On April 10, 2009, less than two years after eliminating all price restrictions on short sales, the Securities and Exchange Commission (“SEC”) published a release seeking comment on two alternatives for reinstating short sale price restrictions and three versions of a less pervasive circuit breaker rule, which would impose such restrictions only upon a significant intra-day price decline in a stock and only for the impacted stock. See “Amendments to Regulation SHO,” SEC Release No. 34-59748 (April 10, 2009)(“Proposing Release”). On May 5, 2009, the SEC hosted an all-day “Roundtable to Examine Short Sale Price Test and Circuit Breaker Restrictions” (“Roundtable”), during which the Commission heard statements from and asked questions of three panels, comprised of representatives of self-regulatory organizations, retail and institutional broker-dealers, hedge funds, public companies and academia.1
In the wake of the Rule Proposal and Roundtable, several key themes have emerged. First, there is no empirical support for a price test or circuit breaker rule; rather, as the Commission acknowledges, the primary impetus for the rule proposals has been the desire to address the “deterioration in investor confidence” over the past nine months. Id. Second, short selling provides beneficial price discovery and liquidity and there is concern among some market participants that the proposed restrictions would have an adverse impact on such functions, resulting in wider spreads, less liquidity and greater transaction costs. Third, a number of market participants have expressed the view that if there is going to be new rulemaking in this area, then a circuit breaker may be preferable to a price test, and if there is going to be a price test, a test based upon the last bid may be preferable to one based upon the last sale. Finally, while not directly related to the rule proposals, there continues to be considerable discussion as to whether public disclosure of short sale and credit default swap (“CDS”) transactions and positions should be mandated in the interests of, inter alia, addressing the loss of investor confidence through greater market transparency.
Overview of Rule Proposals
The scope of the proposed price tests and circuit breaker rules is parallel to that of SEC Regulation NMS and hence extends to (1) all “trading centers”—a broad term that includes national securities exchanges, self-regulatory organization trading facilities, alternative trading systems, exchange and over-the-counter market makers and any other broker or dealer that executes orders internally by trading as principal or crossing orders as agent; and (2) all “covered securities”—any stock for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan.2 The proposed restrictions would not apply to Bulletin Board and over-the-counter stocks, fixed income securities, options, futures or derivative transactions. The price tests also would not apply to “after-hours” trading during periods when quotations are not disseminated on a real-time basis (currently between 4 p.m. (ET) and 8 p.m. (ET)).
The SEC’s proposing release notes that if one of the alternatives discussed below is adopted, it could be in the form of either: (a) a “policies and procedures requirement” (similar to that currently embodied in Regulation NMS) under which all trading centers would be required to have in place policies and procedures reasonably designed to prevent violations of the rule and if such controls are in place, would not be sanctioned for inadvertent violations; or (b) a “rule prohibition” (similar to that embodied in former SEC Rule 10a-1) under which any transaction that violates the price test in the rule could result in sanctions irrespective of the preventive measures implemented by the executing broker-dealer. A majority of the panelists at the Roundtable expressed the view that no matter what rule were adopted, it should be in the form of a policies and procedures requirement due to the velocity of the markets and the likelihood that inadvertent and unpreventable violations could occur. Rick Ketchum, Chief Executive Officer of FINRA, noted that such an approach would avoid the trade breaks and cancellations that might result from the need to avoid technical violations under a rule prohibition.
The five proposed rules are:
Price Tests:
1. “Modified Uptick Rule.” This rule, which is similar to former NASD Rule 3350, essentially would limit short selling to a price above the current bid in a declining market and at or above the current bid in a rising market. The Modified Uptick Rule focuses upon the current national best bid (“NBB”) and the last differently priced NBB preceding it, as opposed to the former uptick rule, which focused upon the last reported sale price and the last different reported price preceding it. Under the Modified Uptick Rule, if the last differently priced NBB was higher than the current NBB, i.e., the market is declining, then short sale orders can only be displayed or executed if they are priced higher than the current NBB (which is analogous to an “uptick”). However, if the last differently priced NBB was lower than the current NBB, i.e., the market is rising, then short sale orders also can be displayed or executed if they are equal to the current NBB (which is analogous to a “zero plus tick”).3 The SEC currently favors this proposed rule over the Uptick Rule (discussed immediately below) because it views bids, which are sequenced across trading centers, as a more accurate reflection of the market than last reported sales, which are often out of sequence due to the requirement that they be reported within a 90-second window.
2. “Uptick Rule.” This proposed rule essentially would reinstate former SEC Rule 10a-1 but extend it to cover all markets. The Uptick Rule would limit the execution of a short sale to a price above the last reported sale in a declining market (“plus tick”), while in a rising market, the Rule would limit the execution of a short sale to a price at or above the last reported sale (a “zero-plus tick”). This proposed rule would be in the form of a straight prohibition, similar to that of former SEC Rule 10a-1, instead of a “policies and procedures” requirement, thereby signaling that there would be very little tolerance of inadvertent or erroneous executions at impermissible prices. During the May 5th Roundtable, all panelists who expressed an opinion, opposed the reintroduction of this Rule on the ground that the nature of the trading markets has changed, particularly in terms of speed of execution, thereby making it extremely difficult if not impossible to determine what was the “last sale.”
Circuit Breakers:
3. “Circuit Breaker Halt Rule.” This rule would be triggered by a 10% or more decrease in the price of a covered security from the price of the previous day’s last reported trade, and would prohibit any person from selling short the covered security “wherever traded” for the remainder of the trading day. The Proposing Release notes that the circuit breaker halt could operate in place of one of the above price test rules or in combination with one of the above price tests. There is an exception from the halt for 10% or more decreases in a covered security’s price that occur 30 minutes or less from the end of regular trading hours. During the Roundtable, one panelist, representing a major institutional broker-dealer, supported a Circuit Breaker Halt Rule and indicated that this alternative would take only about three months for broker-dealers to implement.
4. “Circuit Breaker Modified Uptick Rule.” When triggered by a 10% or more decrease in the price of a covered security from the price of the previous day’s last reported trade, this rule would require adherence to the above Modified Uptick Rule for that covered security for the remainder of the trading day. There is an exception for 10% or more decreases in a covered security’s price that occur within 30 minutes from the end of regular trading hours. This proposal appeared to have the most support at the Roundtable.
5. “Circuit Breaker Uptick Rule.” When triggered by a 10% or more decrease in the price of a covered security from the price of the previous day’s last reported trade, this rule would require adherence to the Uptick Rule for that covered security for the remainder of the trading day. There is an exception for 10% or more decreases in a covered security’s price that occur within 30 minutes from the end of regular trading hours.
“Circuit Breaker Passive Modified Uptick Rule.” In addition to the above SEC rule proposals, through a comment letter dated March 24, 2009, the U.S. national securities exchanges (the “U.S. Exchanges”) have proposed a further restriction upon the Modified Uptick Rule under which short selling could only be initiated at a price above the NBB by posting a quote for a short sale order priced above the NBB, and short sales could only be executed on a passive basis (short sales could not hit bids). In the comment letter, the U.S. Exchanges urge the SEC to adopt their proposed Passive Modified Uptick Rule as part of a circuit breaker so that it would be triggered only upon the price of a covered security declining by a specified percentage on an intra-day basis and would apply only to the impacted security. In addition, the U.S. Exchanges urge the SEC to adopt the rule as a policies and procedures requirement. During the Roundtable, Rick Ketchum of FINRA and Dr. Hathaway of Nasdaq OMX supported this proposal and Mr. Ketchum advocated extending the circuit breaker price test beyond the day on which it is triggered.
If one of the price test rules described above were adopted, broker-dealers would be provided with a period of three months after the effective date of the rule to modify their systems and procedures to comply with the new rule’s requirements.
What the Current Empirical Data Shows
In the Proposing Release, the SEC notes that the empirical data that has been gathered to date does not establish the efficacy of price test restrictions for counteracting rapid market declines. Several studies have been conducted, including those that focused upon the market break of May 28, 1962, the market decline of September/October 1976, the market break of Oct. 19, 1987, and the Nasdaq market decline of 2000–01. According to the SEC, these studies found that the prior uptick rule “did not prevent short sales in extreme down markets and did limit short selling in up markets. . . .” The SEC’s analysis of the events of September 2008 noted that:
- “a price test would likely have been most restrictive during periods of low volatility, with greatest impact on short selling in lower priced and more active stocks,” and
- [“l]ong sellers were primarily responsible for price declines during this period.”
Many of the Roundtable panelists, including Dr. Hathaway of Nasdaq OMX, focused upon the above-mentioned studies as conclusive refutation of the need for new price test restrictions. However, several panelists noted the unique extreme volatility of today’s market conditions and suggested that a pilot program be instituted to assess the efficacy of price restrictions in such an environment. In the Proposing Release, the SEC seeks comment on whether it should adopt one of the three versions of the circuit breaker rules on a pilot basis and if so, which one. The SEC also seeks comment on issues such as how long a pilot program should remain in place; whether the securities that could be subject to the pilot could be comprised of a subset of the Russell 3000 index and how the securities that would comprise a pilot should be selected.
“Loss of Investor Confidence” as a Justification for New Regulation
The SEC clearly is aware that any short sale price restriction that is ultimately adopted may be challenged and wind up in the same court that defeated the SEC’s attempt to subject hedge fund managers to investment adviser registration in the Goldstein case. During the Roundtable, there was extensive discussion about whether the adoption of new regulation could be justified solely on the basis of it hopefully having a positive impact on investor confidence. The majority of panelists expressed the belief that such a justification could not counterbalance the anticipated adverse impact of the new regulation. Further, panelists expressed the view that because the proposed price tests could make it more difficult for even retail investors to execute their trades, there would continue to be a loss of investor confidence even if one of the proposed rules were adopted. A number of panelists also noted that investors have erroneously targeted short selling as the cause of the recent market decline and that better education of retail investors may be most effective in restoring investor confidence.
During the Roundtable, the Commissioners questioned whether it would be possible to study the anticipated impact of new regulation upon investor confidence. It was noted such studies are underway in Australia and other countries.
Anticipated Detrimental Effects of New Regulation
The SEC acknowledges, in the Proposing Release, that the adoption of a short sale price test “may lead to a decrease in market efficiency and price discovery, less protection against upward stock price manipulation, a less efficient allocation of capital, an increase in trading costs, and a decrease in liquidity.” Concern as to the anticipated detrimental impact of the proposed rules was echoed by all of the market participant panelists at the Roundtable. It was noted that high frequency traders account for approximately two-thirds of market volume and would be particularly impacted by the proposed price tests and may withdraw liquidity from the market in response. In addition, some panelists noted that the proposed circuit breaker rules could have a “magnet effect,” whereby short selling would increase as a stock’s price decline approached the 10% trigger level, thereby increasing volatility.
Exemptions
The proposed rules permit a broker-dealer submitting a short sale order to mark the order “short exempt” if (a) pursuant to its policies and procedures, the broker-dealer has identified the order as compliant with the respective rule’s price test; (b) the seller owns the stock but is experiencing a delivery delay; (c) the order is from a market maker attempting to offset or liquidate an odd lot trade; (d) the order is part of a bona fide domestic arbitrage transaction; (e) the order is part of a bona fide international arbitrage transaction; (f) the order is placed by an underwriter in an over-allotted offering and relates to “lay-off sales” that are part of a rights or standby underwriting commitment; (g) the order facilitates a “riskless principal” trade; or (h) the order is priced at a volume weighted average price (“VWAP”).4 During the Roundtable, a number of the panelists expressed the belief that the anticipated adverse effects of the proposed restrictions could be reduced to some degree through broadly scoped exemptions from any price test that is implemented either across-the-board or as part of a circuit breaker rule. The consensus of the market participant panelists was that the exemptions set forth in the proposing release were not enough.
Bona Fide Market Makers
The Commission considered and rejected a “short exempt” category for short sales that are part of bona fide market making because such a broad exemption could undermine the goals of the proposed price tests.5 Accordingly, only the proposed Circuit Breaker Halt Rule contains an exemption for short sales that are part of bona fide market making and it is limited to market making in covered securities and options.6 The SEC has sought comment on the need for a market maker exemption, “including the extent to which market makers would need to sell short at or below the current national best bid in their market making capacity.”
Market makers have traditionally taken the position that they need an exemption from short sale price test rules in order to fill incoming customer buy orders and to build up short positions to fill future buy orders. During the Roundtable, some market participant panelists ardently contended that a broad market maker exemption was essential to the proper functioning of the markets with either of the price tests in place. They asserted that such an exemption should extend to short sales by convertibles and derivatives dealers, as well as short sales by sponsors/creators of Exchange Traded Funds (“ETF’s”) and Exchange Traded Notes (“ETN’s”).
Derivative Transactions
As noted above, derivative transactions would not be subject to the proposed price tests or circuit breakers. Further, short sales in covered securities would be exempted from the Circuit Breaker Halt Rule if effected in connection with bona fide market making in derivatives.7 Thus, as was true with respect to the SEC’s temporary short sale ban in September 2008, synthetic shorting activity will not be directly impacted by any price test or circuit breaker that is adopted. At the time of the short sale ban, a number of public officials expressed the view that the effectiveness of the ban was compromised by the fact that synthetic shorting had been permitted to continue unfettered. In connection with the proposed pricing restrictions, the SEC has asked for comments on the extent to which the ability to obtain a short position through a “synthetic short sale” or other instruments (such as inverse leveraged exchange traded funds) undermine the goals of short sale price test restrictions.
ETFs and ETNs
While there is an exemption from the proposed Circuit Breaker Halt Rule for short sales effected in the component stocks of ETFs and ETNs as part of bona fide market making and hedging activities, ETFs and ETNs would not be exempt from the proposed price tests. For years, sponsors of ETFs and ETNs have sought exemption from Regulation NMS’ trade-through prohibitions due to the incompatibility between the operation of those restrictions and the manner in which ETFs and ETNs are priced. The SEC has questioned whether the proposed uptick rule or modified uptick rule should include a “short exempt” marking provision for transactions in exchange traded funds and, if so, what qualifications or conditions should apply.
Domestic and International Arbitrage
The SEC proposes to reinstate the exemptions in former SEC Rules 10a-1(e)(7) and 10a-1(e)(8), which would exempt short sellers from the proposed price tests and circuit breaker price tests with respect to short sale orders associated with certain bona fide domestic and international arbitrage transactions. Pursuant to this exemption, a broker-dealer could mark the seller’s order “short exempt” if it has a reasonable basis to believe that the short sale order is for a “good faith account” (a vehicle for financing arbitrage transactions pursuant to Federal Reserve Board Regulation T) by a person seeking to profit from a current price differential based upon a convertible security that entitles him to acquire an equivalent number of the securities sold short. To the extent that the above-mentioned convertible security is acquired and/or held through a broker-dealer other than the one executing the potentially exempt short sale, the reasonable basis for marking the order “short exempt” will rest upon the representations of the short seller to the broker-dealer marking the order. The parties to such communications would be well-served to document them.
Market participants are likely to view the proposed exemptions as too narrow and hence entirely inadequate to prevent the potentially significant interference with arbitrage strategies that could result from adoption of the proposed price tests. For one, the proposed exemptions focus on simple price arbitrage and may not cover hedging of different types of convertible securities (e.g., swaps, ADR’s, delta-one structures). In addition, the proposed exemptions do not cover “cash settled” or “net share settled” convertibles, nor (due to their requirement of immediate convertibility) do they cover contingent or European-style convertibles.
Seller’s Delay in Delivery of Owned Shares
The exemption in former SEC Rule 10a-1(e)(1) would also be reinstated in connection with the proposed price tests and circuit breaker price tests. It is intended to address situations where a seller owns a security but is unable to effect delivery by settlement date, such as in the sale of formerly restricted Rule 144 stock or where a convertible security has been tendered for conversion or exchange but the underlying security is not expected to be received by settlement date. In such situations, Rule 200(g) of Regulation SHO requires that the broker-dealer mark the seller’s order as “short.” Under both proposed rules, the broker-dealer may mark the order as “short exempt” provided that it has a “reasonable basis” to believe that the seller owns the security being sold and that the seller intends to deliver the security as soon as all restrictions on delivery have been removed. Here too, the seller’s representations to its broker-dealer are likely to provide the above-mentioned reasonable basis in many instances, thereby placing increased emphasis upon the documentation of such communications.
Customer Election Whether to Reprice or Cancel Impermissibly Priced Orders
The proposed Modified Uptick Rule would give trading centers the option, upon receiving such an order, to re-price the order at the lowest permissible price and hold it (if the market has moved away from the order) for later execution at its new price or better. The trading center can repeatedly re-price and display the order at the lowest permissible price eventually reaching the order’s original limit price. Trading centers would not be required to reprice impermissibly-priced limit orders, rather the choice whether to reprice or cancel would be made by the customer submitting the order. The Proposing Release suggests that “trading centers could offer their customers various order types regarding the handling of impermissibly priced orders such that a trading center either could reject…or reprice the order at the lowest permissible price until the order is filled.” The Proposing Release notes that this feature of the proposed Modified Uptick Rule” potentially allows for the more efficient functioning of the markets than the proposed uptick rule [and its predecessor SEC Rule 10a-1] because trading centers would not have to reject or cancel impermissibly priced orders unless instructed to do so by the … customer….” It remains to be seen how, if the Modified Uptick Rule is adopted, this newly-created re-pricing option would impact speed of execution, transactions costs and order flow.
International Implications—Price Restrictions or More Disclosure?
The Proposing Release notes that under the prior uptick rule, the SEC consistently took the position that trades that are negotiated in the U.S. but booked through a foreign broker-dealer or custodian were subject to the rule, and that the SEC has taken the same position with respect to the scope and application of Regulation SHO.8 According to the Release, the SEC will take a similar position with respect to the proposed price tests and circuit breaker rules, which will be applicable to any transaction in covered securities that is agreed to in the U.S.
We note that the SEC’s adoption of a temporary ban on short sales of certain stocks in September 2008 prompted a wave of short sale bans and restrictions across the world as other countries’ regulators attempted to prevent the movement of short selling activity from U.S. markets to their markets. If some version of the above-mentioned short sale price restrictions is adopted by the SEC, a similar wave of international regulatory pricing restrictions may follow. Alternatively, the SEC may adopt an approach similar to that taken by the U.K. Financial Services Authority, which indicated in a discussion paper released in February 2009 that it is inclined to impose short sale disclosure requirements but not price restrictions.9 As the debate over the future of short sale regulation rages on, we will keep you informed of further developments.
