December 23, 2003
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street
Washington DC 20549-0609
By email to firstname.lastname@example.org
Proposed Short Sale Rule
File No. S7-23-03
Lek Securities Corporation ("LSC") is pleased to comment on the Commission's proposed new short sale Regulation SHO. LSC is a member of the New York Stock Exchange, the American Stock Exchange, the regional stock exchanges and the NASD. In addition, LSC is a member of all of the domestic options exchanges. LSC is best known for its ROX® electronic order management system. ROX® provides its users electronic access to a large number of exchanges, ECNs and market makers from one convenient place on a trader's desktop. ROX® is known as the "Gateway to the Markets". The system displays integrated quote montages from multiple market centers and allows its users immediate access to a wide range of liquidity sources through a simple click of the mouse.
LSC is a broker dealer that executes equities and options orders for professional customers. LSC executes many thousands of orders for its customers every day and in the process the firm has become familiar with how professional customers conduct short sales. LSC is also a full clearing member of the Depository Trust and Clearing Corporation ("DTCC") and is thus experienced with delivery fails and buy-ins related to shorts sales.
Proposed Regulation SHO would, among other things, require short sellers in all equity securities to locate securities to borrow before selling, and would also impose strict delivery requirements on securities where many sellers have failed to deliver. Proposed Regulation SHO would also institute a new uniform bid test allowing short sales to be effected at a price one cent above the consolidated best bid. This test would apply to all exchange-listed securities and Nasdaq National Market System Securities (NMS Securities), wherever traded.
The Commission is also contemplating a temporary rule that would suspend the operation of the proposed bid test for specified liquid securities during a two-year pilot period. The temporary suspension would allow the Commission to study the effects of relatively unrestricted short selling on market volatility, price efficiency, and liquidity.
LSC's comments are summarized as follows:
LSC believes that fears surrounding short selling are largely unfounded. Like any selling interest, short sales put downward pressure on prices, but short positions must eventually be covered and the resulting buy orders counteract that effect. Long sales may actually be more damaging to fair and orderly markets, because they never need to be covered. Some may feel that betting that the market will decline is "bad", even "un-American," but, in our opinion, short sales help increase pricing fairness, and fairly priced markets benefit the investors and serve the public interest. Speculative short sellers do not in any way manipulate the markets, because they are at the risk of the market, and they are just as likely to lose as make money. Short sales are also necessary for market makers in derivative products and arbitrageurs to hedge their positions. These market professionals perform an important role in providing liquidity to the public and there is nothing objectionable about this kind of short selling. Thus, short sales fulfill a legitimate and justifiable role and should not be unduly impaired.
Short selling in an emotional issue: many investors blame short sellers for losses caused by the burst of the stock market bubble of 2000. There is, however, no empirical evidence to support such emotion-driven allegations. That some market professionals may have profited from the bursting of the market bubble through effective short selling, while individuals may have not, does not mean that the short sales were illegitimate or that the short sellers are in any way blameworthy. The Commission's effort would be better spent in preventing such bubbles, than engaging in unhelpful and improper attempts to identify scapegoats for the market's inevitable return to reality.
Although rules designed to prevent selling may appear to support the price of a security, they eventually do more harm than good. Moreover, LSC believes that many market analysts incorrectly overlook that short selling increases the "float" in a security, and that therefore short selling has less impact on total market capitalization than many might believe. Just like bank credit increases the money supply, "stock credit" increases the float1.
Critics of short selling have argued that stock loans lead to dilution. This is incorrect. Dilution has a negative connotation since it implies that fixed benefits of stock ownership are spread out over an increasing number of shareholders, thus reducing the value of each share. In this case however, the benefits that accrue to shareholders are not fixed. As the number of shares outstanding increases, so do the benefits, since the shorts are required to make up for the benefits. For example, people with short positions must pay dividends out of their own pockets.
a) The Tick Test
The regulation of short sales has been in effect in its current form for more than 60 years. LSC believes that modernization is needed and welcomes the Commission's review. The proposed new bid test would allow short sales to be executed at one cent above the consolidated best bid, whether the bid is higher or lower than the previous bid. The new test will achieve the Commission's objectives as it will (a) continue to allow relatively unrestricted short selling in an advancing market, but (b) prevent short selling at successively lower prices, and thus eliminate short selling as a tool for driving the market down, and (c) prevent short sellers from accelerating a declining market by exhausting all remaining bids at one price level. The new test is a significant improvement. It is simple, easily understandable, and applicable across markets and will thus level the playing field and foil "regulatory arbitrage".
It is not, however, perfect. We believe, for example, that the consolidated bid test will not work in the opening and closing rotations on the NYSE and AMEX since there is no obvious bid. The Commission will therefore either need to exempt trades executed "on open" or "at the close", or specify exactly which bid should be used as a reference.
We consider the new tick test to be a significant improvement, but we also feel that any tick test has outlived its usefulness. We believe the Commission already may share that view since it has proposed a temporary rule that would suspend the tick test entirely for highly liquid securities for a two-year trial period. While LSC understands that it would be a major decision for the Commission to abolish a regulation that has already passed the half- century mark, we do not believe the tick test has impeded short sellers materially and we suggest that the test can be abolished outright with no real risk to the markets.
We believe that something can be learned from observing how ADRs on European companies trade in relation to ordinaries. Ordinaries start trading long before the U.S. markets open. Then until around midday Eastern Time, the European and U.S. markets are both open for business. ADRs continue to trade in the U.S. after the European markets close. Most ADRs that trade in the U.S. are subject to the uptick rule, but in Europe shares can be shorted without a similar restriction. The price of both securities are however kept closely in line, and although business is most active when both markets are open, trading patterns do not change very much throughout the day. We believe that this is an indication that the current tick test does not measurably influence the price or volatility of a security.
Moreover, traders who want to evade the tick test have been able to do so for many years. Certain short sellers routinely bought "married puts" to evade the tick test. A married put is the purchase of a deep in the money put option on a security and the simultaneous purchase of the corresponding number of shares in the same security. Sometimes the married put is accompanied by the sale of a call option struck at the same price as the put option. In such a case, the entire package is known as a conversion/reversal or a bullet. Often these transactions are entered into on an intraday basis. The transaction is designed to make the buyer long as defined by Rule 3-b3, and thereby enable him to avoid the tick test of Rule 10a-1. Such "married puts" have no economic purpose, and are specifically designed to avoid market risk.
The Commission recently issued an interpretative release2 condemning married puts as a sham. This may end the practice, but the tick test has nonetheless been widely evaded. Although LSC as a matter of policy does not accommodate its customers with these types of transactions, we believe the use of married puts to evade the rule has been widespread. In LSC's opinion, anyone who has wanted to establish short position has been able to do so regardless of price. Thus, we feel the tick test has merely served as an illusion of protection against the negative effects of short selling. In reality, the rule has provided little or no protection at all.
Over the past half-century the markets have become much more liquid, and are now resilient enough to operate without a tick test. The Commission has succeeded in increasing market transparency, and this has resulted in increased liquidity and competition. Technological advances have greatly improved the distribution of market data, and a vast number of investors are now able to react immediately to even the smallest incremental price change. As a result, the markets are now independently capable of preventing short sellers from accelerating a declining market. Short selling creates interest by investors who are willing to take advantage of buying opportunities, and this interest balances the downward pressure from the short selling. The markets have already proven to be self-stabilizing enough to be able to thrive without regulatory protection against short sellers.
Another indication that the tick test has not stymied short sellers has been the failure of the single stock futures markets to attract significant interest. Single stock futures were widely heralded as having the "advantage" of not being subject to the tick test. However it appears that few if any market participants have regarded this instrument as a major benefit over the traditional equity markets.
Finally, the tick test has never existed for Nasdaq SmallCap, OTCBB and Pink Sheet stocks, and the Commission is not proposing at this time to extend the uniform bid test to those securities not currently covered. This exclusion only makes sense if the bid test is jettisoned altogether, because if any stocks need protection against abusive short selling, it is these illiquid and opaque stocks. Despite the fact that their markets are less liquid and the dissemination of market data less sophisticated, however, these markets have flourished without the protection of a tick test. It therefore seems illogical to us why large actively traded stocks would require such protection. The Commission correctly notes in its proposal that as trading volume increases, it becomes less likely that a trader would be able to manipulate the price of a security profitably.
LSC believes that the market centers, and many other industry participants, will incur substantial expenses in converting their systems to implement the new bid test. If the Commission's pilot program proves successful, however, this expense will be unnecessary because the test will be eliminated altogether. LSC believes that tick test can be eliminated on a trial basis, and if (contrary to our expectations) the elimination has undesirable consequences, the bid test could be adopted as an improvement to now existing trading restrictions.
LSC proposes that the Commission completely eliminate its current trading restrictions on short sales on a trial basis. Short selling should however not be unrestricted. We believe the general anti-fraud and anti-manipulation provisions of the federal securities laws will provide protection against improper attempts to influence the price of a security. Moreover, we propose that the Commission establish a rule requiring that any person (or group of persons acting in concert) accumulating a short position that exceeds 5% of the issuer's outstanding equity securities must file a report with the Commission disclosing the size of the position, and explaining why it should not be deemed to be an illegal manipulation. (It is hard to imagine that any bona fide short seller would require a position of this size). The filing requirement would increase market transparency, and the 5% limit would mirror the 13D filing requirements of anyone acquiring a substantial long position.
b) Delivery Requirements
The Commission is proposing three new rules with respect to securities where there are fails to deliver of 10,000 shares or more per security, and that is equal to at least one-half of one percent of the issue's total shares outstanding.
First, if for any reason such security is not delivered within two days after the settlement date, the rule would restrict broker-dealers, including market makers, from executing future short sales in such security for the person for whose account the failure to deliver occurred unless the broker-dealer or the person for whose account the short sale is executed borrowed the security, or entered into a bona fide arrangement to borrow the security, prior to executing the short sale and delivered on settlement date. The restriction would be in effect for a period of 90 calendar days. Second, any registered clearing agency would be required the report the failing member to the member's SRO, and third, the clearing agency, effectively the CNS system of the DTCC, would be required to withhold any favorable mark on the failed position.
LSC finds these restrictions inadvisable for a number of reasons. The completion of sell orders on behalf of customers is already sufficiently regulated in the Commission's Rule 15c3-3(m), and we have seen no evidence to suggest that fails create significant problems for the market or have any important destabilizing effects. In fact, we believe that the CNS deals with the matter quite efficiently. In our experience, fails are not typically caused by naked short3 selling. DTCC participants usually only fail because they are being failed to themselves. More often than not, fails are caused by custodian banks failing to deliver on behalf of their customers for a number of different reasons. The following example may serve to illustrate this point:
A foreign domiciled customer is engaged in ADR arbitrage and operates under the international arbitrage exemption. On a typical day, the customer might sell 100,000 shares of a stock and buy 90,000 shares of the same stock. The customer always maintains an overall "flat" position. Therefore he will be long 10,000 shares overseas. Assuming no other trading in the same security, his broker will owe 10,000 shares to CNS on the settlement date. The customer clears though a foreign bank, which in turn clears through a U.S. custodian bank. The U.S. custodian bank has a policy of not accepting partial deliveries.
This type of trading often results in fails to deliver, even though the customer did not enter into a "naked" short position. First, there is a deadlock that must be dealt with. The customer cannot deliver the 100,000 shares he is short until he receives them from the broker, but the broker cannot make the delivery since he is in turn short to CNS. Although the customer could convert the 10,000 shares from ordinaries to ADRs, this is expensive and can take some time to complete. Thus the customer may fail for a few days until the situation can be sorted out.
In the above example, if the Commission were to adopt the proposed new delivery requirement rules, the broker could be penalized for appearing to accommodate a naked short, even though no such transaction was ever contemplated or entered into. Withholding a positive mark would jeopardize compliance with the Commission's Customer Protection Rule, since the mark should be deposited in the Special Reserve Account4 and not be left in the hands of CNS.
Additionally, the rule would restrict short sales for a period of 90 days, unless the broker-dealer (or the person for whose account the short sale is executed): (1) borrowed the security, or entered into an arrangement for its borrowing, or (2) had reasonable grounds to believe it could borrow the security so it would be capable of delivering the securities on the date delivery is due. This restriction is relatively meaningless since the broker dealer should have located the stock (except in case of a bona fide market-maker) before entering into the short sale in the first place.
Moreover, there exists no reason to suppose that a short seller would fail intentionally. There are no advantages to failing; a failing seller does not get paid and foregoes interest on the proceeds. In addition, someone who fails to deliver has breached a contractual obligation and is subject to civil remedies. Accordingly, fails can result in costly buy-ins.
Some countries, such as Spain, impose penalties on parties that fail to deliver securities. Such penalties have, however, done little if anything to increase confidence in those markets. The DTCC, in contrast, is the largest and most efficient clearing agency in the world. LSC would urge the Commission to exercise caution before ordering the clearing agency to change its business practices. The clearing process is complicated and any change in rules or procedures can result in unexpected repercussions.
With regard to failed deliveries as a result of short sales: The typical remedy to resolve a fail is for the buyer to close out the contract and buy-in the failing seller. Any loss is debited to the seller's DTCC participant account through an SPO5 charge. The problem is that a buy-in often does not resolve the fail since the seller can renew the short position by selling into the buy-in. This creates another fail and yet another buy-in, and this cycle can continue indefinitely. Existing rules prohibit a short seller with outstanding fails to enter into additional short sales because the seller obviously has not been able to locate stock. If they were enforced, these rules would prevent the fail/buy-in cycle. Unfortunately, enforcement has been elusive. Buyers who need delivery of stock can complain to their SROs, but complaints seldom result in immediate action. The aggrieved buyer may not be able to pursue a civil claim, because of the hesitancy of the court system to permit private rights of action in regulated contexts. To prevent the possibility that illegal short sellers can take advantage of the securities rules to dodge ordinary legal remedies, LSC urges the Commission to ensure proper enforcement of existing rules and to make clear that private rights of action remain available to victims of failed short sales. The securities laws are designed to act a sword to discourage unjust deeds in the securities industry, not as a shield for offenders to hide behind. Unfortunately, we fear that the regulatory environment might prevent a buyer who is victimized by a series of fails and unsuccessful buy-ins from obtaining the necessary equitable relief to stop the cycle.
1. Short Sales
Q. What harms result from naked short selling? Conversely, what benefits accrue from naked short selling?
A. LSC does not believe that naked short selling is a concern that constitutes significant problems for the markets in general. Most buyers do not object to being failed to since it allows them to delay payment and earn interest on the float. However, sometimes a buyer needs delivery of securities. It that case he may need additional remedies. A buy-in does not necessarily result in delivery since naked short sellers can sell into the buy-in, resulting in yet another fail. The seller is liable for a breach of contract, but the prevailing regulatory environment may have the perverse effect of limiting the buyer's rights in court. There are no benefits to allowing naked short selling, and existing rules do not permit it. Naked short selling is tantamount to entering a contract with no intention of fulfilling one's obligations. We see two tasks for the Commission: (a) Put a halt to the buy-in/fail cycle and (b) ensure that a buyer who is failed to has all the civil remedies as anyone else who has suffered damages as a result of a breach of contract.
Q. Are there negative tax consequences associated with naked short selling, in terms of dividends paid or otherwise?
A. There could be negative tax consequences to the aggrieved buyer. Because the dividend in a failed short sale comes from the failing party (as opposed to directly from the corporation), the dividend may not qualify for the recently enacted beneficial tax treatment accorded to dividends. The buyer is therefore entitled to additional damages from the failing seller. This underscores our point that a buyer who is being failed to should have the same rights as anyone else who suffers damages as a consequence of a breach of contract.
Q. What is the appropriate manner by which short sellers can comply with the requirement to have "reasonable grounds" to believe that securities sold short could be borrowed? Should short sellers be permitted to rely on blanket assurances that stock is available for borrowing, i.e., "hard to borrow" or "easy to borrow" lists? Is the equity lending market transparent enough to allow an efficient means of creating these lists?
A. Market participants should be given discretion in determining what constitutes "reasonable grounds". However, the proof will be in the pudding: If it repeatedly turns out that the method used results in a firm not actually being able to borrow stock, the method relied upon should be considered lacking and the firm should be considered not to have had "reasonable grounds".
Q. Should short sales effected by a market maker in connection with bona fide market making be excepted from the proposed "locate" requirements? Should the exception be tied to certain qualifications or conditions? If so, what should these qualifications or conditions be?
A. There should no exceptions. Market makers can easily determine whether the stocks in which they operate can be borrowed. Naked sales by market makers result in the same potential damage to buyers, and they should be liable for their contractual delivery obligations just like any other market participant.
Q. Should the proposed additional delivery requirements be limited to securities in which there are significant failures to deliver? If so, is the proposed threshold an accurate indication of securities with excessive fails to deliver? Should it be higher or lower? Should additional criteria be used?
A. As outlined, LSC believes that the proposed additional delivery requirements are ill advised and should not be implemented. If they are, nonetheless, adopted by the Commission, we would urge that the scope be as limited as possible.
Q. Are the proposed consequences for failing to deliver securities appropriate and effective measures to address the abuses in naked short selling? If not, why not? What other measures would be effective? Should broker-dealers buying on behalf of customers be obligated to effect a buy-in for aged fails?
A. In our opinion, naked short selling does not have serious negative effects on the integrity of the markets. Failed short sales can, however, damage individual buyers, albeit on rare occasions, and the Commission should ensure that aggrieved buyers have adequate and effective remedies for non-delivery. The requirement that customer sales be completed is sufficiently regulated in 15c3-3(m). There should be no requirement to buy in broker dealers or CNS since these fails are marked to market and can be secured. This should be left to the discretion of the buyer.
Q. Is the restriction preventing a broker-dealer, for a period of 90 calendar days, from executing short sales in the particular security for his own account or the account of the person for whose account the failure to deliver occurred without having pre-borrowed the securities an appropriate and effective measure to address the abuses in naked short selling? Should this restriction apply to all short sales by the broker-dealer in this particular security? Should the restriction also apply to all further short sales by the person for whose account the failure to deliver occurred, effected by any broker-dealer?
A. Short sales where the seller knows, or should have known, that he will unable to effect proper delivery are already prohibited. Therefore the additional restriction appears to be redundant.
Q. Should short sales effected by a market maker in connection with bona-fide market making be exempted from the proposed delivery requirements targeted at securities in which there are significant failures to deliver? If so, what reasons support such an exemption, and how should bona-fide market making be identified?
A. There should be no exception for market makers. Since they operate in a limited number of stocks, they can easily determine whether they can borrow the required securities. Naked sales by market makers result in the same potential damage to buyers and therefore they should be liable for their contractual delivery obligations in the same manner as any other market participant.
Q. Under what circumstances might a market maker need to maintain a fail to deliver on a short sale longer than two days past settlement date in the course of bona fide market making? Is two days the appropriate time period to use?
A. This should be at the discretion of the buyer. Most buyers do not mind being failed to since they can delay payment for the securities and earn interest on the float. But any buyer should have the right to delivery. The Commission should not establish inflexible rules. Sometimes fails happen and in most cases it is disadvantageous to the seller, not the buyer. Inflexible rules will make the clearing and settlement less efficient. Many fails happen for reasons other than naked short selling. The Commission should, however, ensure that individual buyers can enforce their rights if and when they need to do so. However there is no widespread market problem that requires additional regulatory attention.
Q. Are there any circumstances in which a party not engaging in bona-fide market making might need to maintain a fail to deliver on a short sale longer than two days past settlement? If so, can such positions be identified? Should they be excepted from the proposed borrow and delivery requirements, and if so, why, and for how long?
A. As outlined in detail above, LSC believes the proposed additional delivery requirements are inadvisable.
2. Long Sales
Q. Are the delivery requirements in proposed Rule 203(a) appropriate?
A. Proposed Rule 203(a) will ensure greater consistency across markets and securities, and this is naturally an improvement. Nonetheless, the forced buy-in is not well thought out.
First, it constitutes an unwelcome regulatory interference with the delivery process. An individual buyer only needs a remedy when the buyer requires delivery. Fails do not constitute a general market problem, especially not when they are marked to market and collateralized daily. A "one size fits all" rule, where the Commission attempts to determine who should be bought in and when, may jeopardize market efficiency and does nothing to protect a buyer's right when he actually requires delivery. The regulatory environment is so pervasive that it actually serves to curtail buyers' rights by possibly removing a private right of action.
Moreover, the forced buy-in rule is toothless since the customer will either assure the broker that he is in the process of delivering the securities, or he will claim that he made a mistake and that he was actually short. In both cases the broker will be exempted from the buy-in. The rule would only be applicable if the customer boldly told his broker that he possesses the securities is nonetheless not going to deliver them, an event that would be unlikely and that would cause the broker to close out the contract for credit concerns.
A. The Uniform Bid Test
We are assuming that it will continue to be appropriate to enter an order at any price, as long as it is properly market "short," and that the onus will be on the market center to ensure that an order is not executed unless it complies with the new bid test. Compliance would be almost impossible if the person entering the order were to be prohibited from hitting the bid because, in some rapidly quoted securities, the bid moves around too quickly.
Q. Should short sales continue to be limited by a price test? If the Commission did not adopt a price test under Regulation SHO, should it also preclude the ability of the SROs to have price tests?
A. For the reasons set forth above, a price test can be eliminated. The tick rule has been so widely evaded that, for all practical purposes, it has already been abolished. If the Commission were to eliminate the tick test, we do not believe it would be in the interest of market transparency to permit the SROs to have their own price test.
Q. Would there be any benefits in eliminating a short sale price test? Would the elimination of a price test benefit the markets by allowing investors to more freely short sell potentially overvalued securities so that their price more accurately reflects their fundamental value? Are there other benefits to the removal of a price test, such as elimination of systems and surveillance costs?
A. The tick test should be eliminated because it has outlived its usefulness. The markets have developed to a point where such a test is no longer needed. Because a price test does nothing that affects the price of a stock, there would be no benefit in removing it to allow investors to more freely sell overvalued securities. There would however be some benefit to reducing systems and surveillance costs.
Q. Would the proposed "bid test" in Rule 201, allowing short sales above the best consolidated bid, effectively prevent short selling being used as a tool for driving the market down?
A. LSC believes that securities find an appropriate price level based on supply and demand. Although the price of small stocks can be manipulated, the current tick tests do not do anything to prevent such manipulation. Moreover, the naked short selling is not a source of such manipulation. The proposed bid test is, in all respects, less restrictive and therefore even less effective in preventing market manipulation. The Commission has more powerful tools available to take action against such behavior.
Q. Would short sale regulation using the proposed bid test operate effectively in an auction market? If not, why not?
A. The bid test will operate effectively in an auction market (like the NYSE), but would require a costly conversion of computer systems that will be unnecessary because, as anticipated, the Commission's pilot test will be so successful that price tests will be eliminated in their entirety. The Commission would need to provide clarification how the bid test will operate in opening and closing rotations.
Q. Would short sale regulation using the proposed bid test operate effectively in a dealer market? If not, why not?
A. The proposed bid test is more straightforward than Nasdaq's current up-bid rule, and we consider it an improvement. However the bid moves around so quickly in many Nasdaq stocks that the price test will have almost no impact.
Q. Would there ever be a circumstance where there would not be a consolidated bid in an exchange-listed or Nasdaq NMS security? If so, please describe.
A. Provided that specialists and market makers live up to their responsibility, there will always be a bid in an exchange-listed or Nasdaq NMS securities. Moreover, no one needs to be concerned about a short seller knocking out a non-existent bid
Q. The proposed bid test likely would inhibit short sales in a declining market because there would be few execution opportunities above the best bid. Is this appropriate?
A. We do not believe the bid test will inhibit short sales. With decimalization, there are so many price levels that even in a severely declining market there is likely to be a trade above the bid.
Q. Is a one-cent increment an appropriate standard for allowing short sales above the best consolidated bid? If not, what is an appropriate increment?
A. One cent is enough to allow long sellers priority at any given price level, so we believe that the one-cent increment is appropriate.
Q. Would short sale regulation using the proposed bid test present any automated systems problems for market participants?
A. As already indicated, we believe that the conversion is unnecessary. Systems can be adapted, but the cost to do so significantly outweighs any benefit.
Q. Would the proposed bid test operate effectively in the current decimal environment, i.e., would bid flickering inhibit the operation of the test?
A. The test would not be very effective. It is an improvement compared with the existing price tests, and accordingly it will do no harm. However, it will also do little good, because even in a severely declining market there are likely to be trades above the bid, particularly given the number of price point in a decimalized environment.
Q. Would the proposed bid test fulfill the fundamental goals of short sale regulation?
A. No. Price tests have little or no impact on the market.
Q. Would the alternative test allowing short selling at a price equal to or above the consolidated best bid if it is an upbid better fulfill the goals of short sale regulation?
A. We believe the bid test is an improvement, but neither test does very much to stabilize the price of a stock, let alone prevent price manipulation.
B. Scope of the Uniform Bid Test
Q. Should the proposed uniform bid test be extended to Nasdaq SmallCap and OTCBB Securities? Do these securities need the protection of the proposed uniform bid test?
A. In theory, one would think that Nasdaq SmallCap and OTCBB stocks would need more protection than large liquid stocks. This does not appear to be the case in practice, because the market for these securities has clearly been functioning properly without a price test. Accordingly, we believe it would be more appropriate to eliminate the price test altogether,
Q. Should the proposed uniform bid test be extended to other OTC securities, e.g., those quoted in the Pink Sheets? If so, are quotes in these securities disseminated in a manner that would allow for the use of the proposed uniform bid test? In addition, would the proposed bid test be workable due to the fact that the best bid in these securities could be outstanding for long periods of time? If not, could a last sale test or some other test be applied to these securities?
A. The uniform bid test would not function well for Pink Sheets securities, because quotes for these securities are updated in a non-automated fashion. Moreover, quotes are not always firm, which could complicate determining what the actual bid really is. A last sale test could be used, but for the reasons stated above, we would advocate against any expansion of the scope of a price test.
Q. Do VWAP transactions create perverse incentives for broker-dealers, such that they should not be granted an exception? If an exception is included, are there ways to detect and limit the effects of these perverse incentives?
A. VWAP transactions do not create perverse incentives for broker-dealers. These transactions should be granted an exception. VWAP orders are entirely benign and as long as the short sales used to execute or hedge the VWAP are themselves subject to the bid test, there is no reason to fear that they can do any harm.
Q. Are the proposed conditions for the VWAP exception appropriate? If not, why not? Should there be any additional conditions?
A. We find all the Commission's proposed conditions for the exception unnecessary and onerous. For example, why must VWAP orders be placed before the opening? Intraday VWAP orders are common and harmless. And why prescribe how the VWAP is calculated? The Commission should grant a blanket exception for all trades where the price is derived algorithmically, so long as the pricing mechanism operates independently from both the buyer and the seller.
Q. Is the proposed rule temporarily suspending the short sale price test for liquid stocks appropriate? Are liquid stocks more difficult to manipulate through short selling?
A. The suspension of the price test is appropriate. LSC believes it is almost impossible to manipulate the price of any stock through short selling, particularly liquid stocks with readily identifiable markets. The short seller is at the risk of the market and therefore unlikely to be involved in any form of manipulation. Like any additional selling interest, a short sale will put downward pressure on the price of the stock but the sale will eventually have to be covered, which will have the opposite effect. A long seller, in contrast, could actually put more downward pressure on the price since his trade will not need not be covered.
LSC believes that most price manipulation occurs through misuse or manipulation of information, such as spreading false rumors, misusing non-public information, or issuing false statements. Price manipulation through trading patterns is possible, but such activities would typically involve strategies where the seller would be engaged in a conspiracy where he avoids actually being at risk of the market, such as a wash sale, or a scheme where seller and buyer may agree in advance to unwind a trade at a pre-arranged price, or to sell a stock back and forth to each other, or by printing non-existing trades to the tape. Persistent short sales by deep-pocketed traders could put severe downward pressure on the price of a stock, but as long as the trader is at risk, it is hard to see how it could be manipulation.
LSC nevertheless believes that it would be in the interest of the investing public if large short positions were subject to scrutiny. We therefore propose that the Commission establish a rule requiring any person (or group of persons acting in concert) that accumulates a position exceeding 5% of the issuer's outstanding equity securities to file a report with the Commission disclosing the position and explaining why it is needed. It is hard to imagine that any bona fide short seller would require a position of this size. Moreover, the filing requirement would increase market transparency, and the 5% limit would mirror the 13D filing requirements of anyone acquiring a substantial long position.
Q. Is a two-year temporary suspension of the short sale price test a sufficient period to fully study the impact? If not, what time period should be selected? Commenters should provide specific reasons to support their view in favor of establishing another time period.
A. We cannot comment on this without knowing what the Commission is going to study and what conclusions can be drawn from the data. Suppose that after the two-year period the stocks included in the pilot would have lagged the market by 1%. It would be almost impossible, even with this information, to determine if this was attributable to the suspension of the price test.
Q. Is the proposed selection method for the pilot, including our contemplated use of the Russell 1000, appropriate? If not, what other selection method should be considered? Is it possible that one market could benefit over another market depending on the selection of stocks for the pilot?
A. We do not believe the selection method is scientifically sound. To properly study the effects of the suspension of the tick test, a control group is necessary. Thus the Commission could, for example, rank the Russell 1000 stocks in order of market capitalization and pick every other stock to participate in the pilot. This would provide two lists of stocks: one where the price test is suspended, the other where it is not. We could however imagine that issuers might object to being randomly included in the pilot. However the randomness is necessary to obtain proper scientific data. Moreover, it would be difficult for market participants to keep track of which stocks are included in the test and which ones are not. Overall, we do not believe that a pilot comprised of a limited list of stocks is a good idea. In any case we believe the tick test can be eliminated entirely, but we grant that we could be wrong. Therefore, a safeguard as suggested in the next question could be appropriate for a limited trial period.
Q. Should the short sale price test be automatically reinstituted in extraordinary market conditions, for instance, if, on an intraday basis, the price of a security falls more than a certain percentage based on the day's opening price (e.g., if the price of a security falls 10% from the day's opening price short sale restrictions would be reinstituted)?
A. LSC believes the price test can be eliminated without any appreciable harm to the market. If there are concerns about eliminating the test prematurely, the Commission could eliminate it tentatively, for a trial period, subject to reinstatement if a security falls by more than a certain percentage. After the trial period is over, the results could be studied and the price test could either be eliminated or reinstated. Any drop should be measured from the previous day's close, not the opening. However, so as not to saddle market centers with unnecessary expenses, we would suggest leaving the existing tick tests in place during the pilot period.
Q. The pilot, in part, would allow the Commission to obtain data to assess whether the price test should be removed for some types of securities and to study trading behavior in the absence of the proposed bid test. After analyzing the results of the pilot, the Commission may propose that the bid test be removed for certain exchange-listed and NMS securities. Should the Commission await the results of the pilot before applying the uniform bid test to exchange-listed and Nasdaq NMS securities that may later have the bid test removed?
A. Although we believe the proposed bid test is an improvement, we envision that the Commission will eventually eliminate the price test entirely. Therefore, we recommend that a switchover to the proposed bid test be postponed until the Commission has decided that any price tests continue to be appropriate.
Q. Should the pilot apply to existing short sale rules even if we do not adopt the new uniform bid test?
A. Testing the benefits of eliminating price tests altogether can be done regardless of whether the Commission adopts the new uniform bid test.
Q. The securities included in the pilot would still be marked and specialists and market makers can observe this mark prior to executing the short sale. How would this affect the outcome and reliability of the pilot, if at all?
A. We do not believe it will have any effect. The study requires a control group if it is to be reliable.
1. Long Seller's Delay in Delivery
Q. Should this exception be retained in its current form?
A. A person who actually owns a security is, for all practical purposes, considered long, but the exception is required since the definition of a short sale is unnecessarily broad. Rule 3b-3 defines a sale to be short if (a) the seller does not own the security, or (b) the delivery is effected with borrowed securities. Because of the inclusion of the second condition, trades that would be characterized as long sales at inception become ex post facto short sales due to complications with delivery. The Commission clearly does not want to consider someone who has bona fide problems delivering stock to have violated the short sale rule, and has therefore adopted the current exception. It would be more straightforward to eliminate the second half of the short sale definition, which would also eliminate the need for the exception. We believe that it should be determined at the time of the trade if a sale is long or short. How the trade is eventually settled is irrelevant.
Q. Is this exception outdated?
A. For the reasons stated above, we find that the exception is outdated. How the delivery is eventually achieved should have no bearing on whether the sale was long or short.
2. Error in Marking a Short Sale
Q. Should this exception be retained in its current form?
A. The exceptions should be maintained so as not to implicate a broker dealer who makes a bona fide error
3. Odd Lot Transactions
Q. Are these exceptions relating to odd-lots appropriate in today's markets?
Q. Should these exceptions apply to all market makers in odd-lots or should the exception be more limited?
Q. Are these odd-lot exceptions susceptible to abuse?
Q. Should all odd-lot transactions have an exception from the Rule? Would providing an exception for all odd-lot transactions pose a risk of increased short sale manipulation, e.g., would traders break up trades into 99 share odd-lots in order to avoid the price test?
A. We believe that handling odd-lots differently from round lots is outdated and invites abuse. Odd-lot orders often receive favorable treatment, such as automatic execution and exemption from rules such as the short sale restriction. The favorable treatment is intended to benefit small investors, who have little impact on the market as a whole. However, we believe that all orders should be treated equally. Moreover, there is evidence that sophisticated market participants are breaking large orders into odd-lots to benefit from advantages intended for small investors. Generally this creates a violation in its own right, but catching the offenders can be difficult and creates a compliance and enforcement problem in its own right. It is simply more effective to eliminate the incentive by taking away the advantages afforded to odd-lots. Accordingly, LSC does not support any type of odd-lot exception.
4. Domestic Arbitrage
Q. Should the exception be retained for purposes of the proposed Rule 201? If not, state specific reasons why the exception should be removed from the Rule.
A. We believe that the exception should be retained since bona fide arbitrage does not drive down the price of a stock or otherwise have negative influence on the market.
Q. Minor changes have been made to the text of existing exception (e)(7) in the proposed rule to simplify its language. Are these changes helpful? Does the proposed amendment to the exception alter its meaning in a way that would affect its substance?
A. We believe the changes are beneficial.
Q. Is the proposed amended exception too narrow or too broad? If so, state specifically why, and how it should be restructured in relation to the purposes of Regulation SHO.
A. The proposed exception is appropriate in our opinion.
Q. Should the requirement that the transactions be made in a separate domestic arbitrage account be eliminated? If so, should the exception permit domestic arbitrage to be effected in an arbitrage account in which international arbitrage could also be effected?
A. We do not believe having a separate account makes a difference, so we advocate eliminating the requirement as an unnecessary burden.
Q. Should exception (e)(7) be combined with (e)(8), the international arbitrage exception? Would such a combination create compliance problems or other issues?
A. We do not believe this would make any difference.
Q. Should short sales effected in connection with a merger be excepted from the provisions of Rule 201? If so, at what point in the merger process should a party be deemed entitled to acquire the acquiring company's stock?
A. If a person is scheduled to receive stock because of a merger, it would seem to us that he should be considered long, just like a person who enters into a contract to acquire stock is long. The fact that the right to acquire the stock flows from the merger agreement rather than the purchase agreement appears to be a mere formality with little substantive difference. Accordingly, we believe the exception should be applicable, as long as the merger price and the closing date are "certain". The seller should be aware that securities involved in mergers are (by their very nature) often hard to borrow and there should be no exception to the delivery obligations on account of the merger.
5. International Arbitrage
Q. Should the international arbitrage exception be retained for purposes of the proposed Rule 201? If not, state specific reasons why the exception should be removed from the Rule.
A. We believe that the exception should be retained since bona fide arbitrage does not drive down the price of a stock or otherwise have negative influence on the market.
Q. Minor changes have been made to the proposed rule to simplify the language of the existing exception. Are these changes helpful? Do they alter the meaning of the exception in a way that diminishes its value or prohibits bona fide international arbitrage activity in relation to Rule 201?
A. We believe the changes are beneficial.
Q. Is the proposed amended exception too narrow? If so, state specifically why it is too narrow and how it should be restructured to allow beneficial international arbitrage activity that does not carry the kind of manipulative or destabilizing trading that proposed Rule 201 is designed to address.
A. The proposed exemption is appropriate in our opinion.
Q. Should the requirement that the transactions be made in a separate international arbitrage account be eliminated? If so, should the exception permit international arbitrage to be effected in an arbitrage account in which domestic arbitrage could also be effected, rather than in a separate international arbitrage account?
A. We do not believe that having a separate account makes a difference, so we advocate eliminating the requirement as an unnecessary burden.
Q. Should exception (e)(8) be combined with (e)(7), the domestic arbitrage exception? Would such a combination create compliance problems or other issues?
A. We do not believe this would make a difference.
6. Distribution Over-Allotment
Q. Is this exception necessary? Under what circumstances would an underwriter or syndicate member price an offering below the best bid? Would extending the exception to short sales below the bid have any negative market impact?
A. The exception is necessary to allow an underwriter to sell at the offering price if the bid for the security is above the offering price.
7. Equalizing Short Sales and Trade-Throughs
Q. Would an exception from the proposed bid test permitting a short sale to be effected at the consolidated best offer if the market is locked or crossed be useful or necessary to remedy problems associated with locked and crossed markets? If so, describe such circumstances and the market participants to whom the exception should apply.
A. The exception is necessary so as not to implicate a short seller in a rule violation that was caused by an unrelated party locking the market.
Q. Would such an exception be used appropriately to remedy the problem of locked and crossed markets, or could such an exception be susceptible to abuse? Is there another way to design an exception for locked and crossed markets?
A. The exception will not remedy the problem of locked and crossed markets. The Commission should address the problem separately since locking or crossing a market is in our opinion manipulative by its very nature.
Q. Some market participants that provide their customers with guaranteed executions of their buy orders at a price equal to the consolidated best offer would be prevented from selling short to fill customer buy orders in a locked or crossed market, due to the fact that the short sale would be executed at a price equal to or below the best bid. Should there be an exception to allow these market participants to execute short sales at their offer to facilitate customer buy orders in locked or crossed markets?
A. We believe the interest of the customer outweighs the harm of a broker dealer making a sale below the bid, and that accordingly the exception is appropriate.
Q. Is there any reason why exception (e)(6) should be retained?
Q. Is there any reason why exception (e)(5)(i) should be retained? For example, would broker-dealers that provide customers with executions at a price equal to transaction prices on a primary exchange require an exception to facilitate customer buy orders?
A. The proposed new bid test is based on the consolidated best bid and has accordingly rendered the exceptions contained in sub sections (e)(5)(i) and (e)(6) obsolete.
Q. Should the Commission provide relief from proposed Rule 201 of Regulation SHO for transactions in ETFs? If so, are the conditions for relief appropriate? If not, please explain why.
A. We believe that relief for ETFs is appropriate for the reasons put forth by the Commission.
Q. Should the relief be codified as an exception to proposed Rule 201 of Regulation SHO?
A. The relief should be codified for consistency and ease of reference.
Q. Do closing price transactions create perverse incentives for broker-dealers, such that they should not be granted an exception?
A. Trades executed at an independently established price pose little threat to the markets and should be permitted. Our opinion on this issue mirrors what was observed with respect to VWAP orders. The Commission should in our opinion grant a blanket exception for all trades where the price is derived algorithmically so long as the pricing mechanism operates independently from both the buyer and the seller.
Q. Should the relief be codified as an exception to proposed Rule 201 of Regulation SHO?
A. The relief should be codified for consistency and ease of reference.
Q. Should the proposed uniform bid test include a bona fide market making exception? If so, why? How important is it for a market maker to be able to profit from position trading? Could there potentially be negative consequences to the market if there is not an exception for bona-fide market making transactions? Please describe.
A. The proposed uniform bid test should not include an exception for bona fide market making because selling at the bid is by definition not what bona fide market makers do. Arguments by the NASD that market makers must be able to adjust their positions quickly, presumably to be able to absorb customer selling interest, are unconvincing. Such adjustments sound more like front running than market making. Like any market participant, market makers want to profit from position trading, but they should not be given any special privileges, particularly not privileges that would necessarily come at the expense of other market participants. Market makers typically earn the spread as compensation for providing liquidity. They should not be permitted to trade ahead of customer orders, whether real or anticipated.
Q. If a market making exception from the bid test is necessary, what should be done to limit its use to those engaged in bona-fide market making? Should the exception be tied to certain qualifications or conditions? If so, what should these qualifications or conditions be?
A. For the reasons stated above, we do not believe that bona fide market making ever includes selling at the bid. A market maker is supposed to be the bid.
Q. If inclusion of a bona fide market making exception is necessary, would there be any circumstances where a market maker acting in his market making capacity would need to sell short below the bid?
A. We do not believe that such an exception is necessary.
Q. How often do market makers or other broker-dealers sell short at the bid in response to customer buy orders? Would it be feasible to allow market makers or other broker-dealers to sell short at the bid to facilitate customer buy orders without undermining the purposes of the price test? If so, should there be limits on such short sales, for example to prevent a dominant market maker from filling customer orders at the bid in order to place downward pressure on the security's price?
A. It is difficult to envision a situation where a market maker would need to sell short at the bid. After all, the bid is where the market maker should be willing to buy stock, not sell it.
Q. What other type of transactions should qualify for a bona fide market making exception?
Q. What type of additional costs and burdens, if any, would be associated with requiring orders to be marked "short exempt?"
A. Theoretically marking an order "short exempt" should not create a burden, but our experience has shown that different market centers handle orders differently. For example, certain market centers appear to route orders that are market exempt away from automated matching systems, which can result in a slower execution than an order that is marked long. On balance, we do not believe the requirement to mark an order exempt (as opposed to long) serves much purpose. We doubt that it actually aids in surveillance and it certainly does nothing to facilitate the actual settlement process.
Q. Does the requirement that a broker has physical possession or control of the security or will have physical possession or control prior to settlement place undue or unreasonable hardship on long sellers?
A. The requirement that a broker have or will have physical possession or control of the security before settlement does not place an undue or unreasonable hardship on long sellers.
Q. Should proposed Rule 200 require a broker or dealer marking a sell order "short exempt" to identify the specific exception that the broker or dealer is relying on in marking it "short exempt?" If not, state why not.
A. LSC believes that requiring a broker dealer to identify the specific exception would place a serious burden on the market, most notably because broker dealers, exchanges and SROs would need to record and preserve the information in order for it to be useful. This would require a systems upgrade to allow for a database field "Exempt Reason," and market participants would have to agree on a uniform code that relates back to the exemption reason. Electronic order routing message formats would also have to be changed, which can be cumbersome to say the least. Although all of this can be done, we question whether surveillance efforts would not be better spent elsewhere.
Q. Does the proposed riskless principal exception allow brokers and dealers to facilitate customer orders handled on a riskless principal basis regardless of their proprietary net position? Are the conditions appropriate? In particular, is the requirement to allocate the offsetting transaction to the customer within 60 seconds appropriate?
A. For practical purposes, a riskless principal transaction is equivalent to an agency transaction. We therefore believe it is appropriate to look at the customer's position as opposed the broker-dealer's position. The requirement that the offsetting transaction be executed within 60 seconds is appropriate.
Q. Is there any concern that this provision is not consistent with the goals of short sale regulation? If so, how?
A. We see no such concern.
LSC believes that the Commission should consider a person's overall economic position to determine whether a seller is long or short, not at ownership as currently the case. We believe that using this quasi-legal position as a guide is outdated, and does not serve the Commission's goals. A person can have title to a security but still be economically short. Positions in derivatives and other complicated instruments make this easy to accomplish. The use of married puts is just one of the many ways someone can meet the formal requirements of Rule 3b-3 while in effect still being short. The Commission has taken the position that someone who enters into a married put transaction for the sole reason of avoiding the tick test is involved in a manipulation. However there are many bona fide market participants who have title to the security who are still economically short. An options specialist who is short calls and long stock as a hedge could sell long, even though his position may be weighted in a fashion that he would benefit from a market collapse. Thus, there would be nothing to stop him from driving down the stock and accomplishing exactly what the Commission is seeking to protect against. (The fear is of course based on the presumption that this can actually be accomplished - something that LSC finds unlikely.) Similarly, an options specialist who is short stock and long calls and/or short puts would suffer damage if the market declined, but he is not permitted to sell on a down tick. This creates an undue burden since the specialist must wait for an uptick to neutralize his position, which in our opinion exposes him to unwarranted risk and creates a disincentive to provide a liquid market.
We believe that looking at legal title is outdated and invites market participants to construct complicated strategies to evade the tick test. These strategies are comparable to tax shelters. The market will devise a new strategy and the Commission will then seek to close the loophole. We recommend that the Commission avoid this "arms race" by simply looking at the economic position rather than legal title. Portfolios that contain derivative securities are now usually margined based on a risk-based model. The Commission should use the same methodology to determine if someone is truly long or short.
Q. Should proposed Rule 200 provide that in order for a person to be deemed to own a security by virtue of the fact that he has entered into an unconditional contract to purchase the security, the contract must specify the price and amount of the security to be purchased? If not, state why not.
A. The above question underscores our point: a great deal of creative effort will be expended by market participants seeking to evade the tick test, and many transactions will be created for the sole purpose of accomplishing this. Married puts are fairly straightforward, but there may be other mechanisms to accomplish the same effect that will not be so easy to decipher or uncover. The concern that contracts involving unfixed price and/or quantity of securities could lead to abuse is well founded, and a market participant who enters into such a contract should not be considered long. As long as the Commission uses ownership as a guide to determine whether a seller is long or short, we can be assured that new creative strategies will emerge that accomplish exactly what the Commission is trying to avoid.
Q. Should proposed Rule 200 require a definite time frame that limits when the buyer can consider themselves long, i.e., a buyer would be deemed to own the securities only if the contract contemplates the buyer will receive the securities within 30 days?
A. A person who has entered into an unconditional contract to acquire securities at a fixed price should be considered long even if the delivery is far in the future. It is significant that the delivery date is fixed and that the contract is binding on the buyer. As long as these conditions are satisfied, the buyer will lose money if the market declines, and he should therefore be considered long.
Q. If so, what should the time frame be? Does industry practice provide some objective standard that is reasonable?
A. LSC does not believe that time is of the essence in this respect.
Q. Should proposed Rule 200 require delivery of the securities underlying a futures contract before a person can consider himself long for the purposes of short sale regulation?
A. A person who holds a security future obligating him to take delivery of the underlying securities by physical settlement should be considered long these securities for purposes of proposed Rule 100. The person has met all requirements of Rule 3b-3 and the Commission's concerns, i.e. that the contract might not be "unconditional", are fully satisfied by the terms of the futures contract.
The argument that a someone who is long a futures contract should be considered long for the purpose of Rule 100 is not inconsistent with the requirement that options, rights, warrants, and convertibles must be exercised or converted before a person is considered long, because these instruments are materially different. They give the holder the right to acquire the securities, but not the obligation to do so. Therefore, there is no binding contract on the part of the holder of these types of instruments to acquire the securities. Whether there is a binding obligation or merely an option to acquire the securities should be controlling.
Q. Is this relief necessary for multi-service firms? How easily can these firms estimate their real time positions for individual trading units? What about for the entire firm?
A. The difficulty for large multi-service firms to aggregate real time positions across trading desks depends on the individual circumstances of each firm. Advances in technology should simplify the monitoring of firm-wide positions, but we believe that, for many firms, relief will still be necessary. It is noteworthy that trading desks that sell long based on this relief may have to make delivery with borrowed securities, because the firm may have an overall short position at DTCC. This underscores our earlier argument that Rule 3b-3 should be amended to drop the delivery test from the definition of a short sale.
Q. Are the conditions included in proposed Rule 200 appropriate? Should there be additional conditions?
A. We find the conditions appropriate.
Q. Can the utility of the aggregation unit provision to multi-service firms be improved? If so, how? Are the designated conditions appropriate?
A. We are not aware of any way to accomplish this.
Q. Should the aggregation unit provision be available to non-broker-dealers, for example, to hedge funds?
A. We do not believe it necessary to expand the relief to non-broker-dealers. We think it would be very difficult to enforce compliance with the conditions set by the Commission on an entity that is not subject to routine audit by an SRO. Moreover, different desks at hedge funds are typically organized as separate legal entities.
Q. On its face, Rule 3b-3 contemplates that a sale must be marked based on positions in all proprietary accounts in that security at the time of the sale. In light of the advances in technology since 1990, is it possible for firms or other entities to be able to determine their aggregate position in all proprietary accounts contemporaneously throughout the day? If not, why not?
A. The Commission could, of course, simply mandate that firms aggregate their positions across trading desks on a real time basis to comply with the letter of Rule 3b-3. Given recent technological advances this could be accomplished. The decision before the Commission is whether compliance efforts are not better spent elsewhere. As indicated above, we believe that short selling is not a threat to the market, and that the marginal benefit in requiring strict adherence to the letter of Rule 3b-3 when no malice is intended does not justify the expense.
Q. If firms or other entities are unable to determine their aggregate position in all proprietary accounts contemporaneously throughout the day, is there a means of allocating a daily aggregate position within the firm that would be capable of surveillance?
A. Desks that are long stock and have no intention of liquidating the position could allocate their long positions to be "sold long" by other desks. We believe however that setting up a system of trading "long selling rights" between desks would require almost the same effort as a system to track firm wide positions in real time. We would therefore advise against it. We believe that broker-dealers have more worthy compliance and enforcement objectives.
Q. Does the block-positioner exception continue to be needed?
Q. Does the block-positioner exception require any amendments? If so, what are alternatives to the way the rule currently operates?
A. A firm must be engaged in arbitrage to qualify for an exception as a block positioner. The rational is that, due to the offsetting position in a derivative security, the block positioner is not economically short and should therefore be exempted from the tick test. We agree, but we see no reason to limit the exception to broker-dealers that are specifically involved in this type of arbitrage. We have already argued that the Commission should always look at a seller's economic position as opposed to legal title. There are many other forms of arbitrage and trading activities that serve an equally important role in maintaining efficient markets, and we find this exception favoring one specific form of arbitrage unwarranted and discriminatory versus other legitimate activities. The exception is also too trivial. The Commission should require that the economic position be calculated using the same mathematical models used by firms' risk departments in determining true delta-weighted exposure. These calculations are common and are universally available to arbitrage desks involved in block positioning. Current regulation does not require that the net risk position be weighted "long" before granting the exemption, and thus opens the door to abuse. The term "fully offset" and "delta-neutral" are not equivalent.
Q. Is the relief for certain index arbitrage activities proposed to be incorporated in Rule 200 necessary under proposed Regulation SHO? Are the conditions appropriate?
A. LSC finds this relief appropriate but wrongly limited to a specific form of arbitrage. There is always justification to exempt a trading activity where the seller's economic position is long "deltas", but where he does not hold legal title to the securities as essentially required by Rule3b-3. Why should someone involved in index arbitrage be exempted and not a market maker in Exchange Traded Funds (ETFs)? The Commission's list of exceptions all point to a simple common ground: economic position should be controlling - not legal title.
Q. Should a hedging exception be added to proposed Rule 201? If so, how should such an exception be designed so that it can be monitored and is not subject to abuse?
A. LSC believes that, to determine when a person is short, a seller's economic position should be evaluated using mathematical models. This is how firms evaluate the exposure of their own trading desks, and these types of calculations are also widely used to margin customer accounts. This is the only scientifically correct way to measure whether someone will make money or lose money if the market declines, and therefore the only way to determine if someone has an incentive to try to drive down the market. (Once again, assuming it is possible at all to manipulate the market in this way.)
The Commission should not be concerned that this methodology will be misused. Broker dealers have an incentive to calculate their exposure accurately. Risk models are admittedly complicated, but they are widely used even by individual options market makers. We believe it is much easier to abuse the quasi- legal title test of Rule 3b-3. Legal title and the appearance of compliance with Rule 3b-3 can be easily accomplished, even though a trader's true intention is solely to evade a price test. Moreover, the line between bona fide trading and an attempt to evade the tick test is blurred. For example, an options specialist may need to purchase options because he is short premium and would lose money if the market moved in either direction. He could buy call options and sell stock against the purchase in order remain delta neutral; or he could buy puts and stock to accomplish the same goal. A rational trader would enter into the transaction that can be established at the lowest cost, but this is not always known in advance. An added advantage in buying puts and stock is that it will allow the specialist to become long under Rule 3b-3, whereas the call buying alternative makes him short. The long position will allow the specialist to sell long the next time he'll need to sell stock. The specialist is clearly not involved in manipulation if he opts for the put and stock buying alternative, even though someone who establishes a married put position (essentially the same transaction) may be considered to have illegally tried to evade the tick test. Thus in the current regulatory scenario, a seller's intention must be evaluated to determine whether he is acting with culpable intent. The specialist is clearly involved in legitimate trading whereas the married put may be involved in a manipulation, the specialist's next sale on a down tick will have the same effect on the market as the married put buyer's sale. LSC believes the Commission should be concerned with the effect the selling might have on the market, and not the mental culpability of the seller.
Q. Does the advent of trading in security futures absent short sale regulation, when combined with the proposed bid test and short sale pilot, address the concerns expressed by participants requesting an exception from Rule 201 for hedging? If not, why not?
A. LSC believes the concerns expressed by participants requesting an exception from Rule 201 for hedging securities futures contract will be properly addressed if the underlying securities are exempted from the tick test. However, we believe that true economic position should be controlling and that therefore all hedges should be exempted.
Q. Should a hedging exception be included in Rule 201 that only applies to a particular group of market participants, i.e., OTC market makers, option market makers, or specialists, that would allow short selling without regard to either a tick or bid test to offset the risk associated with their role in maintaining fair and orderly markets? Who should qualify for such an exception, what criteria would be used for determining whether short selling was part of maintaining fair and orderly markets, and how could the SROs and Commission surveil for compliance with such an exception?
A. True economic position should be controlling for all sales, as this is the only legitimate test whether a seller has an incentive to drive down the market. As explained above, we believe surveillance of actual risk is more straightforward than determining whether a trader has established a legal long position for the mere purpose of evading a price test. Surveillance for compliance by non-broker dealers, such as hedge funds, is more difficult as for regulated entities subject to routine SRO audits, but this is true under the current regulatory scheme as well. Moreover, broker-dealers have a natural incentive to monitor and control the risk exposure of their customers and they are probably less in a position to determine whether a hedge fund is entering into a married put as a legitimate trade or as a means to evade a price test.
Q. Are there any regulatory or operational reasons to allow markets to use their own bid information in regulating short sales under the proposed rule?
Q. Would allowing markets to use their own bid information affect the operation or effectiveness of the proposed rule? If so, how?
Q. Is there any reason to retain the requirements of existing subparagraph (a)(3) of Rule 10a-1, which allows for the adjustment to the sale price of a security after a security goes ex-dividend, ex-right, or ex any other distribution, under the proposed bid test? For example, do exchanges that match opening trades prior to the opening quotes require such a provision?
A. The only problem we can foresee with the new consolidated bid test is that it will not work in the opening and closing rotations on the NYSE and AMEX because there is no obvious bid in these contexts. The Commission will therefore, in our opinion, need to exempt trades executed "on open" or "at the close" from any price test. If the Commission does not issue an exception, the current methodology used by the NYSE and AMEX (i.e. the uptick rule) will need to remain in effect, as would the requirement to adjust the price of a security after going ex-dividend. We would however find this confusing and it would be burdensome for market participants to have to deal with two types of tick tests at the same time.
Q. Should corporate bonds be excluded from proposed Rule 201?
A. LSC believes that bonds should remain exempted.
A. After-Hours Trading
Q. Does the consolidated quote information that is collected and published after hours provide sufficient information to allow short selling after hours at a price above the consolidated best bid, or should the rule impose a fixed reference point above which all short sales must be effected, such as the consolidated best bid at the close of the regular session?
A. We believe that U.S. securities will eventually trade around the clock. Accordingly, if the close of the consolidated tape effectively prohibits short sales below the closing bid, we would oppose it. After hours trading is typically conducted between sophisticated professionals and prices established after hours typically have little or no effect of the next day's opening price. We therefore feel that a rule that impedes after hours trading would be counterproductive and give market participants an incentive to move offshore.
Q. Should the proposed short sale rule allow short selling above the best bid after the time that the consolidated best bid ceases to be collected and disseminated, if reliable quotes are still published? Would this approach, which would most likely have multiple reference points, be a feasible alternative?
A. It the Commission feels that a price test is required for after hours trading, we believe that an individual market center/ECN reference is preferable to using the last consolidated tape bid, since the latter alternative would effectively shut down after hours trading altogether.
B. Off-Shore Trading
Q. What factors should be used to determine whether a trade in a covered security is agreed to in the U.S.? If a trade is agreed to by a broker-dealer located outside the U.S., should the trade be viewed as agreed to outside the U.S., regardless of the location of the seller? Would the requirement that trades agreed to in the U.S. be effected at a price above the current best bid disadvantage U.S. broker-dealers in favor of foreign broker-dealers? If so, please explain.
A. In LSC's opinion there are two issues. First, some broker-dealers may seek to evade U.S. rules by claiming that transactions are booked offshore, even when they are negotiated in the United States. Second, business may truly move overseas if regulation becomes too burdensome. In principle we agree that if a trade is negotiated in the United States, it should be subject to United States rules regardless of the booking location. In our opinion, the location of the person receiving the call should be controlling. However, U.S. securities already trade actively overseas and we do not believe the Commission accomplishes much good if it results in pushing American business abroad. There is little harm in a sophisticated seller transacting a large block trade with a U.S. broker dealer after hours regardless of price. After all, the trade wouldn't probably even print, so what possible harm could it do to the market as a whole? LSC believes that short sale regulation accomplishes little or no good, let alone regulation of short sales after hours between sophisticated market participants.
Q. For trades agreed to in the United States and executed overseas, is the time of agreement a sufficient determinative event for the triggering of the rule?
A. LSC proposes that if the Commission should decide that some short sale regulation continues to be warranted, any such regulation should be limited in effect to between 9:30 am and 4:00 pm (ET). Otherwise, business will move offshore. Most sophisticated institutional investors already have overseas offices, and we believe the Commission should be concerned with the development of the U.S. market and not with regulation that has the potential of driving business overseas.
Q. Should short selling be restricted or prevented during a period of significant market decline, such as after circuit breakers have been lifted? If so, at what level should the restrictions take place, i.e., if the market declines 10%, 20% etc.? How long a period of time should the restrictions remain in effect?
Q. Should short selling be restricted or prevented for any particular security if the price of that security declines significantly during the course of a trading day? If so, at what level should the restrictions take place, i.e., if the price of the security declines 10%, 20% etc.? How long a period of time should the restrictions remain in effect?
A. We have recommended that the tick test be suspended in its entirety for a trial period of two years. After expiration of the trial period, the Commission could evaluate whether to permanently suspend the rule, or possibly reinstate it. As mentioned, we do not believe that price tests influence the market, but we realize that we could be wrong. Accordingly, we would recommend that existing tick tests be reinstated if the price of a security declines more than 10% from the previous day's close, adjusted for dividends, etc. We do not believe that short selling has a significant impact on the market as a whole, and the existing circuit breakers are in any case sufficient to accomplish what they were intended to do. Accordingly, we see no need to suspend or restrict short selling during periods of significant market decline.
LSC is not involved in underwriting and we do not feel qualified to comment on the public offering issues.
Samuel F. Lek
Chief Executive Officer
1 Assume a company has 1 million shares outstanding and its stock trades at $20 per share. Total market capitalization is $20 million. Short sellers subsequently borrow all the outstanding stock and sell it, and the selling pressure knocks the price down to $10. Total market capitalization has not declined to $10 million but remains at $20 million since there are now 2 million shares outstanding: Assume the stock was actually bought by the original holders. They will now own 2 million shares at $10 or $20 million worth of stock. If total market capitalization had declined to $10 million, as we think many would believe, a buy-out offer at $15 may succeed. After all, it would be at 50% premium if total market capitalization were actually $10 million. But it is clear that the holders of $20 million worth of stock would not be inclined to sell their position for $15 million, which we believe proves our point: In calculating the "damage" that short selling can do, the increase in outstanding shares must be taken into account. Accordingly, we believe that short selling, even if it does cause prices to drop, does much less harm than many might believe.
2 See SEC Interpretive Release - Commission Guidance on Rule 3b-3 and Married Put Transactions - 17 CFR Part 241 - Release No. 34-48795
3 The Commission defines a "naked" short as a short sale where the seller does not arrange to borrow securities to effectuate the delivery.
4 The short sale creates a credit balance in the customer's account, which is a credit under Rule 15c3-3 Exhibit A, Line 1. The offsetting short position is a debit item on Line 11, but because there is a positive mark, the amount on Line 11 will be less than the amount on Line 1. The difference must be deposited in the Reserve Account.
5 An SPO charge, or a Special Payment Order, is a way for one DTCC participant to collect money from another participant. The charge is initiated by the payee and will go through unless reclaimed by the payor.