Last week, the Securities and Exchange Commission (SEC) utilized its rulemaking authority to issue emergency orders relating to the regulation of short sales in order to preserve the integrity of the securities markets and calm investor concerns. The rules limit both the way traders must effect and report short sales, and the stocks they are allowed to sell short. In addition to the temporary restrictions, both the SEC and the New York State Attorney General pledged to intensify their enforcement efforts concerning short selling abuses.

The Emergency Short Sale Rules

The SEC, acting in concert with Britain’s Financial Services Authority, issued two orders regulating short sales in the current market:

  • The first prohibits the short sales of approximately 799 financial company stocks, • including Goldman Sachs Group, Inc., Morgan Stanley Dean Witter & Co. and Barclays, PLC. See Securities Exchange Act Release No. 34-58592 (September 18, 2008). The SEC issued an amended order noting that some financial services firms were left off of the SEC’s original list. The SEC then directed the listing markets to select and publish a list of the individual financial firms with securities covered by the prohibition against short sales of these financial firms. See Securities Exchange Act Release No. 34-58611 (September 21, 2008). The NYSE published its list at The NASDAQ published its list at
  •  The second requires institutional money managers with account values of at least $100 million on the last day of any month of any calendar year to report any new short sales of any 13(f) securities — including the number of shares and value of the securities sold — unless the short position represents less than 0.25 percent of the issuer’s outstanding shares, and is valued at less than $1 million. The sales must be reported on the new Form SH that accompanied the emergency order. See Securities Exchange Act Release No. 34-58591 (September 18, 2008). Technical amendments to the order were approved yesterday, including a provision making Form SH filings initially non-public but providing public access via the Commission’s EDGAR database two weeks after filing. See Securities Exchange Act Release No. 34-58591A (September 21, 2008). Any investment manager who filed a Form 13F for the calendar quarter ended June 30, 2008 will be required to file a new Form SH on September 29, 2008. Thereafter, a new Form SH is required to be filed before 5:30 p.m. on the first business day of every calendar week immediately following a week in which the institutional investment manager effected short sales. The SEC also noted that its confidential treatment procedures will not apply to the Form SH.

The emergency rules are effective immediately and will stay in effect until at least 11:59 p.m. (EST) on October 2, 2008; they may be extended by the SEC for an additional 30 days.

These orders follow the Commission’s earlier actions to protect investors from the impact of “naked’ short selling, which provide that

  •  short sellers and their broker-dealers must deliver securities by the close of business on the settlement date (three days after the sale transaction date, or T+3) or they will be penalized for failing to do so, including a prohibition from further short sales in the same security unless the shares are not only located but also pre-borrowed;
  •  the options market maker exception from the close-out requirement of Rule 203(b)(3) in Regulation SHO be eliminated, and, as a result, options market makers will be treated in the same way as all other market participants, and therefore must abide by the hard T+3 closeout; and
  •  the Rule 10b-21, which expressly targets fraudulent short selling transactions, be adopted (The new rule makes it illegal for short sellers to deceive broker-dealers or any other market participants, for example, by misrepresenting their intention or ability to deliver securities in time for settlement).

See Securities Exchange Act Release No. 34-58572 (September 17, 2008).

Finally, the SEC eased restrictions placed upon issuers seeking to effect the repurchase of their own securities and issued an emergency order modifying Exchange Act Rule 10b-18 to provide additional flexibility and certainty to issuers during current market conditions.

Increased Enforcement Efforts

On Thursday, SEC Chairman Christopher Cox warned that the Commission issued the orders to address short selling abuses “[i]n order to ensure that hidden manipulation, illegal naked short selling, or illegitimate trading tactics do not drive market behavior and undermine confidence.” The Commission’s Division of Enforcement announced a “sweeping expansion” of its ongoing investigation into potential market manipulation in the securities of several financial institutions. SEC Director of Enforcement Linda Chatman Thomsen added that her staff is “committed to using every weapon in [its] arsenal to combat market manipulation that threatens investors and capital markets.” Significantly, the SEC approved a formal order of investigation, and announced that institutions will be subpoenaed and that hedge fund managers, broker-dealers and institutional investors with considerable trading activity in financial issuers and/or positions in credit default swaps will be required, under oath, to disclose those positions to the Commission and provide other information. See

New York Attorney General Andrew Cuomo reminded Wall Street of the enforcement powers he has under New York’s tough securities laws. Comparing short sellers to “looters after a hurricane,” Cuomo announced that he was launching a probe of short sellers’ activities in shares of Lehman Bros. Holdings Inc., American International Group and other battered financial stocks.

NYSE Regulation and FINRA will also be conducting separate, parallel investigations in coordination with the SEC through on-site visits to various broker-dealers to address concerns about recent short selling activity.

Tips for Broker-Dealers to Ensure Compliance

In the wake of the announcement that regulators will monitor compliance with the SEC’s new Short Sale Rules, the SEC, along with FINRA and NYSE, provided the following guidance to assist firms in establishing policies, procedures and controls to avoid any potential failure to deliver securities:

  •  Borrowing – Actually borrow and obtain control of the securities you are selling prior to settlement, as opposed to entering into an agreement to do so at a later time.
  •  Arrangements to Borrow – Enter into a contract to borrow the security in order to ensure the firm will be able to settle the transaction in compliance with T+3 trading.
  •  Earmarking – Shares can be specifically earmarked for each arrangement to borrow to ensure compliance with T+3 trading.
  •  Maintain an inventory – Sustain an adequate inventory of securities in which the firm frequently executes short sales.
  •  Document the source of shares – If the customer relies on a broker-dealer other than the executing broker-dealer to settle a transaction, the settling broker-dealer should document the source of the customer’s pre-borrow.
  •  Encouraging timely affirmations – Institutional clients should develop efficient systems for confirmation and affirmation of trades to assure timely delivery of DVP trades.
  •  Direct market access/sponsored access – Firms may want to consider the practices outlined here in conjunction with their policies and procedures regarding short sales entered via direct market access or sponsored participant arrangements, such as documenting the source of pre-borrowed shares.