Amendments to Regulation SHO

Federal RegisterApr 20, 2009

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 242

[Release No. 34-59748; File No. S7-08-09]

RIN 3235-AK35

Amendments to Regulation SHO

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is proposing amendments to Regulation SHO under the Securities Exchange Act of 1934 (“Exchange Act”). We are proposing two approaches to restrictions on short selling—one is a price test that would apply on a market wide and permanent basis (“short sale price test” or “short sale price test restriction”) and one that would apply only to a particular security during severe market declines in that security (“circuit breaker”). With respect to the first approach, we propose two alternative short sale price tests: One based on the national best bid and the second based on the last sale price. With respect to the second approach, we propose two basic alternatives: One alternative is a circuit breaker rule that would temporarily prohibit short selling in a particular security when there is a severe decline in the price of that security (a “halt”), which could operate in place of, or in addition to, a short sale price test rule; and the second alternative is a circuit breaker rule that would trigger a short sale price test rule; we propose that such a short sale price test either be based on the national best bid for any security for which there has been a severe price decline or be based on the last sale price for any security for which there has been a severe price decline.

Due to the extreme market conditions that we are currently facing and the resulting deterioration in investor confidence, we believe it is appropriate at this time to re-evaluate and seek comment on some form of short sale price test restriction, either in the form of a short sale price test such as the proposed modified uptick rule or proposed uptick rule, or a circuit breaker rule.

For each of the proposed short sale price test restrictions and proposed circuit breaker rules, we are also proposing to amend Regulation SHO to require that a broker-dealer mark certain sell orders “short exempt.” If the Commission adopts a short sale price test proposal or a circuit breaker proposal, and adopts a “short exempt” marking requirement, we are proposing that the implementation period for these amendments would be three months from the effective date of the amendments.

DATES:

Comments should be received on or before June 19, 2009.

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 S7-08-09 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 Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-08-09. 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/final.shtml

). Comments are also available for public inspection and copying in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 am and 3 p.m. 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 Brigagliano, Deputy Director; Jo Anne Swindler, Acting Associate Director; Josephine Tao, Assistant Director; Victoria Crane, Branch Chief; Joan Collopy, Special Counsel; Christina Adams, Special Counsel; or Matthew Sparkes, Staff Attorney, Division of Trading and Markets, at (202) 551-5720, at the Commission, 100 F Street, NE., Washington, DC 20549-6628.

SUPPLEMENTARY INFORMATION:

The Commission is requesting public comment on proposed amendments to Rules 200(g) and 201 of Regulation SHO, 17 CFR 242.200(g) and 17 CFR 242.201, under the Exchange Act. The Commission is soliciting comments on all aspects of the proposed amendments.

I. Executive Summary

In July 2007, the Commission eliminated all short sale price test restrictions. At that time, short sale price test restrictions included Rule 10a-1 under the Exchange Act, also known as the “uptick rule” or “tick test” (“former Rule 10a-1”), that applied to exchange-listed securities, and the National Association of Securities Dealers, Inc.'s (“NASD”)

bid test, that applied to certain Nasdaq securities. The Commission's removal of short sale price test restrictions followed a careful, deliberative rulemaking process, carried out in multiple stages from 1999 through 2006, and was open to the public at every stage.

NASD is now known as the Financial Industry Regulatory Authority, Inc. (“FINRA”).

In 1999, the Commission published a concept release in which it sought comment regarding short sale price test regulation, including on whether to eliminate such regulation.

See

Securities Exchange Act Release No. 42037 (Oct. 20, 1999), 64 FR 57996 (Oct. 28, 1999).

Prior to taking that action, the Commission took a number of steps, including seeking extensive public comment and staff study to consider removing short sale price test restrictions. For example, beginning in 1999, the Commission published a concept release in which it sought comment regarding short sale price test regulation, including on whether to eliminate such regulation.

In 2004, the Commission initiated a year-long pilot to study the removal of short sale price tests for approximately one-third of the largest stocks.

Short sale data was made publicly available during this pilot to allow the public and Commission staff to study the effects of eliminating short sale price test restrictions. The findings of third party researchers were presented and discussed in a public Roundtable in September 2006.

In addition, the results of the Commission staff study of the pilot data were made publicly available in draft form in September 2006 and in final form in February 2007.

See

Securities Exchange Act Release No. 42037 (Oct. 20, 1999), 64 FR 57996 (Oct. 28, 1999).

See

Securities Exchange Act Release No. 50104 (July 28, 2004), 69 FR 48032 (Aug. 6, 2004) (“Pilot Release”).

See

http://www.sec.gov/about/economic/shopilottrans091506.pdf.

See

http://www.sec.gov/about/economic/shopilot091506/draft_reg_sho_pilot_report.pdf

and

http://www.sec.gov/news/studies/2007/regshopilot020607.pdf

See also

discussion of findings of staff study,

supra

notes 25 to 41 and accompanying text.

As discussed in detail below,

concurrent with the development of the subprime mortgage crisis and credit crisis in 2007, market volatility, including steep price declines, particularly in the stocks of certain financial services issuers, has increased markedly in the U.S. and in every major stock market around the world (including markets that continued to operate under short sale price test restrictions). As market conditions have continued to worsen, investor confidence has eroded, and the Commission has received requests from many commenters to consider imposing restrictions with respect to short selling, in part in the belief that such action would help restore investor confidence.

See infra

Section II(C).

Due to the extreme market conditions that we are currently facing and the resulting deterioration in investor confidence, we believe it is appropriate at this time to re-examine and seek comment on whether to restore restrictions with respect to short selling. Thus, we are proposing two approaches to restrictions on short selling. One approach would apply a price test on a market wide and permanent basis. With respect to this approach, we propose two alternative price tests. The first alternative price test, in many ways similar to NASD's former bid test, would be based on the national best bid (the “proposed modified uptick rule”). The second alternative price test, similar to former Rule 10a-1, would be based on the last sale price (the “proposed uptick rule”).

In 2003, the Commission proposed a short sale price test based on the national best bid (“uniform bid test”).

See

Securities Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR 62972 (Nov. 6, 2003) (“2003 Regulation SHO Proposing Release”). The Commission determined not to proceed with the uniform bid test, but instead established a pilot program pursuant to which it could evaluate the overall effectiveness of short sale price test restrictions on short sales.

See

Securities Exchange Act Release No. 50103 (July 28, 2004), 69 FR 48008, 48009 (Aug. 6, 2004) (“2004 Regulation SHO Adopting Release”).

See also

infra

Section II(B) (discussing the pilot program).

The other approach would apply only to a particular security during a severe market decline in that security (collectively, the “proposed circuit breaker rules”). With respect to this second approach, we are proposing two basic alternatives. First, we propose a circuit breaker rule that, when triggered by a severe price decline in a particular security, would temporarily prohibit any person from selling short that security, subject to certain exceptions (“proposed circuit breaker halt rule”). The proposed circuit breaker halt rule could operate in place of, or in addition to, a short sale price test restriction. Second, we propose a circuit breaker rule that, when triggered by a severe price decline in a particular security, would trigger a temporary short sale price test for that security. In connection with this approach, we are proposing two price tests. One is the modified uptick rule—that is, we propose a circuit breaker rule that would, when triggered by a severe decline in a particular security, temporarily impose the proposed modified uptick rule for that security (“proposed circuit breaker modified uptick rule”). The other is the uptick rule—that is, we propose a circuit breaker rule that would, when triggered by a severe market decline in a particular security, temporarily impose the proposed uptick rule for that security (“proposed circuit breaker uptick rule”). A circuit breaker that triggers a short sale price test rule such as the proposed modified uptick rule or the proposed uptick rule would operate in place of a short sale price test rule (collectively, the “circuit breaker price test rules”).

As discussed in detail below, we preliminarily believe that of the short sale price test proposals, a price test based on the national best bid would have advantages over a test based on the last sale price in today's markets. Among other reasons, we believe that bids generally are a more accurate reflection of current prices for a security than last sale prices due to delays that can occur in the reporting of last sale price information and the manner in which last sale price information is published to the markets. For example, sale transactions may be reported manually up to 90 seconds after they occur. Even sale transactions that are reported automatically can be reported out-of-sequence if trades are occurring in multiple trading venues. This may make the proposed uptick rule more difficult to implement. In addition, last sale price information is published to the markets in reporting sequence rather than in transaction sequence. Thus, we preliminarily believe that if we were to adopt a short sale price test restriction, whether as a full-time rule or as part of a circuit breaker rule, that it would be more appropriate for such short sale price test restrictions to be based on the national best bid rather than on the last sale price.

A short sale price test similar to former Rule 10a-1 that is based on the last sale price, a short sale price test based on a national best bid, and a circuit breaker rule resulting in a short sale halt, should generally be familiar to investors and market participants. Former Rule 10a-1 was in place for almost 70 years. NASD adopted its bid test in 1994 and that rule was in place for over a decade. Various circuit breaker rules have been in place throughout the markets for many years.

A circuit breaker rule resulting in a short sale price test for particular stocks that have suffered a severe price decline would be an amalgamation of these familiar rules.

See,

e.g.,

infra

note 239 and accompanying text.

To offer straight-forward alternatives, this release proposes a modified uptick rule based on the national best bid that would apply to trading centers

and applies a policies and procedures approach that would require that trading centers have policies and procedures reasonably designed to prevent the execution or display of short sales at impermissible prices. As an alternative short sale price test, this release proposes an uptick rule based on the last sale price that, similar to former Rule 10a-1, applies a straight prohibition approach that would prohibit any person from effecting short sales at impermissible prices. However, either alternative could ultimately be implemented through a policies and procedures approach or through a prohibition approach or some combination thereof.

A “trading center” means a national securities exchange or national securities association that operates an SRO trading facility, an alternative trading system, an exchange market maker, an OTC market maker, or any other broker or dealer that executes orders internally by trading as principal or crossing orders as agent.

See infra

note 111 and supporting text.

For instance, the approaches could be combined so that persons are prohibited from selling short on a downbid and trading centers are also required to have reasonable policies and procedures to prevent the execution or display of a short sale on a downbid.

We are also proposing circuit breaker rules.

As noted above, these are the proposed circuit breaker halt rule, the proposed circuit breaker modified uptick rule, and the proposed circuit breaker uptick rule. In addition, we are proposing that a broker-dealer be required to mark a sell order “short exempt” if the seller is relying on an exemption under the proposed short sale price test rules or proposed circuit breaker rules.

See

Section III.C below discussing the proposed circuit breaker rules.

II. Background on Short Sale Restrictions

Short selling involves a sale of a security that the seller does not own or a 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 will borrow the security, typically from a broker-dealer or an institutional investor. Typically, the short seller later closes out the position by purchasing equivalent securities on the open market 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 an economic long position in the same security or in a related security.

See

17 CFR 242.200(a).

See,

e.g.,

Securities Exchange Act Release No. 54891 (Dec. 7, 2006), 71 FR 75068, 75069 (Dec. 13, 2006) (“2006 Price Test Elimination Proposing Release”); 2003 Regulation SHO Proposing Release, 68 FR at 62974.

A. Short Selling and Its Market Impact

The Commission has long held the view that short selling provides the market with important benefits, including market liquidity and pricing efficiency.

Market liquidity is often provided through short selling by market professionals, such as market makers (including specialists) and block positioners, who offset temporary imbalances in the buying and selling interest for securities. Short sales effected in the market add to the selling interest of stock available to purchasers and reduce the risk that the price paid by investors is artificially high because of a temporary imbalance between buying and selling interest. Short sellers covering their sales also may add to the buying interest of stock available to sellers.

See id.

See also

Securities Exchange Act Release No. 29278 (June 7, 1991), 56 FR 27280 (June 13, 1991); 2004 Regulation SHO Adopting Release, 69 FR 48008, n. 6; Boehmer, Ekkehart and Wu, Julie,

Short Selling and the Informational Efficiency of Prices

(Jan. 8, 2009).

See,

e.g.,

2006 Price Test Elimination Proposing Release, 71 FR at 75069; 2003 Regulation SHO Proposing Release, 68 FR at 62974.

Short selling also can contribute to the pricing efficiency of the equities markets.

When a short seller speculates or hedges against a downward movement in a security, his transaction is a mirror image of the person who purchases the security in anticipation that the security's price will rise or to hedge against such an increase. Both the purchaser and the short seller hope to profit, or hedge against loss, by buying the security at one price and selling at a higher price. The strategies primarily differ in the sequence of transactions. Market participants who believe a stock is overvalued may engage in short sales in an attempt to profit from a perceived divergence of prices from true economic values. Such short sellers add to stock pricing efficiency because their transactions inform the market of their evaluation of future stock price performance. This evaluation is reflected in the resulting market price of the security.

See id.

Arbitrageurs also contribute to pricing efficiency by utilizing short sales to profit from price disparities between a stock and a derivative security, such as a convertible security or an option on that stock. For example, an arbitrageur may purchase a convertible security and sell the underlying stock short to profit from a current price differential between two economically similar positions.

See id.

We recognize that, to the extent that the proposed short sale price test restrictions would result in increased costs to short selling in equity securities, it may lessen some of the benefits of legitimate short selling. Such a reduction may lead to a decrease in market efficiency and price discovery, less protection against upward stock price manipulations, a less efficient allocation of capital, an increase in trading costs, and a decrease in liquidity. Thus, we believe there may be potential costs associated with the proposed short sale price tests in terms of potential impact of such price tests on quote depths, spread widths, and market liquidity. We also believe costs may be incurred in terms of execution and pricing inefficiencies. For example, requiring all short sale orders to be executed or displayed above the best bid, or last sale price, in a declining market may slow the speed of executions and impose additional costs on market participants, including buyers. Also, by not allowing short sellers to sell at the bid, or last sale price, the proposed short sale price tests may impede trading and distort market pricing.

Although short selling serves useful market purposes, it also may be used to illegally manipulate stock prices.

One example is the “bear raid” where an equity security is sold short in an effort to drive down the price of the security by creating an imbalance of sell-side interest.

This unrestricted short selling could exacerbate a declining market in a security by increasing pressure from the sell-side, eliminating bids, and causing a further reduction in the price of a security by creating an appearance that the security price is falling for fundamental reasons, when the decline, or the speed of the decline, is being driven by other factors.

See,

e.g.,

U.S.

Russo,

74 F.3d 1383, 1392 (2d Cir. 1996) (short sales were sufficiently connected to the manipulation scheme as to constitute a violation of Exchange Act Section 10(b) and Rule 10b-5);

S.E.C.

Gardiner,

48 S.E.C. Docket 811, No. 91 Civ. 2091 (S.D.N.Y. March 27, 1991) (alleged manipulation by sales representative by directing or inducing customers to sell stock short in order to depress its price).

Many people blamed “bear raids” for the 1929 stock market crash and the market's prolonged inability to recover from the crash.

See

8 Louis Loss and Joel Seligman, Securities Regulation, section 8-B-3 (3d ed. 2006).

See

2006 Price Test Elimination Proposing Release, 71 FR at 75069; 2003 Regulation SHO Proposing Release, 68 FR at 62074.

B. History of Short Sale Price Test Restrictions in the U.S.

Section 10(a) of the Exchange Act

gives the Commission plenary authority to regulate short sales of securities registered on a national securities exchange, as necessary or appropriate in the public interest or for the protection of investors.

After conducting an inquiry into the effects of concentrated short selling during the market break of 1937,

the Commission adopted former Rule 10a-1 (also known as the “tick test” or “uptick rule”) in 1938 to restrict short selling in a declining market.

15 U.S.C. 78j(a).

See also

2006 Price Test Elimination Proposing Release, 71 FR at 75068; 2003 Regulation SHO Proposing Release, 68 FR at 62973.

The study covered two weekly periods, that of September 7-13, 1937, and that of October 18-23, 1937.

See

Securities Exchange Act Release No. 1548 (Jan. 24, 1938), 3 FR 213 (Jan. 26, 1938) (“Former Rule 10a-1 Adopting Release”).

See id.

Former Rule 10a-1 provided that, subject to certain exceptions, a listed security could be sold short (i) at a price above the price at which the immediately preceding sale was effected (plus tick), or (ii) at the last sale price if it was higher than the last different price (zero plus tick).

The core provisions of former Rule 10a-1 remained virtually unchanged for almost 70 years. Over the years, however, in response to changes in the securities markets, including changes in trading strategies and systems used in the marketplace, the Commission added exceptions to former Rule 10a-1 and granted numerous written requests for relief from the rule's restrictions. These market changes included decimalization, the increased use of matching systems that execute trades at independently derived prices during random times within specific time intervals,

and the spread of fully automated markets. In addition, market developments over the years led to the application of different price tests to securities trading in different markets.

See,

e.g.,

Letter from Larry E. Bergmann, Senior Associate Director, Division of Market Regulation, SEC, to Andre E. Owens, Schiff Hardin & Waite, dated April 23, 2003 (granting exemptive relief from former Rule 10a-1 for trades executed through an alternative trading system that matches buying and selling interest among institutional investors and broker-dealers at various set times during the day).

See,

e.g.,

Securities Exchange Act Release No. 55245 (Feb. 5, 2007), 72 FR 6635 (Feb. 12, 2007). Former Rule 10a-1 applied only to short sale transactions in exchange-listed securities. In 1994, the Commission granted temporary approval to

NASD to apply its own short sale rule, known as the “bid test,” on a pilot basis that was renewed annually until the Commission repealed short sale price tests. NASD's bid test prohibited short sales in Nasdaq Global Market securities (then known as Nasdaq National Market securities) at or below the current (inside) bid when the current best (inside) bid was below the previous best (inside) bid in a security. As a result, until the Commission eliminated former Rule 10a-1, and prohibited any self-regulatory organization (“SRO”) from having a short sale price test in July 2007, Nasdaq Global Market securities traded on Nasdaq or the OTC market and reported to a NASD facility were subject to a bid test. Other listed securities traded on an exchange, or otherwise, were subject to former Rule 10a-1. Nasdaq securities traded on exchanges other than Nasdaq were not subject to any price test. In addition, many thinly-traded securities, such as Nasdaq Capital Market securities, and securities quoted on the over-the-counter (“OTC”) Bulletin Board and Pink Sheets, were not subject to any price test wherever traded. According to the Commission's Office of Economic Analysis (“OEA”), in 2005, prior to the start of the Pilot, NASD Rule 3350 applied to approximately 2,800 securities, while former Rule 10a-1 applied to approximately 4,000 securities.

In July 2004, the Commission adopted Rule 202T of Regulation SHO,

which established procedures for the Commission to temporarily suspend short sale price tests for a prescribed set of securities so that the Commission could study the effectiveness of these tests.

Pursuant to the process established in Rule 202T, the Commission issued an order creating a one year pilot (“Pilot”) temporarily suspending the tick test of former Rule 10a-1(a) and any price test of any exchange or national securities association for short sales of certain securities.

The Pilot was designed to assist the Commission in assessing whether changes to current short sale price test regulation were appropriate at that time in light of then-current market practices and the purposes underlying short sale price test regulation.

17 CFR 242.202T.

See

17 CFR 242.202T;

see also

2004 Regulation SHO Adopting Release, 69 FR at 48012-48013.

See

Pilot Release, 69 FR 48032 (commencing the Pilot on January 3, 2005 and terminating the Pilot on December 31, 2005). On November 29, 2004, the Commission issued an order resetting the Pilot to commence on May 2, 2005 and end on April 28, 2006 to give market participants additional time to make systems changes necessary to comply with the Pilot.

See

Securities Exchange Act Release No. 50747 (Nov. 29, 2004), 69 FR 70480 (Dec. 6, 2004). On April 20, 2006, the Commission issued an order extending the termination date of the Pilot to August 6, 2007.

See

Securities Exchange Act Release No. 53684 (April 20, 2006), 71 FR 24765 (April 26, 2006).

See

Pilot Release, 69 FR at 48032. In the 2004 Regulation SHO Adopting Release we noted that “the purpose of the [P]ilot is to assist the Commission in considering alternatives, such as: (1) Eliminating a Commission-mandated price test for an appropriate group of securities, which may be all securities; (2) adopting a uniform bid test, and any exceptions, with the possibility of extending a uniform bid test to securities for which there is currently no price test; or (3) leaving in place the current price tests.” 2004 Regulation SHO Adopting Release, 69 FR at 48010.

OEA gathered the data made public during the Pilot, analyzed the data and provided the Commission with a summary report on the Pilot (“OEA Staff's Summary Pilot Report”).

The OEA Staff's Summary Pilot Report, which was made public, examined several aspects of market quality including the overall effect of price tests on short selling, liquidity, volatility and price efficiency.

The Pilot was also designed to allow the Commission and members of the public to examine whether the effects of short sale price tests were similar across stocks.

See supra

note 6.

OEA selected the securities to be included in the Pilot by sorting the 2004 Russell 3000, first by listing market and then by average daily dollar volume from June 2003 through May 2004, and then within each listing market, selecting every third company starting with the second. Because the selection process relied on average daily dollar volume, companies that had their Initial Public Offering (“IPO”) in May or June 2004, just prior to the Russell reconstitution, were not included. The securities in the control group came from the remainder of the 2004 Russell 3000 not included in the Pilot (excluding the IPOs in May or June 2004 and any securities added to the Russell 3000 after June 2004).

See

OEA Staff's Summary Pilot Report at 22 (discussing the selection of securities included in the Pilot and the control group).

In the 2004 Regulation SHO Adopting Release, the Commission stated its expectation that data on trading during the Pilot would be made available to the public to encourage independent researchers to study the Pilot.

See

2004 Regulation SHO Adopting Release, 69 FR at 48009, n.9. Accordingly, nine SROs began publicly releasing transactional short selling data on January 3, 2005. The nine SROs at that time were the Amex, ARCA, BSE, CHX, NASD, Nasdaq, National Stock Exchange, NYSE and Phlx. The SROs agreed to collect and make publicly available trading data on each executed short sale involving equity securities reported by the SRO to a securities information processor. The SROs published the information on a monthly basis on their Internet Web sites.

As set forth in the OEA Staff's Summary Pilot Report, OEA found little empirical justification at that time for maintaining short sale price test restrictions, especially for actively traded securities. Amongst its results, OEA found that short sale price tests did not have a significant impact on daily volatility. However, OEA also found some evidence that short sale price tests dampened intraday volatility for smaller stocks.

See

OEA Staff's Summary Pilot Report, at 55 n. 61-63 and supporting text.

OEA also found that the Pilot data provided limited evidence that price test restrictions distort a security's price.

In addition, OEA found that price test restrictions resulted in an increase in quote depths.

Realized liquidity levels, however, were unaffected by the removal of short sale price test restrictions.

The Pilot data also provided evidence that short sale price test restrictions reduce the volume of executed short sales to total volume and, therefore, act as a constraint on short selling.

OEA did not find, however, a significant difference in short interest positions between those securities subject to a short sale price test versus those securities that were not subject to such a test during the Pilot.

On the day the Pilot went into effect, listed Pilot securities underperformed listed control group securities by approximately 24 basis points. The Pilot and control group securities, however, had similar returns over the first six months of the Pilot.

See

OEA Staff's Summary Pilot Report at 8.

See

OEA Staff's Summary Pilot Report, at 55 n. 61-63 and supporting text.

This conclusion is based on the result that changes in effective spreads were not economically significant (less than a basis point) and that the changes in the bid and ask depth appear not to affect the transaction costs paid by investors. Arguably, the changes in bid and ask depth appeared to affect the intraday volatility. However, OEA concluded that overall, the Pilot data did not suggest a deleterious impact on market quality or liquidity.

See

OEA Staff's Summary Pilot Report at 42, 56.

See

OEA Staff's Summary Pilot Report at 35.

See id.

In addition, the Commission encouraged outside researchers to examine the Pilot data. In response to this request, the Commission received four completed studies (the “Academic Studies”) from outside researchers that specifically examined the Pilot data.

The Commission also held a public roundtable (the “Regulation SHO Roundtable”) that focused on the empirical evidence learned from the Pilot data (the OEA Staff's Summary Pilot Report, Academic Studies, and Regulation SHO Roundtable are referred to collectively herein as, the “Pilot Results”).

The Pilot Results contained a variety of observations, which the Commission considered in determining whether or not to propose removal of then-current short sale price test restrictions and subsequently whether or not to eliminate such restrictions. Generally, the Pilot Results supported removal of short sale price test restrictions at that time.

In addition to the Pilot Results, thirteen other analyses by SEC staff and various third party

researchers were conducted between 1963 and 2004 addressing price test restrictions.

Among these were several studies that evaluated short sale price tests during times of severe market decline, including the market break of May 28, 1962, the market decline in September and October 1976, the market break of October 19, 1987, and the Nasdaq market decline of 2000-2001. The results of these studies were mixed, but generally they found that former Rule 10a-1 did not prevent short sales in extreme down markets and did limit short selling in up markets and provided additional support for the removal of short sale price restrictions.

See

Karl B. Diether, Kuan Hui Lee and Ingrid M. Werner, 2009,

It's SHO Time! Short-Sale Price-Tests and Market Quality,

Journal of Finance 64:37-73; Gordon J. Alexander and Mark A. Peterson, 2008,

The Effect of Price Tests on Trader Behavior and Market Quality: An Analysis of Reg. SHO,

Journal of Financial Markets 11:84-111; J. Julie Wu,

Uptick Rule, short selling and price efficiency,

August 14, 2006; Lynn Bai, 2008,

The Uptick Rule of Short Sale Regulation—Can it Alleviate Downward Price Pressure from Negative Earnings Shocks?

Rutgers Business Law Journal 5:1-63 (“Bai”).

See supra

note 5.

See

2006 Price Test Elimination Proposing Release, 71 FR at 75072-75075 (discussing the Pilot Results).

See

OEA Staff's Summary Pilot Report at 14, 17-22 (discussing the thirteen studies).

In December 2006, the Commission proposed to eliminate former Rule 10a-1 by removing restrictions on the execution prices of short sales, as well as prohibiting any SRO from having a price test.

The Commission received 27 comment letters in response to its proposal to eliminate former Rule 10a-1 and prohibit any SRO from having a short sale price test. The comments in response to the proposed amendments varied. Most commenters (including individual traders, academics, broker-dealers, SROs and trade associations) advocated removing all price test restrictions.

Generally, these commenters believed that price test restrictions were no longer necessary due to increased market transparency and the existence of real-time regulatory surveillance that could monitor for and detect any potential short sale manipulation.

See

2006 Price Test Elimination Proposing Release, 71 FR 75068.

See,

e.g.,

letter from Howard Teitelman, CSO, Trillium Trading (Feb. 6, 2007) (“Teitelman Letter”); letter from S. Kevin An, Deputy General Counsel, E*TRADE (Feb. 9, 2007) (“E*TRADE Letter”); letter from Carl Giannone (Feb. 11, 2007) (“Giannone Letter”); letter from David Schwarz (Feb. 12, 2007) (“Schwarz Letter”); letter from John G. Gaine, President, MFA (Feb. 12, 2007) (“MFA Letter”); letter from Lisa M. Utasi, Chairman of the Board and John C. Giesea, President and CEO, STA (Feb. 12, 2007) (“STA Letter”); letter from Gerard S. Citera, Executive Director, U.S. Equities, UBS (Feb. 14, 2007) (“UBS Letter”); letter from Mary Yeager, Assistant Secretary, NYSE (Feb. 14, 2007) (“NYSE Letter”); letter from James J. Angel, Ph.D., CFA, Associate Professor of Finance, McDonough School of Business, Georgetown University (Feb. 14, 2007) (“Angel Letter”); letter from Ira D. Hammerman, SIFMA Managing Director and General Counsel (Feb. 16, 2007) (“SIFMA Letter”);

see also

Securities Exchange Act Release No. 55970 (June 28, 2007), 72 FR 36348, 36350-36351 (July 3, 2007) (“2007 Price Test Adopting Release”) (discussing the comment letters).

See,

e.g.,

Giannone Letter; E*TRADE Letter; STA Letter; UBS Letter;

see also

Securities Exchange Act Release No. 55970 (June 28, 2007), 72 FR 36348, 36350-36351 (July 3, 2007) (discussing the comment letters).

Two commenters (both individual investors) opposed the proposed amendments noting the need for price tests to prevent “bear raids.”

One commenter, although generally in support of removing all price test restrictions, stated the belief that at some level unrestricted short selling should be collared.

This commenter supported having a 10% circuit breaker to prevent panic in the event there is a major market collapse.

The NYSE also noted its concern about unrestricted short selling during periods of unusually rapid and large market declines. The NYSE stated that the effects of an unusually rapid and large market decline could not be measured or analyzed during the Pilot because such decline did not occur during the period studied.

See,

e.g.,

letter from Jim Ferguson (Dec. 19, 2006); letters from David Patch (Jan. 1, 2007; Jan. 12, 2007) (“Patch Letters”).

See

Giannone Letter.

See id.

See

NYSE Letter.

Effective July 3, 2007, the Commission eliminated former Rule 10a-1 and added Rule 201 of Regulation SHO prohibiting any SRO from having a short sale price test.

The Commission stated that it determined to eliminate all short sale price test restrictions after reviewing the comments received in response to its proposal to eliminate all short sale price test restrictions, the Pilot Results, and taking into account the market developments that had occurred in the securities industry since the Commission adopted former Rule 10a-1 in 1938.

In addition, the Commission stated that it believed that the amendments would bring increased uniformity to short sale regulation, level the playing field for market participants, and remove an opportunity for regulatory arbitrage.

See

2007 Price Test Adopting Release, 72 FR 36348.

See id

at 36352.

See id.

C. Changes in Market Conditions Since Elimination of Rule 10a-1

Recently, market volatility has increased markedly in the U.S., as well as in every major stock market around the world. Although we are not aware of specific empirical evidence that the elimination of short sale price tests has contributed to the increased volatility in U.S. markets, many members of the public currently associate the removal of former Rule 10a-1 with the recent volatility, including steep declines in some securities' prices, and the loss of investor confidence in our markets.

In addition, we have received numerous requests for reinstatement of short sale price test restrictions from a variety of individuals, including investors, issuers, academics, trade associations, and members of Congress.

Most of these commenters have asked that we reinstate short sale price test restrictions because they believe that such a measure would help restore investor confidence.

See,

e.g.,

letter to Mary Schapiro, Chairman, from Rep. Barney Frank and other Members of the House Financial Services Committee, dated March 11, 2009; letter to Mary Schapiro, Chairman, Commission, from Professor Constantine Katsoris (“Katsoris letter”), Fordham University School of Law, dated March 4, 2009; letter from Albert C. Roelse, dated Feb. 20, 2009; letter from Robert A. Lee, dated Feb. 10, 2009; letter from Giulio Liotine, dated Jan. 22, 2009 (“Liotine Letter”); letter from Edward L. Yingling, American Bankers Association, dated Dec. 16, 2008 (“American Bankers Assn. 2008 Letter”); letter from Peter Brown, dated Dec. 12, 2008 (“Brown Letter”); letter to Christopher Cox, Chairman, Commission, from Peter T. King, Member of Congress, dated Oct. 7, 2008; letter to Christopher Cox, Chairman, Commission, from Bill Sali, Member of Congress, dated Oct. 1, 2008; letter to Christopher Cox, Chairman, Commission, from T.J. Rodgers, President and CEO, Cypress Semiconductor Corp., dated October 1, 2008; letter to Christopher Cox, Chairman, Commission, from Carl H. Tiedmann, General Partner, Tiedmann Investment Group, dated Sept. 22, 2008; letter to Christopher Cox, Chairman, Commission, from Hillary Rodham Clinton, Senator, dated Sept. 17, 2008 (“Clinton Letter”). The Commission's Office of Investor Education and Advocacy estimates that it has received over 4,000 requests (including duplicate requests) from individuals regarding reinstating a short sale price test.

See,

e.g.,

letter from Chris Baratta, dated March 9, 2009 (“Baratta Letter”); letter from Paul Kent, dated March 7, 2009; letter from Troy Williams, dated March 6, 2009; letter from Briggs Diuguid, dated March 5, 2009 (“Diuguid Letter”); letter from Bob Young, dated March 5, 2009; letter from Kevin Girard, dated March 4, 2009; letter from Mike Rogers, dated March 3, 2009; letter from George Flagg, dated March 3, 2009; letter from Arleen Golden, dated March 2, 2009; letter from Doug Cameron, dated March 2, 2009; letter from Dr. Bill Daniel, dated Feb. 26, 2009; letter from Glenn Webster, dated Feb. 26, 2009; letter from Robert Lounsbury, dated Feb. 25, 2009; letter from Karl Findorff, dated Feb. 19, 2009; letter from Robert Levine, dated Feb. 17, 2009; letter from Robert Lee, dated Feb. 10, 2009; American Bankers Assn. 2008 letter; letter from David Campbell and Natalie Win, dated Nov. 25, 2008; letter from Josh Dodson, dated Nov. 21, 2008; letter from J. Geddes Parsons, dated Nov. 21, 2008; letter from Charles Rudisill, dated Nov. 21, 2008; letter from Mike Ryan, dated Nov. 21, 2008; letter from Jeff Brower, dated Nov. 20, 2008; letter from Mike Abraham, dated Nov. 20, 2008; letter from Marvin Dingott, dated Nov. 20, 2008; letter from W. Romain Spell, dated Nov. 19, 2008; letter from Phil Mason, dated Nov. 19, 2008; letter from David Sheridan, dated Nov. 18, 2008; letter from Lynn Miller, dated Nov. 13, 2008; letter from Patrick McQuaid, dated Oct. 29, 2008; letter from Scotland Settle, dated Oct. 27, 2008; letter from Jenna Spurrier, dated Oct. 24, 2008; letter from Joe Garrett, dated Oct. 15, 2008; letter from Peter Eckle, dated Oct. 11, 2008; letter from Maureen Christensen, dated Oct. 9, 2008; letter from Richard Vulpi, dated Sept. 24, 2008;

see also

Katsoris Letter (stating that elimination of former Rule 10a-1 “* * * hardly generates confidence on the part of a true investor who is entrusting his or her life's savings * * * to the current market”).

Some of these commenters have stated that a lack of price test restrictions makes them question whether they should invest in the stock market.

Other commenters have stated that they believe a short sale price test would aid small investors.

In addition, some commenters have asserted that restricting the prices at which securities may be sold short would help address recent steep declines in securities' prices. For example, the American Bankers Association (the “ABA”) noted that its members, “both large and small, are telling [the ABA] that short sellers are taking advantage of the uptick rule's absence and that their stock prices are experiencing excessive downward price pressure * * *.”

This commenter further noted that “its members strongly believe that reinstatement of the uptick rule in some format would help limit these downward stock spirals and restore investor confidence.”

See,

e.g.,

letter from Tim Zanni, dated Feb. 19, 2009; letter from Jeff Boyd, dated Feb. 10, 2009.

See,

e.g.,

Baratta Letter (noting that while price test restrictions could not reasonably be expected to prevent market downturns, they would, in his opinion, “give the little investor a chance” in the current conditions).

See also

Young Letter (suggesting that reinstatement of the uptick rule “will not be a quick or total fix, but it will help”); letter to Mary Schapiro, Chairman, Commission, from Paul D. Mendelsohn, President of Windham Financial Services, Inc., dated March 6, 2009 (stating that he believes former Rule 10a-1 “protected” the markets and that “suspension of the uptick rule has opened a security hole into our financial system”).

See

American Bankers Assn. 2009 Letter.

See id.

See also letter to Christopher Cox, Chairman, Commission, from Paul Tudor Jones II, Tudor Investment Corporation, dated Oct. 10, 2008 (stating that he believes that one way to “immediately stem the decline” in the stock market would be to reinstate the uptick rule); letter to Mary Schapiro, Chairman, Commission, from James F. Kane, Jr., dated Feb. 6, 2009 (stating that he believes that reinstating “the Up-tick Rule will go a long way in preventing speculators from ganging up on a particular stock and forcing it down”); Diuguid Letter (stating that while short sellers “make efficient markets,” he is nonetheless concerned that short selling may be a tool of manipulators when short sales are “piled on” a particular company).

In commenting on the recent market volatility and the absence of a short sale price test, one member of Congress recently stated that “[o]ne of the simplest but most important and effective initiatives that the SEC could undertake immediately to combat market volatility is the reinstatement of a * * * `uptick rule'.”

A former U.S. Senator urged the Commission to “* * * give close consideration to the many calls for the immediate restoration of the uptick rule whose repeal has been linked to the recent market volatility and proliferation of abusive short sale transactions.”

SRO representatives and others have also commented on the need for a short sale price test.

Researchers have also indicated that they believe that they have collected data that establishes a possible association between the current market downturn and the elimination of former Rule 10a-1.

In addition, we note that recently there are reports of significant short selling in connection with credit default swaps, particularly in the securities of significant financial institutions.

One commenter has suggested that the interaction between and amplifying effects of credit default swaps and short selling may be a reason to reinstate a short sale price test.

See

letter to Mary Schapiro, Chairman, Commission, from Gary L. Ackerman, Member of Congress, dated Jan. 27, 2009.

See

Clinton Letter.

See,

e.g.,

Edgar Ortega,

Short-Sale Rule Undermined as Bernanke Backs Review,

Bloomberg News Service, March 4, 2009 (noting comments by Duncan Niederauer, CEO, The NYSE/Euronext Group, Inc., that imposing a measure such as former Rule 10a-1 “would go a long way to adding confidence” in our markets); Ben Stein,

How to Deal with a 3 A.M. Fear,

The New York Times, March 8, 2009; Charles R. Schwab,

Restore the Uptick Rule, Restore Confidence,

Wall Street Journal Online, December 9, 2008. The Federal Reserve Chairman also recently noted that, while the “traditional literature on this doesn't seem to find much effect of the uptick rule,” short sale price test restrictions are “worth looking at” and that the rule (

i.e.,

former Rule 10a-1) “might have had some benefit.”

Monetary Policy and the State of the Economy: Hearing Before the House Financial Services Comm., 111th Cong., 1st Sess.

(Lexis Federal News Service at 33) (Feb. 25, 2009).

See also

letter from Duncan Niederauer, CEO, The NYSE/Euronext Group, Inc., Robert Greifeld, CEO, The NASDAQ OMX Group, Inc., Joe Ratterman, CEO, BATS Exchange, Inc., Joseph Rizzello, CEO, National Stock Exchange, dated March 24, 2009 (“National Exchanges Letter”) (stating that the United States national securities exchanges welcome the announcement that the Commission will consider a proposal to adopt a rule to combat abusive short selling and suggesting that any such rule proposal include a circuit breaker in the form discussed therein).

See

D. Harmon and Y. Bar-Yam, 2008,

Technical Report on the SEC Uptick Repeal Pilot,

New England Complex Systems Institute;

see also

Robert C. Pozen and Dr. Yaneer Bar-Yam,

There's a Better Way to Prevent Bear Raids,

The Wall Street Journal, Opinion, November 18, 2008 (stating that the “uptick rule” is an effective way to prevent “bear raids”).

But cf.

John C. Bogle, Jr. and Howard Flinker,

Uptick Rule Won't Prevent More Raids by the Bear,

The Wall Street Journal, Opinion Section (November 26, 2008).

See

George Soros,

The Game Changer,

available at

http://www.ft.com/cms/s/0/49b1654a-ed60-11dd-bd60-0000779fd2ac.html.

See id.

(concluding that Lehman, AIG and other financial institutions were destroyed by “bear raids” in which the shorting of stocks and buying of CDS amplified and reinforced each other).

Questions and comments have been raised about the role that short selling, and in particular potentially abusive short selling, may have in connection with the price fluctuations and disruption in our markets. As such, recently we took a number of short sale-related actions aimed at addressing these concerns. For example, due to our concerns that false rumors spread by short sellers regarding financial institutions of significance in the U.S. may have fueled market volatility in the securities of some of these institutions, on July 15, 2008, we issued an emergency order (“July Emergency Order”)

pursuant to Section 12(k)(2) of the Exchange Act

which imposed borrowing and delivery requirements on short sales of the equity securities of certain financial institutions. We noted in the July Emergency Order that false rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by “naked” short selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process.

If significant financial institutions are involved, this chain of events can threaten disruption of our markets.

See

Securities Exchange Act Release No. 58166 (July 15, 2008), 73 FR 42379 (July 21, 2008).

15 U.S.C. 78

(k).

See

July Emergency Order, 73 FR 42379.

See id.

Due to our concerns regarding the impact of short selling on the prices of financial institution securities, on September 18, 2008, we issued another emergency order prohibiting short selling in the publicly traded securities of certain financial institutions.

Our concerns, however, have not been limited to financial institutions given the importance of confidence in our markets and recent rapid and steep declines in the prices of securities generally.

Such rapid and steep price declines can give rise to questions about the underlying financial condition of an institution, which in turn can erode confidence even without an underlying fundamental basis.

This erosion of confidence can impair the liquidity and ultimate viability of an institution, with potentially broad market consequences.

See

Securities Exchange Act Release No. 58592 (Sept. 18, 2008), 73 FR 55169 (Sept. 24, 2008).

See,

e.g.,

July Emergency Order, 73 FR 42379; Securities Exchange Act Release No. 58592 (Sept. 18, 2008), 73 FR 55169 (Sept. 24, 2008) (“Short Sale Ban Emergency Order”); Securities Exchange Act Release No. 58572 (Sept. 17, 2008), 73 FR 54875 (Sept. 23, 2008) (“September Emergency Order”).

See

Short Sale Ban Emergency Order, 73 FR 55169; September Emergency Order, 73 FR 54875.

See id.

These concerns resulted in our issuance on September 17, 2008 of an emergency order under Section 12(k)(2) of the Exchange Act, in part targeting

short selling in all equity securities.

Pursuant to the September Emergency Order we imposed enhanced delivery requirements on sales of all equity securities under Rule 204T of Regulation SHO.

See

September Emergency Order, 73 FR 54875.

See id.

We subsequently issued an interim final temporary rule imposing the delivery requirements of Rule 204T of Regulation SHO until July 31, 2009.

See

Securities Exchange Act Release No. 58773 (Oct. 14, 2008), 73 FR 61706 (Oct. 17, 2008) (“Interim Final Temporary Rule 204T”). We and Commission staff are currently reviewing the comment letters received in response to that rule. In addition, we issued an emergency order, and subsequent interim final temporary rule, to require disclosure of short sales and short positions in certain securities. The temporary rule expires on August 1, 2009. We and Commission staff are currently reviewing comment letters received in response to the temporary rule.

See

Securities Exchange Act Release No. 58591 (Sept. 18, 2008).

See also

Securities Exchange Act Release No. 58785 (Oct. 15, 2008), 73 FR 61678 (Oct. 17, 2008).

The enhanced close-out requirements of Rule 204T of Regulation SHO in the September Emergency Order, which, among other things, require participants of a registered clearing agency to close-out fails to deliver resulting from short sales of any equity security by purchasing or borrowing the security by no later than the beginning of trading on the day after the fail to deliver occurs, appear to be having a positive effect toward achieving our goal of reducing fails to deliver.

As we stated in the October 2008 release adopting Rule 204T as an interim final temporary rule, we are concerned about the potentially negative market impact of large and persistent fails to deliver.

Thus, our adoption of Rule 204T followed a series of other steps aimed at reducing such fails to deliver and addressing potentially abusive short selling. Such steps included eliminating the “grandfather” and options market maker exceptions to Regulation SHO's close-out requirement,

and proposing and subsequently adopting a “naked” short selling anti-fraud rule, Rule 10b-21.

Although we recognize that fails to deliver can occur for legitimate reasons, we are concerned about the impact of large and persistent fails to deliver on market confidence. Preliminary results from OEA indicate that our actions to further reduce fails to deliver and, thereby, address potentially abusive short selling are having their intended effect. For example, preliminary results from OEA indicate that fails to deliver in all equity securities have declined significantly since the adoption of Rule 204T.

See

September Emergency Order, 73 FR 54875.

See

Interim Final Temporary Rule 204T, 73 FR at 61708.

See

Securities Exchange Act Release No. 56212 (Aug. 7, 2007), 72 FR 45544 (Aug. 14, 2007) (eliminating the “grandfather” exception to Regulation SHO's close-out requirement); September Emergency Order, 73 FR 54875 (eliminating the options market maker exception to Regulation SHO's close-out requirement). Following the issuance of the September Emergency Order, we adopted amendments making permanent the elimination of the options market maker exception.

See

Securities Exchange Act Release No. 58775 (Oct. 14, 2008), 73 FR 61690 (Oct. 17, 2008).

See

Securities Exchange Act Release No. 58774 (Oct. 14, 2008), 73 FR 61666 (Oct. 17, 2008); Securities Exchange Act Release No. 57511 (March 17, 2008), 73 FR 15376 (March 21, 2008).

See

Memorandum from OEA Re: Impact of Recent SHO Rule Changes on Fails to Deliver, November 26, 2008 at

http://www.sec.gov/comments/s7-30-08/s73008-37.pdf;

Memorandum from OEA Re: Impact of Recent SHO Rule Changes on Fails to Deliver, March 20, 2009 at

http://www.sec.gov/comments/s7-30-08/s73008-107.pdf

(stating, among other things, that the average daily number of aggregate fails to deliver for all securities decreased from 1.1 billion to 582 million for a total decline of 47.2% when comparing a pre-Rule to post-Rule period).

Questions persist, however, about the rapid and steep declines in the prices of securities, and we recognize the concern over the continuing erosion of investor confidence in our markets. Thus, we have continued to examine whether there are other actions that the Commission might consider, including re-evaluating whether a short sale price test ought to be reintroduced or a circuit breaker rule should be imposed, in light of the extreme market declines and volatility, as well as the loss of investor confidence we continue to experience.

We also note that when we eliminated all short sale price test restrictions in July 2007, we acknowledged that circumstances may develop that would warrant relief from the prohibition in Rule 201 of Regulation SHO for a short sale price test, including a short sale price test of an SRO, to apply to short sales in any security.

Thus, in determining whether or not to propose a short sale price test rule or circuit breaker rule, we have considered the recent turmoil in the financial sector and steep declines and extreme volatility in securities prices. The turbulence in the financial markets has been underscored over the past 18 months by events such as the March 2008 sale of Bear Stearns Corporation, and the crisis surrounding the collapse of Lehman Brothers in September 2008.

See

2007 Price Test Adopting Release, 72 FR 36348.

In addition, between July 2007 and March 2009, the Dow Jones Industrial Average (“DJIA”) lost roughly 50% of its value, while the Standard and Poor's 500 Index fell approximately 54%.

The publicly traded securities of significant financial institutions have experienced large reductions in value in 2008 and early 2009.

For example, one significant financial institution's stock price declined from approximately $49 per share in the beginning of July 2007, to approximately $1 per share in March 2009. Similarly, in July 2007, another significant financial institution's stock price declined from approximately $49 per share to approximately $3 per share in March 2009. In addition, in 2008, a number of major banks became the subjects of federal seizure.

A total of 25 banks failed in 2008, resulting in a $33.5 billion expenditure of the fund used by the Federal Deposit Insurance Corporation (“FDIC”) to protect individual depositors' savings.

Put simply, market conditions have changed dramatically in recent months.

On July 3, 2007, the DJIA closed at 13,577, and on March 3, 2009, the DJIA closed at 6,726. On July 3, 2007, the S&P 500 Index closed at 1524.87, and on March 3, 2009, the S&P 500 Index closed at 700.82.

We note that we have no empirical evidence that such falling prices are the result of short selling activity and the lack of short sale price test restrictions.

See, e.g.,

Office of Thrift Supervision,

Receivership Of A Federal Saving Association,

dated Sept. 25, 2008 at

http://files.ots.treas.gov/680024.pdf;

Office of Thrift Supervision,

Pass-Through Receivership Of A Federal Savings Association Into A De Novo Federal Savings Association That Is Placed Into Conservatorship With the FDIC,

dated July 11, 2008 at

http://files.ots.treas.gov/680018.pdf

See

Alison Vekshin,

Bair Says Insurance Fund Could Be Insolvent This Year,

http://www.bloomberg.com/apps/news?pid=washingtonstory&sid=alsJZqIFuN3k,

March 4, 2009.

We note, however, that stock markets have incurred significant declines in value under former short sale price test restrictions, most notably the 1987 Market Crash and the 2000 Tech Bubble Burst.

In addition, as noted above, in response to the proposed amendments to eliminate former Rule 10a-1, one commenter expressed its concern about unrestricted short selling during periods of unusually rapid and large market declines.

This concern has been echoed in recent comment letters to the Commission.

We note, however, that in the 2007 Price Test Adopting Release, we noted that because of the Commission's stated objective when it adopted Rule 10a-1 and our concerns about the potential use of short sales to manipulate stock prices, OEA examined the Pilot data for any indication that there is an association between extreme price movements and price test

restrictions. OEA, however, did not find any such association.

See

NYSE letter.

See,

e.g.,

Brown Letter (noting that “the investigation performed before the uptick rule was rescinded was insufficient, particularly [because] it covered a period of relative market stability and studied the side effects of the rule rather than the primary effect of the rule which would only be seen in a sharply down market such as we have just suffered”); Liotine Letter (stating that “[t]he research done prior to the [amendment] of rule 10-A was far too short” and that the study should have lasted longer to “ensure at least one bear market was involved in the study”).

See

2007 Price Test Adopting Release, 72 FR at 36351.

Due to the extreme market conditions with which we are currently faced and the resulting deterioration in investor confidence, we believe it is appropriate at this time to propose amending Regulation SHO to add a short sale price test or a circuit breaker rule. In issuing this proposing release, we seek empirical data regarding the costs and benefits of reinstating short sale price test restrictions or imposing circuit breaker rules, including the potential impact on legitimate short selling. We note that although we have received numerous letters requesting reinstatement of short sale price test restrictions, such requests have not included empirical data, but rather focus on what such commenters believe might be the impact on the markets of reinstating such restrictions. In addition, such requests do not discuss the potential impact of short sale price test restrictions on the benefits of legitimate short selling.

As discussed in this release, we remain mindful that there are benefits of short selling. For example, legitimate short selling can play an important and constructive functional role in the markets, providing liquidity and price efficiency. Short sellers also play an important role in correcting upward stock price manipulation.

Because short sale price test restrictions may lessen some of these benefits, it is important that any short sale price test regulation be designed to limit any potentially unnecessary impact on legitimate short selling.

See

OEA Staff's Summary Pilot Report, at 9.

We also recognize that some market participants may be advocating for a short sale price test because such participants may believe that it would put them at a competitive advantage over other participants who may be less able to implement or adjust their trading strategies to account for a short sale price test or may otherwise benefit at the expense of investors. Other market participants may favor a short sale price test due to concerns about the imposition of a greater restriction on short selling.

We believe that all arguments, both for and against a short sale price test rule and a possible circuit breaker rule, should be considered and addressed in light of current market conditions and recent experience. Thus, we believe it is important at this time to propose and obtain informed public comment regarding restricting the prices at which securities can be sold short before determining whether or not to impose any such restrictions, and what any such restrictions should be, as well as the proposed circuit breaker rules.

As discussed in detail below, we are proposing two alternative price tests. The first test would be the proposed modified uptick rule that would be based on the national best bid. The second test would be the proposed uptick rule that would be a modified version of the tick test under former Rule 10a-1. We are also proposing amendments to Rule 200(g) of Regulation SHO that would require that a broker-dealer mark certain sell orders “short exempt.”

In considering whether to reinstitute short sale price test restrictions, it is important that the Commission take into account any extant empirical data and analyses that would shed light on the potential impact of such restrictions on capital markets. In that connection, we note that OEA has analyzed the impact that a short sale price test might have had during a thirteen day period in September of 2008

as well as whether and the extent to which short selling drove prices downward during a volatile period in early September 2008.

The first of these studies noted that, although its data were limited to historical trade and quote data from a period when no price test was in place and the shape of order book and trading sequences might have differed had a price test been in place, a price test would likely have been most restrictive during periods of low volatility, with greatest impact on short selling in lower priced and more active stocks.

The second study found that long sellers were primarily responsible for price declines during this period. It also found that, on average, short sale volume as a fraction of total volume was highest during periods of positive returns, noting, however, that it was also possible that there were instances in which short selling activity peaked during periods of extreme negative returns.

The Commission looks forward to receiving additional analysis of relevant data and factors.

See

Office of Economic Analysis,

Analysis of a short sale price test using intraday quote and trade data,

Dec. 17, 2008.

See

Office of Economic Analysis,

Analysis of Short Selling Activity during the First Weeks of September, 2008,

Dec. 16, 2008.

See

OEA analysis (Dec. 17, 2008),

supra

note 92.

See

OEA analysis (Dec. 16, 2008),

supra

note 93.

Similarly, it is important that the Commission take into account any extant empirical data and analyses that would shed light on the potential impact of such restrictions on capital markets, and it looks forward to receiving analysis of relevant data.

III. Discussion of Proposed Short Sale Restrictions

We discuss below our price test approach, the alternatives contained therein and our circuit breaker approach. As noted above, we preliminarily believe that a price test based on the national best bid would have advantages over a test based on the last sale price in today's markets. In particular, we believe that bids generally are a more accurate reflection of current prices for a security than last sale prices due to delays that can occur in the reporting of last sale price information and because last sale price information is published to the markets in reporting rather than trade sequence.

In adopting a final rule, we could take several different approaches, or a combination of approaches. For example, we could consider a straight prohibition approach prohibiting all persons from effecting short sales under a price test that references either the national best bid or the last sale price; a policies and procedures approach imposing obligations on market participants to adopt policies and procedures to guard against impermissible short selling; or a combination of a straight prohibition and a policies and procedures approach.

We discuss below the proposed modified uptick rule which would require trading centers to have policies and procedures reasonably designed to prevent the execution or display of short sales at impermissible prices. As an alternative, in Section II.B, below, we discuss the proposed uptick rule that is based on the last sale price and that, similar to former Rule 10a-1, would apply a straight prohibition approach that would prohibit any person from effecting short sales at impermissible prices. However, either alternative could ultimately be implemented through a policies and procedures or through a straight prohibition approach or some combination thereof.

We also discuss below our circuit breaker approach, which includes two basic alternatives—a halt and a price test. The proposed circuit breaker price test rule would temporarily result in either the proposed modified uptick rule or the proposed uptick rule applying to a specific security if there was a severe decline in the price of that security. As with the proposed short sale price test rules, the proposed circuit breaker price test rules could also be in the form of either a straight prohibition

or a policies and procedures approach. The proposed circuit breaker halt rule, which would temporarily halt short selling in a specific security if there is a severe price decline in that security, could operate either in addition to, or in place of, a proposed short sale price test rule.

A. Proposed Modified Uptick Rule

1. Operation of the Proposed Modified Uptick Rule

We are proposing to amend Rule 201 of Regulation SHO to add a short sale price test that would use the national best bid as a reference point for short sale orders. Specifically, the proposed modified uptick rule would provide that “[a] trading center shall establish, maintain, and enforce written policies and procedures reasonably designed to prevent the execution or display of a short sale order in a covered security at a down-bid price.”

The proposed modified uptick rule defines a “down-bid price” as “a price that is less than the current national best bid or, if the last differently priced national best bid was greater than the current national best bid, a price that is less than or equal to the current national best bid.”

See

Proposed Rule 201(b)(1).

Proposed Rule 201(a)(2).

Thus, under the proposed modified uptick rule, a trading center would be required to have policies and procedures reasonably designed to prevent it from executing or displaying any short sale order, absent an exception, at a price that is below the national best bid. If the current national best bid is below the last differently priced national best bid, a trading center would be required to have policies and procedures reasonably designed to prevent it from executing or displaying the order unless the order is priced above the current national best bid. Such a rule might help prevent short sellers from driving the market down. In addition, the proposed modified uptick rule might help prevent short sales from being used as a tool to accelerate a declining market.

The following example demonstrates the operation of the proposed modified uptick rule. If the current national best bid in a security is $47.00, and the immediately preceding national best bid was $46.99 (

i.e.,

the current bid is above the previous bid), a trading center could immediately execute a short sale order at $47.00 or above. Similarly, a trading center could display a short sale order priced at $47.00 or above.

If the current national best bid in a security is $47.00, and the immediately preceding bid was $47.01 (

i.e.,

the current bid is below the previous bid), a trading center could execute or display a short sale order at a price above $47.00.

If the current national best bid in a security is $47.00, and the immediately preceding national best bid was $47.00, but that bid was above the prior national best bid (

i.e.,

the last differently priced national best bid), a trading center could execute a short sale order at $47.00 or above. Similarly, a trading center could display a short sale order priced at $47.00 or above.

100

If the current national best bid is $47.00, and the immediately preceding national best bid was $47.00, but that was below the prior national best bid (

i.e.,

the last differently priced national best bid), a trading center could execute or display a short sale at a price above $47.00.

101

A trading center could display a short sale order priced at $47.00 provided such order would comply with the locking or crossing requirements of any Commission or SRO rule.

See, e.g.,

17 CFR 242.610(d).

Any such execution or display would also need to be in compliance with applicable rules regarding minimum pricing increments.

See

17 CFR 242.612.

100

A trading center could display a short sale order priced at $47.00 provided such order would comply with the locking or crossing requirements of any Commission or SRO rule.

See, e.g.,

17 CFR 242.610(d).

101

Any such execution or display would also need to be in compliance with applicable rules regarding minimum pricing increments.

See

17 CFR 242.612.

The proposed modified uptick rule would apply to any “covered security,” which is defined as an “NMS stock” under Rule 600(b)(47) of Regulation NMS.

102

Rule 600(b)(47) of Regulation NMS defines an “NMS stock” as “any NMS security other than an option.”

103

Rule 600(b)(46) of Regulation NMS defines an “NMS security” as “any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options.”

104

Thus, the proposed modified uptick rule would apply to any security or class of securities, except options, for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan.

105

As a result, the proposed modified uptick rule generally would cover all securities, except options, listed on a national securities exchange whether traded on an exchange or in the over-the-counter (“OTC”) market. It would not include non-NMS stocks quoted on the OTC Bulletin Board or elsewhere in the OTC market. We are not proposing to apply the proposed modified uptick rule to non-NMS stocks quoted on the OTC Bulletin Board or elsewhere in the OTC market because a national best bid and offer currently is not required to be collected, consolidated, and disseminated for such securities. In addition, former Rule 10a-1 did not apply to non-exchange listed securities quoted on the OTC Bulletin Board or elsewhere in the OTC market. We recognize, however, that issuers of securities quoted in the OTC market may believe that they are particularly vulnerable to abusive short selling. Thus, we seek specific comment regarding whether the proposed modified uptick rule or some other form of price test, or any other restrictions on short sales, should apply to these types of securities.

102

See

proposed Rule 201(a)(1).

103

17 CFR 242.600(b)(47).

104

17 CFR 242.600(b)(46).

105

See

proposed Rule 201(a)(1) (providing that a “covered security” shall mean all “NMS stock” as defined in § 242.600(b)(47) of Regulation NMS).

The scope of securities covered by the proposed modified uptick rule would be similar to the scope of securities covered by former Rule 10a-1. Former Rule 10a-1(a) applied to securities registered on, or admitted to unlisted trading privileges on, a national securities exchange, if trades of the security were reported pursuant to an effective transaction reporting plan and information regarding such trades was made available in accordance with such plan on a real-time basis to vendors of market transaction information. All securities that would have been subject to former Rule 10a-1 would also be subject to the proposed modified uptick rule. In addition, certain securities,

i.e.,

securities traded on Nasdaq prior to its regulation as an exchange, that were not subject to former Rule 10a-1, would be subject to the proposed modified uptick rule.

106

When Nasdaq became a national securities exchange in 2006, absent an exemption from former Rule 10a-1, all Nasdaq securities would have been subject to former Rule 10a-1. The Commission provided Nasdaq with an exemption from the application of the provisions of former Rule 10a-1 to securities traded on Nasdaq because the Pilot was already in progress, and the Commission believed it was necessary and appropriate to maintain the status quo for short sale price tests during the Pilot, and to ensure that market participants would not be burdened with costs associated with implementing a price test that might be temporary.

See

letter to Marc Menchel, Executive Vice President and General Counsel, NASD, Inc., June 26, 2006.

Market information for NMS stocks, including quotes, is disseminated pursuant to three different national market system plans.

107

The national

securities exchanges and FINRA participate in these joint-industry plans (“Plans”).

108

The Plans establish three separate networks to disseminate market information for NMS stocks.

109

These networks are designed to ensure that, among other things, consolidated bids from the various trading centers that trade NMS stocks are continually collected and disseminated on a real-time basis, in a single stream of information. Thus, all trading centers would have access to the consolidated bids for all the securities that would be subject to the proposed modified uptick rule.

110

As discussed in further detail below, however, we note that the national best bid can change rapidly and repeatedly and potentially there might be latencies in obtaining data regarding the national best bid.

107

The three joint-industry plans are (1) the Consolidated Tape Association Plan (“CTA Plan”), which disseminates transaction information for

securities primarily listed on an exchange other than Nasdaq, (2) the Consolidated Quotation Plan (“CQ Plan”), which disseminates consolidated quotation information for securities primarily listed on an exchange other than Nasdaq, and (3) the Nasdaq UTP Plan, which disseminates consolidated transaction and quotation information for securities primarily listed on Nasdaq.

108

Rule 603(b) of Regulation NMS provides that every national securities exchange on which an NMS stock is traded and national securities association shall act jointly pursuant to one or more effective national market system plans to disseminate consolidated information, including a national best bid and national best offer, for NMS stocks.

See

17 CFR 242.603(b).

109

These networks can be categorized as follows: (1) Network A—securities primarily listed on the NYSE; (2) Network B—securities listed on exchanges other than the NYSE and Nasdaq; and (3) Network C—securities primarily listed on Nasdaq.

110

See

Securities Exchange Act Release No. 51808 (June 9, 2005), 70 FR 37496, 37503 (June 29, 2005) (“Regulation NMS Adopting Release”).

The proposed modified uptick rule would apply to any trading center that executes or displays a short sale order in a covered security. It would define a “trading center” as “a national securities exchange or national securities association that operates an SRO trading facility, an alternative trading system, an exchange market maker, an OTC market maker, or any other broker or dealer that executes orders internally by trading as principal or crossing orders as agent.”

111

The proposed definition encompasses all entities that may execute short sale orders. Thus, the proposed modified uptick rule would apply to any entity that executes short sale orders.

111

See

17 CFR 242.600(b)(78);

see also

proposed Rule 201(a)(7) (providing that the term “trading center” shall have the same meaning as in § 242.600(b)(78) of Regulation NMS).

Under the proposed modified uptick rule, a trading center would be required to have written policies and procedures reasonably designed to prevent the execution or display of short sale orders on a down-bid price. Thus, upon receipt of a short sale order, a trading center's policies and procedures would have to require that the trading center be able to determine whether or not the short sale order could be executed or displayed in accordance with the provisions of proposed Rule 201(b)(1). If the order is marketable at a permissible price, the trading center would be able to present the order for immediate execution or, if not immediately marketable, hold for execution later at its specified price.

The proposed modified uptick rule would permit a trading center to display an order provided it is permissibly priced at the time the trading center displays the order. If an order is impermissibly priced, the trading center could, in accordance with policies and procedures reasonably designed to prevent the execution or display of a short sale order at a down-bid price, re-price the order at the lowest permissible price and hold it for later execution at its new price or better.

112

As quoted prices change, the proposed rule would allow a trading center to repeatedly re-price and display an order at the lowest permissible price down to the order's original limit order price (or, if a market order, until the order is filled).

112

For example, if a trading center receives a short sale order priced at $47.00 when the current national best bid in the security is $47.00, but the immediately preceding national best bid was $47.01 (

i.e.,

the current bid is below the previous bid), the trading center could re-price the order at the permissible offer price of $47.01, and display the order for execution at this new limit price.

In addition, paragraph (b)(1)(i) of the proposed rule would require a trading center's policies and procedures to be reasonably designed to permit a trading center to execute a displayed short sale order at a down-bid price provided that, at the time the order was displayed by the trading center it was permissibly priced,

i.e.,

not on a down-bid price.

113

This exception for properly displayed short sale orders would help avoid a conflict between the proposed modified uptick rule and the “Quote Rule” under Rule 602 of Regulation NMS. The Quote Rule requires that, subject to certain exceptions, the broker-dealer responsible for communicating a quotation shall be obligated to execute any order to buy or sell presented to him, other than an odd lot order, at a price at least as favorable to such buyer or seller as the responsible broker-dealer's published bid or published offer in any amount up to his published quotation size.

114

Thus, pursuant to this exception, a trading center would be able to comply with the “firm quote” requirement of Rule 602 of Regulation NMS by executing a presented order to buy against its displayed offer to sell as long as the displayed offer to sell was permissibly priced under the proposed rule at the time it was first displayed, even if the execution of the transaction would be on a down-bid price at the time of execution.

113

See

proposed Rule 201(b)(1)(i).

114

See

17 CFR 242.602(b)(2). We note that to the extent that a short sale order is undisplayed, the proposed modified uptick rule would prevent the trading center from executing the order unless at the time of execution, the execution price complies with the proposed modified uptick rule at the time of execution of the order.

Because a trading center could re-price and display a previously impermissibly priced short sale order the proposed modified uptick rule potentially allows for the more efficient functioning of the markets than the proposed uptick rule because trading centers would not have to reject or cancel impermissibly priced orders unless instructed to do so by the trading center's customer submitting the short sale order. We recognize that some trading centers might not want to re-price an impermissibly priced short sale order. Thus, re-pricing would not be a requirement under the proposed modified uptick rule.

In addition, the proposed modified uptick rule would provide trading centers and their customers with flexibility in determining how to handle orders that are not immediately executable or displayable by the trading center because the order is impermissibly priced. For example, trading centers could offer their customers various order types regarding the handling of impermissibly priced orders such that a trading center either could reject an impermissibly priced order or re-price the order at the lowest permissible price until the order is filled.

The proposed modified uptick rule would focus on a trading center's written policies and procedures as the mechanism through which to prevent the execution or display of short sale orders on a down-bid price. Under this approach, trading centers would be required to have policies and procedures reasonably designed to prevent the execution or display of short sale orders at impermissible prices and to surveil the effectiveness of the policies and procedures. Thus, short sale orders executed or displayed at impermissible prices would require the trading center that executed or displayed the short sales to take prompt action to remedy any deficiencies.

We also note that the policies and procedures requirements of the proposed modified uptick rule are similar to those set forth under

Regulation NMS.

115

In accordance with Regulation NMS, trading centers must have in place written policies and procedures in connection with that Regulation's order protection rule.

116

Thus, trading centers are already familiar with establishing, maintaining, and enforcing trading-related policies and procedures, including programming their trading systems in accordance with such policies and procedures. This familiarity should reduce the implementation costs of the proposed modified uptick rule on trading centers.

115

See

Regulation NMS Adopting Release, 70 FR 37496;

see also

17 CFR 242.611.

116

See id.

Similar to the requirements under Regulation NMS in connection with the order protection rule,

117

at a minimum, a trading center's policies and procedures would need to enable a trading center to monitor, on a real-time basis, the national best bid, and whether the current national best bid is an up- or down-bid from the last differently priced national best bid, so as to determine the price at which the trading center may execute or display a short sale order. In addition, a trading center would need to have policies and procedures reasonably designed to permit the execution or display of a short sale order of a covered security marked “short exempt” without regard to whether the order is at a down-bid price.

118

A trading center's policies and procedures would not, however, have to include mechanisms to determine on which provision a broker-dealer is relying in marking an order “short exempt” in accordance with paragraph (c) or (d) of the proposed modified uptick rule.

119

117

See id.

118

See

Section V below discussing short sale orders marked “short exempt.”

119

See

proposed Rules 201(c) and 201(d).

A trading center would also need to take such steps as would be necessary to enable it to enforce its policies and procedures effectively. For example, trading centers could establish policies and procedures that could include regular exception reports to evaluate their trading practices. If a trading center's policies and procedures include exception reports, any such reports would need to be examined by the trading center to affirm that a trading center's policies and procedures have been followed by its personnel and properly coded into its automated systems and, if not, promptly identify the reasons and take remedial action.

To help ensure compliance with the proposed modified uptick rule, trading centers could also have policies and procedures that would enable a trading center to have a record identifying the current national best bid at the time of execution or display of a short sale order, as well as the last differently priced national best bid. Such “snapshots” of the market would aid SROs in evaluating a trading center's written policies and procedures and compliance with the proposed modified uptick rule. In addition, such snapshots would aid trading centers in verifying that a short sale order was priced in accordance with the provisions of proposed Rule 201(b)(1) if bid “flickering,”

i.e.,

rapid and repeated changes in the current national best bid during the period between identification of the current national best bid and the execution or display of the short sale order, creates confusion regarding whether or not the short sale order was executed or displayed at a permissible price. Snapshots of the market at the time of execution or display of an order would also aid trading centers in dealing with time lags in receiving data regarding the national best bid from different data sources. A trading center's policies and procedures would be required to address latencies in obtaining data regarding the national best bid. In addition, to the extent such latencies occur, a trading center's policies and procedures would need to implement reasonable steps to monitor such latencies on a continuing basis and take appropriate steps to address a problem should one develop.

Trading centers would be required to conduct surveillance under the proposed modified uptick rule. Proposed Rule 201(b)(2) provides that a trading center must regularly surveil to ascertain the effectiveness of the policies and procedures required under the proposed modified uptick rule and must take prompt action to remedy deficiencies in such policies and procedures.

120

This provision would reinforce the ongoing maintenance and enforcement requirements of proposed Rule 201(b)(1) by explicitly assigning an affirmative responsibility to trading centers to surveil to ascertain the effectiveness of their policies and procedures.

121

Thus, under the proposed modified uptick rule, trading centers would not be able to merely establish policies and procedures that may be reasonable when created and assume that such policies and procedures would continue to satisfy the requirements of proposed Rule 201(b). Rather, trading centers would be required to regularly assess the continuing effectiveness of their procedures and take prompt action when needed to remedy deficiencies. In particular, trading centers would need to engage in regular and periodic surveillance to determine whether executions or displays of short sale orders on impermissible bids are occurring without an applicable exception and whether the trading center has failed to implement and maintain policies and procedures that would have reasonably prevented such impermissible executions or displays of short sale orders.

120

See

proposed Rule 201(b)(2).

121

We note that Rule 611(a)(2) of Regulation NMS contains a similar provision for trading centers.

See

17 CFR 242.611(a)(2).

The proposed modified uptick rule would differ from the tick test of former Rule 10a-1, and the alternative proposed uptick rule discussed below. Similar to former Rule 10a-1, the alternative proposed uptick rule would be based on the last sale price, rather than the national best bid, and it would not include an explicit policies and procedures requirement. The proposed uptick rule would prevent the execution of short sale orders below the last sale price, unless an exception applies. The proposed modified uptick rule would prevent the execution or display of short sale orders below the current national best bid, unless, among other things, the order is marked “short exempt.” Because the proposed modified uptick rule would use the national best bid as its reference point, short selling could occur below the last sale price.

The two proposed alternative short sale price tests would operate similarly, however, in that they would be designed to achieve a similar purpose. In addition, to help limit the impact of the proposed alternative short sale price tests on legitimate short selling, both rules would permit short selling at an increment above the national best bid, or the last sale price, as applicable, in a declining market. As commenters have noted, the higher the increment the more restrictive such an increment could be on short selling and could even be tantamount to a ban on short selling.

122

See supra

note 94;

see also

letter from Dan Mathisson, Managing Director, Credit Suisse Securities USA, LLC, dated March 30, 2009 (“letter from Credit Suisse”) (stating that “requiring an uptick of more than one cent would be tantamount to a total ban for any stock that trades actively”).

In addition, the proposed modified uptick rule, similar to the proposed uptick rule, would not result in the type of disparate short sale regulation that existed under former Rule 10a-1.

123

The proposed modified uptick rule would apply a uniform rule to trades in the same securities that can occur in

multiple, dispersed, and diverse markets. One of the reasons for the elimination of former Rule 10a-1 and the prohibition on any SRO from having a short sale price test in July 2007 was because the application of short sale price tests had become disjointed with different price tests applying to the same securities trading in different markets. Under the proposed modified uptick rule, all covered securities, wherever traded, would be subject to one short sale price test, the proposed modified uptick rule. To further this goal of having a uniform short sale price test, subsection (e) of proposed Rule 201 would provide that no SRO shall have any rule that is not in conformity with, or conflicts with proposed Rule 201.

124

In addition, just as market participants would be familiar with the proposed uptick rule because it is a modified version of former Rule 10a-1 that was in existence for almost 70 years, market participants would also be familiar with using the current national best bid as a reference point because NASD's bid test, which was in existence from 1994 to mid-2007, was based on the current national best bid.

125

123

See

proposed Rule 201(e).

124

See

proposed Rule 201(e).

125

See supra

note 27 (discussing NASD Rule 3350). Similar to the proposed modified uptick rule, NASD's bid test referenced the national best bid and was designed to help prevent short selling at or below the current national best bid in a declining market. NASD's bid test, however, took a straight prohibition approach, rather than a policies and procedures approach, and, by its terms, applied only to Nasdaq Global Market securities.

We preliminarily believe that a short sale price test based on the national best bid would be more suitable to today's markets than a short sale price test based on the last sale price. Although we recognize that a quotation proposes a transaction, whereas the last trade price reflects an actual trade, we note that pursuant to Commission and SRO rules, quotations for all covered securities must be firm.

126

By requiring that quotations are firm, the Commission intended to ensure that quotations provide reliable information to the marketplace so that broker-dealers are able to make best execution decisions for their customers' orders and customers are able to make informed investment decisions.

127

Moreover, quotation information has significant value to the marketplace because it reflects the various factors affecting the market, including current levels of buying and selling interest.

128

Both retail and institutional investors rely on quotation information to understand the market forces at work at a given time and to assist in the formulation of investment strategies.

129

126

See e.g.,

17 CFR 242.602.

127

See

Securities Exchange Act Release No. 43085 (July 28, 2000), 65 FR 47918 (Aug. 4, 2000).

128

See id.

129

See id.

Further, we believe that bids generally are a more accurate reflection of current prices for a security because changes in the national best bid are sequenced across trading centers. In contrast, transactions may be reported within a 90 second window, which can easily result in out-of-sequence reports. Even transactions that are executed and reported automatically may be out of sequence if they occur in different trading centers. For example, trade reporting for covered securities can involve multiple trading centers reporting trades in the same stock from different locations using different means of reporting. In addition, trades are published in reporting sequence, not trade sequence.

130

Thus, for those covered securities for which a significant amount of trading occurs manually, or in multiple trading centers, a price test based on the national best bid may be a fairer and more effective means of regulating short selling than a test based on the last sale price because the manner in which trades are reported may create up-ticks and down-ticks that may not accurately reflect actual price movements in the security for the purpose of a test based on the last sale price.

130

See

FINRA Rule 6380A.

The proposed modified uptick rule would be designed to restrict short selling at successively lower prices and, thereby, might help prevent short selling, including potentially abusive or manipulative short selling, from being used as a tool to drive the markets down and from being used to accelerate a decline in the market by exhausting all remaining bids at one price level. By seeking to advance these goals, the proposed modified uptick rule might restore investor confidence in our securities markets.

In addition, the proposed modified uptick rule would be designed to preserve instant execution and liquidity by allowing relatively unrestricted short selling in an advancing market. As discussed above, one of the benefits of legitimate short selling is that it provides market liquidity by, for example, adding to the selling interest of stock available to purchasers, and, when sellers are covering their short sales, adding to the buying interest of stock available to sellers.

In addition, we believe the proposed modified uptick rule would accommodate trading systems and strategies used in the marketplace today, such as the automated trade matching systems that offer price improvement based on the national best bid and offer. These passive pricing systems often effect trades at an independently-derived price, such as at the mid-point of the bid-offer spread. Such pricing would often not satisfy the tick test of former Rule 10a-1 because matches could potentially occur at a price below the last reported sale price. Thus, we provided a limited exception from former Rule 10a-1 for these trading systems.

131

The proposed modified uptick rule would accommodate matching systems that execute trades at an independently derived price because such systems are designed so that matches occur above the current national best bid.

132

Thus, even in a declining market where a trading center could execute or display an order only if it is priced above the current national best bid at the time of execution or display, such matching system executions would comply with the proposed modified uptick rule.

131

See,

e.g.

supra

note 26.

132

See id.

;

see e.g.

, letter from James A. Brigagliano, Acting Associate Director, Division of Market Regulation, to Alan J. Reed, Jr., First Vice President and Director of Compliance, Instinet Group, LLC. (June 15, 2006) (granting Instinet modified exemptive relief from Rule 10a-1 for certain transactions executed through Instinet's Intraday Crossing System); POSIT letter.

If we were to adopt the proposed modified uptick rule, we are proposing that there would be a three month implementation period such that trading centers would have to comply with the proposed modified uptick rule three months following the effective date of the proposed modified uptick rule. We believe that a proposed three month implementation period would provide trading centers with sufficient time in which to modify their systems and procedures in order to comply with the requirements of the proposed modified uptick rule. Because the proposed modified uptick rule would require the implementation of policies and procedures similar to those required for trading centers under Regulation NMS, we believe that a three month implementation period would be reasonable. The addition of an implementation period should alleviate any potential disruptive effects of the proposal.

We realize, however, that a shorter or longer implementation period may be manageable or preferable. In the Solicitation of Comment below, we seek specific comment as to what length of implementation period would be necessary or appropriate, and why, such that trading centers would be able to

meet the proposed short sale price test restrictions, if adopted.

2. “Short Exempt” Provision of Proposed Modified Uptick Rule

Paragraph (b)(1)(ii) of the proposed modified uptick rule provides that a trading center's policies and procedures must be reasonably designed to permit the execution or display of a short sale order of a covered security marked “short exempt” without regard to whether the order is at a down-bid price.

133

Thus, a trading center's policies and procedures must be reasonably designed to recognize when an order is marked “short exempt” so that the trading center's policies and procedures would not prevent the execution or display of such orders on a down-bid price.

134

133

See

proposed Rule 201(b)(1)(ii).

134

See

proposed Rule 201(b)(1)(ii).

As discussed in more detail below, proposed Rule 200(g)(2) of Regulation SHO provides that a sale order shall be marked “short exempt” only if the provisions of paragraph (c) or (d) of proposed Rule 201 are met.

135

Paragraphs (c) and (d) of the proposed modified uptick rule set forth when a broker-dealer may mark a short sale order “short exempt.” The provisions contained in paragraphs (c) and (d) of the proposed modified uptick rule are designed to promote the workability of the proposed modified uptick rule, while at the same time furthering the Commission's stated goals.

135

See

Section V below discussing proposed Rule 200(g)(2).

In addition, we note that the provisions contained in paragraph (d) of proposed Rule 201 would parallel exceptions to former Rule 10a-1 and exemptive relief granted pursuant to that rule. These exceptions and exemptions from former Rule 10a-1, as applicable, had been in place under former Rule 10a-1 for several years. We are not aware of any reason that the rationales underlying these exceptions and exemptions from former Rule 10a-1 would not still hold true today. Moreover, due to the limited scope of these exceptions and exemptions to former Rule 10a-1, we do not believe that including provisions that would parallel these exceptions and exemptions to former Rule 10a-1 would undermine the Commission's stated goals for proposing short sale price test restrictions.

Thus, the provisions in proposed Rule 201(d) parallel exceptions to and exemptive relief granted under former Rule 10a-1, as applicable.

136

As set forth in more detail below, however, we seek comment regarding each of these provisions, including whether or not these provisions would be appropriate or necessary under the proposed modified uptick rule.

136

We note that NASD Rule 3350 contained exceptions to that rule similar to exceptions to former Rule 10a-1. In addition, we note NASD Rule 3350 included an exception related to bona fide market making activity.

See infra

note 190 and accompanying text (discussing our decision not to propose that a broker-dealer may mark an order “short exempt” in connection with bona fide market making activity).

See also

supra

note 125.

a. Broker-Dealer Provision

Proposed Rule 201(c) provides that a broker-dealer may mark a short sale order of a covered security “short exempt” if a broker-dealer that submits a short sale order to a trading center identifies that the short sale order is not on a down-bid price at the time of submission of the order to the trading center.

137

The proposed rule would require any broker-dealer relying on this provision to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the incorrect identification of orders as being priced in accordance with the requirements of proposed Rule 201(c)(1).

138

137

See

proposed Rule 201(c)(1).

138

See

proposed Rule 201(c)(1).

We are proposing this provision to provide broker-dealers with the option to manage their order flow, rather than having to always rely on their trading centers to manage their order flow on their behalf. In addition, we note that this provision would not undermine the Commission's goals for short sale regulation because any broker-dealer marking an order “short exempt” in accordance with this provision would have to address whether its short sale order was not on a down-bid price at the time of submission of the order to a trading center.

As discussed in more detail below, we are proposing amendments to Rule 200(g) of Regulation SHO to require, in part, that a sale order shall be marked “short exempt” only if the provisions of paragraph (c) of proposed Rule 201 of the proposed modified uptick rule are met.

139

See

proposed Rule 200(g)(2).

To mark an order “short exempt” pursuant to paragraph (c) of the proposed modified uptick rule, the broker-dealer must have mechanisms in place to enable the broker-dealer to identify the short sale order as priced in accordance with the provisions of proposed Rule 201(c)(1). In accordance with proposed Rule 201(c)(1), these mechanisms must include written policies and procedures reasonably designed to prevent the incorrect identification of orders as being permissibly priced in accordance with the provisions of proposed Rule 201(c)(1).

140

Thus, although a broker-dealer relying on this provision in marking an order “short exempt” would not need to identify the order as permissibly priced to the trading center, it would need to have written policies and procedures in place reasonably designed to enable it to identify that an order was permissibly priced at the time of submission of the order to a trading center.

141

140

See

proposed Rule 201(c)(1).

141

Such policies and procedures would be similar to those required for trading centers complying with paragraph (b) of the proposed modified uptick rule.

At a minimum, a broker-dealer's policies and procedures would need to be reasonably designed to enable a broker-dealer to monitor, on a real-time basis, the national best bid, and whether the current national best bid is an up- or down-bid from the last differently priced national best bid, so as to determine the price at which the broker-dealer may submit a short sale order to a trading center in compliance with the provisions of proposed Rule 201(c)(1).

A broker-dealer would also need to take such steps as would be necessary to enable it to enforce its policies and procedures effectively.

142

For example, broker-dealers could establish policies and procedures that could include regular exception reports to evaluate their trading practices. If a broker-dealer's policies and procedures include exception reports, any such reports would need to be examined to affirm that a broker-dealer's policies and procedures have been followed by its personnel and properly coded into its automated systems and, if not, promptly identify the reasons and take remedial action.

142

See

proposed Rule 201(c)(1).

To ensure compliance with proposed Rule 201(c)(1), a broker-dealer could also have policies and procedures that would enable it to have a record identifying the current national best bid at the time of submission of a short sale order, as well as the last differently priced national best bid. Such “snapshots” of the market would also aid SROs in evaluating a broker-dealer's written policies and procedures and compliance with proposed Rule 201(c). In addition, such snapshots would aid broker-dealers in verifying that a short sale order was priced in accordance with the provisions of proposed Rule 201(c)(1) if bid flickering during the period between identification of the current national best bid and the

submission of the short sale order to a trading center creates confusion regarding whether or not the short sale order was submitted at a permissible price. Snapshots of the market at the time of submission of an order would also aid broker-dealers in dealing with time lags in receiving data regarding the national best bid from different data sources. A broker-dealer's policies and procedures would be required to address any such latencies in obtaining data regarding the national best bid. In addition, to the extent such latencies occur, a broker-dealer's policies and procedures would need to implement reasonable steps to monitor such latencies on a continuing basis and take appropriate steps to address a problem should one develop.

Surveillance would be a required part of a broker-dealer's satisfaction of its legal obligations. Proposed Rule 201(c)(1) provides that a broker-dealer must regularly surveil to ascertain the effectiveness of the policies and procedures required under proposed Rule 201(c)(2) and must take prompt action to remedy deficiencies in such policies and procedures.

143

This provision would reinforce the ongoing maintenance and enforcement requirements of proposed Rule 201(c)(2) by explicitly assigning an affirmative responsibility to broker-dealers to surveil to ascertain the effectiveness of their policies and procedures.

144

Thus, under proposed Rule 201(c)(1) and (c)(2), broker-dealers would not be able to merely establish policies and procedures that may be reasonable when created and assume that such policies and procedures would continue to satisfy the requirements of the proposed rule. Rather, broker-dealers would be required to regularly assess the continuing effectiveness of their procedures and take prompt action when needed to remedy deficiencies. In particular, each broker-dealer would need to engage in regular and periodic surveillance to determine whether it is submitting short sale orders marked “short exempt” without complying with the requirements of proposed Rule 201(c)(1) and whether the broker-dealer has failed to implement and maintain policies and procedures that would have reasonably prevented such impermissible submissions.

143

See

proposed Rule 201(c)(2).

144

We note that Rule 611(a)(2) of Regulation NMS contains a similar surveillance provision.

See

17 CFR 242.611(a)(2).

b. Seller's Delay in Delivery

The proposed modified uptick rule provides that a broker-dealer may mark an order “short exempt” if the broker-dealer has a reasonable basis to believe that the seller owns the security being sold and that the seller intends to deliver the security as soon as all restrictions on delivery have been removed.

145

Specifically, proposed Rule 201(d)(1) provides that a broker-dealer may mark a short sale order of a covered security “short exempt” if the broker-dealer has a reasonable basis to believe the short sale order of a covered security is by a person that is deemed to own the covered security pursuant to Rule 200 of Regulation SHO,

146

provided that the person intends to deliver the security as soon as all restrictions on delivery have been removed.

147

145

Subsection (e)(1) of former Rule 10a-1 contained an exception relating to a seller's delay in the delivery of securities. The provision in proposed Rule 201(d)(1) parallels the exception contained in former Rule 10a-1(e)(1).

146

17 CFR 242.200.

147

See

proposed Rule 201(d)(1). This proposed provision is also consistent with Rule 203(b)(2)(ii) of Regulation SHO that provides an exception from the “locate” requirement of Rule 203(b)(1) of Regulation SHO for “[a]ny sale of a security that a person is deemed to own pursuant to § 242.200, provided that the broker or dealer has been reasonably informed that the person intends to deliver such security as soon as all restrictions on delivery have been removed * * *” 17 CFR 242.203(b)(2)(ii).

Rule 200(g)(1) of Regulation SHO provides that a sale can be marked “long” only if the seller is deemed to own the security being sold and either (i) the security is in the broker-dealer's physical possession or control, or (ii) it is reasonably expected that the security will be in the broker-dealer's physical possession or control by settlement of the transaction.

148

Thus, even where a seller owns a security, if delivery will be delayed, such as in the sale of formerly restricted securities pursuant to Rule 144 of the Securities Act of 1933, or where a convertible security, option, or warrant has been tendered for conversion or exchange, but the underlying security is not reasonably expected to be received by settlement date, such sales must be marked “short.” As a result, proposed Rule 201(d)(1) would be necessary to allow for sales of securities that although owned, are subject to the provisions of Regulation SHO governing short sales due solely to the seller being unable to deliver the security to its broker-dealer prior to settlement based on circumstances outside the seller's control.

148

See

17 CFR 242.200(g)(1).

c. Odd Lot Transactions

Proposed Rule 201(d)(2) would provide that a broker-dealer may mark a short sale order “short exempt” if the broker-dealer has a reasonable basis to believe that the short sale order is by a market maker to off-set a customer odd-lot

149

order or liquidate an odd-lot position which changes such broker-dealer's position by no more than a unit of trading.

150

149

Proposed Rule 201(a)(5) provides that the term “odd lot” shall have the same meaning as in 17 CFR 242.600(b)(49). Rule 600(b)(49) defines an “odd lot” as “an order for the purchase or sale of an NMS stock in an amount less than a round lot.” 17 CFR 242.600(b)(49).

150

See

proposed Rule 201(d)(2). SRO rules define a “unit of trading” or “normal unit of trading,” and generally means 100 shares,

i.e.

, a round lot. For example, FINRA Rule 6320A(7) defines a “normal unit of trading” to mean “100 shares of a security unless, with respect to a particular security, FINRA determines that a normal unit of trading shall constitute other than 100 shares.” NYSE Rule 55 states that “[t]he unit of trading in stocks shall be 100 shares, except that in the case of certain stocks designated by the Exchange the unit of trading shall be such lesser number of shares as may be determined by the Exchange, with respect to each stock so designated * * *.”

Under former Rule 10a-1, an exception for certain odd-lot transactions was created in an effort to reduce the burden and inconvenience that short sale restrictions would place on odd-lot transactions. In 1938, the Commission found that odd-lot transactions played a very minor role in potential manipulation by short selling. Initially, sales of odd-lots were not subject to the restrictions of Rule 10a-1.

151

However, the Commission became concerned over the volume of odd-lot transactions, which possibly indicated that the exception was being used to circumvent the rule. As a result, the exception was changed to include the two odd lot exceptions described below.

152

151

The Commission initially adopted three exceptions for odd-lot transactions. While the first one, excepting all odd-lot transactions, seemed to make other odd-lot exceptions unnecessary, the 1938 adopting release included all three exceptions without discussion.

See supra

note 24, Former Rule 10a-1 Adopting Release 3 FR 213.

152

See

Securities Exchange Act Release No. 11030 (Sept. 27, 1974), 39 FR 35570 (Oct. 2, 1974).

Former Rule 10a-1(e)(3) contained a limited exception for odd-lot dealers registered in the security and third market makers. The exception allowed short sales by odd-lot dealers registered in the security and by third market makers of covered securities to fill customer odd lot orders. Former Rule 10a-1(e)(4) provided an exception under the rule for any sale to liquidate an odd-lot position by a single round lot sell order that changed the broker-dealer's position by no more than a unit of trading.

We believe that a provision that would allow a broker-dealer to mark a short sale order “short exempt” if it has a reasonable basis to believe that the

short sale order is by a market maker to off-set a customer odd-lot order or liquidate an odd-lot position which changes such broker-dealer's position by no more than a unit of trading would continue to be of utility under the proposed modified uptick rule because it would not be in conflict with the goals of the proposed rule.

Thus, the provision in proposed Rule 201(d)(2) parallels the exceptions in subsections (e)(3) and (e)(4) of former Rule 10a-1. In addition, however, we propose extending the provision to cover all market makers acting in the capacity of an odd-lot dealer. When former Rule 10a-1 was adopted, odd-lot dealers dealt exclusively with odd-lot transactions, and were so registered. Today, market makers registered in a security typically also act as odd-lot dealers of the security. Thus, we propose to broaden the provision in proposed Rule 201(d)(2) to all broker-dealers acting as “market makers” in odd lots.

153

Section 3(a)(38) of the Exchange Act defines a “market maker,” and includes specialists.

See

15 U.S.C. 78c(a)(38).

We believe that this provision would be appropriate. Because odd-lot transactions by market makers to facilitate customer orders are not of a size that could facilitate a downward movement in the market, we do not believe that proposed Rule 201(d)(2) would adversely affect the goals of short sale regulation that the proposed modified uptick rule seeks to advance. Thus, we believe that a broker-dealer should be able to mark such orders “short exempt” so that those acting in the capacity of a “market maker,” with the commensurate negative and positive obligations, would be able to off-set a customer odd-lot order and liquidate an odd-lot position without a trading center's policies and procedures preventing the execution or display of such orders at a down-bid price.

d. Domestic Arbitrage

Proposed Rule 201(d)(3) would provide that a broker-dealer may mark “short exempt” short sale orders associated with certain bona fide domestic arbitrage transactions. Subsection (e)(7) of former Rule 10a-1 contained an exception related to domestic arbitrage.

154

That exception applied to bona fide arbitrage undertaken to profit from a current difference in price between a convertible security and the underlying common stock.

155

The term “bona fide arbitrage” describes an activity undertaken by market professionals in which essentially contemporaneous purchases and sales are effected in order to lock in a gross profit or spread resulting from a current differential in pricing of two related securities.

156

For example, a person may sell short securities to profit from a current price differential based upon a convertible security that entitles him to acquire an equivalent number of securities of the securities sold short. We continue to believe that bona fide arbitrage activities are beneficial to the markets because they tend to reduce pricing disparities between related securities.

157

Thus, bona fide arbitrage transactions promote market efficiency.

154

See

Securities Exchange Act Release No. 1645 (Apr. 8, 1938).

155

See

Securities Exchange Act Release No. 42037 (Oct. 20, 1999), 64 FR 57996 (Oct. 28, 1999) (“1999 Concept Release”).

156

1999 Concept Release, 64 FR at n.54 and accompanying text (discussing the domestic arbitrage exception under former Rule 10a-1).

See also

Section 220.6(b) of Regulation T which states that the term “bona fide arbitrage” means: “(1) A purchase or sale of a security in one market together with an offsetting sale or purchase of the same security in a different market at as nearly the same time as practicable for the purpose of taking advantage of a difference in prices in the two markets; or (2) A purchase of a security which is, without restriction other than the payment of money, exchangeable or convertible within 90 calendar days of the purchase into a second security together with an offsetting sale of the second security at or about the same time, for the purpose of taking advantage of a concurrent disparity in the prices of the two securities.” 12 CFR 220.6(b).

See also

Securities Exchange Act Release No. 15533 (Jan. 29, 1979), 44 FR 6084 (Jan. 31, 1979) (interpretation concerning the application of Section 11(a)(1) to bona fide arbitrage).

157

See

Securities Exchange Act Release No. 15533 (Jan. 29, 1979), 44 FR 6084 (Jan. 31, 1979) (interpretation concerning the application of Section 11(a)(1) to bona fide arbitrage).

Proposed Rule 201(d)(3) would parallel the exception in former Rule 10a-1(e)(7). Specifically, proposed Rule 201(d)(3) would provide that a broker-dealer may mark a short sale order of a covered security “short exempt” if the broker-dealer has a reasonable basis to believe that the short sale order is “for a good faith account by a person who owns another security by virtue of which he is, or presently will be, entitled to acquire an equivalent number of securities of the same class as the securities sold, provided such sale, or the purchase which such sale offsets, is effected for the bona fide purpose of profiting from the difference between the price of the security sold and the security owned and that such right of acquisition was originally attached to or represented by another security or was issued to all the holders of any such securities of the issuer.”

158

Proposed Rule 201(d)(3).

The domestic arbitrage exception in former Rule 10a-1 was intended to be consistent with the arbitrage provision of Regulation T.

159

Thus, consistent with that provision, former Rule 10a-1(e)(7) referred to a “special arbitrage account” and not a “good faith account.”

160

The Federal Reserve Board amended Regulation T in 1998 to eliminate the “special arbitrage account” and allow the functions formerly effected in that account to be effected in a “good faith account.” Thus, proposed Rule 201(d)(3) also refers to a “good faith account.” We note, however, that we request specific comment regarding whether or not the use of a “good faith account” or any other separate account continues to be appropriate or necessary for purposes of this proposed Rule 201(d)(3).

159

See

12 CFR 220.6.

160

Section 220.3(b) of Regulation T, titled “Separation of accounts,” generally provides that requirements for an account may not be met by considering items in any other account. Further, Regulation T identifies three types of customer accounts—cash accounts, margin accounts and good faith accounts—in which customer transactions may be booked. A broker-dealer can extend credit to customers through a margin account or a good faith account. Generally, positions held in a good faith account are subject to good faith margin, whereas positions held in a margin account are subject to the margin requirements otherwise set forth in Regulation T and SRO margin requirements.

Because allowing domestic arbitrage at a down-bid price would potentially promote market efficiency, the proposed modified uptick rule would include a limited provision to allow broker-dealers to mark short sale orders “short exempt” provided the broker-dealer has a reasonable basis to believe that the conditions in proposed Rule 201(d)(3) have been met. Thus, the proposed rule is designed to permit the execution or display on a down-bid price of such orders in connection with bona fide arbitrage transactions involving convertible, exchangeable, and other rights to acquire the securities sold short, where such rights of acquisition were originally attached to, or represented by, another security, or were issued to all the holders of any such class of securities of the issuer.

e. International Arbitrage

Proposed Rule 201(d)(4) would provide that a broker-dealer may mark “short exempt” short sale orders associated with certain international arbitrage transactions. Former Rule 10a-1(e)(8) included an international arbitrage exception that was adopted in 1939.

161

In adopting the exception, the Commission stated that it was necessary

to facilitate “transactions which are of a true arbitrage nature, namely, transactions in which a position is taken on one exchange which is to be immediately covered on a foreign market.”

162

We believe likewise that such transactions would have utility under the proposed modified uptick rule. As discussed above in connection with domestic arbitrage, bona fide arbitrage transactions promote market efficiency because they equalize prices at an instant in time in different markets or between relatively equivalent securities. Thus, we do not believe that permitting broker-dealers to mark these orders “short exempt” would undermine the goals of short sale price test regulation.

161

See

Securities Exchange Act Release No. 2039 (Mar. 10, 1939), 4 FR 1209 (Mar. 14, 1939).

162

See id.

Proposed Rule 201(d)(4) would parallel the exception contained in former Rule 10a-1(e)(8). Specifically, proposed Rule 201(d)(4) would provide that a broker-dealer may mark a short sale order of a covered security “short exempt” if the broker-dealer has a reasonable basis to believe that the short sale order is “for a good faith account submitted to profit from a current price difference between a security on a foreign securities market and a security on a securities market subject to the jurisdiction of the United States, provided that the short seller has an offer to buy on a foreign market that allows the seller to immediately cover the short sale at the time it was made.”

163

Proposed Rule 201(d)(4).

In proposed Rule 201(d)(4), we have simplified the language of former Rule 10a-1(e)(8) to make it more understandable.

164

In addition, we have changed the reference in former Rule 10a-1(e)(8) from a “special international arbitrage account” to a “good faith account.” As discussed above in connection with the domestic arbitrage provision of proposed Rule 201(d)(3), this revision is necessary to make the proposed provision consistent with the arbitrage provision in Regulation T. We note, however, that we request specific comment regarding whether or not the use of a “good faith account” or any other separate account continues to be appropriate or necessary for purposes of proposed Rule 201(d)(4).

164

Former Rule 10a-1(e)(8) provided that the short sale price test restrictions of that rule shall not apply to: “Any sale of a security registered on, or admitted to unlisted trading privileges on, a national securities exchange effected for a special international arbitrage account for the bona fide purpose of profiting [sic] from a current difference between the price of such security on a securities market not within or subject to the jurisdiction of the United States and on a securities market subject to the jurisdiction of the United States; provided the seller at the time of such sale knows or, by virtue of information currently received, has reasonable grounds to believe that an offer enabling him to cover such sale is then available to him such foreign securities market and intends to accept such offer immediately.”

In addition, we have incorporated language from the exception in former Rule 10a-1(e)(12) that provided that, for purposes of the international arbitrage exception, a depository receipt for a security shall be deemed to be the same security represented by the receipt. This language was originally included in the Commission's 1939 release adopting the international arbitrage exception, but was incorporated separately in former Rule 10a-1(e)(12).

165

We likewise believe this language is appropriate and should be incorporated into proposed Rule 201(d)(4). We seek comment, however, regarding whether for purposes of the international arbitrage provision, a depository receipt for a security should be deemed to be the same security represented by the receipt.

165

See supra

note 161.

As with the exception in former Rule 10a-1(e)(8), proposed Rule 201(d)(4) would apply only to bona fide arbitrage transactions. Thus, this provision would only be applicable if at the time of the short sale there is a corresponding offer in a foreign securities market, so that the immediate covering purchase would have the effect of neutralizing the short sale. We believe proposed Rule 201(d)(4) would be necessary to facilitate arbitrage transactions in which a position is taken in a security in the U.S. market, and which is to be immediately covered in a foreign market.

166

We note that the requirement that the transaction be “immediately” covered on a foreign market requires the foreign market to be open for trading at the time of the transaction.

See

2003 Regulation SHO Proposing Release, 68 FR at 62986.

f. Over-Allotments and Lay-Off Sales

Proposed Rule 201(d)(5) would provide that a broker-dealer may mark “short exempt” short sale orders by underwriters or syndicate members participating in a distribution in connection with an over-allotment, and any short sale orders with respect to lay-off sales by such persons in connection with a distribution of securities through a rights or standby underwriting commitment.

Former Rule 10a-1(e)(10) contained an exception for over-allotment and lay-off sales.

167

Although the exception was not adopted until 1974, the Commission's approval of the concept of excepting over-allotments and lay-off sales from short sale rules is long-standing.

168

In addition, we note that recently we excepted these sales from the July Emergency Order, which among other things required that short sellers borrow or arrange to borrow securities prior to effecting a short sale, stating that it was not necessary for the Order to cover such sales because such activity is covered by Regulation M under the Exchange Act,

169

an anti-manipulation rule.

170

In accordance with the long-standing Commission position regarding these sales, we are including through proposed Rule 201(d)(5) a provision for short sale orders in connection with over-allotment and lay-off sales that would parallel the exception in former Rule 10a-1(e)(10).

167

See

Securities Exchange Act Release No. 11030 (Sept. 7, 1974), 39 FR 35570 (Oct. 2, 1974).

168

See, e.g.,

Securities Exchange Act Release No. 3454 (July 6, 1946), in which the Commission approved the NYSE's special offering plan, which permitted short sales in the form of over-allotments to facilitate market stabilization.

169

17 CFR 242.100

et seq.

170

See

Securities Exchange Act Release No. 58190 (July 18, 2008), 73 FR 42837 (July 23, 2008) (amending the July Emergency Order to include exceptions for certain short sales).

g. Riskless Principal Transactions

Proposed Rule 201(d)(6) would provide that a broker-dealer may mark “short exempt” short sale orders where broker-dealers are facilitating customer buy orders or sell orders where the customer is net long, and the broker-dealer is net short but is effecting the sale as riskless principal.

171

See

proposed Rule 201(d)(6).

In 2005, the Commission granted exemptive relief under former Rule 10a-1 for any broker-dealer that facilitates a customer buy or long sell order on a riskless principal basis.

172

In granting the relief, the Commission noted representations made in the letter requesting relief that in the situation where the amount of securities that the broker-dealer purchases for the customer may not be sufficient to give the broker-dealer an overall net “long” position, former Rule 10a-1 would constrain the ability of the broker-dealer to fill the customer buy order. Further, the Commission noted representations in the letter requesting relief that because such short sales would be effected only in response to a customer buy order, this should vitiate any concerns about such sales having a depressing impact on the security's price.

173

172

See

letter from James A. Brigagliano to Ira Hammerman, Senior Vice President and General Counsel, Securities Industry Association, dated July 18, 2005 (“Riskless Principal Letter”).

173

See id.

In addition, the Commission noted representations made in the letter

requesting relief that where a broker-dealer is facilitating a customer long sale order in a riskless principal transaction, because the ultimate seller is long the shares being sold, these transactions present none of the potential abuses that former Rule 10a-1 was designed to address.

174

The Commission also noted representations that the application of former Rule 10a-1 to riskless principal transactions involving a customer long sale can inhibit the broker-dealer's ability to provide timely (or any) execution to such customer long sale. Specifically, if the broker-dealer has a net short position, the broker-dealer will be restricted from executing its own principal trade to complete the first leg of the riskless principal transaction.

175

Thus, compliance with former Rule 10a-1 would adversely affect a broker-dealer's ability to provide best execution to a customer order.

176

174

See id.

175

See id.

176

See id.

Consistent with the relief granted in the Riskless Principal Letter, we believe that including a provision to permit a broker-dealer to mark “short exempt” short sale orders in connection with riskless principal transactions would be appropriate and would not undermine our goals in proposing short sale price test regulation. In particular, we note that such a provision would facilitate a broker-dealer's ability to provide best execution to customer orders. Accordingly, taken together proposed Rules 201(a)(6) and (d)(6) would parallel the conditions for relief in the Riskless Principal Letter.

177

These conditions are also consistent with the definition of “riskless principal transactions” under Rule 10b-18 of the Exchange Act.

See

17 CFR 240.10b-18(a)(12).

Specifically, proposed Rule 201(a)(6) would define the term “riskless principal” to mean “a transaction in which a broker or dealer, after having received an order to buy a security, purchases the security as principal at the same price to satisfy the order to buy or, after having received an order to sell, sells the security as principal at the same price to satisfy the order to sell.”

178

Proposed Rule 201(d)(6) would provide that a broker-dealer may mark a short sale order “short exempt” if the broker-dealer has a reasonable basis to believe that the short sale order is to effect the execution of a customer purchase or the execution of a customer “long” sale on a riskless principal basis and provided the sell order is given the same per-share price at which the broker-dealer bought shares to satisfy the facilitated order, exclusive of any explicitly disclosed markup or markdown, commission equivalent or other fee.

179

In addition, proposed Rule 201(d)(6) would require the broker-dealer, if it marks an order “short exempt” under this provision, to have policies and procedures in place to assure that, at a minimum: the customer order was received prior to the offsetting transaction; the offsetting transaction is allocated to a riskless principal or customer account within 60 seconds of execution; and that it has supervisory systems in place to produce records that enable the broker-dealer to accurately and readily reconstruct, in a time-sequenced manner, all orders on which the broker-dealer relies pursuant to this provision.

180

178

In addition to being consistent with the conditions in the Riskless Principal Letter and Rule 10b-18 of the Exchange Act, this definition is consistent with the definition of “riskless principal” in FINRA Rule 6642.

179

This requirement is also consistent with FINRA's trade reporting rules which require a riskless principal transaction in which both legs are executed at the same price to be reported once, in the same manner as an agency transaction, exclusive of any markup, markdown, commission equivalent, or other fee.

See

FINRA Rule 6380A(d)(3)(B).

180

See

proposed Rule 201(d)(6).

We believe that proposed Rule 201(d)(6) would provide broker-dealers with additional flexibility to facilitate customer orders and provide best execution. In addition, we believe that the conditions set forth in proposed Rule 201(d)(6) would provide a mechanism for the surveillance of the provision's use by linking it to specific incoming orders and executions, and by requiring broker-dealers to establish procedures for handling such transactions. These requirements would help ensure that broker-dealers are complying with proposed Rule 201(d)(6).

h. Transactions on a Volume-Weighted Average Price Basis

Proposed Rule 201(d)(7) would provide that a broker-dealer may mark “short exempt” certain sale orders executed on a volume-weighted average price (“VWAP”) basis. Under former Rule 10a-1, the Commission granted limited relief from that rule in connection with short sales executed on a VWAP basis.

181

The relief was limited to VWAP transactions that are arranged or “matched” before the market opens at 9:30 a.m., but are not assigned a price until after the close of trading when the VWAP value is calculated. The Commission granted the exemptions based, in part, on the fact that these VWAP short sale transactions appeared to pose little risk of facilitating the type of market effects that former Rule 10a-1 was designed to prevent.

182

In particular, the Commission noted that the pre-opening VWAP short sale transactions do not participate in or affect the determination of the VWAP for a particular security.

183

Moreover, the Commission stated that all trades used to calculate the day's VWAP would continue to be subject to former Rule 10a-1.

184

181

See e.g.

letter from Larry E. Bergmann, Senior Associate Director, Division of Market Regulation, SEC, to Edith Hallahan, Counsel, Phlx, dated March 24, 1999; letter from Larry E. Bergmann, Senior Associate Director, Division of Market Regulation, SEC, to Soo J. Yim, Wilmer, Cutler & Pickering, dated December 7, 2000; letter from James Brigagliano, Assistant Director, Division of Market Regulation, SEC, to Andre E. Owens, Schiff Hardin & Waite, dated March 30, 2001; letter from James Brigagliano, Assistant Director, Division of Market Regulation, SEC, to Sam Scott Miller, Esq., Orrick, Herrington & Sutcliffe LLP, dated May 12, 2001; letter from James Brigagliano, Assistant Director, Division of Market Regulation, SEC, to William W. Uchimoto, Esq., Vie Institutional Services, dated February 12, 2003.

182

See id.

183

See id.

184

See id.

Consistent with the relief granted under former Rule 10a-1, we propose providing that a broker-dealer may mark “short exempt” certain short sale orders executed at the VWAP. Proposed Rule 201(d)(7) would differ from the relief granted under former Rule 10a-1, however, in that it would not be limited to VWAP transactions that are arranged or “matched” before the market opens at 9:30 a.m., or that are not assigned a price until after the close of trading when the VWAP value is calculated. We believe this restriction would not be necessary because VWAP short sale transactions appear to pose little risk of facilitating the type of market effects that a short sale price test restriction would be designed to prevent. In addition, in accordance with proposed Rule 201(d)(7), no short sale orders used to calculate the VWAP may be marked “short exempt.”

185

This would help limit any potential for manipulation.

185

See

proposed Rule 201(b)(7).

Thus, pursuant to proposed Rule 201(d)(7), a broker-dealer may mark a short sale order of a covered security “short exempt” if the broker-dealer has a reasonable basis to believe that the short sale order is for the sale of a covered security at the VWAP that meets the following conditions:

186

(1) The VWAP for the covered security is calculated by: Calculating the values for every regular way trade reported in the consolidated system for the security during the regular trading session, by multiplying each such price by the total

number of shares traded at that price; compiling an aggregate sum of all values; and dividing the aggregate sum by the total number of reported shares for that day in the security; (2) the transactions are reported using a special VWAP trade modifier; (3) no short sales used to calculate the VWAP are marked “short exempt”; (4) the VWAP matched security qualifies as an “actively traded security” (as defined under Rules 101(c)(1) and 102(d)(1) of Regulation M), or where the subject listed security is not an “actively traded security,” the proposed short sale transaction will be permitted only if it is conducted as part of a basket transaction of twenty or more securities in which the subject security does not comprise more than 5% of the value of the basket traded; (5) the transaction is not effected for the purpose of creating actual, or apparent, active trading in or otherwise affecting the price of any security; and (6) a broker or dealer will act as principal on the contra-side to fill customer short sale orders only if the broker-dealer's position in the subject security, as committed by the broker-dealer during the pre-opening period of a trading day and aggregated across all of its customers who propose to sell short the same security on a VWAP basis, does not exceed 10% of the covered security's relevant average daily trading volume, as defined in Regulation M.

187

186

See

proposed Rule 201(d)(7).

187

17 CFR 242.100(b).

Except as discussed above, the conditions set forth in proposed Rule 201(d)(7) parallel the conditions contained in the exemptive relief from former Rule 10a-1 granted for VWAP short sale transactions. We believe that these conditions worked well in restricting the exemptive relief to situations that generally would not raise the harms that short sale price tests are designed to prevent. We believe they would be similarly effective in serving that function today and, therefore, should be incorporated into proposed Rule 201(d)(7).

i. Decision Not To Propose That a Broker-Dealer May Mark an Order “Short Exempt” in Connection With Bona Fide Market Making Activity

Former Rule 10a-1(e)(5) provided a limited exception from the restrictions of that rule for “[a]ny sale * * * by a registered specialist or registered exchange market maker for its own account on any exchange with which it is registered for such security, or by a third market maker for its own account over-the-counter, (i) Effected at a price equal to or above the last sale, regular way, reported for such security pursuant to an effective transaction reporting plan. * * *

Provided, however,

That any exchange, by rule, may prohibit its registered specialist and registered exchange market makers from availing themselves of the exemption afforded by this paragraph (e)(5) if that exchange determines that such action is necessary or appropriate in its market in the public interest or for the protection of investors.” Unless prohibited by exchange rule, this exception was intended to permit registered specialists or market makers to protect customer orders against transactions in other markets in the consolidated system by allowing them to sell short at a price equal to the last trade price reported to the consolidated system, even if that sale was on a minus or zero-minus tick.

188

Although former Rule 10a-1 included this exception for market makers, exchanges adopted rules that prohibited their registered specialists and market makers from availing themselves of this exception.

189

In addition, former Rule 10a-1 did not contain a general exception for short selling in connection with bona fide market making activities.

190

188

See

Securities Exchange Act Release No. 11030 (Sept. 27, 1974), 39 FR 35570 (Oct. 2, 1974). Former Rule 10a-1(a)(1)(i) referenced the last sale price reported to an effective transaction reporting plan, but former Rule 10a-1(a)(2) also permitted an exchange to make an election to use the last sale price reported in that exchange market. Certain exchanges, such as the NYSE, implemented short sale price test rules consistent with former Rule 10a-1(a)(2).

See, e.g.,

former NYSE Rule 440B.

189

See id.

190

We note, however, that NASD's bid test contained an exception for short sales executed by qualified market makers in connection with bona fide market making. When, however, the Commission approved NASD's bid test and the market maker exception to the bid test it noted concerns that the market maker exception could create opportunities for abusive short selling.

See

1994 NASD Bid Test Approval, 59 FR 34885.

See also

McCormick, D. Timothy and Zeigler, Bram, 1997,

The Nasdaq short sale rule: Analysis of market quality effects and the market maker exemption. Working paper, NASD Economic Research,

p. 28 (finding that market makers' short sales at the bid or below on down-bids amounted to only 1.17% of their trading).

We seek comment, however, on the importance of a market maker provision in the context of a market maker's role in providing liquidity, including the extent to which market makers would need to sell short at or below the current national best bid in their market making capacity. We also seek comment on the extent to which the proposed riskless principal provision, as well as any other proposed provisions, would address concerns regarding the need for a more general market maker provision. In addition, we seek comment regarding what conditions should apply if a general market maker provision were added to when a broker-dealer may mark an order “short exempt” under the proposed modified uptick rule. We also seek comment on whether a general market maker exception should be limited to registered market makers.

3. Proposed Modified Uptick Rule and After-Hours Trading

Regular trading hours in the U.S. are from 9:30 a.m. to 4 p.m. Eastern Time (“ET”).

194

A high volume of trading occurs, however, outside of these regular trading hours. Accordingly, the Commission interpreted former Rule 10a-1 to apply to all trades in covered securities, whenever they occurred.

195

By its terms, former Rule 10a-1 used as a reference point the last sale price reported to the consolidated tape. Thus, after the consolidated tape ceased to operate, the rule prevented any person from effecting a short sale in a listed security at a price lower than the last sale reported to the consolidated tape.

196

Although former Rule 10a-1 applied in the after-hours market, we do not believe that the proposed modified uptick rule should apply to covered securities during periods that the national best bid is not collected, calculated and disseminated.

194

See, e.g.,

Rule 600(64) of Regulation NMS, defining the term “regular trading hours.”

195

See

2003 Regulation SHO Proposing Release, 68 FR at 62997 (stating that the Commission interprets former Rule 10a-1 to apply to all trades in listed securities whenever they occur).

196

We note, however, that NASD did not extend its short sale price test rule to the after-hours market.

See

NASD Head Trader Alert #2000-55.

As discussed above, market information for quotes in NMS stocks is disseminated pursuant to two different national market system plans, the CQ Plan, and Nasdaq UTP Plan.

197

Quotation information is made available pursuant to the CQ Plan between 9 a.m. and 6:30 p.m. ET, while one or more participants is open for trading. In addition, quotation information is made available pursuant to the CQ Plan during any other period in which any one or more participants wish to furnish quotation information to the Plan.

198

Quotation information is made available by the Nasdaq UTP Plan between 9:30 a.m. and 4 p.m. ET. The Nasdaq UTP Plan also collects, processes, and disseminates quotation information between 4 a.m. and 9:30 a.m. (ET), and after 4 p.m. when any participant is open for trading, until 8 p.m. ET.

199

197

See supra

note 107.

See also

17 CFR 242.603(b). Rule 603 of Regulation NMS requires that every national securities exchange on which an NMS stock is traded and national securities association shall act jointly pursuant to one or more effective national market system plans to disseminate consolidated information, including a national best bid and national best offer, on quotations for and transactions in NMS stocks.

198

See http://www.nyxdata.com/cta.

199

See http://www.utpdata.com/docs/UTP_PlanAmendment.pdf.

During the time periods in which these Plans do not operate, real-time quote information is not collected, calculated and disseminated. We do not believe that it would further the goals of short sale price test regulation to apply the proposed modified uptick rule when the national best bid is not being collected, calculated and disseminated on a real-time basis. Thus, the proposed modified uptick rule would only apply at times when quotation information and, therefore, the national best bid, is collected, processed, and disseminated pursuant to a national market system plan. Thus, proposed Rule 201(f) limits application of the proposed modified uptick rule to times when “a national best bid for [an] NMS stock is calculated and disseminated on a current and continuing basis by a plan processor pursuant to an effective national market system plan.”

200

However, we seek comment on these issues.

200

See

proposed Rule 201(e).

B. Proposed Uptick Rule

1. Operation of the Proposed Uptick Rule

As an alternative to proposing a short sale price test based on the national best bid, we are proposing a modified version of former Rule 10a-1 to provide the public with an opportunity to comment on the utility of such a price test, especially in light of the recent changes in market conditions.

201

The proposed uptick rule would use the last sale price as the reference point for short sale orders.

201

See supra

Section II, discussing the history of short sale price test regulation in the United States and changes in market conditions and resulting erosion of investor confidence.

Specifically, the proposed uptick rule would provide that “[n]o person shall, for his own account or for the account of any other person, effect a short sale of any covered security, if trades in such security are reported pursuant to an effective transaction reporting plan

202

and information as to such trades is made available in accordance with such plan on a real-time basis to vendors of market transaction information: (i) Below the price at which the last sale thereof, regular way, was reported pursuant to an effective transaction reporting plan; or (ii) At such price unless such price is above the next preceding different price at which a sale of such security, regular way, was reported pursuant to an effective transaction reporting plan.”

203

Thus, under the proposed uptick rule, no short sale order may be effected below the last sale price. Short sale orders may be effected at the last sale price only if the last sale price is above the last different price. Otherwise, all short sale orders must be effected above the last sale price.

202

Proposed Rule 201(a)(3) provides that the term “transaction reporting plan” shall have the same meaning as in § 242.600(22) of Regulation NMS.

203

Proposed Rule 201(b).

The following transactions illustrate the operation of the proposed uptick rule:

EP17AP09.008

The first execution at 47.04 is a plus tick since it is higher than the previous last trade price of 47.00. The next transaction at 47.04 is a zero-plus tick since there is no change in trade price but the last change was a plus tick. Short sales could be executed at 47.04 or above in both of these cases. The final two transactions at 47.00 are minus and zero-minus transactions, respectively. Short sales in these two circumstances would have to be effected at a price above 47.00 in order to comply with proposed uptick rule.

Similar to the proposed modified uptick rule, the proposed uptick rule would apply to any “covered security,” which is defined as an “NMS stock” under Rule 600(a)(47) of Regulation NMS. Rule 600(a)(47) of Regulation NMS defines an “NMS stock” as “any NMS security other than an option.”

204

Rule 600(a)(46) of Regulation NMS defines an “NMS security” as “any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options.”

205

As a result, the proposed uptick rule would effectively cover all securities, other than options, listed on a national securities exchange whether traded on an exchange or in the OTC market. It would not include non-NMS stocks quoted on the OTC Bulletin Board or elsewhere in the OTC market.

204

17 CFR 242.600(a)(47).

205

17 CFR 242.600(a)(46).

We are not proposing to apply the proposed uptick rule to non-NMS stocks quoted on

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