Alert September 30, 2008

SEC Issues Guidance on Treatment of Loaned Securities under Regulation SHO

The staff of the SEC (the “SEC staff”) issued guidance providing that securities out on loan will be deemed to be owned by the lender for purposes of the SEC’s short sale regulations, and therefore can be sold long, if the lender issues a bona fide recall of those securities within two days of the sale.  Prior to the guidance, lenders were concerned that they would not be deemed to own securities on loan for purposes of the various SEC short sale regulations, including Regulation SHO as amended by new Rule 204T, the SEC emergency short sale order banning short sales of financial stocks, and the new temporary Form SH short sale position reporting requirements.  Prior to the SEC staff’s issuance of this guidance, many brokers were marking sales of securities that were out on loan as short sales out of an abundance of caution due to uncertainty regarding the long-short status of the sales.  This resulted in an increased chance of involuntary buy-ins by brokers without pre-notice to lenders.  As a result of this uncertainty, many lenders had considered significantly reducing their participation in securities lending programs, which could have further impacted volume and liquidity of the markets.  This guidance from the SEC staff now makes clear that lenders will not be deemed to have sold short when they sell securities out on loan, provided a recall is effected within two days of the sale.  This is significant because new Rule 204T under Regulation SHO provides that a broker can close-out a delivery failure on a long sale by making a close-out purchase any time before trading begins on the sixth settlement day after the long sale, which means that lenders who sell their loaned securities long have three additional days to buy themselves in so as to not experience a failure to deliver in violation of Rule 204T.  If the sale of loaned securities were deemed “short,” Rule 204T requires a failure to deliver to be closed out no later than the beginning of trading on T+4.  These extra two days for long sales give lenders a greater chance of receiving their loaned securities back from the borrower so that they can deliver the shares before the close out date on T+6 and thus reduces the likelihood that lenders will be bought-in involuntarily by their clearing brokers.