Yesterday, the Securities and Exchange Commission (the “Commission”) announced three changes to the short sale rules: (1) a hard T+3 close-out requirement; (2) a new anti-fraud rule addressing deceptive conduct in connection with abusive short selling; and (3) elimination of the options marketmaker exception to Regulation SHO. Each of these changes is described in detail below.

Also yesterday, SEC Chairman Christopher Cox announced that the Commission will consider, on an emergency basis, a new disclosure rule that would require hedge funds and other large investors to disclose their short positions in order “to ensure transparency in short selling.” The disclosure requirement under consideration would subject managers with more than $100 million invested in securities to public reporting of their daily short positions. We will keep you apprised of any developments with respect to this potential new reporting requirement.

In addition, Chairman Cox and SEC Enforcement Director Linda Thomsen announced an expansion of their ongoing investigations into alleged market manipulation, specifying that they will review the trading of “significant hedge funds and other institutional traders” and that “those institutions will also be required immediately to secure all of their communication records in anticipation of subpoenas for these records." This portends the issuance in the very near future of yet more subpoenas in the SEC’s already broad-ranging investigation of alleged market manipulation in the stock of a number of financial services companies.

New Short Sale Rules Effective September 18, 2008

The Commission issued a temporary order pending proposed rulemaking containing two new interim rules directed at “naked” short-selling of securities: (1) new Rule 204T (informally referred to as the “hard T+3 close-out requirement”) requiring that short sellers and their broker-dealers deliver securities by the close of business on settlement date; and (2) new Rule 10b-21 prohibiting misrepresentation and fraud by short sellers with respect to their intention or ability to deliver securities in time for settlement. The Commission also adopted a final rule eliminating the options market-maker exception from the close-out requirement in Rule 203(b)(3) of Regulation SHO. The above-mentioned rules will apply to the securities of all public companies. Rule 204T, Rule 10b-21 and the elimination of the options market-maker exemption are effective at 12:01 a.m. (EST) on Thursday, September 18, 2008, and apply to trades commenced on or after that date; they expire at 11:59 p.m. on October 1, 2008, unless extended by the Commission. The elimination of the options market-maker exception is also effective immediately; however options market makers will have 35 settlement days, from September 18, to close out any short positions previously within the scope of the exemption.

Rule 204T (Hard T+3 Close-Out Requirement): In addition to applying to the securities of all publicly traded companies, the new interim rule differs from the emergency relief adopted by the Commission this summer in that it does not require that broker-dealers pre-borrow shorted securities. Instead, it requires the broker-dealer to deliver the equity securities that are the subject of a long or short sale by the close of business on the third business day after the transaction date or “T+3.” If there has been a delivery failure, no later than the beginning of regular trading hours on the next settlement date following T+3, subject to certain exceptions noted below, the broker-dealer must either borrow or purchase the subject securities or it will be subject to a penalty whereby the brokerdealer and its clearing firm will be barred from effecting further short sales in the subject security on behalf of any client unless the shares are pre-borrowed. If there is a delivery failure and the clearing firm can document that the failure was in connection with a long position, then it has until the start of trading on the third settlement day following T+3 to close out the position through a buy-in. If there is delivery failure with respect to securities sold pursuant to Rule 144, then the broker-dealer has until the beginning of regular trading hours on the 36th settlement day after T+3 to close out the position through a buy-in.

New Antifraud Rule 10b-21: This rule was proposed by the Commission, in March 2008, specifically to impose liability on anyone found to have engaged in deceptive conduct in connection with “abusive short selling.” The new rule overlaps with the Commission’s general antifraud rules, and expressly states that it is “not intended to limit, or restrict, the applicability of the general antifraud provisions ….” In proposing the new rule, the Commission noted its concern regarding misrepresentations by sellers to broker-dealers about share ownership in an effort to do an end run around Regulation SHO's locate requirement (which applies to broker-dealers, not their customers) and mischaracterization of short sales as long sales. The proposing release refers to a settled enforcement action involving a hedge fund that had aggregated long derivatives holdings with short physical holdings and marked its sales as "long" when in fact it was “short” the underlying securities. The new rule imposes liability on any seller, including a broker-dealer trading for its own accounts, for misrepresentations to broker-dealers, clearing firms, or purchasers in connection with any long or short sale that resulted in a delivery failure. In addition, broker-dealers may be liable for aiding and abetting selling customers that run afoul of the new rule.

Given that the rule only applies where there has been a delivery failure, actions taken to prevent such failures could minimize or eliminate liability. In addition, as with the existing 10b-5 liability standards, the Commission must prove that the putative defendant acted with scienter (i.e., intentionally or recklessly) in order to establish a violation.

Elimination of Options Market-Maker Exception: Finally, the Commission approved a final rule, originally proposed in August 2007, eliminating the options market-maker exception to Regulation SHO, which has allowed designated options market makers to hedge existing options by selling short the underlying security even if the market maker had no ability to deliver the shorted security on settlement date. As a result of the elimination of this exception, options market makers will be required to comply with new Rule 204T.

Practical Considerations

The Commission delivered a message with yesterday’s press release that “these several actions today make it crystal clear that the SEC has zero tolerance for abusive naked short selling,” however, in its 2008 proposing release for antifraud Rule 10b-21, after stating that the new antifraud rule will apply to short sales “only if failure to deliver results,” the Commission acknowledged that 99% of all trades, by dollar value, do not involve any such delivery failure. Accordingly, the impact of the rulemaking initiatives may be limited to a relatively small constituency with the vast majority of ordinary course short selling in liquid securities unaffected.

Nonetheless, because any broker-dealer that fails to timely deliver shorted securities will be subject to the pre-borrow requirement for all short sales in the relevant security in the future, broker-dealers may require greater assurances regarding locates or even may impose their own pre-borrowing requirements for all short sales as prophylactic measures.

With regard to the elimination of the options market-maker exception, whether liquidity in the options market will be affected by the rule change likely will depend upon whether or not options market makers can find other means of hedging positions that are cost effective, such as through synthetic transactions.

Notably, the Commission did not extend the emergency relief that it adopted on an interim basis this summer (see Alerts – “SEC Issues Emergency Order Restricting Short Selling” (July 16, 2008) and “SEC Extends Emergency Relief Restricting Short Selling” (July 30, 2008)) to all publicly traded securities. It also did not reinstate the “uptick rule” or put into place any type of circuit-breakers aimed at curbing market volatility.