In an open meeting on February 24, 2010, the Securities and Exchange Commission (SEC) voted three to two to adopt new rules regulating short selling. The new rules will significantly alter current short-selling practices. In addition, the SEC voted unanimously to reiterate its continuing support for the convergence of U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).1
Short Sale Regulations – The Uptick Rule’s Modified Comeback
Background of the New Rule
In 2007, the SEC eliminated the “uptick rule,” which generally prohibited short sales below the last sale price of that security. However, after the market collapse of 2008, and expiration of temporary restrictions on short selling in stocks of financial services companies, critics clamored for reinstatement of comprehensive short sale regulations, including the uptick rule.
In April 2009, the SEC released for comment five variations on two approaches to the regulation of short selling. The first approach was a market-wide permanent regulation of short sales generally, with either a national best bid threshold (the “modified uptick rule”), or last sale price threshold (the “uptick rule”), for short sales. The second approach was a temporary, security specific “circuit breaker” rule. Here, the SEC offered three options for public comment, including a “circuit breaker halt,” a “circuit breaker uptick” and a “circuit breaker modified uptick.” Then, in August 2009, the SEC released an additional variant of the market-wide rules proposed in April. That proposal, a variant of the modified uptick rule (the “alternative uptick rule”), would have used the current national best bid as a reference point for short sale orders. However, unlike the modified uptick rule, the newly proposed alternative uptick rule would not have permitted short sales at or above the national best bid for the security.
The New Rule – An Uptick Rule for the 21st Century?
What is the new rule?
The SEC adopted an amendment to Rule 201 of Regulation SHO, the “Alternative Uptick Circuit-Breaker” rule for short sales. If an equity security listed on a national securities exchange (whether traded on the exchange or in the over-the-counter market) declines in price 10 percent or more in a single trading day from the prior day’s closing price, a short sale may not be made at a price at or below the national best bid price for the rest of that trading day and the following trading day.
The new rule will require that trading centers establish and maintain a set of policies reasonably likely to ensure that short sale orders in violation of the new amendments are not displayed or submitted to the national system. As the new rule will not allow short sales at or below the national best bid, long sellers will be substantially favored in a down market, allowing them to sell before short sale orders are permitted.
Who is responsible for determinations under the new rules?
The determination of when to impose the circuit breaker alternative uptick test on a specific security will be made by the applicable listing market. The rule will require that the listing market, upon the determination that a security’s price has declined by 10 percent or more from the prior day’s closing price, immediately notify the single prime processor responsible for consolidating information for the particular security. The securities processor will then be responsible for dissemination of that information to the market.
Are there exemptions from the new rules?
The new rule does not contain any overarching “market maker” exemptions. The new rule will include a few limited circumstances in which an order made during the period following activation of the rule could be executed at or below the national best bid. These exceptions, generally consistent with former short-selling Rule 10a-1, include:
- where a broker-dealer submitting a short-sale order identifies the order as priced above the national best bid at the time the broker-dealer submits the order to the trading center (however, broker-dealers relying on this exemption will be required to establish, maintain, enforce and monitor written policies and procedures that are reasonably designed to prevent the incorrect identification of such orders as short exempt);
- where a seller owns the security being sold but there is a delay in delivery;
- certain odd-lot transactions;
- certain domestic and international arbitrage transactions;
- overallotment and lay-off sales;
- riskless principle transactions; and
- transactions on a volume weighted average price basis.
The new rules will amend Rule 200(g) of Regulation SHO to provide a new “short-exempt” marker for orders when a broker-dealer is relying on one of the exemptions listed above.
What is the purpose of the new rule?
Chairman Schapiro stated that new rules were motivated by concern “that excessive downward price pressure on individual securities, accompanied by the fear of unconstrained short selling, can destabilize our markets and undermine investor confidence in our markets.” However, Commissioners Paredes and Casey noted that the adopting release (which is not yet publicly available) concedes that there is no empirical evidence that short selling contributed to recent market volatility. All the Commissioners acknowledged that they have received significant public comment on short-sale issues.
When will the new rules become effective?
The new rules will have a six-month implementation period, reflecting public comment concerning the complexity of the new price restrictions and marking requirements.
The adopting release and the text of the final rule are not yet available, and, accordingly, the descriptions provided in this special alert are based on the SEC press release and statements made by the commissioners and staff at the open meeting.
The Impact of the Short-Selling Rules Adopted in 2009
While the new rule will impact current short-selling practices, it follows significant efforts by the SEC to address the issue of “abusive” short selling, including so-called “naked” short sales. During the market turmoil of late 2008, the SEC adopted temporary rule 204T, which required that short sellers deliver securities by the settlement date or, in the case of a fail to deliver, the broker-dealer must have purchased or borrowed shares to close out the short-sale by no later than the beginning of the trading on the day after the first fail to deliver occurred (T+4). In July 2009, the SEC made Rule 204T permanent by adopting Rule 204.
What was the impact of the permanent short sale rules adopted last year?
During the open meeting, Commissioner Casey asked the staff about trends in fails to deliver, considered an indicator of naked short-selling. The staff indicated that fails to deliver had “dramatically declined” following the adoption of Rule 204 last summer. According to the staff, fails to deliver in threshold securities, those securities with relatively higher levels of fails to deliver, have been reduced by 83 percent, compared to a reduction across all securities of 65 percent, since the fall of 2008.
SEC Statement Reaffirming Commitment to Move U.S. Toward IFRS
The Commissioners voted unanimously to issue a statement reaffirming the SEC’s commitment to a process to determine whether to move U.S. companies toward the use of IFRS for financial reporting, instead of GAAP. The statement adopted by the SEC, which has not yet been made publicly available, is intended to reaffirm the SEC’s support for a single set of globally accepted accounting standards, describe the various issues that need to be further examined and specify the events that must occur between now and 2011, the target date set forth in the November 2008 Proposed Roadmap.2 The Proposed Roadmap set forth the various key milestones that, if met, will lead to a determination by the SEC in 2011 as to whether to adopt the mandatory use of IFRS by U.S. issuers beginning in the year 2014.
In her opening statement, Chairman Schapiro indicated that, although the SEC still does not have all of the information necessary to make any decision at this time, it remains on a “steady path” to be in a position to do so in 2011. Specifically, she noted that the convergence projects between the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) must first be successfully completed, and that the SEC staff must engage in a fact-gathering process to aid the Commissioners in evaluating the impact on U.S. securities markets of the use of IFRS by U.S. companies. The other Commissioners also expressed their general support for the development of a single set of high-quality accounting standards, but The SEC received over 200 comments on the Proposed Roadmap, many of which indicated that the Proposed Roadmap did not sufficiently articulate a plan for identifying specific issues and criteria against which these issues would be evaluated. In response, the SEC’s Chief Accountant Jim Kroeker noted that the staff has developed a “Work Plan” specifying areas on which their fact-gathering efforts will focus in order to identify whether, when and how U.S. issuers should implement IFRS.
The adopted statement will direct the staff to execute the specific steps and affirmative actions identified in the Work Plan, which is intended to address concerns highlighted by commenters to the Proposed Roadmap:
- sufficient development and application of IFRS for the U.S. reporting system;
- independence of the accounting standard-setting process for the benefit of investors;
- investor education and understanding of IFRS;
- examination of U.S. regulatory environments that could be affected by a change in accounting standards;
- impact on large and small issuers due to a change in accounting standards and with regard to corporate governance and litigation considerations; and
- human capital readiness.
The SEC staff noted that these factors consider both (1) the characteristics of IFRS and standard-setting that would be most relevant in determining whether to apply IFRS to the U.S. reporting system for U.S. issuers and (2) the scope and timing in which to successfully incorporate IFRS. In order to gather information to support these factors, the staff indicated that it would perform research and hold discussions with, and analyze information from, various parties involved in the financial reporting process, including investors, auditors, attorneys, other regulators, academics and international organizations. The staff also noted its intention to publish periodic reports, beginning no later than October 2010, describing progress made in execution of the Work Plan.
The text of the SEC statement is not yet available, and, accordingly, the descriptions provided in this special alert are based on the SEC press release and statements made by the commissioners and staff at the open meeting.