Division of Trading and Markets:
Guidance Regarding the Commission's Emergency Order Concerning Rules to Protect Investors against "Naked" Short Selling Abuses
I. Introduction
Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934, on September 17, 2008, the Securities and Exchange Commission ("Commission") issued an Emergency Order temporarily strengthening the delivery requirements for all equity securities. The following questions and answers regarding the Order as amended have been prepared by, and represent the views of, the Staff of the Division of Trading and Markets to assist in the understanding and application of the Order. They are not rules, regulations, or statements of the Commission. Further, the Commission has neither approved nor disapproved these interpretive answers and is not bound by them.
II. Responses to Questions Regarding the Order
Question 1: May a participant of a registered clearing agency allocate responsibility for Rule 204T's close-out requirement (and its restriction on short selling if it does not comply with the close-out requirement) to another broker-dealer that is responsible for the fail position?
Answer: Yes. A participant of a registered clearing agency may allocate responsibility for Rule 204T's close-out requirement to another broker-dealer that is responsible for the fail position, and thereby avoid application of the restrictions to other broker-dealers clearing through the participant if such allocation is reasonable.
A broker-dealer that is allocated responsibility for the close-out requirement but that does not close-out either by means of the Pre-Fail Credit (see Question 2 below) or by purchasing or borrowing securities by no later than the beginning of regular trading hours on the close-out date, must borrow or arrange to borrow securities prior to effecting any further short sales until it purchases to close-out the fail and the purchase has cleared and settled at a registered clearing agency, and should notify the participant immediately when it becomes subject to this requirement. Only the broker-dealer allocated this responsibility would be subject to this requirement and not other broker-dealers clearing through the participant.
Question 2: May a broker-dealer claim credit for purchases made to close out an open short position prior to settlement date?
Answer: Yes. Even if the broker-dealer's clearing broker has not closed out or allocated its CNS fail position, a broker-dealer may receive credit for purchasing securities prior to the beginning of regular trading hours on the settlement day after the settlement date ("close-out date"), including on trade date ("T"), T+1, 2, or 3 ("Pre-Fail Credit"), if:
- The purchase is bona fide;
- The purchase is executed on, or after, trade date but by no later than the end of regular trading hours on settlement date (i.e. T+3);
- The purchase is of a quantity of securities sufficient to cover the entire amount of the open short position for which the broker-dealer is claiming Pre-Fail Credit; and
- The broker-dealer can demonstrate that it has a net long position or net flat position on its books and records on the settlement day for which the broker-dealer is claiming Pre-Fail Credit.
A broker-dealer that is allocated responsibility for Rule 204T's close-out requirement may also receive credit by complying with (a) through (d) above. If it does not do so, the broker-dealer must purchase or borrow securities to close-out its entire fail to deliver position by no later than the beginning of regular trading hours on the close-out date.
If such broker-dealer does not purchase or borrow securities to close out its entire fail to deliver position by no later than the beginning of regular trading hours on the close-out date, the broker-dealer will have violated Rule 204T's close-out requirement and must borrow or arrange to borrow securities prior to effecting any further short sales in that security until it purchases securities to close-out the fail to deliver position and the purchase clears and settles at a registered clearing agency.
Question 3: If a participant becomes subject to the requirement that the participant, and any broker-dealer that clears through the participant, must borrow securities prior to effecting any further short sales (the "pre-borrow penalty"), but the participant has not allocated the responsibility for the fail to another broker-dealer that it clears for, how would a broker-dealer that clears through that participant demonstrate that it should not be included in the pre-borrow penalty?
Answer: A broker-dealer that timely certifies to the participant that it has not incurred a fail to deliver in the security on settlement date would not be subject to the pre-borrow penalty if it is in compliance with (a) through (d) of Question 2 above.
Question 4: How does Rule 204T apply to registered market makers, options market makers, or other market makers obligated to quote in the over-the-counter market, that are selling securities as part of bona fide market making?
Answer: Temporary Rule 204(a) provides that if a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency in any equity security for a long or short sale transaction in that equity security, the participant shall, by no later than the beginning of regular trading hours on the settlement day following the settlement date, immediately close out the fail to deliver position by borrowing or purchasing securities of like kind and quantity.
We are extending temporary Rule 204(a)'s close-out requirement for fails to deliver attributable to bona fide market making activities by registered market makers, options market makers, or other market makers obligated to quote in the over-the-counter market (collectively, "Market Makers"). Thus, a participant must close out the fail to deliver position attributable to a Market Maker by no later than the beginning of regular trading hours on the morning of the third settlement day after the settlement date for the transaction that resulted in the fail to deliver position.
In addition, any Market Maker to which a fail to deliver position at a registered clearing agency is attributable must attest in writing to the market on which it is registered that the fail to deliver position at issue was established solely for the purpose of meeting its bona fide market making obligations. In addition, such written attestation must describe the steps the Market Maker has taken in an effort to deliver securities to its registered clearing agency.
Temporary Rule 204(b) provides that if a participant of a registered clearing agency has a fail to deliver position in any equity security at a registered clearing agency and does not close out the fail to deliver position in accordance with the rule's requirements, the participant and any broker or dealer from which it receives trades for clearance and settlement, including market makers, may not accept a short sale order in the equity security from another person, or effect a short sale in the equity security for its own account, to the extent that the broker or dealer submits its short sales to that participant for clearance and settlement, without first borrowing the security, or entering into a bona-fide arrangement to borrow the security, until the participant closes out the fail to deliver position by purchasing securities of like kind and quantity and that purchase has cleared and settled at a registered clearing agency. To allow Market Makers to facilitate customer orders in a fast moving market without possible delays associated with complying with this requirement of temporary Rule 204(b), we are not applying the borrowing requirements of the rule to Market Makers provided the Market Maker can show that it does not have an open fail to deliver position at the time of any additional short sales.
http://www.sec.gov/divisions/marketreg/204tfaq.htm
