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Federal Register › Vol. 68 › 68 FR 62972

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SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 240 and 242 [Release No. 34-48709; File No. S7-23-03] RIN 3235-AJ00 Short Sales AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (Commission) is publishing for public comment new Regulation SHO, under the Securities Exchange Act of 1934 (Exchange Act), which would replace Rules 3b-3, 10a-1, and 10a-2. The Commission is also proposing amendments to Rule 105 of Regulation M. Proposed Regulation SHO would, among other things, require short sellers in all equity securities to locate securities to borrow before selling, and would also impose strict delivery requirements on securities where many sellers have failed to deliver the securities. In part, this action is designed to address the problem of “naked” short selling. Proposed Regulation SHO would also institute a new uniform bid test allowing short sales to be effected at a price one cent above the consolidated best bid. This test would apply to all exchange-listed securities and Nasdaq National Market System Securities (NMS Securities), wherever traded.

We are also seeking comment on a temporary rule that would suspend the operation of the proposed bid test for specified liquid securities during a two-year pilot period. The temporary suspension would allow the Commission to study the effects of relatively unrestricted short selling on market volatility, price efficiency, and liquidity.

DATES:

Comments must be received on or before January 5, 2004.

ADDRESSES:

To help us process and review your comments more efficiently, comments should be sent by hard copy or e-mail, but not by both methods. Comments sent by hard copy should be submitted in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Comments also may be submitted electronically at the following E-mail address: rule-comments@sec.gov. All comment letters should refer to File No. S7-23-03

s should be sent by hard copy or e-mail, but not by both methods. Comments sent by hard copy should be submitted in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Comments also may be submitted electronically at the following E-mail address: rule-comments@sec.gov. All comment letters should refer to File No. S7-23-03. Comments submitted by E-mail should include this file number in the subject line. Comment letters received will be available for public inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, NW., Washington, DC 20549. Electronically submitted comment letters will be posted on the Commission's Internet Web site ( http://www.sec.gov ). 1

1 Personal identifying information, such as names or e-mail addresses, will not be edited from electronic submission. Submit only information that you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT:

Any of the following attorneys in the Office of Trading Practices, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-1001, at (202) 942-0772: James Brigagliano, Assistant Director, or Gregory Dumark, Kevin Campion, Lillian Hagen, Elizabeth Sandoe and Marla Chidsey, Special Counsels.

SUPPLEMENTARY INFORMATION:

The Commission is publishing for comment proposed Regulation SHO and a proposed temporary rule, Rule 202 2 , and proposed amendments to Regulation M, Rule 105 3 under the Exchange Act.

2 17 CFR 242.202.

3 17 CFR 242.105.

Table of Contents

Contents

I. Introduction A. Background and Current Short Sale Regulation B. Market Effects of Short Selling C. Market Developments II. Naked Short Selling A. Background B. Current Regulatory Requirements C. Proposed Amendments 1. Short Sales 2. Long Sales III. Current Market Structure and the Tick Test IV. Proposed Bid Test A. Operation of the Uniform Bid Test B. Scope of the Uniform Bid Test 1. Securities Subject to the Price Test 2. Securities Not Subject to the Price Test C. Bid Test Flexibility in a Decimals Environment D. Bid Test Flexibility for Passive Pricing Systems V. Pilot Program VI. Rule 10a-1 Exceptions A. Exceptions Proposed to be Retained 1. Long Seller's Delay in Delivery 2. Error in Marking a Short Sale 3. Odd Lot Transactions 4. Domestic Arbitrage 5. International Arbitrage 6. Distribution Over-Allotment 7. Equalizing Short Sales and Trade-Throughs B. Exception Proposed to Be Eliminated VII. Prior Exemption Letters under Rule 10a-1 A. Exchange Traded Funds B. Short Sales Executed at the Closing Price

VIII. Market Maker Exception from Proposed Uniform Bid Test IX. Proposed Changes to the Order Marking Requirement A. Marking Orders B. Marking Requirements for Riskless Principal Transactions X. Rule 3b-3 A. Unconditional Contracts to Purchase Securities B. Ownership of Securities Underlying Securities Futures Products C. Aggregation Units D. Block-Positioner Exception E. Liquidation of Index Arbitrage Positions XI. Hedging Transactions XII. Elimination of Current Subparagraphs 10a-1(a)(2) and (a)(3) XIII. Exclusion of Bonds XIV. After Hours Trading/Foreign Markets Issues A. After-Hours Trading B. Off-Shore Trading XV. Limitations on Short Selling During Significant Market Declines XVI. Rule 105 of Regulation M—Short Sales in Connection with a Public Offering A. Scope of Rule 105 of Regulation M B. Shelf Offerings C. Sham Transactions Designed to Give the Appearance of Covering with Open Market Securities XVII. General Request for Comment XVIII. Paperwork Reduction Act XIX

-Hours Trading B. Off-Shore Trading XV. Limitations on Short Selling During Significant Market Declines XVI. Rule 105 of Regulation M—Short Sales in Connection with a Public Offering A. Scope of Rule 105 of Regulation M B. Shelf Offerings C. Sham Transactions Designed to Give the Appearance of Covering with Open Market Securities XVII. General Request for Comment XVIII. Paperwork Reduction Act XIX. Consideration of Proposed Regulation SHO's Costs and Benefits XX. Consideration on Burden and Promotion of Efficiency, Competition, and Capital Formation XXI. Consideration of Impact on the Economy XXII. Initial Regulatory Flexibility Analysis XXIII. Statutory Authority Text of Proposed Regulation SHO, Amendments and Temporary Rule I. Introduction

Congress, in 1934, directed the Commission to “purge the market” of short selling abuses, and in response, the Commission adopted restrictions that have remained essentially unchanged for over 60 years. Originally adopted in 1938, the Commission's short sale rule, Rule 10a-1, is designed to restrict short sellers from effecting short sales in an exchange-traded security when the price of that security is declining. 4

4 17 CFR 240.10a-1.

Since its adoption, the Commission has engaged in studies, investigations, and reviews of the efficacy of the Rule. 5 6 The Concept Release examined ways to modernize our approach to short sale regulation. We received 2778 comment letters in response to the Release. 7

5 See 2 Securities and Exchange Commission, Report of Special Study of Securities Markets, H.R. Doc. No. 95, 88th Cong., 1st Sess. 247 (1963) (study to determine the relationships between changes in short positions and subsequent price trends); see also Short-Selling Activity in the Stock Market: Market Effects and the Need for Regulation (Part I)(House Report), H.R., Rep. No. 102-414 (1991), reprinted in CCH Federal Securities Law Reports Number 1483 Part II (1992).

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

elationships between changes in short positions and subsequent price trends); see also Short-Selling Activity in the Stock Market: Market Effects and the Need for Regulation (Part I)(House Report), H.R., Rep. No. 102-414 (1991), reprinted in CCH Federal Securities Law Reports Number 1483 Part II (1992).

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

7 The comment letters and a comprehensive summary of the comments are available for inspection in the Commission's Public Reference Room in File No. S7-24-99.

Since the Concept Release was published, we have reviewed the comment letters and reexamined the structure and operation of Rule 10a-1, and related Rules 10a-2 8 and 3b-3. 9 We also considered the status of short sale regulation in the context of requests for relief from Rule 10a-1 submitted to the Commission for a wide range of short selling activities. Finally, we considered recent market changes, including increased instances of “naked” short selling, i.e. , selling short without borrowing the necessary securities to make delivery; decimalization; the advent of security futures trading; and an increasing amount of Nasdaq securities being traded away from the Nasdaq market, and thus not subject to any short sale price test. As a result of this assessment, we are seeking comment on proposed Regulation SHO, which would replace Rules 3b-3, 10a-1, and 10a-2, and that would temporarily suspend the short sale price test for specified liquid stocks. We also propose to amend Rule 105 of Regulation M to eliminate the shelf offering exception. The comments we receive will assist us in determining whether to adopt the proposed changes to these rules and the nature and scope of such changes.

8 17 CFR 240.10a-2.

9 17 CFR 240.3b-3.

A. Background and Current Short Sale Regulation

A short sale is the sale of a security that the seller does not own or any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller

ive will assist us in determining whether to adopt the proposed changes to these rules and the nature and scope of such changes.

8 17 CFR 240.10a-2.

9 17 CFR 240.3b-3.

A. Background and Current Short Sale Regulation

A short sale is the sale of a security that the seller does not own or any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. 10 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. The short seller later closes out the position by purchasing equivalent securities on the open market, or by using an equivalent security it already owned, and returning the security to the lender. In general, short selling is used to profit from an expected downward price movement, to provide liquidity in response to unanticipated demand, or to hedge the risk of a long position in the same security or in a related security.

10 See Rule 3b-3 under the Exchange Act, 17 CFR 240.3b-3.

The following example illustrates a typical short sale transaction:

XYZ stock is currently selling at $50 per share. An investor anticipates that the price of XYZ stock will decline and wants to sell short 100 shares. The investor's broker borrows 100 shares for the investor and executes the short sale. The $5,000 proceeds from the sale (plus, usually, an additional 2%) are posted as collateral with the lender and the investor must also post margin equal to 50% of the purchase price with his broker. 11 At some point in the future the investor must purchase 100 shares to return to the lender. If the investor can purchase the XYZ shares at a price below $50, the investor can cover the short position at a profit. If the price of XYZ shares rises above $50, the investor may have to cover the short position at a loss. 12

11 See, e.g

post margin equal to 50% of the purchase price with his broker. 11 At some point in the future the investor must purchase 100 shares to return to the lender. If the investor can purchase the XYZ shares at a price below $50, the investor can cover the short position at a profit. If the price of XYZ shares rises above $50, the investor may have to cover the short position at a loss. 12

11 See, e.g. , 12 CFR 220.12(c)(1) of Regulation T of the Board of Governors of the Federal Reserve System, which requires margin for a short sale of a nonexempted equity security of 150 percent of the current market value of the security. An investor may be required to deposit additional “maintenance margin” for transactions in short sales under margin requirements imposed by self regulatory organizations (SROs). See, e.g. , NASD Rule 2520(c) and NYSE Rule 431(c). Further, broker-dealers may institute higher short sale margin requirements than those imposed by self-regulatory organization rules. See, e.g. , NASD Rule 2520(d) and NYSE Rule 431(d).

12 This simple example does not include transaction and carrying costs. For a more complete discussion of equity lending and costs of borrowing equity see Securities Lending Transactions: Market Developments and Implications, Technical Committee of the International Organization of Securities Commissions (IOSCO) Committee on Payment and Settlement Systems (CPSS) (July, 1999). This paper can be accessed at www.iosco.org/pubdocs/pdf/IOSCOPD96.pdf. See also Geczy, Musto, and Reed, 2002, Stocks Are Special Too: An Analysis of the Equity Lending Market, Journal of Financial Economics, 66, 241-269.

.iosco.org/pubdocs/pdf/IOSCOPD96.pdf. See also Geczy, Musto, and Reed, 2002, Stocks Are Special Too: An Analysis of the Equity Lending Market, Journal of Financial Economics, 66, 241-269.

Section 10(a) of the Exchange Act gives the Commission plenary authority to regulate short sales of securities registered on a national securities exchange (listed securities), as necessary to protect investors. After conducting an inquiry into the effects of concentrated short selling during the market break of 1937, the Commission adopted Rule 10a-1 in 1938 in order to restrict short selling in a declining market. 13 The core provisions of the Rule are largely the same today as when they were adopted.

13 Securities Exchange Act Release No. 1548 (January 24, 1938), 3 FR 213 (January 26, 1938).

Paragraph (a) of Rule 10a-1 generally covers short sales in listed securities if trades of the security are reported pursuant to an “effective transaction reporting plan” 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. 14 Paragraph (b) applies to short sales on national exchanges in securities that are not covered by paragraph (a).

14 Rule 10a-1 uses the term “effective transaction reporting plan” as defined in Rule 11Aa3-1 (17 CFR 240.11Aa3-1) under the Exchange Act. See 17 CFR 240.10a-1(a)(1)(i).

Rule 10a-1(a)(1) provides that, subject to certain exceptions, a listed security may be sold short (A) at a price above the price at which the immediately preceding sale was effected (plus tick), or (B) at the last sale price if it is higher than the last different price (zero-plus tick). 15 Short sales are not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions. The operation of these provisions, commonly described as the “tick test,” determines the minimum shortable price (MSP) 16 at which a security can be sold short

iately preceding sale was effected (plus tick), or (B) at the last sale price if it is higher than the last different price (zero-plus tick). 15 Short sales are not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions. The operation of these provisions, commonly described as the “tick test,” determines the minimum shortable price (MSP) 16 at which a security can be sold short. The following transactions illustrate the operation of the tick test: 17

15 The last sale price is the price reported pursuant to an effective transaction reporting plan, i.e. , the Consolidated Tape Association, also generally referred to as the “Tape.”

16 The MSP is the lowest price that a stock can be sold short under current short sale regulation. If a stock is trading on a minus or zero-minus tick, a short sell order must be executed at a price higher than the last trade.

17 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. The final two transactions at 47.00 are minus and zero-minus transactions, respectively. Short sales would have to be effected at the next higher increment above 47.00 in order to comply with Rule 10a-1.

EP06NO03.005

In adopting the tick test, the Commission sought to achieve three objectives:

in trade price but the last change was a plus tick. Short sales could be executed at 47.04 or above. The final two transactions at 47.00 are minus and zero-minus transactions, respectively. Short sales would have to be effected at the next higher increment above 47.00 in order to comply with Rule 10a-1.

EP06NO03.005

In adopting the tick test, the Commission sought to achieve three objectives:

(i) allowing relatively unrestricted short selling in an advancing market;

(ii) preventing short selling at successively lower prices, thus eliminating short selling as a tool for driving the market down; and

(iii) preventing short sellers from accelerating a declining market by exhausting all remaining bids at one price level, causing successively lower prices to be established by long sellers. 18

18 See Securities Exchange Act Release No. 13091 (December 21, 1976), 41 FR 56530 (December 28, 1976).

In 1994, the Commission granted temporary approval to the NASD to apply its own short sale rule to Nasdaq NMS securities. 19 NASD Rule 3350 prohibits short sales by NASD members in Nasdaq NMS Securities 20 at or below the current best (inside) bid when that bid is lower than the previous best (inside) bid (commonly referred to as the bid test).

The operation of the bid test in NASD Rule 3350 is illustrated as follows:

19 See Securities Exchange Act Release No. 34277 (June 29, 1994), 59 FR 34885 (July 7, 1994).

20 Rule 11Aa2-1 under the Act sets forth the criteria and procedures by which certain over-the-counter (OTC) securities are designated as NMS Securities. 17 CFR 240.11Aa2-1.

Bid Sequence 47 47.04 47.04 47 47 Current Bid Compared to the previous bid plus bid (compared to last bid at 47) zero-plus bid (compared to last bid at 47.04) minus bid (compared to last bid at 47.04) zero-minus bid (compared to last bid at 47) MSP any price any price 47.01 47.01 B. Market Effects of Short Selling

Short selling provides the market with at least two important benefits: market liquidity and pricing efficiency

7 47 Current Bid Compared to the previous bid plus bid (compared to last bid at 47) zero-plus bid (compared to last bid at 47.04) minus bid (compared to last bid at 47.04) zero-minus bid (compared to last bid at 47) MSP any price any price 47.01 47.01 B. Market Effects of Short Selling

Short selling provides the market with at least two important benefits: market liquidity and pricing efficiency. 21 Market liquidity is generally 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 contraction of selling interest. Short sellers covering their sales also may add to the buying interest of stock available to sellers.

21 See Lamont, Owen A. and Thaler, Richard H, 2003, Can the Market Add and Subtract? Mispricing in Tech Stocks Carve-outs, University of Chicago and NBER.

Short selling also can contribute to the pricing efficiency of the equities markets. Efficient markets require that prices fully reflect all buy and sell interest. 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 based upon speculation 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

nst 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. 22

22 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.

Although short selling serves useful market purposes, it also may be used to illegally manipulate stock prices. 23 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. 24 Further, unrestricted short selling can 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.

23 See, e.g., S.E.C. v. 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); U.S. v. Russo, 74 F.3d 1383, 1392 (2nd 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)

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); U.S. v. Russo, 74 F.3d 1383, 1392 (2nd 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).

24 Many people blamed “bear raids” for the 1929 stock market crash and the market's prolonged inability to recover from the crash. See 7 Louis Loss and Joel Seligman, Securities Regulation 3203-04, note 213 (3d ed. 1989).

Short selling was one of the central issues studied by Congress before enacting the Exchange Act, but Congress did not directly prohibit short selling. 25 Instead, Congress gave the Commission broad authority to regulate short sales in order to stop short selling abuses. 26

25 See 2 Securities and Exchange Commission, Report of Special Study of Securities Markets, H.R. Doc. No. 95, 88th Cong., 1st Sess. 247 (1963) (Special Study).

26 Id.

C. Market Developments

Several significant developments in the securities markets, including, but not limited to, instances of abusive naked short selling, the increasing

II. Naked Short Selling

A. Background

Many issuers and investors have complained about alleged “naked short selling,” especially in thinly-capitalized securities trading over-the-counter. 27 Naked short selling is selling short without borrowing the necessary securities to make delivery, thus potentially resulting in a “fail to deliver” securities to the buyer.

27 For example, see comment letters from John Henry Austin (2675), Bridget Thomas (2297), James McCaffery (492), Richard Ballard (507), and Ken Klaser (596)

cially in thinly-capitalized securities trading over-the-counter. 27 Naked short selling is selling short without borrowing the necessary securities to make delivery, thus potentially resulting in a “fail to deliver” securities to the buyer.

27 For example, see comment letters from John Henry Austin (2675), Bridget Thomas (2297), James McCaffery (492), Richard Ballard (507), and Ken Klaser (596).

Naked short selling can have a number of negative effects on the market, particularly when the fails to deliver persist for an extended period of time and result in a significantly large unfulfilled delivery obligation at the clearing agency where trades are settled. 28 At times, the amount of fails to deliver may be greater than the total public float. In effect the naked short seller unilaterally converts a securities contract (which should settle in three days after the trade date) into an undated futures-type contract, which the buyer might not have agreed to or that would have been priced differently. The seller's failure to deliver securities may also adversely affect certain rights of the buyer, such as the right to vote. More significantly, naked short sellers enjoy greater leverage than if they were required to borrow securities and deliver within a reasonable time period, and they may use this additional leverage to engage in trading activities that deliberately depress the price of a security. 29

28 “Clearing agency” is defined in Section 3(a)(23)(A) of the Exchange Act, 15 U.S.C. 78c(a)(23)(a).

29 The Commission issued a prior statement cautioning broker-dealers that where the broker-dealer has sold short, but did not, for a substantial period of time, effect the offsetting purchase transactions for purpose of delivery, this could generally involve violations of the anti-fraud provisions of the Federal securities laws. See Securities Exchange Act Release No. 6778 (April 16, 1962)

)(a).

The Commission recently brought an enforcement action against certain parties, alleging manipulative naked short selling, in a scheme sometimes termed as a “death spiral.” These schemes generally involve parties arranging financings in public companies that are unable to obtain more conventional financing in the capital markets due to their precarious financial condition. The party providing financing receives from a public company debentures that are later convertible into the stock of the issuer. The terms typically provide that the conversion ratio will be tied to a fixed value of the aggregate underlying shares (typically a discount from the market price of the security at the time of the conversion rather than a conversion price per share). 30 In some cases the parties providing financing have engaged in extensive naked short selling designed to lower the price of the issuer's stock, thus realizing profits when the debentures are converted to cover the short sales. 31

30 For more information, see “Convertible Securities” on the Commission's Web site at www.sec.gov/answers/convertibles.htm

31 The Commission recently settled a case against parties relating to allegations of manipulative short selling in the stock of Sedona Corporation, a Nasdaq Small Cap company. The action alleged that the defendants engaged in massive naked short selling that flooded the market with Sedona stock, and thus depressed its price. The defendants thereby profited by subsequently exercising the conversion rights under the debenture. See Rhino Advisors, Inc. and Thomas Badian, Lit. Rel. No

manipulative short selling in the stock of Sedona Corporation, a Nasdaq Small Cap company. The action alleged that the defendants engaged in massive naked short selling that flooded the market with Sedona stock, and thus depressed its price. The defendants thereby profited by subsequently exercising the conversion rights under the debenture. See Rhino Advisors, Inc. and Thomas Badian, Lit. Rel. No. 18003 (February 27, 2003); see also SEC v. Rhino Advisors, Inc. and Thomas Badian , Civ. Action No. 03 civ 1310 (RO) (Southern District of New York).

Naked short selling has sparked defensive actions by some issuers designed to combat the potentially negative effects on shareholders, broker-dealers, and the clearance and settlement system. 32 Some issuers have taken actions to attempt to make transfer of their securities “custody only,” thus preventing transfer of their stock to or from securities intermediaries such as the Depository Trust Company (DTC) or broker-dealers. A number of issuers have attempted to withdraw their issued securities on deposit at DTC, which makes the securities ineligible for book-entry transfer at a securities depository. 33 Withdrawing securities from DTC or requiring custody-only transfers undermine the goal of a national clearance and settlement system, designed to reduce the physical movement of certificates in the trading markets. 34

32 There have been press reports concerning the actions of some issuers, and questioning whether the cause of declines in their stock prices can be attributed to naked short selling, or to fundamental problems with the company. See, e.g. , Carol S. Remond, Universal Blames Shorts, But What of Dilution?, Dow Jones Newswires (October 6, 2003); Rob Wherry, Wall Street's Next Nightmare? , Forbes.com (October 6, 2003); see also Gretchen Morgenson, If Short Sellers Take Heat, Maybe It's Time to Bail Out , NY Times (January 26, 2003) (citing a study by Professor Owen A

short selling, or to fundamental problems with the company. See, e.g. , Carol S. Remond, Universal Blames Shorts, But What of Dilution?, Dow Jones Newswires (October 6, 2003); Rob Wherry, Wall Street's Next Nightmare? , Forbes.com (October 6, 2003); see also Gretchen Morgenson, If Short Sellers Take Heat, Maybe It's Time to Bail Out , NY Times (January 26, 2003) (citing a study by Professor Owen A. Lamont that analyzed returns at companies that waged public battles with short sellers, and found that their stocks lagged the market by 2.34 percent in each of the twelve months after the battles began). As a matter of practice, the Commission does not opine on the content or accuracy of such reports.

33 The Commission recently approved a DTC rule change clarifying that its rules provide that only its participants may withdraw securities from their accounts at DTC, and establishing a procedure to process issuer withdrawal requests. See Securities Exchange Act Release No. 47978 (June 4, 2003), 68 FR 35037 (June 11, 2003) (File No. SR-DTC-2003-02).

34 See Section 17A(e) of the Exchange Act. 15 U.S.C. 78q-1(e). The Commission noted in the order approving the DTC rule change that the use of certificates can result in significant delays and expenses in processing securities transactions and can raise safety concerns associated with lost, stolen, and forged certificates. See, supra n. 33.

B. Current Regulatory Requirements

The SROs have adopted rules generally requiring that, prior to effecting short sales, members must “locate” stock available for borrowing. 35 For example, NYSE Rule 440C.10 states that no NYSE member or member organization should “fail to deliver” against a short sale of a security on a national securities exchange until a diligent effort has been made by such member or member organization to borrow the necessary securities to make delivery

ing that, prior to effecting short sales, members must “locate” stock available for borrowing. 35 For example, NYSE Rule 440C.10 states that no NYSE member or member organization should “fail to deliver” against a short sale of a security on a national securities exchange until a diligent effort has been made by such member or member organization to borrow the necessary securities to make delivery. 36 An NYSE interpretation to the rule further states that member organizations effecting short sales for their own account or the accounts of customers must be in a position to complete the transaction. The interpretation states that no orders to sell short should be accepted or entered unless prior arrangements to borrow the stock have been made or other acceptable assurances that delivery can 37 These provisions apply to all NYSE member organizations, whether effecting transactions in exchange-listed securities on the NYSE, another national securities exchange, or in the over-the-counter market. Exceptions from the rule are provided for short sales by specialists, market makers, and odd lot dealers in fulfilling their market responsibilities. 38

35 In 1976 the Commission proposed the adoption of Rule 10b-11. Rule 10b-11 would have prohibited any person from effecting a short sale in any equity security ( i.e. , not just exchange-traded securities) for his own account or the account of any other person unless he, or the person for whose account the short sale is effected (i) borrowed the security, or entered into an arrangement for the borrowing of the security, or (ii) had reasonable grounds to believe that he could borrow the security so that, in either event, he would be capable of delivering the securities on the date delivery is due. Securities Exchange Act Release No. 13091 (December 21, 1976), 41 FR 56530 (December 28, 1976)

count the short sale is effected (i) borrowed the security, or entered into an arrangement for the borrowing of the security, or (ii) had reasonable grounds to believe that he could borrow the security so that, in either event, he would be capable of delivering the securities on the date delivery is due. Securities Exchange Act Release No. 13091 (December 21, 1976), 41 FR 56530 (December 28, 1976). In 1988, the Commission withdrew proposed Rule 10b-11, noting that since the time the rule was proposed, the NYSE and the NASD had adopted interpretations specifying that members should not accept or enter a short sale order unless prior arrangements to borrow the stock have been made, or other acceptable assurances that delivery can be made on settlement date have been obtained. The Commission also stated that it believed the general antifraud provisions of the federal securities laws were applicable to activity addressed by proposed Rule 10b-11. Securities Exchange Act Release No. 26182 (October 14, 1988), 53 FR 41206.

36 See NYSE Rule 440C.10.

37 Such assurances include knowledge that the security is available for borrowing, conversion privileges, rights exercise, and the like. One test of reasonableness in short sales against convertible securities, rights and merger securities is whether the security needed for delivery can be exchanged in normal transfer time. A firm that normally relies on the stock loan market without advance borrowing can demonstrate compliance by switching to prior borrowing whenever the stock borrowing market in a particular security becomes tight.” NYSE Rule 440C.10 Interp. /01. See also NYSE Information Memo 91-41 (providing further information regarding compliance with Rule 440C.10).

38 Id

be exchanged in normal transfer time. A firm that normally relies on the stock loan market without advance borrowing can demonstrate compliance by switching to prior borrowing whenever the stock borrowing market in a particular security becomes tight.” NYSE Rule 440C.10 Interp. /01. See also NYSE Information Memo 91-41 (providing further information regarding compliance with Rule 440C.10).

38 Id.

The comparable NASD Rule 3370 generally provides that no member, or person associated with a member, shall effect a short sale for a customer or for its own account unless the member makes an “affirmative determination” that the member can borrow the securities or otherwise provide for delivery of the securities by settlement date. 39 The affirmative determination must be annotated in writing, evidencing that the member firm will receive delivery of the security from the customer or, if the member firm locates the stock, the identity of the individual and firm contacted who offered assurance that the shares would be delivered or were available for borrowing. 40 This requirement applies regardless of how a short sale order is received, e.g. , by the telephone, an electronic transmission, the Internet, or otherwise. 41 This requirement does not apply to transactions in corporate debt securities, to bona fide market making transactions by Nasdaq market makers, 42 or to transactions that result in fully hedged or arbitraged positions. 43

39 See NASD Rule 3370.

d or arbitraged positions. 43

39 See NASD Rule 3370.

40 According to the rule, the manner by which a member or person associated with a member annotates compliance with the affirmative determination requirement is to be decided by each member. Members may rely on “blanket” or standing assurances ( i.e. , “Easy to Borrow” lists) that securities will be available for borrowing on settlement date. For any short sales executed in Nasdaq National Market (“NNM”) or exchange-listed securities, members also may rely on “Hard to Borrow” lists indicating NNM or listed securities that are difficult to borrow or unavailable for borrowing on settlement date provided that: (i) Any securities restricted pursuant to NASD Rule 11830 must be included on such a list; and (ii) the creator of the list attests in writing on the document or otherwise that any NNM or listed securities not included on the list are easy to borrow or are available for borrowing. Members are permitted to use Easy to Borrow or Hard to Borrow lists provided: (i) The information used to generate the list is no less than 24 hours old; and (ii) the member delivers the security on settlement date. Should a member relying on an Easy to Borrow or Hard to Borrow fail to deliver the security on settlement date, the NASD deems such conduct inconsistent with the terms of Rule 3370, absent mitigating circumstances adequately documented by the member. See NASD Rule 3370(b)(4)(C).

41 See NASD Notice to Members 99-98.

e 3370(b)(4)(C).

41 See NASD Notice to Members 99-98.

42 NASD IM-3350 contains language specifying what type of activity does not constitute bona fide market making: “Bona fide market making activity does not include activity that is unrelated to market making functions, such as index arbitrage and risk arbitrage that is independent from a member's market making functions. * * *” IM-3350(a)(2). “Similarly, bona fide market making would exclude activity that is related to speculative selling strategies of the member or investment decisions of the firm and is disproportionate to the usual market making patterns or practices of the member in that security. The Association does not anticipate that a firm could properly take advantage of its market maker exemption to effectuate such speculative or investment short selling decisions. Disproportionate short selling in a market making account to effectuate such strategies will be viewed by the Association as inappropriate activity that does not represent bona fide market making and would therefore be in violation of Rule 3350.” IM-3350(a)(3).

The NASD has instituted disciplinary actions against broker-dealers that the NASD found were abusing the exemption provided for bona-fide market making transactions. See, e.g. , Hearing Panel Decision as to Respondents John Fiero and Fiero Brothers, Inc. (December 6, 2000) (decision affirmed by the National Adjudicatory Council on October 28, 2002); see also John Emshwiller, NASD Moves to Bar Short Seller Fiero, Citing Alleged Manipulation of Stocks , WSJ (January 9, 2001).

43 NASD Rule 3370(b)(5) provides guidelines in determining the availability of the exemption for “bona-fide fully hedged” and “bona-fide fully arbitraged” positions.

The NASD has also adopted several rules addressing failures to deliver

ry Council on October 28, 2002); see also John Emshwiller, NASD Moves to Bar Short Seller Fiero, Citing Alleged Manipulation of Stocks , WSJ (January 9, 2001).

43 NASD Rule 3370(b)(5) provides guidelines in determining the availability of the exemption for “bona-fide fully hedged” and “bona-fide fully arbitraged” positions.

The NASD has also adopted several rules addressing failures to deliver. NASD Rule 3210 prevents a member, or person associated with a member, from selling a security for his own account, or buying a security as a broker for a customer if, with respect to domestic securities, 44 he has a fail to deliver in that security that is 60 days or older. NASD Rule 11830 imposes a mandatory close-out requirement for Nasdaq securities that have a clearing short position of 10,000 shares or more per security and that are equal to at least one-half of one percent of the issue's total shares outstanding. NASD Rule 11830 generally requires that a contract involving a short sale in these securities, for the account of a customer or for an NASD member's own account, which has not resulted in delivery by the broker-dealer representing the seller within 10 business days after the normal settlement date (currently transaction date + 3 business days), must be closed by the broker-dealer representing the seller by purchasing for cash or guaranteed delivery of securities of like kind and quality. This mandatory close-out requirement does not apply to bona-fide market making transactions and transactions that result in fully hedged or arbitraged positions.

44 With respect to foreign securities, if the member has a fail to deliver in that security 90 days or older (except American Depositary Receipt and Canadian securities, which shall be subject to the 60 day provision).

C. Proposed Amendments

1. Short Sales

The Commission believes that these SRO requirements have not fully addressed the problems of naked short selling and extended fails to deliver

th respect to foreign securities, if the member has a fail to deliver in that security 90 days or older (except American Depositary Receipt and Canadian securities, which shall be subject to the 60 day provision).

C. Proposed Amendments

1. Short Sales

The Commission believes that these SRO requirements have not fully addressed the problems of naked short selling and extended fails to deliver. We believe it would be beneficial to establish a uniform standard specifying the procedures for all short sellers to locate securities for borrowing. 45 This would further the goals of regulatory simplification and avoidance of regulatory arbitrage, as well as address some areas not currently covered. We are therefore proposing to incorporate in proposed Regulation SHO a uniform “locate” rule applicable to all equity securities, wherever they are traded. 46 Proposed Rule 203 would prohibit a broker-dealer from executing a short sale order for its own account or the account of another person, unless the broker-dealer, or the person for whose account the short sale is executed (1) borrowed the security, or entered into an arrangement for the borrowing of the security, or (2) had reasonable grounds to believe that it could borrow the security so that it would be capable of delivering the securities on the date delivery is due. 47 Consistent with the current SRO requirements, the proposed rule would require that the locate be made and annotated in writing prior to effecting any short sale, regardless of the fact that the seller's short position may 48 The Commission is proposing an exception from these requirements for short sales executed by specialists or market makers but only in connection with bona-fide market making activities. 49 We believe a narrow exception for market makers and specialists engaged in bona fide market making activities is necessary because they may need to facilitate customer orders in a fast moving market without possible delays associated with complying with the proposed “locate” rule

short sales executed by specialists or market makers but only in connection with bona-fide market making activities. 49 We believe a narrow exception for market makers and specialists engaged in bona fide market making activities is necessary because they may need to facilitate customer orders in a fast moving market without possible delays associated with complying with the proposed “locate” rule. Moreover, we believe that most specialists and market makers seek a net “flat” position in a security at the end of each day and often “offset” short sales with purchases such that they are not required to make delivery under the security settlement system.

45 Some commenters to the Concept Release supported a single, workable approach to locating securities for borrowing before effecting short sales. See letter from Wilkie, Farr & Gallagher (488) (writing on behalf of Bear, Stearns & Co., Inc.; Credit Suisse First Boston Corp.; Deutsche Bank Securities, Inc.; JP Morgan Securities Inc.; PaineWebber Inc.; Prudential Securities Inc.; and Warburg Dillon Read LLC.).

46 See paragraph (b), Rule 203 of proposed Regulation SHO.

47 We are interested in receiving comment on the manner in which persons could satisfy the “reasonable grounds” determination in the proposed rule. As noted above, the current SRO rules generally defer to members to decide the manner of compliance, and permit members to rely on blanket assurances that stock is available for borrowing, i.e. , “hard to borrow” or “easy to borrow” lists. See, supra n. 40. We specifically request comment on whether this present method of compliance provides an accurate assessment of the current lending market in a manner that would not impede liquidity and the ability of market participants to establish short positions, while at the same time guarding against the noted problems inherent with large extended settlement failures.

48 See, e.g., Ko Securities, Inc. and Terrance Y. Yoshikawa , Securities Exchange Act Release No

hod of compliance provides an accurate assessment of the current lending market in a manner that would not impede liquidity and the ability of market participants to establish short positions, while at the same time guarding against the noted problems inherent with large extended settlement failures.

48 See, e.g., Ko Securities, Inc. and Terrance Y. Yoshikawa , Securities Exchange Act Release No. 48550 (September 26, 2003) (holding that an affirmative determination must be made before the securities are sold short regardless of whether the short seller repurchases securities on the same day).

49 The exemption for bona-fide market making activities would exclude activity that is related to speculative selling strategies or investment decisions of the broker-dealer or associated person and is disproportionate to the usual market making patterns or practices of the broker-dealer in that security.

As an additional safeguard against some of the problems associated with naked short selling, we are proposing a delivery requirement targeted at securities where there is evidence of significant settlement failures. We are incorporating the same threshold currently used in NASD Rule 11830, 50 i.e., any security where there are fails to deliver at a clearing agency registered with the Commission of 10,000 shares or more per security, and that is equal to at least one-half of one percent of the issue's total shares outstanding. 51 We are incorporating this standard into proposed Rule 203 because we believe that the levels set in NASD Rule 11830 characterize situations where the ratio of unfulfilled delivery obligations at the clearing agency where trades are settled represents a significant number of shares relative to the company's total shares outstanding, thus requiring remedial action designed to address potential negative effects

rporating this standard into proposed Rule 203 because we believe that the levels set in NASD Rule 11830 characterize situations where the ratio of unfulfilled delivery obligations at the clearing agency where trades are settled represents a significant number of shares relative to the company's total shares outstanding, thus requiring remedial action designed to address potential negative effects. The proposed rule would specify that for short sales of any security meeting this threshold, the selling broker-dealer must deliver the security no later than two days after the settlement date. 52 We believe a two-day grace period is appropriate to allow for transfer delays or delays due to a variety of circumstances that prevent timely delivery. 53 If for any reason such security was not delivered within two days after the settlement date, the rule would restrict the broker-dealer, including market makers, from executing future short sales in such security for the person for whose account the failure to deliver occurred unless the broker-dealer or the person for whose account the short sale is executed borrowed the security, or entered into a bona fide arrangement to borrow the security, prior to executing the short sale and delivered on settlement date. This restriction would be in effect for a period of 90 calendar days. 54 In addition, the rule would require the rules of the registered clearing agency that processed the transaction to include the following provisions: (A) A broker or dealer failing to deliver such securities shall be referred to the NASD and the designated examining authority for such broker-dealer for appropriate action; 55 and (B) The registered clearing agency shall withhold a benefit of any mark-to-market amounts or payments that otherwise would be made to the party failing to deliver, 56 and take other appropriate action, including assessing appropriate charges against the party failing to deliver

hall be referred to the NASD and the designated examining authority for such broker-dealer for appropriate action; 55 and (B) The registered clearing agency shall withhold a benefit of any mark-to-market amounts or payments that otherwise would be made to the party failing to deliver, 56 and take other appropriate action, including assessing appropriate charges against the party failing to deliver. Both of these requirements should assist the Commission in preventing abuses and promote the prompt and accurate clearance and settlement of securities transactions.

50 The National Securities Clearing Corporation (NSCC) currently tracks this information on fails to deliver and provides it to Nasdaq for purposes of administering NASD Rule 11830. Thus, we do not believe that the threshold proposed here would impose unduly burdensome data collection requirements.

51 For example, if an issuer had 1,000,000 shares outstanding, one-half of one percent (.005) would be 5,000 shares. An aggregate fail to deliver position at a clearing agency of 10,000 shares or more would thus meet the threshold. If an issuer had 10,000,000 shares outstanding, one-half of one percent would be 50,000 shares. An aggregate fail to deliver position at a clearing agency of 50,000 shares or greater would meet the threshold.

52 When the trade fails to settle on normal settlement date ( i.e. , T+3), the broker-dealer would have to take actions, such as borrowing the security or effecting a purchase in the cash market, so that actual delivery is made by T+5.

53 Unlike NASD Rule 11830, which provides for delivery of securities meeting this threshold to be delivered within 10 business days after the normal settlement date, we propose a two-day period because we believe it is reasonable period to allow for transfer delays or delays due to some other characteristic of the security while preventing unfulfilled delivery obligations from extending for a period that we believe is characteristic of a more significant problem

es meeting this threshold to be delivered within 10 business days after the normal settlement date, we propose a two-day period because we believe it is reasonable period to allow for transfer delays or delays due to some other characteristic of the security while preventing unfulfilled delivery obligations from extending for a period that we believe is characteristic of a more significant problem.

54 In this context, we believe that a 90-day restricted period is an appropriate consequence for a failure to deliver and a deterrent to prevent failures to deliver in the future. The Federal Reserve Board has taken this approach with respect to transactions in cash accounts where the securities are sold before they have been fully paid for. See , 12 CFR 220.8(c), Regulation T.

55 Referral to the designated examining authority would allow for monitoring of broker or dealers not complying with proposed Rule 203 and allow for possible disciplinary action. In the case of any fail to deliver occurring at the Canadian Depository for Securities (CDS), the registered clearing agency would refer CDS to the Ontario Securities Commission for appropriate action.

56 As part of its Continuous Net Settlement system (CNS) NSCC marks-to-market each day positions for which participants failed to make delivery. In situations where the value of a security that is the subject of a failure to deliver is increasing, NSCC collects the mark from the party that failed to deliver and passes it on to the party that failed to receive the securities. Conversely, in a situation where the value of the security is decreasing, NSCC collects the mark from the party that failed to receive the securities and passes it on to the party that failed to deliver. Under the CNS system, a participant does not receive the actual contract value of the securities ( i.e. , the proceeds from their sale) until actual delivery of securities is made. See National Securities Clearing Corporation Rules of Procedures Rule 11

y is decreasing, NSCC collects the mark from the party that failed to receive the securities and passes it on to the party that failed to deliver. Under the CNS system, a participant does not receive the actual contract value of the securities ( i.e. , the proceeds from their sale) until actual delivery of securities is made. See National Securities Clearing Corporation Rules of Procedures Rule 11. Nevertheless, we believe that withholding the benefit of mark-to-market amounts from the party failing to deliver in a security meeting the specified threshold would serve as a financial incentive to comply with the borrow and delivery requirements during the 90-day restricted period.

These proposed requirements in Rule 203 would differ from the current SRO rules in several respects. First, the proposals require action two days after settlement, as opposed to the current ten days after settlement provided in Rule 11830. 57 Further, the mandatory close-out provision in NASD Rule 11830 currently only applies to Nasdaq securities. We believe that securities with lower market capitalization may be more susceptible to abuse, and therefore believe that these additional delivery requirements should be extended to all equity securities registered under Section 12 of the Exchange Act. Finally, although market makers engaged in bona fide market making are currently exempted from NASD Rule 11830, we believe that extended failures to deliver appear characteristic of an investment or trading strategy, rather than being related to market making. We believe it is questionable whether a market maker carrying a short position in a heavily shorted security for an extended period of time is in fact engaged in providing liquidity for customers, or rather is engaged in a speculative trading strategy. Therefore, we are not proposing an exception from these additional delivery requirements for short sales in connection with market making

t making. We believe it is questionable whether a market maker carrying a short position in a heavily shorted security for an extended period of time is in fact engaged in providing liquidity for customers, or rather is engaged in a speculative trading strategy. Therefore, we are not proposing an exception from these additional delivery requirements for short sales in connection with market making.

57 We solicit comment on any legitimate reasons why a short seller may be unable to deliver securities by at least T+5. We may then choose to except particular types of transactions, or add a specified grace period.

In our view, these delivery requirements would protect and enhance the operation, integrity and stability of the markets and the clearance and settlement system. In

Q. What harms result from naked short selling? Conversely, what benefits accrue from naked short selling?

Q. Are there negative tax consequences associated with naked short selling, in terms of dividends paid or otherwise?

Q. What is the appropriate manner by which short sellers can comply with the requirement to have “reasonable grounds” to believe that securities sold short could be borrowed? Should short sellers be permitted to rely on blanket assurances that stock is available for borrowing, i.e. , “hard to borrow” or “easy to borrow” lists? Is the equity lending market transparent enough to allow an efficient means of creating these lists?

Q. Should short sales effected by a market maker in connection with bona fide market making be excepted from the proposed “locate” requirements? Should the exception be tied to certain qualifications or conditions? If so, what should these qualifications or conditions be?

Q. Should the proposed additional delivery requirements be limited to securities in which there are significant failures to deliver? If so, is the proposed threshold an accurate indication of securities with excessive fails to deliver? Should it be higher or lower? Should additional criteria be used?

tain qualifications or conditions? If so, what should these qualifications or conditions be?

Q. Are the proposed consequences for failing to deliver securities appropriate and effective measures to address the abuses in naked short selling? If not, why not? What other measures would be effective? Should broker-dealers buying on behalf of customers be obligated to effect a buy-in for aged fails?

Q. Is the restriction preventing a broker-dealer, for a period of 90 calendar days, from executing short sales in the particular security for his own account or the account of the person for whose account the failure to deliver occurred without having pre-borrowed the securities an appropriate and effective measure to address the abuses in naked short selling? Should this restriction apply to all short sales by the broker-dealer in this particular security? Should the restriction also apply to all further short sales by the person for whose account the failure to deliver occurred, effected by any broker-dealer?

Q. Should short sales effected by a market maker in connection with bona-fide market making be exempted from the proposed delivery requirements targeted at securities in which there are significant failures to deliver? If so, what reasons support such an exemption, and how should bona-fide market making be identified?

Q. Under what circumstances might a market maker need to maintain a fail to deliver on a short sale longer than two days past settlement date in the course of bona fide market making? Is two days the appropriate time period to use?

ecurities in which there are significant failures to deliver? If so, what reasons support such an exemption, and how should bona-fide market making be identified?

Q. Are there any circumstances in which a party not engaging in bona-fide market making might need to maintain a fail to deliver on a short sale longer than two days past settlement? If so, can such positions be identified? Should they be excepted from the proposed borrow and delivery requirements, and if so, why, and for how long?

2. Long Sales

Current Rule 10a-2 covers delivery requirements applicable to long sales of securities registered or admitted to unlisted trading privileges on a national securities exchange. We are proposing to adopt subparagraph (a) of Rule 203 in proposed Regulation SHO, which would replace and modify Rule 10a-2 to make it consistent with the new delivery requirements in the proposed short sale rule.

Generally, Rule 10a-2 provides that if a broker-dealer knows or should know that a sale is marked long, the broker-dealer must make delivery when due and cannot lend securities to do so. If the broker-dealer does not have the securities, it must make delivery with securities purchased for cash, i.e. , effect a “buy in,” unless it knows that the seller either is in the process of forwarding the securities to the broker-dealer or will do so as soon as possible without undue inconvenience or expense. Broker-dealers are excused from the buy-in requirement in two cases. In sales between broker-dealers, loans are permitted in lieu of a buy-in. The rule also allows a broker-dealer to fail to deliver, or to borrow securities in lieu of buying-in, if, despite the broker-dealer's efforts to ensure that the sale was long, it was in fact short

as soon as possible without undue inconvenience or expense. Broker-dealers are excused from the buy-in requirement in two cases. In sales between broker-dealers, loans are permitted in lieu of a buy-in. The rule also allows a broker-dealer to fail to deliver, or to borrow securities in lieu of buying-in, if, despite the broker-dealer's efforts to ensure that the sale was long, it was in fact short. This exemption is available only if the exchange or national securities association in whose market the sale was effected finds that the sale resulted from a good-faith mistake, the broker-dealer exercised due diligence, and either that requiring a buy-in would result in undue hardship or that the sale had been effected at a permissible price.

Subparagraph (a) of Rule 203 of proposed Regulation SHO preserves the substance of current Rule 10a-2 regarding delivery of securities sold pursuant to orders marked “long.” Only two substantive changes have been made. First, Regulation SHO would extend the delivery requirements of Rule 10a-2 to all securities, including those traded over-the-counter. As with our proposal to apply borrow and delivery requirements for short sales in all equity securities, we believe it is equally important to apply long delivery requirements to securities with lower market capitalization that may be more susceptible to abuse.

Second, proposed Regulation SHO would provide that a loan or failure to deliver is permitted if the seller has informed the broker-dealer that the seller owns the security and will deliver it to the broker-dealer prior to settlement of the transaction, but fails to do so. The proposed modification tracks the proposed amendments to the order marking requirements, which would permit an order to be marked long if the seller owns the securities and the seller's broker-dealer will have physical possession or control of the security prior to settlement

r owns the security and will deliver it to the broker-dealer prior to settlement of the transaction, but fails to do so. The proposed modification tracks the proposed amendments to the order marking requirements, which would permit an order to be marked long if the seller owns the securities and the seller's broker-dealer will have physical possession or control of the security prior to settlement. 58 The proposed rule would permit a broker-dealer to fail to deliver, or to deliver borrowed securities, if an exchange or national securities association found that the broker-dealer used due diligence in obtaining the seller's confirmation that the security would be in the broker-dealer's possession prior to settlement, and that either compelling a buy-in would result in undue hardship, or that the mistake was made by the seller's broker-dealer and the sale was at a permissible price under Proposed Rule 201(b) of Regulation SHO. 59 We believe that this change would facilitate the process of clearance and settlement, while still achieving the goals of short sale regulation.

58 See, infra part IX for a further discussion of the proposed order marking requirements.

59 This exception shall not apply where a broker-dealer knows or has reason to know that an order is incorrectly marked long. Knowledge may be inferred where a broker-dealer repeatedly accepts orders marked long from the same customer that requires borrowed shares for delivery or results in a “fail to deliver” on several occasions.

Q. Are the delivery requirements in proposed Rule 203(a) appropriate?

III. Current Market Structure and the Tick Test

Q. Are the delivery requirements in proposed Rule 203(a) appropriate?

III. Current Market Structure and the Tick Test

The tick test was part of short sale regulation implemented in 1938. The tick test has provided the markets with a generally effective means of regulating short sales for more than 60 years. Nonetheless, arguments have been made to allow greater flexibility in short selling. Indeed, substantial economic arguments have been made that short selling should be deregulated, at least in the case of the tick test. 60 Some 61 A substantial number of other commenters disagreed and expressed support for a price test. 62 We do not believe that proposing complete rescission of the short sale price test would be appropriate at this time, although we request comment about that approach. Instead, we propose a new, uniform price test that would apply to today's markets, and a pilot that would permit us to gather data about trading activity in the absence of a short sale price restriction.

60 See, e.g. , Albert, Smaby, and Robison, 1997, Short Selling and Trading Abuses on Nasdaq, Financial Services Review, 6(1), 27-39; Alexander and Peterson, 1999, Short Selling and the New York Stock Exchange and the Effects of the Uptick Rule, Journal of Financial Intermediation, 8, 90-116; Alexander and Peterson, 2002, Implications of a Reduction in Tick Size on Short-Sale Order Execution, Journal of Financial Intermediation, 11, 37-60; Angel, 1997, Short Selling on the NYSE, working paper, Georgetown University; Jones, 2002, Shorting Restrictions, Liquidity, and Returns, working paper, Columbia University; Lamont, Owen A., 2003, Go Down Fighting: Short Sellers vs. Firms, working paper, University of Chicago and NBER.

61 See, e.g

duction in Tick Size on Short-Sale Order Execution, Journal of Financial Intermediation, 11, 37-60; Angel, 1997, Short Selling on the NYSE, working paper, Georgetown University; Jones, 2002, Shorting Restrictions, Liquidity, and Returns, working paper, Columbia University; Lamont, Owen A., 2003, Go Down Fighting: Short Sellers vs. Firms, working paper, University of Chicago and NBER.

61 See, e.g. , letters from The Chicago Board Options Exchange (32), Cornerstone Securities Corporation (324), Electronic Traders Association (ETA) (327), Interactive Brokers; The Timber Hill Group (329), Island ECN (Island) (431), Managed Funds Association (MFA) (427), Charles Schwab (Schwab) (310), Sierra Trading Group, L.P. (39), Trimark Securities (330).

62 See, e.g. , letters from the NASD (480), NYSE (467), Sherman and Sterling (424), North American Securities Administrators Association (NASAA)(321), Specialist Association (426).

IV. Proposed Bid Test

Current short sale regulation applies different price tests to securities trading in different markets. Rule 10a-1 applies only to short sale transactions in securities listed on a national securities exchange, whether the transaction is effected on an exchange or otherwise. The NASD's bid test applies to short sale transactions in Nasdaq NMS securities effected on either SuperMontage or the NASD's Alternative Display Facility (ADF), but not to Nasdaq SmallCap, OTCBB, and other securities traded over-the-counter. Moreover, no short sale price test applies to short sales of Nasdaq NMS securities executed away from SuperMontage and the ADF, unless the market on which the securities are being traded has adopted its own price test. 63 The end result is disparate short sale regulation of Nasdaq securities, depending on the market where the securities are trading. This situation may lend itself to regulatory arbitrage. 64

63 Transactions in these securities are not subject to short sale regulation under Rule 10a-1. See Securities Exchange Act Release No

on which the securities are being traded has adopted its own price test. 63 The end result is disparate short sale regulation of Nasdaq securities, depending on the market where the securities are trading. This situation may lend itself to regulatory arbitrage. 64

63 Transactions in these securities are not subject to short sale regulation under Rule 10a-1. See Securities Exchange Act Release No. 22975 (March 6, 1986), 51 FR 8801 (March 14, 1986) (the Commission adopted amendments to Exchange Act Rule 10a-1 to exclude from application of the rule transactions in NMS securities that are traded on an exchange on a listed or unlisted trading privileges basis).

64 The Commission recently issued a Concept Release seeking comment on this and other issues presented in a petition submitted by Nasdaq. Securities Exchange Act Release No. 47849 (May 14, 2003), 68 FR 27722 (May 20, 2003).

We note that Nasdaq has also applied to become a national securities exchange. 65 If Nasdaq becomes an exchange, Rule 10a-1 would apply to Nasdaq securities because they would be exchange-listed securities reported pursuant to an “effective transaction reporting plan.” Nasdaq has applied for relief from Rule 10a-1 in conjuction with the exchange registration. 66 The Commission has not yet acted upon the application. If the Commission were to grant an exemption from Rule 10a-1 to allow Nasdaq to apply Rule 3350 to Nasdaq exchange-listed securities, the same securities quoted and traded on Nasdaq and other exchanges would be subject to two different short sale rules. This has the potential for confusion and compliance difficulties. We believe that these considerations, along with the other market developments discussed previously, make this an appropriate time to propose amendments that would provide for a more consistent approach to short sale regulation.

65 See Securities Exchange Act Release No. 44396 (June 7, 2001), 66 FR 31952 (June 13, 2001).

66 See Letter to Jonathan G. Katz, Secretary, Commission, from Edward S

. We believe that these considerations, along with the other market developments discussed previously, make this an appropriate time to propose amendments that would provide for a more consistent approach to short sale regulation.

65 See Securities Exchange Act Release No. 44396 (June 7, 2001), 66 FR 31952 (June 13, 2001).

66 See Letter to Jonathan G. Katz, Secretary, Commission, from Edward S. Knight, Executive Vice President and Chief Legal Officer, NASD (August 7, 2000).

A. Operation of the Uniform Bid Test

The current tick test uses the last trade price in a security as a reference point for determining permissible short sale prices under Rule 10a-1. The effectiveness of this test for exchange-listed securities depends on the centralized auction nature of most exchanges and the historical concentration on exchanges of transactions in exchange-listed securities, which helps produce a consistent sequence of trade reports. In 2002, for example, the NYSE accounted for 87.9% of share volume in NYSE listed equities. 67

67 See 2002 NYSE Annual Report.

The tick test, however, may not be as effective a means of regulating dealer markets. Nasdaq, in contrast to the auction markets, has no single market center that concentrates trading in Nasdaq securities. During regular trading hours, order flow in Nasdaq securities is divided among many different market makers, ECNs, and regional exchanges. 68 Trade reporting for Nasdaq securities involves multiple market makers reporting trades in the same stock from different locations using different means of reporting. Although trades are required to be reported within 90 seconds after execution, they are published in reporting sequence, not trade sequence. 69 This reporting may create upticks and downticks that may not accurately reflect price movements in the security for the purposes of the tick test. To a lesser degree, this phenomenon occurs in exchange-listed securities that are traded in multiple venues

. Although trades are required to be reported within 90 seconds after execution, they are published in reporting sequence, not trade sequence. 69 This reporting may create upticks and downticks that may not accurately reflect price movements in the security for the purposes of the tick test. To a lesser degree, this phenomenon occurs in exchange-listed securities that are traded in multiple venues.

68 For example, in May 2003, there were an average of 73 market makers per issue in the top 1% of Nasdaq stocks by trading volume, 40.5 market makers per issue in the next 9% of stocks, and an overall average of 15.4 market makers per issue. The majority of Nasdaq trading occurs primarily at dealer market centers. The agency markets operated by the seven ECNs in May 2003 accounted for 23.3% of Nasdaq share volume. In addition, the Archipelago Exchange and the Cincinnati Stock Exchange each account for 12.8% of the Nasdaq Share Volume for a total of 25.6% of Nasdaq Share Volume. See www.marketdata.nasdaq.com .

69 NASD Rule 4632, Transaction Reporting, requires market makers to transmit through the Automated Confirmation Transaction Service or “ACT” all last sale reports of transactions in designated securities executed during normal market hours within 90 seconds after execution. See NASD Rule 4632 (NMS securities) and Rule 4642 (Nasdaq SmallCap securities), and Rule 6420 (exchange-listed securities).

We are proposing Rule 201 of Regulation SHO, which would replace Rule 10a-1's tick test with a test using the consolidated best bid as the reference point for permissible short sales. Specifically, subparagraph (b) of proposed Rule 201 would require that all short sales in exchange-listed and Nasdaq NMS securities, wherever traded, be effected at a price at least one cent above the consolidated best bid at the time of execution. 70 A bid test would apply a uniform rule to trades in the same securities that occur in multiple, dispersed, and diverse markets

rmissible short sales. Specifically, subparagraph (b) of proposed Rule 201 would require that all short sales in exchange-listed and Nasdaq NMS securities, wherever traded, be effected at a price at least one cent above the consolidated best bid at the time of execution. 70 A bid test would apply a uniform rule to trades in the same securities that occur in multiple, dispersed, and diverse markets. Moreover, a bid test would provide greater flexibility in effecting short sales in a decimals environment, as discussed below. Finally, a bid test would better accommodate increasingly popular automated trading systems that utilize passive pricing and trading systems that offer price improvement based on the consolidated best bid and offer. 71

70 To address the problem of locked and crossed markets, we have proposed an exception from the proposed bid test allowing a responsible broker or dealer, as defined in 17 CFR 240.11Ac1-1(a)(21), to effect a short sale at a price equal to the consolidated best offer when the market for the covered security is locked or crossed, provided however, that the exception shall not apply to any broker or dealer who initiated the locked or crossed market. See, infra Part VI.A.7 for a further discussion of this exception.

71 Passive pricing systems often effect trades at an independently-derived price, such as the midpoint of the bid-offer spread. Such pricing would often not satisfy the current tick test. However, midpoint pricing would generally satisfy a test requiring a short sale to be priced above the current best bid. We generally do not believe that such passive pricing systems present significant opportunities for short selling abuse. See infra , part IV.D, for a further discussion of passive pricing.

passive pricing systems present significant opportunities for short selling abuse. See infra , part IV.D, for a further discussion of passive pricing.

The proposed bid test in Rule 201 would require that a short sale be effected at a price at least one cent above the best consolidated bid at the 72 This would be a significant change from the current tick test, which is based on last sale prices. The bid test also would operate differently from the current rule for Nasdaq securities. NASD's Rule 3350 prohibits NASD members from effecting short sales in NMS securities at or below the best bid when the best bid displayed is below the preceding best bid in a security. However, if there is an “upbid” in a security, i.e. , the best bid displayed is above the preceding best bid, there is no restriction on the price that a NASD member can sell an NMS security short. 73

72 As stated in the Commission's approval of Nasdaq's penny short sale pilot, a $0.01 increment for a short sale price test is a reasonable increment in a decimals environment. See Securities Exchange Act Release No. 44030 (March 2, 2001), 66 FR 14235 (March 8, 2001). However, the Commission may revisit this requirement upon the completion of its analysis of statistical data relating to quoting and trading activity in a decimals environment.

73 Should the Commission adopt changes to existing short sale regulations, the SROs would need to update their rules to reflect our modifications.

Under the proposed uniform bid test, the price at which a short sale could be effected would move contemporaneously with the movement of the consolidated best bid. 74 In contrast, compliance with the current short sale price tests require a comparison of the previous last sale in relation to the most recent last sale in listed securities or a comparison of the current bid with the previous bid for Nasdaq securities

uniform bid test, the price at which a short sale could be effected would move contemporaneously with the movement of the consolidated best bid. 74 In contrast, compliance with the current short sale price tests require a comparison of the previous last sale in relation to the most recent last sale in listed securities or a comparison of the current bid with the previous bid for Nasdaq securities.

74 Under the proposed bid test, if the best bid in a security is $47.00, short selling would be allowed at $47.01 or higher, regardless of whether the immediately preceding bid was $46.99 or $47.01 ( i.e. , it does not matter whether the current bid is an upbid or downbid from the immediately preceding bid). Also, if the best bid in a security is $47.00, and the last trade price in the security was $47.05, short selling would be allowed at $47.01 or higher ( i.e. , the last sale price is irrelevant).

We recognize that a quotation only proposes a transaction, whereas the last trade price reflects an actual trade. However, pursuant to Commission and SRO rules, quotations for all covered securities must be firm. Further, we believe that bids generally are a more accurate reflection of current prices for a security because last trade prices can be reported out-of-sequence within a 90 second window.

We believe the proposed bid test would promote the fundamental goals of short sale regulation. First, the proposed bid test would facilitate relatively unrestricted short selling in an advancing market, because the short selling reference price would move with the current interest of the market.

an advancing market, because the short selling reference price would move with the current interest of the market.

The proposed bid test also is designed to achieve the second and third objectives of the short sale rule, preventing short selling at successively lower prices and preventing short sellers from accelerating a decline in the market by exhausting all remaining bids at one price level. One of the negative uses of short selling is attempting to establish lower transaction prices in a security, hoping to induce others to liquidate their positions and lower prices further. 75 A short seller may attempt to accomplish this by exhausting higher priced bids in a security, thus creating the appearance of a declining market. 76 Barring short sales at prices equal to or below the consolidated best bid would prevent short sellers from exhausting the bids in a security and thus prevent short sellers from inducing a price decline. Since only long sellers could sell at the consolidated best bid, it is unlikely that short sellers could directly cause short selling at successively lower prices. 77

75 See Securities Exchange Act Release No. 10668 (March 6, 1974), 39 FR 10604 (March 21, 1974).

76 Id .

77 The Commission would view activity by market participants to alter the consolidated best bid solely for the purpose of facilitating short sales as a violation of proposed Regulation SHO, as well as potentially the anti-fraud and anti-manipulation provisions of the federal securities laws, including Sections 9(a), 10(b), and 15(c) of the Exchange Act, and Rules 10b-5 and 15c1-2 thereunder. For example, a broker-dealer may attempt to circumvent the rule by entering into an arrangement with a customer in which the customer would sell short to the dealer one cent above the bid, and the dealer would charge a higher commission to cover the price. The dealer would then sell “long” at the bid. An example of this is as follows: Assume that the best bid is $20.35

10b-5 and 15c1-2 thereunder. For example, a broker-dealer may attempt to circumvent the rule by entering into an arrangement with a customer in which the customer would sell short to the dealer one cent above the bid, and the dealer would charge a higher commission to cover the price. The dealer would then sell “long” at the bid. An example of this is as follows: Assume that the best bid is $20.35. A broker-dealer could arrange with a customer to execute a short sale at $20.36, and include a mark-up or commission of 6 cents. The net to the customer would thus be $20.30. The broker-dealer could then sell long into the bid at $20.35, thus earning a profit on the transaction. Not only may such activity violate reporting rules ( see NASD Rule 6130(d)(3)), such activity could be viewed as fraudulent and/or manipulative by the Commission.

While we believe the uniform bid test is the most flexible approach to modernizing the short sale rule while continuing to promote the goals of short sale regulation, we understand that some market participants may desire an even greater range of prices at which to effect short sales. One alternative would be a bid test allowing short selling at a price equal to or above the consolidated best bid if the current best bid is above the previous bid ( i.e. , an upbid). However, in this alternative, short selling would be restricted to a price at least one cent above the consolidated best bid (not equal to the best bid) if the current best bid is below the previous bid ( i.e. , a downbid). 78 This alternative test would apply to the same securities as our uniform bid test. 79 While we are not proposing this alternative test as part of Regulation SHO, we seek comment on this test as another possible approach to regulating short sales.

re not proposing this alternative test as part of Regulation SHO, we seek comment on this test as another possible approach to regulating short sales.

78 The following example demonstrates the operation of this alternative uniform short sale rule: If the consolidated best bid in a security is $47.00, and the immediately preceding bid was $46.99, short selling would be allowed at $47.00 or higher. If the consolidated best bid in a security is $47.00, and the immediately preceding bid was $47.01, short selling would only be allowed at $47.01 or higher.

79 We note that, unlike the proposed bid test, this alternative test would incorporate the preceding bid into the calculation of the price at which a short sale could be executed. This would add a layer of complexity to the rule and could impose additional programming costs.

We are aware that these proposals represent significant changes in the operation of Rule 10a-1. We request comment about the appropriateness of the proposed bid test and the alternative bid test.

Q. Should short sales continue to be limited by a price test? If the Commission did not adopt a price test under Regulation SHO, should it also preclude the ability of the SROs to have price tests?

Q. Would there be any benefits in eliminating a short sale price test? Would the elimination of a price test benefit the markets by allowing investors to more freely short sell potentially overvalued securities so that their price more accurately reflects their fundamental value? Are there other benefits to the removal of a price test, such as elimination of systems and surveillance costs?

Q. Would the proposed “bid test” in Rule 201, allowing short sales above the best consolidated bid, effectively prevent short selling being used as a tool for driving the market down?

Q. Would short sale regulation using the proposed bid test operate effectively in an auction market? If not, why not?

its to the removal of a price test, such as elimination of systems and surveillance costs?

Q. Would the proposed “bid test” in Rule 201, allowing short sales above the best consolidated bid, effectively prevent short selling being used as a tool for driving the market down?

Q. Would short sale regulation using the proposed bid test operate effectively in an auction market? If not, why not?

Q. Would short sale regulation using the proposed bid test operate effectively in a dealer market? If not, why not?

Q. Would there ever be a circumstance where there would not be a consolidated bid in an exchange-listed or Nasdaq NMS security? If so, please describe.

Q. The proposed bid test likely would inhibit short sales in a declining market because there would be few execution opportunities above the best bid. Is this appropriate?

Q. Is a one-cent increment an appropriate standard for allowing short sales above the best consolidated bid? If not, what is an appropriate increment?

Q. Would short sale regulation using the proposed bid test present any automated systems problems for market participants?

Q. Would the proposed bid test operate effectively in the current decimal environment, i.e. , would bid flickering inhibit the operation of the test?

Q. Would the proposed bid test fulfill the fundamental goals of short sale regulation?

Q. Would the alternative test allowing short selling at a price equal to or above the consolidated best bid if it is an upbid better fulfill the goals of short sale regulation?

B. Scope of the Uniform Bid Test

1. Securities Subject to the Price Test

The proposed bid test would apply to all securities currently subject to short sale price tests, i.e. , exchange-listed and Nasdaq NMS securities, wherever they are traded. Specifically, the proposed bid test would apply to all national market system securities as defined in § 240.11Aa2-1 of this chapter, but shall exclude Nasdaq Small Cap securities, as determined by NASD rules

o the Price Test

Market information for securities, including quotes, is disseminated pursuant to a variety of different national market system plans. Generally, the SROs have developed networks or systems that disseminate market information. 80 The NYSE, Amex, Nasdaq, and the regional exchanges are all required to make available to vendors the best bids in any common stock, long-term warrant, or preferred stock. 81 This information is disseminated as a part of an effective transaction reporting plan pursuant to the Consolidated Tape Association Plan (CTA Plan) and the Consolidated Quotation Plan (CQ Plan). The NYSE, Amex, Nasdaq, and the regional exchanges all participate in the CTA Plan and CQ Plan. 82 Finally, Nasdaq disseminates market information for securities in the two tiers of the Nasdaq market, i.e. , NMS and SmallCap stocks, as well as certain other securities traded OTC. Information for NMS securities is collected and disseminated pursuant to NASD's rules and the Nasdaq/UTP plan. 83

80 In relevant part, these networks can be categorized as follows: (1) Network A—securities listed on the NYSE; (2) Network B—securities listed on Amex or the regional exchanges; and (3) Nasdaq system—securities qualified for inclusion in the Nasdaq system and certain other securities traded in the OTC market.

81 See Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1; Exchange Act Rule 11Ac1-4, 17 CFR 240.11Ac1-4.

82 CTA Plan, Sections I(q) and VII(a)(i) for NYSE securities (Network A), CTA Plan, Sections I(q) and VII(a) for Amex and the regional exchanges (Network B)

nges; and (3) Nasdaq system—securities qualified for inclusion in the Nasdaq system and certain other securities traded in the OTC market.

81 See Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1; Exchange Act Rule 11Ac1-4, 17 CFR 240.11Ac1-4.

82 CTA Plan, Sections I(q) and VII(a)(i) for NYSE securities (Network A), CTA Plan, Sections I(q) and VII(a) for Amex and the regional exchanges (Network B). These plans were adopted pursuant to Rule 11Aa3-1, 17 CFR 240.11Aa3-1, which governs the dissemination of transaction reports and last trade price information in national market system securities (equity securities listed on national securities exchanges or included in the national market tier of Nasdaq). In general, this rule requires an SRO to file a transaction reporting plan for such securities, and it requires SRO members to transmit information required by the plans to the SROs.

83 See Securities Exchange Act Release No. 42208 (December 9, 1999) 64 FR 70613 (December 17, 1999) (concept release requesting comment on the regulation of market information fees and revenues).

These networks are designed to ensure that consolidated bids from the various market centers that trade exchange-listed and Nasdaq NMS securities are continually collected and disseminated on a real-time basis, in a single stream of information. Thus, all market participants would have access to the consolidated bids for all the securities that would be subject to the proposed uniform bid test.

2. Securities Not Subject to the Price Test

We are not proposing at this time to extend the uniform bid test to securities not currently covered by a short sale price test ( i.e. , Nasdaq SmallCap, OTCBB, and Pink Sheet securities) in part because these markets have not been subject to the rule in the past. More significantly, we believe that the proposed locate and deliver requirements may address many of the concerns regarding abusive short selling in thinly-capitalized securities trading over-the-counter

securities not currently covered by a short sale price test ( i.e. , Nasdaq SmallCap, OTCBB, and Pink Sheet securities) in part because these markets have not been subject to the rule in the past. More significantly, we believe that the proposed locate and deliver requirements may address many of the concerns regarding abusive short selling in thinly-capitalized securities trading over-the-counter. In particular, these proposals should significantly discourage efforts to deliberately depress the price of these securities by removing the leverage abusive short sellers enjoy through short selling without incurring the costs of borrowing and delivering. We recognize, however, that issuers of less actively traded securities believe that they are particularly vulnerable to “abusive” short selling, and we seek specific comment on whether the proposed bid test or other price test should be extended to these securities.

Q. Should the proposed uniform bid test be extended to Nasdaq SmallCap and OTCBB Securities? Do these securities need the protection of the proposed uniform bid test?

Q. Should the proposed uniform bid test be extended to other OTC securities, e.g. , those quoted in the Pink Sheets? If so, are quotes in these securities disseminated in a manner that would allow for the use of the proposed uniform bid test? In addition, would the proposed bid test be workable due to the fact that the best bid in these securities could be outstanding for long periods of time? If not, could a last sale test or some other test be applied to these securities?

C. Bid Test Flexibility in a Decimals Environment

The Commission is aware of concerns about the ability to effect short sales using the tick test in a decimals environment. In particular, with the increase in the number of price points from 16 to 100 per dollar as a result of pricing in decimals, there has been an increase in price flickering, i.e. , an increase in the number of times the last trade price in a security changes rapidly

vironment

As a result market participants have sought relief from the tick test provisions of Rule 10a-1. For example, some third market makers in exchange-listed securities offer trade execution for eligible customer orders at a price equal to or better than the consolidated best offer. However, if the consolidated best offer is below the previous last reported sale in a security and the third market maker or specialist has a short position, sales at the consolidated best offer would violate the tick test of Rule 10a-1. The Commission has granted an exemption from Rule 10a-1 to permit registered market makers and exchange specialists publishing two-sided quotes in a security to sell short to facilitate customer market and marketable limit orders at the consolidated best offer, regardless of the last trade price. 84 The exemption provided relief in a decimals environment to market makers and specialists in instances where they would be providing liquidity in response to customer buy orders. Such relief would not be necessary with a bid test, since such sales (by any market participant) would always be effectuated above the best bid, specifically at the consolidated best offer or better.

d always be effectuated above the best bid, specifically at the consolidated best offer or better.

84 See Letter re: Bernard L. Madoff Investment Securities LLC (February 9, 2001) (exemption from Rule 10a-1 to allowing registered market makers and specialists to sell short to facilitate customer market and marketable limit orders at the consolidated best offer regardless of the last trade price). All such short sales effected pursuant to the exemption are required to be reported as “sell short exempt.” This relief is strictly limited to the facilitation of customer market and marketable limit orders and is not available as a means of soliciting customer orders. Moreover, the exemption letter notes that whether an execution at the consolidated best offer constitutes best execution of a customer's trade will depend on all the facts and circumstances.

Permitting short sales above the best bid should alleviate other difficulties complying with the tick test in a decimals environment. The Commission's Office of Economic Analysis (OEA) conducted a study that found that the proposed bid test is considerably less restrictive than the current tick test. 85 Specifically, OEA 86 OEA found that the tick test was more restrictive (the MSP was higher for the tick test than it was for the proposed bid test) 60.4% of the time, the proposed bid test and tick test were equally restrictive (the MSP for the tick test and the proposed bid test were the same) 15.5% of the time, and the proposed bid test was more restrictive (the MSP was at or below the bid) 24.1% of the time. As this study indicates, the proposed bid test should offer more short selling opportunities than the current tick test.

elow the bid) 24.1% of the time. As this study indicates, the proposed bid test should offer more short selling opportunities than the current tick test.

85 The study was conducted using stocks listed on the NYSE during the month of July, 2003. The study did not examine the proposed bid test relative to the current Nasdaq bid test. The study is available in the Commission's Public Reference Room. See also Alexander and Peterson, 1999, Short Selling on the New York Stock Exchange and the Effects of the Uptick Rule, Journal of Financial Intermediation (a study of, among other things, short selling opportunities under the current tick test in a declining market).

86 In OEA's analysis, if the tick test MSP was greater than the MSP from the proposed bid test, then the tick test was more restrictive than the proposed bid test because the bid test allows lower execution prices, and, of course, the converse conclusion would be reached if the opposite was true.

D. Bid Test Flexibility for Passive Pricing Systems

We have granted limited exemptive relief from the tick test provisions of Rule 10a-1 in connection with short sale transactions executed on a volume-weighted average price (VWAP) basis. 87 The relief is 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. 88 We granted the exemption based, in part, on the fact that these VWAP short sale transactions appear to pose little risk of facilitating the type of market effects that Rule 10a-1 was designed to prevent. In particular, the pre-opening VWAP short sale transactions do not participate in or affect the determination of the VWAP for a particular security. Moreover, the Commission stated that all trades used to calculate the day's VWAP would continue to be subject to Rule 10a-1. 89

87 See e.g. Letter re: VWAP Trading System (March 24, 1999); Letter re: Jeffries and Company, Inc

as designed to prevent. In particular, the pre-opening VWAP short sale transactions do not participate in or affect the determination of the VWAP for a particular security. Moreover, the Commission stated that all trades used to calculate the day's VWAP would continue to be subject to Rule 10a-1. 89

87 See e.g. Letter re: VWAP Trading System (March 24, 1999); Letter re: Jeffries and Company, Inc. (Jeffco) (December 7, 2000); Letter re: POSIT (March 30, 2001); Letter re: Morgan, Stanley & Co., Inc. (May 11, 2001); Letter re: Vie Institutional Services (February 12, 2003).

88 The VWAP for each security is generally determined by: (1) Calculating raw values for regular session trades reported by the Consolidated Tape during the regular trading day by multiplying each such price by the total number of shares traded at that price; (2) compiling an aggregate sum by adding each calculated raw value from step one above; and (3) dividing the aggregate sum by the total number of reported shares for that day in the security. See, e.g. , Letter re: POSIT (March 30, 2001).

89 The relief is subject to a number of conditions, including: limiting it to only those securities which would qualify as “actively-traded securities” as defined in Regulation M (unless the security is part of a “basket”) 17 CFR 242.100; that there be no pre-arranged matching sale and purchase orders; a 10% average daily volume limitation when acting as principal on the contra-side of a VWAP short sale transaction; and that no transactions are made for the purpose of creating actual, or apparent, active trading in or otherwise affecting the price of any security. See, supra n. 87.

ent, active trading in or otherwise affecting the price of any security. See, supra n. 87.

There are also electronic trading systems that match and execute trades at other independently-derived prices, such as the midpoint of the consolidated best bid and offer. Limited short sale relief has been granted to certain systems that match customer orders at random times within specific time intervals. 90 These systems had requested relief from Rule 10a-1 because matches could potentially occur at a price below the last reported sale price. Due to the passive nature of pricing and the lack of price discovery, trades executed through the systems generally do not appear to involve the types of abuses that 10a-1 was designed to prevent. 91

90 See e.g. Letter re: POSIT (April 23, 2003).

91 The relief was also conditioned on the fact that none of the persons relying on the exemption would be represented in, or otherwise influence the primary market bid or offer, and that none of the transactions effected on the electronic system would be made for the purpose of depressing or manipulating the price of the security. Id.

We believe that the proposed bid test would accommodate the recent growth of matching systems that execute trades at an independently derived price above the consolidated best bid. Such executions would generally comply with the proposed bid test, while also enabling customer orders to seek executions that would provide price, and possibly size, improvement.

We note, however, that there may be instances where the final execution price of VWAP short sale transactions could be at or below the closing best bid for that security, and thus would violate the proposed bid test. Nevertheless, we propose codifying an exception to the bid test provisions of proposed Rule 201 to permit short sales at the VWAP, subject to the same conditions included in the above exemptions

wever, that there may be instances where the final execution price of VWAP short sale transactions could be at or below the closing best bid for that security, and thus would violate the proposed bid test. Nevertheless, we propose codifying an exception to the bid test provisions of proposed Rule 201 to permit short sales at the VWAP, subject to the same conditions included in the above exemptions. 92 These would be the following: (1) All short sale orders will be received and matched before the regular trading session opens and the execution price of VWAP matched trades will be determined after the close of the regular trading session; (2) the VWAP for the covered security is calculated by: calculating the values for every regular way trade reported in the consolidated system, or on a primary market that accounts for 75% or more of the covered security's average daily trading volume 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; (3) the transactions are reported using a special VWAP trade modifier; (4) short sales used to calculate the VWAP will themselves be subject to the bid test; (5) the VWAP matched security qualifies as an “actively-traded security” (as defined under Rules 101(c)(1) and 102(d)(1) of Regulation M)

ues; and dividing the aggregate sum by the total number of reported shares for that day in the security; (3) the transactions are reported using a special VWAP trade modifier; (4) short sales used to calculate the VWAP will themselves be subject to the bid test; (5) the VWAP matched security qualifies as an “actively-traded security” (as defined under Rules 101(c)(1) and 102(d)(1) of Regulation M). 93 Where the subject listed security is not an “actively-traded security” or a S&P 500 Index security, the proposed short sale transaction would be permitted only if it is conducted as part of a basket transaction of 20 or more securities in which the subject security does not comprise more than 5% of the value of the basket traded; (6) the transaction is not effected for the purpose of creating actual, or apparent, active trading in or otherwise affecting the price of any security; (7) a broker or dealer shall be permitted to act as principal on the contra-side to fill customer short sale orders only if the broker or 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 subject security's relevant average daily trading volume, as defined in Regulation M. 94 Any VWAP short sale transaction that does not meet these conditions would need to comply with the bid test. In addition, all other provisions of Regulation SHO, including the marking requirements in Rule 201 and the locate and deliver requirements in Rule 203, would apply. We request comment on whether the proposed exception for VWAP executions, subject to these conditions, is appropriate.

nts in Rule 203, would apply. We request comment on whether the proposed exception for VWAP executions, subject to these conditions, is appropriate.

92 We believe that these conditions have worked well in restricting the exemptive relief to situations that do not appear to raise the abuses that the short sale price test is designed to prevent, and should be incorporated in the proposed exception. We also note that market participants that have been granted these exceptions have designed their programming and surveillance systems in accordance with these conditions.

93 At this time, securities that qualify as “actively traded securities” under Rule 101 of Regulation M and securities that comprise the S&P 500 index would qualify as “actively traded securities” for purposes of this exception.

94 17 CFR 242.100(b).

Q. Do VWAP transactions create perverse incentives for broker-dealers, such that they should not be granted an exception? If an exception is included, are there ways to detect and limit the effects of these perverse incentives?

Q. Are the proposed conditions for the VWAP exception appropriate? If not, why not? Should there be any additional conditions?

V. Pilot Program

As a part of the Commission's review of short sale regulation, we are also proposing temporary Rule 202 of Regulation SHO that would suspend, on a pilot basis, the operation of the proposed bid test of proposed Rule 201 for specified liquid securities. We believe that the pilot is appropriate for several reasons. The pilot would enable us to study the effects of relatively unrestricted short selling on, among other things, market volatility, price efficiency, and liquidity. This would thus allow us to obtain empirical data to assess whether short sale regulation should be removed, in part or in whole, for actively traded securities

d securities. We believe that the pilot is appropriate for several reasons. The pilot would enable us to study the effects of relatively unrestricted short selling on, among other things, market volatility, price efficiency, and liquidity. This would thus allow us to obtain empirical data to assess whether short sale regulation should be removed, in part or in whole, for actively traded securities. The pilot would also allow the Commission to determine the extent to which the proposed bid test achieves the three objectives of short sale regulation through the comparison of trading activity of similar stocks subject to the test and those not subject to the test.

In 1976 the Commission proposed a suspension of the tick test as a part of a comprehensive review of short sale regulation that was designed to obtain statistical data regarding short selling. 95 The pilot was never implemented due to concerns expressed by trading markets and listed companies. 96 However, there have been significant developments in market surveillance since 1976 that now make a pilot more appropriate. Further, the Commission and SROs now have access to a wide range of trading data on potentially manipulative trading behavior. 97 Access to this information greatly enhances the ability of the Commission and the SROs to monitor trading behavior during the proposed suspension of the bid test and surveil for manipulative short selling.

ances the ability of the Commission and the SROs to monitor trading behavior during the proposed suspension of the bid test and surveil for manipulative short selling.

95 See Securities Exchange Act Release No. 13091 (December 21, 1976), 41 FR 56530. We proposed three alternative temporary rules that would have suspended the tick test to varying degrees in order for critical data to be collected. The three alternative temporary rules would have: (1) Suspended the operation of the short sale rule for all securities registered, or admitted to unlisted trading privileges on a national securities exchange; (2) suspended the operation of the tick test only for equity securities (other than warrants, rights, or options) that are registered, or admitted to unlisted trading privileges, on more than one national securities exchange and for which transactions were reported in the consolidated system; and (3) suspended the operation of the tick test only for the fifty most active equity securities (other than warrants, rights, or options) during the 12 calendar months preceding the effective date of the rule. However, the Commission withdrew this and other short sale rule proposals largely because commenters did not support the changes. Securities Exchange Act Release No. 17347 (December 1, 1980), 45 FR 80834 (December 8, 1980).

96 One commenter expressed concern that removal of the tick test might accelerate market declines and increase volatility as well as create distortions in the market for secondary or tertiary stocks. See Letter from James E. Buck, Secretary, NYSE, to George A. Fitzsimmons, Secretary, SEC (March 17, 1977). Another commenter stated that the tick test should be retained to prevent manipulative short selling even though some arguments could be made that short selling helps adjust markets to their proper levels more quickly

well as create distortions in the market for secondary or tertiary stocks. See Letter from James E. Buck, Secretary, NYSE, to George A. Fitzsimmons, Secretary, SEC (March 17, 1977). Another commenter stated that the tick test should be retained to prevent manipulative short selling even though some arguments could be made that short selling helps adjust markets to their proper levels more quickly. The commenter stated that it was beneficial to retain Rule 10a-1 until such time a rule could be devised that distinguished between manipulative and non-manipulative short sales. See Letter from Frank A. Hutson, Jr., Chairman, Securities Law Committee, American Society of Corporate Secretaries, Inc., to George A. Fitzsimmons, Secretary, SEC (May 3, 1977).

97 For example, the NYSE has since implemented both on-line and off-line automated surveillance capability, and monitors trading on both a real-time and next day basis. Further, the NYSE also utilizes an audit trail through its Intermarket Surveillance Information System (ISIS) data base. Securities Exchange Act Release No. 22183 (June 28, 1985) 50 FR 27875 (July 8, 1985). Further, NYSE adopted a rule requiring all transactions in NYSE-listed stocks that are not reported to the Consolidated Tape to be reported to the Exchange in order to provide an accurate record of overall trading activity. In its filing with the Commission, NYSE stated that the information obtained pursuant to the rule will “augment and enhance its ability to surveil for and investigate, among other matters, insider trading, frontrunning, and manipulative activities, * * *” Securities Exchange Act Release No. 31358 (October 26, 1992) 57 FR 49736 (November 3, 1992) (order approving NYSE Rule 410B).

We also believe that a pilot may be appropriate in light of the Commodity Futures Modernization Act of 2000 (CFMA) lifting the ban on security futures

y to surveil for and investigate, among other matters, insider trading, frontrunning, and manipulative activities, * * *” Securities Exchange Act Release No. 31358 (October 26, 1992) 57 FR 49736 (November 3, 1992) (order approving NYSE Rule 410B).

We also believe that a pilot may be appropriate in light of the Commodity Futures Modernization Act of 2000 (CFMA) lifting the ban on security futures. 98 Among other things, investors are now allowed to enter into futures contracts for the sale of individual securities at a fixed point in the future and at a set price. In authorizing single stock futures trading, Congress exempted transactions in security futures products from short sale regulation. Short security futures, i.e. , obligating a person to make a future delivery of the underlying securities, may function as a substitute for short selling the underlying stock. 99 We believe that to the extent possible, consistent with investor protection, one market should not benefit over another because of regulatory differences. Thus, we intend to include liquid securities subject to futures trading in our proposed pilot.

98 Pub. L. 106-554, 114 Stat. 2763 (2000). Futures involving single stocks are generally defined as futures contracts (or options thereon) on single non-exempt securities and narrow based groups or indices of non-exempt securities.

99 We note that the CFMA exception was a departure from traditional short sale regulation, which is security-based rather than market-based ( i.e. , the tick test applies to a security irrespective of the market in which the short sale occurs.)

As a result, we believe it is appropriate to propose a rule that would establish procedures for a temporary suspension of the trading restrictions of the price test of the Commission's short sale rule, and any short sale price test of any exchange or national securities association, for a limited number of securities

,000 largest companies in the Russell 3000 Index (approximately 92% of the total market capitalization of the Russell 3000 Index). Inclusion in the Russell 1000 index is based completely on objective criteria, i.e. , market capitalization. A pilot containing stocks from the Russell 1000 index would allow us to analyze the effects of removing price restrictions on a broad range of liquid securities. A narrower index of liquid securities might not provide the breadth of information necessary to make an accurate determination of these effects. Conversely, broader indexes may contain certain securities that could be considered less liquid, which may not be appropriate for a pilot that focuses on short selling in liquid securities.

101 In addition, both samples should also contain Nasdaq and NYSE stocks, optionable stocks, stocks with associated security futures, and both value and growth stocks. We hope that both samples would have similar average short interest and similar expected volatility. Even if the two samples differ slightly along these dimensions, researchers can control for the variations using regression techniques.

While we recognize that the price of any security can be manipulated, we believe that as trading volume increases, it becomes less likely that a trader would be able to cost-effectively 102 Further, the high levels of transparency and surveillance for actively-traded securities on exchanges and other regulated markets make it more likely that any manipulation would be detected and pursued. 103

102 See Securities Exchange Act Release No. 37094 (April 11, 1996), 61 FR 17108 (April 18, 1996) (proposing anti-manipulation rules including an exception to the rules for trading activity in high ADTV securities).

103 Id.

The proposed temporary Rule 202 would remain in effect for two years

d other regulated markets make it more likely that any manipulation would be detected and pursued. 103

103 Id.

The proposed temporary Rule 202 would remain in effect for two years. We anticipate that a partial, two-year suspension of the short sale rule would allow the Commission to gather and analyze the data necessary to reach conclusions regarding trading behavior in the absence of short sale price restrictions. The sample period should provide data on advancing and declining markets, high volume and low volume, and different stages of volatility so that the suspension can be studied fully. 104

104 The Commission would study data from the pilot to determine the effect that the removal of the proposed bid test has on trading in the pilot securities. By the end of the two year period, we would consider extending the pilot in light of trading data and whether to pursue rulemaking to permanently remove the proposed bid test for a segment of securities.

The Commission notes that the general anti-fraud and anti-manipulation provisions of the federal securities laws would continue to apply to trading activity in these securities, thus prohibiting trading activity designed to improperly influence the price of a security. 105 Further, the pilot would only suspend the operation of the proposed bid test. All other provisions of proposed Regulation SHO, including the marking requirements of Rule 201 and the locate and deliver requirements of Rule 203, would continue in effect. Finally, the Commission could terminate the operation of the pilot, in whole or in part, prior to the end of the proposed two-year period as it determines necessary or appropriate in the public interest or to protect investors by removing all securities selected for inclusion in the pilot.

105 See, e.g

nts of Rule 201 and the locate and deliver requirements of Rule 203, would continue in effect. Finally, the Commission could terminate the operation of the pilot, in whole or in part, prior to the end of the proposed two-year period as it determines necessary or appropriate in the public interest or to protect investors by removing all securities selected for inclusion in the pilot.

105 See, e.g. , Securities Act Section 17(a), Exchange Act Sections 9(a), 10(b), and 15(c) and Rules 10b-5 and 15c1-2 thereunder.

Q. Is the proposed rule temporarily suspending the short sale price test for liquid stocks appropriate? Are liquid stocks more difficult to manipulate through short selling?

Q. Is a two-year temporary suspension of the short sale price test a sufficient period to fully study the impact? If not, what time period should be selected? Commenters should provide specific reasons to support their view in favor of establishing another time period.

Q. Is the proposed selection method for the pilot, including our contemplated use of the Russell 1000, appropriate? If not, what other selection method should be considered? Is it possible that one market could benefit over another market depending on the selection of stocks for the pilot?

Q. Should the short sale price test be automatically reinstituted in extraordinary market conditions, for instance, if, on an intraday basis, the price of a security falls more than a certain percentage based on the day's opening price ( e.g. , if the price of a security falls 10% from the day's opening price short sale restrictions would be reinstituted)?

restrictions would be reinstituted)?

Q. The pilot, in part, would allow the Commission to obtain data to assess whether the price test should be removed for some types of securities and to study trading behavior in the absence of the proposed bid test. After analyzing the results of the pilot, the Commission may propose that the bid test be removed for certain exchange-listed and NMS securities. Should the Commission await the results of the pilot before applying the uniform bid test to exchange-listed and Nasdaq NMS securities that may later have the bid test removed?

Q. Should the pilot apply to existing short sale rules even if we do not adopt the new uniform bid test?

Q. The securities included in the pilot would still be marked and specialists and market makers can observe this mark prior to executing the short sale. How would this affect the outcome and reliability of the pilot, if at all?

VI. Rule 10a-1 Exceptions

Paragraph (e) of Rule 10a-1 currently contains 13 exceptions to the tick test designed to permit certain types of trading activities that were intended to benefit the markets or that were believed to carry little risk of the kind of manipulative or destabilizing trading that the Rule was designed to address. We have reviewed these exceptions in light of proposed Rule 201, and we propose modifying some exceptions for inclusion in Rule 201 and excluding other exceptions from the Rule.

A. Exceptions Proposed To Be Retained

1. Long Seller's Delay in Delivery

A. Exceptions Proposed To Be Retained

1. Long Seller's Delay in Delivery

Subsection (e)(1) of Rule 10a-1 has existed since the inception of the short sale rule in 1938. This exception allows short sales to be effected without regard to the current tick test if the seller owns the security sold and intends to deliver such security as soon as is possible without undue inconvenience or expense. It was created so that sellers who actually own a security will not be penalized in the event they are unable to deliver the security to their broker prior to settlement, despite every intention of doing so, or in the event the certificate turned in by the seller is not in a form appropriate for transferring.

In the event that the seller's shares are not delivered to the broker-dealer prior to settlement, borrowed shares may be used to consummate the sale. By definition, when borrowed shares are delivered, the sale is a short sale. We believe that this exception continues to be necessary to facilitate those limited circumstances where the seller owned the securities at the time of sale, however delivery may be briefly delayed, as when an option, right or warrant has been exercised but the underlying security has not yet been received by the seller. We propose to retain this exception from the proposed bid test substantially unchanged. 106

106 See subparagraph (d)(1) of proposed Rule 201 of Regulation SHO.

Q. Should this exception be retained in its current form?

Q. Is this exception outdated?

2. Error in Marking a Short Sale

Subsection (e)(2) of Rule 10a-1 has also existed since the inception of the Rule. This exception protects brokers in the event they execute a sale already marked long by another broker-dealer, but the sale turns out to be a short sale. The broker-dealer that marks the order long must abide by the provisions of the marking requirement that dictates when an order may be marked long and the executing broker-dealer may rely on this marking when executing the sell order

of the Rule. This exception protects brokers in the event they execute a sale already marked long by another broker-dealer, but the sale turns out to be a short sale. The broker-dealer that marks the order long must abide by the provisions of the marking requirement that dictates when an order may be marked long and the executing broker-dealer may rely on this marking when executing the sell order. This exemption was created to avoid implicating a broker that has unknowingly participated in a violation of the Rule, and we believe the basis for including the exception still makes sense in the current environment. 107 We propose to retain this exception substantially unchanged. 108

107 This exception does not apply where a broker-dealer knows or has reason to know that an order is incorrectly marked long. Knowledge may be inferred where a broker-dealer repeatedly accepts orders marked long from the same counterparty but requires borrowed shares for delivery or results in a “fail to deliver” on several occasions.

108 See subparagraph (d)(2) of proposed Rule 201 of Regulation SHO.

Q. Should this exception be retained in its current form?

3. Odd Lot Transactions

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. 109 However, the Commission became 110

109 The Commission initially adopted three exceptions for odd-lot transactions. While the first

110 See Securities Exchange Act Release No. 11030 (September 27, 1974), 39 FR 35570.

Subparagraph (e)(3) is limited to odd-lot dealers registered in the security and third-market makers

ly, sales of odd-lots were not subject to the restrictions of Rule 10a-1. 109 However, the Commission became 110

109 The Commission initially adopted three exceptions for odd-lot transactions. While the first

110 See Securities Exchange Act Release No. 11030 (September 27, 1974), 39 FR 35570.

Subparagraph (e)(3) is limited to odd-lot dealers registered in the security and third-market makers. The exception allows short sales by odd-lot dealers registered in the security and by third market-makers (of covered securities) to fill customer odd-lot orders. Subparagraph (e)(4) provides relief for any sale to liquidate an odd-lot position by a single round lot sell order that changes such broker-dealer's position by no more than a unit of trading. We understand the odd lot exception to still be of utility and not in conflict with the goals of the proposed bid test. We propose combining the two exceptions into one odd-lot exception under subparagraph (d)(3) of Rule 201 of proposed Regulation SHO.

In addition, we propose extending these exceptions to all market makers acting in the capacity of an odd-lot dealer. When the Rule was adopted, odd-lot dealers dealt exclusively with odd-lot transactions, and were so registered. Today, specialists assigned to a security are typically the odd-lot dealer in that security. We propose to broaden the use of this exception to all brokers or dealers acting as “market makers” in odd-lots. 111

111 The definition of a “market maker” is found in Section 3(a)(38) of the Exchange Act, and includes specialists. 15 U.S.C. 78c(a)(38).

Odd-lot transactions by market makers to facilitate customer trades are generally not of a size that could facilitate a downward movement in the market

e to broaden the use of this exception to all brokers or dealers acting as “market makers” in odd-lots. 111

111 The definition of a “market maker” is found in Section 3(a)(38) of the Exchange Act, and includes specialists. 15 U.S.C. 78c(a)(38).

Odd-lot transactions by market makers to facilitate customer trades are generally not of a size that could facilitate a downward movement in the market. Therefore, those acting in the capacity of a “market maker” should be able to off-set customer odd-lot orders and liquidate an odd-lot position by a single round lot sell order that changes such broker-dealer's position by no more than a unit of trading without regard to the restrictions of the current tick test or proposed bid test.

Q. Are these exceptions relating to odd-lots appropriate in today's markets?

Q. Should these exceptions apply to all market makers in odd-lots or should the exception be more limited?

Q. Are these odd-lot exceptions susceptible to abuse?

Q. Should all odd-lot transactions have an exception from the Rule? Would providing an exception for all odd-lot transactions pose a risk of increased short sale manipulation, e.g. , would traders break up trades into 99 share odd-lots in order to avoid the price test?

4. Domestic Arbitrage

Current subsection (e)(7) of Rule 10a-1 was adopted in 1938 to allow short selling associated with certain bona fide domestic arbitrage transactions. 112 In adopting this exception, we stated that it “applies only to bona fide arbitrage transactions in a security effected, under certain circumstances described in the exception, by persons who own rights or privileges entitling them to acquire that security.” 113 The exception has remained unchanged since its adoption.

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

113 Id

ons. 112 In adopting this exception, we stated that it “applies only to bona fide arbitrage transactions in a security effected, under certain circumstances described in the exception, by persons who own rights or privileges entitling them to acquire that security.” 113 The exception has remained unchanged since its adoption.

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

113 Id.

The term “bona fide arbitrage” generally 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. 114 The Commission continues to believe that bona fide arbitrage activities are beneficial to the markets because they tend to reduce pricing disparities between securities. 115 These activities also carry limited risk of the kind of manipulative or destabilizing trading that Rule 10a-1 was designed to address.

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

115 Id.

We therefore propose that proposed Rule 201 of Regulation SHO would retain the general exception contained in (e)(7). Subparagraph (d)(5) of Rule 201 would continue to except short sales effected in 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. In addition, we have proposed adding language to the exception to require a person relying on the exception to subsequently acquire or purchase the security upon which the arbitrage is based

uire 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. In addition, we have proposed adding language to the exception to require a person relying on the exception to subsequently acquire or purchase the security upon which the arbitrage is based. 116 For example, if a person sells 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, he must subsequently tender the instrument for conversion to obtain the underlying securities and complete the arbitrage in order to satisfy the terms of the exception. We have also proposed minor amendments to the language of the exception to make it more understandable.

116 As discussed, the Commission has interpreted the term “bona fide arbitrage” to involve the contemporaneous purchase and sale of securities effected to “lock in” a gross profit or spread from a current differential in pricing. Id. We believe requiring a person relying on the exception to subsequently acquire or purchase the security upon which the arbitrage is based is consistent with this interpretation.

Q. Should the exception be retained for purposes of the proposed Rule 201? If not, state specific reasons why the exception should be removed from the Rule.

Q. Minor changes have been made to the text of existing exception (e)(7) in the proposed rule to simplify its language. Are these changes helpful? Does the proposed amendment to the exception alter its meaning in a way that would affect its substance?

Q. Is the proposed amended exception too narrow or too broad? If so, state specifically why, and how it should be restructured in relation to the purposes of Regulation SHO.

to the text of existing exception (e)(7) in the proposed rule to simplify its language. Are these changes helpful? Does the proposed amendment to the exception alter its meaning in a way that would affect its substance?

Q. Is the proposed amended exception too narrow or too broad? If so, state specifically why, and how it should be restructured in relation to the purposes of Regulation SHO.

Q. Should the requirement that the transactions be made in a separate domestic arbitrage account be eliminated? If so, should the exception permit domestic arbitrage to be effected in an arbitrage account in which international arbitrage could also be effected?

Q. Should exception (e)(7) be combined with (e)(8), the international arbitrage exception? Would such a combination create compliance problems or other issues?

Recently, Commission staff has received inquiries regarding the operation of (e)(7) in the context of a corporate merger. In particular, market participants have sought advice whether upon finalization of a merger agreement, wherein a date certain is determined for the merger, a party who is entitled to receive stock of the acquiring company under the terms of the merger agreement is entitled to sell short this stock without regard to the tick test pursuant to the domestic arbitrage exception. Unlike the arbitrage contemplated in (e)(7), the right to acquire another security in a merger scenario arises only by the terms of the merger agreement and not through a right vested in the security itself. We believe that this type of arbitrage is not within the scope of paragraph (e)(7), and therefore we are not proposing to include it.

Q. Should short sales effected in connection with a merger be excepted from the provisions of Rule 201? If so, at what point in the merger process should a party be deemed entitled to acquire the acquiring company's stock?

5. International Arbitrage

The international arbitrage exception in Rule 10a-1 (e)(8) has also remained unchanged since its adoption in 1939

e not proposing to include it.

5. International Arbitrage

The international arbitrage exception in Rule 10a-1 (e)(8) has also remained unchanged since its adoption in 1939. 117 The international arbitrage exception was added following an extended study of international arbitrage operations in their relation to short selling. 118 The Commission concluded that the exception 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.” 119

117 Securities Exchange Act Release No. 2039 (March 10, 1939).

118 Id .

119 Id. We believe that the provision necessitating 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 in order to qualify for this exception.

The Commission proposes to retain the international arbitrage exception because we understand that the exception is still being used and does not conflict with the goals of the proposed bid test. As with the domestic arbitrage exception, we have proposed amendments to the language in the exception in order to make it more understandable. In addition, we have incorporated language from current exception (e)(12) of Rule 10a-1 that provides that, for the operation of the international arbitrage exception, a depositary receipt for a security shall be deemed to be the same as the 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 subparagraph (e)(12)

nt exception (e)(12) of Rule 10a-1 that provides that, for the operation of the international arbitrage exception, a depositary receipt for a security shall be deemed to be the same as the 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 subparagraph (e)(12). We believe this provision should be moved from its current location to the international arbitrage exception because it directly pertains to the operation of that exception.

Q. Should the international arbitrage exception be retained for purposes of the proposed Rule 201? If not, state specific reasons why the exception should be removed from the Rule.

Q. Minor changes have been made to the proposed rule to simplify the language of the existing exception. Are these changes helpful? Do they alter the meaning of the exception in a way that diminishes its value or prohibits bona fide international arbitrage activity in relation to Rule 201?

Q. Is the proposed amended exception too narrow? If so, state specifically why it is too narrow and how it should be restructured to allow beneficial international arbitrage activity that does not carry the kind of manipulative or destabilizing trading that proposed Rule 201 is designed to address.

Q. Should the requirement that the transactions be made in a separate international arbitrage account be eliminated? If so, should the exception permit international arbitrage to be effected in an arbitrage account in which domestic arbitrage could also be effected, rather than in a separate international arbitrage account?

Q. Should exception (e)(8) be combined with (e)(7), the domestic arbitrage exception? Would such a combination create compliance problems or other issues?

bitrage account be eliminated? If so, should the exception permit international arbitrage to be effected in an arbitrage account in which domestic arbitrage could also be effected, rather than in a separate international arbitrage account?

Q. Should exception (e)(8) be combined with (e)(7), the domestic arbitrage exception? Would such a combination create compliance problems or other issues?

6. Distribution Over-Allotment

Subsection (e)(10) generally excepts from Rule 10a-1 sales of securities by underwriters or syndicate members participating in a distribution in connection with an over-allotment, and any lay-off sales by such a person in connection with a distribution of securities through rights or a standby underwriting commitment. 120 Proposed Rule 201 would retain the over-allotment exception in substance, although minor changes have been made to simplify its language. 121 Under the proposed bid test, the exception would permit short sales in connection with an over-allotment at or below the bid, thus enabling an underwriter to price an offering at or below the last bid. We propose including this exception in Rule 201 of Regulation SHO because these sales are all at the offering price and, therefore, do not implicate one of the goals of short sale regulation, i.e. , preventing short sellers from accelerating a declining market by exhausting all remaining bids at one price level.

120 See Securities Exchange Act Release No. 11030 (September 27, 1974), 39 FR 35570 (October 2, 1974). Although the exception was not adopted until 1974, the Commission's approval of the concept of excepting over-allotments from the short sale rule is long-standing. 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.

121 See subparagraph (d)(7) of proposed Rule 201 of Regulation SHO.

approval of the concept of excepting over-allotments from the short sale rule is long-standing. 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.

121 See subparagraph (d)(7) of proposed Rule 201 of Regulation SHO.

Q. Is this exception necessary? Under what circumstances would an underwriter or syndicate member price an offering below the best bid? Would extending the exception to short sales below the bid have any negative market impact?

7. Equalizing Short Sales and Trade-Throughs

Exceptions (e)(5)(ii) and (e)(11) were adopted in order to eliminate a potential conflict between Rule 10a-1 and Rule 11Ac1-1 under the Exchange Act (Quote Rule). 122 The (e)(5) equalizing exception, as discussed in further detail below, permits market makers to effect short sales on a zero-minus tick ( i.e. , at the same price as the last trade price), but does not permit short sales, either as a dealer or agent, at a price lower than the last trade price reported in the consolidated system ( i.e. , on a minus tick). As a result, there arose a potential conflict between the operation of Rule 10a-1 and the “firmness requirement” 123 of the Quote Rule in situations where execution of an offer quotation by a broker or dealer would be rendered unlawful because of a trade-through 124 even though the offer had been at a price permitted under Rule 10a-1 at the time that broker or dealer had communicated it to its exchange or association for inclusion in the consolidated quotation system. 125

122 See Securities Exchange Act Release No. 17314 (November 20, 1980), 45 FR 231 (November 28, 1980).

123 17 CFR 240.11Ac1-1(c)(1)

uld be rendered unlawful because of a trade-through 124 even though the offer had been at a price permitted under Rule 10a-1 at the time that broker or dealer had communicated it to its exchange or association for inclusion in the consolidated quotation system. 125

122 See Securities Exchange Act Release No. 17314 (November 20, 1980), 45 FR 231 (November 28, 1980).

123 17 CFR 240.11Ac1-1(c)(1). The Quote Rule requires that, subject to certain exceptions, the broker or 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 comprising the responsible broker or dealer's published bid or offer in any amount up to his published quotation size.

124 A trade-through generally occurs when an Intermarket Trading System (ITS) participant purchases an ITS security at a price that is higher than the displayed price at which the security is being offered at another ITS participating market, or sells an ITS security at a price that is lower than the displayed price at which the security is being bid at another ITS participant.

125 The following example from the release adopting the exception illustrates the potential conflict: A market maker who currently has a short position in XYZ stock communicates an offer which, if executed against at that time, would be in compliance with Rule 10a-1, e.g. , at a price of 20 1/8 when the last trade price reported in the consolidated system is also 20 1/8 . There is a “trade through” of the market maker's offer on another market center that causes an up-tick to be reported in the consolidated system at 20 1/4 . Finally, a buy order is sent to the market maker after the trade through at 20 1/4 has been reported

d be in compliance with Rule 10a-1, e.g. , at a price of 20 1/8 when the last trade price reported in the consolidated system is also 20 1/8 . There is a “trade through” of the market maker's offer on another market center that causes an up-tick to be reported in the consolidated system at 20 1/4 . Finally, a buy order is sent to the market maker after the trade through at 20 1/4 has been reported. In order to ensure compliance with 10a-1, the market maker must refuse to execute the order at his offer of 20 1/8 because doing so would result in a short sale being effected on an impermissible minus tick, however, in refusing to effect the trade, he would arguably violate the “firmness requirement” of the Quote Rule. In addition, when a market maker “backs away” from an order, he may, in effect be revealing that he had a short position in the security, thus making it more difficult to liquidate that position at favorable prices. See, supra n. 122.

In order to resolve this potential conflict, the Commission adopted (e)(5)(ii) to permit market makers to execute transactions at their offer following a trade-through, and (e)(11) to permit non-market makers to effect a short sale at a price equal to the price associated with their most recently communicated offer up to the size of that offer 126 so long as the offer was at e.g. , public agency orders or proprietary orders of non-market makers) that also might be ineligible for execution under Rule 10a-1 following a trade-through in another market. 127

126 The Commission explained in the release that the scope of the exception in Rule 10a-1(e)(11) was limited to the size of the broker or dealer's displayed offer because the need for the exception only arises to the extent that the broker or dealer's See, supra n. 122 at n.20

et makers) that also might be ineligible for execution under Rule 10a-1 following a trade-through in another market. 127

127 This concern was illustrated with the following example: A specialist who is short XYZ stock quotes an offer for 1,000 shares at 20 1/8 at a time when the last sale reported in the consolidated system was such that the offer, if executed at that time, would be in compliance with Rule 10a-1. This offer for 1,000 shares consists of 300 shares offered by the specialist, a 400-share limit order in the specialist's book, and an offer from the crowd at the specialist's post for 300 shares, all at 20 1/8 . A trade through of this offer occurs on another exchange and an up-tick is reported in the consolidated system at 20 1/4 . A buy order for 1,000 shares at 20 1/8 is then sent to the exchange—after the trade through at 20 1/4 is reported. Without (e)(11), filling the complete order for 1,000 shares would not be permissible, since (e)(5)(ii), by its terms, applies only to a sale by a market maker for its own account. Id at n.18.

We believe that the rationale for adopting exceptions (e)(5)(ii) and (e)(11), namely resolving a conflict between the short sale rule and the quote rule arising from a trade-through, would not exist under the proposed bid test. Under the proposed rule, the reference point for a market participant seeking to execute a short sale would not be the last trade price, which could be a down tick created by a trade through, but rather the current consolidated best bid.

It appears that under the proposed bid test, a comparable situation as that envisioned under (e)(5)(ii) and (e)(11) would result in a locked or crossed market

. Under the proposed rule, the reference point for a market participant seeking to execute a short sale would not be the last trade price, which could be a down tick created by a trade through, but rather the current consolidated best bid.

It appears that under the proposed bid test, a comparable situation as that envisioned under (e)(5)(ii) and (e)(11) would result in a locked or crossed market. 128 Locking or crossing a quote temporarily frustrates trading in a particular security, and there are various rules and regulations that guard against such practices. 129 We have stated in prior releases that continued locking and crossing of the market can negatively impact market quality, and have approved SRO rules aimed at reducing the frequency of locked and crossed markets and providing more informative quotation information, facilitating price discovery, and contributing to the maintenance of a fair and orderly market. 130

128 In a locked market, the best bid price equals the best ask price; in a crossed market, the best bid price exceeds the best ask price. For example, assume that the current consolidated best bid for a security is 10.00. A market participant who has a short position in a security posts an offer to sell at 10.05. The market participant would be able to execute its short sale so long as it was above the consolidated best bid. Any bid that was posted at 10.05 would lock the market, and any bid posted above 10.05 would cross the market.

.05 would lock the market, and any bid posted above 10.05 would cross the market.

129 See, e.g. NASD Rule 4613(e). NASD Rule 4613(e)(2) states that “A market maker shall, prior to entering a quotation that locks or crosses another quotation, make reasonable efforts to avoid such locked and crossed market by executing transactions with all market makers whose quotations would be locked or crossed. Pursuant to the provisions of paragraph (b) of this Rule 4613, a market maker whose quotations are causing a locked or crossed market is required to execute transactions at its quotations as displayed through Nasdaq at the time of receipt of any order.”

130 See Securities Exchange Act Release No. 43863 (January 19, 2001), 66 FR 8020, 8046 (January 26, 2001); Securities Exchange Act Release No. 46410 (August 23, 2002), 67 FR 55897 (August 30, 2002) (File No. SR-NASD-2002-56). See also Securities Exchange Act Release No. 47735 (April 24, 2003), 68 FR 23787 (May 5, 2003) (File No. NASD-2003-38).

However, we recognize that locked and crossed markets have not been eliminated entirely, and thus the same conflict between the firm quote rule and the short sale rule could arise under the proposed bid test. We believe that this situation would exist where a market participant posts an offer to sell short at a valid price, i.e. , above the best bid, but the bid subsequently moves up and either locks or crosses the market participant's posted offer. A market participant in this situation could still be required to execute buy orders directed to its posted offer, which would be at or below the best bid

We believe that this situation would exist where a market participant posts an offer to sell short at a valid price, i.e. , above the best bid, but the bid subsequently moves up and either locks or crosses the market participant's posted offer. A market participant in this situation could still be required to execute buy orders directed to its posted offer, which would be at or below the best bid. 131 The Commission thus proposes to include an exception to Rule 201 of Regulation SHO permitting a responsible broker-dealer, as defined in Rule 11Ac1-1 under the Exchange Act 132 to effect a short sale at a price equal to its posted offer when the market is locked or crossed, when consistent with best execution obligations, provided however, that the exception would not apply to any broker-dealer who initiated the locked or crossed market.

131 See 17 CFR 240.11Ac1-1; see also supra n. 129. Paragraph (b) of Rule 4613 is the NASD Firm Quote Rule.

132 Rule 11Ac1-1(a)(21) defines the term responsible broker or dealer to mean: (i) When used with respect to bids or offers communicated on an exchange, any member of such exchange who communicates to another member on such exchange, at the location (or locations) designated by such exchange for trading in a covered security, a bid or offer for such covered security, as either principal or agent; provided, however, That, in the event two or more members of an exchange have communicated on such exchange bids or offers for a covered security at the same price, each such member shall be considered a “responsible broker or dealer” for that bid or offer, subject to the rules of priority and precedence then in effect on that exchange; and further provided, That for a bid or offer which is transmitted from one member of an exchange to another member who undertakes to represent such bid or offer on such exchange as agent, only the last such member who undertakes to represent such bid or offer as agent shall be considered the “responsible broker or dealer” with respect to that bid

y and precedence then in effect on that exchange; and further provided, That for a bid or offer which is transmitted from one member of an exchange to another member who undertakes to represent such bid or offer on such exchange as agent, only the last such member who undertakes to represent such bid or offer as agent shall be considered the “responsible broker or dealer” with respect to that bid or offer; and (2) when used with respect to bids and offers communicated by a member of an association to another broker or dealer or to a customer otherwise than on an exchange, the member communicating the bid or offer (regardless of whether such bid or offer is for its own account or on behalf of another person).

Q. Would an exception from the proposed bid test permitting a short sale to be effected at the consolida

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