On February 24th, the Securities and Exchange Commission (the “SEC” or the “Commission”) held an open meeting at which the commissioners voted 3-2 to approve a new short sale pricing rule – Rule 201 under Regulation SHO (“Rule 201” or the “new rule”). Rule 201 combines the “circuit breaker” concept embodied in one of the short sale price restrictions proposed in April 20091 with the “alternative uptick rule” proposed in August 2009.2 Rule 201 will apply to “covered securities,”3 generally, any equity security listed on a national securities exchange, whether that security is traded on an exchange or it is traded over-the-counter. Under Rule 201:
- Each covered security will be evaluated independently.
- The circuit breaker will be triggered for a particular security on any day that its price declines by 10 percent or more from the security’s price on its principal listing market as of the close of regular trading on the previous day.
- Once the circuit breaker is triggered, the alternative uptick rule will apply to all short sale orders in that security for the remainder of that day and for the following trading day. Under the alternative uptick rule, short sales of that security will be permitted only if the sale price is above the security’s current national best bid (“NBB”) price.
The final rule will require each trading center4 to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the execution or display of prohibited short sale orders. There will be exceptions from the rule for:
- Orders where a broker-dealer identifies the price as above the NBB at the time the order is submitted to the trading center;
- Orders where the seller owns the security but there will be a delay in delivery;
- Overallotment and layoff sales;
- Certain odd lot, arbitrage, and riskless principal transactions; and
- Transactions effected on a volume weighted average price (“VWAP”) basis.
Short sale orders subject to the foregoing exceptions will have to be marked “short exempt.” Importantly, there is no market maker exemption in the rule.
Once triggered, the price restriction in the new rule is more restrictive than either of the price restrictions proposed by the SEC in April 2009, or for that matter the short sale uptick rule and Nasdaq bid rule that were eliminated in 2007. Each of those rules permitted short sales at the current NBB price or most recent sale price if that price was above the previous different NBB or last sale price. Under the new rule, however, short sales will not be permitted at the current NBB price for the stock, even if the NBB price is above the previous NBB price. Instead, once the circuit breaker is triggered, all short sales in the stock must be priced above the NBB price.
According to SEC Chairman Mary Schapiro’s statements at the open meeting, the new rule “is the result of a thorough and deliberative process.” She explained that the Commission proposed several alternative price restrictions in April and August of 2009, which led to more than 4,300 comments. While acknowledging the many other short sale restrictions that have been adopted in the past few years, including the “naked” short selling anti-fraud rule and the rule requiring broker-dealers to promptly purchase or borrow securities for delivery, she noted that there still are concerns regarding short sales, which led the SEC to impose the price restrictions found in the new rule. Although recognizing the benefits provided by short selling in terms of liquidity and pricing efficiency, Chairman Schapiro expressed concern about excessive downward price pressure on securities accompanied by fears of unconstrained short selling, which can destabilize markets and undermine investor confidence.
In declaring support for the new rule, Commissioner Walter highlighted the importance of short sale issues to all members of the investing public, especially retail investors. Emphasizing the importance of restoring investor confidence in the markets, she declared that it is incumbent upon regulators to listen to such sentiments, even when they are “difficult to quantify.” She admitted that some people will be disappointed by the new rule, thinking either that it goes too far or does not go far enough; nevertheless, she supports the new rule because of its “measured, targeted approach.” Commissioner Aguilar began by expressing regret that Congress has not yet passed comprehensive derivatives legislation, because he believes that the SEC’s oversight of the capital markets is undermined by “gaping holes” in its authority over swaps, which can be used as the economic equivalent to short sales. Nevertheless, although acknowledging the success of the SEC’s existing short sale rules, and the need for care when balancing the negative and positive aspects of short selling, he supports Rule 201 because it strikes a “workable balance.”
Commissioners Casey and Paredes voted against the proposal, both noting the lack of empirical evidence that short sales were a significant contributing factor to the market disruptions of 2008. Commissioner Casey emphasized that the Rule’s 300-plus page adopting release contains little evidence that the new rule will promote investor confidence, or achieve any of its other stated goals. She pointed out that only 10 of the 90 pages in the release devoted to cost-benefit analysis focus on benefits; the rest is devoted to costs. Moreover, those 10 pages simply focus on the fact that Rule 201 is less intrusive than any of the other proposed restrictions would have been. According to Commissioner Casey, if the SEC cannot specifically identify any truly anticipated benefits from the proposed rule, it should not act “merely to say we have acted, and then choose the most palatable of the unsavory options.” She suggested that the Commission was engaging in “regulation by placebo,” and cautioned that compliance costs for the new rule are estimated to be “in the billions.” Commissioner Paredes provided a detailed analysis of what he views as the new rule’s shortcomings, and the flaws in the underlying assumptions on which the new rule is based, including an apparent inconsistency in one of the arguments in support of the new rule – that it will prevent short selling from exacerbating a security’s price decline, but will not unduly impact liquidity, price discovery, and hedging. According to Commissioner Paredes, if the new rule does not appreciably prevent short selling from driving down the price of a security (which would likely have an impact on liquidity, price discovery, and hedging), then its purported benefits will not materialize and there is no reason to adopt it.
The new rule will be effective 60 days after publication of the adopting release in the Federal Register. Once effective, there will be a six-month implementation period in order to provide trading centers and others with sufficient time to prepare for complying with the new rule. The text of Rule 201, and its adopting release, have not yet been published. We will provide additional details once this occurs.