Amendments to Exchange Act Rules 203(b)(3) and
200(e) of Regulation SHO

A Small Entity Compliance Guide¹

I. Introduction

The Securities and Exchange Commission adopted amendments to Rule 203(b)(3) of Regulation SHO under the Securities and Exchange Act of 1934 to further reduce fails to deliver in certain equity securities by eliminating the "grandfather" provision under the rule. The Commission also modified the close-out requirement of Regulation SHO for fails to deliver resulting from sales of threshold securities pursuant to Rule 144 of the Securities Act of 1933 ("Securities Act"). In addition, the Commission updated the market decline limitation referenced in Rule 200(e) of Regulation SHO.

II. Background

A. Regulation SHO and Short Selling

Regulation SHO, which became fully effective on January 3, 2005, sets forth a regulatory framework governing short sales. Short selling involves a sale of a security that the seller does not own and any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. In order to deliver the security to the purchaser, the short seller will borrow the security, typically from a broker-dealer or an institutional investor. The short seller later closes out the position by purchasing equivalent securities on the open market. In general, short selling is used to profit from an expected downward price movement, to provide liquidity in response to unanticipated demand, or to hedge the risk of a long position in the same security or in a related security.

B. Regulation SHO's Close-Out Requirement

Among other things, Regulation SHO includes a close-out requirement intended to address persistent failures to deliver stock on trade settlement date ("fails to deliver"). A "fail to deliver" occurs when a broker-dealer fails to deliver securities to the party on the other side of the transaction on settlement date (i.e., T+3). Regulation SHO's close-out requirement provides that a participant of a registered clearing agency must take action to close-out fails to deliver in securities in which there are a relatively substantial number of extended fails to deliver at a registered clearing agency ("threshold securities") if the fails to deliver have persisted for 13 consecutive settlement days. The participant must close-out such fails to deliver by purchasing securities of like kind and quantity. Until the position is closed out, the participant and any broker-dealer for which it clears transactions, including market makers, may not effect further short sales in that 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 (also known as the "pre-borrow" requirement).

C. The "Grandfather" Exception and its Elimination

As adopted, Regulation SHO included a "grandfather" exception to the close-out requirement which provided that a participant of a registered clearing agency did not have to close out any fail to deliver position in a threshold security that existed on the settlement day immediately preceding the day on which the security became a threshold security.

On August 7, 2007, the Commission amended Regulation SHO to eliminate the grandfather exception to the rule's close-out requirement. The amendment became effective on October 15, 2007. The amendment included a one-time phase-in period which allowed participants to close out fails to deliver in threshold securities that existed on the effective date of the amendment (October 15, 2007) within 35 consecutive settlement days of the effective date. The phase-in period ended on December 5, 2007.

D. Sales of Threshold Securities under Rule 144 of the Securities Act

On August 7, 2007, the Commission also amended Regulation SHO to extend the close-out requirement from 13 to 35 consecutive settlement days for fails to deliver resulting from sales of threshold securities under Rule 144 of the Securities Act (i.e., restricted securities). In addition, the Commission added a pre-borrow requirement for these fails to deliver. Accordingly, if the fail to deliver position persists for 35 consecutive settlement days, the amendment prohibits a participant of a registered clearing agency, and any broker-dealer for which it clears transactions, including market makers, 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.

E. Rule 200(e)(3) of Regulation SHO

The Commission also amended Rule 200(e)(3) of Regulation SHO. Regulation SHO requires sales to be marked "long" or "short." Rule 200(g) states that a sale can be marked "long" only if the seller is deemed to own the security being sold and either the security is in the physical possession or control of the broker or dealer or it is reasonably expected that the security will be in the physical possession or control of the broker or dealer no later than the settlement of the transaction. Rule 200(c) provides that a person is "deemed to own" a security only to the extent that he has a net long position in such securities.

Rule 200(e)(3) of Regulation SHO provides a limited exception from the requirement that a person selling a security will only be deemed to own a security if it is net long. This provision provides that a broker-dealer will be deemed to own a security even if it is not net long if the broker-dealer is unwinding an index arbitrage position involving long baskets of stocks and short index futures or options if, and to the extent that, the short stock positions are fully hedged. As originally contained in Regulation SHO, this exception was not available if the sale occurred during a period commencing at a time when the Dow Jones Industrial Average ("DJIA") had declined below its closing value on the previous trading day by at least two percent and terminating upon the establishment of the closing value of the DJIA on the next succeeding trading day.

The Commission amended the Rule to: (i) reference the NYSE Composite Index ("NYA") instead of the DJIA; (ii) add language to clarify how the two percent limitation is to be calculated for purposes of the market decline limitation; and (iii) provide that the market decline limitation will remain in effect for the remainder of the trading day.

III. How do the amendments to Regulation SHO affect small-business entities?

The entities covered by the amendments discussed above include small entities that are participants of a registered clearing agency, and small broker-dealers for which the participant clears trades or for which it is responsible for settlement. In addition, the entities covered by these amendments include all small entities that effect sales subject to the requirements of Regulation SHO.

The amendments may have imposed some new or additional reporting, recordkeeping, or compliance costs on small entities that are participants of a clearing agency registered with the Commission. In order to comply with Regulation SHO when it became effective in January 2005, small entities needed to modify their systems and surveillance mechanisms. As a result, the infrastructure necessary to comply with the 2007 amendment regarding elimination of the grandfather provision has likely been in place since the modifications were made in 2005 to comply with Regulation SHO. Any additional changes to the infrastructure are expected to be minimal. In adopting the amendments, the Commission stated its belief that no specialized professional skills will be necessary to comply with these new requirements.

Other Resources

The proposing release for these amendments to Regulation SHO can be found on the SEC's website at http://sec.gov/rules/proposed/2006/34-54154.pdf. The adopting release for the amendments can be found on the SEC's website at http://sec.gov/rules/final/2007/34-56212.pdf.

Contacting the SEC

The SEC's Division of Trading and Markets is happy to assist small entities with questions regarding these amendments to Regulation SHO. The Division's Office of Interpretation and Guidance answers questions submitted by telephone at (202) 551-5777 or by e-mail at tradingandmarkets@sec.gov.

¹ This guide was prepared by the staff of the U.S. Securities and Exchange Commission as a "small entity compliance guide" under Section 212 of the Small Business Regulatory Enforcement Fairness Act of 1996, as amended. The guide summarizes and explains rules adopted by the SEC, but is not a substitute for any rule itself. Only the rule itself can provide complete and definitive information regarding its requirements.

http://www.sec.gov/divisions/marketreg/tmcompliance/rules203b3-200e-secg.htm