SEC Adopts Changes to Short Sale Rules, Disclosures Regarding Advisory Contract Approval and Investment Company Governance Provisions


Washington, D.C., June 23, 2004 -- The Securities and Exchange Commission today voted to adopt changes to its rules regarding short selling; its requirements for disclosures by investment companies concerning board approval of advisory contracts; and its investment company exemptive rules, designed to improve fund governance practices.

1. Amendments to Short Sale Regulation — Regulation SHO

The Securities and Exchange Commission voted to adopt new Regulation SHO under the Securities Exchange Act of 1934. Regulation SHO, which provides a new regulatory framework governing short selling of securities, includes the following.

  • Rule 202(T), which establishes procedures to allow the Commission to temporarily suspend the operation of the current "tick" test in Rule 10a-1, and any short sale price test of any exchange or national securities association, for specified securities.
    • Through a separate order, the Commission will suspend, on a pilot basis for a period of one-year, the tick test provision of paragraph (a) of Rule 10a-1, and any short sale price test of any exchange or national securities association, for approximately one-third of stocks in the Russell 3000 index.
    • The order also will suspend, on a pilot basis for a period of one year, the tick test provision of paragraph (a) of Rule 10a-1 for short sales executed in any security included in the Russell 1000 index after 4:15 p.m. Eastern, and all other securities after the close of the consolidated tape, and until the open of the consolidated tape the next day.
    • The pilot will commence on January 3, 2005 to permit broker-dealers and self-regulatory organizations to make the necessary programming adjustments.
  • The Commission deferred consideration of the proposal to replace the current "tick" test of Rule 10a-1 with a new uniform bid test. The Commission could reconsider any further action on these proposals after the completion of the pilot.
  • Rule 203, which will incorporate current Rule 10a-2 and will create a uniform Commission rule requiring broker-dealers, prior to effecting short sales in all equity securities, to "locate" securities available for borrowing.
    • There will be limited exceptions from the locate requirement, including for short sales by registered market makers in connection with bona-fide market making.
    • Rule 203 also imposes additional requirements on designated "threshold securities." Rule 203 defines a threshold security to mean an equity security for which there is an aggregate fail to deliver position for five consecutive settlement days at a registered clearing agency of 10,000 shares or more and that is equal to at least 0.5% of the issue's total shares outstanding.
    • Where a clearing agency participant has a fail to deliver position in threshold securities that persists for ten consecutive days after settlement, the participant must take action to close out the position. Until the position is closed out, the participant, and any broker-dealer for which it clears transactions, may not effect further short sales in the particular threshold security without borrowing or entering into a bona fide arrangement to borrow the security.
    • Rule 203 will become effective 30 days after publication with a compliance date of January 3, 2005, to permit firms to make programming and procedural adjustments.
  • Rule 200, which among other things, will redesignate current Rule 3b-3 with some modifications to define ownership and aggregation of securities positions, and include a requirement to mark all sell orders in all equity securities. Rule 200 will become effective 30 days after publication.
  • The Commission also adopted amendments to Rule 105 of Regulation M to remove the current shelf offering exception, and issued interpretive guidance addressing sham transactions designed to evade the rule.
    • The amendment applies to short sales effected within five days prior to the pricing of a shelf offering. Such short sales may not be covered with offering securities purchased from an underwriter or other broker-dealer participating in the offering.
    • The Rule 105 amendments will be effective 30 days after publication in the Federal Register, and the interpretive guidance will be effective upon such publication.

2. Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies

The Commission voted to adopt amendments to its rules and forms that are designed to improve the disclosure that mutual funds and other registered management investment companies provide to their shareholders regarding the reasons for the fund board's approval of an investment advisory contract. The amendments are intended to encourage fund boards to consider investment advisory contracts more carefully and to encourage investors to consider more carefully the costs and value of the services rendered by the fund's investment adviser.

The amendments will require fund shareholder reports to discuss, in reasonable detail, the material factors and the conclusions with respect to these factors that formed the basis for the board of directors' approval of advisory contracts during the most recent fiscal half-year. Because fund shareholder reports will contain disclosure with respect to all advisory contracts approved by the board, the amendments will remove the existing requirement for disclosure in the Statement of Additional Information.

The amendments will include the following enhancements to the existing disclosure requirements in fund proxy statements that will parallel the disclosure in fund shareholder reports.

  • Selection of Adviser and Approval of Advisory Fee. The amendments will clarify that the fund must discuss both the board's selection of the investment adviser and its approval of amounts to be paid under the advisory contract.
  • Specific Factors. The fund will be required to include a discussion of (1) the nature, extent, and quality of the services to be provided by the investment adviser; (2) the investment performance of the fund and the investment adviser; (3) the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the fund; (4) the extent to which economies of scale would be realized as the fund grows; and (5) whether fee levels reflect these economies of scale for the benefit of fund investors.
  • Comparison of Fees and Services Provided by Adviser. The fund's discussion will be required to indicate whether the board relied upon comparisons of the services to be rendered and the amounts to be paid under the contract with those under other investment advisory contracts, such as contracts of the same and other investment advisers with other registered investment companies or other types of clients (e.g., pension funds and other institutional investors).

Fund reports to shareholders for periods ending on or after March 31, 2005, and fund proxy statements filed on or after Oct. 31, 2004, will be required to comply with these amendments.

3. Investment Company Governance

The Commission voted to adopt amendments designed to improve the governance of investment companies (funds) and the independence of fund directors. These amendments are the latest in a series of reforms pursued by the Commission to address problems identified with the management of mutual funds. The Commission proposed these amendments last January and received over 180 comment letters in response.

Mutual fund boards of directors play an important role in protecting fund investors. They have overall responsibility for the fund, and they oversee the activities of the fund adviser and negotiate the terms of the advisory contract, including the amount of the advisory fees and other fund expenses. Certain exemptive rules under the Investment Company Act require the oversight and approval of the independent directors if the fund engages in transactions with the fund manager and other affiliates, which transactions can involve inherent conflicts of interest between the fund and its managers. The Commission voted to adopt the following amendments to these exemptive rules, to enhance the independence and effectiveness of the fund's independent directors in overseeing or approving these transactions:

  • Independent Composition of the Board. Independent directors will be required to constitute at least 75 percent of the fund's board. An exception to this 75 percent requirement will allow fund boards with three directors to have all but one director be independent. This requirement is designed to strengthen the presence of independent directors and improve their ability to negotiate lower advisory fees and other important matters on behalf of the fund.
  • Independent Chairman. The board will be required to appoint a chairman who is an independent director. The board's chairman typically controls the board's agenda and can have a strong influence on the board's deliberations.
  • Annual Self-Assessment. The board will be required to assess its own effectiveness at least once a year. Its assessment will have to include consideration of the board's committee structure and the number of funds on whose boards the directors serve.
  • Separate Meetings of Independent Directors. The independent directors will be required to meet in separate sessions at least once a quarter. This requirement could provide independent directors the opportunity for candid discussions about management's performance, and could help improve collegiality.
  • Independent Director Staff. The fund will be required to authorize the independent directors to hire their own staff. This requirement is designed to help independent directors deal with matters on which they need outside assistance.

Compliance with these amendments will be required 18 months after their publication in the Federal Register.

The full text of detailed releases concerning each of these items will be posted to the SEC Web site as soon as possible.

Last modified: 6/23/2004