On April 8, 2009, the Securities and Exchange Commission (the “SEC”) voted to seek public comment on whether to impose restrictions on the short sale of securities. A copy of the SEC’s proposals on short sales (Amendments to Regulation SHO) can be found online. The actions come in response to “extreme market conditions” and aim to address a “deterioration in investor confidence.” Short selling has been cited by some as a cause of recent market conditions and involves the sale of borrowed shares by an investor in the hope of profiting by buying an equal number of shares later at a lower price to replace the borrowed stock.
These proposals mark an abrupt about-face for the SEC, which just two years ago eliminated similar short sale restrictions, and fall into two categories: one approach would impose market-wide, permanent restrictions on the short sale of securities, and the other approach would apply only to particular securities experiencing steep price declines. The SEC has stressed that it could adopt one of the proposals, a combination of the proposals, or none of them.
Proposed Market-Wide, Permanent Restrictions
The SEC proposed two rules that would apply at all times to all short sales of any stock listed on a national securities exchange, whether traded in the over-the counter market or on an exchange, but excluding bulleting board and pink sheet securities and options (“Covered Securities”). The first, the “uptick rule,” would restrict short sales based on the last sale price of a Covered Security, and the second, the “modified uptick rule,” would restrict short sales based on the national best bid (the highest quoted price that any prospective purchaser will pay for a security) for a Covered Security.
Uptick Rule: The uptick rule would adopt a market-wide short sale price test based on the last sale price, or tick, for a Covered Security, and is an update of the former Exchange Act Rule 10a-1 price test. Subject to certain exceptions, the rule would prevent short sales of a Covered Security at prices beneath the last sale price of a security or, if the last sale price was at a price below the last sale that occurred at a different price, the rule would prevent short sales at prices equal to or beneath the last sale price.
Modified Uptick Rule: The so-called modified uptick rule would adopt a market-wide short sale price test based on the national best bid for a Covered Security, and is similar to the bid test formerly used by the NASD. This rule would prevent short sales at a price that is below the national best bid or, if the current national best bid is below the last different national best bid, at a price less than or equal to the current national best bid. The SEC has stated that it believes that this approach would be preferable to the uptick rule in today’s markets because, among other reasons, a bid is generally a more accurate reflection of the current price of a security than its last sale price.
Proposed Security Specific, Temporary Restrictions
In addition to the two rules covering all securities, the SEC proposed three “circuit breaker” rules that would apply only to Covered Securities that experience precipitous declines in price. Upon the triggering of a “circuit breaker” (as proposed, an intraday 10% decline in the price of a Covered Security) one of three events would occur: all short sales with respect to the Covered Security would be banned, the uptick rule would apply to short sales of the Covered Security, or the modified uptick rule would apply to short sales of the Covered Security.
Short Sale Ban Circuit Breaker: This rule would ban short selling in a Covered Security for the remainder of the trading day if the circuit breaker is triggered.
Uptick Rule Circuit Breaker: This rule would, if the circuit breaker is triggered, make short sales of the Covered Security subject to the uptick rule for the remainder of the trading day.
Modified Uptick Rule Circuit Breaker: This rule would, if the circuit breaker is triggered, make short sales of the Covered Security subject to the modified uptick rule for the remainder of the trading day.
Regardless of which approach (if any) it eventually adopts, the SEC through these rules will effect significant changes in how short sales of securities can take place. Clients should be aware of and understand how these rules may affect the market for their securities.