The Securities and Exchange Commission recently published amendments to Regulation SHO that will implement a new short sale price test restriction. The amendments are aimed at preserving stability and efficiency in the market by limiting short selling in a security whose price has decreased by 10% or more in a single day.

Background

Short selling involves the sale of a security that the seller does not own or a sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. Historically, short selling in the U.S. markets had been subject to longstanding restrictions, in the form of a price test (also known as the “uptick rule”) under former Rule 10a-1 under the Securities Exchange Act of 1934, which applied to exchange-listed securities, and a bid test under former rules of the NASD, which applied to certain Nasdaq securities. Both of these tests were eliminated in July 2007 after the SEC conducted extensive studies, ran a pilot program, and sought and considered public comment on the effects of eliminating restrictions on short selling.

In the period following the elimination of these short selling restrictions, substantial changes in market conditions, including turmoil in the financial sector, extreme volatility in prices of securities and ensuing deterioration of investor confidence, led the SEC to issue a series of emergency orders affecting short selling and subsequently to adopt new permanent rules, including a requirement to close out short sales within three days after the transaction date. In connection with these rulemakings, the SEC decided to re-consider the adoption of price test restrictions on short selling and proposed amendments to Regulation SHO in April 2009 (and re-opened the proposal for comment in August 2009). These proposals included several variations of short sale price tests and circuit breaker restrictions for consideration.

Short Sale Price Test Restriction

As adopted, the new version of Rule 201 combines a price test with a circuit breaker trigger. Generally, any securities listed on a national securities exchange (whether traded on an exchange or the OTC market) are covered by Rule 201. The circuit breaker is triggered on any day when a covered security's price decreases by 10% or more from the previous day's closing price. After tripping the circuit breaker, no short sales at or below the current national best bid are permitted for the remainder of that day or the following trading day.

The 10% circuit breaker threshold of Rule 201 will likely impact only a small subset of securities (i.e., those facing substantial price decreases in a single day). Based on trading data research, the SEC estimated that, between 2001 and 2009, approximately 4% of covered securities would have been affected by the short sale price test restriction had it been in place during that time. During the less volatile period from 2004 to 2006, only about 1.3% of covered securities would have been affected.

Role of Trading Centers

Under the amended rules, a trading center (which is defined to include any entity that may execute short sale orders) is responsible for establishing, maintaining and enforcing written policies and procedures that are reasonably designed to (i) prevent execution or display of a short sale order of a security that has triggered the circuit breaker and (ii) impose the short sale price test restriction for the required timeframe. Also, a trading center must assess its policies and procedures regularly and take any remedial actions promptly.

Exemptions

Rule 201 contains a list of exceptions for short sale orders submitted by broker-dealers in the following circumstances: (i) where the seller intends to deliver the security as soon as delivery restrictions are removed, (ii) certain odd-lot transactions, (iii) certain domestic and international arbitrage transactions, (iv) over-allotments or lay-off sales conducted by underwriters or syndicate members, (v) certain riskless principal transactions and (vi) certain transactions on a volume-weighted average price basis. For these exceptions, broker-dealers should mark the short sale orders as “short-exempt” where they have reasonable basis to believe that is the case. Rule 200(g) was revised to allow for marking orders “short-exempt” as opposed to either “long” or “short.”

In addition to the enumerated list of short-exempt orders, Rule 201 also contains a provision for exemptive procedures, pursuant to which the SEC may grant exemptive relief either upon written request or its own motion, and with or without conditions attached to such relief, when the SEC determines that it is necessary or appropriate in the public interest and consistent with the protection of investors.

Implementation of New Rules

Though the SEC considered whether to conduct a pilot study of the new rules on only certain securities, it opted not to do so. The amendments to Regulation SHO will become effective as of May 10, 2010, and are subject to a six-month implementation period, with an ultimate compliance date of November 10, 2010, in order to provide market participants with sufficient time to prepare and revise their policies, procedures and systems.