• SEC Adopts Final Short/Long Sale Antifraud Rule 10b-21 
  • Elimination of Options Market Maker Exception to Regulation SHO Close-Out Requirement Made Final by SEC 
  • Broker-Dealer Hard T+3 Delivery Requirement Extended by SEC as Interim Temporary Final Rule 204T

On Oct. 14, 2008, the Securities and Exchange Commission (“SEC” or “Commission”) issued a trio of rule-making releases: (1) adopting, as a final rule, antifraud Rule 10b-21, which is aimed at short sellers who deceive broker-dealers, participants in registered clearing agencies or purchasers about their intention or ability to deliver the securities at settlement and then fail to deliver; (2) adopting, as final amendments to Regulation SHO, the elimination of the options market maker exemption to the close out requirements of Regulation SHO; and (3) adopting temporary Rule 204T and thereby extending the broker-dealer hard T+3 delivery requirements and immediate close-out requirements imposed by the SEC’s Sept. 17th Emergency Order until July 31, 2009.

Adoption of Final Antifraud Rule 10b-21

The Commission adopted new Rule 10b-21—first proposed on March 17, 2008—as a final rule, effective Oct. 17, 2008. Rule 10b-21 imposes liability on any seller of an equity security who: (1) deceives a broker-dealer, clearing agency or purchaser about its intention or ability to deliver the security on or before the settlement date; and (2) actually fails to deliver the security on or before the settlement date. While the SEC focuses on short sellers who may engage in abusive naked short selling when they intend to fail to deliver securities and then in fact fail to deliver them, the Rule by its terms applies both to long and short sales in which there has been a misrepresentation concerning the seller’s ability to deliver the shares and a failure to deliver.

Rule 203(b)(1) of Regulation SHO imposes upon broker-dealers the obligation to “locate” securities that are the subject of a short sale, and the broker-dealer often relies upon the short seller to specify the source of shares to be borrowed to satisfy the locate requirement. The adopting release notes that “[i]f a seller elects to provide its own locate source to a broker-dealer, the seller is representing that it has contacted that source and reasonably believes that the source can or intends to deliver the full amount of the securities to be sold short by settlement date.” The release further makes clear that sellers that enter a short sale order into a broker-dealer’s direct market access or sponsored access system along with information as to a locate source are making a representation for purposes of Rule 10b-21. It is therefore imperative for short sellers to maintain records with respect to their identification of locate sources. Conversely, the adopting release makes clear that if a seller is relying upon a broker-dealer to comply with Regulation SHO’s locate requirement, including reliance upon the broker-dealer’s “easy to borrow” list, then the seller is not making any representation for purposes of Rule 10b-21.

Rule 200(g) of Regulation SHO requires broker-dealers to mark each sale of equity securities either “long” or “short,” and in doing so, the broker-dealer often relies upon the seller’s representations as to whether or not they “own” the security, within the meaning of Rule 200. The adopting release makes clear that, “[a] seller will be liable for a violation of Rule 10b-21 for causing a broker-dealer to mark an order to sell a security ‘long’ if the seller knows or recklessly disregards that it is not ‘deemed to own’ the security being sold, as defined in Rules 200(a) through (f) of Regulation SHO or if the seller knows or recklessly disregards that the security being sold is not, or cannot reasonably be expected to be, in the broker-dealer’s physical possession or control by the date delivery is due, and the seller fails to deliver the security by the settlement date.”

In the release, the Commission specifically rejected arguments that: (1) Rule 10b-21 was not necessary because the conduct already was covered by existing antifraud rules; (2) no private right of action under Rule 10b-21 should be implied; and (3) broker-dealers should not be subject to potential aiding and abetting liability for their customer’s primary violations of Rule 10b-21.

Elimination of Options Market Maker Exception to Reg SHO Close-Out Requirements; Clarification of “Bona Fide Market Making” for Purposes of Exemption from Locate Requirement and New Temporary Rule 204T

As anticipated, the Commission has made permanent the elimination of the options market maker exception from the close-out requirements in Regulation SHO Rule 203(b)(3), which was originally adopted in its September 17th Emergency Order. Options market makers must now purchase shares to close out any fails to deliver in securities with large and persistent fails to deliver (“threshold securities”) and under new Rule 204T, any other equity securities and pending such close-out, they will be required to borrow, or arrange to borrow, any shares of the subject security that they want to sell short. The Commission also provided additional guidance on the activities that constitute “bona fide market making” for purposes of the exemption from the locate requirements in Regulation SHO Rule 203(b)(1).

As adopted in August 2004, Rule 203(b)(3) of Regulation SHO contained an exception from the Rule’s close- out requirements for any fail-to-deliver position in a threshold security resulting from short sales effected by a registered options market maker to establish or maintain a hedge on options positions that were created before the underlying security became a threshold security. Since then, the Commission has been evaluating whether or not to eliminate the exception. In July 2006, the Commission proposed amendments to Regulation SHO that narrowed the exceptions scope; then, in June 2007, the Commission proposed eliminating the exception altogether. The Commission undertook empirical tests and re-opened for comment the issue of eliminating the options market maker exception in July 2008. About a month after the comment period expired in August 2008, the Commission issued its Emergency Order, temporarily eliminating the exception. In anticipation of the Sept. 17th Emergency Order expiring on Oct. 17, 2008, the Commission has permanently eliminated this exception from the close-out requirements. However, under new temporary Rule 204T, if a fail- to-deliver position is attributable to bona fide market making activities by a registered market maker, options market maker, or other market maker obligated to quote in the over-the-counter market, two additional settlement days are afforded to the clearing firm to close out the fail-to-deliver position.

Under Rule 203(b)(1) of Regulation SHO, market makers engaged in bona fide market making are exempt from that Rule’s requirements that a broker-dealer obtain a locate at the time that it accepts or executes any short sale order in an equity security. The Commission’s adopting release provides interpretive guidance regarding the kinds of activities that would and would not constitute bona fide market making for purposes of this exemption. The Commission states that “whether the market maker incurs any economic or market risk with respect to the securities (e.g., by putting their own capital at risk to provide continuous two-sided quotes in markets)” is significant. Under this test, broker-dealers that are parties to bilateral contracts that hedge their exposure may not be deemed to be engaged in market-making and may be required to comply with Regulation SHO’s locate requirements. Further, if the market maker effects “both purchases and sales in roughly comparable amounts to provide liquidity to customers or other broker-dealers,” it is an indication of bona fide market making, as are “continuous quotations that are at or near the market on both sides and that are communicated and represented in a way that makes them widely accessible to investors and other broker-dealers.”

On the other hand, the adopting release makes clear that bona fide market making does not include: (a) “activity that is related to speculative selling strategies or investment purposes of the broker-dealer and is disproportionate to the usual market making patterns or practices of the broker-dealer in that security;” (b) the posting of quotes continually at or near the best offer, while not also posting at or near the best bid; or (c) the continual execution of short sales away from the broker-dealer’s posted quotes.

Broker-Dealer Rule 204T Hard T+3 Delivery and Immediate Close Out Requirements Extended through July 31, 2009

By adopting Rule 204T of Regulation SHO as a temporary rule, which will be effective during the period from Oct. 17, 2008, through July 31, 2009, the Commission has extended the “hard T+3 delivery” and close-out requirements that were imposed upon broker-dealers by the Commission’s Sept. 17th Emergency Order pending completion of the final rule-making process.

The Rule 204T that was adopted on Oct. 14 contains several modifications from the earlier version in the Emergency Order. Most importantly, the Rule now contains a “pre-fail credit” provision under which a broker-dealer will be deemed to have complied with the Rule’s close-out requirement if, on or after trade date but no later than settlement date, the broker-dealer executes a bona fide purchase sufficient to cover the open short position.1 As noted above, the Rule also provides an extension of two additional settlement days to comply with the close-out requirements for fails to deliver attributable to bona fide market-making activities (discussed above) by registered market makers, options market makers or other market makers obligated to quote in the over-the-counter market. Finally, the Rule explicitly permits a clearing firm to “reasonably” allocate a portion of a fail to deliver position to the executing broker whose trading activities have caused the fail to deliver position and for which it clears trades, thereby subjecting that broker-dealer and not the clearing firm to the Rule’s immediate close out requirement and pre-borrow penalty with respect to the allocated position.

In all other respects, interim Rule 204T extends the existing requirements imposed upon broker-dealers by the September 17th Emergency Order, which requires, in pertinent part, that: (a) clearing firms deliver securities to a registered clearing agency for clearance and settlement on a long or short sale in any equity security by settlement date; (b) clearing firms close out a fail-to-deliver position on a short sale by borrowing or purchasing securities of like kind and quantity no later than the beginning of regular trading hours on the next settlement date following the failure to deliver or in the case of a documented long sale, no later than the beginning of regular trading hours on the third consecutive settlement date following the failure to deliver, and (c) a clearing firm that fails to comply with these requirements, and any broker-dealer from which the clearing firm receives trades for clearance and settlement that is not able to establish that it did not incur a failure to deliver in the subject security on the relevant settlement date, will be required to pre-borrow in connection with any short sales in the subject security until the clearing firm closes out the failure to deliver by purchasing securities of like kind and quantity. 2

The Commission has proposed extensive questions for public comment and comment letters regarding the interim final temporary rule must be received on or before 60 days after publication of the release in the Federal Register.