Alert October 21, 2008

SEC Eliminates Regulation SHO Options Market Maker Exception and Provides Guidance on Bona Fide Marketing for Purposes of the Reg SHO Market Maker Exception

The SEC amended Regulation SHO to eliminate the options market maker exception to the Regulation’s close out provisions for threshold securities (as defined in the Regulation).  The October 17, 2008 effectiveness of this amendment made permanent the temporary repeal of this exception effected by the SEC’s September 17, 2008 emergency order (the “September Emergency Order”) (as discussed in the September 18, 2008 Alert), which expired on October 17, 2008. 

Under the amendments, all fails to deliver in a threshold security resulting from short sales by a registered options market maker effected to establish or maintain a hedge on options positions established before the security became a threshold security will, like all other fails to deliver in threshold securities, have to be closed out in accordance with the close-out requirements of Regulation SHO.  The adoption of the amendments does not alter or add to the one-time 35 day phase-in period running from the effectiveness of the September Emergency Order.

In addition, the amendments prohibit any participant in a registered clearing agency (and any broker-dealer for which it clears transactions, including any market maker) from accepting any short sale orders or effecting further short sales in the particular threshold security without borrowing, or entering into a bona-fide arrangement to borrow, the security until the participant closes out the entire fail to deliver position by purchasing securities of like kind and quantity. 

The SEC also provided some additional new guidance regarding what it considers to constitute “bona fide” market making activity for purposes of the market maker exception to Regulation SHO’s “locate” requirement.  The SEC provided specific factors it would consider in determining what constitutes bona fide market making, indicating that the following factors would weigh in favor of finding that a dealer was engaged in bona fide market making: (1) when a dealer incurs economic or market risk with respect to the securities (e.g., by putting its own capital at risk to provide continuous two-sided quotes in markets); (2) when a dealer engages in a trading pattern that includes both purchases and sales in roughly comparable amounts to provide liquidity to customers or other broker-dealers; (3) in the course of fulfilling its obligations as a market maker, when a dealer provides liquidity to a security's market, takes the other side of trades when there are short-term buy-and-sell-side imbalances in customer orders, or attempts to prevent excess volatility.  Under the SEC guidance all such activities will result in the market maker assuming some market risk with respect to a particular trade or a related set of trades.  This guidance places a heightened importance on the assumption of market risk in determining whether a dealer is engaged in bona fide market making.  In addition to guidance regarding what would be considered bona fide market making, the SEC also provided additional examples of what would not be considered bona fide market making, including: (1) a market maker that continually executes short sales away from its posted quotes, and (2) a market maker that posts continually at or near the best offer, but does not also post at or near the best bid.