Willkie Farr & Gallagher
787 Seventh Avenue
New York, NY 10019-6099
212 728 8000
Direct: 212 728 8206
Roger D. Blanc
May 23, 2000
Securities and Exchange Commission
450 Fifth Street
Washington, DC 20549
Attention: Jonathan G. Katz, Secretary
Re: SEC Concept Release: Short Sales;
SEC File No. S7-24-99
Ladies and Gentlemen:
We are writing on behalf of Bear, Stearns & Co. Inc.; Credit Suisse First Boston Corporation; Deutsche Bank Securities, Inc.; J.P. Morgan Securities Inc.; PaineWebber Incorporated; Prudential Securities Incorporated; and Warburg Dillon Read LLC (each a "Firm" and, collectively, the "Firms"), in response to the Commission's request for comment on its Concept Release on Short Sales, Release No. 42037 (October 20, 1999) under the Securities Exchange Act of 1934 (the "Exchange Act"). The Firms appreciate the opportunity the Commission has afforded them to comment on this important subject.
The Firms regard short selling as an important market activity that often is helpful in providing liquidity to the market, particularly to facilitate customer transactions, and in offsetting market exposure in other related securities and instruments. Short selling can be beneficial to the market since it can help the market reach an appropriate new equilibrium after a change in overall market conditions or in the mix of information regarding particular issuers. The Firms have differing views in some respects as to whether continued regulation of short sale pricing is necessary or desirable. Several of the Firms may be submitting additional letters on the Concept Release to express further views on the subjects raised. This group letter expresses the points of view on which the Firms have reached a consensus.
Conclusions. The conclusions the Firms have reached as a group are as follows:
Exceptions for hedging. Rule 10a-1 should be amended to add exceptions for the establishment and maintenance of hedged positions, including a hedged position undertaken in the course of a risk arbitrage strategy involving a publicly announced exchange offer or stock-for-stock merger. The determination of an excepted hedge should not require the use of a 1:1 ratio, but should take into account responsible methods of evaluating risk exposure and offset at the time of the transaction, including but not limited to risk modeling using delta-based analysis.
Limit application of Rule 10a-1 to trading hours when there is real-time last-sale reporting. The Commission should amend the rule to make it clear that it does not apply during the period when real-time last sale reporting has ceased. After last-sale reporting has ceased on a real-time basis, the risk that short selling will affect the U.S. market is outweighed by the risk that application of the prohibition will result simply in driving the trading offshore.
Expansion of Rule 10a-1 to cover Nasdaq stocks. The NASD's quotation-based short sale rule, under current market circumstances, seems reasonably well attuned to the unique market conditions affecting the Nasdaq market. As a result, it is not necessary to import the trade-based concepts of Rule 10a-1 to the Nasdaq market. If the Nasdaq market later takes on more auction-based characteristics than it has today, however, it may be appropriate to reconsider this conclusion at that time. Of course, the registration of Nasdaq as a national securities exchange will necessitate amending Rule 10a-1 if a separate quotation-based rule is to be preserved for the Nasdaq market.
4. Harmonize NASD Rules 3350 and 3370. Nonetheless, the Firms recommend that the Commission urge the NASD to amend its short-sale rule to parallel changes made to the exemptive provisions of Rule 10a-1. In addition, the Firms believe the NASD's approach to locating securities in connection with short selling under NASD Rule 3370 should be harmonized more closely with the approach of the New York Stock Exchange (the "NYSE") in its Rule 440C.
A. Responding to Decimalization.
The Firms have given substantial consideration to ways in which Rule 10a-1 might be adjusted to take into account the possible effects of decimalization, particularly any reduction in the effective minimum trading increment that might occur (e.g., reduction from 1/16th to pennies or even mills). The Firms have evaluated, for example, whether it would make sense to introduce a concept of "down limits", pursuant to which the rule's application would be suspended unless and until the market in a given stock had declined by some set percentage from the previous day's closing price. The Firms also have considered whether a general exemption should be granted for all stocks that meet some volume-based threshold, on the theory that high-volume stocks are less susceptible to manipulation.
While some of these approaches have merit, the Firms as a group believe it would be preferable at the moment, particularly given the shortness of time before decimalization is to be introduced, for the Commission to defer rulemaking under the Administrative Procedure Act and instead to await the introduction of decimalization and respond by no-action position if needed to resolve difficult compliance problems in the several months that follow. Depending on what happens, the Commission will then be in a position to consider what rulemaking action to take.
B. Additional Exception for Hedging and Hedged Transactions.
The Firms believe that, in the interim before a full evaluation of Rule 10a-1 should be undertaken, an additional exception should be added to the rule to apply to hedging and hedged transactions. Short sales resulting in positions that hedge other positions, or that themselves are so hedged, in either event sufficiently to eliminate any significant downward bias should be excepted from Rule 10a-1. For example, the creation of a traditional reverse conversion position (short stock coupled with a short put and a long call struck at or about the price of the short sale) should not be subject to short sale regulation because the put and call will tend to make the resulting combination of positions market neutral and, through arbitrage between the stock and options markets, will tend to counteract the downward market pressure that the short sale itself would exert. Other examples would include (a) a short sale of a stock or basket against a long call or future involving the physical security, an index or future and (b) a short sale of a stock or basket against a long swap of the same interests.1 The Firms strongly recommend against attempting to write an exclusive definition of the positions that would be deemed to constitute a hedge.2
The hedging exception should allow dynamic, model-based (e.g., delta) hedging, adjustments to existing hedges and unwinding of hedges. It should not require hedging on a 1:1 ratio. Permissible models should be those devised by each individual firm that are reasonably calculated to result in an economically hedged position and should apply to risk arbitrage in connection with exchange offers and stock-for-stock mergers3 as well as other hedging situations.4
One example of a trade that should be covered by the exemption in the cross-border context is a customer facilitation involving American Depository Receipts and ordinary shares.5 Trades of this type have the elements of a hedge since the trade in the ordinaries would offset the trade in the ADRs, but the Commission could, if it wished, fashion a separate, discrete exemption if it wished for these types of trades.
Broker-dealers should not have to receive advance approval from the Commission or a self-regulatory organization to implement a risk-assessment model and should be permitted to update their models as they deem appropriate as long as they continue to reflect a reasonable approach to risk measurement and the determination of risk offsets. Firms should not have to receive advance approval from the Commission or a self-regulatory organization to implement or revise a hedging model. Firms seeking to rely on the hedging exception would bear the burden in a given case of establishing their entitlement to the exception.6 Except as currently permitted under Rule 10a-1 (e.g., paragraph (e)(13)), neither hedged short positions nor hedged long positions should be excluded from the required overall net short calculation by the firm or by a particular aggregation unit.
C. After-Hours Trading.
Rule 10a-1 should be amended to make it clear that it does not apply to short selling at times when real-time last sale reporting has ceased. The Firms recognize that application of the NASD's short sale rule, Rule 3350, currently stops at 4:00 P.M. rather than 6:30 P.M.7 The Firms are not aware of any significant incidence of manipulative short selling in the period after 4:00 P.M. The Firms believe the rules should be harmonized.
Application of Rule 10a-1 to after-hours trading in the United States once real-time, last-sale reporting has ended is unnecessary and inappropriate since it would not accomplish any useful anti-manipulative purpose and the practical effect may be to drive the trading off-shore at a time when the elimination of NYSE Rule 390 otherwise could reduce the volume of off-shore trading in NYSE-listed securities.
D. Nasdaq National Market Stocks.
Currently, as the Commission knows, NASD Rule 3350, and not Rule 10a-1 under the Exchange Act, regulates short selling in Nasdaq National Market stocks and does so on the basis of quotations rather than last sale data. The Firms do not believe that it is necessary at this time to alter that procedure. If the Nasdaq National Market takes on significantly more auction-like features, however, that conclusion may need to be reassessed. Nonetheless, the benchmark used for determining when short selling is permitted in Nasdaq National Market stocks may need to be reexamined in light of the decimalization of that market. The Firms are inclined to believe that an approach such as the one suggested below for Rule 10a-1 may be needed in such an event. In any event, of course, the registration of Nasdaq as a national securities exchange will require some alteration of Rule 10a-1 as it now stands if the quotation-based system embodied in NASD Rule 3350 is to be preserved.
The Firms also recommend that the Commission urge the self-regulatory organizations to establish a single, workable approach to locating securities for borrowing before effecting short sales. The NASD's approach, embodying hard-to-borrow lists, is not workable and creates real back-office problems because of the need to comply with multiple procedures for locating securities. The Firms understand that the NASD has been examining this issue.8 The Firms would encourage the NASD to find a solution that is at least in harmony with the NYSE approach. Indeed, the NYSE's recordkeeping requirements are themselves more elaborate and burdensome than they need to be, but whatever procedures are to be followed should at least be uniform and, it is hoped, should be as simple and straightforward as possible.
E. Possible Deregulation.
The Firms have considered the possibility of deregulating short selling more generally. Short selling would of course remain subject to the general anti-fraud and anti-manipulative provisions of the federal securities laws, particularly including Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, as well as the "locate" requirements in NYSE Rule 440C and NASD Rule 3370, even in the absence of prophylactic rules such as Rule 10a-1 and NASD Rule 3350. Rule 10a-1 was adopted at a time well before the availability of computer-driven recordkeeping and surveillance systems. By flatly prohibiting short selling on a down tick, subject to enumerated exceptions, the rule relieves the Commission of the burden of proving intent under the anti-manipulative provisions of Section 9(a) of the Exchange Act and scienter under Section 10(b) and Rule 10b-5. The question is whether the prophylaxis continues to be needed or, from another perspective, whether the cost to the market in terms of reduced flexibility and the reduction in liquidity imposed by pricing restraints on short selling continue to be justified.
When the Commission begins introducing decimal pricing in the markets, if that results in a reduction of the effective minimum increment, it may be appropriate to revise Rule 10a-1. While some of the Firms believe the Commission could respond to decimalization by proposing rules today, the Firms have not reached a consensus as to what the response should be. The Firms recommend therefore that the Commission do the following:
1. Await the actual introduction of decimalization before taking formal action under the Administrative Procedure Act to amend Rule 10a-1.
2. Watch closely the actual response of the markets to decimalization and the effect of an unchanged application of Rule 10a-1. If the rule appears to be incapable of effective compliance (because, for example, the minimum trading increment is shrinking and it becomes impractical to monitor and comply with rule in an environment where the ticks go up and down in rapid succession), the Commission should be flexible in enforcing the rule to prevent the rule from disrupting the market or unfairly penalizing brokers that are making conscientious efforts to comply.
3. In light of whatever the post-decimalization experience shows, there may not be sufficient time for the Commission to deal with problems under the rule by taking formal action to amend it. In such a case, the Commission should proceed by granting temporary no-action positions (e.g., for certain high volume stocks) pending the Commission's assessment of the experience under the rule before determining whether and how to amend Rule 10a-1 itself.
G. Aggregation units.
The system of aggregation units permitted for use by multi-service firms under the Division of Market Regulation's Letter Regarding Aggregation Units (November 23, 1998) is sensible in concept, but the Firms, over a year after the no-action position was granted, are still having difficulty devising procedures to meet those very elaborate and exacting requirements. The Firms believe alternative solutions would be desirable and would look forward to discussing this with the staff.
* * *
The Firms would very much like to meet with the staff of the Division of Market Regulation to discuss the points made in this letter and to discuss more generally the issues raised in the Concept Release. We will contact the staff directly in the near future to request such a meeting.
If we or any of the Firms may be of further service to the Commission or its staff in their evaluation of these matters, please let me know.
Roger D. Blanc
cc: The Hon. Arthur Levitt, Chairman
The Hon. Norman S. Johnson, Commissioner
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Paul R. Carey, Commissioner
The Hon. Laura S. Unger, Commissioner
Ms. Annette L. Nazareth, Director,
Division of Market Regulation
Mr. Robert L. D. Colby, Deputy Director,
Division of Market Regulation
Mr. Larry E. Bergmann, Associate Director,
Division of Market Regulation
Mr. James A. Brigagliano, Assistant Director,
Division of Market Regulation
Mr. Michael R. Trocchio, Division of Market Regulation
1 In hedging baskets and indices, it is commonplace not to replicate exactly the physical stocks or other interests in the basket or index but instead to hedge with a sufficient sample to reduce the tracking error to acceptable parameters. The hedging exception should cover such practices.
2 In its 1979 release on Section 11(a), Securities Exchange Act Release No. 15533 (January 29, 1979), the Commission wisely avoided attempting to give an exclusive definition of the terms "block positioning", "bona fide arbitrage", "risk arbitrage" and "bona fide hedge" because it recognized that any such definition would rapidly become obsolete as the markets and trading practices changed. The Firms recommend that the Commission follow a similar approach here.
3 The NASD in its Rule 3350 recognizes that risk arbitrage in such situations is properly regarded as a form of hedging. See NASD Interpretation IM-3350(a)(2); see also NASD Special Notice to Members 94-68 (August 25, 1994).
4 The Section 11(a) interpretation discussed in footnote contemplates that market participants may "leg" into a hedge by deliberately introducing a delay, often only minutes or hours but sometimes for a longer period of time, between establishing a position and then hedging it. The exception for hedging the Firms envision, however, would apply only to (i) a short-sale transaction that hedged part or all of a preexisting position (in, e.g., options, futures or swaps), or (ii) a short sale that preceded the transaction it was intended to hedge only by such an interval as was reasonably possible under the market conditions then prevailing. It would not cover a situation where a trader effected a short sale for which exception was sought and then deliberately introduced a delay of more than the amount of time needed to obtain best execution under current market circumstances before hedging the short sale with other securities or interests.
5 In a number of cases, customers selling ordinary shares through a U.S. broker-dealer or its affiliate outside the United States wish to have the firm purchase the shares as a principal to facilitate the trade. In a case where ADRs are traded in the United States, Firms often will sell the ADR short and then purchase the ordinaries at a price reflecting the price at which the ADRs were sold. The short sale in such a case does not present any of the abuses Rule 10a-1 is designed to address and should be exempted. The Commission should state in the release proposing a hedge exemption that such trades are intended to be included within the exemption.
6 The exception the Firms recommend would read as follows:
(e)( ) Any sale of a security by a broker-dealer if such sale (i) hedges a preexisting position in another security, commodity future, swap contract or other interest; or (ii) is contemporaneously hedged by a position taken in another security, commodity future, swap contract or other interest; or (iii) is undertaken as part of risk arbitrage in connection with a publicly announced exchange offer or merger involving the exchange of stocks; or (iv) adjusts a hedge or risk arbitrage position described in clause (i), (ii) or (iii) of this subsection. For purposes of this subsection (e)( ), the terms "hedge" and "risk arbitrage" shall have the meanings ascribed to them in Securities Exchange Act Release No. 15533 (January 29, 1979), except that an arbitrage or hedge need not involve a 1:1 ratio of risk to offset and can instead involve what a ratio hedge effected in accordance with a reasonably designed economic model that measures risk and risk offsets.
7 See NASD Special Notice to Members 94-68 (August 25, 1994).
8 The NASD is putting into effect on June 9, 2000 amendments to NASD Rule 3370 that will permit use of a hard-to-borrow list to comply with the affirmative-determination requirement applicable to short sales in Nasdaq National Market and exchange-listed securities. See NASD Notice to Members 00-28 (May 2000).