Speech by SEC Staff:
The Road Ahead: Short Sale Regulation for Today’s Markets
James A. Brigagliano
Co-Acting Director, Division of Trading and Markets
U.S. Securities and Exchange Commission
STA’s 13th Annual Washington Conference, Regulatory Reset in 2009
May 5, 2009
Good afternoon. 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
The Commission is currently engaged in a number of initiatives related to the regulation of short selling. In fact, I just arrived from the Commission’s roundtable examining the recently proposed short sale price tests and circuit breaker restrictions, which I expect will materially inform the public policy debate on short sale regulation. A close look at the road of short sale regulation that we have recently traveled as well as the current landscape suggests the likely path forward, but there may be some unforeseen bends in the road.
Measured Steps to Modernize Short Sale Regulation
In a series of carefully measured steps, the Commission set off on a new path in short sale regulation when it eliminated all short sale price test restrictions and began targeting fails to deliver and potentially abusive “naked” short selling.
The Commission first considered this new path in 1999 with the publication of a concept release seeking comment on the broad subject of short sale price test restrictions, and the specific issue of whether such restrictions should be eliminated.
In 2004, the Commission adopted Regulation SHO, the first major overhaul of short sale regulation since 1938. This was the Commission’s first step down the road of short sale price test reform and reductions in persistent fails to deliver.
With the adoption of Regulation SHO in 2004, the Commission initiated a year-long pilot that eliminated short sale price test restrictions from approximately one-third of the largest stocks in order to study how removal of price test restrictions impacted the market. Short sale data from the pilot was made publicly available and in September 2006 the Commission hosted a public roundtable discussion where third party researchers presented their findings on the analysis of the publicly available data. The staff of the Commission’s Office of Economic Analysis (OEA) made its own findings regarding the pilot data available in draft form in September 2006, and in final form in February 2007. The findings of the third party researchers and the OEA staff generally concluded that price tests did not have a large impact on market quality. The findings also did not evidence an increase in manipulative short selling after removal of price tests. In December 2006, the Commission proposed to eliminate all price test restrictions on short sales and solicited comments on that proposal. All short sale price test restrictions were eliminated in mid-2007.
At the same time that the Commission was taking measured and deliberative steps regarding whether to eliminate short sale price test restrictions, the Commission set out on a path to address potentially abusive “naked” short selling by instituting regulations designed to reduce fails to deliver with its adoption of Regulation SHO. Specifically Regulation SHO, among other things, sets forth a uniform standard requiring broker-dealers, prior to effecting a short sale in any equity security, to “locate” securities available for borrowing and imposes strict close-out requirements on securities with persistent and large levels of fails to deliver, so-called “threshold securities.”
As adopted, Regulation SHO included two exceptions to the rule’s close-out requirements: (i) the “grandfather exception,” which excepted fail positions that were established prior to a security becoming a threshold security, and (ii) the “options market maker exception,” which excepted fails to deliver that resulted from short sales that hedge options positions that were established prior to the underlying security becoming a threshold security.
Regulation SHO began as, and remains, a carefully targeted approach to short sale regulation. While Regulation SHO, as initially adopted, resulted in a significant reduction in the number of fails to deliver without disruption to the market, the Commission continued to observe a small number of threshold securities with substantial and persistent fail to deliver positions. Accordingly, the Commission amended Regulation SHO in August 2007 to eliminate the grandfather provision.
Afterwards, an analysis of fails data revealed that while fails had decreased in non-optionable securities, they had increased in optionable threshold securities. As a result, the Commission proposed to eliminate the options market maker exception.
In a related measure, the Commission also proposed a “naked” short selling anti-fraud rule in March 2008, Rule 10b-21. Although abusive “naked” short selling as a part of a manipulative scheme is always illegal under the general anti-fraud provisions of the federal securities laws, Rule 10b-21 highlights the specific liability of persons that deceive broker-dealers, participants of a registered clearing agency and purchasers about their intention or ability to deliver securities in time for settlement, including persons who deceive their broker-dealer about their locate source or ownership of shares, and who fail to deliver by settlement date.
Accelerated Action in 2008 in Response to the Financial Crisis
As 2008 progressed and the subprime mortgage crisis and credit crisis developed, the Commission took off at a run down the path of short sale regulation.
On July 15, 2008 the Commission issued an emergency order to enhance investor protections against potentially abusive “naked” short selling in the securities of Fannie Mae, Freddie Mac, and primary dealers at commercial and investment banks. The emergency order required that anyone effecting a short sale in these securities arrange beforehand to borrow the securities and deliver them at settlement. The Commission imposed the emergency order with the stated intent of additionally undertaking a rulemaking to address fails to deliver issues across the entire market. The emergency order took effect on July 21, 2008 and terminated on August 12, 2008.
On September 17, 2008 the Commission adopted three rules on an emergency basis to strengthen investor protections against potentially abusive “naked” short selling, including actions addressing fails to deliver. The rules became effective on September 18, 2008.
First, the Commission adopted Temporary Rule 204T, requiring that short sellers and their broker-dealers close out fails to deliver immediately after they occur and imposing penalties for failure to do so. Second, the Commission adopted amendments to Regulation SHO to eliminate the options market maker exception from the close-out requirement of Regulation SHO. As a result of the change, options market makers are treated in the same way as all other market participants, and are required to immediately close out fails to deliver in threshold securities. The third Commission action on September 17 was the adoption of the “naked” short selling anti-fraud rule, Rule 10b-21, which, as I previously mentioned, was proposed in March 2008 and expressly targets fraudulent short selling transactions. Specifically, the new rule highlights that those who lie about their intention or ability to deliver securities in time for settlement are violating the law when they fail to deliver.
The Commission also issued two additional emergency orders on September 18, 2008. First, the Commission, acting in concert with the U.K. Financial Services Authority, took temporary emergency action to prohibit short selling in the securities of substantial financial companies to protect the integrity and quality of the securities market and strengthen investor confidence. The order became effective on September 19, 2008 and terminated on October 8, 2008. In a second emergency order issued that same day, the Commission adopted a rule requiring that institutional money managers report to the Commission their short sales of certain publicly traded securities. The order was effective on September 22, 2008.
Each of the three emergency orders issued on September 17, as well as the short sale disclosure order issued on September 18, were set to terminate on October 17, 2008. However, to ensure there would be no regulatory gap, the Commission took several actions, effective October 17, 2008, to either adopt the changes as final or to continue the rulemaking process.
First, the Commission adopted amendments to Regulation SHO to eliminate the options market maker exception from the close-out requirement and adopted Rule 10b-21, the “naked” short selling anti-fraud rule. These were both adopted as final rules.
The Commission simultaneously adopted Temporary Rule 204T as an interim final temporary rule, effective until July 31, 2009. Accordingly, the closeout requirements and penalties for failure to meet those requirements remain in place, with some exceptions that were added in response to operational concerns raised by commenters.
Finally, the Commission adopted Rule 10a-3T, the short sale disclosure rule, as an interim final temporary rule requiring that institutional money managers report their new short sales of certain publicly traded securities, effective until August 1, 2009.
A Promising Path Forward in Rule 204T
The elimination of the options market maker exception and the enhanced close-out requirements of Temporary Rule 204T have gone a long way toward achieving the Commission’s goal of reducing fails to deliver.
The staff has been closely monitoring the impact of Temporary Rule 204T on fails to deliver. A recent study by the Commission’s Office of Economic Analysis on Rule 204T, as well as on the elimination of the options market maker exception to Regulation SHO’s close-out requirement, indicates that, as of March 31, 2009, the number of fails to deliver and threshold securities has decreased significantly. For example, the average daily number of aggregate fails for all securities decreased from 1.1 billion to 478 million for a total decline of 56.6%. The report also reflected that the average daily number of threshold list securities has decreased from 480 to 108 for a total decline of 77.5%.
Further, the number of threshold securities has plummeted from over 500 in the summer of 2008 to about 70 as of April 2009. Additionally, the Commission’s actions to restrict short sales are viewed by some in the press as related to recent rallies in stock prices and a boost in investor confidence.
The staff expects to make recommendations to the Commission this Spring regarding Temporary Rule 204T.
A Sharp Turn in the Road Brings the Commission Back to the Price Test
As I discussed at the beginning of this presentation, the Commission eliminated all short sale price test restrictions in July 2007 by eliminating the tick test of Rule 10a-1 and prohibiting SROs from having their own price tests. However, as I’m sure you’re aware, market conditions have changed dramatically since the Commission conducted the pilot study of the effects of removing short sale price test restrictions and since the Commission acted to eliminate all short sale price test restrictions. Concurrent with the development of the subprime mortgage crisis and credit crisis, market volatility, including steep price declines, particularly in the stocks of certain financial issuers, has increased markedly in the U.S. and in every major stock market around the world. As market conditions have continued to worsen, investor confidence has eroded. And many members of the public have come to associate short selling with that volatility and the loss of investor confidence in our markets, which has been expressed to the Commission in the form of numerous requests from commenters to reinstate short sale price test restrictions.
Due to extreme market conditions and continued concern for restoring investor confidence in our markets, the Commission, on April 8, 2009, proposed two approaches to restrictions on short selling: first, alternative price tests that would apply on a market-wide and permanent basis and second, a so-called “circuit breaker” that would apply only to a particular security during severe market declines in that security.
In the context of the short sale price test approach, it is important to understand that, at the time that the Commission eliminated short sale price tests, there were actually two different types of price tests in place: the Nasdaq bid test, which was based on the national best bid, and the tick test of Rule 10a-1, which was based on the last sale price. In 2005, prior to the start of the pilot study, the Nasdaq bid test covered approximately 2,800 securities (or 44 million short sales) while the Commission’s former tick test of Rule 10a-1 covered approximately 4,000 securities (or 68 million short sales).
Accordingly, the first proposed approach, a market-wide, permanent short sale price test, could be based on either the last bid, like the former Nasdaq bid test, or on the last sale price, like the former tick test of Rule 10a-1. The Commission believes that bids generally are a more accurate reflection of current prices for a security because the last trade price can be reported out-of-sequence within a 90 second window. This reporting may create up-ticks and down-ticks that may not accurately reflect price movements in the security for the purpose of a test based on the last sale price. Thus, for those securities for which the majority of trading occurs in dealer markets, or in multiple venues, a price test based on the national best bid may be a more effective means of regulating short selling than a test based on the last sale price. Either type of a price test could be imposed as a straight prohibition, a policies and procedures requirement for brokers and exchanges, or a mix of both.
The second proposed approach consists of security-specific circuit breaker rules. A circuit breaker, when triggered by a specified percentage intraday decline in the price of a security, could trigger a number of consequences, such as a ban on short selling in that particular security for the remainder of the day, or a short sale price test for the remainder of the day, based on either the national best bid or the last sale price.
The proposals would cover all securities listed on a national securities exchange, except options, whether traded on an exchange or in the over-the-counter market. The proposals would not include non-NMS stocks quoted on the OTC Bulletin Board or elsewhere in the OTC market.
The Commission is seeking comments generally on all aspects of the proposed rules, with a particular emphasis on empirical evidence regarding the costs and benefits of the proposed restrictions, including any proposed exceptions. The Commission also seeks to obtain empirical evidence on the potential impact that short sale price or bid test restrictions would have on legitimate short selling and overall market quality.
As you may be aware, today the Commission held a public roundtable at which there was extensive debate regarding short sale price tests and circuit breaker restrictions. The roundtable participants represented all aspects of the investing world, including broker-dealers, issuers, investors, and short sellers.
In addition to the discussions heard today, the Staff and Commission will carefully consider all comments and insights that we receive regarding the effectiveness of short sale price test or circuit breaker restrictions, operational concerns, as well as the costs and benefits of each alternative proposal.
Conclusion — Keeping its Balance as the Commission Continues Down the Path
The mission of the Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Achieving these goals often requires the Commission to carefully balance competing interests. This is particularly true for the regulation of short selling, a practice that has significant market utility but that also can raise concerns. As the Commission continues on the path of short sale regulation, the staff will be very deliberative in our effort to determine what recommendation to the Commission is in the best interest of investors, and to balance fairness and efficiency, investor confidence and liquidity. After all, reasonable people may differ on precisely where regulatory lines should be drawn, but I think we all agree that they should be drawn with precision.
Thank you for your time and I look forward to hearing your views.
1 The U.S. Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author’s colleagues on the staff of the Commission.