Last week, the SEC finalized its new rules relating to short selling; two rules, previously proposed, were adopted in final form and two others were adopted as temporary final rules. This marks the SEC’s latest attempt to address abusive short selling and market manipulation.
As we have previously noted,1 the SEC addressed the problem of naked short selling with its emergency orders beginning on September 17, 2008 (the “Emergency Orders”), which required some modifications and guidance along the way.2 At that time, the SEC created a hard T+3 close-out requirement (with penalties for violations), eliminated the market-maker exception to the close-out provisions of Regulation SHO and adopted a new short-selling anti-fraud rule. It also mandated the reporting of all short sales by institutional investment advisors to the SEC on a new Form SH. With these latest releases, the SEC’s Emergency Orders have now been permanently adopted substantially as proposed, with a few notable exceptions—particularly with regards to the new Form SH requirement, which we discuss below.
New Permanent Rules
New Short Sale Fraud Rule
The SEC adopted Rule 10b-21 (which was originally proposed in March 20083 and then implemented through the Emergency Order on September 17, 2008) substantially as proposed.4 In the Rule 10b-21 adopting release (the “Rule 10b-21 Release”), the SEC said that the rule is aimed at parties who are deceptive about their intention or ability to deliver securities in time for settlement, including their source of borrowable shares for purposes of complying with Regulation SHO’s “locate” requirement, and parties who fail to deliver securities by the settlement date, including short sellers who misrepresent to their broker-dealers that they own the shares being sold.
In response to commenters’ questions and concerns, the SEC clarified certain aspects and applications of the rule:
- Scienter is a necessary element for a violation of the rule;
- Rule 10b-21 applies only to equity securities;
- Rule 10b-21 is not meant, in any way, to limit the general antifraud provisions of the federal securities laws, such as Rule 10b-5, and those persons who deceive their broker-dealer about their locate source or ownership of shares are liable under the new and existing anti-fraud rules;
- There is a private right of action for a violation of Rule 10b-21, and a private plaintiff able to prove a Rule 10b-5 claim in a situation covered by Rule 10b-21 would also be able to assert a claim under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; and
- Rule 10b-21 does not impose any additional liability or requirements on any person, including brokerdealers, beyond those of any existing SEC rule.
Market-Maker Exception to Regulation SHO Eliminated
The SEC also adopted its previous proposal to eliminate the options market-maker exception to the close-out requirement of Regulation SHO, in an effort to further Regulation SHO’s goal of reducing fails-to-deliver in equity securities. The SEC provided guidance regarding bona fide market-making activities for purposes of the market-maker exception to Regulation SHO’s locate requirement.5 The SEC had reproposed eliminating the market-maker exception in July 2008,6 and adopted it temporarily through the September 17 Emergency Order. This order expired on October 17, 2008, and so the SEC made the amendment to Regulation SHO effective when the September Emergency Order expired.
As a result of the amendments, fails-to-deliver in threshold securities that result from hedging activities by options market-makers will no longer be excepted from Regulation SHO’s close-out requirement. In justifying the new rule, the SEC cited several continuing concerns about the effect that fails-to-deliver have on markets and shareholders, and the connection of fails-to-deliver to manipulative “naked” short selling.
Interim Final Temporary Rules
SEC Adopts Hard T+3 Close-Out Requirement; Penalties for Violation Include Prohibition of Further Short Sales, Mandatory Pre-borrow
The SEC adopted Rule 204T as an interim final temporary rule, with the intent of “preventing substantial disruption of the securities markets.”7 Rule 204T requires that short sellers and their broker-dealers deliver securities by the close of business on the settlement date (three days after the sale transaction date, or T+3), and imposes penalties for failure to do so. The close-out requirement requires that the participant take affirmative action to purchase or borrow securities, and that the participant may not offset the amount of its fail with shares that the participant will receive on or before the close-out date. If a short sale violates the new closeout requirement, then any broker-dealer acting on the short seller’s behalf will be prohibited from further short sales in the same security unless the shares are not only located but also pre-borrowed. The prohibition on the broker-dealer’s activity applies not only to short sales for the particular naked short seller, but to all short sales for any customer. This temporary rule took effect on October 17, 2008, at the expiration of the September Emergency Order, and will automatically expire on July 31, 2009.
The SEC has adopted 204T based on the September Emergency Order, with some modifications to address operational and technical concerns resulting from the requirements of that temporary rule. The SEC hopes that this temporary rule will provide a powerful disincentive to those who might otherwise engage in potentially abusive “naked” short selling.
One such modification was the settlement requirements for securities sold pursuant to Rule 144. Securities sold pursuant to Rule 144 under the Securities Act are securities that a seller is “deemed to own,” under existing Rule 200(a) of Regulation SHO. The securities, however, may not be capable of being delivered on the settlement date due to processing delays related to removal of the restrictive legend and, therefore, sales of these securities frequently result in fails-to-deliver. To address this issue, the SEC instituted a close-out requirement of 35 consecutive settlement days from the settlement date for fails-to-deliver resulting from sales of all equity securities sold pursuant to Rule 144. The SEC concluded this would permit the orderly settlement of such sales without the risk of causing market disruption due to unnecessary purchasing activity, and would allow participants to close out fails-to-deliver resulting from the sale of the security with the security sold, rather than having to close out the failed position by purchasing securities in the market. If, however, a fail-to-deliver position resulting from the sale of an equity security pursuant to Rule 144 is not closed out in accordance with the requirements outlined above, the borrowing requirements of the new rules will apply.
Additionally, the SEC is also aware that sellers that own restricted equity securities that wish to sell pursuant to an effective resale registration statement under Rule 415 of the Securities Act experience similar types of potential settlement delays as sales of securities pursuant to Rule 144. Thus, fails-to-deliver in such securities may be closed out in a manner similar to Rule 144 securities if the fails-to-deliver resulted from sales of securities that were outstanding at the time they were sold and the sale occurred after a registration has become effective.8 The same also applies to sales pursuant to broker-assisted cashless exercises of compensatory options to purchase a company’s stock.
Because most transactions settle by T+3 and because delivery on all sales should be made by settlement date, participants should consider having in place policies and procedures to help ensure that delivery is being made by the settlement date. The SEC has stated it intends to examine participants’ policies and procedures to determine whether such policies and procedures monitor for delivery by the settlement date.
New Disclosure Requirements for Institutional Investment Advisors’ Short Positions
Finally, the SEC adopted an interim final temporary rule, Rule 10a-3T, requiring institutional investment advisors to report their short sales and positions of Section 13(f) securities, other than options, on Form SH. The rule was effective on October 18 (after the expiration of the Emergency Order), and will continue in place until August 1, 2009.9 The SEC made some modifications to Form SH and the procedures and requirements for filing:
- Beginning on October 18, 2008, the Form SH weekly filing deadline is now the last business day of the calendar week following a calendar week in which short sales are effected (generally Friday), instead of the first business day, providing filers with additional time to gather and verify the necessary information and file the forms.
- Form SH filers are no longer to be required to disclose the value of the securities sold short (currently column 5 of Form SH), the largest intraday short position (currently column 7 of Form SH) and the time of day of the largest intraday short positions (currently column 8 of Form SH). The SEC eliminated these requirements because of comments that the information has been difficult for filers to obtain.
- Form SH filers will be required to report all short positions, including short positions effected prior to September 22, 2008, when reporting Short Position (Start of Day), Number of Securities Sold Short (Day) and Short Position (End of Day) (data elements 5, 6 and 7) on the revised Form SH.
- The threshold for reporting short sales or positions has been raised from a fair market value of $1 million to a fair market value of $10 million. The SEC raised this threshold due to the new requirement to disclose pre-September 22, 2008, short sales and positions.
- Filers will be required to submit an XML tagged data file to the Commission providing the requested data beginning with filings due on November 7, 2008.
For the October 24 and October 31, 2008, Form SH filing, a filer may exclude disclosure of short positions reflecting short sales before September 22, 2008, from the Form SH report filed on either or both of those dates if the short position constitutes less than 0.25 percent of the issuer’s outstanding shares and the fair market value of the short position in the section 13(f) security is less than $1,000,000. However, this phase-in period ends November 7, 2008.
Under the adopted rule, Rule 10a-3T does not require a Form SH to report short sales and positions if • the institutional investment manager has not effected any short sales of section 13(f) securities during the reporting period covered by the Form SH due to be filed10; or • on each calendar day during the calendar week, the start of day short position, the gross number of securities sold short during the day and the end of day short position constitute less than 0.25 percent of the issuer’s outstanding shares and the fair market value of the start of day short position, the gross number of securities sold short during the day and the end of day short position is less than $10,000,000. If any of the data elements (start of day short position, gross short sales that day and end of day short position) are below the requisite threshold outlined above, then that part of the form may contain an “N/A” instead of the number.11 Unlike most disclosures and filings made to the SEC, Form SH will not be available to the public. It appears that the main purpose of the disclosure is for the staff to gather information about the markets and trading practices. The SEC stated that Form SH “will provide useful information to the staff to analyze the effects of our rulemakings relating to short sales and in evaluating whether our current rules are working as intended, particularly in times of financial stress in our markets. The reports will supply the Commission with important information about the size and changes in short sales of particular issuers by particular investors. That information will be available to the Commission to consider when questions about the propriety of certain short selling occur.” The SEC staff also provided some informal guidance since the adoption of Rule 10a-3T. Following its adoption, questions were raised as to whether the Rule 10a-3T requires reporting of all short positions in section 13(f) securities during the reporting period, or just of short sales executed in section 13(f) securities during the reporting period. All short positions held during the reporting period that are required to be reported, even those in securities that were not sold short during the relevant week, must be included in the Form SH filing. To date, the SEC staff has not issued any FAQs or other written guidance and it is not clear whether they will do so.