Speech by SEC Staff:
Short Sale Regulation: A Targeted Approach for Efficient Markets
James A. Brigagliano
Associate Director, Office of Trading Practices and Processing, Division of Market Regulation
U.S. Securities and Exchange Commission
Keynote Address at the MFA Seminar Series 2007
New York, New York
March 22, 2007
Good morning. At the outset, let me remind you that the views I express are my own and not necessarily the views of the Commission, the individual Commissioners, or my colleagues on the Commission staff.1
Now, on to business. The Commission is currently engaged in a number of initiatives to modernize the regulation of short selling. These efforts demonstrate both the Commission's commitment to reducing fails and preventing abusive naked short selling as well as its intention that these goals be achieved with minimal impact on liquidity. The Commission has a statutory mandate to protect investors and promote fair and efficient markets. In balancing fairness and efficiency, regulation often involves line drawing. And, while it is inevitable that we will sometimes differ at where precisely the lines should be drawn, I am certain we do agree that the lines should be drawn with precision. Proscriptions on activities should be as narrowly drawn as possible, while affirmative duties should be no greater than necessary to achieve regulatory goals. I believe that the Commission's recent efforts to revise short sale regulation have consistently exemplified that targeted regulatory approach.
Specifically, the Commission is engaged in three important short-sale related rulemakings — proposed amendments to Regulation SHO, Rule 105 of Regulation M, and short sale price tests.
I will discuss each proposal in turn.
A. Proposed Amendments to Regulation SHO
Regulation SHO, which was adopted on June 23, 2004, is designed to reduce failures to deliver in equity securities, and to target potentially problematic short selling. For instance, the rule requires that, before accepting or effecting a short sale order, brokers and dealers must locate a source of borrowable securities that they reasonably believe they can timely deliver. In addition, the close-out requirement provides that brokers and dealers that have a fail to deliver in threshold securities that has persisted for 13 consecutive settlement days must immediately close out the fail to deliver by purchasing securities. The close-out requirement of Regulation SHO illustrates a regulatory approach of focusing on specific areas of concern while being careful not to disrupt a market that is working well. Thus, the close-out requirement applies to only the very small percentage of securities (called "threshold securities") that have persistent high levels of fails as compared to total shares outstanding. Rather than requiring immediate close-outs of all fails, as some have urged, the Commission has taken a targeted approach by addressing only specifically problematic fails.
There are two exceptions to the close-out requirement. The grandfather provision excepts fails that occurred before a security became a threshold security. The options market maker exception excepts fails in threshold securities attributable to short sales effected by an options market maker to establish or maintain a hedge on an options position before the security became a threshold security.
Since Regulation SHO's effective date, the Commission staff and the SROs have been examining firms for compliance with Regulation SHO. Commission staff continues to observe a small number of threshold securities with substantial and persistent fail to deliver positions that are not being closed out.2 Although high fails levels exist only for a small percentage of issuers, the Commission is concerned that large and persistent fails to deliver may have a negative effect on the market in these securities.
Moreover, the staff believes that these persistent fail positions may be attributable primarily to the grandfather provision and, secondarily, to reliance on the options market maker exception. As a result, the Commission proposed amendments to Regulation SHO that are intended to further reduce the number of persistent fails by eliminating the grandfather provision and narrowing the options market maker exception. The Commission received over 400 comment letters on the proposals (including one from MFA) and the staff expects to recommend that the Commission act on them this spring.
NYSE Regulation SHO cases
The SROs have been active in enforcing Regulation SHO. In June 2006, NYSE Regulation censured and fined four member firms for Regulation SHO violations that included: failing to obtain or properly document locates, mismarking, failing to determine whether locates were reasonable or whether the firm was inappropriately lending shares on mismarked long sales, not closing out when required, and failing to have policies and procedures in place to prohibit short sellers from covering short sales executed during a restricted period with offering shares in violation of Regulation M Rule 105.
B. Proposed Amendments to Rule 105 of Regulation M
Rule 105 is the Commission's rule that seeks to prevent a trading practice known as "shorting into the deal." Shorting into the deal refers to a practice in which investors sell short securities that are the subject of a registered offering and cover such short positions with securities obtained in the offering. The Commission has long been concerned that short sales effected just prior to offerings that are covered with offering securities can be harmful to the market and can have a substantial impact on issuers and shareholders.
Rule 105 currently prohibits a person from covering a short sale with securities sold in an offering, if such person sold short within five days prior to pricing.3 As it has recently noted, the Commission continues to believe that short selling is a valuable price discovery mechanism. Rule 105 does not ban short sales because certain short sales may be motivated by a short seller's evaluation of a security's future performance and contribute to pricing efficiency and price discovery. The rule does not unduly restrict short selling because persons are not prohibited from short selling and persons expecting to receive allocations of offering shares can effect short sales prior to the Rule 105 restricted period.
In recent years, the Commission has brought enforcement actions for Rule 105 violations in the face of activity meant to conceal the prohibited covering. For instance, some traders have made post-offering sales and purchases in order to give the appearance that the restricted period short sales were covered with shares other than the offering allocation — also known as "sham" transactions. The Commission has nevertheless charged these traders with violations of Rule 105 because contemporaneous or nearly contemporaneous post-offering purchases and sales do not undo the Rule 105 violation.
In light of the prevalence of this activity, the Commission in December proposed amendments to Rule 105 aimed at curbing this type of non-compliance with the rule. Instead of prohibiting a person who has made a short sale just before an offering from covering his or her short position with securities from the offering, the amendment would prohibit any short seller during the Rule 105 restricted period from purchasing any securities in the offering.
Similar to Regulation SHO, Rule 105 is a narrowly-focused rule that only addresses potentially problematic short selling that occurs during the sensitive five-day pricing period before an offering. A primary purpose of the proposed amendment is to put an end to the progression of schemes that have been engineered to camouflage covering activity outlawed by Rule 105. The alternative would be to continue to have the Commission address each variation on a case-by-case basis, which could increase uncertainty in the marketplace. The proposed amendment to Rule 105 should promote and simplify compliance with the Rule.
The comment period ended February 12, 2006. We received 13 comment letters, including the MFA's letter. A number of the comment letters contained thoughtful suggestions and we are currently considering these comments. As we formulate a recommendation to the Commission on Rule 105, we remain mindful of the Commission's goal to promote capital formation while deterring abusive trading.
C. Proposed Amendments to the Price Test
Even while taking steps to tighten the rules on borrowing, delivery, and shorting into the deal, the Commission has also taken steps towards a broad and historic deregulation of short selling in its proposed amendments to remove short sale price test restrictions. Under the proposed amendment, the Commission would eliminate Rule 10a-1, which provides that, subject to certain exceptions, a listed security may be sold short only on an uptick or a zero plus tick. In addition, NASD and Nasdaq's bid tests would also be eliminated under the Commission's proposal.
The core provisions of Rule 10a-1 have remained virtually unchanged since its adoption almost 70 years ago. Over the years, however, the Commission has added exceptions to Rule 10a-1 and granted requests for relief from the rule's restrictions, the number of which have increased dramatically in recent years in response to significant developments in the securities markets, such as decimalization, the increased use of matching systems, and, most recently, the spread of fully automated markets. In addition, decimal increments have resulted in a rule that is no longer suited to the wide variety of trading strategies and systems used in the marketplace.
Today's markets also are characterized by high levels of transparency and regulatory surveillance, which greatly reduce the risk of undetected manipulation and permit regulators to monitor for the types of activities that short sale price tests are designed to prevent. In addition, the Commission noted that the general anti-fraud and anti-manipulation provisions of the federal securities laws, including Rule 105 of Regulation M, continue to prohibit activity designed to improperly influence the price of a security. These developments have led to the sense that the price test for short sales may not be a good fit for the modern markets and may impose trading and compliance costs that exceed the rule's benefits.
For all these reasons, the Commission issued orders creating a Pilot temporarily suspending the provisions of Rule 10a-1 and any short sale price test of any exchange or national securities association for short sales of certain securities.4 The Commission's Office of Economic Analysis ("OEA") gathered the data made public during the Pilot, analyzed this data and publicly issued a report on the Pilot, which can be found on the Commission's website. Generally, the OEA study, other academic studies of the Pilot data, and the panelists at the Commission's Regulation SHO Roundtable, concluded that price tests do not have a large impact on market quality and urged removal of short sale price test restrictions. In addition, OEA's analysis of the Pilot results did not evidence an increase in manipulative short selling after removal of price tests.
The comment period ended February 12, 2006. We received 26 comment letters, and we plan to recommend that the Commission consider the proposed amendments to Regulation SHO, Rule 105 of Regulation M, and price test restrictions, collectively later this spring. I also note that the Commission is aware that many market participants are currently reprogramming their systems to facilitate NMS compliance. Commission staff has been working with the industry to coordinate the NMS reprogramming with the consideration of possible modifications of price tests in an effort to minimize compliance costs.
Prime Broker Letter
In addition to these three rulemaking efforts, Commission staff is considering how the changes resulting from Regulation SHO could affect prime brokerage issues. Prime brokerage arrangements, which have become an increasingly important part of the securities business, allow consolidation of the clearance and settlement function as well as other services while permitting an active trader to obtain execution in a variety of venues. In 1994, the SIA obtained a no-action position from Commission staff to address the application of a number of rules in the prime brokerage context. In the 13 years since issuance of the letter, certain market and regulatory developments have prompted the staff to begin the process of updating the letter. Much of that updating concerns Regulation SHO.
For long sales, Regulation SHO requires that in order to mark a sale long or lend securities to the customer, brokers must have reasonable grounds to believe that a customer owns the security and can deliver it in time for settlement. To determine reasonableness, the broker must determine whether the customer has previously failed on purported long sales. However, in a prime brokerage arrangement, the customer usually informs the executing broker that it owns the security but delivers to, or fails at, the prime broker. Thus, the executing broker doesn't have information to determine whether the customer is really long, and the prime broker cannot lend on, or fail on, long sales because it did not receive information from the customer that it owned securities that it could deliver in time.
For short sales, the locate requirement of Regulation SHO requires that before it can execute a short sale, a broker can rely on a customer's source so long as it reasonably believes the source can deliver borrowable shares in time for settlement. To determine reasonableness, the executing broker needs to know whether the customer's source has made timely delivery for previous short sales. However, in a prime brokerage arrangement, the customer provides this information to the executing broker but delivers to, or fails at, the prime broker. Thus, the executing broker will not have information as to whether the customer failed on a sale marked "short." Because of these concerns, the staff believes relief should be premised on communication between these entities within the prime brokerage relationship. Thus, the staff is evaluating whether no-action relief would be appropriate if the prime broker and the executing broker communicated to ascertain whether there were any discrepancies (should they occur) between the customer's representations to the executing broker regarding the sale and the information possessed by the prime broker.
The importance of a prime broker's compliance obligations is illustrated by the recent settled enforcement proceedings against Goldman Sachs Execution and Clearing L.P. (Goldman) for its violations arising from its customers' scheme to mismark short sales as long sales in order to conceal the fact that they were covering short sales with offering shares in violation of Rule 105. To carry out their scheme, the customers placed their orders to sell through Goldman's REDI System — Goldman's direct market access system — and falsely marked the orders "long." Relying exclusively on its customers' representations, Goldman executed the transactions as long sales. In addition, because the customers could not deliver the securities at settlement date because they did not own the securities, Goldman loaned securities to the customers to avoid fails. Goldman's confirmations indicated that its customers covered their long sales with deal stock. Given Goldman's possession of all of this information, Goldman's exclusive reliance on its customers' representations that they owned the offered securities was unreasonable.
As you can tell from the number of initiatives that are currently in the works, the Commission and staff have been spending substantial resources on short selling issues. Each aspect of short sale regulation I have discussed represents a carefully honed approach to address abuses with the least invasive treatment possible. And, I want to emphasize that the Commission's and the staff's chances of success in striking the right balance are substantially enhanced by an energetic and thorough dialogue between regulators and market participants. For example, we appreciated that the MFA submitted comment letters regarding the proposals to amend Regulation SHO, price test restrictions, and Rule 105 of Regulation M. The MFA and its members have also provided input regarding prime brokerage arrangements. Every comment letter is read and considered and thoughtful comments inform the rulemaking process. In particular they can provide alternatives to rule proposals that further regulatory goals while minimizing frictions on free markets. And, that balance is our ultimate goal — so keep those cards and letters coming!
I now open the floor for questions.