The comment period for rules recently proposed by the Securities and Exchange Commission (the “SEC”) to restrict short selling (the “Proposed Rules”) expired on June 19, 2009.1 The SEC received over 4,000 unique comments, the overwhelming majority from small investors encouraging the SEC to reinstate some form of uptick rule.2 On August 17, 2009, the SEC announced that it was reopening the comment period to solicit feedback regarding an alternative uptick test to the tests contained in the Proposed Rules. The comment period will be open for 30 days after publication of the release in the Federal Register, which is expected to occur in the coming days.

Background

The Proposed Rules contemplated five alternate approaches to restrict short selling. The different approaches can be grouped into two categories: those that apply on a permanent basis to all stocks and those that apply only to a particular stock during a period of severe market decline (a “circuit breaker”). Within these categories the SEC considered two alternative short sale price tests: one based on the current national best bid and one based on the last sales price (e.g., the same test used under the former uptick rule until its elimination in July 2007). The SEC also considered an outright prohibition on short selling after a circuit breaker was triggered. For ease of reference, attached as Appendix A is a diagram outlining the five alternate approaches under the Proposed Rules.

Alternative Uptick Test

The SEC is now soliciting comments on whether it should permit short sales only at a price that is above the current national best bid (the “alternative uptick test”) rather than at the current national best bid (the “modified uptick test”) contemplated under two of the five alternatives in the Proposed Rules. Permitting short sales to be executed only above the current national best bid would be more restrictive than permitting them to be executed at the current national best bid. While this might restrict some legitimate short selling activities, key industry participants, including the Securities Industry and Financial Markets Association, the NYSE and a number of investment banks, have indicated that the alternative uptick test would be simpler and/or less costly to implement than other approaches. Among other things, this is because the alternative uptick test only requires monitoring whether a short sale is executed above the current national best bid (e.g., one parameter). Conversely, the modified uptick test would require monitoring whether the current national best bid was above or below the previous national best bid (e.g., two parameters).3

The SEC notes that, if adopted, the alternative uptick test could be implemented in the same manner as the other alternatives under the Proposed Rules, namely:

  • on the basis of requiring trading center to implement policies and procedures to prevent the display or execution of short sales at impermissible prices OR on the basis of an outright prohibition on a person effecting a short sale at an impermissible price; and
  • in connection with a “circuit breaker” approach (e.g., following a set percentage decline in the price of an individual equity security) OR on a permanent basis (e.g., to all stocks).

In addition, the SEC notes that the alternative uptick test would be subject to the same exceptions contained in the Proposed Rules for the modified uptick test.

Commentary

It is worth noting that comment letters received from key industry participants indicate a broad consensus against reinstatement of the former uptick rule. The former uptick rule was based on the last sale price, which is no longer appropriate for today’s markets, not least because it would impose significant costs to develop an appropriate tracking infrastructure. There appears to be general support for an uptick rule that is triggered based on a circuit breaker test; however, many commentators suggest that a percentage decline of ten percent may be too small and, in some cases, suggest a higher percentage for lower priced stocks, which tend to exhibit higher price volatility. It should be noted that a number of commentators expressed concern that the circuit breaker approach could attract significant short selling just above the triggering percentage and that it could result in affected stocks being unduly stigmatized.

In the course of soliciting comments, the SEC has asked specifically whether a two-month implementation period would be sufficient following the effective date of any new rules that it adopts. The SEC’s extension of the comment period in order to highlight a specific proposal indicates that the SEC remains focused on addressing short sales and is likely to issue final rules before the end of the year.

Diagram of the Proposed Short Sale Restrictions