Statement by SEC Chairman:
Opening Statement at the Commission Open Meeting
Chairman Christopher Cox
U.S. Securities and Exchange Commission
June 13, 2007
Good morning. This is a meeting of the Securities and Exchange Commission conducted under the Government in the Sunshine Act on June 13, 2007. Today, we consider three recommendations from the Division of Market Regulation related to short selling.
The changes to our short selling rules we consider today are aimed squarely at abusive short-selling and market manipulation — and promoting fair, efficient, and orderly markets. Keeping those objectives in mind will help us achieve our constant and overarching goal to protect investors.
The first two items on today's agenda are proposed and final amendments to Regulation SHO, part of the Commission's regulatory framework governing short selling. In 2004, the Commission adopted Regulation SHO to address problems with failures to deliver stock by the end of the standard three-day settlement period for trades. The principal provisions of Regulation SHO include order marking requirements, the locate requirement, and the close-out requirement.
We will be discussing the close-out requirement this morning. This requirement, among other things, targets potentially abusive "naked" short selling. Generally, this abusive practice, which involves selling short while knowingly and intentionally failing to have stock available for delivery within the standard three-day settlement period, is a fraud that the Commission is bound to prevent and to punish.
While the vast majority of trades settle on time, Regulation SHO is intended to address situations where the fails to deliver for particular stocks are so substantial that they might harm the market for the affected securities. We have been particularly concerned that these fails to deliver can deprive shareholders of the benefits of ownership, such as voting and lending. Moreover, fails can indicate abusive "naked" short selling, which could be used as a tool to drive down a company's stock price. They may also undermine the confidence of investors in the market who may believe that the fails to deliver are evidence of manipulative "naked" short selling in the stock. In turn, issuers may be harmed, as investors may be reluctant to commit capital to a stock that they believe is subject to abusive "naked" short selling.
In July 2006, to further address these concerns, the Commission proposed amendments to strengthen Regulation SHO by eliminating what is known as the grandfather exception and by narrowing the options market maker exception to Regulation SHO. The proposals were based, in part, on examinations conducted by the Commission's staff and several self-regulatory organizations. Preliminary data indicate that Regulation SHO appears to be significantly reducing fails to deliver without disruption to the markets. There, however, continue to be a number of securities on the Regulation SHO threshold list — which lists securities with substantial and persistent fails to deliver — the fail positions of which are not being closed out under existing delivery and settlement requirements. It appears that many of these persistent fails are attributable to the grandfather and options market maker exceptions to the delivery requirements of Regulation SHO. The grandfather exception applies to fails that occurred before Regulation SHO's effective date and those that occurred before a security was added to the threshold list. The options market maker exception applies to fails resulting from short sales by a registered options market maker to hedge options positions created before the underlying security was added to the threshold list.
The Commission's proposals attracted significant public interest and more than 900 comment letters. After considering the comments, the staff recommends today that we adopt the amendments to eliminate the grandfather exception, as proposed. The staff also recommends that we re-propose amendments that would not just narrow the options market maker exception, but eliminate it entirely, and that we consider other alternatives. These recommendations are intended to further reduce the number of persistent fails to deliver securities.
The third and final item we consider today concerns the elimination of short-sale price tests. The Commission's regulation of short selling has sought to strike an appropriate balance between its legitimate benefits and the potential risks it poses of injury to the markets and investors. Historically, one way that the Commission and certain SROs have sought to strike that balance is by permitting short selling in advancing markets, while preventing short selling at successively lower prices.
Exchange Act Rule 10a-1, commonly known as the "tick test," permits short sales only at a price above the last sale price or at the last sale price, if that price is higher than the previous price. The core provisions of Rule 10a-1, however, have remained virtually unchanged since its adoption in 1938. Over the years, decimalization and changes in trading strategies have undermined the effectiveness of the tick test, while increased transparency and better means of surveillance appear to have lessened the need for the test.
In June 2004, when the Commission adopted Regulation SHO, it authorized a Pilot program to test the premises of short sale price restrictions. The Pilot program suspended all short sale price tests for a select group of equity securities. Through the Pilot, we sought better to understand the effect of this particular regulation on our modern-day markets. The evidence from the Pilot shows little empirical justification for maintaining short sale price test restrictions, at least for the exchange-traded stocks in the Pilot.
In December 2006, in light of the Pilot results and the significant market developments that have occurred in the securities industry since the tick test was adopted, the Commission proposed to remove the tick test and the short-sale price test of any SRO. After considering the public comments received, the staff is recommending that we adopt the amendments as proposed.
Finally, in addition to today's measures, and because abusive "naked" short selling is illegal under the general antifraud provisions of the federal securities laws, I have asked the staff to draft a recommendation for a future rule proposal that would specifically state that abusive "naked" short selling is fraud. Such a rule holds the potential of streamlining the prosecution of this apparently rare form of market manipulation and, if today's measures leave any doubt, would direct still more Commission power to stamping out such abuses.
I would like to thank the staff of the Division of Market Regulation for their commendable work on these matters, specifically Director Erik Sirri, Deputy Director Robert Colby, James Brigagliano, Josephine Tao, Joan Collopy, Lillian Hagen, Elizabeth Sandoe, and Victoria Crane. I would also like to thank their colleagues in the offices of the General Counsel, Economic Analysis, and Compliance Inspections and Examinations, as well as the Divisions of Enforcement, Corporation Finance, and Investment Management, for their contributions and collaborative efforts. Finally, I would like to thank the other Commissioners and all of our counsels for their work and comments on these final and proposed rules.
Each of the other Commissioners will now make opening statements, and then I'll turn the floor over to the Director of the Division of Market Regulation, Erik Sirri, for a more detailed description of each of the items we are considering today. He will present the closely related items 1 and 2 together, then item 3, and I and the other Commissioners will ask questions we may have after each of Mr. Sirri's presentations.