January 30, 2004
Via e-mail: email@example.com
U.S. Securities and Exchange Commission
Re: Proposed Regulation SHO; File No. S7-23-03
Ladies and Gentlemen:
We are writing on behalf of J.P. Morgan Securities Inc. and UBS Securities LLC (the "Firms"), in response to the request by the Securities and Exchange Commission (the "Commission") for comment on its proposed rule on short sales ("Regulation SHO") in Release No. 34-48709 (October 29, 2003) (the "Release") under the Securities Exchange Act of 1934 (the "Exchange Act"). The Firms also comment below on the Commission's interpretive release concerning "married puts", Securities Exchange Act Release No. 48795 (November 17, 2003) (the "Married Put Release"). The Firms appreciate the opportunity the Commission has afforded them to comment on these important subjects.
The Firms regard short selling as an important market activity that often is helpful in providing liquidity to the market, particularly to facilitate customer transactions, and in offsetting market exposure in other related securities and instruments. Short selling can be beneficial to the market since it can help the market reach an appropriate new equilibrium after a change in overall market conditions or in the mix of information regarding particular issuers. At the same time, the Firms recognize that abuses in short selling, as is the case with other abusive conduct, can adversely affect the markets. In proposing Regulation SHO, the Commission seeks to limit the opportunities for such abuses while broadening the availability of short selling for bona fide purposes. The Firms believe the Commission ultimately should eliminate all pricing regulation of short selling, but they recognize that the Commission wishes to move slowly toward that goal. In the interim, the Firms hope that their comments on proposed Regulation SHO will help the Commission in revising its proposal to avoid unintended adverse consequences.
COMMENTS AND RECOMMENDATIONS
The Firms offer the following comments and recommendations regarding proposed Regulation SHO:
1. Proposed Rule 202(T) - Large Cap Exception.
The Firms congratulate the Commission on its proposal of Rule 202(T), which would establish a pilot program that would exempt large capitalization stocks from the bid test of Proposed Rule 201(b). The Firms question in general the continued usefulness of substantive short sale regulation in today's markets in light of improved electronic monitoring by the New York Stock Exchange, Nasdaq and other bodies. The costs of short sale regulation almost certainly exceed whatever benefits are thought to derive from it. The short sale rule's usefulness is particularly limited in the case of stocks where there is an active trading market with many market participants. Fails to deliver have not been a notable problem with the large-capitalization stocks. The Firms therefore recommend that the Commission expand the proposed pilot program to exempt large capitalization stocks from both the bid test of Proposed Rule 201(b) and, in the case of securities that typically are not difficult to borrow, the locate and delivery requirements under Proposed Rule 203. The securities to be included in the pilot should, of course, be clearly identified and should not be varied during the course of the pilot, given the administrative difficulties that inevitably will attend firms' trying to exclude those stocks from their short-sale pricing compliance programs.
Rule 202(T) would not be the first laboratory test for deregulating short selling. As the Commission knows, there has not been any substantive regulation of short selling in Nasdaq securities traded on the regional exchanges since neither the Commission's Rule 10a-1 nor NASD Rule 3350 applies. The Firms are not aware of any enforcement actions, investigations or notorious factual situations that would suggest that the absence of short-sale regulation in those markets has led to any significant problems. Indeed, many of the securities involved would not qualify as large capitalization securities for purposes of proposed Rule 202(T), and therefore might be thought to involve greater potential regulatory risks than the Commission would run with its proposed pilot program. The Commission should take comfort from the experience with Nasdaq stocks on the regional exchanges in concluding that it should go forward with the pilot program in Rule 202(T). Upon conclusion of the pilot program, the Commission will have a clear basis for expanding its deregulatory program to medium- and small-capitalization stocks.
The recent study on short selling issued by the Financial Services Authority of the United Kingdom (the "FSA") evaluated the usefulness of substantive short sale regulation. It concluded that no preventive measures are necessary with respect to short sales and recommended disclosure in place of a short-sale rule.1 The Firms believe the FSA's conclusions are correct and that the Commission should move in a similar direction.
One possible approach would be for the Commission to adopt the pilot program and put it into effect first, before acting on the other proposals. It may be that the information gleaned from operation of the pilot will give the Commission a better data base than it has now for deciding on which, if any, of the additional proposals should be adopted.
2. The Bid Test - Proposed Rule 201(b).
A. The Firms agree with the Commission that if there is to be a short sale rule, it should be uniform across all equity markets. A uniform rule addresses the problem of regulatory arbitrage and the imposition of a single, market-wide price test would be preferable in concept to the current disparity between Rule 10a-1 and Rule 3350 for many of the reasons the Commission cited in the Release.
The Firms believe, however, that the pricing test proposed in Rule 201(b) is the wrong one, at least in its application to short sales in a rising market and broker-dealers' market-making and block-facilitation sales to their customers and that it would be dysfunctional. The proposed one-cent "tax" would prevent short sellers from hitting the best bid and would require them instead to improve2 the prevailing best offer by inserting an offer at least one-cent over the prevailing best bid. That requirement, the Firms believe, is unnecessary and would be unworkable in a rising market because, presumably, short sellers would have to increase their offer prices by at least one cent above the current consolidated bid every time the consolidated bid moved up. Why in any event should a short seller be under a greater obligation than a long seller to provide price improvement over the prices at which the best buyers in the market were prepared to transact? For example, if the market were $X.05 bid and $X.07 asked, requiring a short seller to place its sell (i.e., ask) quotation at $X.06 or higher would penalize the short seller, increasing its risk of adverse selection (execution followed by upward market movement), without achieving any useful purpose. If the short seller posted a limit order at $X.06 in such a case and then did not compete successfully in a race condition to get its trade executed and the market moved to $X.06 bid/$X.08 asked, and then to $X.07 bid/$X.09 asked, would the short seller have to offer additional price improvement a second and then a third time, chasing the market up? The one-cent tax, by making it difficult to get short sales off at all would likely divert trading volume into the derivatives markets, such as the single-stock futures market (where, as you know, the Commission is prohibited3 from imposing short sale regulation) and into foreign markets.
The Firms believe that, in the case of trades by persons other than broker-dealers selling to their customers, the Commission should revise the proposed bid test to implement the alternative suggestion in the Release, that the bid test should look to whether the consolidated best bid is higher than the last preceding different bid.4 In the case of broker-dealers selling to customers, even that test would be disadvantageous to investors and the markets. The loss of liquidity that would be occasioned by prohibiting the broker-dealer from selling short to its customers at the consolidated best bid would not be justified by any regulatory benefit. As the Firms suggest below, moreover, the Commission should provide for even greater flexibility for block positioners selling short to customers to facilitate the customers' block purchases.
In any event, there is no evidence of which the Firms are aware, and the Commission did not cite any in the Release, to the effect that selling at the bid is per se bad for the markets or manipulative. All transactions in the public market tend to "eat up" the existing trading interest at prevailing quoted prices, whether at the bid or at the offer; that is a necessary part of market operation. Why should short sellers be penalized, and indeed perhaps impeded from trading, any more than buyers should be penalized or impeded from trading at the prevailing bid price, particularly when the market is rising?
It is likely that proposed Regulation SHO would introduce to the market several unintended consequences, and opportunities for game-playing. It would, for example, provide an incentive to the party at the best bid to lower its bid by a penny to invite short sellers to post ask quotations at the original bid price. That could occur in successive instances, possibly aided by computer-driven quotation generators, promoting a steadily declining market.
In addition to making short selling more difficult, the proposed rule could also make short selling more expensive than it currently is for two reasons. First, a short-sale order could not be a market order under the proposed rules and would require constant monitoring to make sure that the price is always one cent above the current consolidated bid. Second, the proposed locate-and-deliver requirements would be more cumbersome than those currently in effect. It is likely that those requirements would promote their own games, such as (i) firms giving locates and then refusing to lend stock, promoting short squeezes, and (ii) firms holding short sellers up for exorbitant lending prices so as to avoid fails that would result in the proposed 90-day freeze on short sellers who fail to make delivery.
B. The use of the consolidated best bid will itself pose problems due to inaccessible bids, whether from regional exchanges or exchanges that are slow to report or exchanges where the bid may be inaccessible. In particular, the outmoded and inadequate communications technology of the American Stock Exchange (the "Amex") will be particularly problematic since quotations from the Amex are frequently stale. The Firms suggest that the Commission consider addressing this problem in one of three ways, or a combination thereof:
(a) exclude the Amex from the NBBO for purposes of the bid test until the Amex can demonstrate that it has improved its technology to the point where its inclusion in the bid test will no longer produce dysfunctional results;
(b) have a local exchange exception such as existing Rule 10a-1(a)(2) currently provides, under which the NYSE and Amex have elected to have short sales governed by the prices on their floors; or
(c) permit the use of the current Nasdaq bid test instead of Amex pricing for purposes of Nasdaq-quoted securities that are also traded on Amex (or for other stocks traded on the Amex if delays in Amex information technology cause problems there as well).
3. After-Hours Trading/Foreign Markets.
The proposed rule would prevent short selling at a price at or below the last published consolidated best bid after the consolidated best bid ceases to be calculated and disseminated. Currently, NASD Rule 3350 ceases to apply at 4:00 p.m., while a pilot program the Commission has approved for Nasdaq extends the operation of key trade and price reporting systems until 6:30 p.m.
U.S. short sale regulation should relate to trades that result in a trade report in the United States. Regulation SHO should not apply to after-hours trading that does not print in the United States because after-hours trading does not "evade" short sale regulation. It should not be subject to the regulation because, in the absence of publication of the prices, the risk of manipulative effect is slim to none. After the U.S. markets close, the pricing of securities is going to be determined largely by economic factors, including news affecting the markets generally and news affecting the particular company, none of which has any necessary relation to the last reported U.S. sale. To tie short selling to a stale U.S. price after the U.S. markets have closed makes no economic sense and does not serve any regulatory purpose. The Firms are not aware of any evidence that the 4:00 P.M. cut-off for NASD Rule 3350 has led to any problems. The Commission does not cite any in the Release. Accordingly, the Firms recommend that when the consolidated tape stops, Regulation SHO should as well.
The Firms also do not believe there is any sound justification for the regulation of trades that do not print in the United States but instead print in jurisdictions outside the United States. The Commission offers no data demonstrating that such trading is harmful to the markets or is manipulative. Exchange Act Rule 10a-1 and NASD Rule 3350 are essentially designed to control "tape painting", trading to demoralize the market. Trades that occur after U.S. trading closes and do not print on a real-time basis in the United States are not in need of regulation, whether they are organized inside or outside the United States. Regulation SHO should not apply to them.
One consequence of rigidly applying Regulation SHO to after-hours trading is that it would severely affect the current derivatives market, in which firms that have engaged in derivatives trades with clients need to hedge their derivatives exposures by shorting stock below the current market. Today, much of that volume is done in Europe after hours. If Regulation SHO is put into effect, such hedging transactions would be prohibited. Of course, U.S. firms could do derivatives trades with European counterparties, who would then execute their own short sales of the underlying stocks, but that would do little more than add cost and complexity without furthering any regulatory objectives.
The derivatives problem could be cured with a sensibly designed hedging exemption, which could apply in circumstances where the hedging firm had written a derivative to a client (e.g., a put) and sought to hedge its exposure through a short sale. The Firms recommend that the Commission consider fashioning such an exemption.
4. The Block-Positioner Exception - Proposed Rule 200(d)(1).
Regulation SHO does not address the problem of liquidity for blocks. Proposed Regulation SHO would provide a block-positioner exception only to broker-dealers acting in the capacity of block positioner and then only if the short position were created in the course of bona fide arbitrage, risk arbitrage, or bona fide hedging activities.5 The Firms believe, however, that a more general exception should be provided that would allow broker-dealers to short stock to a customer to facilitate the customer's block purchase below as well as above the consolidated best bid. In such cases, as the New York Stock Exchange (the "NYSE") recognizes in its Rule 97, the broker-dealer has not decided to take a directionally biased position but is instead facilitating a customer. To limit the broker-dealer's short sale to the customer to sales above the consolidated best bid is to deny the customer liquidity in circumstances where it is unlikely the short sale would be manipulative or otherwise harmful to the market. The Commission should allow block positioners greater pricing flexibility in both Nasdaq securities and exchange-listed securities. The Firms recommend, therefore, that the Commission create a general exception for broker-dealers selling stock to a customer to facilitate the customer's purchase of a block of securities.
NYSE Rule 97 is based on the premise that securities firms acting as block positioners in the course of facilitating customer sales typically are taking on securities positions they would not independently have assumed. Indeed, Rule 97 assumes that firms purchasing securities to facilitate their customers' trades may, therefore, have an incentive to prop up the market until they can dispose of the long positions they have taken on and it seeks to control the firms' trading in such cases. The Firms suggest a similar rationale should apply to firms that sell short to customers in the course of facilitating customer block purchases. The Commission should recognize in Regulation SHO that firms facilitating customer block purchases by shorting to the customers are acting as intermediaries, not as independently motivated stock speculators. The Regulation should not deny investors the liquidity block positioning firms provide since that liquidity tends to promote fair and orderly markets. Instead, the Commission should except from the general prohibition block positioners' short sales that facilitate customer block purchases.
5. The Market Maker Exception.
The Commission provides no basis for its proposal to prohibit market makers from selling short at or below the bid.6 The Commission states in support of the proposal that "a market maker should rarely need to sell short at or below the bid in its market making capacity".7 The Firms note, however, that Nasdaq market makers frequently sell short at the bid to their customers in the ordinary course of their market making, just as they buy long at the offer.
Not having an exception to short sale pricing regulation for legitimate market-making transactions will deprive the market of liquidity and promote greater volatility than is presently the case. For example, if the market in a given stock drops because of negative news, a market maker that is not held captive to the pre-announcement prices can dampen the downward spiral by providing stock to buyers at the new, lower prices. If the market maker cannot short to its buyers at the new prices that result from the market's revaluation of the stock, the price may continue to fluctuate until natural sellers come into the market and are prepared to provide liquidity. Often, time is of the essence in such cases, and taking the intermediaries and their liquidity out of the market can have a seriously disruptive effect, resulting in greater volatility and greater risk for the buyers who do come in to buy at the new prices.
The market-maker exception, if carefully designed and limited to legitimate market making transactions with customers, is a useful and necessary means of providing for liquidity, particularly in stocks where trading is thin and liquidity may otherwise not be available to customers. As noted above, the Firms believe broker-dealers should be able to sell short to their customers at the consolidated best bid and, in facilitating a customer's block purchase, at prices below the best bid.
If the Commission wishes to distinguish between legitimate market-making transactions and other transactions that are for proprietary, speculative purposes, one way may be to look at how the broker-dealer in fact behaves. A market-maker, as is well known, tends to stay "flat" whenever possible because it makes its money by profiting from spreads, not from taking a directionally biased position at market risk. A firm that holds a short or long position in size for a considerable period of time probably did not acquire the position in true market-making. That can easily be uncovered in an inspection. Simply eliminating the market-making exception from the short sale rule has many negative consequences, as suggested above, and does far more than is needed to address real abuses.
6. The VWAP Exception - Proposed Rule 201(d)(8).
The proposed exception from the bid test rule for short sale transactions executed on a volume-weighted average price ("VWAP") basis is limited to VWAP transactions arranged or "matched" before the market opens at 9:30 a.m.8 The Firms believe the exemptive treatment of VWAP trades in proposed Rule 201(d)(8) is not appropriately drawn. The before-opening condition does not address any abuse or other harm of which the Firms are aware. The Commission does not cite any. The Firms surmise the Commission may be concerned about VWAP orders being entered late in the trading session. The Firms suggest that VWAP orders entered in the last 20 minutes before the close should not be exempt from the rule; VWAP orders entered earlier in an actively traded stock need not be subjected to short sale regulation. In addition to VWAP trades, proposed Rule 201(d)(8) also should be applied to market-on-close orders.9
7. Unconditional Contracts and the Definition of "Long" - Proposed Rule 202(b).
The Commission proposes to amend the definition of "unconditional contract" under current Rule 3b-3 by providing in proposed Rule 202(b)(2) that for a person to be deemed to own a security by virtue of the fact that he has entered into an unconditional contract to purchase the security, the contract must specify the price and amount of the security to be purchased. The Firms find the implied redefinition of "long" problematic. The Firms believe that one consequence of the proposed rule would be to prohibit treating as long a position that is to be priced later with reference to an independent marker, for example, the closing price or VWAP. Once a market maker or broker has agreed with a customer to purchase securities for the customer, where the price is to be determined by a price referent not within the control of either party, there is a valid and binding contract under New York law, which usually is the law specified in securities trading in the United States.10 Again, the Commission's reason for imposing the condition is unstated and the Firms are not aware of any actual abuses that need remedying. The condition seems to be a solution in search of a problem. In the case of a VWAP trade agreed to before the end of the trading session, the market maker or broker has assumed the risk of the position and should be considered to be long.
Broker-dealers often intermediate a market that does not provide full liquidity on an agency basis. As a result, the broker-dealers often trade as principal to facilitate a customer. The broker-dealers are not seeking in such cases to take a directionally biased risk; they take the same risk whether the customer is long or short. There is no demonstrated incidence of harm or abuse from the existing definition of "long" in Rule 3b-3. Proposed Rule 202(b)(2) is not needed to address any real problems.
The Commission's guidance on Rule 3b-3 in the Married Put Release should be clarified and then incorporated into proposed Regulation SHO. Clarification is needed because certain statements made in the Married Put Release suggest that the six-factor test set forth there applies to an unspecified possible range of transactions beyond married puts, including "conversion transactions"11 and gives little if any guidance as to how to guard against the risk that enforcement action may be based, in hindsight, on transactions that meet some but not all the six factors (e.g., multiple transactions with the same counterparty). That leaves entirely too much discretion to enforcement and gives insufficient guidance to market participants that are conscientiously trying to understand and comply with the law, without any apparent regulatory reason other than an unfairly opaque, in terrorem effect. In codifying the interpretation put forward in the Married Put Release, the Commission should withdraw the suggestion that a mechanical rule such as Regulation SHO has mixed into it subjective, imprecise tests such as are suggested in the Married Put Release. Instead, as is the case with Exchange Act Rule 14e-4 relating to short tendering, the tests as to what is prohibited should not turn on intent or other motivational factors but should be objective and unambiguous. Trading rules that are designed to be prophylactic and not to turn on intent should not have subjective or uncertain application.
8. Locate and Deliver Requirements - Proposed Rule 203.
The Commission's proposed locate and deliver requirements are too burdensome. In recent years, the number of fails has decreased, not increased.12 At a minimum, there should be exceptions to the locate and deliver rule of the kind the NASD currently provides to deal with circumstances where no delivery by the executing broker-dealer is in fact contemplated. Examples of this include DVP and prime brokerage transactions where the executing broker does not have possession or control of the stock. Such sales should be exempt from the locate rule under Regulation SHO if the broker-dealer receives a representation from the customer that it has the securities in custody and that its custodian will deliver them. Exempting legitimate circumstances where delivery will not be required would not cut against the objective of protecting against collusive shorting, for example, through "daisy chain" trading.
In support of the application of the proposed locate and deliver requirements to market makers, the Commission states: "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. The Firms believe that a market maker should rarely need to sell short at or below the bid in its market making capacity."13 As noted above, that assertion is factually inaccurate. The current NASD rule excepts market makers because they do not intend to stay short over night. Requiring market makers to locate would be needlessly burdensome. Market makers should only be required to locate and deliver for trades in illiquid stocks and only when they are net short at the end of the day.
The Commission also should consider the unintended consequences of the proposed locate and deliver requirements. The proposed rules would encourage short sellers to borrow shares in advance at unprecedented levels. Also, the rules would encourage the development of manipulative "games" to squeeze the short sellers, particularly given the proposed requirement that delivery be made within five business days of trade date. Since a "locate" does not necessarily commit the holder of the located shares to lend them to the locating party, short sellers will locate shares that they then discover are not available for loan on the sale date and they will be forced to cover the trades, often at a loss. This has substantial manipulative potential. Securities lenders would be able to make shares available for locates on days when there is significant, that is, negative, news activity but then decline to lend them to the street on the sale date. That, in turn, will force the broker-dealers to buy in the new shorts, driving the price up.
The regime the Commission proposes is, at bottom, an anachronism. In a world of dematerialized (that is, uncertificated) securities, the requirement of delivery makes less and less sense. To curb manipulation, daily chain trading and the like, the Commission should focus more precisely on that activity and not put in place an unnecessarily cumbersome delivery requirement with few, if any, exceptions. The Commission's net capital and customer protection rules, Exchange Act Rules 15c3-1 and 15c3-3, are sufficient to protect customers against bucketing of orders. The delivery requirement proposed in Regulation SHO would not add meaningfully to that protection. Instead, it would require significant over-locating, that is, locating shares to borrow in many, many circumstances where no delivery would ultimately be required - e.g., where the short seller traded out of the short before the end of the day. The recent amendments to Article 8 of the Uniform Commercial Code represented a significant step forward in dealing with an uncertificated market. The Firms believe the Commission's approach in proposed Regulation SHO does not take advantage of those legal developments, fails to accord with the realities of how trading is done today and, if adopted and implemented, would have severely dysfunctional effects.
Furthermore, in a situation where a delivery fail does occur, should the Commission deem it necessary to retain locate requirements, five days seems too little time to allow for fails before the broker-dealer must execute the buy-in. The Firms recommend that the Commission keep in place the current ten-day requirement. Even the best efforts of broker-dealers to locate, borrow in advance and deliver all shares on all deliveries will not always ensure success. Setting a two-day failure to deliver as the cut-off for restricting new short sales allows too little time.
The question of how to modernize the current rules dealing with locates and delivery against shorts is a complex one, which the Securities Industry Association's Securities Lending Division Executive Committee, the Securities Operations Division, the Clearing Committee and the Prime Broker Committee and other industry participants such as the DTCC and options clearing firms have been discussing with the New York Stock Exchange and others. The Firms do not wish to prejudge the outcome of those discussions, but believe the Commission should be guided by those outcomes in revising the approach taken in Regulation SHO. The Firms believe a suitable approach to the issue of locate delivery obligations would include the following:
(1) the Commission should endorse the adoption of standard regulatory buy-in requirements for fails aged more than a specified number of days on securities that are experiencing Street-wide clearance problems. Such requirements should be similar to NASD Uniform Practice Code Rule 11830 to avoid regulatory inconsistencies, but not necessarily identical. The Firms recommend that the NYSE, the NASD and the Commission seek comments as to whether the current criteria for Rule 11830 be modified and uniformly applied;
(2) The resulting standards should require that firms that accept orders to sell short in securities which are listed on a Rule 11830 list adopt additional practices to lessen the potential for incurring fails upon settlement;
(3) The standards also should require that executing and prime brokers reconcile trade information received from the customer regarding whether the sale is long or short; and
(4) The standards should revise current buy-in rules to provide for a better allocation of responsibilities, more uniformity, more timeliness and greater efficiencies.
9. Aggregation Units - Proposed Rule 200(e).
The test stated in proposed Rule 200(e)(3) is difficult to apply in practice since it often is difficult to know whether trading objectives that involve, for example, short-term holding can be put in different aggregation units if they are similar in appearance but involve different, computer-driven trading algorithms, such as black boxes and mean reversion strategies, that are not designed by a single individual or group working together. Requiring the aggregation of such trading programs for short sale purposes is not workable and is not required for investor protection. In addition, the Firms recommend that the Commission consider expanding the availability of the exception to include the buy-side, including collective investment vehicles that are not registered as broker-dealers.
10. Arbitrage Exceptions - Proposed Rule 201(d)(5).
In general, the Firms believe the Commission should update the arbitrage exceptions to cover any trading strategy, including a hedged strategy, where the positions offset most if not all the risk of one another. The test should not turn on "intent", which is subjective and often difficult to measure, but should turn instead on whether, using the Black-Scholes pricing model or another "responsible method"14 of determining risk and the offsetting of risk, the strategy involves hedged positions rather than a directionally biased position favoring a market decline. In addition, the original 1986 Merrill Lynch relief15 should be expanded to cover the following:
(i) rebalancing of proprietary long or short positions in stocks underlying broad-based indices, that is, indices involving 20 or more stocks, where the sponsor of the index is changing the composition of the index (either the stocks included or the weighting, or both);
(ii) the unwinding of an arbitrage between an exchange-traded fund (an "ETF"), such as the "QQQ" ETF, and a portfolio consisting of all, or a representative sample, of the stocks underlying the ETF; and
(iii) the unwinding of an arbitrage between a warrant on a broad-based index where the warrant is listed on a national securities exchange in the United States and the underlying stocks, where in any of these three cases the sales would be deemed short solely as a result of the netting of the arbitrage position with short positions created in the course of Section 11(a)(1)(D) activities.
The Firms further suggest the exception should apply equally to both convertible securities and "exchangeable" securities, that is securities exchangeable for securities of a different issuer. In addition, the Commission should delete the limitation in the proposed rule that is not in current paragraph (e)(7) of Rule 10a-1, that to be eligible for the exemption the investor must thereafter exercise the embedded right and acquire the underlying securities. Read literally, that further condition would make the rule unavailable after the fact if the firm relying on the exception to make the short sale thereafter decided not to convert the overlying security because, e.g., it was no longer in the money. The exception should instead be available regardless of exercise and regardless of whether the convertible or exchangeable security, upon exercise, results in a receipt of the physical security that underlies it or instead of the cash-equivalent value.
11. Merger Arbitrage - Proposed Rule 201(e)(7).
Merger arbitrage involves a hedged transaction and an exemption from short sale regulation for merger arbitrage is not likely to promote abuse. The Firms, therefore, recommend that the Commission include a merger arbitrage exemption in proposed Rule 201(e)(7). As in other forms of arbitrage, merger arbitrage involves a hedge between what may be viewed as two markets, the current market price and the contingent parity value if the merger is consummated.16
12. 2% DJIA Decline as a Condition for Liquidations of Index Arbitrage
This new test seems unnecessary, particularly in view of existing circuit breakers. It is not clear what problem the Commission proposes to solve with this provision. The Firms recommend that, unless the current relief under the Merrill Lynch letter has caused problems in times of market decline, the 2% test should be eliminated.
13. Debt Securities.
In the Release, the Commission asks whether Regulation SHO should be expanded to cover bonds. The Firms recommend against such an expansion. Fixed-income securities, including convertible debt and preferred, trade in relation to one another and at spreads to benchmark Treasury securities. They are not susceptible to manipulative conduct of the type short sale price regulation is intended to deter.
* * *
The Firms appreciate the opportunity to offer their comments to the Commission on Regulation SHO. If they may be of further service to the Commission or its staff in their evaluation of these matters, please let me know.
cc (w/att): The Hon. William H. Donaldson, Chairman