The Securities and Exchange Commission (SEC) has recently taken several measures to curb "naked" short sales. Short selling involves any sale of a security that the seller does not own or any sale that is consummated by the delivery of a security that is borrowed by, or for the account of, the seller. A naked short sale involves the sale of a security that the seller does not own and does not borrow in time to make delivery within the standard three-day settlement period.

 On July 27, 2009, the SEC:

  • Made permanent a temporary rule aimed at curtailing naked short sales and failures to deliver by adopting Rule 204 of Regulation SHO.
  • Announced that it was working with several of the self regulatory organizations (SROs) to make short sale volume and transaction data available through the SRO websites. This is expected to provide a substantial increase over the information previously required by Temporary 10a-3T, which expired on August 1.
  • Announced a plan to hold a public roundtable on September 30, to discuss securities lending, pre-borrowing and possible additional short sale disclosures. The roundtable will consider, among other topics, the potential impact of a program requiring short sellers to pre-borrow their securities, possibly on a pilot basis, and adding a short sale indicator to the tapes to which transactions are reported for exchange-listed securities.
Shortly after these actions, the SEC took its first enforcement actions for violations of Regulation SHO and requested additional comments on an alternative approach to its proposed short selling price test restrictions.

New Rule 204 of Regulation SHO

The SEC adopted Rule 204 of Regulation SHO, modifying temporary Rule 204T and making it permanent. Temporary Rule 204T was adopted in October 2008 to address abusive naked short selling. In its adopting release for permanent Rule 204, the SEC noted that the daily average number of failures to deliver had declined by 56.6 percent since the adoption of temporary Rule 204T.

Close Out Requirement
If a broker-dealer or other participant in a registered clearing agency fails to deliver equity securities for settlement by the settlement date (usually T+3), Rule 204(a) requires it to close out its fail to deliver position by no later than the beginning of regular trading hours on the next trading day (T+4) by borrowing or purchasing securities of like kind and quantity. There are extended periods to close out a position in the following circumstances:

  • Long Sales — If it can be demonstrated that the fail to deliver position resulted from a long sale, the broker-dealer or other participant can close out the fail to deliver position by no later than the beginning of trading on the third trading day after the settlement date (T+6) .
  • Market Making — If the fail to deliver position is attributable to bona fide market making activity by a registered market maker, options market maker or other market maker required to quote in the over-the-counter market, it will also have until the beginning of trading on the third trading day after the settlement date (T+6) to close out the fail to deliver position.
  • Rule 144 and Other Securities Deemed to Be Owned — If the fail to deliver position resulted from the sale of a security a person is deemed to own under Rule 200 of Regulation SHO and that person intends to deliver as soon as all restrictions on delivery have been removed, the fail to deliver position must be closed out by the beginning of trading on the 35th calendar day following the trade date. This would apply to securities sold pursuant to Rule 144 and could also apply to securities issuable upon conversion or exercise of convertible securities or warrants or options which have been tendered for conversion or exercise. This provides relief for sales of securities a person owns, but is unable to deliver.
If a participant can identify the broker-dealer whose trading activity caused the fail to deliver position, it can allocate the responsibility to close out the position to that broker-dealer.

Borrowing Requirement
If a broker-dealer or other participant has violated the close out requirements of Rule 204(a) for a security, until it has closed out its fail to deliver position by a purchase of securities of like kind and quantity that has cleared and settled at a registered clearing agency, Rule 204(b) prohibits it from accepting or effecting further short sales in that security until it has borrowed, or entered into a bona fide arrangement to borrow, the security.

The same restriction applies to each broker-dealer from which the participant receives trades for clearance and settlement, to the extent that the broker-dealer submits its short sales to that participant for clearance and settlement, unless the broker dealer can demonstrate that it was not responsible for the participant's fail to deliver position. Rule 204(c) requires a participant to notify all broker-dealers from which it receives trades that a fail to deliver position has not been closed out in accordance with Rule 204(a), so those broker-dealers are aware that all short sales in the security that have not been closed out will be subject to the borrowing requirements of Rule 204(b).
    
Credit for Early Close Out
A broker or dealer may avoid the requirements of Section 204(a) and (b) by purchasing or borrowing securities prior to end of regular trading hours on the settlement date. In that case, the requirements of Section 204(a) and (b) would not apply, even if the broker or dealer has a fail to deliver position on the settlement date. To qualify for this exemption, the purchase or borrowing must be bona fide and must be for a quantity sufficient to cover the entire fail to deliver position. The broker or dealer must be able to demonstrate that it had a net flat or long position on the day of the purchase or borrowing, and the broker or dealer must not have known or have reason to know that purchased or borrowed securities will not be delivered.

Enforcement Actions

The SEC charged Hazan Capital Management LLC (HCM) and its principal trader and majority owner, Steven M. Hazan, with Regulation SHO violations. It separately charged TJM Proprietary Trading LLC and one of its traders, Michael R. Benson, with Regulation SHO violations while also charging TJM's chief operating officer for failing to supervise Benson. The firms and individuals agreed to settle the SEC's charges without admitting or denying the findings.

In the HCM proceeding, the SEC found that HCM engaged in misconduct from January 2005 to October 2007 and received ill-gotten gains of at least $3 million. It ordered HCM to cease and desist from committing or causing, and Hazan to cease and desist from causing, any violations and future violations of Rules 203(b)(1) and 203(b)(3) of Regulation SHO. It also  censured HCM and barred Hazan from association with any broker-dealer, with the right to reapply for association after five years.

In the TJM proceeding, the SEC found that TJM engaged in misconduct from January 2007 to July 2007 and ordered TJM to cease and desist from committing or causing, and Benson to cease and desist from causing, any violations and any future violations of Rules 203(b)(1) and 203(b)(3) of Regulation SHO. It also censured TJM, suspended Benson from associating with any broker or dealer for a period of three months, and suspended Burke from acting in a supervisory capacity with a broker or dealer for a period of nine months. The SEC ordered TJM to pay disgorgement in the amount of $541,000.

Short Selling Price Restrictions

On August  17, 2009, the SEC re-opened the comment period for comment on its proposed price restrictions on short sales and proposed for comment an additional approach that would permit short sales only at a price above the current national best bid.

How Can I get More Information on these Developments?

For more information on these developments, please contact any member of our Securities Practice Group.