On Feb. 24, 2010, the Securities and Exchange Commission (“SEC”) voted 3-2 to adopt a new rule restricting short selling when the price of a security has dropped more than 10 percent from its prior day’s closing price. Rule 201—the “alternative uptick rule”—provides that once the 10 percent “circuit-breaker” has been triggered, all short sales must be above the national best bid (“NBB”) for that security, through the end of the following day. Securities exchanges, broker-dealers and other “trading centers” will have at least eight months to implement policies and procedures to comply with the new Rule.1
As discussed in our June 4, 2009, client memorandum, available here, the SEC considered several variations of short-selling restrictions in its initial rule proposal and solicited additional comments on the “alternative uptick rule” on Aug. 17, 2009.2 In adopting Rule 201, SEC Chairman Mary Schapiro stated that “the rule is designed to preserve investor confidence and promote market efficiency, recognizing short selling can potentially have both a beneficial and a harmful impact on the market.”
Further detail with respect to Rule 201 and its application will be provided when the rule and its adopting release are published. The following is a brief review of the Rule.
- Covered Securities: The new rule applies to all equities listed on a national securities exchange, whether traded on an wxchange or in the over-the-counter market.
- Short Sale-Related Circuit Breaker: The circuit-breaker restrictions upon a security are triggered when the price of that security declines by 10 percent or more from its prior day’s closing price. The security’s listing market is responsible for determining whether the circuit breaker has been triggered.
- Price Restriction Period: Once the circuit breaker is triggered, short sales at or below the NBB are prohibited for the remainder of that day as well as the following day, unless one of the exemptions (discussed below) applies.
- Trading Centers’ Responsibilities: Broker-dealers, exchanges and other entities that function as “trading centers”3 will be required to establish, maintain and enforce policies and procedures reasonably designed to prevent the execution or display of prohibited short sale orders.
- Exemptions: Where a circuit-breaker restriction is in effect, the new rule will nonetheless permit trading centers to display or execute short sales at or below the NBB under certain circumstances, including where: (1) a seller owns the stock but is experiencing a delivery delay; (2) a market maker attempts to offset or liquidate an odd lot trade; (3) short sales are part of domestic or international arbitrage transactions; (4) an underwriter executes short sales in connection with over-allotments and “lay-off sales” as part of a distribution of securities; (5) transactions involve volume weighted average pricing; and (6) short sales facilitate a “riskless principal” trade. Broker-dealers routing such orders to trading centers must mark them as “exempt.”
During yesterday’s open meeting, at which the Commission voted to adopt Rule 201, certain key themes emerged. The support of the three Commissioners who voted for the adoption of the Rule—Chairman Mary Schapiro and Commissioners Elisse Walter and Luis Aguilar—was largely premised on their belief that downward pressure on the price of a stock results in a loss of investor confidence, which can have a detrimental impact on the market as a whole. While acknowledging that price restrictions can negatively impact market efficiency and create additional compliance costs on the industry, these Commissioners noted that the new Rule was narrowly focused on those securities with significant downward price pressure, thereby largely preserving the benefits of short selling in other circumstances. Commissioners Kathleen Casey and Troy Paredes, who opposed the adoption of the new Rule, noted the absence of empirical evidence indicating that short sale price restrictions counteract rapid market declines. Their comments focused on the positive hedging, liquidity and price discovery benefits of short selling. Commissioner Casey warned that adoption of the rule would compromise the SEC’s credibility with respect to the circumstances under which it engages in rulemaking and also would be ineffective in achieving the goal of market stability.
While the adopting release has not yet been published, the new Rule appears to impose liability on trading centers—including broker-dealers that are over-the-counter market makers or that execute orders internally by trading as principal or crossing orders as agents—where violations of the short-selling restrictions occur due to a trading center’s failure to implement policies and procedures reasonably designed to prevent the execution or display of prohibited short sale orders. As a practical matter, the new Rule will significantly impact the manner in which short sales are executed once a circuit breaker has been triggered and, hence, will impact “buy side” traders who engage in short selling.
The new Rule’s impact upon such traders will largely depend upon what types of policies and procedures are adopted by trading centers to comply with their obligations under the Rule. For example, it remains to be seen whether trading centers will program their systems to reject any short sale orders at bids that are at or below the NBB for the relevant security upon a circuit breaker being triggered, or will “hold” those orders until marketable, effectively treating them as limit orders. Another open question is what procedures, if any, will be implemented by such trading centers to detect abusive use of short sale exemptions and what representations will be required in support of marking a short sale order as “exempt.”4 The SEC may shed some light on these issues when it publishes the adopting release for the new Rule; however, the Rule’s full impact will not be known until the new system controls have been put into place and are triggered.
During yesterday’s open meeting, the SEC staff assured the Commissioners that, given concerns that the Rule may have unintended adverse effects on short selling, the staff will monitor implementation and provide exemptive relief, where appropriate.