Regulatory Update SEC Proposes Significant Amendments to the Short Sale Rule 1

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1 Regulatory Update SEC Proposes Significant Amendments to the Short Sale Rule 1 November 14, 2003 Distributed By: The Securities and Futures Market Regulation and Litigation Group SCHIFF HARDIN LLP 1101 Connecticut Avenue, N.W. Suite 600 Washington, DC t f

2 The Securities and Exchange Commission ( SEC or Commission ) has proposed Regulation SHO, which would modernize and replace existing SEC and selfregulatory organization ( SRO ) rules governing short sales. Specifically, the SEC has proposed (i) to replace the existing tick test under Rule 10a-1 of the Securities Exchange Act of 1934 ( Exchange Act ) for listed stocks and the NASD s bid test for Nasdaq NM securities with a new type of bid test that would apply to exchange-listed and Nasdaq NM securities, (ii) a uniform affirmative determination or locate rule, (iii) strict delivery requirements in connection with securities that are the subject of significant levels of failed transactions, (iv) to clarify the terms pursuant to which a person may deem themselves long for purposes of the new bid test, and (v) modifications to Rule 105 of Regulation M, which governs short selling in connection with public offerings. Securities Exchange Act Release No (October 28, 2003); 68 FR (November 6, 2003)( Proposing Release ). The Proposing Release also requests comment on a two year pilot program that would temporarily suspend the new short sale price test for certain specified securities. Comments from interested parties are due on January 5, Proposed Uniform Bid Test Regulation SHO would replace the current Rule 10a-1 tick test and bid test of NASD Rule 3350 with a uniform bid test that would apply to all exchange-listed and Nasdaq NM securities regardless of where they are traded. Under proposed Rule 201, broker-dealers executing short sales would look to the consolidated best bid in a security as the reference point for measuring the permissibility of short sales. The uniform bid test would require that all short sales be executed at a price no less than $0.01 above the consolidated best bid for the security being sold at the time of execution. This represents a departure not just from the tick test of Rule 10a-1, but also from NASD Rule 3350, which permits short sales in Nasdaq NM securities at the Nasdaq best bid provided that that bid is higher than the last preceding different bid. The new uniform bid test also would apply to after hours trades by using the current consolidated best bid for a security as the reference price for determining the permissibility of short sales when the after-hours tape is operating and the last published consolidated best bid as the reference price after the tape has closed. The Commission does not propose to apply the new bid test to smaller, less liquid securities (e.g., OTC bulletin board, pink sheets, and Nasdaq Small Cap) as these securities have not be subject to short sale pricing restrictions in the past. The Proposing Release seeks comment on a number of proposed exceptions to the uniform bid test. Subject to express conditions, proposed Rule 201 would incorporate exceptions relating to: executions during locked and crossed markets, volume weighted average price (VWAP) executions, broker-dealer executions of customer long sales on a riskless principal basis, and broker-dealer short sales at (rather than above) the consolidated best bid to fill customer orders as required pursuant to SRO rules (e.g., NASD Manning Interpretation). The SEC also proposes to retain exceptions currently available under Rule 10a-1 relating to a long seller s delay in delivery, errors in marking short sales, odd lot transactions, domestic and international arbitrage, and distribution over-allotments. Interestingly, while Regulation SHO would retain the convertible arbitrage exemption currently found in Rule 10a-1(e)(7), it would impose a new requirement compelling a person relying on this exemption to acquire or purchase the security on which the arbitrage is based subsequent to the exempt short sale. The current limited block positioner exemption also would be excepted from the new bid test, as would liquidations of certain index arbitrage provisions (currently conducted pursuant to staff interpretive relief under the Merrill Lynch letter). To be consistent with NYSE Rule 80A, however, the SEC has proposed that the index arbitrage liquidation exemption should be available only at times when the Dow Jones Industrial Average has not declined by 2% or more from its previous close. The Commission also proposes to codify the so-called aggregation unit letter, which allows multi-service brokerdealers to aggregate their positions by separate trading units in determining the status of these units as long or short (rather than determining long or short status by reference to positions of the firm as a whole). The SEC asks whether it should extend the aggregation unit approach to other entities such as hedge funds (but does not now propose to do so). In addition to those exceptions expressly proposed, the SEC asks whether transactions in listed non-convertible corporate bonds effected on an exchange should be excluded from the new uniform price test. The SEC also asks whether it should codify conditional relief granted to national securities exchanges and broker-dealers to execute short sales in afterhours crossing sessions at a price equal to the closing price of a security. Additionally, the SEC requests comment on whether it should provide relief from proposed Rule 201 for transactions in exchange traded funds (this would essentially codify current 2

3 exemptive relief granted to ETFs regarding compliance with Rule 10a-1). Significantly, and unlike NASD Rule 3350, proposed Rule 201 would not provide an exemption for short sales in connection with bona fide market making, although the Proposing Release requests comment on this issue. The SEC also has proposed eliminating the equalizing exception currently found in subsections (e)(5) and (e)(6) of Rule 10a-1 as unnecessary in light of the use of the consolidated bid by all market participants. This stems from Regulation SHO s use solely of the consolidated bid, in contrast to the ability for an exchange to use its own transactions as the basis for the tick test under Rule 10a-1. Addressing the so-called fax market for effecting short sales off-shore, the SEC indicated that the short sale regulations of the Exchange Act apply to any trade agreed to in the U.S., even if that trade is booked in a non-u.s. jurisdiction. Temporary Suspension of Price Test The SEC also has proposed to suspend the new uniform price test, for a two-year pilot basis, for a select group of liquid securities to be determined by the SEC (i.e., a subset of the securities in the Russell 1000 index). The SEC would choose a group of approximately 300 stocks that could be used for a matched pair statistical analysis to determine whether a price test is needed at all for actively traded securities. The use of a matched pair test would mean that similar stocks would be subject to different short sale regulation regimes during the test period some with a bid test and others exempt from a bid test (e.g., Ford subject to the price test but General Motors exempt from a price test). The Commission also requests a variety of comments on the proposed pilot, including whether a short sale price test should be automatically reinstituted if the price of a security in the pilot experiences a significant intraday market decline. Uniform Locate Requirement To address naked short selling, the SEC has proposed Rule 203, which would incorporate existing SRO affirmative determination or locate requirements into a uniform rule applicable to all equity securities regardless of where they are traded. New Rule 203 also would impose additional requirements on securities that have failures to deliver in excess of a specified amount. In the event of a failure to deliver by a broker-dealer executing a short sale in these securities by two days after the settlement date, the selling broker-dealer would be prohibited for ninety days from executing short sales for the person for whose account the failure to deliver occurred. The prohibition during the 90 days would not apply to a short sale where the person borrowed the security, or entered into a bona fide arrangement to borrow the security, prior to executing the short sale and actually delivered on the settlement date. The SEC also has proposed that, except for market makers and exchange specialists engaging in bona-fide market making activities, a locate must be made and annotated in writing prior to effecting any short sale. The SEC requests comment on the appropriate means by which the uniform locate requirement might be satisfied (such as through the reliance on easy to borrow and hard to borrow lists). Definition of "Short Sale" Proposed Rule 200 would replace Exchange Act Rule 3b- 3. The most significant change is to the provision that allows a person to deem itself long if it has entered into a binding, unconditional contract to purchase a security. Rule 200 would require that the contract specify an irrevocable fixed price and amount of securities to be delivered in order to have a long position with respect to the shares that are subject to the contract. This provision would codify a position proposed by the SEC in 1992 but never adopted by the Commission or followed within the securities industry. Adoption of this new requirement could significantly affect the ability of broker-dealers to effect sales to facilitate a client s order to sell based on the VWAP or closing price of a security. It appears the SEC is suggesting that the such prices may not be fixed prices at the time the agreement to buy at such prices are entered into. The proposed rules also would provide that a person holding a long security futures position is not to be deemed long the underlying shares until expiration of the future. The proposals also would require broker-dealers to mark all sell orders of any security as either long, short, or short exempt. A broker-dealer would be permitted to mark a sell order long only if the seller owns the security being sold and either: 1) the security to be delivered is in physical possession or control of the broker-dealer, or 2) the security will be in the physical possession of the brokerdealer no later than when the transaction is settled. Any exempted trades may be marked short exempt (e.g., sales by a person who own a security and intend to deliver 3

4 it as soon as possible are exempt). Importantly, the SEC also has proposed allowing broker-dealers to mark sell orders as long based on a customer s net long position when the broker-dealer is effecting the execution for the selling customer on a riskless principal basis. In contrast to the proposal regarding the definition of an unconditional contract noted above, this provision could assist brokerdealers in facilitating customers sell orders (although it is not clear how this provision would square with proposed Rule 200 in the event of riskless principal facilitations of customer long sales to be effected on a VWAP or closing-price basis). Proposed Amendments to Regulation M The SEC also has proposed to eliminate the shelf registration exception to Rule 105 of Regulation M. Rule 105 generally prohibits the use of shares purchased in an offering to cover short sales made just prior to the offering. In proposing to eliminate the shelf registration exception, the SEC now believes that sales pursuant to such offerings can have the same manipulative potential as prepricing short sales made in connection with non-shelf offerings. As a result, short selling prior to offerings off the shelf will be treated just like short sales prior to underwritten, fixed priced offerings, so that such short sales could not be covered by shares purchased in either type of distribution. 4

5 For Further Information If you have questions concerning this memorandum or Proposed Regulation SHO, please contact any of the following members of our Securities and Futures Market Regulation and Litigation Group in our Washington office: Andrew M. Klein Howard L. Kramer Laura S. Pruitt James L. Eastman This paper is intended as a brief description of recent SEC action and not as legal advice. 5