Late yesterday, the Securities and Exchange Commission (“SEC”) issued an Emergency Order adopting, effective at midnight last night, a new temporary rule, Rule 204T of Regulation SHO, that (1) prohibits clearing brokers from failing to deliver shares on both long and short sales by settlement date and (2) imposes penalties on both clearing brokers and the broker-dealers who send them trades for clearance and settlement, including market makers, when a clearing broker does not close out failures to deliver on long and short sales within the timeframes specified in Rule 204T. The Emergency Order implementing new Rule 204T terminates at 11:59 a.m. (EST) on Wednesday, October 1, 2008 but can be renewed by the SEC. In the same Emergency Order, the SEC also made effective as of midnight last night its previously proposed amendments to Regulation SHO that eliminate the options market maker exception from Regulation SHO’s close out requirements for threshold securities. The Emergency Order also made effective immediately the SEC’s previously proposed new Rule 10b-21, which implements specific rule-based antifraud provisions regarding certain naked short selling activities.
Also last night, Chairman Cox announced his intention for the SEC to adopt new rules requiring certain large institutional managers to publicly disclose their daily short positions in equity securities and specifically mentioned hedge funds as being one of the primary targets of the contemplated short position reporting requirements.
Rule 204T – Enhanced Delivery Requirements
Citing “sudden and unexplained declines in the prices of securities” and the danger to the broader market of “a crisis of confidence without a fundamental underlying basis,” the SEC reacted to the recent turmoil in the US equity markets by adopting on an emergency and temporary basis new Rule 204T. Temporary Rule 204T imposes enhanced delivery requirements mandating delivery of shares on both long and short sales by settlement date and imposes a pre-borrow requirement for short sales in a particular stock that is triggered whenever a clearing broker has failed to deliver on a sale and does not close out the fail within the timeframes required by the rule, as discussed in more detail below. In the press release announcing the new rule, the SEC stated that the rule imposes “hard T+3 closeout requirements that effectively ban naked short selling.”
New Delivery Requirement For Both Long and Short Sales: The enhanced delivery requirements of Rule 204T require clearing firms to either (a) deliver shares on all long and short sales of a publicly traded equity security by “settlement date” or (b) close out any failures to deliver in that equity security by the different timeframes set forth in Rule 204T for short and long sales. Any failure to deliver position that the clearing broker has at a clearing agency in the equity security that resulted from a short sale must be closed out by the clearing broker no later than the beginning of trading on the settlement day following the settlement date for the short sale that caused the failure to deliver (i.e., close out by beginning of T+4 from the original short sale). Fails that the clearing broker can demonstrate were due to a long sale must be closed out no later than the beginning of trading on the third settlement date following the settlement date of the failed long sale (i.e., by the beginning of T+6 from the long sale). Fails on short sales can be closed out by the clearing firm by either borrowing or purchasing the security that was the subject of the fail, while fails caused by long sales can only be closed out by the clearing firm by purchasing the security.
Notably, this rule does not make every failure to deliver by T+3 a violation of the rule. Rather, a failure to deliver can be cleaned up and will not constitute a violation of Rule 204T if the fail is timely closed out by the clearing firm either borrowing or purchasing, as applicable, the same security that was the cause of the fail. It should also be noted that settlement of the close out transaction is not required for a clearing broker to satisfy the close out provisions of Rule 204T and thereby avoid a violation of the rule.
Penalties for Failing to Close Out: If a clearing broker has a fail for either a long or short sale of an equity security that it does not close out in compliance with the provisions above, then the penalty provisions of Rule 204T kick in. The penalty provisions prohibit a clearing broker with a fail position in an equity that has not been closed out in accordance with Rule 204T from effecting any further short sales in the same security, either for its own account or for the account of any introducing brokers or market makers for which is acts as clearing broker, unless the security is “pre-borrowed” (i.e., either the clearing broker actually borrows the security before short selling or has entered into a bona-fide arrangement to borrow the security). This pre-borrow requirement stays in effect until the clearing broker has closed out the fail that triggered the penalty provisions by purchasing the security and until the close-out purchase transaction effected by the clearing broker has settled.
In addition to restricting the clearing broker who has a fail position in an equity security, the penalty provisions of Rule 204T also apply to any other broker-dealer who uses the clearing broker to clear and settle its trades, including introducing brokers and market makers. This means that, if an introducing broker uses a clearing broker that fails to deliver an equity security and the clearing broker does not close out the fail in accordance with Rule 204T, then the introducing broker is prohibited from accepting a short sale order for the security from any of its customers unless the security has been pre-borrowed, until the clearing broker closes out the fail and the close out purchase has settled. This also means that market makers who clear and settle their trades with the clearing broker who has not closed out the fail properly would be prohibited from effecting a short sale of the security for their own accounts unless they have pre-borrowed the security, until the clearing broker’s close-out purchase has settled - this effectively eliminates the market maker locate exception of Regulation SHO for any market makers that are not self-clearing firms.
A very important aspect to note with regard to Rule 204T is that, despite statements by the SEC in the press release announcing the new rule that it would apply to “short sellers and their brokers,” the enhanced delivery requirements of Rule 204T only directly apply to clearing firms, and the penalty provisions of the new rule only apply to clearing brokers and the brokers that use them for clearance and settlement of their trades. While it is clear that in practice clearing firms and the brokers that clear through them will in effect force their customers to ensure that shares are available to deliver on both short and long sales so that the clearing firms and introducing firms do not fail to deliver in violation of Rule 204T, Rule 204T does not actually impose a delivery requirement or a pre-borrow requirement on non-broker-dealers as the SEC had indicated it would in the press release. As such, the SEC’s “effective” ban in naked shorting will be effected by the clearing firms that accept trades for clearance and settlement and the introducing firms that accept orders for execution, while non-broker-dealers are not subject to violations of Rule 204T.
Repeal of Reg SHO Options Market Maker Exception
The Emergency Order also immediately made effective the amendments the SEC proposed in August of 2007 to eliminate the options market maker exception to the Reg SHO close out provisions for threshold securities. As now amended, Reg SHO requires any clearing broker with a fail position in a threshold security (as defined in Reg SHO) to close out within 35 days of today all fail positions in an equity security that were attributable to options market makers that were previously excluded from the close-out provisions of Reg SHO. The amended rule also prohibits any clearing firm and any broker-dealer that clears through the clearing broker from either accepting short sale orders for a threshold security or effecting transactions for its own account in the threshold security if the clearing firm has a fail to deliver position in the threshold security for 35 days from today.
Rule 10b-21 Short Selling Antifraud Rule
The Emergency Order also adopted immediately the new naked shorting provisions set forth in Rule 10b-21 under the Securities Exchange Act of 1934, which was proposed in March of this year. Rule 10b-21 makes it a violation of the Exchange Act’s antifraud provisions for any person (not just brokers or dealers) who enters a short sale order for an equity security to deceive a broker-dealer or clearing firm regarding such person’s ability to deliver the security before settlement date if such person ends up failing to deliver the security. In effect, this new rule does not impose any new prohibitions against naked short selling, but rather it is intended by the SEC to highlight in a specific rule and in an express manner that certain actions in connection with short selling are, and have always been, fraudulent. These actions include, but are not limited to: (1) misrepresenting that a sale was long when in fact it was short, (2) misrepresenting or making a false statement regarding the location of borrowed shares and (3) misrepresenting that shares have been located or pre-borrowed when in fact they have not been.
Links to the Emergency Order, which contains the text of the new rules, and the SEC’s press release announcing the new rules can be found at:
Emergency Order: http://www.sec.gov/rules/other/2008/34-58572.pdf
SEC Press Release: http://www.sec.gov/news/press/2008/2008-204.htm