Morgan, Lewis & Bockius LLP
101 Park Avenue
New York, New York 10178
February 4, 2000
Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549-0609
Attention: Jonathan G. Katz, Secretary
Re: Exchange Act Release No. 34-42037
File No. S7-24-99
Ladies and Gentlemen:
On behalf of certain of our clients who, as part of their investment strategy, engage in hedging transactions, we appreciate the opportunity to comment on Release No. 34-42037, the Commission's recent concept release on short sales. We are writing in support of an exception from short sale regulation for bona fide hedging transactions.
We would like to commend the Commission and the members of the Staff for their initiative in reviewing, and seeking comments on, the short sale rule. We note that the basic provisions of Rule 10a-1 have remained unchanged since 1939, and we agree with the Commission's suggestion in the concept release that developments in the markets since that time may have diminished the need for the Rule in its current form. We further agree with the Commission that the national securities exchanges today have high levels of transparency and regulatory surveillance, and that this transparency helps market participants observe and evaluate market price movements, thereby limiting the ability of short sales to unevenly affect prices. We further agree with the Commission that the self-regulatory organizations (SROs) have developed sophisticated surveillance technologies that allow them to monitor market activity on a real-time basis, again reducing the risk of undetected manipulation and permitting regulators to monitor the types of activities that Rule 10a-1 is designed to prevent.
We further agree with the Commission that short selling is instrumental to a growing number of sophisticated investment models and instruments and that restrictions in the rule may inject unnecessary inefficiencies into these trading strategies. We further agree with the Commission that the growing array of requests for relief indicate that present short sale regulation may have become unduly burdensome and possibly ill-suited for the present and future markets.
Accordingly, we support efforts by the Commission to reconsider various aspects of the short sale rule, including a proposal to suspend the short sale tick rule when a security or market is above a threshold price. However, in this letter, we would like to focus on the Commission's proposal to add an exception to Rule 10a-1 that would cover short sales conducted exclusively for the purpose of establishing a bona fide hedge.
Excepting Bona Fide Hedging Transactions from Short Sale Regulation
We agree with the Commission that short selling today is integral to many complex trading strategies involving a variety of sophisticated financial instruments and that short sales are often used in these strategies to hedge a position in another security or a related financial instrument. We believe, as suggested by the Commission, that complying with Rule 10a-1 increases transaction costs on persons using short hedging because of delays caused by waiting for upticks. In addition, we agree with the Commission that the risks involved in these strategies may increase as a result of the Rule. Accordingly, we support an exception to the tick provisions of the short sale rule for bona fide hedging transactions.
We note that an exception for bona fide hedging transactions would involve further expansion of exceptions to the short sale tick rule previously allowed by the Commission and the Staff. We believe that an exception for bona fide hedging transactions is consistent with the principles underlying these prior exceptions.
In 1983 the Commission adopted an exception from the tick provisions of the short sale rule. "Certain Sales by Block Positioners," Release No. 34-20230 (September 27, 1983). The exception allows a broker-dealer, when selling a security that it acquired while acting in the capacity of a block positioner and determining whether it has a net long position in the security, to disregard a proprietary short position in the security if and to the extent that such short position was the subject of one or more offsetting positions created in the course of bona fide arbitrage, risk arbitrage or bona fide hedge activities.
Subsequent to the adoption of this exception, in 1986 the Staff granted no-action relief to Merrill Lynch, Pierce, Fenner & Smith, Inc. (December 17, 1986) regarding the application of the tick provisions of the short sale rule to the unwinding of index arbitrage positions. The relief granted in the letter allows a broker-dealer, when selling a security in connection with the unwinding of an index arbitrage position and determining whether it has a net long position in the security, to disregard a proprietary short position in the security if and to the extent that such short position was the subject of one or more offsetting positions created in the course of bona fide arbitrage, risk arbitrage or bona fide hedge activities. The Commission provided further guidance regarding this exception in a subsequent release. "Short Sales," Exchange Act Release No. 34-30772 (June 9, 1992).
In the 1983 and 1992 releases, as well as in the Merrill Lynch letter, the Commission acknowledges implicitly that application of the short sale rule is not appropriate when a short position in a stock is the subject of one or more offsetting positions in connection with bona fide hedging activities. In the relief granted for block positioning, the Commission does not provide a broad exception for sales of securities acquired as block positioner when the block positioner has a net short position; rather, the relief only applies to the extent the short position was the subject of one or more offsetting positions created in the course of bona fide hedge activities. Similarly, in the relief granted for unwinding of index arbitrage positions, the Commission does not provide a broad exception from the tick provisions of the short sale rule; rather, the relief from the tick provisions of the short sale rule applies only to the extent the short position is the subject of one or more offsetting positions created in the course of bona fide hedge activities. Accordingly, implicit in the relief provided in each of these situations is the notion that application of the short sale rule is not appropriate when a short position in a stock is the subject of one or more offsetting positions in connection with bona fide hedging activities.
The Commission correctly has recognized that application of the short sale rule is not appropriate when the party making a sale does not have an economic interest in driving down the market price of the security being sold. We propose that the Commission follow the reasoning of its prior positions and provide a broader exception for bona fide hedging activities.
Objectives of Short Sale Regulation
The Commission has consistently analyzed short sale regulation in terms of three possible objectives:
"(i) Allowing relatively unrestricted short selling in an advancing market;
(ii) Preventing short selling at successively lower prices, thus eliminating short selling as a tool for driving the market down; and
(iii) Preventing short sellers from accelerating a declining market by exhausting all remaining bids at one price level, causing successively lower prices to be established by long sellers."
See "Notice of Public Fact-Finding Investigation and Rulemaking Proceeding," Release No. 34-13091 (December 21, 1976). When a short sale is subject to a bona fide hedge, the investor's gain from any decrease in the price of the security sold short (sometimes referred to herein as the "underlying security") should be offset by, or should offset, an increase in the value of the security or other financial instrument which hedges that short sale or which that short sale hedges (sometimes referred to herein as the "offsetting position"). Accordingly, the Commission's concern for eliminating short selling as a tool for driving the market down or accelerating a declining market should not be present when a short sale is subject to an offsetting position. (See, for example, footnote 14 to the 1983 release cited above: "The gain from the short stock would be offset by a loss in the equivalent security or securities making up the bona fide hedge or arbitrage position.").
Definition of Bona fide Hedging
In the 1983 and 1992 releases cited above, the Commission determined that "bona fide hedging" should be defined by reference to the definition set forth in Section 11(a) of the Exchange Act and the Commission's rules thereunder. We believe that this definition is an appropriate starting point but should be expanded, as suggested by the Commission in the concept release, to cover offsetting positions that are not securities.
Adopted as part of the Securities Acts Amendments of 1975, Section 11(a) of the Exchange Act prohibits a stock exchange member from effecting transactions on any exchange of which it is a member for its own account, the account of an associated person or an account with respect to which the member or an associated person exercises investment discretion. Exempt from this prohibition are certain types of transactions which, as stated in the legislative history, ". . . contribute to the fairness and orderliness of exchange markets or which have not given rise to serious problems." See Securities Acts Amendments of 1975, Report of the Senate Comm. On Banking, Housing and Urban Affairs to Accompany S. 249, S. Rep. No. 94-75, 9th Cong., 1st Sess. 99 (1975).
One of the exceptions proposed by Congress and subsequently enacted was an exception for ". . . any bona fide hedge transaction involving a long or short position in an equity security and a long or short position in a security entitling the holder to acquire or sell such equity security . . ."
In 1979 the Commission adopted Rule 11a1-3(T) under Section 11(a) which provides that:
"A bona fide hedge transaction effected on a national securities exchange by a member for its own account or an account of an associated person thereof and involving a long or short position in a security entitling the holder to acquire or sell an equity security, and a long or short position in one or more other securities entitling the holder to acquire or sell such equity security, shall be deemed to be of a kind which is consistent with the purposes of Section 11(a)(1) of the Act, the protection of investors, and the maintenance of fair and orderly markets."
The exception was drafted broadly because of the Commission's understanding of the complexity and variety of hedging techniques. The Commission wrote as follows in the 1979 release adopting this rule:
"The question whether particular combinations of stock positions and options positions result in risk reduction in each of the positions involves subjective judgments as to the volatility and risk characteristics of those positions. For example, "ratio" hedges are frequently used when the risk involved in a stock position is offset by the writing of options. In such ratio hedges, the number of underlying shares deliverable upon exercise of the options exceeds the number of shares in the stock position that is being hedged. The hedge ratio reflects a calculation of the relative degree of risk involved in each position. In establishing a suitable ratio, some industry participants use the "delta factor" derived from the Black-Scholes pricing formula; the delta factor predicts price movements in an option as a function of movements in the underlying stock. Other industry participants have developed their own models. The Commission recognizes that the calculation of volatility and risk can only be approximate, and believes that, for purposes of Section 11(a)(1)(D), the determination of what constitutes an offset may be made by the use of any responsible method of calculating the risk of stock and options positions."
"Securities Transactions by Members of National Securities Exchanges" (Release No. 34-15533 (January 29, 1979).
While we agree with the Commission's general approach and guidance in the 1979 release, we would recommend expanding the definition of bona fide hedge (as set forth in Rule 11a1-3(T)) to cover situations where the offsetting position is a futures contract, forward contract, repurchase agreement, swap agreement or similar agreement because the same delta analysis applies. Similarly, an offsetting position may not entitle the holder to acquire or sell the underlying security but may instead entitle the holder to receive a payment or require the holder to make a payment based upon changes in the price of the underlying security. We believe that this type of offsetting position also should be included with the exception for bona fide hedging transactions.
We also suggest that a bona fide hedge include an offsetting position that, at the time of the short sale, an investor has a present intention to establish within a short period thereafter.
Proposals to Improve Monitoring
In the concept release, the Commission requests comments on what type of surveillance it should consider for monitoring short sales conducted as part of economically neutral transactions. We propose, as a condition to the exception from the tick provisions of the short sale rule for any investor, that the broker-dealer executing the short sale should require the investor to identify to the broker-dealer the accounts whose positions are being offset and provide evidence of the offsetting positions. These requirements would provide a clearer audit trail for the broker-dealer, as well as for the Commission and the SROs, to monitor for compliance with the short sale rule and ensure that claimed exceptions to the tick test are valid.
In addition, we do not propose that short positions subject to bona fide hedging be excluded for purposes of calculating a person's net position in a stock (except in the situations previously approved by the Commission or the Staff). Rather, we propose an exception to Rule 10a-1 that would cover short sales subject to bona fide hedging transactions. This would similarly provide a clearer audit trail for the broker-dealer, as well as for the Commission and the SROs, to monitor for compliance with the short sale rule and ensure that claimed exceptions to the tick test are valid.
We hope that the Commission will find our comments helpful. Please call me at (212) 309-6030 to discuss further any aspect of these comments.