In October 2008, in response to the unusual U.S. market conditions at that time, the U.S. Securities and Exchange Commission (the "SEC") enacted temporary Rule 204T, which imposed and enhanced delivery requirements on sales of all equity securities, and temporary Rule 10a-3T, which required the reporting of short-sales by certain institutional investment managers.1 The SEC intended the temporary rules to provide powerful disincentives to persons who might exacerbate artificial price movements through "naked" short selling and to make short sales more transparent. Temporary Rule 204T was set to expire on July 31, 2009. However, because of the positive impact temporary Rule 204T has had on reducing failures to deliver securities ("fails to deliver"), on July 27, 2009 the SEC adopted the provisions of temporary Rule 204T, with limited modifications, in permanent Rule 204 of Regulation SHO.2 On the same day, the SEC decided not to extend or renew temporary Rule 10a-3T beyond its expiration date of August 1, 2009.
A short sale of a security occurs when a seller sells a security he does not own. In such a situation the seller is required to either buy or borrow securities to deliver to the purchaser. In a "naked" short sale, however, the seller does not borrow or purchase the securities in time to make delivery to the purchaser when delivery is due, which is typically three days after the trade date. Occasionally sellers intentionally fail to deliver securities in order to manipulate the price of a security or to avoid borrowing costs associated with short sales.
Rule 204
The SEC created Rule 204 to address its concerns about the negative impact fails to deliver have on the markets and shareholders. Unlike the close-out requirements of Rule 203 of Regulation SHO, which only apply to threshold securities3, the close-out requirements of Rule 204 apply to fails to deliver in all equity securities.
Close-Out Requirements
Rule 204(a), as adopted, requires that short sellers and their broker-dealers deliver securities by the close of business on the settlement date (trade date ("T"+3), and imposes a penalty on any participant of a registered clearing agency, and any broker-dealer from which it receives trades for clearance and settlement, for having a fail to deliver position at a registered clearing agency in any equity security. If a clearing agency participant has a fail to deliver position at a registered clearing agency in any equity security for a long or short sale transaction in that equity security, the participant must, by no later than the beginning of regular trading hours on the settlement day following the settlement date (T+4), immediately close out the fail to deliver position by borrowing or purchasing securities of like kind and quantity.
Subsections (a)(1) through (3) of Rule 204 set forth certain circumstances in which a participant has additional time to close out a fail to deliver position. Subsections (a)(1) and (a)(3) provide that, subject to certain conditions, fails to deliver resulting from long sales or certain bona fide market making activity must be closed out by no later than the beginning of regular trading hours on the close-out date (T+6). The final version of Rule 204 allows participants to close out a fail to deliver position at a registered clearing agency resulting from a long sale or attributable to bona fide market making activities by a market maker by either purchasing or borrowing securities. Under temporary Rule 204T, participants were not allowed to borrow the securities to close out the fail to deliver.
Subsection (a)(2) of temporary Rule 204T applied only to fail to deliver positions resulting from Rule 144 sales. However, the SEC expanded the scope of this section in final Rule 204 to cover any equity security a person is "deemed to own" pursuant to Rule 200 of Regulation SHO and that such person intends to deliver as soon as all restrictions on delivery have been removed. If a broker-dealer has a fail to deliver position in a security it is "deemed to own," it must, no later than the beginning of regular trading hours on the thirty-fifth consecutive calendar day4 following the trade date for the transaction, immediately close out the position by purchasing securities of like kind and quantity.
Borrowing Requirement
If a broker-dealer fails to comply with the close-out requirements described above, the broker-dealer violates the close-out requirement of the rule. Rule 204(b) imposes on the broker-dealer a requirement to borrow or arrange to borrow securities prior to accepting or effecting further short sales in the security for which it has a fail to deliver position until the broker-dealer closes out its fail to deliver position by purchasing the securities and the purchase has cleared and settled.5
Credit For Early Close-Outs
As adopted, Rule 204(e) allows broker-dealers to obtain credit ("pre-fail credit") for purchases or borrows to close out fails to deliver positions resulting from short sales.6 In order to obtain such credit, the purchase or borrow must be executed after the trade date, but no later than the end of regular trading hours on the settlement date (T+3) for the transaction. In addition, the broker-dealer must purchase or borrow a quantity of securities sufficient to cover the entire amount of that broker-dealer's fail to deliver position at a registered clearing agency in that security. The pre-fail credit exempts the broker-dealer from the pre-borrow requirements described above.
Allocation Of Fail To Deliver Position
Under subsection (d) of Rule 204, a clearing agency participant may allocate a portion of a fail to deliver position to another broker-dealer for which it clears trades or from which it receives trades for settlement, based on such broker-dealer's short position. In such a situation, the provisions of Rule 204(a) and (b) apply to the broker-dealer that was allocated the position, not the participant.
Sham Close-Outs
Subsection (f ) of Rule 204 provides that a participant of a registered clearing agency will not be deemed to have fulfilled the close-out requirements of Rule 204 if it enters into an agreement with another person to purchase or borrow securities and the participant knows, or has reason to know, that the other person will not deliver securities in settlement of the purchase or borrow.
Expiration Of Rule 10a-3T And Form SH Filing Requirement
Pursuant to temporary Rule 10a-3T, which was adopted by the SEC in October 2008, certain institutional investment managers were required to file with the SEC weekly reports on Form SH disclosing short sale and short position information. The SEC chose to allow Rule 10a-3T, and the corresponding requirement to File Form SH, to expire on August 1, 2009.
The SEC is working with several self-regulatory organizations ("SRO") to make short sale volume and transaction data available through the SRO web sites in the next few weeks. The data will contain significantly more information about short sales and short positions than what was required by temporary 10a-3T.
Roundtable Discussion
The SEC will hold a public roundtable on September 30, 2009 to solicit the views of investors, issuers, financial services firms, self-regulatory organizations and the academic community regarding a variety of trading and market related practices. The roundtable will focus on issues related to securities lending, pre-borrowing, and possible additional short sale disclosures.
Footnotes
1. SEC Release No. 34-58733 (October 14, 2008); SEC Release No. 34-58785 (October 15, 2008).
2. SEC Release No. 34-60388 (July 27, 2009). Rule
203(c)(6) of Regulation SHO defines a "threshold
security" as any equity security of an issuer that is
registered pursuant to section 12 of the Securities Exchange Act
(the "Exchange Act") or for which the issuer is
required to file reports pursuant to section 15(d) of the Exchange
Act:
(i) for which there is an aggregate fail to deliver position for
five consecutive settlement days at a registered clearing agency of
10,000 shares or more, and that is equal to at least 0.5% of the
issue's total shares outstanding; and
(ii) is included on a list disseminated to its members by a
self-regulatory organization.
A security shall cease to be a threshold security if the aggregate
fail to deliver position at a registered clearing agency does not
exceed the level specified in paragraph (i) above for five
consecutive settlement days.
4. Temporary Rule 204T(a)(2) imposed a delivery time-frame of 36 consecutive settlement days from the settlement date. The SEC revised the close-out period in Rule 204(a)(2) to require delivery within 35 consecutive calendar days from the trade date; thereby tracking the delivery period required in Rule 203(b)(2)(ii) of Regulation SHO.
5. The SEC removed from the final version of Rule 204, the exception found in temporary Rule 204(b) to the pre-borrow requirements for market makers.
6. Under Temporary Rule 204T(e), broker-dealers could not obtain pre-fail credit by borrowing the security.
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