[16844]
December 5, 2003
TO: EQUITY MARKETS ADVISORY COMMITTEE No. 35-03
SEC RULES COMMITTEE No. 99-03
RE: SEC PROPOSES REGULATION SHO RELATING TO SHORT SALES
The Securities and Exchange Commission has published for comment proposed
Regulation SHO relating to short sales.1 Proposed Regulation SHO would, among other things,
institute a uniform bid test allowing short sales to be effected at a price one cent above the
consolidated best bid; implement a uniform “locate” requirement to address the problem of
“naked” short selling; and amend the definition of a “short sale.” The proposal also requests
comment on a temporary rule that would suspend the operation of the proposed bid test for
specified liquid securities during a two-year pilot period. Proposed Regulation SHO would
replace the current rules relating to short sales, specifically Rules 3b-3, 10a-1, and 10a-2 under
the Securities Exchange Act of 1934. The most significant aspects of the SEC’s proposal are
summarized below.
Comments on the proposal must be received by the SEC no later than January 5, 2004.
We have scheduled a conference call to discuss proposed Regulation SHO and the Institute’s
comment letter for December 9 at 12 pm Eastern. The dial-in number for the call will be 888-
673-9781 and the passcode for the call will be 56223. If you, or someone else at your firm,
would like to participate in the conference call, please contact Monica Carter-Johnson by
phone at 202-326-5823 or by e-mail at mcarter@ici.org.
I. Proposed Uniform Bid Test
Currently, short sale regulation applies different price tests to securities trading in
different markets. In particular, Rule 10a-1’s tick test applies only to short sale transactions in
securities listed on a national securities exchange, whether the transaction is effected on an
exchange or otherwise. The NASD’s bid test applies to short sale transactions in Nasdaq NMS
securities effected on either Nasdaq’s SuperMontage or the NASD’s Alternative Display Facility
(“ADF”) (but not to Nasdaq SmallCap, OTCBB, and other securities traded over-the-counter).
In addition, no short sale price test applies to short sales of Nasdaq NMS securities executed
1 Securities Exchange Act Release No. 48709 (October 28, 2003), 68 FR 62972 (November 6, 2003) (“Release”). The
Release can be found on the SEC’s website at http://www.sec.gov/rules/proposed/34-48709.htm.
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away from SuperMontage and the ADF, unless the market on which the securities are being
traded has adopted its own price test.
In order to create uniformity in the application of short sale regulation, the SEC is
proposing Rule 201 of Regulation SHO, which would replace Rule 10a-1’s tick test with a test
using the consolidated best bid as the reference point for permissible short sales. Specifically,
proposed Rule 201 would require that all short sales in exchange-listed and Nasdaq NMS
securities, wherever traded, be effected at a price at least one cent above the consolidated best
bid at the time of execution. The SEC is not proposing to extend the uniform bid test to
securities not currently covered by a short sale price test (i.e., Nasdaq SmallCap, OTCBB, and
Pink Sheet securities).2
The SEC also requests comment on an alternative to the proposed bid test, in particular,
allowing short selling at a price equal to or above the consolidated best bid if the current best
bid is above the previous bid (i.e., an upbid). However, in this alternative, short selling would
be restricted to a price at least one cent above the consolidated best bid (not equal to the best
bid) if the current best bid is below the previous bid (i.e., a downbid). This alternative test
would apply to the same securities as the uniform bid test.3
II. Application of Proposed Uniform Bid Test
Rule 10a-1 currently contains thirteen exceptions to the tick test designed to permit
certain types of trading activities that were intended to benefit the markets or that were
believed to carry little risk of the kind of manipulative or destabilizing trading that the rule was
designed to address. The SEC has proposed modifying some exceptions for inclusion in
proposed Rule 201 and excluding other exceptions from the rule. Exceptions proposed to be
retained include, among other things, exceptions relating to a long seller’s delay in delivery; an
error in marking a short sale; odd lot transactions; domestic and international arbitrage;
distribution over-allotment; equalizing short sales and trade-throughs.
In addition, NASD Rule 3350 currently exempts from operation of the NASD’s bid test
short sales executed by qualified market makers in connection with bona fide market making.
There is no similar exception in Rule 10a-1 for the bona fide market making activities of
specialists and third market makers in exchange-listed securities. The Release states that
because the proposed rule permits unrestricted short sales at the offer or at any other price that
is one cent or more above the bid, the need for an exception to allow market makers to sell at or
below the best bid seems limited. The SEC is seeking comment, however, on the importance of
a market maker exception in the context of a market maker’s role in providing liquidity and on
the extent to which market makers might need to be able to short at the bid in order to facilitate
2 The SEC requests comment on whether the proposed uniform bid test should be extended to these securities and
whether these securities need the protection of the proposed uniform bid test.
3 The SEC requests comment on several aspects of the proposed bid test, including whether there would be any
benefits in eliminating a short sale price test; whether there ever would be a circumstance where there would not be a
consolidated bid in an exchange-listed or Nasdaq NMS security; whether a one-cent increment is an appropriate
standard for allowing short sales above the best consolidated bid; and whether the proposed bid test would operate
effectively in the current decimal environment, i.e., would bid flickering inhibit the operation of the test.
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a customer buy order, and whether an exception limited to those situations would be necessary
or appropriate.
The proposed uniform short sale rule also would apply to after hours trades in all
covered securities. In particular, after the time the consolidated best bid ceases to be calculated
and disseminated, the proposed rule would prevent short selling at a price at or below the last
published consolidated best bid.4 Finally, the Release states that short sale regulation applies to
trades in reported securities when the trade is agreed to in the United States, even if the trades
are “booked” overseas.
III. Pilot Program Suspending Proposed Bid Test
The SEC is proposing temporary Rule 202 of Regulation SHO that would suspend, on a
pilot basis, the operation of the proposed bid test for specified liquid securities. The Release
states that the pilot would enable the SEC to study the effects of relatively unrestricted short
selling on, among other things, market volatility, price efficiency, and liquidity and to assess
whether short sale regulation should be removed, in part or in whole, for actively traded
securities.5
The Release states that the securities included in the pilot could be comprised of a subset
of the Russell 1000 index (e.g., one-third of the securities in the index), or such other securities as
the SEC designates after giving due consideration to the security’s liquidity, volatility, market
depth and trading market. The proposed temporary rule would remain in effect for two years.6
IV. Uniform Locate Requirement
The Release states that many issuers and investors have complained about alleged
“naked short selling,” which occurs when someone is selling short without borrowing the
necessary securities to make delivery. The SEC believes that current SRO requirements have
not fully addressed the problems of naked short selling and that it would be beneficial to
establish a uniform standard specifying the procedures that all short sellers would follow to
locate securities for borrowing. The SEC is therefore proposing to incorporate in proposed
Regulation SHO a uniform “locate” rule applicable to all equity securities, wherever they are
traded. In particular, proposed Rule 203 would prohibit a broker-dealer from executing a short
sale order for its own account or the account of another person, unless the broker-dealer, or the
person for whose account the short sale is executed: (1) borrowed the security, or entered into
4 The SEC requests comment on whether the consolidated quote information that is collected and published after
hours provides sufficient information to allow short selling or whether the rule should 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.
5 The pilot would only suspend the operation of the proposed bid test. All other provisions of proposed Regulation
SHO would continue in effect.
6 The SEC requests comment on several aspects of the pilot program including, among other things, if temporarily
suspending the short sale price test for liquid stocks is appropriate and whether liquid stocks are more difficult to
manipulate through short selling; whether a two-year temporary suspension of the short sale price test is a sufficient
period to fully study its impact; whether one market could benefit over another market depending on the selection of
stocks for the pilot; and whether the short sale price test should be automatically reinstituted in extraordinary market
conditions.
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an arrangement for the borrowing of the security, or (2) had reasonable grounds to believe that
it could borrow the security so that it would be capable of delivering the securities on the date
delivery is due.
V. Definition of “Short Sale”
Rule 3b-3 defines the term “short sale” as any sale of a security that the seller does not
own or any sale that is consummated by the delivery of a security borrowed by, or for the
account of, the seller. Rule 3b-3 also defines specific instances when a person shall be deemed
to own a security for the purposes of Rule 10a-1. The SEC is proposing new Rule 200 to replace
Rule 3b-3. In particular, proposed Rule 200 would require that a person not only have entered
into an unconditional contract, binding on both parties, to purchase the security, but also that
the contract specify the irrevocable price and amount of securities purchased and provide for
present delivery.
The Release states that a fixed price and quantity, as well as present delivery, are
essential elements in determining whether a contract to purchase securities conveys ownership
for purposes of short sale regulation, and requiring these elements would restrict certain
activities designed to manipulate the market. In addition, without an express requirement that
the contract contemplate present delivery, there is a danger that contracts would be formed
solely for the purposes of creating a long position to evade the short sale rule, in cases where
there is no real intention to actually acquire the securities pursuant to the contract.7
Ari Burstein
Associate Counsel
7 The SEC specifically requests comment on whether proposed Rule 200 should require a definite timeframe that
limits when the buyer can consider itself long (e.g., a buyer would be deemed to own the securities only if the
contract contemplates the buyer will receive the securities within 30 days), and, if so, what the timeframe should be.