• Short sales of equity securities must be settled on T+3
  • Failures to deliver must be satisfied by covering or borrowing, and the broker-dealer may not effect short sales in such equity security for any customer until covered or borrowed


    • delivery failures due to a long sale have three trading days after T+3 to cover; and
    • delivery failures relating to equity securities sold pursuant to Rule 144 that continue for 35 consecutive settlement days, must be covered on 36th settlement day
  • Naked short selling now subject to antifraud rules potentially carrying criminal penalties

In response to the ongoing market turmoil and in an effort to stave off a “crisis in confidence” in the financial markets, the Securities and Exchange Commission (SEC) on Wednesday, September 17, exercised its emergency powers today, September 18, by adopting effective new rules aimed at restricting what the SEC characterized as “abusive” forms of short selling. While the SEC invoked similar powers this summer to temporarily ban “naked” short selling on the shares of a limited number of financial institutions (including issuers such as Fannie Mae, Freddie Mac, Merrill Lynch and Lehman Brothers), the new rules have been expanded to apply to equity securities of all publicly traded issuers.

In ordinary short sales, an investor borrows a stock from a third party, and then sells the borrowed stock in the market, betting that the price will go down. To close the short position, the investor must buy back the stock in the open market to return it to the lender. In abusive “naked” short transactions, the investor does not actually borrow the stock, and instead misrepresents to its broker or dealer that it has either done so or that it owns the position long. The naked short seller then fails to deliver the stock sold by the broker-dealer to the buyer. The potential effect of this naked short sale is to allow more sales in the security than there are securities in the market, thereby potentially artificially accelerating a downward price spiral in that security. The SEC stated that “such price declines can give rise to questions about the underlying financial condition of an issuer, which in turn can create a crisis of confidence without a fundamental underlying basis.”

As a further step to address abusive short selling practices, SEC Chairman Christopher Cox plans to have the Commission consider a further new rule that would require hedge funds and other large-scale investors to publicly disclose their short positions. Investment managers with more than $100 million invested in securities would be required to begin public reporting of their daily short positions. Currently, the managers are only required to report their long positions. No formal action has yet been taken about this reporting proposal.

SEC Chairman Christopher Cox said of these new rules, “[these] several actions today make it crystal clear that the SEC has zero tolerance for abusive naked short selling.”

The new rules specify mandatory delivery requirements and impose strict penalties for failures to comply with those requirements. Short sellers and their broker-dealers must now deliver the securities that are sold short within three trading days of the sale transaction date (T+3).

Failure to deliver on the T+3 settlement date carries the following consequences. The broker-dealer is required to go into the market and cover (i.e., buy shares at the then prevailing market price to cure the delivery failure) or borrow shares to cure the delivery failure. The brokerdealer also is prohibited from effecting any further short sales in that issuer’s equity security, not only for the customer who failed to deliver, but also for all of that broker-dealer’s customers, unless its other short selling customers have first actually borrowed or pre-borrowed the securities. These prohibitions remain in place until the delivery failure is covered. There are two exceptions to these prohibitions. If the broker-dealer can demonstrate that the delivery failure is due to a long sale, then the rules allow an additional three trading days to cure the failure. Also, if the delivery failure relates to equity securities sold pursuant to SEC Rule 144, and the failure continues for 35 consecutive trading days after T+3, then the delivery failure must be cured (i.e., covered) by the 36th consecutive trading day after T+3.

As a companion provision to these trading requirements, the new rules make it a “manipulative and deceptive device or contrivance” under Section 10(b) of the Securities Exchange Act, and therefore potentially subject to criminal penalties, to submit an order to sell an equity security if the seller deceives the broker-dealer, clearing agency or the purchaser, about “its intention or ability to deliver the security on or before the settlement date” and such person fails to so deliver.

The new rules also eliminate the options market maker exception from Regulation SHO relating to naked shorts. Market makers are now required to abide by the T+3 settlement date, thereby treating them the same as all other market participants.

Unless further extended by the SEC, the above rules will terminate at 11:59 P.M. on October 1, 2008.