Darla C. Stuckey
Via email to firstname.lastname@example.org
March 1, 2004
Jonathan G. Katz
Reference: File No. S7-23-03
Dear Mr. Katz:
The New York Stock Exchange, Inc. ("the Exchange") is pleased to have the opportunity to respond to the Securities and Exchange Commission's ("the Commission") request for comments on proposed Regulation SHO (Regulation of Short Sales), as discussed in Release No. 34-48709.
Locate and Delivery Requirements
The Exchange believes that broker-dealers effecting short sales for their own account or the accounts of customers, must be in a position to complete the transaction. This requires the broker-dealer to make an affirmative determination, evidenced in writing, that there are excess securities at the broker-dealer available to make the delivery, or that the stock is available to be borrowed.
The Exchange supports the use of "easy to borrow" lists as proposed under Rule 203 as an appropriate manner by which short sellers can comply with the requirement to have "reasonable grounds" to believe that securities sold short could be borrowed. The reliance on "easy to borrow" lists should require broker-dealers to keep current and maintain adequate procedures for updating and removing securities on the list on a continuing basis.
Generally, securities that are on an "easy to borrow" list should not fail to be delivered. In the event that a security that is on an "easy to borrow" list fails to be delivered, we believe that utilization of an "easy to borrow" list may not be relied upon. Fails that occur based upon reliance on an "easy to borrow" list should subject the broker-dealer to significant penalties similar to penalties proposed for not delivering securities within two days after the settlement date for securities where there is evidence of significant settlement failures.
The Exchange would generally not favor the use of "hard to borrow" lists, which are utilized by some firms today. If a security is not on a "hard to borrow" list, then the presumption is that the security is available and therefore a short sale may be executed. We believe that the use of "easy to borrow" lists, together with an industry wide list of securities where there is evidence of significant settlement failures (i.e. those for which there are fails to deliver at a clearing agency of 10,000 shares or more and that is equal to at least one-half of one percent of the issue's total shares outstanding), prepared daily by the National Securities Clearing Corporation ("NSCC") as proposed, would be a more appropriate means of determining whether a security sold short could be borrowed. Consequently, the Exchange believes that broker-dealers should be required to make an affirmative determination for those securities that are not on the "easy to borrow" list.
Proposed Regulation 203(b) permits the broker-dealer "or the person for whose account the short sale is executed" to borrow or enter into an arrangement to borrow the security. The Exchange believes that the locate requirement should be imposed on the broker-dealer, a regulated entity, and not the "customer". As a result of recent special examinations performed by the Exchange at certain member firms regarding short sales and delivery requirements, the Exchange believes that reliance on the "customer" to provide a valid locate is problematic. Allowing the customer to satisfy the locate requirement may not be consistent with the two previous "No-Action" letters from the Commission related to prime brokerage arrangements. However, if the final Rule does allow for the customer to satisfy the locate requirements of Regulation 203(b) then, in addition to having adequate policy and procedures addressing such practices, if fails to deliver occur in that security after reliance on the customer to satisfy the locate requirements, then the benefit of utilizing the customer's locate should not be allowed for reliance in the future for a period of ninety days consistent with the restrictions as proposed under Rule 203 regarding non-delivery of securities sold short.
The Exchange recommends that all publicly traded equity securities should be subject to a two-day delivery requirement, not just limited to those securities where there is evidence of significant settlement failures.
Proposed Rule 203 imposes consequences for broker-dealers that do not deliver securities within the T+5 time frame, which restricts the broker-dealer from executing future short sales in such security for ninety days unless the broker-dealer or the person whose account the short sale was executed for borrowed the security or entered into an arrangement to borrow the security prior to executing the short sale. The Exchange believes that the broker-dealer should be required to pre-borrow securities for that account during the ninety-day period. Additionally, the proposed rule would require the rules of the registered clearing agency to include the provision that the broker-dealer failing to deliver shall be referred to the NASD and its Designated Examining Authority ("DEA") for appropriate action. The Exchange is of the view that, to prevent regulatory duplication, the broker-dealer need be referred only to its DEA.
Specialist and Market Maker Exemption
Proposed Regulation SHO provides a Specialist or Market Maker exemption from the locate rules in connection with bona-fide market maker activities. The Exchange agrees with this exemption. However, the Commission should adopt certain standards in making the determination that market making is "bona-fide". With respect to specialists and market makers and proposed Rule 203's ninety-day restriction from short selling for its own account or for a customer who has failed to deliver by T+5 certain securities where there is evidence of significant settlement failures, the Exchange believes that the specialist should not be penalized by this restriction which could inhibit its ability to fulfill its market-making obligations. Nevertheless, the Exchange believes that adequate procedures should be in place at the clearing firm that clears the specialist/market-maker activity in order to attempt to make the required deliveries on behalf of the specialist/market-maker.
Uniform Bid Test
Proposed Rule 201 replaces the current "tick" test with a "bid" test. The Exchange believes that the "tick" test is better than the proposed "bid" test because it is based on a validated price (i.e., an actual sale) rather than a bid, which reflects an interest in trading and may not be supported by a readily verifiable order. In addition, the possibility of unsynchronized time clocks in different markets, the existence of "phantom bids" (i.e., bids not supported by actual or verifiable orders), and "bid flickering" (i.e., rapidly changing bids) also reflect the superiority of the "tick" test. For example, a recent analysis of one day's bids in the top 100 Exchange-listed securities disclosed an actual bid duration, on average, of approximately 2.9 seconds. A similar analysis of bids in Nasdaq's top 100 securities for the same day disclosed an average bid duration of approximately 0.8 seconds. In addition, use of a "bid" test may cause problems on the open, as it is unclear what bid would control - the last bid that controls after-hours trading under the proposed rule or some other bid. Moreover, the Exchange believes the "bid" test will increase the ability to manipulate short selling in secondary and tertiary securities.
The proposed "bid" test will slow down trading and result in artificially high prices that will cost investors money. For example, under the current "tick" test, if the market is five cents bid, offered at seven cents, a short sale could occur at six cents. This would also be true under the proposed "bid" test. However, if the bid is then changed to six cents, under existing rules, a short sale could occur at that price, but not under the proposed "bid" test. That second short sale would have to occur at seven cents. In other words, the second short-selling customer would receive at least one cent less than the previous short seller, simply because he or she was second in line. In contrast, under the proposed pilot (no price restrictions for 300 liquid securities) short sellers will be able to hit the bid continuously, driving prices down. This is particularly true in gap quote situations, where a sell imbalance exists. The specialist disseminates the existence of such imbalance by widening the quote, but this may simply encourage short sellers to "pile-on" adding increased sell pressure. As such, the combination of these rules will likely contribute to increased volatility, particularly in severe market declines.
In support of the "tick" test, the Exchange notes that it has shown to be effective with decimal pricing. The Exchange suggests it would be more efficient and enhance market transparency to require more rapid reporting of non-Exchange transactions to address the Commission's concerns that "ticks" may occur out of sequence. One of the Commission's stated reasons for proposing the "bid" test is that the last sale used for "tick" test purposes may not be the most current consolidated last sale, given the ninety-second reporting timeframe for NMS and NASDAQ SmallCap securities. However, given the Commission's view that technological advancements have made execution speed a prominent consideration, it seems incongruous to permit reporting of these "speedy" executions to be delayed for more than a minute. Requiring more timely transaction reporting would solve the concern that tick-altering transactions are being reported out of sequence. Further, the "tick" test promotes market transparency by providing investors with real-time information about actual trades and prices, rather than the indications of interest represented by bids.
Accordingly, the Exchange recommends the current "tick" test be preserved, with more speedy trade reporting required from other markets. Should the Commission adopt the "bid" test, the Exchange requests an extended implementation period as there are significant technology issues that would need to be addressed.
Proposed Pilot Program
Proposed Rule 202 immediately suspends the operation of the new "bid" test for a group of 300 securities (to be identified at a later date) for a period of two years. The stated purpose of this pilot is to compare the trading in these securities with those subject to the restrictions of the "bid" test to determine whether continued price restrictions, at least for certain securities, continue to be warranted.
The Exchange, its members and its listed companies strongly support continued price restrictions for short sales in all securities. These restrictions, whether by a "tick" test or a "bid" test, dampen undue volatility and prevent unscrupulous market participants from forcing stock prices lower for reasons unrelated to actual market forces. Short sale price restrictions assist in providing balanced protection for all market participants, including both professional traders and individual investors.
However, should the Commission determine to eliminate price restrictions for short sales in any security, the Exchange believes that, in the absence of federal regulation, each market should be free to adopt whatever rules it believes are appropriate for that market and that are consistent with the protection of investors. In this case, the Exchange strongly believes that price restrictions on short sales are appropriate and should be permitted to retain them in the absence of federal regulations to the contrary.
Similarly, the Exchange, its members and its listed companies strongly urge that short sale price restrictions apply to all securities equally. Otherwise it will create a confusing system that will slow trading, lead to errors and baffle market participants. Moreover, two sets of short sale rules could lead to artificially anomalous price situations, particularly for securities within the same industry where some are subject to a "tick" or "bid" test and others are not. The pilot will cause artificial "financial engineering" in that trading decisions may be based on something other than market mechanisms.
Moreover, the proposed length of the pilot - two years - is an exceptionally long time, particularly without any quick mechanism to shorten or end it should the pilot prove dislocating to market prices.
Accordingly, the Exchange recommends that the pilot proposal be withdrawn.
Short Sales to Equalize Price of Foreign Security
Currently, pursuant to a statement in a 1992 Commission rule proposal, specialists have been able to effect short sales at the open to equalize the price of a foreign security traded on the Exchange with the last reported price for that security in its principal market (see Securities Exchange Act Release No. 34-30772, 908 SEC Docket 905, 909 [June 3, 1992]). Proposed Regulation SHO is silent with respect to this matter. The Exchange believes that this type of short sale is consistent with and necessary to the creation of fair and orderly markets and should be continued. Accordingly, the Exchange suggests this type of short sale transaction be added to the proposed rule.
Initial Sale of IPO
Proposed Regulation SHO is silent with respect to a 1955 Commission interpretation that the initial sale of a security newly-listed on the Exchange may be a short sale. The Exchange seeks clarification on the continued validity of this interpretation, as well. However, in this regard, the Exchange believes that investor protection is not served by permitting short sales on the open in a security with no previous public market, if the price is below the offering price, because short selling in that circumstance may give rise to the manipulative concerns the rules were designed to combat (see Securities Exchange Act Release No. 34-30772, 908 SEC Docket 905, 907, footnote 19 [June 3, 1992]). While Regulation SHO's proposed amendment to Rule 105 of Regulation M, eliminating the shelf offering exception, attempts to address this issue in part, it does not cure these concerns.
Exclusion of Bonds from Short Sale Regulations
The Exchange supports the Commission's proposal to exclude bonds and debentures from proposed Rule 201 regulating short selling. Since bond prices are generally related to changes in interest rates, the Exchange believes that it is not necessary for the Commission to restrict short selling in bonds in the same manner as it has, and now proposes for equities. In addition, there is no short sale rule covering off-exchange trading of corporate bonds, including such trading of exchange-traded bonds.
We urge that the Commission exclude convertible bonds from the short sale requirements of current Rule 10a-1 and proposed Rule 201. NYSE-traded convertible bonds are reported with other Exchange traded bonds on a separate bond data feed and, thus, are not reported on a consolidated basis with other markets. The Exchange also notes that, as with non-convertible bonds, there is no rule covering off-exchange short sales of convertible bonds. Convertible bonds represent a small proportion (under 10%) of outstanding corporate debt. It should also be noted that the short sale rules apply only to exchange-traded convertible bonds. In addition, much convertible debt trades "out of conversion" and, thus, trades as straight debt, while many other convertibles, are "deep in the money" and rarely trade since the large majority of the offerings have been converted into the underlying equity.
Finally, the proliferation of new debt securities with descriptions other than "bond or debenture" suggests that a broader and more comprehensive definition of debt security would be appropriate.
The Commission's 1992 release (footnote 43) asked for comment on a more comprehensive definition of debt security as "(1) a note, bond, debenture, or evidence of indebtedness, (2) a certificate of interest or participation in any such note, bond, debenture, or evidence of indebtedness, or (3) a temporary certificate for, or guarantee of, any such note, bond, debenture, evidence of indebtedness, or certificate."
We recommend that the Commission adopt this more comprehensive definition.
Please feel free to contact Elaine Michitsch at (212) 656-5441 or Albert Lucks at (212) 656-5782, should you have any questions concerning the above.
/s/ Darla C. Stuckey