Securities and Exchange Commission

17 CFR PARTS 240 and 242

[Release No. 34-48709; File No. S7-23-03]

RIN 3235-AJ00

Short Sales

Agency: Securities and Exchange Commission.

Action: Proposed rule.

Summary: The Securities and Exchange Commission (Commission) is publishing for public comment new Regulation SHO, under the Securities Exchange Act of 1934 (Exchange Act), which would replace Rules 3b-3, 10a-1, and 10a-2. The Commission is also proposing amendments to Rule 105 of Regulation M. Proposed Regulation SHO would, among other things, require short sellers in all equity securities to locate securities to borrow before selling, and would also impose strict delivery requirements on securities where many sellers have failed to deliver the securities. In part, this action is designed to address the problem of "naked" short selling. Proposed Regulation SHO would also institute a new uniform bid test allowing short sales to be effected at a price one cent above the consolidated best bid. This test would apply to all exchange-listed securities and Nasdaq National Market System Securities (NMS Securities), wherever traded.

We are also seeking comment on a temporary rule that would suspend the operation of the proposed bid test for specified liquid securities during a two-year pilot period. The temporary suspension would allow the Commission to study the effects of relatively unrestricted short selling on market volatility, price efficiency, and liquidity.

Dates: Comments must be received on or before January 5, 2004.

Addresses: To help us process and review your comments more efficiently, comments should be sent by hard copy or e-mail, but not by both methods. Comments sent by hard copy should be submitted in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. Comments also may be submitted electronically at the following E-mail address: rule-comments@sec.gov. All comment letters should refer to File No. S7-23-03. Comments submitted by E-mail should include this file number in the subject line. Comment letters received will be available for public inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, NW, Washington, DC 20549. Electronically submitted comment letters will be posted on the Commission's Internet web site (http://www.sec.gov).¹

For Further Information Contact: Any of the following attorneys in the Office of Trading Practices, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-1001, at (202) 942-0772: James Brigagliano, Assistant Director, or Gregory Dumark, Kevin Campion, Lillian Hagen, Elizabeth Sandoe and Marla Chidsey, Special Counsels.

Supplementary Information: The Commission is publishing for comment proposed Regulation SHO and a proposed temporary rule, Rule 202², and proposed amendments to Regulation M, Rule 105³ under the Exchange Act.

Table of Contents

1. Introduction
1. Background and Current Short Sale Regulation
2. Market Effects of Short Selling
3. Market Developments
2. Naked Short Selling
1. Background
2. Current Regulatory Requirements
3. Proposed Amendments
1. Short Sales
2. Long Sales
3. Current Market Structure and the Tick Test
4. Proposed Bid Test
1. Operation of the Uniform Bid Test
2. Scope of the Uniform Bid Test
1. Securities Subject to the Price Test
2. Securities Not Subject to the Price Test
3. Bid Test Flexibility in a Decimals Environment
4. Bid Test Flexibility for Passive Pricing Systems
5. Pilot Program
6. Rule 10a-1 Exceptions
1. Exceptions Proposed to be Retained
1. Long Seller's Delay in Delivery
2. Error in Marking a Short Sale
3. Odd Lot Transactions
4. Domestic Arbitrage
5. International Arbitrage
6. Distribution Over-Allotment
7. Equalizing Short Sales and Trade-Throughs
2. Exception Proposed to Be Eliminated
7. Prior Exemption Letters under Rule 10a-1
1. Exchange Traded Funds
2. Short Sales Executed at the Closing Price
8. Market Maker Exception from Proposed Uniform Bid Test
9. Proposed Changes to the Order Marking Requirement
1. Marking Orders
2. Marking Requirements for Riskless Principal Transactions
10. Rule 3b-3
1. Unconditional Contracts to Purchase Securities
2. Ownership of Securities Underlying Securities Futures Products
3. Aggregation Units
4. Block-Positioner Exception
5. Liquidation of Index Arbitrage Positions
11. Hedging Transactions
12. Elimination of Current Subparagraphs 10a-1(a)(2) and (a)(3)
13. Exclusion of Bonds
14. After Hours Trading/ Foreign Markets Issues
1. After-Hours Trading
2. Off-Shore Trading
15. Limitations on Short Selling During Significant Market Declines
16. Rule 105 of Regulation M — Short Sales in Connection with a Public Offering
1. Scope of Rule 105 of Regulation M
2. Shelf Offerings
3. Sham Transactions Designed to Give the Appearance of Covering with Open Market Securities
17. General Request for Comment
18. Paperwork Reduction Act
19. Consideration of Proposed Regulation SHO's Costs and Benefits
20. Consideration on Burden and Promotion of Efficiency, Competition, and Capital Formation
21. Consideration of Impact on the Economy
22. Initial Regulatory Flexibility Analysis
23. Statutory Authority

Text of Proposed Regulation SHO, Amendments and Temporary Rule

I. Introduction

Congress, in 1934, directed the Commission to "purge the market" of short selling abuses, and in response, the Commission adopted restrictions that have remained essentially unchanged for over 60 years. Originally adopted in 1938, the Commission's short sale rule, Rule 10a-1, is designed to restrict short sellers from effecting short sales in an exchange-traded security when the price of that security is declining.⁴

Since its adoption, the Commission has engaged in studies, investigations, and reviews of the efficacy of the Rule.⁵ Most recently, in 1999, the Commission issued a release requesting public comment on the regulation of short sales of securities (Concept Release).⁶ The Concept Release examined ways to modernize our approach to short sale regulation. We received 2778 comment letters in response to the Release.⁷

Since the Concept Release was published, we have reviewed the comment letters and reexamined the structure and operation of Rule 10a-1, and related Rules 10a-2⁸ and 3b-3.⁹ We also considered the status of short sale regulation in the context of requests for relief from Rule 10a-1 submitted to the Commission for a wide range of short selling activities. Finally, we considered recent market changes, including increased instances of "naked" short selling, i.e., selling short without borrowing the necessary securities to make delivery; decimalization; the advent of security futures trading; and an increasing amount of Nasdaq securities being traded away from the Nasdaq market, and thus not subject to any short sale price test. As a result of this assessment, we are seeking comment on proposed Regulation SHO, which would replace Rules 3b-3, 10a-1, and 10a-2, and that would temporarily suspend the short sale price test for specified liquid

stocks. We also propose to amend Rule 105 of Regulation M to eliminate the shelf offering exception. The comments we receive will assist us in determining whether to adopt the proposed changes to these rules and the nature and scope of such changes.

A. Background and Current Short Sale Regulation

A short sale is the sale of a security that the seller does not own or any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller.¹⁰ 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, or by using an equivalent security it already owned, and returning the security to the lender. 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.

The following example illustrates a typical short sale transaction:

XYZ stock is currently selling at $50 per share. An investor anticipates that the price of XYZ stock will decline and wants to sell short 100 shares. The investor's broker borrows 100 shares for the investor and executes the short sale. The $5,000 proceeds from the sale (plus, usually, an additional 2%) are posted as collateral with the lender and the investor must also post margin equal to 50% of the purchase price with his broker.¹¹ At some point in the future the investor must purchase 100 shares to return to the lender. If the investor can purchase the XYZ shares at a price below $50, the investor can cover the short position at a profit. If the price of XYZ shares rises above $50, the investor may have to cover the short position at a loss.¹²

Section 10(a) of the Exchange Act gives the Commission plenary authority to regulate short sales of securities registered on a national securities exchange (listed securities), as necessary to protect investors. After conducting an inquiry into the effects of concentrated short selling during the market break of 1937, the Commission adopted Rule 10a-1 in 1938 in order to restrict short selling in a declining market.¹³ The core provisions of the Rule are largely the same today as when they were adopted.

Paragraph (a) of Rule 10a-1 generally covers short sales in listed securities if trades of the security are reported pursuant to an "effective transaction reporting plan" and information as to such trades is made available in accordance with such plan on a real-time basis to vendors of market transaction information.¹⁴ Paragraph (b) applies to short sales on national exchanges in securities that are not covered by paragraph (a).

Rule 10a-1(a)(1) provides that, subject to certain exceptions, a listed security may be sold short (A) at a price above the price at which the immediately preceding sale was effected (plus tick), or (B) at the last sale price if it is higher than the last different price (zero-plus tick).¹⁵ Short sales are not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions. The operation of these provisions, commonly described as the "tick test," determines the minimum shortable price (MSP)¹⁶ at which a security can be sold short. The following transactions illustrate the operation of the tick test: ¹⁷

In adopting the tick test, the Commission sought to achieve three 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.¹⁸

In 1994, the Commission granted temporary approval to the NASD to apply its own short sale rule to Nasdaq NMS securities.¹⁹ NASD Rule 3350 prohibits short sales by NASD members in Nasdaq NMS Securities²⁰ at or below the current best (inside) bid when that bid is lower than the previous best (inside) bid (commonly referred to as the bid test). The operation of the bid test in NASD Rule 3350 is illustrated as follows:

B. Market Effects of Short Selling

Short selling provides the market with at least two important benefits: market liquidity and pricing efficiency.²¹ Market liquidity is generally provided through short selling by market professionals, such as market makers (including specialists) and block positioners, who offset temporary imbalances in the buying and selling interest for securities. Short sales effected in the market add to the selling interest of stock available to purchasers and reduce the risk that the price paid by investors is artificially high because of a temporary contraction of selling interest. Short sellers covering their sales also may add to the buying interest of stock available to sellers.

Short selling also can contribute to the pricing efficiency of the equities markets. Efficient markets require that prices fully reflect all buy and sell interest. When a short seller speculates or hedges against a downward movement in a security, his transaction is a mirror image of the person who purchases the security based upon speculation that the security's price will rise or to hedge against such an increase. Both the purchaser and the short seller hope to profit, or hedge against loss, by buying the security at one price and selling at a higher price. The strategies primarily differ in the sequence of transactions. Market participants who believe a stock is overvalued may engage in short sales in an attempt to profit from a perceived divergence of prices from true economic values. Such short sellers add to stock pricing efficiency because their transactions inform the market of their evaluation of future stock price performance. This evaluation is reflected in the resulting market price of the security.²²

Although short selling serves useful market purposes, it also may be used to illegally manipulate stock prices.²³ One example is the "bear raid" where an equity security is sold short in an effort to drive down the price of the security by creating an imbalance of sell-side interest.²⁴ Further, unrestricted short selling can exacerbate a declining market in a security by increasing pressure from the sell-side, eliminating bids, and causing a further reduction in the price of a security by creating an appearance that the security price is falling for fundamental reasons.

Short selling was one of the central issues studied by Congress before enacting the Exchange Act, but Congress did not directly prohibit short selling.²⁵ Instead, Congress gave the Commission broad authority to regulate short sales in order to stop short selling abuses.²⁶

C. Market Developments

Several significant developments in the securities markets, including, but not limited to, instances of abusive naked short selling, the increasing number of Nasdaq securities trading away from the Nasdaq market (and thus not subject to any price test), the advent of security futures trading, and decimalization have caused the Commission to reexamine short sale regulation. At a minimum, the Commission believes that adjustments to short sale regulation are required to keep pace with these market developments.

II. Naked Short Selling

A. Background

Many issuers and investors have complained about alleged "naked short selling," especially in thinly-capitalized securities trading over-the-counter.²⁷ Naked short selling is selling short without borrowing the necessary securities to make delivery, thus potentially resulting in a "fail to deliver" securities to the buyer.

Naked short selling can have a number of negative effects on the market, particularly when the fails to deliver persist for an extended period of time and result in a significantly large unfulfilled delivery obligation at the clearing agency where trades are settled.²⁸ At times, the amount of fails to deliver may be greater than the total public float. In effect the naked short seller unilaterally converts a securities contract (which should settle in three days after the trade date) into an undated futures-type contract, which the buyer might not have agreed to or that would have been priced differently. The seller's failure to deliver securities may also adversely affect certain rights of the buyer, such as the right to vote. More significantly, naked short sellers enjoy greater leverage than if they were required to borrow securities and deliver within a reasonable time period, and they may use this additional leverage to engage in trading activities that deliberately depress the price of a security.²⁹

The Commission recently brought an enforcement action against certain parties, alleging manipulative naked short selling, in a scheme sometimes termed as a "death spiral." These schemes generally involve parties arranging financings in public companies that are unable to obtain more conventional financing in the capital markets due to their precarious financial condition. The party providing financing receives from a public company debentures that are later convertible into the stock of the issuer. The terms typically provide that the conversion ratio will be tied to a fixed value of the aggregate underlying shares (typically a discount from the market price of the security at the time of the conversion rather than a conversion price per share).³⁰ In some cases the parties providing financing have engaged in extensive naked short selling designed to lower the price of the issuer's stock, thus realizing profits when the debentures are converted to cover the short sales.³¹

Naked short selling has sparked defensive actions by some issuers designed to combat the potentially negative effects on shareholders, broker-dealers, and the clearance and settlement system.³² Some issuers have taken actions to attempt to make transfer of their securities "custody only," thus preventing transfer of their stock to or from securities intermediaries such as the Depository Trust Company (DTC) or broker-dealers. A number of issuers have attempted to withdraw their issued securities on deposit at DTC, which makes the securities ineligible for book-entry transfer at a securities depository.³³ Withdrawing securities from DTC or requiring custody-only transfers undermine the goal of a national clearance and settlement system, designed to reduce the physical movement of certificates in the trading markets.³⁴

B. Current Regulatory Requirements

The SROs have adopted rules generally requiring that, prior to effecting short sales, members must "locate" stock available for borrowing.³⁵ For example, NYSE Rule 440C.10 states that no NYSE member or member organization should "fail to deliver" against a short sale of a security on a national securities exchange until a diligent effort has been made by such member or member organization to borrow the necessary securities to make delivery.³⁶ An NYSE interpretation to the rule further states that member organizations effecting short sales for their own account or the accounts of customers must be in a position to complete the transaction. The interpretation states that no orders to sell short should be accepted or entered unless prior arrangements to borrow the stock have been made or other acceptable assurances that delivery can be made on settlement date.³⁷ These provisions apply to all NYSE member organizations, whether effecting transactions in exchange-listed securities on the NYSE, another national securities exchange, or in the over-the-counter market. Exceptions from the rule are provided for short sales by specialists, market makers, and odd lot dealers in fulfilling their market responsibilities.³⁸

The comparable NASD Rule 3370 generally provides that no member, or person associated with a member, shall effect a short sale for a customer or for its own account unless the member makes an "affirmative determination" that the member can borrow the securities or otherwise provide for delivery of the securities by settlement date.³⁹ The affirmative determination must be annotated in writing, evidencing that the member firm will receive delivery of the security from the customer or, if the member firm locates the stock, the identity of the individual and firm contacted who offered assurance that the shares would be delivered or were available for borrowing.⁴⁰ This requirement applies regardless of how a short sale order is received, e.g., by the telephone, an electronic transmission, the Internet, or otherwise.⁴¹ This requirement does not apply to transactions in corporate debt securities, to bona fide market making transactions by Nasdaq market makers,⁴² or to transactions that result in fully hedged or arbitraged positions.⁴³

The NASD has also adopted several rules addressing failures to deliver. NASD Rule 3210 prevents a member, or person associated with a member, from selling a security for his own account, or buying a security as a broker for a customer if, with respect to domestic securities,⁴⁴ he has a fail to deliver in that security that is 60 days or older. NASD Rule 11830 imposes a mandatory close-out requirement for Nasdaq securities that have a clearing short position of 10,000 shares or more per security and that are equal to at least one-half of one percent of the issue's total shares outstanding. NASD Rule 11830 generally requires that a contract involving a short sale in these securities, for the account of a customer or for an NASD member's own account, which has not resulted in delivery by the broker-dealer representing the seller within 10 business days after the normal settlement date (currently transaction date + 3 business days), must be closed by the broker-dealer representing the seller by purchasing for cash or guaranteed delivery of securities of like kind and quality. This mandatory close-out requirement does not apply to bona-fide market making transactions and transactions that result in fully hedged or arbitraged positions.

C. Proposed Amendments

1. Short Sales

The Commission believes that these SRO requirements have not fully addressed the problems of naked short selling and extended fails to deliver. We believe it would be beneficial to establish a uniform standard specifying the procedures for all short sellers to locate securities for borrowing.⁴⁵ This would further the goals of regulatory simplification and avoidance of regulatory arbitrage, as well as address some areas not currently covered. We are therefore proposing to incorporate in proposed Regulation SHO a uniform "locate" rule applicable to all equity securities, wherever they are traded.⁴⁶ Proposed Rule 203 would prohibit a broker-dealer from executing a short sale order for its own account or the account of another person, unless the broker-dealer, or the person for whose account the short sale is executed (1) borrowed the security, or entered into an arrangement for the borrowing of the security, or (2) had reasonable grounds to believe that it could borrow the security so that it would be capable of delivering the securities on the date delivery is due.⁴⁷ Consistent with the current SRO requirements, the proposed rule would require that the locate be made and annotated in writing prior to effecting any short sale, regardless of the fact that the seller's short position may be closed out by purchasing securities the same day.⁴⁸ The Commission is proposing an exception from these requirements for short sales executed by specialists or market makers but only in connection with bona-fide market making activities.⁴⁹ We believe a narrow exception for market makers and specialists engaged in bona fide market making activities is necessary because they may need to facilitate customer orders in a fast moving market without possible delays associated with complying with the proposed "locate" rule. Moreover, we believe that most specialists and market makers seek a net "flat" position in a security at the end of each day and often "offset" short sales with purchases such that they are not required to make delivery under the security settlement system.

As an additional safeguard against some of the problems associated with naked short selling, we are proposing a delivery requirement targeted at securities where there is evidence of significant settlement failures. We are incorporating the same threshold currently used in NASD Rule 11830,⁵⁰ i.e., any security where there are fails to deliver at a clearing agency registered with the Commission of 10,000 shares or more per security, and that is equal to at least one-half of one percent of the issue's total shares outstanding.⁵¹ We are incorporating this standard into proposed Rule 203 because we believe that the levels set in NASD Rule 11830 characterize situations where the ratio of unfulfilled delivery obligations at the clearing agency where trades are settled represents a significant number of shares relative to the company's total shares outstanding, thus requiring remedial action designed to address potential negative effects. The proposed rule would specify that for short sales of any security meeting this threshold, the selling broker-dealer must deliver the security no later than two days after the settlement date.⁵² We believe a two-day grace period is appropriate to allow for transfer delays or delays due to a variety of circumstances that prevent timely delivery.⁵³ If for any reason such security was not delivered within two days after the settlement date, the rule would restrict the broker-dealer, including market makers, from executing future short sales in such security for the person for whose account the failure to deliver occurred unless the broker-dealer or the person for whose account the short sale is executed borrowed the security, or entered into a bona fide arrangement to borrow the security, prior to executing the short sale and delivered on settlement date. This restriction would be in effect for a period of 90 calendar days.⁵⁴ In addition, the rule would require the rules of the registered clearing agency that processed the transaction to include the following provisions: (A) A broker or dealer failing to deliver such securities shall be referred to the NASD and the designated examining authority for such broker-dealer for appropriate action;⁵⁵ and (B) The registered clearing agency shall withhold a benefit of any mark-to-market amounts or payments that otherwise would be made to the party failing to deliver,⁵⁶ and take other appropriate action, including assessing appropriate charges against the party failing to deliver. Both of these requirements should assist the Commission in preventing abuses and promote the prompt and accurate clearance and settlement of securities transactions.

These proposed requirements in Rule 203 would differ from the current SRO rules in several respects. First, the proposals require action two days after settlement, as opposed to the current ten days after settlement provided in Rule 11830.⁵⁷ Further, the mandatory close-out provision in NASD Rule 11830 currently only applies to Nasdaq securities. We believe that securities with lower market capitalization may be more susceptible to abuse, and therefore believe that these additional delivery requirements should be extended to all equity securities registered under Section 12 of the Exchange Act. Finally, although market makers engaged in bona fide market making are currently exempted from NASD Rule 11830, we believe that extended failures to deliver appear characteristic of an investment or trading strategy, rather than being related to market making. We believe it is questionable whether a market maker carrying a short position in a heavily shorted security for an extended period of time is in fact engaged in providing liquidity for customers, or rather is engaged in a speculative trading strategy. Therefore, we are not proposing an exception from these additional delivery requirements for short sales in connection with market making.

In our view, these delivery requirements would protect and enhance the operation, integrity and stability of the markets and the clearance and settlement system. In particular, we believe that they will protect buyers of securities by substantially curtailing naked short selling. We request comment on the extent to which the proposed rules will achieve these objectives.

Q. What harms result from naked short selling? Conversely, what benefits accrue from naked short selling?

Q. Are there negative tax consequences associated with naked short selling, in terms of dividends paid or otherwise?

Q. What is the appropriate manner by which short sellers can comply with the requirement to have "reasonable grounds" to believe that securities sold short could be borrowed? Should short sellers be permitted to rely on blanket assurances that stock is available for borrowing, i.e., "hard to borrow" or "easy to borrow" lists? Is the equity lending market transparent enough to allow an efficient means of creating these lists?

Q. Should short sales effected by a market maker in connection with bona fide market making be excepted from the proposed "locate" requirements? Should the exception be tied to certain qualifications or conditions? If so, what should these qualifications or conditions be?

Q. Should the proposed additional delivery requirements be limited to securities in which there are significant failures to deliver? If so, is the proposed threshold an accurate indication of securities with excessive fails to deliver? Should it be higher or lower? Should additional criteria be used?

Q. Are the proposed consequences for failing to deliver securities appropriate and effective measures to address the abuses in naked short selling? If not, why not? What other measures would be effective? Should broker-dealers buying on behalf of customers be obligated to effect a buy-in for aged fails?

Q. Is the restriction preventing a broker-dealer, for a period of 90 calendar days, from executing short sales in the particular security for his own account or the account of the person for whose account the failure to deliver occurred without having pre-borrowed the securities an appropriate and effective measure to address the abuses in naked short selling? Should this restriction apply to all short sales by the broker-dealer in this particular security? Should the restriction also apply to all further short sales by the person for whose account the failure to deliver occurred, effected by any broker-dealer?

Q. Should short sales effected by a market maker in connection with bona-fide market making be exempted from the proposed delivery requirements targeted at securities in which there are significant failures to deliver? If so, what reasons support such an exemption, and how should bona-fide market making be identified?

Q. Under what circumstances might a market maker need to maintain a fail to deliver on a short sale longer than two days past settlement date in the course of bona fide market making? Is two days the appropriate time period to use?

Q. Are there any circumstances in which a party not engaging in bona-fide market making might need to maintain a fail to deliver on a short sale longer than two days past settlement? If so, can such positions be identified? Should they be excepted from the proposed borrow and delivery requirements, and if so, why, and for how long?

2. Long Sales

Current Rule 10a-2 covers delivery requirements applicable to long sales of securities registered or admitted to unlisted trading privileges on a national securities exchange. We are proposing to adopt subparagraph (a) of Rule 203 in proposed Regulation SHO, which would replace and modify Rule 10a-2 to make it consistent with the new delivery requirements in the proposed short sale rule.

Generally, Rule 10a-2 provides that if a broker-dealer knows or should know that a sale is marked long, the broker-dealer must make delivery when due and cannot lend securities to do so. If the broker-dealer does not have the securities, it must make delivery with securities purchased for cash, i.e., effect a "buy in," unless it knows that the seller either is in the process of forwarding the securities to the broker-dealer or will do so as soon as possible without undue inconvenience or expense. Broker-dealers are excused from the buy-in requirement in two cases. In sales between broker-dealers, loans are permitted in lieu of a buy-in. The rule also allows a broker-dealer to fail to deliver, or to borrow securities in lieu of buying-in, if, despite the broker-dealer's efforts to ensure that the sale was long, it was in fact short. This exemption is available only if the exchange or national securities association in whose market the sale was effected finds that the sale resulted from a good-faith mistake, the broker-dealer exercised due diligence, and either that requiring a buy-in would result in undue hardship or that the sale had been effected at a permissible price.

Subparagraph (a) of Rule 203 of proposed Regulation SHO preserves the substance of current Rule 10a-2 regarding delivery of securities sold pursuant to orders marked "long." Only two substantive changes have been made. First, Regulation SHO would extend the delivery requirements of Rule 10a-2 to all securities, including those traded over-the-counter. As with our proposal to apply borrow and delivery requirements for short sales in all equity securities, we believe it is equally important to apply long delivery requirements to securities with lower market capitalization that may be more susceptible to abuse.

Second, proposed Regulation SHO would provide that a loan or failure to deliver is permitted if the seller has informed the broker-dealer that the seller owns the security and will deliver it to the broker-dealer prior to settlement of the transaction, but fails to do so. The proposed modification tracks the proposed amendments to the order marking requirements, which would permit an order to be marked long if the seller owns the securities and the seller's broker-dealer will have physical possession or control of the security prior to settlement.⁵⁸ The proposed rule would permit a broker-dealer to fail to deliver, or to deliver borrowed securities, if an exchange or national securities association found that the broker-dealer used due diligence in obtaining the seller's confirmation that the security would be in the broker-dealer's possession prior to settlement, and that either compelling a buy-in would result in undue hardship, or that the mistake was made by the seller's broker-dealer and the sale was at a permissible price under Proposed Rule 201(b) of Regulation SHO.⁵⁹ We believe that this change would facilitate the process of clearance and settlement, while still achieving the goals of short sale regulation.

Q. Are the delivery requirements in proposed Rule 203(a) appropriate?

III. Current Market Structure and the Tick Test

The tick test was part of short sale regulation implemented in 1938. The tick test has provided the markets with a generally effective means of regulating short sales for more than 60 years. Nonetheless, arguments have been made to allow greater flexibility in short selling. Indeed, substantial economic arguments have been made that short selling should be deregulated, at least in the case of the tick test.⁶⁰ Some commenters to the Concept Release took that position.⁶¹ A substantial number of other commenters disagreed and expressed support for a price test.⁶² We do not believe that proposing complete rescission of the short sale price test would be appropriate at this time, although we request comment about that approach. Instead, we propose a new, uniform price test that would apply to today's markets, and a pilot that would permit us to gather data about trading activity in the absence of a short sale price restriction.

IV. Proposed Bid Test

Current short sale regulation applies different price tests to securities trading in different markets. Rule 10a-1 applies only to short sale transactions in securities listed on a national securities exchange, whether the transaction is effected on an exchange or otherwise. The NASD's bid test applies to short sale transactions in Nasdaq NMS securities effected on either SuperMontage or the NASD's Alternative Display Facility (ADF), but not to Nasdaq SmallCap, OTCBB, and other securities traded over-the-counter. Moreover, no short sale price test applies to short sales of Nasdaq NMS securities executed away from SuperMontage and the ADF, unless the market on which the securities are being traded has adopted its own price test.⁶³ The end result is disparate short sale regulation of Nasdaq securities, depending on the market where the securities are trading. This situation may lend itself to regulatory arbitrage.⁶⁴

We note that Nasdaq has also applied to become a national securities exchange.⁶⁵ If Nasdaq becomes an exchange, Rule 10a-1 would apply to Nasdaq securities because they would be exchange-listed securities reported pursuant to an "effective transaction reporting plan." Nasdaq has applied for relief from Rule 10a-1 in conjuction with the exchange registration.⁶⁶ The Commission has not yet acted upon the application. If the Commission were to grant an exemption from Rule 10a-1 to allow Nasdaq to apply Rule 3350 to Nasdaq exchange-listed securities, the same securities quoted and traded on Nasdaq and other exchanges would be subject to two different short sale rules. This has the potential for confusion and compliance difficulties. We believe that these considerations, along with the other market developments discussed previously, make this an appropriate time to propose amendments that would provide for a more consistent approach to short sale regulation.

A. Operation of the Uniform Bid Test

The current tick test uses the last trade price in a security as a reference point for determining permissible short sale prices under Rule 10a-1. The effectiveness of this test for exchange-listed securities depends on the centralized auction nature of most exchanges and the historical concentration on exchanges of transactions in exchange-listed securities, which helps produce a consistent sequence of trade reports. In 2002, for example, the NYSE accounted for 87.9% of share volume in NYSE listed equities.⁶⁷

The tick test, however, may not be as effective a means of regulating dealer markets. Nasdaq, in contrast to the auction markets, has no single market center that concentrates trading in Nasdaq securities. During regular trading hours, order flow in Nasdaq securities is divided among many different market makers, ECNs, and regional exchanges.⁶⁸ Trade reporting for Nasdaq securities involves multiple market makers reporting trades in the same stock from different locations using different means of reporting. Although trades are required to be reported within 90 seconds after execution, they are published in reporting sequence, not trade sequence.⁶⁹ This reporting may create upticks and downticks that may not accurately reflect price movements in the security for the purposes of the tick test. To a lesser degree, this phenomenon occurs in exchange-listed securities that are traded in multiple venues.

We are proposing Rule 201 of Regulation SHO, which would replace Rule 10a-1's tick test with a test using the consolidated best bid as the reference point for permissible short sales. Specifically, subparagraph (b) of proposed Rule 201 would require that all short sales in exchange-listed and Nasdaq NMS securities, wherever traded, be effected at a price at least one cent above the consolidated best bid at the time of execution.⁷⁰ A bid test would apply a uniform rule to trades in the same securities that occur in multiple, dispersed, and diverse markets. Moreover, a bid test would provide greater flexibility in effecting short sales in a decimals environment, as discussed below. Finally, a bid test would better accommodate increasingly popular automated trading systems that utilize passive pricing and trading systems that offer price improvement based on the consolidated best bid and offer.⁷¹

The proposed bid test in Rule 201 would require that a short sale be effected at a price at least one cent above the best consolidated bid at the time of execution.⁷² This would be a significant change from the current tick test, which is based on last sale prices. The bid test also would operate differently from the current rule for Nasdaq securities. NASD's Rule 3350 prohibits NASD members from effecting short sales in NMS securities at or below the best bid when the best bid displayed is below the preceding best bid in a security. However, if there is an "upbid" in a security, i.e., the best bid displayed is above the preceding best bid, there is no restriction on the price that a NASD member can sell an NMS security short.⁷³

Under the proposed uniform bid test, the price at which a short sale could be effected would move contemporaneously with the movement of the consolidated best bid.⁷⁴ In contrast, compliance with the current short sale price tests require a comparison of the previous last sale in relation to the most recent last sale in listed securities or a comparison of the current bid with the previous bid for Nasdaq securities.

We recognize that a quotation only proposes a transaction, whereas the last trade price reflects an actual trade. However, pursuant to Commission and SRO rules, quotations for all covered securities must be firm. Further, we believe that bids generally are a more accurate reflection of current prices for a security because last trade prices can be reported out-of-sequence within a 90 second window.

We believe the proposed bid test would promote the fundamental goals of short sale regulation. First, the proposed bid test would facilitate relatively unrestricted short selling in an advancing market, because the short selling reference price would move with the current interest of the market.

The proposed bid test also is designed to achieve the second and third objectives of the short sale rule, preventing short selling at successively lower prices and preventing short sellers from accelerating a decline in the market by exhausting all remaining bids at one price level. One of the negative uses of short selling is attempting to establish lower transaction prices in a security, hoping to induce others to liquidate their positions and lower prices further.⁷⁵ A short seller may attempt to accomplish this by exhausting higher priced bids in a security, thus creating the appearance of a declining market.⁷⁶ Barring short sales at prices equal to or below the consolidated best bid would prevent short sellers from exhausting the bids in a security and thus prevent short sellers from inducing a price decline. Since only long sellers could sell at the consolidated best bid, it is unlikely that short sellers could directly cause short selling at successively lower prices.⁷⁷

While we believe the uniform bid test is the most flexible approach to modernizing the short sale rule while continuing to promote the goals of short sale regulation, we understand that some market participants may desire an even greater range of prices at which to effect short sales. One alternative would be a bid test allowing short selling at a price equal to or above the consolidated best bid if the current best bid is above the previous bid (i.e., an upbid). However, in this alternative, short selling would be restricted to a price at least one cent above the consolidated best bid (not equal to the best bid) if the current best bid is below the previous bid (i.e., a downbid).⁷⁸ This alternative test would apply to the same securities as our uniform bid test.⁷⁹ While we are not proposing this alternative test as part of Regulation SHO, we seek comment on this test as another possible approach to regulating short sales.

We are aware that these proposals represent significant changes in the operation of Rule 10a-1. We request comment about the appropriateness of the proposed bid test and the alternative bid test.

Q. Should short sales continue to be limited by a price test? If the Commission did not adopt a price test under Regulation SHO, should it also preclude the ability of the SROs to have price tests?

Q. Would there be any benefits in eliminating a short sale price test? Would the elimination of a price test benefit the markets by allowing investors to more freely short sell potentially overvalued securities so that their price more accurately reflects their fundamental value? Are there other benefits to the removal of a price test, such as elimination of systems and surveillance costs?

Q. Would the proposed "bid test" in Rule 201, allowing short sales above the best consolidated bid, effectively prevent short selling being used as a tool for driving the market down?

Q. Would short sale regulation using the proposed bid test operate effectively in an auction market? If not, why not?

Q. Would short sale regulation using the proposed bid test operate effectively in a dealer market? If not, why not?

Q. Would there ever be a circumstance where there would not be a consolidated bid in an exchange-listed or Nasdaq NMS security? If so, please describe.

Q. The proposed bid test likely would inhibit short sales in a declining market because there would be few execution opportunities above the best bid. Is this appropriate?

Q. Is a one-cent increment an appropriate standard for allowing short sales above the best consolidated bid? If not, what is an appropriate increment?

Q. Would short sale regulation using the proposed bid test present any automated systems problems for market participants?

Q. Would the proposed bid test operate effectively in the current decimal environment, i.e., would bid flickering inhibit the operation of the test?

Q. Would the proposed bid test fulfill the fundamental goals of short sale regulation?

Q. Would the alternative test allowing short selling at a price equal to or above the consolidated best bid if it is an upbid better fulfill the goals of short sale regulation?

B. Scope of the Uniform Bid Test

1. Securities Subject to the Price Test

The proposed bid test would apply to all securities currently subject to short sale price tests, i.e., exchange-listed and Nasdaq NMS securities, wherever they are traded. Specifically, the proposed bid test would apply to all national market system securities as defined in §240.11Aa2-1 of this chapter, but shall exclude Nasdaq Small Cap securities, as determined by NASD rules.

Market information for securities, including quotes, is disseminated pursuant to a variety of different national market system plans. Generally, the SROs have developed networks or systems that disseminate market information.⁸⁰ The NYSE, Amex, Nasdaq, and the regional exchanges are all required to make available to vendors the best bids in any common stock, long-term warrant, or preferred stock.⁸¹ This information is disseminated as a part of an effective transaction reporting plan pursuant to the Consolidated Tape Association Plan (CTA Plan) and the Consolidated Quotation Plan (CQ Plan). The NYSE, Amex, Nasdaq, and the regional exchanges all participate in the CTA Plan and CQ Plan.⁸² Finally, Nasdaq disseminates market information for securities in the two tiers of the Nasdaq market, i.e., NMS and SmallCap stocks, as well as certain other securities traded OTC. Information for NMS securities is collected and disseminated pursuant to NASD's rules and the Nasdaq/UTP plan.⁸³

These networks are designed to ensure that consolidated bids from the various market centers that trade exchange-listed and Nasdaq NMS securities are continually collected and disseminated on a real-time basis, in a single stream of information. Thus, all market participants would have access to the consolidated bids for all the securities that would be subject to the proposed uniform bid test.

2. Securities Not Subject to the Price Test

We are not proposing at this time to extend the uniform bid test to securities not currently covered by a short sale price test (i.e., Nasdaq SmallCap, OTCBB, and Pink Sheet securities) in part because these markets have not been subject to the rule in the past. More significantly, we believe that the proposed locate and deliver requirements may address many of the concerns regarding abusive short selling in thinly-capitalized securities trading over-the-counter. In particular, these proposals should significantly discourage efforts to deliberately depress the price of these securities by removing the leverage abusive short sellers enjoy through short selling without incurring the costs of borrowing and delivering. We recognize, however, that issuers of less actively traded securities believe that they are particularly vulnerable to "abusive" short selling, and we seek specific comment on whether the proposed bid test or other price test should be extended to these securities.

Q. Should the proposed uniform bid test be extended to Nasdaq SmallCap and OTCBB Securities? Do these securities need the protection of the proposed uniform bid test?

Q. Should the proposed uniform bid test be extended to other OTC securities, e.g., those quoted in the Pink Sheets? If so, are quotes in these securities disseminated in a manner that would allow for the use of the proposed uniform bid test? In addition, would the proposed bid test be workable due to the fact that the best bid in these securities could be outstanding for long periods of time? If not, could a last sale test or some other test be applied to these securities?

C. Bid Test Flexibility in a Decimals Environment

The Commission is aware of concerns about the ability to effect short sales using the tick test in a decimals environment. In particular, with the increase in the number of price points from 16 to 100 per dollar as a result of pricing in decimals, there has been an increase in price flickering, i.e., an increase in the number of times the last trade price in a security changes rapidly.

As a result market participants have sought relief from the tick test provisions of Rule 10a-1. For example, some third market makers in exchange-listed securities offer trade execution for eligible customer orders at a price equal to or better than the consolidated best offer. However, if the consolidated best offer is below the previous last reported sale in a security and the third market maker or specialist has a short position, sales at the consolidated best offer would violate the tick test of Rule 10a-1. The Commission has granted an exemption from Rule 10a-1 to permit registered market makers and exchange specialists publishing two-sided quotes in a security to sell short to facilitate customer market and marketable limit orders at the consolidated best offer, regardless of the last trade price.⁸⁴ The exemption provided relief in a decimals environment to market makers and specialists in instances where they would be providing liquidity in response to customer buy orders. Such relief would not be necessary with a bid test, since such sales (by any market participant) would always be effectuated above the best bid, specifically at the consolidated best offer or better.

Permitting short sales above the best bid should alleviate other difficulties complying with the tick test in a decimals environment. The Commission's Office of Economic Analysis (OEA) conducted a study that found that the proposed bid test is considerably less restrictive than the current tick test.⁸⁵ Specifically, OEA compared the minimum shortable price (MSP) using the proposed bid test and the current tick test. Under the proposed bid test, the MSP is always a minimum increment above the bid. Under the tick test, if the last transaction was on an uptick or zero-plus uptick, the MSP is equal to the latest transaction price. If the latest transaction price was on a minus tick or a zero-minus tick, the MSP is equal to the latest transaction price plus one tick.⁸⁶ OEA found that the tick test was more restrictive (the MSP was higher for the tick test than it was for the proposed bid test) 60.4% of the time, the proposed bid test and tick test were equally restrictive (the MSP for the tick test and the proposed bid test were the same) 15.5% of the time, and the proposed bid test was more restrictive (the MSP was at or below the bid) 24.1% of the time. As this study indicates, the proposed bid test should offer more short selling opportunities than the current tick test.

D. Bid Test Flexibility for Passive Pricing Systems

We have granted limited exemptive relief from the tick test provisions of Rule 10a-1 in connection with short sale transactions executed on a volume-weighted average price (VWAP) basis.⁸⁷ The relief is limited to VWAP transactions that are arranged or "matched" before the market opens at 9:30 a.m. but are not assigned a price until after the close of trading when the VWAP value is calculated.⁸⁸ We granted the exemption based, in part, on the fact that these VWAP short sale transactions appear to pose little risk of facilitating the type of market effects that Rule 10a-1 was designed to prevent. In particular, the pre-opening VWAP short sale transactions do not participate in or affect the determination of the VWAP for a particular security. Moreover, the Commission stated that all trades used to calculate the day's VWAP would continue to be subject to Rule 10a-1.⁸⁹

There are also electronic trading systems that match and execute trades at other independently-derived prices, such as the midpoint of the consolidated best bid and offer. Limited short sale relief has been granted to certain systems that match customer orders at random times within specific time intervals.⁹⁰ These systems had requested relief from Rule 10a-1 because matches could potentially occur at a price below the last reported sale price. Due to the passive nature of pricing and the lack of price discovery, trades executed through the systems generally do not appear to involve the types of abuses that 10a-1 was designed to prevent.⁹¹

We believe that the proposed bid test would accommodate the recent growth of matching systems that execute trades at an independently derived price above the consolidated best bid. Such executions would generally comply with the proposed bid test, while also enabling customer orders to seek executions that would provide price, and possibly size, improvement.

We note, however, that there may be instances where the final execution price of VWAP short sale transactions could be at or below the closing best bid for that security, and thus would violate the proposed bid test. Nevertheless, we propose codifying an exception to the bid test provisions of proposed Rule 201 to permit short sales at the VWAP, subject to the same conditions included in the above exemptions.⁹² These would be the following: (1) all short sale orders will be received and matched before the regular trading session opens and the execution price of VWAP matched trades will be determined after the close of the regular trading session; (2) the VWAP for the covered security is calculated by: calculating the values for every regular way trade reported in the consolidated system, or on a primary market that accounts for seventy-five percent or more of the covered security's average daily trading volume for the security during the regular trading session, by multiplying each such price by the total number of shares traded at that price; compiling an aggregate sum of all values; and dividing the aggregate sum by the total number of reported shares for that day in the security; (3) the transactions are reported using a special VWAP trade modifier; (4) short sales used to calculate the VWAP will themselves be subject to the bid test; (5) the VWAP matched security qualifies as an "actively-traded security" (as defined under Rules 101(c)(1) and 102(d)(1) of Regulation M).⁹³ Where the subject listed security is not an "actively-traded security" or a S&P 500 Index security, the proposed short sale transaction would be permitted only if it is conducted as part of a basket transaction of 20 or more securities in which the subject security does not comprise more than 5% of the value of the basket traded; (6) the transaction is not effected for the purpose of creating actual, or apparent, active trading in or otherwise affecting the price of any security; (7) a broker or dealer shall be permitted to act as principal on the contra-side to fill customer short sale orders only if the broker or dealer's position in the subject security, as committed by the broker-dealer during the pre-opening period of a trading day and aggregated across all of its customers who propose to sell short the same security on a VWAP basis, does not exceed 10% of the subject security's relevant average daily trading volume, as defined in Regulation M.⁹⁴ Any VWAP short sale transaction that does not meet these conditions would need to comply with the bid test. In addition, all other provisions of Regulation SHO, including the marking requirements in Rule 201 and the locate and deliver requirements in Rule 203, would apply. We request comment on whether the proposed exception for VWAP executions, subject to these conditions, is appropriate.

Q. Do VWAP transactions create perverse incentives for broker-dealers, such that they should not be granted an exception? If an exception is included, are there ways to detect and limit the effects of these perverse incentives?

Q. Are the proposed conditions for the VWAP exception appropriate? If not, why not? Should there be any additional conditions?

V. Pilot Program

As a part of the Commission's review of short sale regulation, we are also proposing temporary Rule 202 of Regulation SHO that would suspend, on a pilot basis, the operation of the proposed bid test of proposed Rule 201 for specified liquid securities. We believe that the pilot is appropriate for several reasons. The pilot would enable us to study the effects of relatively unrestricted short selling on, among other things, market volatility, price efficiency, and liquidity. This would thus allow us to obtain empirical data to assess whether short sale regulation should be removed, in part or in whole, for actively traded securities. The pilot would also allow the Commission to determine the extent to which the proposed bid test achieves the three objectives of short sale regulation through the comparison of trading activity of similar stocks subject to the test and those not subject to the test.

In 1976 the Commission proposed a suspension of the tick test as a part of a comprehensive review of short sale regulation that was designed to obtain statistical data regarding short selling.⁹⁵ The pilot was never implemented due to concerns expressed by trading markets and listed companies.⁹⁶ However, there have been significant developments in market surveillance since 1976 that now make a pilot more appropriate. Further, the Commission and SROs now have access to a wide range of trading data on potentially manipulative trading behavior.⁹⁷ Access to this information greatly enhances the ability of the Commission and the SROs to monitor trading behavior during the proposed suspension of the bid test and surveil for manipulative short selling.

We also believe that a pilot may be appropriate in light of the Commodity Futures Modernization Act of 2000 (CFMA) lifting the ban on security futures.⁹⁸ Among other things, investors are now allowed to enter into futures contracts for the sale of individual securities at a fixed point in the future and at a set price. In authorizing single stock futures trading, Congress exempted transactions in security futures products from short sale regulation. Short security futures, i.e., obligating a person to make a future delivery of the underlying securities, may function as a substitute for short selling the underlying stock.⁹⁹ We believe that to the extent possible, consistent with investor protection, one market should not benefit over another because of regulatory differences. Thus, we intend to include liquid securities subject to futures trading in our proposed pilot.

As a result, we believe it is appropriate to propose a rule that would establish procedures for a temporary suspension of the trading restrictions of the price test of the Commission's short sale rule, and any short sale price test of any exchange or national securities association, for a limited number of securities. The securities that could be included in the pilot could be comprised of a subset of the Russell 1000 index, or such other securities as the Commission designates by order as necessary or appropriate in the public interest and consistent with the protection of investors after giving due consideration to the security's liquidity, volatility, market depth and trading market. The relative weight given to these factors would vary. In particular, the Commission would consider including in the pilot one-third of the securities in the Russell 1000 Index.¹⁰⁰ To select the stocks for the pilot if we were to use the Russell 1000, we would sort the Russell 1000 by average daily dollar volume over the calendar year prior to the start of the pilot and use an objective method that would create two samples that should be approximately similar in average market value and average volume.¹⁰¹ Of course, as noted above, the Commission might include different stocks in the pilot or base the pilot on a different broad-based index if it were necessary or appropriate in the public interest and consistent with the protection of investors.

While we recognize that the price of any security can be manipulated, we believe that as trading volume increases, it becomes less likely that a trader would be able to cost-effectively manipulate the price of a security.¹⁰² Further, the high levels of transparency and surveillance for actively-traded securities on exchanges and other regulated markets make it more likely that any manipulation would be detected and pursued.¹⁰³

The proposed temporary Rule 202 would remain in effect for two years. We anticipate that a partial, two-year suspension of the short sale rule would allow the Commission to gather and analyze the data necessary to reach conclusions regarding trading behavior in the absence of short sale price restrictions. The sample period should provide data on advancing and declining markets, high volume and low volume, and different stages of volatility so that the suspension can be studied fully.¹⁰⁴

The Commission notes that the general anti-fraud and anti-manipulation provisions of the federal securities laws would continue to apply to trading activity in these securities, thus prohibiting trading activity designed to improperly influence the price of a security.¹⁰⁵ Further, the pilot would only suspend the operation of the proposed bid test. All other provisions of proposed Regulation SHO, including the marking requirements of Rule 201 and the locate and deliver requirements of Rule 203, would continue in effect. Finally, the Commission could terminate the operation of the pilot, in whole or in part, prior to the end of the proposed two-year period as it determines necessary or appropriate in the public interest or to protect investors by removing all securities selected for inclusion in the pilot.

Q. Is the proposed rule temporarily suspending the short sale price test for liquid stocks appropriate? Are liquid stocks more difficult to manipulate through short selling?

Q. Is a two-year temporary suspension of the short sale price test a sufficient period to fully study the impact? If not, what time period should be selected? Commenters should provide specific reasons to support their view in favor of establishing another time period.

Q. Is the proposed selection method for the pilot, including our contemplated use of the Russell 1000, appropriate? If not, what other selection method should be considered? Is it possible that one market could benefit over another market depending on the selection of stocks for the pilot?

Q. Should the short sale price test be automatically reinstituted in extraordinary market conditions, for instance, if, on an intraday basis, the price of a security falls more than a certain percentage based on the day's opening price (e.g., if the price of a security falls 10% from the day's opening price short sale restrictions would be reinstituted)?

Q. The pilot, in part, would allow the Commission to obtain data to assess whether the price test should be removed for some types of securities and to study trading behavior in the absence of the proposed bid test. After analyzing the results of the pilot, the Commission may propose that the bid test be removed for certain exchange-listed and NMS securities. Should the Commission await the results of the pilot before applying the uniform bid test to exchange-listed and Nasdaq NMS securities that may later have the bid test removed?

Q. Should the pilot apply to existing short sale rules even if we do not adopt the new uniform bid test?

Q. The securities included in the pilot would still be marked and specialists and market makers can observe this mark prior to executing the short sale. How would this affect the outcome and reliability of the pilot, if at all?

VI. Rule 10a-1 Exceptions

Paragraph (e) of Rule 10a-1 currently contains 13 exceptions to the tick test designed to permit certain types of trading activities that were intended to benefit the markets or that were believed to carry little risk of the kind of manipulative or destabilizing trading that the Rule was designed to address. We have reviewed these exceptions in light of proposed Rule 201, and we propose modifying some exceptions for inclusion in Rule 201 and excluding other exceptions from the Rule.

A. Exceptions Proposed to be Retained

1. Long Seller's Delay in Delivery

Subsection (e)(1) of Rule 10a-1 has existed since the inception of the short sale rule in 1938. This exception allows short sales to be effected without regard to the current tick test if the seller owns the security sold and intends to deliver such security as soon as is possible without undue inconvenience or expense. It was created so that sellers who actually own a security will not be penalized in the event they are unable to deliver the security to their broker prior to settlement, despite every intention of doing so, or in the event the certificate turned in by the seller is not in a form appropriate for transferring.

In the event that the seller's shares are not delivered to the broker-dealer prior to settlement, borrowed shares may be used to consummate the sale. By definition, when borrowed shares are delivered, the sale is a short sale. We believe that this exception continues to be necessary to facilitate those limited circumstances where the seller owned the securities at the time of sale, however delivery may be briefly delayed, as when an option, right or warrant has been exercised but the underlying security has not yet been received by the seller. We propose to retain this exception from the proposed bid test substantially unchanged.¹⁰⁶

Q. Should this exception be retained in its current form?

Q. Is this exception outdated?

2. Error in Marking a Short Sale

Subsection (e)(2) of Rule 10a-1 has also existed since the inception of the Rule. This exception protects brokers in the event they execute a sale already marked long by another broker-dealer, but the sale turns out to be a short sale. The broker-dealer that marks the order long must abide by the provisions of the marking requirement that dictates when an order may be marked long and the executing broker-dealer may rely on this marking when executing the sell order. This exemption was created to avoid implicating a broker that has unknowingly participated in a violation of the Rule, and we believe the basis for including the exception still makes sense in the current environment.¹⁰⁷ We propose to retain this exception substantially unchanged.¹⁰⁸

Q. Should this exception be retained in its current form?

3. Odd Lot Transactions

An exception for certain odd-lot transactions was created in an effort to reduce the burden and inconvenience that short sale restrictions would place on odd-lot transactions. In 1938, the Commission found that odd-lot transactions played a very minor role in potential manipulation by short selling. Initially, sales of odd-lots were not subject to the restrictions of Rule 10a-1.¹⁰⁹ However, the Commission became concerned over the volume of odd-lot transactions, which possibly indicated that the exception was being used to circumvent the Rule. As a result, the exception was changed to the present two exceptions.¹¹⁰

Subparagraph (e)(3) is limited to odd-lot dealers registered in the security and third-market makers. The exception allows short sales by odd-lot dealers registered in the security and by third market-makers (of covered securities) to fill customer odd-lot orders. Subparagraph (e)(4) provides relief for any sale to liquidate an odd-lot position by a single round lot sell order that changes such broker-dealer's position by no more than a unit of trading. We understand the odd lot exception to still be of utility and not in conflict with the goals of the proposed bid test. We propose combining the two exceptions into one odd-lot exception under subparagraph (d)(3) of Rule 201 of proposed Regulation SHO.

In addition, we propose extending these exceptions to all market makers acting in the capacity of an odd-lot dealer. When the Rule was adopted, odd-lot dealers dealt exclusively with odd-lot transactions, and were so registered. Today, specialists assigned to a security are typically the odd-lot dealer in that security. We propose to broaden the use of this exception to all brokers or dealers acting as "market makers" in odd-lots.¹¹¹

Odd-lot transactions by market makers to facilitate customer trades are generally not of a size that could facilitate a downward movement in the market. Therefore, those acting in the capacity of a "market maker" should be able to off-set customer odd-lot orders and liquidate an odd-lot position by a single round lot sell order that changes such broker-dealer's position by no more than a unit of trading without regard to the restrictions of the current tick test or proposed bid test.

Q. Are these exceptions relating to odd-lots appropriate in today's markets?

Q. Should these exceptions apply to all market makers in odd-lots or should the exception be more limited?

Q. Are these odd-lot exceptions susceptible to abuse?

Q. Should all odd-lot transactions have an exception from the Rule? Would providing an exception for all odd-lot transactions pose a risk of increased short sale manipulation, e.g., would traders break up trades into 99 share odd-lots in order to avoid the price test?

4. Domestic Arbitrage

Current subsection (e)(7) of Rule 10a-1 was adopted in 1938 to allow short selling associated with certain bona fide domestic arbitrage transactions.¹¹² In adopting this exception, we stated that it "applies only to bona fide arbitrage transactions in a security effected, under certain circumstances described in the exception, by persons who own rights or privileges entitling them to acquire that security."¹¹³ The exception has remained unchanged since its adoption.

The term "bona fide arbitrage" generally describes an activity undertaken by market professionals in which essentially contemporaneous purchases and sales are effected in order to lock in a gross profit or spread resulting from a current differential in pricing of two related securities.¹¹⁴ The Commission continues to believe that bona fide arbitrage activities are beneficial to the markets because they tend to reduce pricing disparities between securities.¹¹⁵ These activities also carry limited risk of the kind of manipulative or destabilizing trading that Rule 10a-1 was designed to address.

We therefore propose that proposed Rule 201 of Regulation SHO would retain the general exception contained in (e)(7). Subparagraph (d)(5) of Rule 201 would continue to except short sales effected in bona fide arbitrage transactions involving convertible, exchangeable, and other rights to acquire the securities sold short, where such rights of acquisition were originally attached to or represented by another security, or were issued to all the holders of any such class of securities of the issuer. In addition, we have proposed adding language to the exception to require a person relying on the exception to subsequently acquire or purchase the security upon which the arbitrage is based.¹¹⁶ For example, if a person sells short securities to profit from a current price differential based upon a convertible security that entitles him to acquire an equivalent number of securities of the securities sold short, he must subsequently tender the instrument for conversion to obtain the underlying securities and complete the arbitrage in order to satisfy the terms of the exception. We have also proposed minor amendments to the language of the exception to make it more understandable.

Q. Should the exception be retained for purposes of the proposed Rule 201? If not, state specific reasons why the exception should be removed from the Rule.

Q. Minor changes have been made to the text of existing exception (e)(7) in the proposed rule to simplify its language. Are these changes helpful? Does the proposed amendment to the exception alter its meaning in a way that would affect its substance?

Q. Is the proposed amended exception too narrow or too broad? If so, state specifically why, and how it should be restructured in relation to the purposes of Regulation SHO.

Q. Should the requirement that the transactions be made in a separate domestic arbitrage account be eliminated? If so, should the exception permit domestic arbitrage to be effected in an arbitrage account in which international arbitrage could also be effected?

Q. Should exception (e)(7) be combined with (e)(8), the international arbitrage exception? Would such a combination create compliance problems or other issues?

Recently, Commission staff has received inquiries regarding the operation of (e)(7) in the context of a corporate merger. In particular, market participants have sought advice whether upon finalization of a merger agreement, wherein a date certain is determined for the merger, a party who is entitled to receive stock of the acquiring company under the terms of the merger agreement is entitled to sell short this stock without regard to the tick test pursuant to the domestic arbitrage exception. Unlike the arbitrage contemplated in (e)(7), the right to acquire another security in a merger scenario arises only by the terms of the merger agreement and not through a right vested in the security itself. We believe that this type of arbitrage is not within the scope of paragraph (e)(7), and therefore we are not proposing to include it.

Q. Should short sales effected in connection with a merger be excepted from the provisions of Rule 201? If so, at what point in the merger process should a party be deemed entitled to acquire the acquiring company's stock?

5. International Arbitrage

The international arbitrage exception in Rule 10a-1 (e)(8) has also remained unchanged since its adoption in 1939.¹¹⁷ The international arbitrage exception was added following an extended study of international arbitrage operations in their relation to short selling.¹¹⁸ The Commission concluded that the exception was necessary to facilitate "transactions which are of a true arbitrage nature, namely, transactions in which a position is taken on one exchange which is to be immediately covered on a foreign market."¹¹⁹

The Commission proposes to retain the international arbitrage exception because we understand that the exception is still being used and does not conflict with the goals of the proposed bid test. As with the domestic arbitrage exception, we have proposed amendments to the language in the exception in order to make it more understandable. In addition, we have incorporated language from current exception (e)(12) of Rule 10a-1 that provides that, for the operation of the international arbitrage exception, a depositary receipt for a security shall be deemed to be the same as the security represented by the receipt. This language was originally included in the Commission's 1939 release adopting the international arbitrage exception, but was incorporated separately in subparagraph (e)(12). We believe this provision should be moved from its current location to the international arbitrage exception because it directly pertains to the operation of that exception.

Q. Should the international arbitrage exception be retained for purposes of the proposed Rule 201? If not, state specific reasons why the exception should be removed from the Rule.

Q. Minor changes have been made to the proposed rule to simplify the language of the existing exception. Are these changes helpful? Do they alter the meaning of the exception in a way that diminishes its value or prohibits bona fide international arbitrage activity in relation to Rule 201?

Q. Is the proposed amended exception too narrow? If so, state specifically why it is too narrow and how it should be restructured to allow beneficial international arbitrage activity that does not carry the kind of manipulative or destabilizing trading that proposed Rule 201 is designed to address.

Q. Should the requirement that the transactions be made in a separate international arbitrage account be eliminated? If so, should the exception permit international arbitrage to be effected in an arbitrage account in which domestic arbitrage could also be effected, rather than in a separate international arbitrage account?

Q. Should exception (e)(8) be combined with (e)(7), the domestic arbitrage exception? Would such a combination create compliance problems or other issues?

6. Distribution Over-Allotment

Subsection (e)(10) generally excepts from Rule 10a-1 sales of securities by underwriters or syndicate members participating in a distribution in connection with an over-allotment, and any lay-off sales by such a person in connection with a distribution of securities through rights or a standby underwriting commitment.¹²⁰ Proposed Rule 201 would retain the over-allotment exception in substance, although minor changes have been made to simplify its language.¹²¹ Under the proposed bid test, the exception would permit short sales in connection with an over-allotment at or below the bid, thus enabling an underwriter to price an offering at or below the last bid. We propose including this exception in Rule 201 of Regulation SHO because these sales are all at the offering price and, therefore, do not implicate one of the goals of short sale regulation, i.e., preventing short sellers from accelerating a declining market by exhausting all remaining bids at one price level.

Q. Is this exception necessary? Under what circumstances would an underwriter or syndicate member price an offering below the best bid? Would extending the exception to short sales below the bid have any negative market impact?

7. Equalizing Short Sales and Trade-Throughs

Exceptions (e)(5)(ii) and (e)(11) were adopted in order to eliminate a potential conflict between Rule 10a-1 and Rule 11Ac1-1 under the Exchange Act (Quote Rule).¹²² The (e)(5) equalizing exception, as discussed in further detail below, permits market makers to effect short sales on a zero-minus tick (i.e., at the same price as the last trade price), but does not permit short sales, either as a dealer or agent, at a price lower than the last trade price reported in the consolidated system (i.e., on a minus tick). As a result, there arose a potential conflict between the operation of Rule 10a-1 and the "firmness requirement"¹²³ of the Quote Rule in situations where execution of an offer quotation by a broker or dealer would be rendered unlawful because of a trade-through¹²⁴ even though the offer had been at a price permitted under Rule 10a-1 at the time that broker or dealer had communicated it to its exchange or association for inclusion in the consolidated quotation system.¹²⁵

In order to resolve this potential conflict, the Commission adopted (e)(5)(ii) to permit market makers to execute transactions at their offer following a trade-through, and (e)(11) to permit non-market makers to effect a short sale at a price equal to the price associated with their most recently communicated offer up to the size of that offer¹²⁶ so long as the offer was at a price, when communicated, that was permissible under Rule 10a-1. The (e)(11) exception was added in response to several comments that, in addition to orders for their own account, specialists and other floor members also often represent as part of their displayed quotations orders of other market participants (e.g., public agency orders or proprietary orders of non-market makers) that also might be ineligible for execution under Rule 10a-1 following a trade-through in another market.¹²⁷

We believe that the rationale for adopting exceptions (e)(5)(ii) and (e)(11), namely resolving a conflict between the short sale rule and the quote rule arising from a trade-through, would not exist under the proposed bid test. Under the proposed rule, the reference point for a market participant seeking to execute a short sale would not be the last trade price, which could be a down tick created by a trade through, but rather the current consolidated best bid.

It appears that under the proposed bid test, a comparable situation as that envisioned under (e)(5)(ii) and (e)(11) would result in a locked or crossed market.¹²⁸ Locking or crossing a quote temporarily frustrates trading in a particular security, and there are various rules and regulations that guard against such practices.¹²⁹ We have stated in prior releases that continued locking and crossing of the market can negatively impact market quality, and have approved SRO rules aimed at reducing the frequency of locked and crossed markets and providing more informative quotation information, facilitating price discovery, and contributing to the maintenance of a fair and orderly market.¹³⁰

However, we recognize that locked and crossed markets have not been eliminated entirely, and thus the same conflict between the firm quote rule and the short sale rule could arise under the proposed bid test. We believe that this situation would exist where a market participant posts an offer to sell short at a valid price, i.e., above the best bid, but the bid subsequently moves up and either locks or crosses the market participant's posted offer. A market participant in this situation could still be required to execute buy orders directed to its posted offer, which would be at or below the best bid.¹³¹ The Commission thus proposes to include an exception to Rule 201 of Regulation SHO permitting a responsible broker-dealer, as defined in Rule 11Ac1-1 under the Exchange Act¹³² to effect a short sale at a price equal to its posted offer when the market is locked or crossed, when consistent with best execution obligations, provided however, that the exception would not apply to any broker-dealer who initiated the locked or crossed market.

Q. Would an exception from the proposed bid test permitting a short sale to be effected at the consolidated best offer if the market is locked or crossed be useful or necessary to remedy problems associated with locked and crossed markets? If so, describe such circumstances and the market participants to whom the exception should apply.

Q. Would such an exception be used appropriately to remedy the problem of locked and crossed markets, or could such an exception be susceptible to abuse? Is there another way to design an exception for locked and crossed markets?

Q. Some market participants that provide their customers with guaranteed executions of their buy orders at a price equal to the consolidated best offer would be prevented from selling short to fill customer buy orders in a locked or crossed market, due to the fact that the short sale would be executed at a price equal to or below the best bid. Should there be an exception to allow these market participants to execute short sales at their offer to facilitate customer buy orders in locked or crossed markets?

B. Exception Proposed to Be Eliminated

Exception (e)(6) of Rule 10a-1, the original "equalizing exception," was adopted by the Commission in 1938 to allow a short sale of a security on a regional exchange at the same price as the then current price for the same security on the principal exchange, even though the short sale on the regional exchange would constitute a zero-minus or minus tick in relation to the last preceding trade price on the principal exchange.¹³³ The exception, limited to short sales effected on an exchange, permitted regional specialists to guarantee execution at a price at least as favorable to the customer as he would have obtained had his order been exposed to the principal exchange market.¹³⁴ The Commission believed that unless the regional exchanges were allowed to fill purchase orders at prices that would have been obtained on the principal exchanges, regional exchanges would be unable to attract sufficient order flow to remain viable.¹³⁵

In 1975 the Commission adopted amendments to Rule 10a-1 in conjunction with the full implementation of the consolidated transaction reporting system ("consolidated system").¹³⁶ As amended, Rule 10a-1 applies a tick test referencing the last trade price reported in the consolidated system, however permits an exchange to make an election to use a tick test that references the last trade price reported in that exchange market.¹³⁷

In addition to altering the reference point for determining the permissibility of short sales, the amendments also altered the reference point for the permissibility of equalizing short sales. Subsection (e)(5)(i) was added to provide an exception for short sales of certain securities effected by a registered specialist, exchange market maker, or third market maker at a price equal to the last price reported in the consolidated system.¹³⁸ The exception applies to short sales of securities registered or admitted to unlisted trading privileges on an exchange, whether effected on an exchange or over-the-counter, if transactions in the security are reported pursuant to an effective transaction reporting plan and made available on a real time basis to vendors of market transaction information.

The exception is intended to permit market professionals to protect customer orders against transactions in other markets in the consolidated system by allowing them to sell short at a price equal to the last trade price reported in the consolidated system, even if that sale was on a minus tick (a so-called "zero-minus tick").¹³⁹ Concurrent with the adoption of subsection (e)(5)(i), exception (e)(6) was amended to apply only to short sales of securities covered by Rule 10a-1(b), i.e., to short sales of exchange-listed securities that are not reported to the consolidated system or made available on a real-time basis.¹⁴⁰

We do not believe that the equalizing exceptions should be retained as part of proposed Regulation SHO. The rationale for exceptions (e)(6) and (e)(5)(i), i.e., allowing short selling at a price that matches a given security's last trade price on another market center, would not exist under our proposed short sale rule. The proposed rule would reference the real-time consolidated best bid rather than the last trade price, and would not depend on prices in individual markets.¹⁴¹ We therefore do not believe that a registered specialist or exchange market maker would need to "equalize" their price with a price on another market center.

Q. Is there any reason why exception (e)(6) should be retained?

Q. Is there any reason why exception (e)(5)(i) should be retained? For example, would broker-dealers that provide customers with executions at a price equal to transaction prices on a primary exchange require an exception to facilitate customer buy orders?

VII. Prior Exemption Letters under Rule 10a-1

A. Exchange Traded Funds

Exchange Traded Funds (ETFs) are designed to provide investment results that correspond generally to price and yield performance of securities included in a particular index or securities portfolio. In light of the composite and derivative nature of ETFs, the Commission found that trading in ETFs would not be susceptible to the practices that Rule 10a-1 is designed to prevent and granted an exemption from Rule 10a-1 for transactions in these securities.¹⁴² In particular, the Commission found that ETFs should rise or fall based on changes in the net asset value of the component stocks of the particular index and supply and demand.¹⁴³

The relief is subject to a number of specified conditions. In particular, the corresponding index or portfolio represented by the ETF must consist of a "basket" of twenty or more different component stocks, in which the most heavily weighted component stock cannot exceed 25% of the weight of the index or portfolio. Moreover, the component stocks that in the aggregate account for a least 85% of the weight of the underlying index or portfolio must have a minimum public float value of at least $150 million and, with certain exceptions, a minimum ADTV with a value of at least $1 million during each of the previous 2 months of trading prior to the formation of the ETF series. We believe that these conditions continue to be necessary to ensure the composition of the ETFs is such that short selling in the ETFs does not implicate the type of trading activity that short sale regulation was designed to prevent.

The relief previously granted under Rule 10a-1 would continue to apply to cover exemptions from the price test provisions of Rule 201 of Regulation SHO.

Q. Should the Commission provide relief from proposed Rule 201 of Regulation SHO for transactions in ETFs? If so, are the conditions for relief appropriate? If not, please explain why.

Q. Should the relief be codified as an exception to proposed Rule 201 of Regulation SHO?

B. Short Sales Executed at the Closing Price

The Commission has granted conditional relief from the price test provisions of Rule 10a-1 to allow requesting exchanges¹⁴⁴ and broker-dealers¹⁴⁵ to execute short sales in after-hours crossing sessions at a price equal to the closing price of the security.¹⁴⁶ Absent relief, such short sales could violate Rule 10a-1, in that the matching price (the closing price) of a security could be on a minus or zero-minus tick with respect to the last sale in the consolidated transaction reporting system. In granting this conditional relief, we have noted that short sale transactions executed at the closing price generally do not represent the type of abusive practices that Rule 10a-1 is designed to prevent. In particular, short sale orders entered in the after-hours crossing sessions cannot influence the matching price, but rather are priced by unrelated order flow and transactions occurring during the primary trading session, which are subject to the tick test. The relief previously granted under 10a-1 would continue to apply to cover exemptions from the price test provisions of Rule 201 of Regulation SHO.

Q. Do closing price transactions create perverse incentives for broker-dealers, such that they should not be granted an exception?

Q. Should the relief be codified as an exception to proposed Rule 201 of Regulation SHO?

VIII. Market Maker Exception from Proposed Uniform Bid Test

It has been argued that short selling by market makers helps offset imbalances in the supply and demand or gaps in the flow of buy and sell orders.¹⁴⁷ NASD Rule 3350 exempts from operation of the NASD's bid test short sales executed by qualified market makers in connection with bona fide market making.¹⁴⁸ There is currently no similar exception in Rule 10a-1, however, for the bona fide market making activities of specialists and third market makers in exchange-listed securities.

The chief reason advanced in support of the NASD market maker exception is that it enhances liquidity by permitting market makers to adjust inventory positions quickly.¹⁴⁹ If market makers were required to wait for an upbid to make a short sale, it is asserted that their ability to satisfy their market making functions would be impaired. The NASD has also argued that market makers perform an important market stabilizing function. According to a 1997 study by NASD Economic Research, market makers provide immediate, stabilizing liquidity.¹⁵⁰ If there is heavy selling pressure by investors and the market is moving down, market makers provide stability by standing ready to buy stock. According to the study, application of a short sale rule to market makers could reduce a market maker's ability to adjust inventory positions quickly, thereby reducing its supply of immediate liquidity to the marketplace.¹⁵¹ The NASD study also states that application of the short sale rule to market makers could increase market makers' costs, which would be passed on to investors in the form of wider spreads.¹⁵²

We do not find these arguments persuasive in the context of the proposed uniform bid test. In providing liquidity to customers, a market maker primarily buys at the bid and sells at the offer, or in between the bid and offer. We believe that a market maker should rarely need to sell short at or below the bid in its market making capacity.¹⁵³ The proposed rule permits unrestricted short sales at the offer or at any other price that is one cent or more above the bid, and thus the need for an exception to allow market makers to sell at or below the best bid seems limited.¹⁵⁴

We are also concerned that the exception may be being used by entities that are not actually engaged in bona-fide market making.¹⁵⁵ For example, some issuers and investors have argued that some market makers are relying on the exception to continuously sell short into the bid — an activity that, as mentioned above, we find inconsistent with bona fide market making. The Commission believes that for the rule to have its intended positive effect on the market, all market participants, including market makers, should be subject to the rule.¹⁵⁶

A market maker that is positioning inventory to profit from market moves would find it advantageous to be able to short into the bid, like any speculator. One of the historical goals of short sale regulation is to prevent short sellers from accelerating a declining market by exhausting all remaining bids at one price level, and causing successively lower prices to be established by long sellers.¹⁵⁷ If such a seller is able to exhaust the existing bids in a security with short sales, and is able to attract long sellers to the market, the goal of accelerating the price decline of a particular security would be accomplished. Another goal of short sale regulation is that long sellers should have the right to sell first in a declining market.

Nevertheless, we believe that the proposed exception that would allow broker-dealers to execute customer sales on a riskless principal basis by looking to the customer's position would provide broker-dealers with additional flexibility to facilitate customer orders.¹⁵⁸ In addition, we are proposing an exception from Rule 201 to allow broker-dealers to sell short at a price equal to the consolidated best bid, when consistent with best execution obligations, in order to fill customer orders it is required to execute pursuant to federal securities laws or SRO rules, such as NASD IM-2110-2 and the related interpretation of IM-2110-2 (Manning Interpretation). According to Nasdaq, the Manning Interpretation is designed to ensure that customer limit orders are executed in a fair manner and at similar prices at which a firm has traded for its own account.¹⁵⁹ If a broker-dealer executed an incoming market sell order at the consolidated best bid, it would then be obligated to fill other customer limit orders it held at that price.¹⁶⁰ However, if the broker-dealer had a net short position, it would be prohibited by proposed Rule 201 from filling the customer buy order at a price equal to the bid. We believe the proposed exception would remedy this conflict.

We seek comment on the importance of a market maker exception in the context of a market maker's role in providing liquidity. We also seek comment on the extent to which market makers might need to be able to short at the bid in order to facilitate a customer buy order, and inquire whether an exception limited to those situations would be necessary or appropriate.

Q. Should the proposed uniform bid test include a bona fide market making exception? If so, why? How important is it for a market maker to be able to profit from position trading? Could there potentially be negative consequences to the market if there is not an exception for bona-fide market making transactions? Please describe.

Q. If a market making exception from the bid test is necessary, what should be done to limit its use to those engaged in bona-fide market making? Should the exception be tied to certain qualifications or conditions? If so, what should these qualifications or conditions be?

Q. If inclusion of a bona fide market making exception is necessary, would there be any circumstances where a market maker acting in his market making capacity would need to sell short below the bid?

Q. How often do market makers or other broker-dealers sell short at the bid in response to customer buy orders? Would it be feasible to allow market makers or other broker-dealers to sell short at the bid to facilitate customer buy orders without undermining the purposes of the price test? If so, should there be limits on such short sales, for example to prevent a dominant market maker from filling customer orders at the bid in order to place downward pressure on the security's price?

Q. What other type of transactions should qualify for a bona fide market making exception?

IX. Proposed Changes to the Order Marking Requirement

A. Marking Orders

We propose combining current marking requirements in subsections (c) and (d) of Rule 10a-1 into new subsection (c) of Rule 201. New subsection (c) generally would differentiate between "long," "short," and "short exempt" orders. The marking requirement would apply to all exchange-listed securities and over-the-counter securities. An order could only be marked "long" when the seller owns the security being sold and the security either is in the physical possession or control of the broker-dealer or will be prior to the settlement of the transaction. A sell order would be required to be marked "short exempt" if it were a short sale effected pursuant to an exception in Rule 201.

We believe that the proposed change would eliminate the current discrepancy between how Rule 3b-3 defines a short sale and the marking provisions found in Rule 10a-1. There are circumstances where an order can be marked "long," but is a short sale executed without regard to the current tick test. For example, a person placing a sell order may be deemed to own a security under current Rule 3b-3(b) — (e),¹⁶¹ but must borrow securities to consummate the delivery (e.g., because the securities due upon a conversion of a security have not been received). While borrowing to settle a sale constitutes a short sale under Rule 3b-3, the seller would not be subject to the current tick test if at the time of the trade the seller owns the security and intends to deliver such security "as soon as possible without undue inconvenience or expense."¹⁶² This sale would be marked "long" under the current marking provisions of Rule 10a-1(d).

Under our proposed amendment, the sell order described above would not be marked "long" because, while the above seller may own the security, the security is neither in the physical possession or control of the broker-dealer nor is it reasonably expected to be prior to the settlement of the transaction. The seller would thus have to borrow the stock in order to effectuate delivery to the buyer. Instead the seller, availing themselves of exception (d)(1) of Rule 201, would mark the order "short exempt." Requiring the order to be marked "short exempt" promotes consistency among related rules and uniformity among markets and market participants in the manner in which short sales are marked.

We believe that the proposed amendments would provide several benefits. The current marking requirements can lead to undetected violations of Rule 10a-1 because once the order is marked "long," it is processed and executed as such, even though borrowed shares consummate the delivery on the sale. This complicates surveillance for violations of Rule 10a-1, as short sales executed under an exception from the rule can be masked as "long" sales. Further, under the current marking requirements there is no record of how short sellers are availing themselves of the various exceptions to Rule 10a-1. We believe that surveillance for compliance with proposed Rule 201 would be facilitated with accurate indications of when and under what circumstances the exceptions are utilized.

The practice of designating an order as "short exempt," as proposed, has already developed. Many broker-dealers are already required to mark short sales as short exempt if they are effected under one of the exceptions from Rule 10a-1. For example, ITS participants¹⁶³ are required to designate commitment orders as "short exempt" when the short sale falls under an exception to the application of Rule 10a-1.¹⁶⁴ The NYSE has advised its members that it is "appropriate" to mark those short sale orders covered under exceptions to the rule as "short exempt."¹⁶⁵ In addition, NASD Rule 4991(i) requires all orders executed on Nasdaq be designated as "buy," "sell long," "sell short," or "sell short exempt."¹⁶⁶ The proposed amendment would require orders to be marked as either "long," "short," or "short exempt," providing greater uniformity.

Further, we believe that requiring a broker dealer to have physical possession or control of the security at execution, or, in the alternative, that the broker dealer obtain physical possession or control of the security prior to settlement, before marking the order "long" should facilitate the process of clearance and settlement in the current T + 3 environment. Disturbances in settlement processes can affect the stability and integrity of the financial system in general. Clearance and settlement systems are designed to preserve financial integrity and minimize the likelihood of systematic disturbances by instituting risk-management systems.¹⁶⁷ Requiring a broker-dealer to have possession or control of the securities before the broker-dealer can mark an order long should help to reduce failures to deliver. We anticipate that this proposed amendment would not be burdensome to market participants because most customer securities are not held by investors in physical form, but rather are held indirectly through their broker-dealer, i.e., in "street name."¹⁶⁸

Q. What type of additional costs and burdens, if any, would be associated with requiring orders to be marked "short exempt?"

Q. Does the requirement that a broker has physical possession or control of the security or will have physical possession or control prior to settlement place undue or unreasonable hardship on long sellers?

Q. Should proposed Rule 200 require a broker or dealer marking a sell order "short exempt" to identify the specific exception that the broker or dealer is relying on in marking it "short exempt?" If not, state why not.

B. Marking Requirements for Riskless Principal Transactions

Recently, some market makers have indicated that they would like exemptive relief from Rule 10a-1 to mark sell orders based on a customer's net position when a broker-dealer or market maker is effecting the execution of the customer's order on a riskless principal basis.¹⁶⁹ For example, a customer who is net long 1,000 shares of XYZ security enters an order to sell those securities with a market maker, the market maker then seeks to sell 1,000 shares of XYZ from his proprietary account to facilitate the trade prior to obtaining the securities from the customer. In this situation, market makers acting as riskless principal have sought an exemption from Rule 10a-1 to mark the market maker's sale from its proprietary account as "long" based on the customer's long position, regardless of the market maker's proprietary position in the security.

We believe that for the purposes of short sale regulation, the position of a broker-dealer should be deemed to be the same as a customer's position, regardless of whether the broker-dealer has a proprietary net "long" or "short" position, when the broker-dealer acts in a riskless principal capacity.¹⁷⁰ We believe that in this context, the broker-dealer effects the sale in a manner analogous to an agency execution. A short sale effected on an agency basis is marked according to the customer's net position. We therefore propose adding an exception to the proposed bid test of Regulation SHO that would allow broker-dealers to mark such sell orders "short exempt."¹⁷¹ Allowing a broker-dealer to mark an order in this manner does not implicate the stated concerns raised by short selling, i.e., where a customer is long, specialist or market maker principal transactions should not be restricted in the same manner as short sales.¹⁷²

We are concerned, however, that this exception from proposed Rule 201 not be used in an abusive or manipulative manner. Towards that goal, we would restrict this provision to riskless principal transactions as follows:

• a transaction in which a broker or dealer, after having received an order to sell a security, sells the security as principal at the same price to satisfy the order to sell;
   
• the sell order must be given the same per-share price at which the broker or dealer sold shares to satisfy the facilitated order, exclusive of any explicitly disclosed markup or markdown, commission equivalent or other fee;
   
• the broker or dealer must have written policies and procedures in place to assure that, at a minimum: the customer order was received prior to the offsetting transaction; the offsetting transaction is allocated to a riskless principal account or customer account within 60 seconds of execution; the broker or dealer has supervisory systems in place to produce records that enable the broker or dealer to accurately and readily reconstruct, in a time-sequenced manner, all orders effected pursuant to this exception.

We believe that these conditions would allow for the surveillance of the exception by linking the exception to specific incoming orders and executions, and by requiring the brokers and dealers to establish procedures for handling such transactions. Moreover, requiring the orders to be received prior to the offsetting transaction and the allocation of the offsetting transaction to the customer within 60 seconds would help avoid the exception from being abused by brokers or dealers who may attempt to retroactively claim the exception for transactions that were not done on a riskless principal basis.¹⁷³

In order to assess whether this proposed exception properly addresses the needs of specialists or market makers, we ask the following questions:

Q. Does the proposed riskless principal exception allow brokers and dealers to facilitate customer orders handled on a riskless principal basis regardless of their proprietary net position? Are the conditions appropriate? In particular, is the requirement to allocate the offsetting transaction to the customer within 60 seconds appropriate?

Q. Is there any concern that this provision is not consistent with the goals of short sale regulation? If so, how?

X. Rule 3b-3

Rule 3b-3 defines the term "short sale" as any sale of a security that the seller does not own or any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. Rule 3b-3 also defines specific instances when a person shall be deemed to own a security, i.e., a long position, for the purposes of Rule 10a-1.

We are proposing new Rule 200 to replace Rule 3b-3 and include several amendments to Rule 3b-3. As discussed in further detail below, we seek comment on including a modified version of current subparagraph (b) of Rule 3b-3 in Rule 200 that would require that a person not only have entered into an unconditional contract, binding on both parties thereto, to purchase the security, but also that the contract specify the irrevocable price and amount of securities purchased and provides for present delivery. We also propose amending the Rule to allow broker-dealers to calculate net positions in a particular security within defined trading units. Additionally, we propose that the definition of a short sale include the block-positioner exception from the current Rule 10a-1(e)(13). We also propose codifying in Rule 200 prior interpretations related to security futures products, and the unwinding of certain index arbitrage positions.

A. Unconditional Contracts to Purchase Securities

Under Rule 3b-3, a person owns a security if the person has "purchased, or has entered into an unconditional contract, binding on both parties thereto, to purchase it but has not yet received it."¹⁷⁴ The staff has recently received inquiries about whether certain transactions qualify as an "unconditional contract" for the purposes of short sale regulation. In particular these inquiries focus on whether it is necessary for a contract to specify the price and amount of securities to be purchased in order to be considered an unconditional contract.

In 1992 the Commission proposed to clarify that an "unconditional contract" must specify a fixed, currently ascertainable price, and the exact amount of securities to be obtained in order for a person to be deemed to own a security under subparagraph (b) of Rule 3b-3.¹⁷⁵ The proposed amendments were intended to address potentially abusive trading practices associated with contracts for future purchases of securities where the price or volume was based on a formula or other contingent event. We were concerned about the potential for abuse associated with securities contracts where the purchase price is based on the next following closing