U.S. Securities Law Briefing

Transcription

1 24 April 2009 U.S. Securities Law Briefing SEC Proposes Alternatives for Restricting Short Sales Following public pressure to take further action with respect to short sales, the U.S. Securities and Exchange Commission (the SEC ) recently released a proposed rule (the Proposal ) 1 that would place further restrictions on short selling. 2 The Proposal offers two possible approaches to such restrictions, with five specific options amongst them: (1) A market-wide, price test approach (the Price Test Approach ): A short sale price test based on the national best bid that applies a policies and procedures approach to prevent trading centers from executing and displaying short sales at a price less than the national best bid price (the Modified Uptick Rule ); or A short sale price test based on the last sale price that applies a straight prohibition approach prohibiting any person from effecting short sales at a price less than the last sale price (the ); or (2) A security-specific, temporary circuit breaker approach, pursuant to which one of the following would be triggered if a security experienced a 10% price decline as compared to the prior day s closing price (the Circuit Breaker Approach ): Short sales with respect to the specific security would be prohibited for the remainder of the day; The Modified would be imposed with respect to the specific security for the remainder of the day; or The would be imposed with respect to the specific security for the remainder of the day. The alternatives proposed are not exclusive to each other, and the Proposal expressly states that the SEC will also be considering combinations of the various approaches. Please see Appendix A for a summary chart comparing the features of the various approaches. Comments on the Proposal are due by 19 June Background In 1938, the SEC adopted Rule 10a-1 under the Securities Exchange Act of 1934 (the Exchange Act ) to restrict short selling in a declining market by allowing short sales only when a stock's price 1 2 The Proposal, entitled Amendments to Regulation SHO (SEC Release No ), is available at Short selling is the practice of selling a security that the seller does not own or consummating a sale by the delivery of a security borrowed by, or for the account of, the seller, which is typically closed out by the short seller purchasing equivalent securities on the open market and returning the borrowed security to the lender. Short selling is generally used to profit from an expected downward price movement, to provide liquidity or to hedge the risk of a long position in the same security. April 2009 Page 1 of 9

2 3 was at or above its preceding sale price, or on a plus tick (the Original ). Although the core of Rule 10a-1 did not change over the course of 70 years, the SEC added exceptions and granted numerous requests for relief from the rule in response to changes in the securities markets, including decimalisation, the increased use of matching systems that executed trades at independently derived prices during random times within specific time intervals, and the spread of fully automated markets. Market developments over the years also led to the application of different price tests to securities trading in different markets. In July 2007, following significant study, the SEC eliminated Rule 10a-1 after finding no discernible association between extreme price movements and existing short sale price test restrictions. However, the market instability that followed not long afterwards has caused many to associate the elimination of the Original with the stock prices of many companies, particularly financial institutions, being driven down by hedge funds and other short sellers, even though there appears to be little specific empirical evidence, if any, of such cause and effect. As a result of such these sharp declines, the SEC issued a number of temporary emergency short sale restrictions in September and October 2008, including the imposition of enhanced delivery requirements on sales of all equity securities under Rule 204T of Regulation SHO and a temporary ban on short sales of the stock of nearly 1,000 financial institutions. During the same time period, the New York Attorney General also announced an investigation into the short sales of financial institution stocks. Although then-sec Chairman Christopher Cox later said that the three-week ban was the biggest mistake of his tenure as chairman, the SEC has continued to receive a great deal of political pressure to take more action with regards to short sales, including a return of the Original, which is supported both by Senator Christopher Dodd, the chair of the U.S. Senate Banking Committee, and Representative Barney Frank, chair of the U.S. House of Representatives Financial Services Committee. Most recently, a week before the 8 April 2009 open meeting held by the SEC to vote on the Proposal (the Open Meeting ), six senators wrote to SEC Chairman Mary Schapiro urging her to take action with respect to naked or abusive short selling and warning that unless the SEC shows an unambiguous commitment to promulgate and enforce regulations that put an end to naked short selling, Congress will consider legislation directing the SEC to do so. 4 Alternatives Under the Proposal At the Open Meeting, all five SEC Commissioners voted to release the Proposal. Although Commissioners Kathleen Casey and Troy Paredes (the two Republicans on the Commission) both expressed concern about the lack of empirical research support for the alternatives offered by the Proposal, the Commissioners were in general supportive of at least releasing the Proposal in order to obtain public comment. Price Test Approach The Price Test Approach proposed by the SEC staff (the Staff ) would be based on either the national best bid (the Modified ) or the last sale price (the ) and would be imposed on a market-wide, permanent basis. With respect to the Price Test Approach, the Proposal expresses a preliminary preference for the Modified over the because the Staff believes that quotation information has significant value to the market and that bids generally are a more 3 4 Rule 10a-1 covered short sales in securities registered on, or admitted to unlisted trading privileges on, a national securities exchange, if trades of the security were reported pursuant to an effective transaction reporting plan and information regarding such trades was made available in accordance with such plan on a real-time basis to vendors of market transaction information. Under the rule, subject to certain exceptions, a listed security could be sold short (i) at a price above the price at which the immediately preceding sale was effected ( plus tick ), or (ii) at the last sale price if it is higher than the last different price. Short sales were not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions. The 1 April 2009 letter to Chairman Schapiro from the six senators is available at In light of the recent issuance by the Financial Accounting Standards Board of revised fair value guidance in direct response to political pressure, the SEC appears to be taking the congressional threat very seriously. April 2009 Page 2 of 9

3 accurate reflection of current prices of a security, because changes in the national best bid are sequenced across trading centers. By comparison, according to the Proposal, even transactions that are executed and reported automatically may be out of sequence if they occur in different trading centers. The Staff is also concerned that even though the Original was only recently eliminated, extensive systems changes in response to Regulation NMS 5 may make programming systems for the burdensome. Price Test Approach Modified The first alternative proposed by the Proposal would prohibit the execution or display by a trading center 6 of a short sale order in a covered security at a down-bid price, which is a price that is less than the current national best bid (or if the last differently priced national best bid was greater than the current national best bid, a price that is less than or equal to the current national best bid). Trading centers would be required to establish policies and procedures reasonably designed to prevent the execution or display of any short sale order at a price below the national best bid, absent an exemption. The following is an example of how the Modified would operate: Current National Best Bid Immediately Preceding National Best Bid Permitted Execution/Display $47.00 $46.99 $47.00 or above $47.00 $47.01 Above $47.00 $47.00 $47.00, above the prior national best bid $47.00 or above $47.00 $47.00, below the prior national best bid Above $47.00 The Modified would apply to any NMS stock as defined under Rule 600(b)(47) of Regulation NMS, which means it would cover any security, except options, for which transactions reports are collected, processed and made available pursuant to an effective transaction reporting plan. 7 In other words, the rule would cover all securities, except options, listed on a national securities exchange, whether traded on an exchange or in the over-the-counter ( OTC ) market. It would not cover non-nms stocks (i.e., stocks for which no transaction reports are collected) quoted on the OTC Bulletin Board or elsewhere in the OTC market. The Proposal seeks further comment on whether the Modified should apply to non-exchange listed securities quoted on the OTC Bulletin Board or elsewhere in the OTC market, since the issuers of such securities believe they are particularly vulnerable to abusive short sales. All securities that were covered by the Original would be covered by the Modified, as well as all securities traded on Nasdaq prior to its regulation as an exchange that were not subject to former Rule 10a-1. 8 The Modified allows for the execution and display of securities marked short exempt even if the order is at a down-bid price. In general, these are the same exemptions that were provided under the Original, and allow a broker-dealer to mark a short sale order short exempt in the following situations: Regulation NMS consists of a series of initiatives implemented in 2005 that were designed to modernise and strengthen the national market system for equity securities. Trading centers would be defined to include: national securities exchanges or national securities associations that operate self-regulatory organisation trading facilities, an exchange market maker, an OTC market maker, or any other broker or dealer that executes orders internally by trading as principal or crossing orders as agent. The definition is meant to encompass all entities that may execute short sale orders. Under Regulation NMS, an NMS stock is defined as any NMS security other than an option, and an NMS security is any security or class of securities for which transaction reports are collected, processed and made available pursuant to an effective transaction reporting plan, or an effective national market system for reporting transactions in listed options. Prior to 2006, when Nasdaq was an automated inter-dealer quotation system, it was not subject to former Rule 10a-1 because it was not an exchange. When Nasdaq became a registered national securities exchange in 2006, the SEC provided it with an exemption from the application of former Rule 10a-1. April 2009 Page 3 of 9

4 Broker-dealer provision where the broker-dealer is not on a down-bid price at the time of submission of the order to the trading center; Seller s delay on delivery where the broker-dealer has a reasonable basis to believe that the seller owns the security being sold and the seller intends to deliver the security as soon as all restrictions on delivery have been removed; Odd lot transactions where the broker-dealer has a reasonable basis to believe that the short sale order is by a market maker to offset a customer odd-lot order to liquidate an odd-lot position that changes the broker-dealer s position by no more than a unit of trading; Domestic/international arbitrage short sale orders associated with certain bona fide domestic or international arbitrage transactions; Over-allotments and lay-off sales short sale orders by underwriters or syndicate members participating in a distribution in connection with an over-allotment or with respect to lay-off sales by such persons in connection with a distribution of securities through a rights or standby underwriting commitment; Riskless principal transaction where the broker-dealer is facilitating customer buy orders where the customer is net long and the broker-dealer is net short but effecting the sale as a riskless principal; and Transactions on volume-weighted average price basis short sale orders executed on a volume-weighted average price ( VWAP ) basis that are arranged or matched before the market opens at 9:30am or that are not assigned a price until after the close of trading when the VWAP is calculated. The Modified does not provide an exemption for broker-dealers to mark an order short exempt in connection with a bona fide market making activity, as was the case with the Original. Also, unlike the Original, the Proposal would not apply the Modified Uptick Rule to the after-hours market, since the national best bid is not collected during that period. Price Test Approach The second alternative under the Price Test Approach is a modernised version of the Original Uptick Rule. Like the Original, the would be based on the last sale price, rather than the national best bid, and it would not include an explicit policies and procedures requirement. although many market participants would likely adopt such an approach. The would prevent the execution of short sale orders below the last sale price, unless an exception applies. The rule would apply to the same securities as the Modified. The Staff expects that the may be more burdensome to apply than the Modified Uptick Rule because it would not allow any short sale at an impermissible price, even if inadvertent, unless an exception applies. The exceptions would in general be parallel to the ones for marking an order short exempt under the Modified discussed above, and would also include the following exceptions: Error in marking a short sale where a broker-dealer effects a sale order marked long by another broker-dealer but the order was mismarked such that it should have been marked as a short sale order; Electronic trading systems any sale of a covered security in an electronic trading system that matches buying and selling at various times of the day if certain conditions are met; Trade-throughs allowing market makers to execute transactions at their offer quotation following a trade-through and non-market makers to effect a short sale at a price equal to April 2009 Page 4 of 9

5 the price associated with their most recently communicated offer up to the size of that offer, if certain conditions are met; and Facilitation of customer buy orders short sales by registered market makers or specialists publishing two-sided quotes to sell short at the offer to facilitate customer market and marketable buy limit orders regardless of the last sale price. As with the Modified, the would not apply during after-hours trading, since last sale price information is not being collected. Circuit Breaker Approach Under the Circuit Breaker Approach, one of three proposed options the ban on all short sales, the Modified or the would be triggered by a specified decline in the price of a particular security. Once triggered, the restrictions would apply to an individual equity security, wherever it is traded, for the remainder of the trading day if the price of the security has declined by at least 10% 9 from the prior day s closing price, as measured by the closing price of the security on the consolidated system. However, the circuit breaker would not be triggered if the market decline threshold is reached within 30 minutes of the end of the regular trading day, in order to avoid market disruption. As proposed, the rule would apply to all NMS stocks, although the Staff is seeking comment on the scope of the rule s application and the securities to which it should apply. Circuit Breaker Approach Short Sales Ban Under the short sales ban approach, all short selling would be halted in an individual equity security, wherever it is traded, for the remainder of the trading day if the price of the security has declined by at least 10%. The proposed short sales ban approach would include exceptions substantially identical to the ones in the emergency short sales restrictions imposed in September and October 2008, including for: Market makers and options market makers engaged in bona fide market making activities; Bona fide market making in derivatives; Options and futures contract expiration; Assignment to call writers upon exercise of an option; and Owned securities (such as the sale of formerly restricted securities pursuant to Rule 144 under the Securities Act of 1933, or a convertible security, option or warrant tendered for exchange). Circuit Breaker Approach Modified The second proposed option under the Circuit Breaker Approach would trigger the Modified Uptick Rule with respect to a security that had experienced a 10% intraday decline in price from the prior day s closing price. The exceptions would be the same as those proposed for the Modified Uptick Rule. Circuit Breaker Approach Under the third circuit breaker option, the would be triggered for an individual security that had experienced a 10% intraday decline. The exceptions would be the same as those proposed for the. 9 The 10% trigger is consistent with the current circuit breaker rules that the U.S. stock exchanges and the Financial Industry Regulatory Authority have in place. The SEC also received a letter last month, available at from several exchanges, including The NYSE/Euronext Group and The NASDAQ OMX Group, suggesting the adoption of a circuit breaker with a 10% trigger. April 2009 Page 5 of 9

6 Marking Sell Orders The Staff is also proposing to require broker-dealers to mark all sell orders of any security as long, short, or short exempt. Currently, Rule 200(g) of Regulation SHO only requires sell orders to be marked long or short ; the short exempt requirement was removed when Rule 10a-1 was eliminated. The purpose of bringing back the short exempt requirement is to aid surveillance by the SEC and the exchanges for compliance with any short sale price restrictions that are adopted. Overseas Transactions The Proposal notes that in connection with the Original, the SEC consistently took the position that the rule applied to trades in securities subject to that rule where the trade was agreed to in the United States but booked overseas. The Staff s view is that the same principle should apply under the proposed Price Test or Circuit Breaker Approaches, but the Proposal requests comments on the costs and benefits of applying the proposed short sale restrictions to overseas transactions and whether the restrictions would result in sellers transacting in short sales in foreign markets to avoid the U.S. restrictions. Other Short Sale Regulations Following the Open Meeting, Erik Sirri, the director of the SEC Division of Trading and Markets ( Trading and Markets ), said that Trading and Markets is also likely to recommend that the SEC extend an interim final temporary measure that tightens the delivery requirements for short sales and continue with some version of another interim final temporary rule that requires the disclosure of short sale positions. Of the temporary emergency measures introduced during the volatile period of September 2008 to curb naked short sales, two remain: Rule 204T under Regulation SHO, which requires short sellers and their broker-dealers to deliver securities by the close of business on settlement date, or three days after the transaction date; and Rule 10a-3T, which requires certain investment managers to disclose weekly to the SEC their daily new short positions. Rule 204T expires 31 July 2009 and Rule 10a-3T expires 1 August A recent study by the SEC's Office of Economic Analysis found that after Rule 204T was implemented, fails to deliver decreased by 47%, while the number of threshold securities (stocks that have an aggregate fail-to-deliver position) fell from 500 in 2008 to 70 in February Consequently, Sirri said that Trading and Markets is likely to recommend the extension of Rule 204T in its current form. With respect to Rule 10a-3T, Sirri said that Trading and Markets would re-evaluate and may recommend continuing with it, though possibly in a different form. * * * * The SEC is facing considerable political pressure to take action to restrict short sales. This is likely due to the widespread perception that the ability of hedge funds and other short sellers to talk down, and then to engage in unrestricted short selling of, financial stocks in the second half of 2008 contributed materially to the price collapses of such stocks and the current financial crisis. There is also a widespread assumption (or at least a perception), particularly to the extent that many are drawing parallels between the 1929 stock market crash and the ensuing Great Depression of the 1930s on the one hand, and the stock market collapse of 2008 and the current severe recession on the other, that the Original, which was in effect during the period between 1938 to 2007, did in fact help cushion the market, and indeed the broader economy, from collapse brought about by bear raids and other short sellers. Finally, and perhaps most importantly in the current environment, there is very little political sympathy for hedge funds and other short sellers who might be victimised by these restrictions. April 2009 Page 6 of 9

7 It nevertheless remains the case, at least for the time being, that there is little, if any, empirical evidence that any such restrictions on short sales will have a significant effect on market volatility, and a re-imposition of restrictions on short sales in the absence of such evidence would stand in stark contrast to the extensive study that preceded the elimination of such restrictions in As noted by Commissioner Kathleen Casey during the Open Meeting, if the SEC ignores the principle that empirical evidence must guide regulatory decisions, the U.S. Court of Appeals for the District of Columbia stands ready to provide another reminder. Not surprisingly, the SEC s focus in its request for comments is for empirical data. We expect a great deal of debate over this controversial issue, which as Chairman Schapiro remarked at the Open Meeting has resulted in more letters from investors, brokerage firms and exchanges, more inquiries from members of Congress, and more questions from reporters than any other topic. The open-ended nature of many of the more than 150 questions and requests for comments raised within the Proposal is likely to draw hundreds of comments letters, which will be available on the SEC website at The SEC has also tentatively scheduled a roundtable to discuss short sale restrictions for 5 May We will continue to monitor developments in this area and welcome any queries you may have. April 2009 Page 7 of 9

8 Please address any queries to your Linklaters contacts or any of the following: Office Tel No. Contact Address London Jason Manketo Alexander Naidenov Tom O Neill Cecil Quillen Brigid Rentoul Jennifer Schneck Patrick Sheil Pam Shores Tom Shropshire Steve Thierbach New York Gary Barnett Joshua Berick Lorna Bowen Scott Bowie Jeff Cohen Stephen Culhane Ray Fisher Edward Fleischman Adam Glass Stan Renas Scott Sonnenblick Larry Vranka Hong Kong Hyung Ahn Jon Gray Sang Lee David Ludwick jason.manketo@linklaters.com alexander.naidenov@linklaters.com tom.oneill@linklaters.com cecil.quillen@linklaters.com brigid.rentoul@linklaters.com jennifer.schneck@linklaters.com patrick.sheil@linklaters.com pam.shores@linklaters.com tom.shropshire@linklaters.com steve.thierbach@linklaters.com gary.barnett@linklaters.com joshua.berick@linklaters.com lorna.bowen@linklaters.com scott.bowie@linklaters.com jeff.cohen@linklaters.com stephen.culhane@linklaters.com raymond.fisher@linklaters.com edward.fleischman@linklaters.com adam.glass@linklaters.com stan.renas@linklaters.com scott.sonnenblick@linklaters.com larry.vranka@linklaters.com hyung.ahn@linklaters.com jon.gray@linklaters.com sang.lee@linklaters.com david.ludwick@linklaters.com Frankfurt Mark Devlin mark.devlin@linklaters.com Milan Rome Luigi Sensi luigi.sensi@linklaters.com Paris Luis Roth luis.roth@linklaters.com Singapore Arun Balasubramanian arun.balasubramanian@linklaters.com This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2009 Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com. Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ and such persons are either solicitors, registered foreign lawyers or European lawyers. April 2009 A Page 8 of 9

9 Appendix A: Comparison of Proposed Alternatives Restrictions Securities Covered Securities Not Covered Exemptions Other Original (Rule 10a-1) Short sales allowed only (i) at a price above the price at which the immediately preceding sale was effected; or (ii) at the last sale price if it is higher than the last different price. Securities registered on or admitted to unlisted trading privileges on national securities exchange, if the trades are reported under an effective transaction reporting plan and information re the trades are available under the plan Securities traded on Nasdaq - Seller s delay in delivery - Odd lot transactions - Domestic/int l arbitrage - Over-allotments, lay-off sales - Riskless principal transactions - Transactions on VWAP basis - Error in marking short sale - Electronic trading systems - Trade-throughs - Facilitation of customer buy orders - Broker-dealer marking an order short exempt in connection with a bona fide market making activity Applies to after-hours trading Proposed Price Test Approach Modified Trading centers must adopt policies to prevent execution or display of short sales at a price less than the current national best bid. - NMS stock, meaning all securities, except options, for which transactions reports and collected, processed and made available pursuant to an effective transaction reporting plan - Includes securities traded on Nasdaq - Options - Non-NMS stocks quoted on the OTC Bulletin Board or elsewhere in OTC market - Broker-dealer provision - Seller s delay in delivery - Odd lot transactions - Domestic/int l arbitrage - Over-allotments, lay-off sales - Riskless principal transactions - Transactions on VWAP basis Does not apply to after-hours trading Proposed Circuit Breaker Approach Short Sale Ban Modified No person may effect a short sale (i) below a security s last sale price or (ii) at the last sale price unless the price is above the next preceding different price. Same as Modified Uptick Rule Same as Modified Uptick Rule - Seller s delay in delivery - Odd lot transactions - Domestic/int l arbitrage - Over-allotments, lay-off sales - Riskless principal transactions - Transactions on VWAP basis - Error in marking a short sale - Electronic trading systems - Trade-throughs - Facilitation of customer buy orders Does not apply to after-hours trading No further short sales for the rest of the day in a security if its price has declined by 10%. Only applies to a specific NMS security whose price has declined by 10% from the previous day s closing price. Only applies as stated above. - Market makers and options market makers engaged in bona fide market making activities - Bona fide market making in derivatives - Options and futures contract expiration - Assignment to call writers upon exercise of an option - Owned securities Does not apply if decline is in last half hour of trading day Modified uptick rule imposed with respect to short sales in a security if its prices has declined by 10%. Only applies to a specific NMS security whose price has declined by 10% from the previous day s closing price. Only applies as stated above. Same as for Modified Does not apply if decline is in last half hour of trading day Uptick rule imposed with respect to short sales in a security if its prices has declined by 10%. Only applies to a specific NMS security whose price has declined by 10% from the previous day s closing price. Only applies as stated above. Same as for Uptick Rule Does not apply if decline is in last half hour of trading day Page 9 of 9