Short Sale Price Test Restrictions
A Small Entity Compliance Guide*
The Securities and Exchange Commission has adopted amendments to Regulation SHO under the Securities Exchange Act of 1934 ("Exchange Act") to implement a short sale-related circuit breaker that, if triggered, will restrict the prices at which securities may be sold short and to impose a "short exempt" marking requirement. The amendments are located in Rules 201 and 200(g) of Regulation SHO (17 CFR 242.201, 17 CFR 242.200(g)). The Commission adopted the amendments to help prevent short selling, including potentially abusive or manipulative short selling, from being used as a tool to exacerbate a decline in a security's price and to address concerns that excessive downward price pressure on individual securities, accompanied by the fear of unconstrained short selling, can undermine investor confidence in the markets.
Short Sale Price Test Restriction
Rule 201 of Regulation SHO requires a trading center1 to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent it from executing or displaying any short sale order of a "covered security," absent an exception, at a price that is equal to or below the current national best bid if the price of that security declines intra-day by 10% or more from the security's closing price as determined by the covered security's listing market as of the end of regular trading hours on the prior day. If the security experiences such a 10% or more price decline, the Rule's restrictions will be in place for the trading day on which the circuit breaker is triggered and the following day. In addition, a trading center's policies and procedures must be reasonably designed to permit the execution or display of an order marked "short exempt," regardless of its price. A trading center must also regularly surveil its policies and procedures to ascertain their effectiveness and take prompt action to remedy any deficiencies.
Rule 201 applies to any "covered security," which is any NMS stock.2 Thus, Rule 201 generally applies to all securities, except options, that are listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market.
"Short Exempt" Marking Requirement
In addition to Rule 201, the Commission amended Rules 200(g) and 200(g)(2) of Regulation SHO relating to broker-dealer marking of certain qualifying sell orders as "short exempt." Rule 200(g) provides that a broker or dealer must mark all sell orders of any equity security as "long," "short," or "short exempt." Rule 200(g)(2) provides that a sale order shall be marked "short exempt" only if the provisions of Rule 201(c) or 201(d) of Regulation SHO are met.
Rule 201(c) — Broker-Dealer Provision
Rule 201(c) of Regulation SHO allows a broker-dealer to mark a sale "short exempt" if the broker-dealer identifies the order as being at a price above the current national best bid at the time of submission of the order to a trading center. The broker-dealer must establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the incorrect identification of orders as priced above the current national best bid. Reliance on this provision is optional, but if a broker-dealer does rely on this provision, it must mark the order "short exempt" pursuant to Rule 200(g) and it must have the specified policies and procedures.
Rule 201(d) — Exceptions
Rule 201(d) sets forth limited exceptions to Rule 201 that allow broker-dealers to mark orders as "short exempt" if they are related to certain activities and fulfill all of the requirements set forth in the applicable provision of the Rule. Broker-dealers may mark orders as "short exempt" in relation to: a seller's delay in delivery, where the short sale order is by a person who owns the security pursuant to Rule 200 of Regulation SHO and intends to deliver the security as soon as all restrictions on delivery have been removed; certain odd-lot transactions; certain domestic arbitrage transactions; certain international arbitrage transactions; sales in connection with over-allotments and lay-off sales; and transactions executed on a volume weighted average price basis.
In addition, Rule 201(d)(6) includes an exception for riskless principal transactions. This exception is available if the broker-dealer is facilitating a customer buy order or sell order where the customer is net long, and the broker-dealer is net short but effecting the sale as riskless principal. To rely on this exception to mark an order "short exempt," the broker-dealer must establish, maintain, and enforce written policies and procedures to assure that, at a minimum: (i) the customer order was received prior to the offsetting transaction; (ii) the offsetting transaction is allocated to a riskless principal or customer account within 60 seconds of execution; and (iii) it has supervisory systems in place to produce records that enable the broker-dealer to accurately and readily reconstruct, in a time-sequenced manner, all orders on which the broker-dealer relies pursuant to this provision.
The Adopting Release covering these amendments was published in the Federal Register on March 10, 2010, and the effective date for these amendments is May 10, 2010. However, all market participants will have until November 10, 2010 to fully comply with the requirements of Rules 201 and 200(g) of Regulation SHO.
How do the amendments to Regulation SHO affect small entities?
Small entities that qualify as trading centers under Rule 201, as well as other small broker-dealers that may choose to rely on Rule 201(c) or 201(d), are affected by the amendments. Rules 201 and 200(g) will impose some new or additional reporting, recordkeeping, or compliance requirements on small entities that are trading centers and/or small broker-dealers.
Trading centers that are small entities will be required to establish, maintain, and enforce policies and procedures in accordance with Rule 201(b). Small broker-dealers that choose to rely on Rule 201(c) or 201(d)(6) will likewise be required to establish, maintain, and enforce certain policies and procedures. The nature and extent of policies and procedures will vary depending on the type, size, and nature of the trading center or broker-dealer. The policies and procedures required in connection with Regulation NMS's Order Protection Rule may help form a basis for the policies and procedures under Rule 201. Trading centers and broker-dealers that have already established policies and procedures in connection with the Order Protection Rule may be able to leverage this experience to establish, maintain, and enforce policies and procedures under Rule 201.
Small broker-dealers that determine to rely on Rule 201(c) may conclude that it is cost-effective to outsource certain functions necessary to comply with Rule 201(c) to larger broker-dealers, rather than performing such functions in house, to remain competitive in the market. In addition, order management software providers may integrate changes imposed by Rules 201 and 200(g) into their products, thereby providing another cost-effective way for small broker-dealers to comply with the requirements of Rule 201(c).
With respect to the amendment to Rule 200(g), the Commission stated its belief that costs associated with the "short exempt" marking requirement will be limited because small broker-dealers already have established systems, processes, and procedures in place to comply with the current marking requirements of Rule 200(g) of Regulation SHO. Small broker-dealers should be able to leverage such systems, processes, and procedures to comply with the "short exempt" marking requirement in Rules 200(g) and 200(g)(2).
The Adopting Release for the amendments can be found on the SEC's Web site at http://www.sec.gov/rules/final/2010/34-61595.pdf.
Additional materials regarding short sales and Regulation SHO generally are available on the SEC's Web site at http://www.sec.gov/spotlight/
Contacting the SEC
The SEC's Division of Trading and Markets is happy to assist small entities with questions regarding the amendments to Rules 201 and 200(g) of Regulation SHO. The Division's Office of Interpretation and Guidance answers questions submitted by email and telephone. You can submit a question by email to firstname.lastname@example.org or you can contact the Office of Interpretation and Guidance at (202) 551-5777.
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