effective date of the amendment.

We chose 35 settlement days because 35 days was used in Regulation SHO as adopted in August 2004, and in Regulation SHO, as amended.
See
Adopting Release, 69 FR at 48031; Securities Exchange Act Release No. 56212 (Aug. 7, 2007). In addition, we believe that 35 settlement days would allow participants time to close out their previously-excepted fail to deliver positions given that some participants may have large previously-excepted fails with respect to a number of securities.

60
For example, assume that on the effective date of the amendment XYZ security is a threshold security and a participant of a registered clearing agency has fails to deliver in XYZ security that resulted from short sales by a registered options market maker to hedge options positions that were created before XYZ security became a threshold security. The participant must close out the fails to deliver in XYZ security within 35 consecutive settlement days of the effective date of the amendment, including any additional fails to deliver during that 35-day period that result from short sales by the registered options market maker to hedge options positions that were created before XYZ security became a threshold security. After the

35-day period has expired, if XYZ security remains a threshold security, any additional fails to deliver in XYZ security must be closed out in accordance with Regulation SHO's 13 consecutive settlement day close-out requirement, regardless of whether or not the fails to deliver resulted from short sales by a registered options market maker to hedge options positions that were created before XYZ security became a threshold security.

In addition, similar to the pre-borrow requirement of Rule 203(b)(3)(iv) of Regulation SHO, if the fail to deliver position persists for 35 consecutive settlement days from the effective date of the amendment, the proposed amendment 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. Any fails to deliver that were not previously-excepted from the close-out requirement of Rule 203(b)(3) of Regulation SHO as of the effective date of the amendment and, therefore, not subject to the one-time 35 consecutive settlement day phase-in period, would be subject to the pre-borrow requirement of Rule 203(b)(3)(iv) of Regulation SHO.

If a security becomes a threshold security after the effective date of the amendment, any fails to deliver that result or resulted from short sales effected by a registered options market maker to establish or maintain a hedge on options positions that were created before the security became 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.

For the reasons discussed above and in the 2006 Proposing Release, we believe that no fail to deliver position should be left open indefinitely. Although we included in Rule 203 of Regulation SHO exceptions to the close-out requirement of the rule, we also stated that we would pay close attention to the operation and efficacy of the provisions adopted in Rule 203, and would consider whether any further action was warranted.
61

As discussed above, we continue to see a small number of threshold securities with large and persistent fails to deliver that are not being closed out under existing delivery and settlement requirements. We are concerned that these fails to deliver may have a potentially negative impact on the market for these securities by impeding the orderly functioning of the markets for these securities, depriving investors of ownership rights, undermining investor and issuer confidence in the markets, and being indicative of potentially manipulative trading activities. In addition, a seller that fails to deliver securities on trade settlement date effectively unilaterally converts a securities contract (that should settle within the standard 3-day settlement period) into an undated futures-type contract, to which the buyer might not have agreed, or that might have been priced differently.

61

See
Adopting Release, 69 FR at 48019.

Thus, by proposing to eliminate the current options market maker exception of Regulation SHO so that all fails to deliver in threshold securities that result from short sales effected to maintain or establish a hedge on options positions would have to be closed out within Regulation SHO's current mandatory 13 consecutive settlement day close-out requirement similar to all other fails to deliver in threshold securities, we hope to reduce the number of threshold securities with large and persistent fails to deliver and, thereby, limit any potential negative impact of such fails to deliver on the market for these securities.

In addition, the overly-broad interpretation of the current options market maker exception, as discussed above, could be contributing to some securities with listed options having large and persistent fails to deliver and remaining on the threshold securities list. Thus, we further believe it would be appropriate to eliminate the current exception.

By proposing to eliminate the current options market maker exception, fails to deliver from hedging activities by options market makers would be treated similarly to fails to deliver resulting from sales in the equities markets so that market participants trading threshold securities in the options market would not receive an advantage over those trading such securities in the equities markets.

In addition, we believe the proposed amendment would be warranted because it strikes the appropriate balance between reducing large and persistent fails to deliver in threshold securities while still allowing participants some flexibility in conducting their hedging activities. Under the proposed amendment, other than those previously-excepted fails to deliver that would be subject to the one-time 35-day phase-in period, all fails to deliver in threshold securities would be subject to the current mandatory 13 consecutive settlement day close-out requirement of Rule 203(b)(3) of Regulation SHO. Thus, the proposed amendment would provide flexibility because it would allow an extended period of time (
i.e.
, 13 consecutive settlement days) within which to close out all fails to deliver in threshold securities, rather than, for example, requiring that such fails to deliver be closed out immediately, or even within the standard 3-day settlement period. During the period of time that the fail to deliver position could remain open, options market makers would be able to continue any hedging activity without having to close out the fail to deliver position or pre-borrow to maintain the hedge.

In addition, we note that the one-time 35 consecutive settlement day phase-in period would help reduce any potential for market disruption, such as increased volatility or short squeezes, from having to close-out previously-excepted fail to deliver positions particularly as participants would be able to begin to close out such positions at anytime before the 35-day phase-in period.

Request for Comment

The Commission seeks comment generally on all aspects of this proposed amendment to Regulation SHO. In addition, we seek comment on the following:

• The proposed amendment to eliminate the options market maker exception would require that fails to deliver that result from short sales effected to maintain or establish a hedge on options positions be closed out within Regulation SHO's current mandatory 13 consecutive settlement day close-out requirement similar to other fails to deliver in any threshold security. We believe that fails to deliver in threshold securities should not last indefinitely. Thus, we proposed and adopted amendments to eliminate the grandfather provision in Regulation SHO so that fails to deliver resulting from long or short sales in the equities markets must be closed out within 13 consecutive settlement days. Should fails to deliver that result from short sales effected to maintain or establish a hedge on options positions be treated differently from fails to deliver that result from short or long sales of threshold securities in the equities markets? If so, why? Should market makers in the options markets be permitted to maintain a fail to deliver position in a threshold security for an extended period of time or indefinitely when market makers in the equities markets are not able to do so? If so, why? If not, why not?

• The options market maker exception was created to provide options market makers with flexibility in establishing and maintaining hedges on options positions created before the underlying security became a threshold security. Would elimination of the options market maker exception be appropriate? If so, why? If not, why not? Would elimination of the options market maker exception result in fewer options on threshold securities and what effect would this have on market efficiency and capital formation? Would eliminating the exception reduce the willingness of options market makers to make markets in securities that might become threshold securities or that are threshold securities? Would eliminating the exception result in increased costs to investors? Would options investors bear any additional costs that are not borne by the equivalent equity investors? Would eliminating this exception reduce liquidity in securities that might become threshold securities or that are threshold securities? How significant would such an impact be, if any, given that fails to deliver would be subject to Regulation SHO's current 13 consecutive settlement days close-out requirement similar to all other fails to deliver in threshold securities and that we are not aware that compliance with the current mandatory close-out requirement of Regulation SHO for non-excepted fails to deliver has resulted in market disruption? What other measures or time-frames would be effective in fostering Regulation SHO's goal of reducing fails to deliver while at the same time allowing market making by options market makers?

• Based on current experience with Regulation SHO, what have been the costs and benefits of the current options market maker exception?

• What are the costs and benefits of the proposed amendment to eliminate the options market maker exception?

• What technical or operational challenges would options market makers face in complying with the proposed amendment?

• Would the proposed amendment create additional costs, such as costs associated with systems, surveillance, or recordkeeping modifications that may be needed for participants to track fails to deliver subject to the 35 consecutive settlement day phase-in period from fails to deliver that are not eligible for the phase-in period? If there are additional costs associated with tracking fails to deliver subject to the 35 versus 13 consecutive settlement day requirements, would these additional costs justify the benefits of providing firms with a 35 consecutive settlement day phase-in period? Would a 35 consecutive settlement day phase-in period be necessary given that firms would have been on notice that they would have to close out these fail to deliver positions following the effective date of the amendment?

• Should we consider changing the proposed phase-in period to 35 calendar days? If not, why not? If so, would this create systems problems or other costs? Would a phase-in period create examination or surveillance difficulties?

• Please provide specific comment as to what length of implementation period would be necessary such that participants would be able to meet the requirements that fail to deliver positions in threshold securities be closed out within the applicable time-frames, if adopted.

B. Alternatives To Eliminating the Options Market Maker Exception

As discussed above, due to the fact that large and persistent fails to deliver are not being closed out under existing delivery and settlement requirements and because we are concerned that these fails to deliver may have a negative impact on the market for those securities, we believe that the options market maker exception to the mandatory close-out requirement of Rule 203(b)(3) of Regulation SHO should be eliminated. In addition, we believe that the options market maker exception should be eliminated because we believe that fails to deliver resulting from hedging activities by options market makers should be treated similarly to fails to deliver resulting from sales in the equities markets so that market participants trading threshold securities in the options markets do not receive an advantage over those trading such securities in the equities market.

We anticipate, however, that in response to our request for comment on the proposed amendments to eliminate the options market maker exception, we will receive comment that an options market maker exception, similar to the current exception in Regulation SHO, is necessary. It has become apparent to us, however, that the current exception is being interpreted in such a way that the exception seems to be operating significantly differently from our original expectations, and that options market makers might be using the current exception to improperly avoid closing out certain fails to deliver in threshold securities. In addition, commenters stated that the proposed amendments to the options market maker exception set forth in the 2006 Proposing Release would be impractical given the industry practice of using hedges to manage the risk of an entire inventory, not just a specific options position.
62

Thus, in conjunction with our proposal to eliminate the options market maker exception, we have determined to solicit comment regarding two narrowly-tailored alternatives to the current options market maker exception and to our proposed elimination of that exception.

62

See, e.g.
, letters from CBOE,
supra
note 31; CTC LLC,
supra
note 31; Citigroup,
supra
note 31; Wolverine,
supra
note 31.

Because we are concerned that any exception to Regulation SHO's close-out requirement for fails to deliver resulting from short sales effected to establish or maintain a hedge on options positions might result in continued large and persistent fails to deliver in securities with options traded on them, the proposed alternatives would provide very limited exceptions to the close-out requirement of Regulation SHO so that all fails to deliver in threshold securities underlying options would eventually have to be closed out. Similar to elimination of the options market maker exception, by proposing to require that all fails to deliver be closed out within specific time-frames, the proposed alternatives should reduce large and persistent fails to deliver. The proposed alternatives, however, would provide participants of a registered clearing agency, or options market makers for which they clear transactions, longer periods of time than Regulation SHO's current mandatory 13 consecutive settlement day close-out requirement, within which to close out such fails to deliver.

Also, similar to the proposed amendment to eliminate the options market maker exception, by proposing to require that fails to deliver be closed out within specific time-frames, the proposed alternatives would be more likely to result in shareholders receiving the benefits of ownership than under the current options market maker exception. Sellers would also be less able to unilaterally convert securities contracts into undated futures-type contracts to which the buyer may not have agreed, or that would have been priced differently. In addition, the delivery requirements of the proposed alternatives could enhance investor confidence as they make investment decisions by providing investors with greater assurance that securities would be delivered as expected. An increase in investor confidence in the market could facilitate investment.

The proposed alternatives could benefit issuers because investors may be

more willing to commit capital where fails levels are lower. In addition, some issuers could believe that a reduction in fails to deliver could reverse unwarranted reputational damage potentially caused by large and persistent fails to deliver and what they believe might be an indication of manipulative trading activities, such as “naked” short selling.
63

Thus, the proposed requirement that all fails to deliver be closed out within specific time-frames, as proposed to be required by the alternatives, could decrease the possibility of artificial market influences and, therefore, could contribute to price efficiency.

63

See, e.g., supra
note 8 (citing to comment letters from issuers and investors discussing extended fails to deliver in connection with “naked” short selling).

Although the proposed alternatives could lessen the potential negative impact of large and persistent fails to deliver similar to the proposed elimination of the options market maker exception because the proposed alternatives would require that fails to deliver in threshold securities eventually be closed out, we believe that complete elimination of the options market maker exception would achieve this goal more effectively. Under the proposed elimination of the options market maker exception, all fails to deliver in threshold securities would have to be closed out within Regulation SHO's mandatory 13 consecutive settlement day close-out requirement. The proposed alternatives, however, would each allow a longer period of time for fail to deliver positions to be closed out. Specifically, the first alternative would allow certain fails to deliver to be closed out within 35 consecutive settlement days of the security becoming a threshold security. Under the second alternative, although some fails to deliver would be required to be closed out in less than 35 consecutive settlement days, other fails to deliver would not have be closed out until 35 consecutive settlement days from the security becoming a threshold security.

Similar to our discussions above in connection with our response to comments regarding the proposed amendment in the 2006 Proposing Release to limit the duration of the current options market maker exception and regarding the proposed amendment to eliminate the options market maker exception, we believe the mandatory close-out requirements of each of the proposed alternatives would similarly minimally impact, if at all, liquidity, hedging costs, spreads, or depth in the securities subject to the close-out requirements of the proposed alternatives, or the willingness of options market makers to make markets in such securities.

We believe that these potential effects of the close-out requirements of the proposed alternatives would be minimal, if any, because the number of securities that would be impacted by the close-requirements would be relatively small. The proposed alternatives would apply only to those threshold securities with listed options
64

and would only impact fails to deliver in those securities that resulted from short sales by registered options market makers to hedge options series that were created before, rather than after, the security became a threshold security because all other fails to deliver in threshold securities are subject to Regulation SHO's current mandatory 13 consecutive settlement day close-out requirement.

64

See
letter from Options Exchanges,
supra
note 49 (discussing the number of threshold securities with listed options).

In addition, the proposed alternatives would provide options market makers with flexibility in conducting their hedging activities because they would each allow an extended period of time (
i.e.
, 35 consecutive settlement days for purposes of proposed Alternative 1 and 13 or 35 consecutive settlement days for purposes of proposed Alternative 2) within which to close out all fails to deliver in threshold securities. As discussed above in connection with the proposed amendment to eliminate the options market maker exception, we believe that even a 13 consecutive settlement day close-out requirement would result in minimal impact on the willingness of options market makers to make markets, liquidity, hedging costs, depth, and spreads because it would allow options market makers flexibility in conducting their hedging activities by permitting fails to deliver to remain open for an extended period of time (
i.e.
, 13 consecutive settlement days) rather than, for example, requiring that such fails to deliver be closed out immediately, or even within the standard 3-day settlement period. During the period of time that the fail to deliver position can remain open, options market makers would be able to continue any hedging activity without having to close out the fail to deliver position or pre-borrow to maintain the hedge.

The extended close-out requirements of the proposed alternatives would expire, however, after 35 consecutive settlement days of the security becoming a threshold security. In each of the proposed alternatives, after the excepted period expires, any additional fails to deliver that result from short sales in the threshold security, whether or not effected to establish or maintain a hedge on options series in the portfolio that were created before the security became a threshold security, would have to be closed within Rule 203(b)(3)'s mandatory 13 consecutive settlement day close-out requirement.

The proposed alternatives are narrowly tailored in response to our concerns that options market makers are interpreting the current exception more broadly than the Commission intended and in response to comments that options market makers manage their risk based on an assessment of the entire portfolio rather than of a specific options position. Based on comments that portfolio hedging is the industry practice, the proposed alternatives refer to the hedging of options series in a portfolio rather than an options position. In addition, the proposed alternatives would permit options market makers to adjust their hedges on options series created before the underlying security became a threshold security provided any resulting fails to deliver are closed out within the applicable time-frames.

The proposed alternatives would also require that participants of a registered clearing agency and options market makers document that any fails to deliver in threshold securities that have not been closed out in accordance with the 13 consecutive settlement days close-out requirement of Rule 203(b)(3) of Regulation SHO are eligible for the options market maker exception.
65

The current exception does not set forth a specific documentation requirement, although some options market makers may in fact keep records that relate to their compliance with the exception. In the absence of such a requirement, we are concerned that many options market makers are not preparing or retaining records with regard to their eligibility for the exception. Without such a documentation requirement, it may be difficult for the Commission and SROs to monitor whether the options market maker exception is being applied consistently with the rule.

65
Commenters to the 2006 Proposing Release urged the Commission to add specific documentation requirements for establishing eligibility for the options market maker exception.
See, e.g.,
letters from NASAA,
supra
note 31; TASER, supra note 8.

Thus, to the extent we retain an options market maker exception, we believe it would be necessary to add a provision to Regulation SHO that would

require both options market makers and participants of a registered clearing agency that rely on the options market maker exception to not close out a fail to deliver position in accordance with the mandatory close-out requirement of Rule 203(b)(3) of Regulation SHO to obtain, prepare, and keep documentation demonstrating that a fail to deliver position has not been closed out because it qualified for the exception. Such documentation could indicate, among other things, when the series being hedged was created, when the underlying security became a threshold security, and the age of the fail to deliver position that is not being closed out.

A documentation requirement would enable the Commission and the SROs to monitor more effectively whether or not the options market maker exception is being applied correctly. In addition, the information would provide a record that would aid surveillance for compliance with this limited exception to Regulation SHO's close-out requirement.

The Alternatives

We are requesting comment regarding specific alternatives, as described below, to eliminating the options market maker exception. Each of the proposed alternatives would provide for a 35 consecutive settlement day phase-in period similar to the phase-in period discussed above for securities that are threshold securities on the effective date of the amendment and that have previously excepted fail to deliver positions.
66

In addition, as explained in more detail below, these alternatives would apply only to fails to deliver resulting from short sales effected by a registered options market maker to establish or maintain a hedge on any options series created before an underlying security became a threshold security. These alternatives would also require such fails to deliver to be closed out within specific time-frames so that the fails to deliver would not last indefinitely.

66
This 35 consecutive settlement day phase-in period would operate in the same manner as that outlined above in the discussion of the elimination of the options market maker exception.

i. Alternative 1

We request comment regarding an options market maker exception that would require a participant of a registered clearing agency that has a fail to deliver position in a threshold security that results or resulted from a short sale by a registered options market maker to establish or maintain a hedge on any options series within a portfolio that were created before the security became a threshold security to close out the entire fail to deliver position, including any adjustments to that position, within 35 consecutive settlement days of the security becoming a threshold security. After the 35 consecutive settlement days has expired, any additional fails to deliver would be subject to the mandatory 13 consecutive settlement day close-out requirement of Rule 203(b)(3) of Regulation SHO.

We propose 35 consecutive settlement days for purposes of proposed Alternative 1 because 35 days was used in Regulation SHO as adopted in August 2004, and in Regulation SHO, as amended and, therefore, is a period of time with which market participants subject to Regulation SHO are familiar.
67

In addition, because we believe that all fails to deliver should be closed out within specific time-frames we did not want to propose an alternative that would allow fails to deliver to continue indefinitely, or for a period of time that would undermine the goal of requiring that all fails to deliver be closed out within a reasonable time period. We believe that 35 consecutive settlement days would allow participants time to close out their excepted fail to deliver positions without extending the close-out requirement beyond what we believe would be a reasonable period of time within which fails to deliver should be closed out.

67

See
Adopting Release, 69 FR at 48031; Securities Exchange Act Release No. 56212 (Aug. 7, 2007).

In addition, similar to the pre-borrow requirement of Rule 203(b)(3)(iv) of Regulation SHO, if the fail to deliver position persists for 35 consecutive settlement days, the proposed alternative 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.

Example:

The following is an example of how proposed Alternative 1 would work if it were effective in February. XYZ security becomes a threshold security in March. On the date on which XYZ security becomes a threshold security, a participant of a registered clearing agency has fails to deliver in XYZ security that resulted from short sales by a registered options market maker to hedge options series in XYZ portfolio that were created before XYZ security became a threshold security. The participant must close out the entire fail to deliver position in XYZ security, including any additional fails that result from short sales to hedge options series in XYZ portfolio that were created before XYZ security became a threshold security, within 35 consecutive settlement days of the date on which XYZ security became a threshold security in March. After the 35 consecutive settlement days, any additional fails to deliver in XYZ security, whether or not they result or resulted from short sales by a registered options market maker to hedge options series in XYZ portfolio that were created before XYZ security became a threshold security, must be closed out in accordance with Regulation SHO's mandatory 13 consecutive settlement day close-out requirement.

ii. Alternative 2

As another alternative to eliminating the options market maker exception, we request comment regarding a proposed options market maker exception that would require a participant of a registered clearing agency that has a fail to deliver position in a threshold security that results or resulted from a short sale by a registered options market maker to establish or maintain a hedge on any options series in a portfolio that were created before the security became a threshold security to close out the entire fail to deliver position, including any adjustments to that position, within the earlier of: (i) 35 Consecutive settlement days from the date on which the security became a threshold security, or (ii) 13 consecutive settlement days from the last date on which all options series within the portfolio that were created before the security became a threshold security expire or are liquidated. After the 35 or 13 consecutive settlement days has expired, any additional fails to deliver would be subject to the mandatory 13 consecutive settlement day close-out requirement of Rule 203(b)(3) of Regulation SHO.

We propose to require in Alternative 2 that fails to deliver be closed out within 13 consecutive settlement days if all options series within the portfolio that were created before the security became a threshold security expire or are liquidated because, at that point, there would be nothing in the portfolio for the original short sale and resulting fail to deliver position to hedge. We chose a proposed close-out requirement of 13 consecutive settlement days for such situations because it is a time-frame currently used in the mandatory close-out requirement of Rule 203(b)(3) of Regulation SHO
68

and, therefore, is a time-frame with which market

participants subject to the close-out requirement of Regulation SHO are currently familiar and with which such entities appear able to comply.

68

See
17 CFR 242.203(b)(3).

In addition, as discussed above for proposed Alternative 1, we chose 35 consecutive settlement days for purposes of proposed Alternative 2 because this is also a time-frame already used in Regulation SHO as adopted in August 2004, and in Regulation SHO, as amended and, therefore, is a time-frame with which market participants subject to Regulation SHO are already familiar.
69

In addition, because we believe that all fails to deliver should be closed out within specific time-frames we did not want to propose an alternative that would allow fails to deliver to continue indefinitely, or for a period of time that would undermine the goal of requiring that all fails to deliver be closed out within a reasonable time period. We believe that a close-out requirement that provides that fails to deliver must be closed out within the time-frames specified by proposed Alternative 2 would allow participants time to close out their excepted fail to deliver positions without extending the close-out requirement beyond what we believe would be a reasonable period of time within which fails to deliver should be closed out.

69

See
Adopting Release, 69 FR at 48031; Securities Exchange Act Release No. 56212 (Aug. 7, 2007).

In addition, similar to the pre-borrow requirement of Rule 203(b)(3)(iv) of Regulation SHO, if the excepted fail to deliver position has persisted for longer than the earlier of: (i) 35 Consecutive settlement days from the date on which the security became a threshold security, or (ii) 13 consecutive settlement days from the last date on which all options series within the portfolio that were created before the security became a threshold security expire or are liquidated, 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 excepted fail to deliver position by purchasing securities of like kind and quantity.

Example 1.

The following is an example of how proposed Alternative 2 would work if it were effective in February. XYZ security becomes a threshold security in March. On the date on which XYZ security becomes a threshold security, a participant of a registered clearing agency has fails to deliver in XYZ security that resulted from short sales by a registered options market maker to hedge its XYZ portfolio that were created before XYZ security became a threshold security. On the date on which XYZ security becomes a threshold security, XYZ portfolio consists of XYZ April 50 Calls and XYZ July 50 Calls. The last date on which the options within XYZ portfolio expire is July, which is later than 35 consecutive settlement days from the date on which XYZ security became a threshold security. In addition, none of the options series within XYZ portfolio have been exercised. Thus, the participant must close out the entire fail to deliver position in XYZ security, including any additional fails that result from short sales to hedge options series in XYZ portfolio that were created before XYZ security became a threshold security, within 35 consecutive settlement days of the date on which XYZ security became a threshold security in March. After the 35 consecutive settlement days, any additional fails to deliver in XYZ security, whether or not they result or resulted from short sales by a registered options market maker to hedge options series in XYZ portfolio that were created before XYZ security became a threshold security, must be closed out in accordance with Regulation SHO's mandatory 13 consecutive settlement day close-out requirement.

Example 2.

The following is another example of how proposed Alternative 2 would work if it were effective in February. XYZ security becomes a threshold security in March. On the date on which XYZ security becomes a threshold security, a participant of a registered clearing agency has fails to deliver in XYZ security that resulted from short sales by a registered options market maker to hedge options series in its XYZ portfolio that were created before XYZ security became a threshold security. On the date on which XYZ security becomes a threshold security, XYZ portfolio consists of XYZ April 50 Calls and XYZ July 50 Calls. Options market maker firm exercises both call options in March, shortly after XYZ security became a threshold security. Because options market maker firm liquidated the entire XYZ portfolio prior to the expiration of 35 consecutive settlement days from the date on which XYZ security became a threshold security, or the last expiration date for the options comprising the XYZ portfolio, the participant must close out the entire fail to deliver position in XYZ security, including any additional fails to deliver that result from short sales by a registered options market maker to hedge options series in XYZ portfolio that were created before XYZ security became a threshold security, within 13 consecutive settlement days of the date on which the options series within XYZ portfolio were exercised.

Request for Comment

The Commission seeks comment generally on all aspects of the proposed alternatives to elimination of the options market maker exception. In addition, we seek comment on the following:

• As set forth in proposed Alternative 1, should participants of a registered clearing agency, or options market makers that have been allocated the close-out requirement under Regulation SHO, have a limited exception to the close-out requirement that would allow 35 consecutive settlement days from the security becoming a threshold security for the fail to deliver position to be closed out? If so, why? If not, why not? Alternatively, as set forth in proposed Alternative 2, should the limited exception allow the earlier of: (i) 35 Consecutive settlement days from the date on which the security becomes a threshold security, or (ii) 13 consecutive settlement days from the last date on which all options series within the portfolio that were created before the security became a threshold security expire or are liquidated, for the fail to deliver position to be closed out? If so, why?

• In our discussion above regarding the impact of the proposed amendment to eliminate Regulation SHO's current options market maker exception on liquidity, spreads, depth, and hedging costs, we stated that we believe that such an impact would be minimal, if any. For similar reasons, we believe that the impact of the mandatory close-out requirements in the proposed alternatives on liquidity, spreads, depth, and hedging costs would be minimal, if any. To what extent would an options market maker exception as set forth in the proposed alternatives, rather than eliminating the exception, impact liquidity in securities that might become threshold securities or in threshold securities? To what extent would an options market maker exception as set forth in the proposed alternatives, rather than eliminating the exception, impact the willingness of options market makers to make markets in securities that might become threshold securities or in threshold securities? What other measures or time-frames would be effective in fostering Regulation SHO's goal of reducing fails to deliver while at the same time not discouraging market making by options market makers?

• In the proposed alternatives to eliminating the options market maker exception, fails to deliver would only be excepted from the close out requirement of Regulation SHO if the fail to deliver position results or resulted from a short sale effected to establish or maintain a hedge on options series created before the security became a threshold security. Is the reference to “options series” appropriate? Please explain.

• Are the terms “expiration” and “liquidation” of an options series sufficiently inclusive to prevent participants from evading the close-out requirements in the proposed alternatives? Are these terms understandable for compliance purposes? If not, what terms would be more appropriate? What difficulties, if any, could arise from having to determine the last date on which all options series within a portfolio that were created before the security became a threshold securities have expired or been liquidated?

• We provide examples of how the proposed alternatives would be applied. We request comment regarding these examples, and suggestions regarding additional examples that would be helpful in understanding how the proposed alternatives would work that could be incorporated by the Commission into any future releases, if the Commission were to adopt either of the proposed alternatives.

• What types of costs would be incurred in complying with the proposed alternatives? For example, what types of costs, if any, could be incurred for tracking the 35 or 13 consecutive settlement day close-out requirements? What types of costs, if any, could be incurred in determining whether or not options series were created before the security became a threshold security? What types of costs could be incurred in determining whether or not a fail to deliver position resulted from a short sale to establish or maintain a hedge on options series created before the security became a threshold security? How would these costs differ from costs incurred to comply with the current options market maker exception in Regulation SHO? Would the costs relating to the alternative proposals justify the benefits of allowing for a limited exception to the close-out requirement for options market makers?

• What would be the costs and benefits of the proposed alternatives to eliminating the options market maker exception?

• Under the proposed alternatives, after the specific time-frames have expired, fails to deliver would be required to be closed out in compliance with the 13 consecutive settlement day close-out requirement of Rule 203(b)(3) of Regulation SHO regardless of whether or not the fails to deliver result or resulted from short sales effected by a registered options market maker to establish or maintain a hedge on options series created before the security became a threshold security. Under the proposed alternatives, might an options market maker need to maintain such fail to deliver positions beyond the 13 consecutive settlement days allowed by the close-out requirement of Rule 203(b)(3) of Regulation SHO? What might be the impact, if any, of requiring such fails to deliver to be closed out?

• What technical or operational challenges would options market makers face in complying with the proposed alternatives?

• Should we consider changing the proposed alternatives to 35 calendar days from the date on which the security becomes a threshold security? If so, would this create systems problems or other costs?

• The proposed alternatives would require that options market makers document eligibility for the exception. What should options market makers and participants of a registered clearing agency be required to include in the documentation? Should we specify in detail what would be required to be retained? For example, should we require that such documentation include, at a minimum, documentation evidencing when the series being hedged was created, when the underlying security became a threshold security, and the age of the fail to deliver position that is not being closed out?

• The proposed alternatives would require that participants of a registered clearing agency maintain documentation to demonstrate that a fail to deliver position has not been closed out due to the options market maker exception. Would this documentation requirement raise compliance concerns or any other concerns for participants? If so, please explain.

• The proposed alternatives would allow for a 35 consecutive settlement day phase-in period for previously excepted fails to deliver to be closed out. Is 35 consecutive settlement days from the effective date of the amendment a long enough period of time, or too long, for fails to deliver that were previously excepted from the close-out requirement of Regulation SHO to be closed out? If so, what would be an appropriate period of time?

• Would the proposed phase-in period create additional costs, such as costs associated with systems, surveillance, or recordkeeping modifications that could be needed for participants to track fails to deliver subject to the 35 consecutive settlement day phase-in period from fails to deliver that are not eligible for the phase-in period? If there were additional costs associated with tracking fails to deliver subject to the phase-in period, would these additional costs justify the benefits of providing firms with a 35 consecutive settlement day phase-in period? Is a 35 consecutive settlement day phase-in period necessary given that firms would have been on notice that they would have to close out these fail to deliver positions following the effective date of the amendment? Please provide estimates of these costs.

• Please provide specific comment as to what length of implementation period would be necessary such that participants would be able to meet the requirements that fail to deliver positions in threshold securities be closed out within the applicable time-frames, if adopted.

IV. Proposed Amendment to Rule 200(g)(1) of Regulation SHO

We are proposing an amendment to the long sale marking provisions of Rule 200(g)(1) of Regulation SHO that would require that brokers-dealers marking orders as “long” sales document the present location of the securities.

Prior to the adoption of Regulation SHO in August 2004, broker-dealers that were members of the NASD were obligated to comply with former NASD Rule 3370(b). Former NASD Rule 3370(b) required a broker-dealer making an affirmative determination that a customer was long to notate on the order ticket at the time an order was taken, the conversation with the customer as to the present location of the securities, whether they were in good deliverable form, and the customer's ability to deliver them to the member within three business days.
70

70
NASD repealed NASD Rule 3370(b), the “affirmative determination” for long sales, following the adoption of Regulation SHO. The repeal of NASD Rule 3370(b) was effective on January 3, 2005, the effective date of Regulation SHO.
See
NASD Notice to Members 04-93.
See also,
Securities Exchange Act Release No. 50822 (Dec. 8, 2004), 69 FR 74554 (Dec. 14, 2004).

Regulation SHO does not contain a similar provision to former NASD Rule 3370(b) regarding documentation of long sales.
71

Rule 200(g)(1) of

Regulation SHO, however, provides that a broker-dealer may mark an order to sell “long” only if the seller is deemed to own the security being sold pursuant to paragraphs (a) through (f) of Rule 200,
72

and either the security is in the physical possession or control of the broker or dealer or it is reasonably expected that the security will be in the physical possession or control of the broker or dealer no later than the settlement of the transaction.
73

Thus, in marking a sell order “long,” a broker-dealer must determine whether the customer is “deemed to own” the securities being sold.

71
Because Regulation SHO does not include a similar provision to former NASD Rule 3370(b) regarding documentation of long sales, on July 20, 2005, the NASD filed with the Commission, pursuant to Section 19(b)(3)(A) of the Exchange Act, a rule filing to amend NASD Rule 3370 to clarify that members must make an affirmative determination and document compliance when effecting long sale orders. In the filing, the NASD stated that it proposed to amend NASD Rule 3370 “to re-adopt expressly the affirmative determination requirements as they now relate to member obligations with respect to long sales under Regulation SHO.” The NASD designated the rule change as “non-controversial.” In response to the proposed rule change, the Commission received three comment letters, the substance of which called into question the “non-controversial” designation of the proposal. The Commission found that it was appropriate in the public interest, for the

protection of investors, and otherwise in furtherance of the purposes of the Exchange Act, to abrogate the proposed rule change.
See
Securities Exchange Act Release No. 52426 (Sept. 14, 2005); Securities Exchange Act Release No. 52131 (July 27, 2005), 70 FR 44707 (Aug. 3, 2005). The NASD took no further action with respect to the proposed rule change.

72
Rule 200(a) defines the term “short sale,” while Rules 200(b) through 200(f) set forth circumstances in which a seller is deemed to own securities.
See
17 CFR 242.200(a)-(f).

73
17 CFR 242.200(g)(1).

In the 2006 Proposing Release we requested comment regarding whether we should consider amending Regulation SHO to include documentation requirements for long sales similar to those required by former NASD Rule 3370(b).
74

We received approximately 8 comment letters in response to the request for comment.
75

74

See
2006 Proposing Release, 71 FR at 41714. Specifically we stated: “Current Rule 203(a) provides that on a long sale, a broker-dealer cannot fail or loan shares unless, in advance of the sale, it has demonstrated that it has ascertained that the customer owned the shares, and had been reasonably informed that the seller would deliver the security prior to settlement of the transaction. Former NASD Rule 3370 required that a broker making an affirmative determination that a customer was long must make a notation on the order ticket at the time an order was taken which reflected the conversation with the customer as to the present location of the securities, whether they were in good deliverable form, and the customer's ability to deliver them to the member within three business days. Should we consider amending Regulation SHO to include these additional documentation requirements? If so, should any modifications be made to these additional requirements? In the prior SRO rules, brokers did not have to document long sales if the securities were on deposit in good deliverable form with certain depositories, if instructions had been forwarded to the depository to deliver the securities against payment (“DVP trades”). Under Regulation SHO, a broker may not lend or arrange to lend, or fail, on any security marked long unless, among other things, the broker knows or has been reasonably informed by the seller that the seller owns the security and that the seller would deliver the security prior to settlement and failed to do so. Is it generally reasonable for a broker to believe that a DVP trade will settle on time? Should we consider including or specifically excluding an exception for DVP trades or other trades on any rule requiring documentation of long sales?”

75

See, e.g.
, letters from NASAA,
supra
note 31; UBS,
supra
note 31; SIA,
supra
note 31.
See also,
letter from Leonard J. Amoruso, Compliance and Regulatory Affairs, Knight Capital Group, Inc., dated Sept. 20, 2006 (“Knight”); letter from John G. Gaine, President, Managed Funds Association, dated Sept. 19, 2006 (“MFA”); letter from Martin Schwartz, Chief Compliance Officer, Millennium Partners, LP, Oct. 10, 2006 (“Millennium”); letter from Susan Trimbath, Ph.D., CEO and Chief Economist, STP Advisory Services, LLC, Aug. 29, 2006 (“Trimbath”); letter from Wayne Klein, Director, Division of Securities, State of Utah Department of Commerce, Sept. 13, 2006 (“Utah Department of Commerce”).

Commenters that supported documentation requirements for long sales argued that the “volume of outstanding fails is too large to permit the execution of trades where there is doubt about delivery.”
76

Commenters opposing documentation requirements for long sales stated that pre-trade documentation would unnecessarily impair efficiency, as broker-dealers already have procedures to ensure orders are marked properly based on information provided by customers and their own books and records, and the documentation requirements would add substantial cost.
77

One commenter stated that compliance with such pre-trade documentation requirements would require a complete revamping of front end systems.
78

Another commenter stated that the requirements would be inconsistent with the goal of fostering liquidity.
79

76

See, e.g.
, Letters from NASAA,
supra
note 31; Utah Department of Commerce,
supra
note 75.

77

See
letters from MFA,
supra
note 75; UBS,
supra
note 31; Knight,
supra
note 75.

78

See
letter from SIA,
supra
note 31.

79

See
letter from Millennium,
supra
note 75.

Commenters also argued that the Commission has not presented evidence that long sales are contributing to a troublesome level of fails
80

or abusive or manipulative activity,
81

and that lack of documentation is related to those fails.
82

One commenter stated that there is no valid purpose to put this additional burden on the industry.
83

Another commenter argued that requiring this additional documentation should be considered only where the benefits clearly outweigh the burdens.
84

Commenters also suggested that if the Commission did adopt additional long sale documentation requirements, it should except prime broker and DVP trades, “done with” trades, and orders submitted electronically,
85

or where settlement instructions are on file with the executing broker.
86

80

See
letter from MFA,
supra
note 75.
See also,
letter from Millennium,
supra
note 75.

81

See
letter from SIA,
supra
note 31 .

82

See
letter from MFA,
supra
note 75.

83

See
letter from UBS,
supra
note 31.

84

See
letter from MFA,
supra
note 75.

85

See
letters from SIA,
supra
note 31; Knight,
supra
note 75. The SIA commented that “a broker-dealer should be provided an exception from such long sale annotation requirements if the broker-dealer has information regarding the client's custodial relationship. Providing such an exception would be consistent with the Commission's long-standing policy of allowing broker-dealers to enter into bona-fide agreements with their customers regarding marking of orders.”
See
letter from SIA,
supra
note 31.

86

See
letter from Knight,
supra
note 75.

Although some commenters stated that pre-trade documentation for long sales would be inconsistent with the goal of fostering liquidity, would unnecessarily impair efficiency, and would add substantial cost,
87

we believe that such costs, to the extent that there are any, would be justified by the benefits of a documentation requirement, as described below. In addition, we note that under former NASD Rule 3370(b), NASD member firms making an affirmative determination that a customer was long were required to make a notation on the order ticket at the time an order was taken which reflected the conversation with the customer as to the present location of the securities, whether they were in good deliverable form, and the customer's ability to deliver them to the member within three business days.
88

Thus, many broker-dealers should already be familiar with a documentation requirement and one method that could be used to comply with such a requirement. Such familiarity should help reduce any costs associated with implementing the proposed documentation requirement. In addition, unlike with former NASD Rule 3370(b), the proposed amendment would not specify the format or methodology of the proposed documentation requirement. The absence of such specifications should help reduce costs to broker-dealers that would have to comply with this proposal because broker-dealers would be able to determine the most cost effective format and methodology for meeting the proposed documentation requirement.

87

See, e.g.
, letters from MFA,
supra
note 75; UBS,
supra
note 31; Knight,
supra
note 75; SIA,
supra
note 31; Millenium,
supra
note 75.

88
Brokers and dealers that were members of the NASD were obligated to comply with former NASD Rule 3370(b) prior to the adoption of Regulation SHO.

We are proposing for further comment a documentation requirement for broker-dealers marking orders to sell “long” pursuant to Regulation SHO that would require such broker-dealers to document the present location of the securities being sold. First, we believe that such a proposed documentation requirement would aid in ensuring the correct marking of sell orders. To the extent that the seller is unable to provide the present location of the securities being sold, the broker-dealer

would have reason to believe that the seller is not “deemed to own” the securities being sold and that the securities would not be in its physical possession or control no later than settlement of the transaction and, therefore, that the broker-dealer would be required to mark the sale “short” rather than “long.”
89

We believe that this proposed documentation requirement could also reduce the number of fails to deliver because, after making the inquiry into the present location of the securities being sold, a broker-dealer would know whether or not it needed to obtain securities for delivery.

89

See
17 CFR 242.200(g).

Second, we are concerned that broker-dealers marking orders “long” may not be making a determination prior to marking the order that the seller is “deemed to own” the security being sold.
90

Rule 200(g)(1) currently requires that broker-dealers ascertain whether the customer is “deemed to own” the securities being sold before marking a sell order “long.”
91

We believe that a proposed documentation requirement would help ensure that the broker-dealer marking the sale “long” has inquired into, and determined that, the seller is “deemed to own” the securities being sold because the broker-dealer would be required to document the present location of the securities being sold.

90

See id.
at 242.200(g)(1).

91
In the Adopting Release, we stated that “* * * Rule 203(a) provides that on a long sale, a broker-dealer cannot fail or loan shares unless, in advance of the sale, it ascertained that the customer owned the shares, and had been reasonably informed that the seller would deliver the security prior to settlement of the transaction. This requirement is consistent with changes being made to the order marking requirements, which require that for an order to be marked long, the seller must own the security.”
See
Adopting Release, 69 FR at 48021.

Third, we believe that the proposed documentation requirement would enable the Commission and SROs to examine for compliance with the long sale marking provisions of Rule 200(g) more effectively because this proposed documentation requirement would provide a record that the seller is “deemed to own” the securities being sold in compliance with that rule. We also believe that the proposed documentation requirement would aid the Commission and SROs in reviewing for mismarking designed to avoid compliance with other rules and regulations of the federal securities laws, such as the “locate” requirement of Regulation SHO,
92

and Rule 105 of Regulation M.
93

92

See
17 CFR 242.203(b)(1). Rule 203(b)(1) of Regulation SHO provides that “[a] broker or dealer may not accept a short sale order in an equity security from another person, or effect a short sale in an equity security for its own account, unless the broker or dealer has: (i) Borrowed the security, or entered into a bona fide arrangement to borrow the security; or (ii) Reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due * * *.” This provision is commonly referred to as the “locate” requirement.

93

See
17 CFR 242.105 (prohibiting persons from covering a short sale with offering securities if the short sale occurred during the Rule 105 restricted period).
See also, In the Matter of Goldman Sachs Execution & Clearing, L.P. f/k/a Spear, Leeds, & Kellogg, L.P.,
Securities Exchange Act Release No. 55465 (Mar. 14, 2007), Admin. Proc. File No. 3-12590 (settling enforcement proceedings against a prime broker and clearing affiliate of The Goldman Sachs Group, Inc., Goldman Sachs Execution and Clearing L.P., for its violations arising from an illegal trading scheme carried out by customers through their accounts at the firm, which included the mismarking of sell orders as “long.”).

We believe that any costs that would arise from the proposed requirement that a broker-dealer must document the present location of securities being sold long when making the determination that a customer is deemed to own the securities being sold would be minimal because Rule 200(g)(1) currently requires that broker-dealers must ascertain whether the customer is “deemed to own” the securities being sold before marking a sell order “long.”
94

Today's proposed amendment would require that the broker-dealer take the additional step of documenting the present location of the securities being sold. Broker-dealers could, however, need to put mechanisms in place to facilitate efficient documenting of the information required by the proposed amendment.

94

See
17 CFR 242.200(g).

Request for Comment

The Commission seeks comment generally on all aspects of the proposed amendment to Rule 200(g) of Regulation SHO. In addition, we seek comment on the following:

• Is the proposed documentation requirement appropriate? If not, why not?

• Commenters that responded to the request for comment regarding documentation of long sales in the 2006 Proposing Release stated that market participants already have in place procedures to ensure that orders to sell shares are properly marked. What are those procedures and how do they ensure that orders are properly marked? How do broker-dealers currently comply with the “deemed to own” requirement of Rule 200(g)(1) of Regulation SHO?

• One commenter that responded to the request for comment regarding documentation of long

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3AE7-15709. Public record. Not legal advice.