Amendment to Regulation SHO to Adopt Exchange Act Rule 204 - A Small Entity Compliance Guide¹

Introduction

The Securities and Exchange Commission ("Commission") has adopted Rule 204 of Regulation SHO under the Securities Exchange Act of 1934 ("Exchange Act"). Rule 204 finalizes amendments to Regulation SHO by making permanent amendments contained in Interim Final Temporary Rule 204T ("temporary Rule 204T") of Regulation SHO, with limited modifications. These amendments are intended to help further the Commission's goals of reducing fails to deliver by maintaining the reductions in fails to deliver achieved by the adoption of temporary Rule 204T, among other rules, and addressing abusive "naked" short selling in all equity securities.

Background

A. Regulation SHO and Short Selling

Regulation SHO establishes a regulatory framework to govern short sales. The term short selling refers to the sale of a security that the seller does not own, or any sale that is consummated by the delivery of a security that was borrowed by, or for the account of, the seller. To deliver the security to the buyer, the short seller will borrow securities, usually from a broker-dealer or institutional investor. The short seller later closes-out the position by purchasing equivalent securities on the open market. Generally, short selling is used to profit from an expected downward price movement. Short selling can provide liquidity in response to unanticipated demand, or function as a hedge to the risk of a long position in the same security or a related security.

B. Regulation SHO's Close-Out Requirement

Among other things, Regulation SHO includes a close-out requirement intended to address large and persistent failures to deliver stock on trade settlement date ("fails to deliver"). A "fail to deliver" occurs when a broker-dealer fails to deliver securities to the party on the other side of the transaction on settlement date (i.e., T+3). Regulation SHO's close-out requirement provides that a participant of a registered clearing agency must take immediate action to close-out fails to deliver that have persisted for 13 consecutive settlement days. The participant must close-out such fails to deliver by purchasing securities of like kind and quantity. Until the position is closed out, the participant and any broker-dealer for which it clears transactions, including market makers, may not effect further short sales in that security without borrowing or entering into a bona fide arrangement to borrow the security until the participant closes out the entire fail to deliver position by purchasing securities of like kind and quantity (also known as the "pre-borrow" requirement).

In the fall of 2008, the Commission adopted temporary Rule 204T to enhance the close-out requirement of Regulation SHO by shortening the time-frame within which fails to deliver must be closed out and apply the close-out requirement to all equity securities rather than just those equity securities with large and persistent fails to deliver.

C. Rule 204 and Regulation SHO

To further the Commission's goals of reducing fails to deliver by maintaining the reductions in fails to deliver achieved by the adoption of temporary Rule 204T, among other rules, and addressing abusive "naked" short selling, Rule 204 makes permanent the amendments contained in temporary Rule 204T, with limited modifications. Like temporary Rule 204T, Rule 204 enhances the delivery requirements of Regulation SHO by requiring that participants of a registered clearing agency deliver securities by settlement date, or if the participants have not delivered securities by settlement date, immediately purchase or borrow securities to close out the fail to deliver position by no later than the beginning of regular trading hours on the settlement date following the day the participant incurred the fail to deliver position, unless an exception applies. Failure to comply with this close-out requirement is a violation of Rule 204. In addition, a participant that does not comply with this close-out requirement, and any broker-dealer from which it receives trades for clearance and settlement, will not be able to short sell the security for itself or for the account of another, unless it has first arranged to borrow or borrowed the security, until the fail to deliver position is closed out.

Rule 204 contains limited modified provisions from temporary Rule 204T to help aid compliance with Rule 204. For example, paragraphs (a)(1) and (a)(3) of Rule 204 provide additional flexibility by permitting a borrow as well as a purchase to close out a fail to deliver position. Also, Rule 204(e) allows broker-dealers to obtain pre-fail credit if they close out their fail to deliver position by purchasing or borrowing a quantity of securities sufficient to cover the entire amount of that broker-dealer's fail to deliver position, rather than the entire amount of the broker-dealer's open short position, as was required by temporary Rule 204T. Lastly, Rule 204(a)(2) expands the additional time to close-out fails provided in temporary Rule 204T(a)(2) to fails resulting from sales of all owned but restricted securities, as opposed to only securities sold pursuant to Rule 144 of the Securities Act of 1933.

How does adoption of Rule 204 impact small entities?

Small entities that are participants of a registered clearing agency, and small broker-dealers from which the participant receives trades for clearance and settlement are affected by the amendments. Additionally, Rule 204 will affect small entities that are market participants effecting sales subject to the provisions of Regulation SHO. Rule 204 may impose some new or additional reporting, recordkeeping or compliance costs on small entities that are participants of a clearing agency registered with the Commission, and small broker-dealers from which the participant receives trades for clearance and settlement. The staff does not believe, at this time, that any specialized professional skills will be necessary to comply with Rule 204.

Other Resources

The adopting release for Rule 204 may be found on the Commission's Internet Web site at http://sec.gov/rules/final/2009/34-60388.pdf

Contacting the Securities and Exchange Commission

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

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

http://www.sec.gov/divisions/marketreg/tmcompliance/34-60388-secg.htm