February 27, 2004
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Short Sales (File No. S7-23-03)
Dear Mr. Katz:
Citigroup Global Markets Inc., Goldman, Sachs & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated, and Morgan Stanley & Co. Incorporated (collectively, "Firms") welcome the opportunity to provide comments on the Securities and Exchange Commission's ("SEC" or "Commission") proposal to adopt Regulation SHO under the Securities Exchange Act of 1934 ("Exchange Act"), which would modify and replace existing SEC and self-regulatory organization ("SRO") rules governing short sales.1
The Firms commend the Commission's desire to more closely tailor short sale regulation to achieve its intended purposes with fewer undesired collateral effects on legitimate trading activities. We take very seriously the concerns underlying Exchange Act Rule 10a-1 ("the Short Sale Rule") and NASD Rule 3350, and agree with the Commission that these rules need a thorough examination to eliminate their application in situations where they serve no purpose and restrict legitimate market activity. However, as we will detail below, certain of the SEC's proposed changes will result in negative consequences for market participants, including buyers and long sellers, such as reduced customer choice, higher costs and inferior executions. Other of the proposed changes could result in unintended consequences, including significant impediments to capital commitment. Accordingly, we urge the Commission to refrain from effecting many of the changes in its proposal until the results of its proposed pilot program ("Pilot Program") and the future direction of short sale price regulation are known.
The Firms recognize that certain of the proposed changes are intended to curb abusive behaviors by some short sellers and to close regulatory loopholes, and we fully support those goals. However, this does not change our conclusion that the Commission should not implement proposed changes that have, or could have, an overbroad and unintended impact on markets and market participants. Instead, we believe that Commission and SROs should rely on existing anti-manipulation and conduct of business rules and regulations to address abusive conduct.
In order to (i) determine the direction and scope of short sale price regulation, (ii) avoid potential negative impact on the availability of liquidity and (iii) address abuses without preventing legitimate, non-manipulative market activity, we believe the Commission should proceed as follows:
Until Completion of the Pilot Program, Refrain from Wholesale Revision of the Short Sale Rule. In particular, the SEC should:
Refrain from imposing a new uniform short sale price test across markets.
Refrain from adopting any short sale rule based on a consolidated best bid until important market structure issues, such as application of the trade through rule, are addressed.
If the Commission determines to apply a new uniform price test at this time, use a standard modeled on current NASD Rule 3350 rather than the bid test of Regulation SHO so that the uniform test does not prevent short sales at the bid in a rising market.
Reconsider the elimination of the exemption for bona fide market making activities and options exchange specialist and market maker hedging.
Compress the time period of the Pilot Program and determine at the outset an objective standard for an actively-traded security to be analyzed during the Pilot Program.
Avoid Overbroad Application of the Short Sale Price Test:
Exempt from short sale pricing restrictions certain trades for which customers require prices to be calculated with reference to a defined benchmark price (e.g., VWAP and stop price trades).
Refrain from adopting the proposed amendment to what constitutes an "unconditional contract" for determining a net long or short position.
Refrain from applying short sale pricing restrictions after regular trading hours.
Adopt Narrowly-Tailored Rule Changes to address Known Abuses without Overbroad Consequences:
Ensure that each market for Nasdaq NM stocks has a short sale rule similar to NASD Rule 3350 to foreclose regulatory arbitrage among marketplaces with respect to the presence or absence of a short sale rule for Nasdaq NM stocks.
As proposed in the SIA comment letter, proceed with adoption of uniform locate and mandatory buy-in rules, but not the proposed 90-day suspension and penalties for certain extended fails to deliver.
Each of these points is discussed more fully below.
The Firms have serious concerns that Regulation SHO would have negative consequences for customers and the markets. Consequently, we strongly believe that the SEC should not impose a uniform rule on all listed and Nasdaq stocks at this time. Regulation SHO would replace with a uniform price test both the tick test of current Rule 10a-1 and the bid test of NASD Rule 3350. Proposed Rule 201 of Regulation SHO would require that all short sales be executed at a price no less than $0.01 above the consolidated best bid for the security being sold at the time of execution. Significantly, this uniform price test differs from that in NASD Rule 3350, which currently permits short sales in Nasdaq NM securities at the Nasdaq best bid provided that that bid is higher than the last preceding different bid. Regulation SHO would restrict all short sales in the same manner, regardless of whether a stock was rising or declining in price. This approach differs starkly from both the Short Sale Rule and NASD Rule 3350, which are intended to primarily limit short sales in declining markets.
Although we agree with the Commission that this is an appropriate time to reassess the current regulatory framework for short sales, we believe that the uniform price test of Regulation SHO, as proposed, will have many collateral effects that are inconsistent with the core purpose of short sale regulation. The Short Sale Rule is intended to prevent short sellers from accelerating a declining market.2 In contrast, the proposed uniform price test would restrict short sales in a rising market unless a market participant committed to pay an additional one cent above the current best bid. Such a standard could spawn serious market effects, to the detriment of investors and the markets.
For example, Regulation SHO could reduce the ability of limit orders at the bid to be executed in rising markets. Customers desiring to buy a stock will be forced to pay more for the stock than originally intended because Regulation SHO will prevent short sellers from selling to displayed limit bids. If a stock's price continues to rise, buyers would be forced to change limit orders to market buy orders, and thus pay a higher price for the stock. This is not a goal that short sale regulation is intended to achieve.
We see no reason for the SEC to restrain any type of selling when the market for a stock is not declining.3 Instead of acting as a check against unrestrained downward pressure on the price of a security, the uniform price test of Regulation SHO could in fact operate to fuel a speculative rise in a security and exacerbate trading "bubbles" by impeding short selling in a rising market. Selling at the bid - particularly when a stock's price is advancing - is a legitimate trading strategy that benefits sellers by providing immediacy of execution and buyers by providing greater opportunities for meeting contra-side interest, and it should not be restricted unnecessarily. Doing so does not further the purposes of the Short Sale Rule.
As we believe that the proposed uniform price test of Regulation SHO would not provide the proper means to promote the objectives of the Short Sale Rule, would cause unintended consequences on market behavior, and would involve large systems costs, the Firms respectfully urge the Commission to leave the tick test for listed securities and the bid test for Nasdaq NM securities (along with the current exemptions contained in those rules) in place until the Commission has had the opportunity to review the results of the Pilot Program. The Pilot Program will provide the SEC with actual data, as opposed to mere anecdotal evidence, on which to base any decision to permanently exempt certain classes of securities from short sale regulation. As the Commission itself previously has recognized, "`the availability of data with respect to short selling continues to be inadequate to establish meaningful conclusions' regarding the general effects of short selling or the efficacy of short sale regulation."4 Once the SEC has reviewed the results of the Pilot Program, it would be in a better position to assess what type of stocks should be subject to short sale regulation and the appropriate short sale pricing restriction to apply to these stocks.
In addition, practical considerations warrant postponement of a uniform price standard across all markets and securities until the Pilot has been concluded. Every broker-dealer, specialist, market maker, alternative trading system and SRO would have to reprogram its trading systems, as well as related surveillance/supervision and information management systems, to accommodate a completely new pricing test. It is possible that these new systems and the related infrastructure may need to be modified or replaced within a few years (or even more quickly), once the SEC has had the opportunity to analyze the results of the Pilot Program.5 The Commission should attempt to minimize the costs that will have to be incurred by market participants in connection with its new regulations.
Finally, until certain market structure issues such as the continuing viability of the trade through rule and the adequacy of market linkages are resolved, introduction of a test based on the consolidated best bid could produce trading dilemmas.6 For example, if the best bid is displayed by a market that is difficult or slow to access or is otherwise unreliable, short sellers will face a difficult choice. A short seller might feel compelled to send the order to the market displaying the best bid because, in that market, there will be a theoretically greater likelihood of execution at the minimum price permitted by the proposed uniform price test. On the other hand, that market may offer a slower execution and the bid at that market could fade or become stale by the time the short seller's order reaches it.7 Even if a short seller sent an order to a market because it was displaying the best bid, another market could increase its bid simultaneously so that the short sale was no longer permissible. For example, assume that a customer's short limit order is sent to an OTC market maker for execution at $20.01, one cent above the consolidated best bid (currently $20.00), but, while the order is making its way to the market maker for execution, another market (such as an ECN or ATS) increases its disseminated bid to $20.01 so that the best bid is now at that other market. What happens to that order now that it is priced at the consolidated best bid? Must it (and even can it) be redirected back to the customer? Will Nasdaq stop the execution of the order? We envision the potential for numerous inadvertent violations of the proposed short sale regulations as a result of trying to ensure customer fills in the current fragmented environment.
Without resolving the market structure issues first, the adoption of Regulation SHO will exacerbate current inefficiencies in the equity markets. Application of a short sale restriction based on a consolidated best bid test under the current market structure is not the proper and efficient manner to effect price discovery, facilitate best execution, promote intermarket competition, or achieve the underlying objectives of the Short Sale Rule. For these reasons, we strongly urge the Commission to resolve the larger pending market structure issues it has been considering before it implements wholesale short sale regulation revisions that could exacerbate market structure shortcomings.
While the Firms have serious concerns with imposing a new uniform short sale standard at this time, we agree with the Commission that it should address immediately the problem of regulatory arbitrage in the context of short sale regulation of Nasdaq NM securities. Currently there is disparate short sale treatment for Nasdaq NM securities depending on the execution venue of a transaction.8 For instance, NASD Rule 3350 applies to a trade in Nasdaq NM securities executed over Nasdaq systems, but that same rule does not apply to an identical transaction in a Nasdaq NM security traded on certain regional securities exchanges pursuant to unlisted trading privileges.9 The Firms believe that there is no logical reason to apply differing short sale regulation to a trade executed in the same security on Nasdaq, on a regional exchange, or over an Electronic Communications Network - the same policy concerns underlying restrictions on short selling would be present in each case.10 Thus, the Firms would support immediate Commission action to require each market trading Nasdaq NM securities to adopt and/or apply a rule similar to NASD Rule 3350 in order to remove this regulatory disparity, even prior to the completion of the Pilot Program.11
If the SEC feels compelled to adopt a uniform short sale pricing rule for listed and Nasdaq NM stocks prior to completion of the Pilot Program, we strongly urge the SEC not to impose the proposed Regulation SHO standard that short sales be effected at a price one penny above the consolidated best bid. Instead, we recommend that the SEC adopt a modified version of the standard used in NASD Rule 3350, under which a short sale would be prohibited at or below the consolidated bid only if the bid is a "down-bid." We believe that the NASD bid test provides a more flexible approach because it does not restrict short sales from occurring at prices that do not truly represent a price decline (e.g., a transaction at a stock's bid quote when the bid is higher than the previous bid quote). Moreover, the SEC has not provided evidence demonstrating any abuse of the NASD bid test during the rule's 10-year existence. Consequently, while the Firms recommend that the SEC wait until the completion of the Pilot Program before choosing a marketwide short sale standard, if the Commission determines to proceed at this time with a uniform standard then we urge the SEC to use the NASD Rule 3350 standard rather than the proposed price test of Regulation SHO. It is critical, however, that this uniform standard not use a consolidated bid as a reference but rather let each market use its own best bid for short sales in its market. As noted earlier in this letter, until market structure issues are resolved, use of a consolidated bid could cause frequent inadvertent violations of short sale restrictions and create great difficulties in complying with the restrictions.
We understand that the SEC may have concern with the bid test in NASD Rule 3350 because it permits short sales below the bid if the bid is an "up-bid." Although we do not share this concern because an increasing bid indicates that stock's price is rising, we recognize the Commission's concerns regarding the ability to sell short at prices below the best bid, even in advancing markets. If this concern sufficiently troubles the Commission, the Firms suggest a modification of the bid test of NASD Rule 3350 to prevent short sales on a market below that market's best bid (not the consolidated best bid) at any time if that would comfort the SEC sufficiently to adopt the NASD bid test as the marketwide standard.12
Although we advocate that the SEC refrain from wholesale revision of short sale regulation at this time, there are certain types of legitimate trading activities that are currently (and unnecessarily) constrained under the Short Sale Rule and/or NASD Rule 3350, and which would be even more constrained under proposed Regulation SHO. These involve trades for which a customer desires an execution at a particular reference price, such as the closing price, VWAP, or a guaranteed stop price. We urge the Commission to exempt from short sale pricing restrictions such transactions and the dealer activity to facilitate such transactions. Providing exemptions for these types of trades from the application of short sale restrictions (be it the Short Sale Rule or Regulation SHO) would not undermine the purposes of short sale regulation, because these trading activities are not manipulative or conducive to driving down the price of a particular stock. Rather, these types of trades are driven by client demands for capital commitment and potential price improvements for their orders. The SEC should act quickly to remove the short sale burdens on these trades either through exemptions or modification of application of the short sale pricing restrictions.
In order to explain the concerns noted with respect to these customer services, we provide below a description of some of the trading services that the Short Sale Rule impedes unnecessarily and that would be exacerbated by the sweeping nature of Regulation SHO.
Many institutional customers of the Firms benefit from the availability of trading "stops" in which a firm guarantees that an institutional customer's buy order (typically large in size) will receive no worse a price than that agreed upon when the order is accepted (such price will be higher than the inside offer at the time, the amount depending upon factors such as the size of the order and the liquidity of the stock). The firm offers the stop guarantee solely as a benefit to customers at their request. Proposed Regulation SHO could impede the client's ability to elect to execute its order at the stop price, as this example demonstrates:
A firm agrees to stop a customer order to buy 200,000 shares of ABC Corp. at 25.00. The market at the time of the stop is 24.90 x 24.95. Assume the firm has no preexisting long position in the stock.
The firm executes, on an agency basis, 100,000 shares of the 200,000 share order at or below the stop price. (Because is it acting as agent, the firm passes all executions constituting these 100,000 shares directly to the customer, print-for-print). The stock then trades through the stop price, and the market price for ABC Corp. stock is now 25.10. The client then calls the firm to elect the stop, which means that the firm is now contractually bound to fill the remainder of the order as principal at the stop price (25.00). The firm does not have sufficient shares of ABC Corp. in inventory to cover this obligation.
Because the firm does not own the balance of the order (100,000 shares), the firm must sell short as principal to fill the remainder of the customer buy order.
Because the stop price (25.00) is now lower than the current market price of the stock (25.10), however, the firm cannot execute the remainder of the order at the stop price in compliance with short sale price restrictions. Rather, the firm must wait for the price of the stock to decline to below the stop price so the remainder of the order subject to the stop can be executed on a good tick. If the stock does not decline to that level by the end of the trading day, the firm is faced with not being able to fill the customer in the U.S.
In this scenario, Regulation SHO would prevent the firm from selling short 100,000 shares to the customer at the $25.00 stop price, unless the bid price of the stock were to decline below that threshold, even though the market for the stock was rising. Since client stops cannot realistically be used to exert downward pressure (whether manipulative or otherwise) on an issuer's stock price - the stop price is above the current market at the time the stop is granted - such a restriction does not comport with the purposes of the Short Sale Rule. The application of the short sale pricing restrictions in this case expose a firm to greater risk because the stock price can continue to rise during the trading day while the firm waits for a price decline in order to execute the stop transaction. The firm may be forced to buy the stock at rising prices in order to get long to be able to sell at the stop price to the customer. The customer is harmed because the firm's stop price will be higher to reflect the uncertainty of being able to effect sales triggered by the stop in a timely manner and the huge economic risk the firm might occur if forced to buy the stock to effectuate the sale to the customer. Moreover, because of the uncertainty, broker-dealers will be less inclined to grant stops, even though the stops result in a better execution for the customer.
Institutional customers of the Firms also request guarantees from the Firms that their buy orders will receive a price no worse than a volume weighted average price ("VWAP"), or a similar guaranteed price calculated with reference to a benchmark price. These types of trades enable a client to obtain an objective benchmark price for their purchases. As with stop trades, however, this type of trading service is impeded by short sale regulation today and would continue to be impeded if Regulation SHO is adopted as proposed. The following is illustrative:
At 9:45 a.m., a U.S. institutional customer submits, and a firm accepts, a $250 million basket/program trade to buy 14 listed securities, on a guaranteed VWAP basis.
At 4:00 p.m., all of the stocks comprising the basket close up for the day, but two of the stocks have a VWAP below the closing consolidated bid.
If the firm is net short or flat the two securities, Regulation SHO would prohibit the firm from executing the customer's $250 million basket trade in its entirety. Instead, the firm would be able to partially execute the program by executing the VWAP trade with the customer at 4:02 p.m. in the twelve stocks for which VWAP prices were at or above the closing prices (or consolidated bids). It would be unable to execute the trade at all in the two remaining stocks because the VWAP execution price would be lower than the closing prices or bids.
Unfortunately, neither the firm nor the customer would realize that the VWAP trade, which they agreed to early in the trading day, could not be consummated until it was too late. The customer, however, may have already taken other actions to manage its portfolio risk in reliance on the expectation that the VWAP trade would have been executable.
As with the stop scenario described above, application of Regulation SHO to VWAP transactions in such a circumstance would unnecessarily preclude a firm from providing a liquidity service to a customer for a transaction that did not implicate the underlying concerns of the Short Sale Rule. Ironically, this scenario is more likely to occur when the stock price is rising because the VWAP will most likely be below the closing price or bid. Consequently, Regulation SHO would restrict a VWAP short sale in the environment in which a short sale restriction is least warranted - a rising market.13
We note that current exemptions from short sale regulation for VWAP transactions that have been granted by the Commission are highly restrictive.14 For instance, as the Commission itself recognized, the exemptive relief is limited to VWAP transactions that are arranged or "matched" before the market opens at 9:30 a.m. but are not assigned a price until after the close of trading when the VWAP value is calculated. In addition, the relief that has been previously granted to VWAP transactions applies when the customer is the seller (but not when the firm that is facilitating the client's VWAP buy trade is the short seller), and is conditioned on the meeting of various volume and liquidity tests. Moreover, the current VWAP exemption does not cover intraday VWAP, yet our customers increasingly request a VWAP based on a discrete portion of a trading day.15
Institutional clients may want to buy a stock at a price based on the closing price but that is discounted to the closing price by several basis points. Regulation SHO could prevent a broker-dealer from guaranteeing a better-than-closing price execution to the customer.
At 10:30 a.m. the institutional customer places an order to buy 50,000 shares of stock XYZ after the close at the closing price minus two cents.
The broker-dealer may only be able to hedge partially during the day. For example, the broker-dealer might be able to buy 30,000 shares as a partial hedge.
The stock closes at $15.00 and the closing bid is $15.00. The broker-dealer can only sell 30,000 shares. Regulation SHO would prevent the broker-dealer from selling the remaining 20,000 shares at $14.98 (the closing price less the discount) because that price is below the closing bid.
* * * * *
The above examples show some of the instances in which client preferences and order enhancement would be frustrated by adoption of Regulation SHO, and that, to some extent, currently are unnecessarily restrained by the Short Sale Rule. For these reasons, we urge the Commission to allow an exemption from operation of the Short Sale Rule, or the uniform price test of Regulation SHO, for a dealer to execute a short sale to fill a customer at a benchmark or formula, be it a stop price, VWAP price, or other formula reference price. The Commission could attach appropriate qualifiers to the exemption to ensure that an exempted transaction had no short sale impact. For example, the Commission could require that, for a stop trade to be exempted, the stop price must be compliant with whichever short sale price test was applicable at the time the stop was granted by the firm (as opposed to when the client elected the stop). In addition, the Commission could require that a short sale at a VWAP have a reference period of at least one hour. In today's markets, this time period is sufficiently long to ensure that the VWAP is a bona fide benchmark pricing formula. Finally, the exempted formula/reference price trades could be required to be reported to the tape with an appropriate modifier, such as a ".w" modifier for formula-based trades and ".stp" for stop trades,16 thereby signaling to the market the reported transaction was based on a reference or benchmark price and was not indicative of the current market price for the security.
The Firms are very troubled by the proposed amendment to the definition of a "net long" position under Rule 3b-3 and believe that this proposal will impede unnecessarily broker-dealers' ability to service customers. In its current form, Rule 3b-3 provides that a person is considered "long" a security if he has "purchased, or has entered into an unconditional contract, binding on both parties thereto, to purchase it but has not yet received it."17 Based on this definition, broker-dealers have considered themselves to own a security if they agree irrevocably to facilitate a customer's sale of a security of a specified amount of shares at a set price. That price could be at a specific number price, the closing price, or a formulaic price such as the VWAP of a security. A broker-dealer that has agreed to such a facilitation would likely hedge its risk by selling the security during the course of the day. The broker-dealer would consider itself to own the number of shares facilitated and add that number to its net long position (for the firm's position or particular aggregation unit's position, as applicable) when determining whether it was net long or short the security when engaging in the hedging sales of the security.18
The Commission now proposes to change Rule 3b-3 to require a person to enter into a contract for a fixed price and amount of securities before the person could deem itself to have entered into an irrevocable contract to purchase those securities (that is, consider itself "long" the security). The requirement of a fixed price would preclude use of a closing price or formula price such as VWAP, even in circumstances in which all of the other elements of the trade are known. The Firms strongly believe that this new standard would seriously impair a broker-dealer's ability to provide facilitation of many orders without in any way furthering the policies underlying the Short Sale Rule.
The ability of a facilitating dealer to treat the facilitation shares as long and add those shares to its net position, whether firm-wide or by aggregation unit, is critical to a firm's willingness to commit capital to facilitate a customer transaction. Otherwise, a firm might be forced to treat the hedging sales as short sales and be required to comply with the Short Sale Rule. This would unduly constrain the firm's hedging and consequently increase the price (or transaction charge) to the customer. For instance, a firm may agree with its customer at 9:45 a.m. to buy 500,000 shares of ABC stock from the customer at the closing price as part of the customer's portfolio rebalancing to reflect the changing of stocks in an index by the index provider (e.g., a Russell 1000 index rebalance). The firm, at that point, has guaranteed the trade, and, correspondingly, has entered into a binding contract to purchase the shares and has the total economic risk of owning the 500,000 shares. As a result, the firm needs the flexibility to make offsetting sales throughout the day in order to hedge the risk of essentially owning the 500,000 shares. If, however, the firm cannot treat itself as owning those shares of ABC stock, and the firm thereby is not otherwise long ABC stock, any such sales throughout the day would have to comply with Short Sale Rule pricing restrictions. This would reduce the incentive to commit capital to handle such orders for customers.
We believe that, as long as all of the other elements of the order are known at the time of the agreement (that is, the identity and amount of the security), and the price of the security is objectively determined pursuant to a reference price (benchmark) or formula that is specified at the time of the agreement, the order should continue to satisfy the test of Rule 3b-3 for an irrevocable contract. Such a price is just as valid and legitimate as a specific price in setting the terms of a facilitation trade.19
Consequently, we urge the Commission not to adopt the proposed change to Rule 3b-3. If the Commission is concerned that use of the closing price or formula price might induce firms facilitating an order to manipulate the closing price of a security, the Firms believe that such concern is far better addressed (with much less unnecessary collateral effect) through use of the general anti-fraud and anti-manipulation provisions of the federal securities laws or through SRO rulemaking specifically targeted to this conduct. To alleviate any concern of the Commission in this regard, however, the Firms suggest that a firm facilitating a customer's sell order be deemed to own the shares in the facilitation order only if the customer is a long seller. In such a scenario, a facilitating firm's hedging sales would constitute the same market activity that would occur if the customer had simply sold long directly into the markets. In other words, the hedging sales would not raise any concerns under the Short Sale Rule or Regulation SHO because those sales merely act as the substitute for a long customer selling directly into the market.
The SEC's proposal that the uniform bid test in Regulation SHO apply continuously (24 hours a day) to all short sales executed or agreed to in the United States is overly broad and unnecessary to meet the objectives of the Short Sale Rule. The SEC currently applies Rule 10a-1 on a 24-hour basis, while NASD Rule 3350 currently does not apply after-hours (i.e., after 4:00 p.m. and before 9:30 a.m). We believe that the Regulation SHO proposal moves in the wrong direction by subjecting all short sales to a 24-hour application of the uniform price test. Instead, we believe that the better approach would be to apply short sale pricing restrictions only from 9:30 a.m. to 4:00 p.m. each trading day for both Nasdaq NM and listed stocks.
The after-hours markets are not developed or robust enough to have reliable and accessible quotes or meaningful last sale data that could support the application of short sale pricing restrictions to after-hours trades. Although the consolidated tape runs until 6:30 p.m. each trading day, trading between 4:00 and 6:30 p.m. is limited and trades effected after 6:30 p.m. are episodic at best. The trades effected after hours often do not reflect current market interest in a security and are often unrelated to existing quotes. Rather, many of the trades effected after 4:00 p.m. are facilitation trades that reflect a previously negotiated, benchmark price, and are not indicative of the market price of the security at that moment in time. The customer wants to execute at the benchmark price because that price represents a product of continuous price discovery during regular market hours. The customer does not want to trade at after-hours prices. Application of short sale price restrictions after-hours will frustrate customers' choices and prevent them from obtaining executions based on regular trading hours prices.20 Furthermore, it is highly unlikely that a short seller would attempt to use after-market trading to drive down the price of a stock. Indeed, institutional investors recognize the lack of informational content of after-hours trade prices, and most retail investors do not have access to after-hours trade prices. These prices are not even included in a stock's high/low prices for a day.
If the Commission decides to impose a uniform price test keyed off of the consolidated best bid of a security as part of Regulation SHO, we strongly recommend that the test only apply when a meaningful consolidated best bid is available. Consolidated best bids are only available during standard market hours - 9:30 a.m. ET to 4:00 p.m. ET. Market participants understand that bids posted on market centers after 4:00 may not reflect true interest in a security, and are likely to be both stale and inaccessible. A market-maker's obligation to maintain two-sided quotes ceases after 4:00 p.m.21 In suspending the operation of Rule 3350 after 4:00 p.m. ET, NASD has already recognized that after-hours bids on Nasdaq NM securities are unreliable. For that same reason, it is inconsistent with the notion of a bid test to apply Regulation SHO to listed or Nasdaq stocks after hours. A bid test is predicated on the dissemination of actionable bids by open markets. When live bids are not being disseminated, a short sale at or below a previous stock bid quote cannot have the effect of wiping out that bid or trending the market down. Hence, there is no need to apply Regulation SHO after normal trading hours (i.e., from 4:01 p.m. ET to 9:29 a.m. ET).
If the Commission refrains from imposing a uniform price test until the Pilot is completed, we urge the Commission to suspend the operation of the tick test in Rule 10a-1 after the time that real-time last sale data reflecting true market interest in a security stops being distributed over the consolidated tape (currently, 4:00 p.m. ET). As noted above, last sale data relating to transactions effected after the close of the consolidated tape does not provide reliable information about current market prices. Market participants recognize that the after-hours market is not a continuous market and view after-hours transactions differently than those during the trading day. As a consequence, after-hours transactions cannot have the effect of "inducing investors to liquidate their holdings."22 Even if the SEC is concerned that short sales might be used to convey pricing information after 4:00 p.m., there is no credible basis for this concern when the after-hours tape is not operating.23 There is absolutely no policy reason to apply the Short Sale Rule to short sales after 6:30 p.m. because such sales cannot generate any price effects associated with the abusive practices that the Short Sale Rule is designed to address.
Exempting after-hours transactions from short sale pricing restrictions would not mean that such trades would be unregulated or that manipulative short sellers would run rampant after-hours. The SEC and SROs currently have access to data on after-hours transactions. Such trades are reported to the NASD for regulatory purposes over ACT.24 In addition, NYSE Rule 410B requires that member firms submit reports of trades in NYSE stocks effected off the exchange and not reported to the tape. Thus, the regulators have ample information to conduct surveillance on after-hours trades and determine if any abusive trading occurs. In addition, the locate requirement and other short sale provisions would continue to apply to after-hours short sales even if the pricing restriction were removed.
The Commission recognizes that certain stocks are sufficiently liquid that it would be difficult to effect a bear raid on these stocks or for short sales to "demoralize" the market during a decline in such securities. The Commission posits the view that the markets for actively traded securities are so liquid that short selling activity will not alter market participants' perceptions of the price discovery process for these securities. For these reasons, the Commission has proposed the Pilot Program to exempt certain actively traded stocks from short sale price restrictions.
Using a pilot program in which certain liquid stocks are exempt from any pricing test is a valid approach for studying the continued efficacy of short sale regulation on actively traded securities. The Firms nevertheless believe that the proposed two-year period for the Pilot Program is too long. The operation of the Pilot Program in its proposed form will, by its deliberate design, result in disparate short sale treatment of similar securities and could cause compliance and systems burdens. The disparate regulatory treatment of similar securities should be minimized by extending the operation of the Pilot Program only for as long as is absolutely necessary. Based on past experience, it is inevitable that the two-year pilot would become a three- or four-year pilot because the Commission would need to analyze the data, draft a rulemaking proposal, publish the proposal for public comment, then draft an adopting release, all of which would take a significant amount of time and lengthen the pilot period.
The Firms recommend instead that the Commission compress the Pilot Program so that the Commission would be in position to publish a resulting rule proposal after a year. The SEC could accomplish this by limiting the data gathering phase of the Pilot Program to six months. We believe that a six-month period should provide sufficient data on a variety of market conditions and will enable the SEC to analyze the effect of the suspension of short sale price regulation in advancing and declining markets, high volume and low volume, and markets with high and low volatility.25 Once the six month data collection period has ended, the Commission could take an additional three months to review data gathered in the Pilot and consider proposing a permanent exemption (all the while continuing to collect and analyze additional data) by the end of one year. Because the Pilot would last until an exemption is adopted permanently, the Commission would continue to obtain the data that it requires and still be able to complete its study and any subsequent rulemaking in a swift manner.
In addition, we strongly suggest that the standard for determining whether a security is "actively traded" for purposes of the Pilot Program should be determined prior to the start of the Pilot. The SEC should know before beginning the Pilot the standard it will analyze for stock activity and liquidity sufficient to warrant an exemption from short sale pricing restrictions. The SEC would then be able to apply consistently this standard in the Pilot Program, and would be in a position to base an exemptive rule on that standard. We believe this will streamline any subsequent rulemaking efforts, as well as reduce ultimate compliance costs (e.g., programming and reprogramming costs).
Finally, the Commission has questioned whether, with respect to securities included in the Pilot, the short sale price test should be automatically reinstituted in extraordinary market conditions, such as when the market price of a security drops a specified percentage amount on an intra-day basis. The Firms oppose a provision for temporary reinstitution of short sale pricing restrictions. Reinstitution of a price test on an episodic, intra-day basis would create difficult logistical and compliance problems. Market participants would have to program their systems with defaults for each security in the Pilot Program to be activated whenever the threshold price drop was met and de-activated if the price rose again. Furthermore, if the Commission seeks to study the true effect of short selling on actively traded securities, it should do so under all market conditions, including extraordinary market conditions.
Another portion of the Regulation SHO proposal that could have unintended consequences is the treatment of the market maker exemption from the NASD bid test. NASD Rule 3350 contains an exemption for Nasdaq market makers engaged in bona fide market making and for the hedging transactions of options exchanges specialists and market makers. Because the Commission has indicated that it believes that a market maker "should rarely need to sell short at or below the bid in its market making capacity,"26 Regulation SHO as proposed does not contain an exemption for market makers engaging in bona fide market making. We are concerned that restricting market makers as proposed under Regulation SHO may have unintended negative consequences that could result in reduced liquidity and the widening of spreads. We understand that the NASD conducted research regarding the effect of its short sale rule and the market maker exemption during the initial period after adoption of NASD Rule 3350. We further understand that the NASD did not find any harmful consequences from the market maker exemption. Accordingly, we believe the Commission should proceed slowly and deliberately in this area and first consider whether it has sufficient data and information before determining whether to remove the market maker exemption.
We note in particular that the Commission's proposed exemption in Regulation SHO to allow a broker-dealer to sell short at the consolidated bid in order to fill customer orders it is required to fill pursuant to SEC or SRO rules would not address completely the possible negative consequences of removing the exemption. There are instances in which a market maker may not be required to sell short to fill a customer's order, but in which the market maker does so in order to enhance the execution of that order. For example, many Nasdaq market makers' proprietary automatic execution systems often execute customers' small-size buy limit orders if the limit price is at or better than the consolidated bid. In addition, a market maker may want to sell short against a rising bid in order to determine the amount of buying strength behind that rising bid.
There may be additional, unforeseen consequences from removing the exemption of options exchange specialists and market makers ("OMMs") hedging transactions from short sale price restrictions in Nasdaq NM stocks. OMMs typically need to sell short to hedge positions they have taken in making markets in options. These short sellers have no motivation or reason to cause a decline in a stock's price. The terms of the current exemption from NASD Rule 3350 for OMMs require that the short sale be a contemporaneous hedge of the offsetting options position. In effecting a contemporaneous hedge, OMMs often must hedge immediately at the prevailing bid on a time-sensitive as opposed to price-sensitive basis. Hence, it is entirely appropriate and necessary for option market makers to sell short at the current consolidated bid. We are concerned that eliminating the current OMM exemption will impair OMMs in performing their important function and thereby harm liquidity in the options markets. This could lead to wider options spreads and a decreased willingness of option market makers to commit capital. Thus, we urge the Commission to proceed carefully and with complete information before taking any action to remove the OMM exemption for Nasdaq NM stocks.
If the Commission were to adopt the uniform bid test of Regulation SHO, there would be an even more compelling reason for the Commission to consider retaining the OMM hedging exemption for Nasdaq NM stocks, and indeed consider whether to extend it to listed stocks. Regulation SHO would preclude options market makers from ever selling short at the consolidated best bid for a stock. Such a prohibition is far more restrictive than if NASD Rule 3350 remained in place but the options market maker exemption were removed. It would preclude OMMs from hedging immediately with a market or marketable limit order to sell the underlying stock short, even in rising markets. It also is more restrictive than the Short Sale Rule, which enables OMMs to sell short at the bid in rising markets (if on an up-tick). OMMs inevitably will factor the hedging uncertainty into the options price. This could cause customers to pay higher options premiums and harm options market liquidity.
It is the Firms' experience that securities offerings are sometimes accompanied by volatility due in part to short selling around the time of the issuance or shortly thereafter. It is uncertain whether the Pilot Program will increase the effect of short selling around offerings for the exempted stocks or what impact the impact of the proposed Regulation M changes will be. We suggest that the SEC review the offering context as it reviews short selling generally.
While the Firms support the Commission's efforts to combat abusive types of naked short selling and extended fails to deliver, we believe that some of the provisions of Regulation SHO relating to the proposed uniform locate and mandatory buy-in provisions should be modified. In general, we believe that the Commission should proceed with adoption of uniform locate and mandatory buy-in rules, but not the proposed 90-day suspension and penalties for certain extended fails to deliver. In this regard, we refer the Commission to the letter addressing proposed Regulation SHO submitted by the Securities Industry Association ("SIA") on the problems that would be engendered by the proposed restrictions.27 We support the SIA's views on the proposed uniform locate and mandatory buy-in rules that are outlined in that letter.
As we discuss above, there are significant systems changes that would need to be made to implement the changes proposed by the Commission. The Firms and other market participants will need substantial lead time to prepare for and implement these changes, as well as time to implement supervisory systems and procedures regarding the new regulatory framework. To the extent that it does determine to adopt any of the regulatory changes outlined in the Proposing Release, the Firms believe the Commission should provide a delayed effective date of at least six months so that market participants can prepare their computer systems and compliance frameworks to help ensure compliance with what likely are to be significant changes.
* * * * * * *
The Firms appreciate the opportunity to provide comments on this proposal. As we indicated, the Firms strongly support the Commission's goal of modernizing current short sale regulation. We have concerns, however, about many aspects of the Commission's approach to doing so. We hope to maintain the cooperative dialogue between the Commission and its staff and the Firms in order to help fashion effective short sale regulation that prevents the abuses that short sale regulation was designed to prevent while not unduly restricting those transactions that inure to the benefit of customers and do not present such potential for abuse. We remain available to provide any assistance to this effort that the Commission or the staff would find useful.
If you have any questions regarding our comments, or would like any additional information, please contact any one of us at the numbers below.
/s/ Amy C. Reich
/s/ Susan Sidd
/s/ Christine Sakach
|/s/ Thomas McManus
Morgan Stanley &
The Honorable William H. Donaldson
The Honorable Paul S. Atkins
Annette L. Nazareth, Director
Division of Market Regulation
1 Exchange Act Rel. No. 48709 (Oct. 28, 2003), 68 FR 62972 (Nov. 6, 2003) ("Proposing Release").
2 See Exchange Act Rel. No. 1548 (Jan. 24, 1938). See also Exchange Act Rel. No. 42037 (Oct. 20, 1999), 64 FR 57996, 57997 (Oct. 28, 1999) ("Concept Release").
3 The Commission itself previously expressed concern that the NASD's bid test "may restrict non-abusive short-selling for lengthy periods of time when the bid is stable after a down-bid." Exchange Act Rel. No. 34277 (June 24, 1994), 59 FR 34885, 34892 (July 7, 1994). This concern should be even greater with respect to Regulation SHO's uniform test, since that proposal would not even permit short sales that would comply with the NASD's current rule.
4 Concept Release, 64 FR at 57988, quoting Exchange Act Rel. No. 13091 (Dec. 21, 1976), 41 FR at 56534.
5 Any cost estimates that may have been provided by firms to the Commission in the past in regard to systems changes needed to accommodate modifications to short sale regulation did not and could not have taken into account the sweeping changes contemplated by Regulation SHO and the Pilot Program. The changes needed to incorporate these changes will be far more extensive than, for example, extending the NASD's bid test to listed stocks.
6 At a February 24, 2004 open meeting, the Commission approved the publication of proposed new Regulation NMS to address market structure issues.
7 This presumes that the firm even has access to the best bid. If the best bid for a particular security is on an ECN that does not (because it is not required to) comply with the fair access requirements of Regulation ATS, there may be no means for a firm that is not a subscriber to that ECN to access that bid.
8 The Commission noted over a decade ago, in connection with its approval of NASD Rule 3350, that "the disparate regulation of short selling in Nasdaq and exchange markets may no longer be warranted or justified by valid regulatory purposes." Exchange Act Rel. No. 34277, 59 FR at 34890.
9 This disparity can lead to regulatory arbitrage, and may be used as a marketing point to attract order flow to certain regional exchanges. For instance, in response to a frequently-asked question, INET notes on its website that "If your firm is an NASD member who enters short sale orders on INET, you may consider discontinuing your compliance with the NASD short sale rule when routing orders to INET in Nasdaq-listed securities." See www.island.com, FAQ-compliance.
10 As the Commission itself noted many years ago, "short sale regulation should ensure that transactions are not effected in one market, in a security that is traded in multiple markets, solely because of the desire of a customer to evade short sale restrictions imposed in another market." See Exchange Act Rel. No. 10668 (Mar. 6, 1974), 39 FR 10604 (Mar. 1974).
11 In connection with such action, the Firms recommend that the Commission clarify the party responsible for compliance with the Short Sale Rule or NASD bid test for orders submitted to an ECN. The Firms believe that a subscriber to an ECN has the obligation to mark a short sale order sent to an ECN as short but that the ECN, which handles the execution of the order, has the responsibility for ensuring that execution of the order complies with the appropriate short sale price restriction.
12 Use of a consolidated bid would make even the modified rule unworkable. For example, a short seller might enter an order into SuperMontage to sell at the best bid displayed, which is an "up-bid." If right before execution an ECN raised its bid one cent above the SuperMontage bid, the short sale would be executed inadvertently below the new consolidated best bid.
13 It is also ironic that if the customer in the example had submitted a basket trade in 15 listed stocks rather than 14 stocks, then the trade could have been effected in NYSE Crossing Session II. The SEC has provided an exemption from the Short Sale Rule to the NYSE's after-hours crossing sessions, but these exemptions are of limited applicability. For instance, a VWAP trade could not be effected in Crossing Session II unless the trade involved 15 or more NYSE-listed securities (i.e., the trade must involve a basket, not a single name). Likewise, Crossing Session I only applies to trades effected at the closing price on the NYSE during regular trading hours. Even if the SEC were to provide relief from Regulation SHO for the two new proposed NYSE Crossing Sessions, Crossing Sessions III and IV, the SEC would need to extend similar relief to Nasdaq and ECNs so as to cover Nasdaq NM stocks and to provide alternative execution venues as a competitive matter.
14 See, e.g., Letters re: Jeffries and Company, Inc. (Jeffco) (December 7, 2000) and Morgan Stanley & Co., Inc. (May 11, 2001).
15 Many clients today want VWAP trades over a much shorter period of time than an entire trading day. If a purpose of short sale price restrictions is to provide a check against unrestrained and immediate downward pressure on stock prices, limiting the exemption for VWAP trades to full-day VWAPs, particularly in a rising market environment, is excessive.
16 We understand that Nasdaq has submitted a Rule 19b-4 filing relating to stop prices to the Commission for publication, which filing is currently pending.
17 Exchange Act Rule 3b-3(b).
18 The same concept also applies to an aggregation unit of a firm that relies on the aggregation unit letter provided by the SEC. Letter from Richard R. Lindsey, Director, Division of Market Regulation, to Roger D. Blanc, Esq., re: Rule 10a-1 - Aggregation Units (TP File No. 97-42) (Nov. 23, 1998).
19 It must also be recognized that an agreement containing a pricing formula dependent on a benchmark, even if the precise price cannot be determined at the time the agreement is entered into, is a valid and enforceable contract under state law. Finding that such an enforceable contract is invalid for short sale regulation purposes flies in the face of this black-letter principle.
20 The SEC has proposed to provide an exemption from Regulation SHO that would permit broker-dealers to execute customer orders on a riskless principal basis by looking to the customer's net position in the security. Such an exemption would not help alleviate the burdens noted above because a facilitating firm often acts on a risk basis to fulfill a customer's need for capital commitment.
21 Because there is no firm quote obligation after-hours, applying the uniform bid test after-hours would permit a broker-dealer with no intention of entering into a transaction at his bid in the after-hours market to hold up legitimate after-hours selling activity merely by entering a bid far away from the closing price of the stock.
22 See Exchange Act Rel. No. 10668 (Mar. 6, 1974), 39 FR 10604 (Mar. 1974).
23 For all practical purposes, the consolidated tape operates only until 6:30 p.m. ET. Although one or more ECNs might operate past 6:30 p.m., almost all markets cease operating by 6:30 p.m.
24 See, e.g., NASD Rules 4632, 5430 and 6420.
25 With regard to the composition of the stocks included in the Pilot Program, if the Commission is going to use a matched pair sample approach, we would urge that the Commission adopt defined, objective criteria for determining which stocks in a particular industry sector should be paired. For instance, it would likely not be a statistically meaningful comparison to merely match two issuers in a single sector as a matched pair if the securities of those issuers trade very differently in the marketplace. Instead, factors such as the relative liquidity and volatility of the issuers' shares, the market capitalization of the issuers, and the relative prices of the shares of the issuer should all be carefully considered.
26 Proposing Release, 68 FR at 62989.
27 See Letter to Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, from George R. Kramer, Vice President and Acting General Counsel, Securities Industry Association, re: Short Sales (File No. S7-23-03), dated January 30, 2004.