March 2010 U.S. Securities Law Briefing. SEC Adopts Circuit Breaker Plus Alternative Uptick Rule Limiting Short Sales. Following a strongly divided vote by its Commissioners, the U.S. Securities and Exchange Commission (the SEC or the Commission ) adopted amendments last week to Regulation SHO (the Amendments ) that would restrict short selling by imposing a circuit breaker combined with an Alternative Uptick Rule on trading centers (the Short Sale Restrictions ). 1 The Short Sale Restrictions would work as follows: > Circuit Breaker A circuit breaker would be triggered for a security any day during which the price declines by 10% or more from the prior day s closing price. > Alternative Uptick Rule Once the circuit breaker has been triggered, short sales in the affected security generally cannot be executed at or below the then current national best bid for the security. Contents Background... 2 Circuit Breaker Plus Alternative Uptick Rule... 2 Exemptions and Short Exempt Marking Requirement... 5 Overseas Transactions... 6 Implementation Period... 6 Conclusion... 6 Appendix A... 8 > Duration Short sales would be restricted for the remainder of the day following the price decline as well as the following day. > Covered Securities The Short Sale Restrictions would generally apply to any equity securities listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market. > Implementation Rather than a straight prohibition, the Short Sale Restrictions would be implemented by requiring trading centers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the execution or display of a prohibited short sale. The Amendments allow for certain limited exemptions to the Short Sale Restrictions, such as odd lot transactions, but such trades must be marked as "short exempt" to identify reliance on one of those exemptions. The Short Sale Restrictions will become effective 10 May 2010, and market participants will have until 10 November 2010 to comply with the requirements. 1 SEC Release No. 34-61595, Amendments to Regulation SHO (the Adopting Release ), is available at http://www.sec.gov/rules/final/2010/34-61595.pdf. 1 SEC Adopts Circuit Breaker Plus Alternative Uptick Rule Limiting Short Sales.
Background 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. 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 was at or above its preceding sale price, or on a plus tick (the Original Uptick Rule ). 2 In July 2007, the SEC eliminated Rule 10a-1 after significant study showed no discernible association between extreme price movements and existing short sale price test restrictions. However, the market instability that followed not long afterwards caused many to associate the elimination of the Original Uptick Rule 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 sharp declines, the SEC issued a number of temporary emergency short sale restrictions in 2008, including a temporary ban on short sales of the stock of nearly 1,000 financial institutions and measures to prevent abusive short selling. In April 2009, following significant public and political pressure to take action on short sales beyond the temporary emergency measures, the Commission issued proposed amendments (the Proposed Amendments ) to Regulation SHO that considered two main approaches to limiting short sales: a marketwide, price test approach similar to the Original Uptick Rule; or a securityspecific, temporary circuit breaker approach, pursuant to which short sale restrictions would be triggered if a security experienced a 10% price decline as compared to the prior day s closing price. The Commission said it would also consider combinations of the various approaches. To help make its decision, the Commission requested in particular empirical data regarding the costs and benefits of reinstating short sale price test restrictions or imposing circuit breaker rules, including the potential impact on legitimate short selling. Circuit Breaker Plus Alternative Uptick Rule Following the review of more than 4,300 comment letters in response to the Proposed Amendments as well as a roundtable discussion, the Commission 2 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. 2 SEC Adopts Circuit Breaker Plus Alternative Uptick Rule Limiting Short Sales.
voted three to two to approve the Amendments as set forth by the SEC s Division of Trading and Markets. 3 The Adopting Release acknowledges that the Commission is not aware of any empirical evidence that the elimination of short sale price tests contributed to the increased volatility of the U.S. markets. Furthermore, none of the available empirical data gave the Commission reason to question the validity of the earlier studies that resulted in the repeal of the Original Uptick Rule in 2007, and the Commission's own internal analysis found that price pressures on financial stocks came from long selling and not short selling. Nevertheless, the Commission decided to reinstate restrictions on short selling because of concerns that excessive downward price pressure on individual securities, accompanied by the fear of unconstrained short selling, can undermine investor confidence meaning investor trust in the fairness of the financial markets in the U.S. markets generally. 4 The Amendments revise Rule 201 of Regulation SHO to require a trading center to implement policies and procedures reasonably designed to prevent it from executing or displaying any short sale order (absent an exception) at a price that is equal to or below the current national best bid if the price of that security decreases by 10% or more from the security s closing price as determined by the listing market for the covered security as of the end of regular trading hours on the prior day. Covered Securities. The Short Sale Restrictions will 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 transaction reports are collected, processed and made available pursuant to an effective transaction reporting plan. 5 In other words, the Rule covers all securities, except options, listed on a national securities exchange, whether traded on an exchange or in the over-the-counter ( OTC ) market. It will 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. Derivatives securities are also not covered, because they would significantly complicate the implementation process. Current National Best Bid. The current national best bid was chosen as the reference price for amended Rule 201 because, among other reasons, the Commission believes it is a more accurate reflection of current prices for a security than the other proposed reference points, such as the last sale price (the reference price in the Original Uptick Rule), which has the potential to be manipulated. Amended Rule 201 does not specify the particular increment 3 4 5 Commissioners Kathleen Casey and Troy Paredes were both strongly against adopting the Amendments, and Commissioner Elisse Walter said that it was not an easy decision for her to vote to approve the Amendments, noting that the issue was very controversial and sparks a great deal of emotion. Commissioners Casey and Paredes were both highly critical of the promotion of investor confidence objective, arguing that the connection between short sale restrictions and investor confidence is unsubstantiated and speculative. They also questioned the Amendments preference for long sellers over short sellers. 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. 3 SEC Adopts Circuit Breaker Plus Alternative Uptick Rule Limiting Short Sales.
above the national best bid at which a covered security may be sold short once the circuit breaker is triggered, although any execution or display must be in compliance with applicable rules regarding minimum pricing increments. Closing Price in Listing Market. Under the Amendments, the reference point for measuring the price decline is the closing price as determined by the covered security s listing market as of the end of regular trading hours on the prior day. The Commission considered the previous day s closing price to be a better reference point for a price decline than others, such as the last price in the consolidated system, which is more likely to reflect an anomolous trade, or the opening price, which is not as certain as the previous day s closing price and can present issues in thinly traded securities. Duration. Amended Rule 201 applies the Alternative Uptick Rule, once triggered by the price decline, for the remainder of the trading day and the rest of the following day. The circuit breaker approaches in the Proposed Amendments had generally considered restrictions applying to only the rest of the trading day, but the Commission was concerned that the shorter duration would not provide sufficient time for the restrictions to have their intended effect. Determination that Circuit Breaker Triggered. The Amendments require the listing market for a covered security to determine whether the circuit breaker has been triggered for that security. Once the listing market has made that determination, it must immediately notify the single plan processor responsible for consolidation of the information for the covered security, and the plan processor must then disseminate such information. Policies and Procedures Approach. Rather than use the Original Uptick Rule s straight prohibition approach, the Amendments instead require trading centers to establish, maintain and enforce written policies and procedures reasonably designed to prevent the execution or display of prohibited short sales. The Commission chose this mechanism since it is similar to the policies and procedures approach under Regulation NMS and provides more flexibility, potentially allowing for more efficient functioning of the securities markets. Among other things, a trading center s policies and procedures must: > require that a trading center be able to determine when a covered security is subject to the Alternative Uptick Rule; > be reasonably designed so that the trading center is able to obtain information from the single plan processor when a covered security becomes subject to the Alternative Uptick Rule; > enable a trading center to monitor, on a real-time basis, the national best bid, and to have a record identifying the current national best bid at the time of execution or display of a short sale order; and > be reasonably designed to permit the execution or display of a short sale order of a covered security marked short exempt without regard 4 SEC Adopts Circuit Breaker Plus Alternative Uptick Rule Limiting Short Sales.
to whether the order is at a price that is less than or equal to the current national best bid. Trading centers will be required to regularly assess the continuing effectiveness of their policies and procedures and take prompt action when needed to remedy deficiencies. To the extent that a trading center s policies and procedures permit any execution or display of prohibited short sales, the trading center could be subject to enforcement action. Also, any conduct by trading centers, or other market participants, facilitating prohibited short sales could also lead to aiding and abetting liability or a violation of Regulation SHO, as well as potential liability under the anti-fraud and anti-manipulation provisions of the U.S. federal securities laws. Exemptions and Short Exempt Marking Requirement The Amendments allow for several limited exemptions and also amend Rule 200(g) of Regulation SHO to require a "short exempt" marking to identify when a broker or dealer is relying on one of those exemptions. Most of the exemptions are similar to the ones that were provided under the Original Uptick Rule, allowing a broker or dealer to mark a prohibited short sale order short exempt in the following circumstances: > Broker-dealer provision where the broker or dealer is above the current national best bid price at the time of submission of the order to the trading center; > Seller s delay in delivery where the broker or 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 or dealer has a reasonable basis to believe that the short sale order is being made by a market maker to offset a customer odd lot order to liquidate an odd lot position that changes the broker or 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 or dealer is facilitating customer buy orders where the customer is net long and the brokerdealer 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 9:30 a.m. or 5 SEC Adopts Circuit Breaker Plus Alternative Uptick Rule Limiting Short Sales.
that are not assigned a price until after the close of trading when the VWAP is calculated. The Commission declined, however, to adopt an exception for bona fide market making in either equities or options, for bona fide hedging activities or for exchange traded funds and other similar broad-based indices and baskets of stocks. Overseas Transactions To clarify the application of the Short Sales Restrictions to foreign transactions, the Adopting Release states that amended Rule 201 applies to any short sale effected using U.S. jurisdictional means, regardless of the jurisdiction in which the short sale is executed. Thus, if a trade is agreed to in the United States, but sent to a foreign market for execution, Regulation SHO would apply to that trade, regardless of whether the broker-dealer is registered with the Commission or relying on an exemption from registration. Implementation Period Trading centers, broker-dealers and other market participants will have six months to modify their systems, policies and procedures in order to comply with the Amendments following their effective date. The Commission rejected proposals for a longer implementation period since the Amendments will not require monitoring of the sequence of bids or last sale prices and the implementation of policies and procedures is similar to those required for trading centers under Regulation NMS. The Commission also rejected requests for adoption of the Amendments on a temporary pilot basis and/or for only a subset of securities, because such temporary or limited measures would not advance the Commission s goal of promoting investor confidence, and undertaking a pilot study would require market participants to undertake as much time, effort and expense as full implementation of the new Rule. Conclusion Given the significant political pressure put on the Commission to act on short sales, it is not surprising that the Amendments were adopted, albeit narrowly. However, as acknowledged in the adopting release itself, there appears to be little, if any, empirical evidence that the Original Uptick Rule, the Alternative Uptick Rule or any of the other short sale restrictions considered by the Commission will have a significant effect on market volatility or even investor confidence as defined by the Commission. This could leave the Amendments open to challenge as arbitrary, an argument to which the U.S. Court of Appeals for the District of Columbia, which vacated the SEC's rule regulating hedge funds in 2006 as completely arbitrary, may be receptive. In the Adopting Release, the Commission states that it will consider whether to amend Rule 201 if at any time it determines that any of the Rule s parameters such as the exceptions to the Rule, the 10% trigger level, the duration of the restrictions or the prior day s closing price as the reference 6 SEC Adopts Circuit Breaker Plus Alternative Uptick Rule Limiting Short Sales.
point for the price decline or changed market conditions result in the Rule not addressing the Commission s concerns or goals. It remains to be seen whether amended Rule 201 will survive in its current form in a more calm political and economic environment. We will continue to monitor developments in this area and welcome any queries you may have. Contacts For further information please contact: Jeff Cohen Partner (+1) 212 903 9014 jeffrey.cohen@linklaters.com Scott Sonnenblick Partner (+1) 212 903 9292 scott.sonnenblick@linklaters.com Jason Manketo Partner (+44) 20 7456 4654 jason.manketo@linklaters.com Jon Gray Partner (+852) 2842 4188 jon.gray@linklaters.com Ed Fleischman Senior Counsel (+1) 212 903 9011 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 2010 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC326345. 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 or on www.linklaters.com and such persons are either solicitors, registered foreign lawyers or European lawyers. 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 emailing us at marketing.database@linklaters.com. edward.fleischman@linklaters.com One Silk Street London EC2Y 8HQ Telephone (+44) 20 7456 2000 Facsimile (+44) 20 7456 2222 Linklaters.com 7 SEC Adopts Circuit Breaker Plus Alternative Uptick Rule Limiting Short Sales. A11771214
Appendix A Comparison of Original Uptick Rule and Circuit Breaker/Alternative Uptick Rule Original Uptick Rule (Former Rule 10a-1) Circuit Breaker/Alternative Uptick Rule (Amended Rule 201) Restrictions Short sales allowed only at a price above the price at which the immediately preceding sale was effected; or at the last sale price if it is higher than the last different price Short sales may not be made at a price equal to or below the current national best bid of a security if the price of that security decreases by 10% or more from its closing price the day before Implementation Straight prohibition Trading centers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent execution or display of prohibited short sales Covered Securities Minimum Short Sale Price Price Decline Reference Point Duration of Restrictions Exemptions Securities registered on or admitted to unlisted trading privileges on national securities exchanges, if the trades are reported under an effective transaction reporting plan and information regarding the trades is available under the plan Above the price at which the immediately preceding sale was effected; or at the last sale price if it is higher than the last different price N/A At all times Seller s delay in delivery Odd lot transactions Domestic/international 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 Any equity security listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market Once the circuit breaker is triggered, only above the current national best bid price Closing price as determined by the covered security s listing market as of end of prior day s regular trading hours The rest of the day following the triggering price decline and the following day Broker-dealer above the current national best bid price at the time of submission of the order to the trading center Seller s delay in delivery Odd lot transactions Domestic/international arbitrage Over-allotments, lay-off sales Riskless principal transaction Transactions on VWAP basis Such sales must be marked short exempt. Effective Date Effective 1938 to 2007 Effective 10 May 2010, and market participants will have until 10 November 2010 to comply with the requirements 8 SEC Adopts Circuit Breaker Plus Alternative Uptick Rule Limiting Short Sales.