In October 2008, the US Securities and Exchange Commission (the "SEC"), responded to the crisis in the financial markets by adopting a series of temporary and permanent measures designed to curb "naked" short-selling and restore confidence in US financial institutions by adopting amendments to Regulation SHO (the "Amended Rules"). As part of the Amended Rules, the SEC adopted Temporary Rule 204T in October 2008 to strengthen close-out requirements and provide other restrictions on, and penalties for, "fails to deliver"1. Effective 31 July 2009, Temporary Rule 204T was made permanent by means of new Rule 204, with certain modifications. The key provisions of the new Rule 204 are summarised below. In addition, the SEC has announced it intends to hold a public discussion on short-selling rules and related topics, with an eye towards additional rule-making in this area, on 30 September 2009.

Hard Close-Out Requirements

Under the new Rule 204, participants of registered clearing agencies (such as broker-dealers) are required to deliver equity securities to such clearing agencies no later than the "settlement date" for both long and short sale equity transactions. The "settlement date" in this context means that investors must complete their security transactions by delivering cash or securities within three business days of the trade date — or "T+3". In the event securities are not delivered by the settlement date, the participant is required to close out the "fail" position as follows:

  1. no later than the beginning of regular trading hours on the business day after the settlement date — ie, the morning of T+4 — for a long or a short sale in any equity security;
  2. no later than the beginning of regular trading hours on the third business day after the settlement date — ie, the morning of T+6 — for fails that the participant can demonstrate resulted from a long sale or that were attributable to a bona fide market-making activities; and
  3. within 35 business days after the settlement date — ie, the morning of T+39 — for any securities sold pursuant to Rule 144 under the Securities Act, or for the securities that the seller is "deemed" to own.

Rule 204 requires a participant to close out fail positions resulting from short sales, long sales, or market-making activities by either borrowing or purchasing the relevant securities. Under temporary Rule 204T, a participant was permitted to either borrow or purchase securities to close out short fails, but if the fails resulted from long sales or market-making activities, it could only close out such fails by purchasing the relevant securities.

Consequences of Violation

If a participant does not close out fail positions within the prescribed time frames under Rule 204, it will be prohibited from accepting a short-sale order or effecting a short-sale order in the same security without first actually borrowing the security or entering into a bona-fide arrangement to borrow the security. It is not sufficient that the participant is able to merely "locate" the security, ie, to determine that the subject securities are generally available to be borrowed. This "pre-borrow" requirement remains in place until the participant closes out the fail position by purchasing the security and the purchase has cleared and settled at a registered clearing agency.

These restrictions apply not only to participants in clearing agencies with fail positions, but to any broker-dealer from which the participant has received a fail. A participant with a fail position must also notify broker-dealers with which it does business:

  1. that it has a fail position; and
  2. when the fail position has been cleared and settled.

Rule 204 removes the exception from the pre-borrow penalty under temporary Rule 204T for market makers that do not have an open short position in the security at the time of any additional short sales. The SEC reasoned that such exception is not necessary because a market maker, like any broker-dealer, is excepted from the borrowing requirements if it certifies to the participant in a timely manner that it has not incurred a fail or that it has taken steps to close out a fail.

Credit for Early Close-outs

Under Rule 204, a broker-dealer can avoid close-out requirements or pre-borrow requirements resulting from a fail if it engages in a bona fide borrowing or purchase of sufficient securities in compliance with certain conditions. In contrast to temporary Rule 204T, Rule 204 allows a broker-dealer to borrow as well as to purchase the securities in order to obtain "pre-fail credit", which will offset a subsequent "fail to deliver." To qualify for the credit, a broker-dealer needs to acquire an amount of securities equal to the amount of the fail position, rather than equal to the amount of the broker-dealer's entire open short position as was required under temporary Rule 204T.

Securities Eligible for Extended Close-out Period

Rule 204 extends the close-out period to 35 consecutive calendar days after the settlement date for fails of certain securities, and expands the universe of securities eligible for this extended close-out period. Under Rule 204T, only Rule 144 securities were eligible for the extended close-out, whereas under Rule 204, eligibility has expanded to include all securities the seller is "deemed to own" and intends to deliver as soon as all restrictions on delivery have been removed. Such circumstances include a situation where a convertible security, option or warrant has been tendered for conversion or exchange but the underlying security is not reasonably expected to be received by settlement date. It should be noted that Rule 204 also reduces the close-out period to 35 consecutive calendar days after the settlement date from the 36 consecutive business days after the settlement date prescribed under the temporary rule.

Short-Sale Disclosure

Finally, in adopting Rule 204, the SEC allowed temporary Rule 10a-3T and Form SH to expire. Temporary Rule 10a-3T required certain institutional investment managers to file with the SEC on a weekly basis a non-public Form SH, reporting daily short-sale information.

Further Developments

The SEC announced that it is working with Self-Regulatory Organizations ("SROs") to make public the following information:

  1. daily aggregate short sale volume in each equity security;
  2. individual short sale transaction information one month after they occur; and
  3. twice monthly publication of fails to deliver rather than once quarterly, for all equity securities, regardless of the level of such fails2.

The full text of the new Rule 204 can be found at The new Rule 204 became effective on 31 July 2009.