Statement by SEC Staff:
Opening Statement at the SEC Open Meeting re: Amendments to Regulation SHO
Erik R. Sirri
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
June 13, 2007
Good morning Chairman Cox and Commissioners. The Division of Market Regulation recommends that the Commission adopt amendments to Regulation SHO to eliminate the grandfather provision and propose for comment amendments to Regulation SHO to eliminate the options market maker exception. These recommendations are intended primarily to further reduce the frequency that stock is not delivered after it is sold.
Regulation SHO, which became fully effective in January 2005, imposes, among other things, a close-out requirement for securities in which a substantial amount of fails to deliver have occurred (also known as "threshold securities"). Where a clearing agency participant has a fail to deliver position in a threshold security that persists for thirteen consecutive settlement days, 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, including market makers, may not effect further short sales in the particular threshold security without borrowing or entering into a bona fide arrangement to borrow the security. Regulation SHO's grandfather provision and options market maker exception provide two exceptions to this close-out requirement.
Regulation SHO's grandfather provision was adopted because the Commission was concerned about creating buy-side volatility through short squeezes if large pre-existing fail to deliver positions had to be closed out too quickly after a security became a threshold security. However, at the time Regulation SHO was adopted, the Commission stated that it would monitor whether grandfathered open fail positions were, in fact, being closed-out under the existing delivery and settlement guidelines or whether further regulatory action was warranted. The Commission also said it would review whether the options market maker exception under the rule was operating differently from the Commission's original expectations.
After closely monitoring the impact and effects of Regulation SHO for more than two years, we have found that Regulation SHO appears to be significantly reducing fails to deliver without disruption to the markets, and have found no evidence that the requirement to close-out fails that have persisted for 13 consecutive settlement days has created volatility or short squeezes. Despite this positive impact, however, we continue to observe a number of threshold securities with substantial and persistent fail to deliver positions that are not being closed-out.
In order to further reduce the number of substantial and persistent fails to deliver, in July 2006, the Commission proposed amendments to eliminate the grandfather provision and limit the duration of the options market maker exception.
We received over 900 comment letters in response to the proposals. The comments were from numerous entities, including issuers, retail investors, broker-dealers, options market makers, SROs, associations, members of Congress, and other elected officials. Many commenters supported the proposals stating that the proposals would restore investor confidence in the markets. Some commenters, however, opposed the proposals. In connection with elimination of the grandfather provision, these commenters stated concerns that it would lead to increased volatility, decreased liquidity, and short squeezes. In connection with the proposal to narrow the options market maker exception, commenters opposing the proposal stated that it would be difficult and costly to implement.
After carefully considering the comments, we recommend that the Commission adopt the amendments to eliminate the grandfather provision, as proposed. The amendments provide a 35-day phase-in period for previously-grandfathered fail to deliver positions in securities that are on the threshold securities list on the effective date of the amendment to allow market participants sufficient time to comply with the new close-out requirements.
Also, after considering the comment letters, we are recommending that the Commission adopt today an amendment to Regulation SHO that will extend the close-out requirement for fails to deliver resulting from sales of threshold securities pursuant to Rule 144 of the Securities Act. Under the amendment, such fails to deliver will have to be closed out within 35 rather than 13 settlement days. The recommended amendments also include a technical amendment that will update the market decline limitation in Regulation SHO.
Options Market Maker
With respect to the options market maker exception, we recommend that the Commission re-propose for comment amendments that would eliminate the exception. In addition, the re-proposal would solicit comment regarding two narrowly-tailored alternatives to elimination of the current options market maker exception that would require fails to deliver in threshold securities underlying options to be closed out within specific time-frames.
Lastly, we recommend that the Commission propose amendments to Regulation SHO that would require that broker-dealers marking a sale as "long" document the present location of the securities being sold.
The items we propose for your consideration will help protect and enhance the operation, integrity, and stability of the markets and the clearance and settlement system.
I would like to thank Jamie Brigagliano, Josephine Tao, Joan Collopy, Lillian Hagen, Elizabeth Sandoe, and Victoria Crane for their work on these releases. I would also like to thank Janice Mitnick and Owen Donley in the Office of General Counsel, and Chester Spatt, Stewart Mayhew, Amy Edwards, and Tim McCormick in the Office of Economic Analysis, for their contributions to these releases.
Thank you. We are happy to answer any questions that you have.