Over the past week the US Securities and Exchange Commission (the "SEC"), responding to "sudden and unexplained declines in the prices of securities" and the danger to the broader market of "a crisis of confidence without a fundamental underlying basis," adopted a series of temporary and permanent measures designed to curb "naked" short selling and restore confidence in the nation's financial institutions.

The SEC's actions consisted of: (1) imposing hard T+3 close-out requirements—and penalties for failure to meet those requirements—meant to prevent "naked" short selling, (2) doing away with certain exceptions to close-out requirements for market makers and (3) implementing a rule creating anti-fraud liability specific to "naked" short selling.

On September 19 the SEC took further action by suspending all short selling in 799 financial companies. Recognizing that under normal conditions short selling contributes to price efficiency and increased liquidity, the SEC stated financial institutions are "particularly vulnerable" in the current environment due to their dependence on the "confidence of their trading counterparties in the conduct of their core business." The SEC also began temporarily: (1) requiring large institutional money managers to report new short sales of most publicly traded securities and (2) easing restrictions on the ability of securities issuers to repurchase their securities. The SEC noted it may consider additional steps to "protect the integrity and quality of the securities markets and strengthen investor confidence" and in fact on September 21 revised some of the September 19 orders to both make them broader and include additional exceptions. The SEC may release further orders in the coming days as it sees fit.

Rule 204T

  • Hard Close-out Requirements 

Effective immediately temporary Rule 204T requires participants of registered clearing agencies (such as broker-dealers) to deliver equity securities to such clearing agencies by "settlement date" for both long and short equities. Settlement date in this context refers to the rule that investors must complete their securities transactions within three business days—or "T+3" in shorthand. In the event securities are not timely delivered, the participant is required to close out the "fail" position when trading begins within:

  1. one business day after the settlement date for short sale transactions—ie, the morning of T+4, 
  1. three businesses days after the settlement date for long sale transactions— ie, the morning of T+6, and 
  1. 35 business days after the settlement date for any securities sold pursuant to Rule 144 under the Securities Act — ie, the morning of T+39.

Short sales can be closed out by either borrowing or purchasing the securities while long sales can be closed out only by purchasing the securities. Participants that close out fail positions within the prescribed time frames are not subject to penalty.

  • Penalties for Violation

If a participant does not close out fail positions within the prescribed time frames it may not accept a short sale order in the same security without first borrowing the security or entering into a bona-fide arrangement to borrow the security.1 This "pre-borrow" requirement remains in place until the participant closes out the fail position by purchasing the security and the purchase has cleared and settled at a registered clearing agency.

These restrictions apply not only to participants in clearing agencies with fail positions, but to any broker dealer it receives trades from. A participant with a fail position must also notify broker-dealers it does business with:

  1. that it has a fail position; and 
  1. when the fail position has cleared and settled.

Rule 204T is set to expire October 1, 2008, but can be renewed at the SEC's discretion.

Repeal of Options Market Maker Exception

Effective immediately the SEC also permanently adopted changes to Reg SHO proposed in August 2007 by eliminating an exception that exempted options market makers from having to close out fail positions in "threshold securities". The SEC originally created the exemption on the theory that market makers play a unique role as liquidity providers. Under the amended Reg SHO, however, broker-dealers (or other "participants" in registered clearing agencies) must now close out fail positions in equity "threshold securities" (as defined in Reg SHO) that were previously attributed to options market makers within 35 settlement (business) days of September 18. Upon expiration of the 35-day period, the same penalties as those discussed immediately above apply until the participant closes out the fail position by purchasing securities of like kind and quantity.

Rule 10b-21 – "Naked" Short Sale Liability

Rule 10b-21 supplements federal securities laws antifraud provisions such as Rule 10b-5. Rule 10b-21 makes it a violation for any person to enter a short sale if that person is deceptive about his intention or ability to deliver the security by settlement date and that person subsequently fails to deliver the security by settlement date. It does not appear this rule has created liabilities where none previously existed, but rather is intended to highlight a specific problem and signal the seriousness with which the SEC will now pursue violators. The new rule is effective immediately.

Suspension of Short Selling

The SEC issued an emergency order, effective immediately, prohibiting short selling of the publicly traded securities of 799 financial firms. The SEC subsequently amended its order to include the publicly traded common equity securities of any issuer identified by any national securities exchange listing such securities as being a financial institution.2

In its order and subsequent amendment the SEC provided exceptions for: (1) short sales made by bona fide market makers in order to allow such market makers to facilitate customer orders, (2) short sales that occur as a result of an automatic exercise or assignment of an equity option held prior to the order, (3) short sales that occur as a result of the expiration of futures contracts held prior to effectiveness of the order, (4) short sales that occur as a result of assignment to call writers upon exercise and (5) short sales by market makers done as bona fide market making in derivatives on the publicly traded securities of the firms on the SEC's list. Market makers may not rely on exception (5), however, if (1) the counterparty position is established after 12:01am on September 22 and (2) the market maker knows the counterparty's transaction will result in the counterparty establishing or increasing an economic net short position in the issued share capital of the firm covered. The emergency order took effect on September 19 and is currently set to expire October 2.

Short Sale Reporting

The SEC also issued an emergency order requiring institutional investment managers to disclose the number and value of certain securities sold short by filing the new Form SH. The order applies only to managers with "Section 13(f) securities"3 that have an aggregate fair market of at least $100,000,000. Short positions of covered securities need not be reported if (1) they constitute less than 0.25% of a securities class and (2) the fair market value of the position is less than $1,000,000.4

The filing will be available to the public two weeks after it is filed. The filing should include disclosure of the number and value of short sales other than short sales in options. The filing also requires certain other metrics relating to the size and timing of the position. It is to be filed on the first business day of every calendar week following a week in which qualifying short positions were taken. The SEC's order took effect September 22 and is set to expire October 2.

Easing of Issuer Purchase Restrictions

Effective immediately the SEC temporarily eased the timing and volume conditions of Exchange Act Rule 10b-18. Rule 10b-18 is a safe harbor provision allowing an issuer to effect a repurchase of its common stock in the market as long as it meets certain timing, manner, price and volume restrictions.

Under the new order the SEC now allows repurchases at any time with the exception of certain previously restricted repurchases following the close of primary trading. The SEC order also modified the volume conditions so that an issuer's repurchases must not exceed 100% of the average daily trading volume of the preceding four calendar weeks.5 The order took effect on September 19 and is set to expire October 2.