July 31, 2009

Update on SEC Actions Regarding Short Sales

Earlier this week the SEC adopted Rule 204 of Regulation SHO in final form, making permanent the delivery and close-out requirements for long and short sales that the SEC originally implemented as Interim Final Temporary Rule 204T in October of 2008. The SEC also announced that it would not renew Interim Final Rule 10a-3T that had required large institutional investment managers to file Forms SH disclosing to the SEC their short positions in certain 13F securities on a weekly basis. As a result, institutional investment managers were required to file their final Forms SH this week and will no longer be required to file Forms SH after August 1, 2009. However, the SEC announced that it will be working with various SROs (FINRA, NYSE and others) to make publicly available certain short sale volume and transaction data on the SROs’ public websites.

Rule 204 of Reg SHO

The SEC adopted Rule 204 of Regulation SHO in substantially the same form as interim final Rule 204T, with a few notable amendments. Thus, permanent Rule 204 (i) still requires brokers to deliver shares on long and short sales of publicly traded equity securities by settlement date, (ii) continues to require brokers to close-out fails to deliver by the beginning of trading on T+4 for short sales and T+6 for long sales, (iii) precludes clearing brokers and their introducing brokers from selling short a security, other than on a pre-borrowed basis, if a fail to deliver in that security is not timely closed out until the fail is closed out and that close-out transaction settles, (iv) allows clearing brokers to allocate fails to introducing brokers and (v) continues to permit brokers to rely upon pre-fail credit to satisfy Rule 204’s close-out requirement to avoid the pre-borrow requirements when a fail at a clearing broker has not been closed out. However, the SEC liberalized certain of these provisions in several regards. For example, permanent Rule 204 now allows a broker to close-out a fail on a long sale by borrowing the security, whereas Rule 204T had only permitted closing out long fails by buying-in, which should alleviate some of the buy-in risk for investors that experience long fails. Similar relief was extended to close-outs for market maker fails, so that a fail from a bona fide market making transaction (including short and long fails) can now be closed out by the beginning of trading on T+6 by borrowing the security. Further, Rule 204 now permits a broker to borrow securities to obtain pre-fail credit for early close-outs, whereas temporary Rule 204T only permitted pre-fail credit to be obtained by purchases of securities.

The SEC also amended Rule 204 by expanding the categories of securities eligible for close-out on T+36 if the seller of a security is “deemed to own” the security -- previously Rule 204T only allowed for this extended close-out deadline to apply to 144 sales, but now all sales of a security that the seller would be deemed to own under Rule 200(b) of Reg SHO can qualify for the extended close-out timeframe.

Notably, the SEC refused requests to extend the close-out deadline for fails to deliver to the close of business on the close-out deadline, choosing instead to retain the requirement that all fails be closed out by the beginning of trading on the applicable close-out deadline. The Commission also rejected requests for a de minimis fail to deliver exception that would have provided an exception from the close-out requirements if a clearing broker’s fail position was below a certain amount but said that it would continue to monitor whether a de minimis or odd lot exception could be warranted.

Form SH and Short Transaction and Volume Reporting

While the SEC has stated that it will not renew temporary Rule 10a3-T, thus making the weekly Form SH filing requirement inapplicable as of August 1, 2009, the SEC did announce that existing short sale information currently required to be provided to the various exchanges and SROs by broker-dealers will be made publicly available through the SROs’ public websites. This information will include (i) daily publication on SRO websites of aggregate short sale volume on each individual equity security; (ii) disclosure on SRO websites of “information regarding individual short sale transactions” in all exchange-listed equity securities, published on a one-month delayed basis; and (iii) enhanced disclosure on the SEC’s website of fails to deliver data so that fails to deliver information is provided twice per month and for all equity securities, regardless of the fails level.

Pursuant to SRO rules (e.g., FINRA Rule 4560) broker-dealers are already required to maintain records of aggregate short positions in all customer and proprietary firm accounts in listed and OTC equities and report such information to SROs as prescribed by the SROs. The short sale transparency initiative announced by the SEC earlier this week will utilize this information provided by broker-dealers. It was not clear from the SEC’s press release what exactly would constitute the “information regarding individual short sale transactions” that will be made public on SROs’ websites, leading many institutional investors and market participants to worry whether individual client-identifiable transaction and position data would be made public. However, the SEC staff has subsequently indicated that no client or customer identifiable information will be released on the SROs’ public websites.

*          *          *

The Commission is still considering various alternatives regarding the possible reinstatement of the uptick rule, but has not yet announced any definitive plans as to whether it will adopt a rule based on the last sale price, last public bid or whether a circuit breaker concept will be introduced. In addition, the Commission has stated that it will continue to examine whether additional measures are needed to further enhance market quality and transparency, as well as address short selling abuses, and that as part of its examination, it will hold a public roundtable on Sept. 30, 2009, that will consider possible additional short sale regulatory requirements, including, among other things, whether to (i) add a short sale indicator to the exchange trade reporting tapes, (ii) require public disclosure of individual large short positions and/or (iii) impose a pre-borrow or enhanced "locate" requirement on short sellers. We are continuing to monitor these and other developments and will be providing further updates and analysis as these issues evolve.