|
Cryptome DVDs are offered by Cryptome. Donate $25 for two DVDs of the Cryptome 12-years collection of 46,000 files from June 1996 to June 2008 (~6.7 GB). Click Paypal or mail check/MO made out to John Young, 251 West 89th Street, New York, NY 10024. The collection includes all files of cryptome.org, jya.com, cartome.org, eyeball-series.org and iraq-kill-maim.org, and 23,000 (updated) pages of counter-intelligence dossiers declassified by the US Army Information and Security Command, dating from 1945 to 1985.The DVDs will be sent anywhere worldwide without extra cost. | |||
17 October 2008
[Federal Register: October 17, 2008 (Volume 73, Number 202)]
[Rules and Regulations]
[Page 61666-61678]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr17oc08-5]
=======================================================================
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-58774; File No. S7-08-08]
RIN 3235-AK06
``Naked'' Short Selling Antifraud Rule
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
-----------------------------------------------------------------------
SUMMARY: The Securities and Exchange Commission (``Commission'') is
adopting an antifraud rule under the Securities Exchange Act of 1934
(``Exchange Act'') to address fails to deliver securities that have
been associated with ``naked'' short selling. The rule will further
evidence the liability of short sellers, including broker-dealers
acting for their own
[[Page 61667]]
accounts, who deceive specified persons about their intention or
ability to deliver securities in time for settlement (including persons
that deceive their broker-dealer about their locate source or ownership
of shares) and that fail to deliver securities by settlement date.
DATES: Effective Date: October 17, 2008.
FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Associate
Director, Josephine J. Tao, Assistant Director, Victoria L. Crane,
Branch Chief, Joan M. Collopy, Special Counsel, Christina M. Adams and
Matthew Sparkes, Staff Attorneys, Office of Trading Practices and
Processing, Division of Trading and Markets, at (202) 551-5720, at the
Securities and Exchange Commission, 100 F Street, NE., Washington, DC
20549-6628.
SUPPLEMENTARY INFORMATION: We are adding Rule 10b-21 [17 CFR 242.10b-
21] under the Exchange Act.
I. Introduction
We are adopting an antifraud rule, Rule 10b-21, aimed at short
sellers, including broker-dealers acting for their own accounts, who
deceive specified persons, such as a broker or dealer, about their
intention or ability to deliver securities in time for settlement and
that fail to deliver securities by settlement date. Among other things,
Rule 10b-21 will target short sellers who deceive their broker-dealers
about their source of borrowable shares for purposes of complying with
Regulation SHO's ``locate'' requirement.\1\ Rule 10b-21 will also apply
to sellers who misrepresent to their broker-dealers that they own the
shares being sold.
---------------------------------------------------------------------------
\1\ See 17 CFR 242.203(b)(1).
---------------------------------------------------------------------------
A seller misrepresenting its short sale locate source or ownership
of shares may intend to fail to deliver securities in time for
settlement and, therefore, engage in abusive ``naked'' short selling.
Although abusive ``naked'' short selling is not defined in the federal
securities laws, it refers generally to selling short without having
stock available for delivery and intentionally failing to deliver stock
within the standard three-day settlement cycle.\2\
---------------------------------------------------------------------------
\2\ See Exchange Act Release No. 56212 (Aug. 7, 2007), 72 FR
45544 (Aug. 14, 2007) (``2007 Regulation SHO Final Amendments'');
Exchange Act Release No. 54154 (July 14, 2006), 71 FR 41710 (July
21, 2006) (``2006 Regulation SHO Proposed Amendments'').
---------------------------------------------------------------------------
Although abusive ``naked'' short selling as part of a manipulative
scheme is always illegal under the general antifraud provisions of the
federal securities laws, including Rule 10b-5 of the Exchange Act,\3\
Rule 10b-21 will further evidence the liability of persons that deceive
others about their intention or ability to deliver securities in time
for settlement, including persons that deceive their broker-dealer
about their locate source or ownership of shares.\4\ We believe that a
rule further evidencing the illegality of these activities will focus
the attention of market participants on such activities. Rule 10b-21
will also further evidence that the Commission believes such deceptive
activities are detrimental to the markets and will provide a measure of
predictability for market participants.
---------------------------------------------------------------------------
\3\ 17 CFR 240.10b-5.
\4\ This conduct is also in violation of other provisions of the
federal securities laws, including the antifraud provisions.
---------------------------------------------------------------------------
All sellers of securities should promptly deliver, or arrange for
delivery of, securities to the respective buyer and all buyers of
securities have the right to expect prompt delivery of securities
purchased. Thus, Rule 10b-21 takes direct aim at an activity that may
create fails to deliver. Those fails can have a negative effect on
shareholders, potentially depriving them of the benefits of ownership,
such as voting and lending. They also may create a misleading
impression of the market for an issuer's securities. Rule 10b-21 will
also aid broker-dealers in complying with the locate requirement of
Regulation SHO and, thereby, potentially reduce fails to deliver. In
addition, Rule 10b-21 could help reduce manipulative schemes involving
``naked'' short selling.
II. Background
A. Regulation SHO
Short selling involves a sale of a security that the seller does
not own or that is consummated by the delivery of a security borrowed
by or on behalf of the seller.\5\ In a ``naked'' short sale, a seller
does not borrow or arrange to borrow securities in time to make
delivery to the buyer within the standard three-day settlement
period.\6\ As a result, the seller fails to deliver securities to the
buyer when delivery is due (known as a ``fail'' or ``fail to
deliver'').\7\ Sellers sometimes intentionally fail to deliver
securities as part of a scheme to manipulate the price of a
security,\8\ or possibly to avoid borrowing costs associated with short
sales.
---------------------------------------------------------------------------
\5\ 17 CFR 242.200(a).
\6\ See Exchange Act Release No. 50103 (July 28, 2004), 69 FR
48008 (Aug. 6, 2004) (``2004 Regulation SHO Adopting Release'')
(stating that ``naked'' short selling generally refers to selling
short without having borrowed the securities to make delivery).
\7\ Generally, investors complete or settle their security
transactions within three business days. This settlement cycle is
known as T+3 (or ``trade date plus three days''). T+3 means that
when the investor purchases a security, the purchaser's payment
generally is received by its brokerage firm no later than three
business days after the trade is executed. When the investor sells a
security, the seller generally delivers its securities, in
certificated or electronic form, to its brokerage firm no later than
three business days after the sale. The three-day settlement period
applies to most security transactions, including stocks, bonds,
municipal securities, mutual funds traded through a brokerage firm,
and limited partnerships that trade on an exchange. Government
securities and stock options settle on the next business day
following the trade. In addition, Rule 15c6-1 prohibits broker-
dealers from effecting or entering into a contract for the purchase
or sale of a security that provides for payment of funds and
delivery of securities later than the third business day after the
date of the contract unless otherwise expressly agreed to by the
parties at the time of the transaction. 17 CFR 240.15c6-1; Exchange
Act Release No. 33023 (Oct. 7, 1993), 58 FR 52891 (Oct. 13, 1993).
However, failure to deliver securities on T+3 does not violate Rule
15c6-1.
\8\ In 2003, the Commission settled a case against certain
parties relating to allegations of manipulative short selling in the
stock of a corporation. The Commission alleged that the defendants
profited from engaging in massive ``naked'' short selling that
flooded the market with the stock, and depressed its price. See
Rhino Advisors, Inc. and Thomas Badian, Lit. Rel. No. 18003 (Feb.
27, 2003); see also SEC v. Rhino Advisors, Inc. and Thomas Badian,
Civ. Action No. 03-civ-1310 (RO) (S.D.N.Y) (Feb. 26, 2003); see also
Securities Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR
62972, 62975 (Nov. 6, 2003) (``2003 Regulation SHO Proposing
Release'') (describing the alleged activity in the settled case
involving stock of Sedona Corporation); 2004 Regulation SHO Adopting
Release, 69 FR at 48016, n.76.
---------------------------------------------------------------------------
Although the majority of trades settle within the standard three-
day settlement period,\9\ we adopted Regulation SHO \10\ in part to
address problems associated with persistent fails to deliver securities
and potentially abusive ``naked'' short selling.\11\ Rule
[[Page 61668]]
203 of Regulation SHO, in particular, contains a ``locate'' requirement
that provides that, ``[a] broker or dealer may not accept a short sale
order in an equity security from another person, or effect a short sale
in an equity security for its own account, unless the broker or dealer
has: (i) Borrowed the security, or entered into a bona-fide arrangement
to borrow the security; or (ii) Reasonable grounds to believe that the
security can be borrowed so that it can be delivered on the date
delivery is due; and (iii) Documented compliance with this paragraph
(b)(1).'' \12\ In the 2004 Regulation SHO Adopting Release, the
Commission explicitly permitted broker-dealers to rely on customer
assurances that the customer has identified its own source of
borrowable securities, provided it is reasonable for the broker-dealer
to do so.\13\ We are concerned, however, that some short sellers may
have been deliberately misrepresenting to broker-dealers that they have
obtained a legitimate locate source.\14\
---------------------------------------------------------------------------
\9\ According to the National Securities Clearing Corporation
(``NSCC''), 99% (by dollar value) of all trades settle on time.
Thus, on an average day, approximately 1% (by dollar value) of all
trades, including equity, debt, and municipal securities fail to
settle. The vast majority of these fails are closed out within five
days after T+3. In addition, fails to deliver may arise from either
short or long sales of securities. There may be legitimate reasons
for a fail to deliver. For example, human or mechanical errors or
processing delays can result from transferring securities in
custodial or other form rather than book-entry form, thereby causing
a fail to deliver on a long sale within the normal three-day
settlement period. In addition, broker-dealers that make markets in
a security (``market makers'') and who sell short thinly-traded,
illiquid stock in response to customer demand may encounter
difficulty in obtaining securities when the time for delivery
arrives. The Commission's Office of Economic Analysis (``OEA'')
estimates that, on an average day between May 1, 2007 and July 31,
2008 (i.e., the time period that includes all full months after the
Commission started receiving price data from NSCC), trades in
``threshold securities,'' as defined in Rule 203(b)(c)(6) of
Regulation SHO, that fail to settle within T+3 account for
approximately 0.3% of dollar value of trading in all equity
securities.
\10\ 17 CFR 242.200. Regulation SHO became effective on January
3, 2005.
\11\ See 2007 Regulation SHO Final Amendments, 72 FR at 45544
(stating that ``[a]mong other things, Regulation SHO imposes a
close-out requirement to address persistent failures to deliver
stock on trade settlement date and to target potentially abusive
``naked'' short selling in certain equity securities.'').
\12\ 17 CFR 242.203(b). Market makers engaged in bona fide
market making in the security at the time they effect the short sale
are excepted from this requirement.
\13\ See 2004 Regulation SHO Adopting Release, 69 FR at 48014.
\14\ See, e.g., Sandell Asset Management Corp., Lars Eric Thomas
Sandell, Patrick T. Burke and Richard F. Ecklord, Securities Act
Release No. 8857 (Oct. 10, 2007) (settled order).
---------------------------------------------------------------------------
In addition, we are concerned that some short sellers may have made
misrepresentations to their broker-dealers about their ownership of
shares as an end run around Regulation SHO's locate requirement.\15\
Some sellers have also misrepresented that their sales are long sales
in order to circumvent Rule 105 of Regulation M,\16\ which prohibits
certain short sellers from purchasing securities in a secondary or
follow-on offering.\17\ Under Rule 200(g)(1) of Regulation SHO, ``[a]n
order to sell shall be marked `long' only if the seller is deemed to
own the security being sold pursuant to paragraphs (a) through (f) of
this section \18\ and either: (i) The security to be delivered is in
the physical possession or control of the broker or dealer; or (ii) it
is reasonably expected that the security will be in the physical
possession or control of the broker or dealer no later than the
settlement of the transaction.'' \19\
---------------------------------------------------------------------------
\15\ See id.
\16\ 17 CFR 242.105.
\17\ See Goldman Sachs Execution and Clearing L.P., Exchange Act
Release No. 55465 (Mar. 14, 2007) (settled order); Weitz and Altman,
Lit. Release No. 18121 (April 30, 2003) (settled civil action).
\18\ Rule 200(b) of Regulation SHO provides that a seller is
deemed to own a security if, ``(1) The person or his agent has title
to it; or (2) The person has purchased, or has entered into an
unconditional contract, binding on both parties thereto, to purchase
it, but has not yet received it; or (3) The person owns a security
convertible into or exchangeable for it and has tendered such
security for conversion or exchange; or (4) The person has an option
to purchase or acquire it and has exercised such option; or (5) The
person has rights or warrants to subscribe to it and has exercised
such rights or warrants; or (6) The person holds a security futures
contract to purchase it and has received notice that the position
will be physically settled and is irrevocably bound to receive the
underlying security.''
\19\ 17 CFR 242.200(g)(1).
---------------------------------------------------------------------------
Under Regulation SHO, the executing or introducing broker-dealer is
responsible for determining whether there are reasonable grounds to
believe that a security can be borrowed so that it can be delivered on
the date delivery is due on a short sale, and whether a seller owns the
security being sold and can reasonably expect that the security will be
in the physical possession or control of the broker-dealer no later
than settlement date for a long sale. However, a broker-dealer relying
on a customer that makes misrepresentations about its locate source or
ownership of shares may not receive shares when delivery is due. For
example, sellers may be making misrepresentations to their broker-
dealers about their locate sources or ownership of shares for
securities that are very difficult or expensive to borrow. Such sellers
may know that they cannot deliver securities by settlement date due to,
for example, a limited number of shares being available to borrow or
purchase, or they may not intend to obtain shares for timely delivery
because the cost of borrowing or purchasing may be high. That result
undermines the Commission's goal of addressing concerns related to
``naked'' short selling and extended fails to deliver.
B. Concerns About ``Naked'' Short Selling
We have been concerned about ``naked'' short selling and, in
particular, abusive ``naked'' short selling, for some time. As
discussed above, our concerns about potentially abusive ``naked'' short
selling were an important reason for our adoption of Regulation SHO in
2004. In addition, due to our concerns about the potentially negative
market impact of large and persistent fails to deliver, and the fact
that we continued to observe a small number of threshold securities
\20\ with fail to deliver positions that were not being closed out
under existing delivery and settlement requirements, in 2007 we
eliminated the ``grandfather'' exception to Regulation SHO's close-out
requirement \21\ and today we adopted amendments to eliminate the
options market maker exception to the close-out requirement.\22\
---------------------------------------------------------------------------
\20\ A ``threshold security'' is defined in Rule 203(c)(6) as
any equity security of an issuer that is registered pursuant to
section 12 of the Exchange Act (15 U.S.C. 78l) or for which the
issuer is required to file reports pursuant to section 15(d) of the
Exchange Act (15 U.S.C. 78o(d)): (i) For which there is an aggregate
fail to deliver position for five consecutive settlement days at a
registered clearing agency of 10,000 shares or more, and that is
equal to at least 0.5% of the issue's total shares outstanding; and
(ii) that is included on a list disseminated to its members by a
self-regulatory organization. 17 CFR 242.203(c)(6).
\21\ See 2007 Regulation SHO Final Amendments, 72 FR 45544. The
``grandfather'' exception had provided that fails to deliver
established prior to a security becoming a threshold security did
not have to be closed out in accordance with Regulation SHO's close-
out requirement. This amendment also contained a one-time phase-in
period that provided that previously-grandfathered fails to deliver
in a security that was a threshold security on the effective date of
the amendment must be closed out within 35 consecutive settlement
days from the effective date of the amendment. The phase-in period
ended December 5, 2007.
\22\ See Exchange Act Release No. 34-58775 (Oct. 14, 2008)
(``2008 Regulation SHO Final Amendments''). The options market maker
exception had excepted from the close-out requirement any fail to
deliver position in a threshold security resulting from short sales
effected by a registered options market maker to establish or
maintain a hedge on options positions that were created before the
underlying security became a threshold security.
---------------------------------------------------------------------------
In addition to the actions we have taken aimed at reducing fails to
deliver and addressing potentially abusive ``naked'' short selling in
threshold securities, recently we took emergency action targeting
``naked'' short selling in some non-threshold securities. Specifically,
on July 15, 2008, we published an emergency order under Section 12(k)
of the Exchange Act (the ``July Emergency Order'') \23\ that
temporarily imposed enhanced requirements on short sales in the
publicly traded securities of certain substantial financial firms.\24\
---------------------------------------------------------------------------
\23\ See Exchange Act Release No. 58166 (July 15, 2008).
\24\ See id. The Emergency Order required that, in connection
with transactions in the publicly traded securities of the
substantial financial firms identified on Appendix A to the
Emergency Order (``Appendix A Securities''), no person could effect
a short sale in the Appendix A Securities using the means or
instrumentalities of interstate commerce unless such person or its
agent had borrowed or arranged to borrow the security or otherwise
had the security available to borrow in its inventory prior to
effecting such short sale and delivered the security on settlement
date.
---------------------------------------------------------------------------
We issued the July Emergency Order because we were concerned that
false rumors spread by short sellers regarding financial institutions
of significance in the U.S. could continue to threaten significant
market disruption. As we
[[Page 61669]]
noted in the July Emergency Order, false rumors can lead to a loss of
confidence in our markets. Such loss of confidence can lead to panic
selling, which may be further exacerbated by ``naked'' short selling.
As a result, the prices of securities may artificially and
unnecessarily decline well below the price level that would have
resulted from the normal price discovery process. If significant
financial institutions are involved, this chain of events can threaten
disruption of our markets.\25\
---------------------------------------------------------------------------
\25\ We delayed the effective date of the Emergency Order to
July 21, 2008 to create the opportunity to address, and to allow
sufficient time for market participants to make, adjustments to
their operations to implement the enhanced requirements. Moreover,
in addressing anticipated operational accommodations necessary for
implementation of the Emergency Order, we issued an amendment to the
Emergency Order on July 18, 2008. See Exchange Act Release No. 58190
(July 18, 2008) (excepting from the Emergency Order bona fide market
makers, short sales in Appendix A Securities sold pursuant to Rule
144 of the Securities Act of 1933, and certain short sales by
underwriters, or members of a syndicate or group participating in
distributions of Appendix A Securities).
---------------------------------------------------------------------------
On July 29, 2008, we extended the July Emergency Order after
carefully reevaluating the current state of the markets in consultation
with officials of the Board of Governors of the Federal Reserve System,
the Department of the Treasury, and the Federal Reserve Bank of New
York. Due to our continued concerns about the ongoing threat of market
disruption and effects on investor confidence, we determined that the
standards of extension had been met.\26\ Pursuant to the extension, the
July Emergency Order terminated at 11:59 p.m. EDT on August 12,
2008.\27\
---------------------------------------------------------------------------
\26\ See Exchange Act Release No. 58248 (July 29, 2008).
\27\ In addition, on September 17, 2008, the Commission further
addressed abusive ``naked'' short selling by issuing an Emergency
Order that temporarily adopted amendments to Regulation SHO's close-
out requirement, amendments to eliminate Regulation SHO's options
market maker exception to the close-out requirement, and Rule 10b-
21. See Exchange Act Release No. 58572 (Sept. 17, 2008). The
Commission also issued emergency orders to require disclosure of
short sales, Exchange Act Release 58591 (Sept. 18, 2008) and 58591A
(Sept. 21, 2008), and temporarily halt short selling in financial
stocks, Exchange Act Release 58592 (Sept. 18, 2008) and Exchange Act
Release 58611 (Sept. 21, 2008).
---------------------------------------------------------------------------
In addition to our adopting Rule 10b-21, as noted above, today we
also adopted amendments to eliminate the options market maker exception
to Regulation SHO's delivery requirement.\28\ We also adopted today an
interim final temporary rule that enhances the delivery requirements
for sales of all equity securities (``2008 Interim Rule'').\29\
---------------------------------------------------------------------------
\28\ See supra note 22.
\29\ See Exchange Act Release No. 58773 (Oct. 14, 2008).
---------------------------------------------------------------------------
The amendments to the options market maker exception and the 2008
Interim Rule that we adopted today both focus on the timely delivery of
securities and are not aimed at pre-trade activity, such as compliance
with Regulation SHO's locate requirement. Because we continue to be
concerned about fails to deliver and potentially abusive ``naked''
short selling, in addition to our initiatives to strengthen Regulation
SHO's delivery requirements, we are adopting Rule 10b-21 to also target
sellers who deceive their broker-dealers or certain other persons about
their source of borrowable shares and their share ownership.
As we stated in the Proposing Release,\30\ we are concerned about
persons that sell short securities and deceive specified persons about
their intention or ability to deliver the securities in time for
settlement, or deceive their broker-dealer about their locate source or
ownership of shares. Commission enforcement actions have contributed to
our concerns about the extent of misrepresentations by short sellers
about their locate sources and ownership of shares, regardless of
whether they result in fails to deliver. For example, the Commission
recently announced a settled enforcement action against hedge fund
adviser Sandell Asset Management Corp. (``SAM''), its chief executive
officer, and two employees in connection with allegedly (i) improperly
marking some short sale orders ``long'' and (ii) misrepresenting to
executing brokers that SAM personnel had located sufficient stock to
borrow for short sale orders.\31\
---------------------------------------------------------------------------
\30\ Exchange Act Release No. 57511 (Mar. 17, 2008), 73 FR
15376, 15377 (Mar. 21, 2008) (``Proposing Release'').
\31\ See Sandell Asset Management Corp., Securities Act Release
No. 8857; see also Goldman Sachs Execution and Clearing L.P.,
Exchange Act Release No. 55465; U.S. v. Naftalin, 441 U.S. 768
(1979) (discussing a market manipulation scheme in which brokers
suffered substantial losses when they had to purchase securities to
replace securities they had borrowed to make delivery on short sale
orders received from an individual investor who had falsely
represented to the brokers that he owned the securities being sold).
---------------------------------------------------------------------------
In addition, as we have stated on several prior occasions, we are
concerned about the negative effect that fails to deliver may have on
the markets and shareholders.\32\ For example, fails to deliver may
deprive shareholders of the benefits of ownership, such as voting and
lending.\33\ In addition, where a seller of securities fails to deliver
securities on settlement date, in effect the seller unilaterally
converts a securities contract (which is expected to settle within the
standard three-day settlement period) into an undated futures-type
contract, to which the buyer might not have agreed, or that might have
been priced differently.\34\
---------------------------------------------------------------------------
\32\ See supra note 22; 2007 Regulation SHO Final Amendments, 72
FR at 45544; 2006 Regulation SHO Proposed Amendments, 71 FR at
41712; 2007 Regulation SHO Proposed Amendments, 72 FR at 45558-
45559; Proposing Release, 73 FR at 15378.
\33\ See id.
\34\ See id.
---------------------------------------------------------------------------
In addition, commenters (including issuers and investors) have
repeatedly expressed concerns about fails to deliver in connection with
manipulative ``naked'' short selling. For example, in response to
proposed amendments to Regulation SHO in 2006 \35\ designed to further
reduce the number of persistent fails to deliver in certain equity
securities by eliminating Regulation SHO's ``grandfather'' exception,
and amending the options market maker exception, we received a number
of comments that expressed concerns about ``naked'' short selling and
extended delivery failures.\36\ Commenters continued to express these
concerns in response to proposed amendments to eliminate the options
market maker exception to the close-out requirement of Regulation SHO
in 2007 \37\ and in response to the Proposing Release.\38\
---------------------------------------------------------------------------
\35\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
\36\ See, e.g., letter from Patrick M. Byrne, Chairman and Chief
Executive Officer, Overstock.com, Inc., dated Sept. 11, 2006
(``Overstock''); letter from Daniel Behrendt, Chief Financial
Officer, and Douglas Klint, General Counsel, TASER International,
dated Sept. 18, 2006 (``TASER''); letter from John Royce, dated
April 30, 2007 (``Royce''); letter from Michael Read, dated April
29, 2007 (``Read''); letter from Robert DeVivo, dated April 26, 2007
(``DeVivo''); letter from Ahmed Akhtar, dated April 26, 2007
(``Akhtar'').
\37\ See, e.g., letter from Jack M. Wedam, dated Oct. 16, 2007;
letter from Michael J. Ryan, Executive Director and Senior Vice
President, Center for Capital Markets Competitiveness, U.S. Chamber
of Commerce, dated Sept. 13, 2007 (``U.S. Chamber of Commerce'');
letter from Robert W. Raybould, CEO Enteleke Capital Corp., dated
Sept. 12, 2007; letter from Mary Helburn, Executive Director,
National Coalition Against Naked Shorting, dated Sept. 11, 2007
(``NCANS 2007'').
\38\ See, e.g., letter from Richard H. Baker, President and
Chief Executive Officer, Managed Funds Association, dated May 21,
2008 (``MFA'') (stating that ``[m]arket manipulation, such as
intentional and abusive naked short selling, undermines the
integrity of the U.S. capital markets and threatens investor
confidence, market liquidity and market efficiency''); letter from
Kurt N. Schacht and Linda Rittenhouse, Centre for Financial Market
Integrity, dated June 17, 2008 (stating that they ``support efforts
by the Commission to curtail naked short selling, for all the
reasons noted in the [Proposing Release] relating to the detrimental
effects on the marketplace. As noted [in the Proposing Release],
this practice not only affects shareowners by depriving the[m] of
the basic benefits of ownership, it also may detrimentally affect
the issuer's reputation and subvert the appropriate workings of the
market by avoiding certain restrictions applicable to those who
deliver on time. All of these issues can ultimately undermine
investor confidence.''); letter from Wallace E. Boston, President
and Chief Executive Officer, American Public Education, Inc., dated
May 20, 2008 (noting that ``[a]s the CEO of a recently public
company, I am acutely aware of the impact that abusive short-selling
can have on issuers and investors.'').
---------------------------------------------------------------------------
[[Page 61670]]
To the extent that fails to deliver might be part of manipulative
``naked'' short selling, which could be used as a tool to drive down a
company's stock price,\39\ such fails to deliver may undermine the
confidence of investors.\40\ These investors, in turn, may be reluctant
to commit capital to an issuer they believe to be subject to such
manipulative conduct.\41\ In addition, issuers may believe that they
have suffered unwarranted reputational damage due to investors'
negative perceptions regarding fails to deliver in the issuer's
security.\42\ Unwarranted reputational damage caused by fails to
deliver might have an adverse impact on the security's price.\43\
---------------------------------------------------------------------------
\39\ See, e.g., Rhino Advisors, Inc. and Thomas Badian, Lit.
Rel. No. 18003 (Feb. 27, 2003); see also SEC v. Rhino Advisors, Inc.
and Thomas Badian, Civ. Action No. 03 civ 1310 (RO) (S.D.N.Y) (Feb.
26, 2003) (settled case in which we alleged that the defendants
profited from engaging in massive ``naked'' short selling that
flooded the market with the company's stock, and depressed its
price); see also S.E.C. v. Gardiner, 48 S.E.C. Docket 811, No. 91
Civ. 2091 (S.D.N.Y. 1991) (alleged manipulation by sales
representative by directing or inducing customers to sell stock
short in order to depress its price); U.S. v. Russo, 74 F.3d 1383,
1392 (2d Cir. 1996) (short sales were sufficiently connected to the
manipulation scheme as to constitute a violation of Exchange Act
Section 10(b) and Rule 10b-5).
\40\ In response to the 2007 Regulation SHO Proposed Amendments,
we received comment letters discussing the impact of fails to
deliver on investor confidence. See, e.g., letter from NCANS 2007.
Commenters expressed similar concerns in response to the 2006
Regulation SHO Proposed Amendments. See, e.g., letter from Mary
Helburn, Executive Director, National Coalition Against Naked
Shorting, dated Sept. 30, 2006 (``NCANS 2006''); letter from Richard
Blumenthal, Attorney General, State of Connecticut, dated Sept. 19,
2006.
\41\ In response to the 2007 Regulation SHO Proposed Amendments,
we received comment letters expressing concern about the impact of
potential ``naked'' short selling on capital formation, claiming
that ``naked'' short selling causes a drop in an issuer's stock
price and may limit the issuer's ability to access the capital
markets. See, e.g., letter from Robert K. Lifton, Chairman and CEO,
Medis Technologies, Inc., dated Sept. 12, 2007; letter from NCANS
2007. Commenters expressed similar concerns in response to the 2006
Regulation SHO Proposed Amendments. See, e.g., letter from
Congressman Tom Feeney--Florida, U.S. House of Representatives,
dated Sept. 25, 2006; see also letter from Zix Corporation, dated
Sept. 19, 2006 (stating that ``[m]any investors attribute the
Company's frequent re-appearances on the Regulation SHO list to
manipulative short selling and frequently demand that the Company
``do something'' about the perceived manipulative short selling.
This perception that manipulative short selling of the Company's
securities is continually occurring has undermined the confidence of
many of the Company's investors in the integrity of the market for
the Company's securities.'').
\42\ Due in part to such concerns, some issuers have taken
actions to attempt to make transfer of their securities ``custody
only,'' thus preventing transfer of their stock to or from
securities intermediaries such as the Depository Trust Company
(``DTC'') or broker-dealers. See 2003 Regulation SHO Proposing
Release, 68 FR at 62975. Some issuers have attempted to withdraw
their issued securities on deposit at DTC, which makes the
securities ineligible for book-entry transfer at a securities
depository. See id. Withdrawing securities from DTC or requiring
custody-only transfers would undermine the goal of a national
clearance and settlement system designed to reduce the physical
movement of certificates in the trading markets. See id. We note,
however, that in 2003 the Commission approved a DTC rule change
clarifying that its rules provide that only its participants may
withdraw securities from their accounts at DTC, and establishing a
procedure to process issuer withdrawal requests. See Exchange Act
Release No. 47978 (June 4, 2003), 68 FR 35037 (June 11, 2003).
\43\ See also 2006 Regulation SHO Proposed Amendments, 71 FR at
41712; 2007 Regulation SHO Amendments, 72 FR at 45544; 2007
Regulation SHO Proposed Amendments, 72 FR at 45558-45559; Proposing
Release, 73 FR at 15378 (providing additional discussion of the
impact of fails to deliver on the market); see also 2003 Regulation
SHO Proposing Release, 68 FR at 62975 (discussing the impact of
``naked'' short selling on the market).
---------------------------------------------------------------------------
Strengthening rules that address ``naked'' short selling will
provide increased confidence in the markets. Since the issuance of the
July Emergency Order, members of the public have repeatedly expressed
their concerns about a loss of confidence in the markets. For example,
one commenter stated that ``financial confidence is critically
important'' for companies to do business.\44\ Another commenter stated
that ``existing laws should be enforced, but further steps should be
taken to prevent any further erosion of the investing publics [sic]
confidence.'' \45\
---------------------------------------------------------------------------
\44\ See Comment of Ron Heller (July 21, 2008) (``Heller'')
(commenting on the Emergency Order).
\45\ See Comment of Ronald L. Rourk (July 21, 2008) (``Rourk'')
(commenting on the proposal to eliminate Regulation SHO's options
market maker exception).
---------------------------------------------------------------------------
We are concerned about the ability of short sellers to use
``naked'' short selling as a tool to manipulate the prices of
securities.\46\ Thus, in conjunction with our other short selling
initiatives aimed at further reducing fails to deliver and addressing
abusive ``naked'' short selling, we have adopted Rule 10b-21
substantially as proposed.
---------------------------------------------------------------------------
\46\ See, e.g., Commission press release, dated July 13, 2008,
announcing that the Commission's Office of Compliance Inspections
and Examinations, as well as FINRA and New York Stock Exchange
Regulation, Inc., will immediately conduct examinations aimed at the
prevention of the intentional spreading of false information
intended to manipulate securities prices. See http://www.sec.gov/
news/press/2008/2008-140.htm. In addition, in April of this year,
the Commission charged Paul S. Berliner, a trader, with securities
fraud and market manipulation for intentionally disseminating a
false rumor concerning The Blackstone Group's acquisition of
Alliance Data Systems Corp (``ADS''). The Commission alleged that
this false rumor caused the price of ADS stock to plummet, and that
Berliner profited by short selling ADS stock and covering those
sales as the false rumor caused the price of ADS stock to fall. See
http://www.sec.gov/litigation/litreleases/2008/lr20537.htm.
---------------------------------------------------------------------------
Proposed Rule 10b-21 was narrowly tailored to specify that it is
unlawful for any person to submit an order to sell a security if such
person deceives a broker-dealer, participant of a registered clearing
agency,\47\ or purchaser regarding its intention or ability to deliver
the security on the date delivery is due, and such person fails to
deliver the security on or before the date delivery is due.\48\ We
received over 700 comment letters in response to the Proposing Release.
---------------------------------------------------------------------------
\47\ The term ``participant'' has the same meaning as in section
3(a)(24) of the Exchange Act. See 15 U.S.C. 78c(a)(24). The term
``registered clearing agency'' means a clearing agency, as defined
in section 3(a)(23) of the Exchange Act, that is registered as such
pursuant to section 17A of the Exchange Act. See 15 U.S.C.
78c(a)(23)(A), 78q-1 and 15 U.S.C. 78q-1(b), respectively.
\48\ See Proposed Rule 10b-21.
---------------------------------------------------------------------------
The comment letters were from numerous entities, including issuers,
retail investors, broker-dealers, SROs, associations, members of
Congress, and other elected officials.\49\ Many commenters supported
our goals of further addressing potentially abusive ``naked'' short
selling and fails to deliver, while not necessarily agreeing with the
Commission's approach. For example, some commenters argued for more
stringent short sale regulation.\50\ Others urged us to take stronger
enforcement action against abusive ``naked'' short sellers under the
current federal securities laws rather than, or in addition to,
adopting Rule 10b-21.\51\
[[Page 61671]]
Some commenters asked that if we adopt Rule 10b-21 as proposed, we
provide certain clarifications regarding the application of the
rule.\52\ We highlight in the discussion below some of the main issues,
concerns, and suggestions raised in the comment letters.
---------------------------------------------------------------------------
\49\ The comment letters are available on the Commission's
Internet Web Site at http://www.sec.gov/comments/s7-08-08/
s70808.shtml.
\50\ See, e.g., letter from Arik B. Fetscher, Esq., dated April
2, 2008; letter from Fred Adams, Jr., Chairman and Chief Executive
Officer, Cal-Maine Foods, Inc., dated May 19, 2008; letter from
David T. Hirschman, President and Chief Executive Officer, Center
for Capital Markets Competitiveness, United States Chamber of
Commerce, dated May 20, 2008 (``Chamber of Commerce''); letter from
Wallace E. Boston, Jr., President and Chief Executive Officer,
American Public Education, Inc., dated May 20, 2008; letter from
Kurt N. Schacht, Executive Director, and Linda L. Rittenhouse,
Senior Policy Analyst, CFA Institute Centre for Financial Market
Integrity, dated June 17, 2008; letter from Guillaume Cloutier,
dated July 25, 2008; letter from Shunliang Wang, dated July 27,
2008; letter from Scott Bridgford, dated July 29, 2008; letter from
Keith Kottwitz, dated Aug. 1, 2008.
\51\ See, e.g., letter from Tony J. Akin, Jr., Financial
Advisor, dated March 31, 2008; letter from Gary D. Owens, CEO, OYO
Geospace, dated April 22, 2008; letter from Daniel J. Popeo,
Chairman & General Counsel, and Paul D. Kamenar, Senior Executive
Counsel, Washington Legal Foundation, dated May 20, 2008; letter
from David Hughes, dated July 17, 2008; letter from Dave Morgan,
dated July 25, 2008; letter from Seth Bradley, dated July 30, 2008;
letter from Michael Kianka, dated Aug. 1, 2008.
\52\ See, e.g., letter from James J. Angel, Associate Professor
of Finance, Georgetown University, dated May 17, 2008 (``Angel'');
letter from Heather Traeger, Assistant Counsel, Investment Company
Institute, dated May 20, 2008; letter from Dr. Robert J. Shapiro,
Chairman, Sonecon, LLC, and former U.S. Under Secretary of Commerce,
dated May 20, 2008 (``Shapiro''); letter from Ira D. Hammerman,
Managing Director and General Counsel, Securities Industry and
Financial Markets Association, dated May 22, 2008 (``SIFMA'');
letter from Michael R. Trocchio, Bingham McCutchen LLP, dated July
14, 2008 (``Bingham''); letter from MFA.
---------------------------------------------------------------------------
III. Discussion of Rule 10b-21
A. Rule 10b-21
After careful consideration of the comments, we are adopting Rule
10b-21 substantially as proposed. Rule 10b-21 specifies that it is
unlawful for any person to submit an order to sell an equity security
if such person deceives a broker-dealer, participant of a registered
clearing agency,\53\ or purchaser regarding its intention or ability to
deliver the security on the date delivery is due, and such person fails
to deliver the security on or before the date delivery is due.\54\
Scienter is a necessary element for a violation of the rule.\55\ Some
commenters questioned whether, similar to Regulation SHO, proposed Rule
10b-21 would apply only to equity securities.\56\ In response to these
comments, we clarify that as proposed and adopted, Rule 10b-21 applies
only to equity securities.\57\
---------------------------------------------------------------------------
\53\ See supra note 47 (defining the terms ``participant'' and
``registered clearing agency'' for purposes of the rule).
\54\ See Rule 10b-21.
\55\ Ernst & Ernst v. Hochfelder, et al., 425 U.S. 185 (1976).
Scienter has been defined as ``a mental state embracing the intent
to deceive, manipulate or defraud.'' Id. at 193, n.12. While the
Supreme Court has not decided the issue (see Aaron v. SEC, 446 U.S.
686 (1980); Ernst & Ernst, 425 at 193 n.12), federal appellate
courts have concluded that scienter may be established by a showing
of either knowing conduct or by ``an `extreme departure from the
standards of ordinary care * * * which presents a danger of
misleading buyers or sellers that is either known to the defendant
or is so obvious that the actor must have been aware of it.' ''
Dolphin & Bradbury v. SEC, 512 F.3d 634 (D.C. Cir. Jan. 11, 2008)
(quoting Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045
(7th Cir. 1977)). Some commenters stated they believe that Rule 10b-
21 should require a finding of ``intentional deception'' to best
achieve our goals without deterring legitimate short selling. See,
e.g., letter from MFA; another commenter, however, requested that we
confirm that the concept of scienter, for purposes of Rule 10b-21,
is identical to established precedent under Section 10(b) of the
Exchange Act and Rule 10b-5 thereunder. See letter from SIFMA. We
intend the scienter requirement of Rule 10b-21 to be the same as
that required under Rule 10b-5.
\56\ See, e.g., letter from MFA.
\57\ See, e.g., Proposing Release, 73 FR at 15380; see also Rule
10b-21.
---------------------------------------------------------------------------
Rule 10b-21 will cover those situations where a seller deceives a
broker-dealer, participant of a registered clearing agency, or a
purchaser about its intention to deliver securities by settlement date,
its locate source, or its share ownership, and the seller fails to
deliver securities by settlement date.\58\ Rule 10b-21 will prohibit
the deception of persons participating in the transaction--broker-
dealers, participants of registered clearing agencies, or purchasers.
Further, because one of the principal goals of Rule 10b-21 is to reduce
fails to deliver, violation of the rule will occur only if a fail to
deliver results from the relevant transaction.
---------------------------------------------------------------------------
\58\ As proposed, the rule referenced ``the date delivery is
due.'' To provide specificity as to when delivery is due for
purposes of the rule, we are modifying this language to ``settlement
date'' and defining ``settlement date'' as ``the business day on
which delivery of a security and payment of money is to be made
through the facilities of a registered clearing agency in connection
with the sale of a security.'' See Rule 10b-21(b).
---------------------------------------------------------------------------
For purposes of Rule 10b-21, broker-dealers (including market
makers) acting for their own accounts will be considered sellers. For
example, a broker-dealer effecting short sales for its own account will
be liable under the rule if it does not obtain a valid locate source
and fails to deliver securities to the purchaser. Such broker-dealers
defraud purchasers that may not receive delivery on time, in effect
unilaterally forcing the purchaser into accepting an undated futures-
type contract.\59\
---------------------------------------------------------------------------
\59\ See supra note 22; 2007 Regulation SHO Final Amendments, 72
FR at 45544; 2006 Regulation SHO Proposed Amendments, 71 FR at
41712; 2007 Regulation SHO Proposed Amendments, 72 FR at 45558-
45559.
---------------------------------------------------------------------------
As noted above, under Regulation SHO, the executing or introducing
broker-dealer is responsible for determining whether there are
reasonable grounds to believe that a security can be borrowed so that
it can be delivered on the date delivery is due on a short sale.\60\ In
the 2004 Regulation SHO Adopting Release, the Commission explicitly
permitted broker-dealers to rely on customer assurances that the
customer has identified its own locate source, provided it is
reasonable for the broker-dealer to do so.\61\ If a seller elects to
provide its own locate source to a broker-dealer, the seller is
representing that it has contacted that source and reasonably believes
that the source can or intends to deliver the full amount of the
securities to be sold short by settlement date. In addition, if a
seller enters a short sale order into a broker-dealer's direct market
access or sponsored access system (``DMA'') with any information
purporting to identify a locate source obtained by the seller, the
seller makes a representation to a broker-dealer for purposes of Rule
10b-21.\62\
---------------------------------------------------------------------------
\60\ See 17 CFR 242.203(b)(3)(1).
\61\ See 2004 Regulation SHO Adopting Release, 69 FR at 48014.
\62\ Broker-dealers offer DMA to some customers by providing
them with electronic access to a market's execution system using the
broker-dealer's market participant identifier. The broker-dealer,
however, retains the ultimate responsibility for the trading
activity of its customer.
---------------------------------------------------------------------------
If a seller deceives a broker-dealer about the validity of its
locate source, the seller will be liable under Rule 10b-21 if the
seller also fails to deliver securities by the date delivery is due.
For example, a seller will be liable for a violation of Rule 10b-21 if
it represented that it had identified a source of borrowable
securities, but the seller never contacted the purported source to
determine whether shares were available and could be delivered in time
for settlement and the seller fails to deliver securities by settlement
date. A seller will also be liable if it contacted the source and
learned that the source did not have sufficient shares for timely
delivery, but the seller misrepresented that the source had sufficient
shares that it could deliver in time for settlement and the seller
fails to deliver securities by settlement date; or, if the seller
contacted the source and the source had sufficient shares that it could
deliver in time for settlement, but the seller never instructed the
source to deliver the shares in time for settlement and the seller
otherwise refused to deliver shares on settlement date such that the
sale results in a fail to deliver.
One commenter recommended that the rule focus on whether there is a
fail to deliver in the Continuous Net Settlement (``CNS'') system,
rather than on a seller's failure to deliver the securities sold.\63\
The majority of equity trades in the United States are cleared and
settled through systems administered by clearing agencies registered
with the Commission. The NSCC clears and settles the majority of equity
securities trades conducted on the exchanges and in the over the
counter market. NSCC clears and settles trades through the CNS system,
which nets the securities delivery and payment obligations of all of
its members. The majority of NSCC's members are broker-
[[Page 61672]]
dealers.\64\ NSCC notifies its members of their securities delivery and
payment obligations daily. In addition, NSCC guarantees the completion
of all transactions and interposes itself as the contraparty to both
sides of the transaction. This commenter noted that a seller's clearing
broker generally bears the responsibility to meet the firm's CNS
delivery requirement and that it is difficult for a broker-dealer to
determine which customer transactions or accounts give rise to a fail
to deliver in the CNS system. We note, however, that Rule 10b-21 as
proposed was not based on whether a fail to deliver occurred in CNS.
Rather, the rule as proposed was concerned with whether an individual
seller delivered securities that it sold. Along those lines, another
commenter stated that the proposed rule should require a failure to
deliver by the seller.\65\
---------------------------------------------------------------------------
\63\ See letter from SIFMA.
\64\ As of July 31, 2008 approximately 91% of members of the
NSCC were registered as broker-dealers.
\65\ See letter from Bingham.
---------------------------------------------------------------------------
We have determined to adopt the rule as proposed. The rule targets
the misconduct of sellers. As discussed above, sellers should promptly
deliver the securities they have sold and purchasers have the right to
the timely receipt of securities that they have purchased. Thus, Rule
10b-21's focus is on whether or not there is a fail to deliver by the
seller, rather than on whether or not there is a fail to deliver in the
CNS system. Because fails to deliver in the CNS system are netted with
pending deliveries, some sellers may be able to postpone delivery if
another customer's purchase is received the same day. Thus, a person
engaging in abusive ``naked'' short selling may be able to avoid
detection for a period of time. This would undermine our goal of
addressing abusive ``naked'' short selling.
B. Seller's Reliance on a Broker-Dealer or ``Easy to Borrow'' Lists
Rule 10b-21 provides that it shall be unlawful for any person to
submit an order to sell an equity security if such person deceives a
broker-dealer, participant of a registered clearing agency, or
purchaser regarding its intention or ability to deliver the security on
the date delivery is due.\66\ Thus, as we discussed in the Proposing
Release,\67\ if a seller is relying on a broker-dealer to comply with
Regulation SHO's locate obligation and to make delivery on a sale, the
seller would not be representing at the time it submits an order to
sell a security that it can or intends to deliver securities on the
date delivery is due. For example, a seller might be relying on its
broker-dealer to borrow or arrange to borrow the security to make
delivery by settlement date. Alternatively, a seller might be relying
on a broker-dealer's ``Easy to Borrow'' list. If a seller in good faith
relies on a broker-dealer's ``Easy to Borrow'' list to satisfy the
locate requirement, the seller would not be deceiving the broker-dealer
at the time it submits an order to sell a security that it can or
intends to deliver securities on the date delivery is due. In
discussing the locate requirement of Regulation SHO, in the 2004
Regulation SHO Adopting Release, the Commission stated that ``absent
countervailing factors, `Easy to Borrow' lists may provide `reasonable
grounds' for a broker-dealer to believe that the security sold short is
available for borrowing without directly contacting the source of the
borrowed securities.'' \68\
---------------------------------------------------------------------------
\66\ See Rule 10b-21.
\67\ See Proposing Release, 73 FR at 15379.
\68\ 2004 Regulation SHO Adopting Release, 69 FR at 48014.
---------------------------------------------------------------------------
C. Bona Fide Market Makers
As we discussed in the Proposing Release,\69\ a market maker
engaged in bona fide market making activity would not be making a
representation at the time it submits an order to sell short that it
can or intends to deliver securities on the date delivery is due,
because such market makers are excepted from the locate requirement of
Regulation SHO. Regulation SHO excepts from the locate requirement
market makers engaged in bona-fide market making activities because
market makers need to facilitate customer orders in a fast moving
market without possible delays associated with complying with the
locate requirement.\70\ Thus, at the time of submitting an order to
sell short, market makers that have an exception from the locate
requirement of Regulation SHO may know that they may not be able to
deliver securities on the date delivery is due.
---------------------------------------------------------------------------
\69\ See Proposing Release, 73 FR at 15379.
\70\ See 2004 Regulation SHO Adopting Release, 69 FR at 48015,
n. 67; see also 2008 Regulation SHO Final Amendments, supra note 22
(providing interpretive guidance regarding bona fide market making
activities for purposes of Regulation SHO).
---------------------------------------------------------------------------
D. ``Long'' Sales
Under Rule 10b-21, a seller will be liable if it deceives a broker-
dealer, participant of a registered clearing agency, or purchaser about
its ownership of shares or the deliverable condition of owned shares
and fails to deliver securities by settlement date.\71\ As we discussed
in the Proposing Release,\72\ a seller will be liable for a violation
of Rule 10b-21 for causing a broker-dealer to mark an order to sell a
security ``long'' if the seller knows or recklessly disregards that it
is not ``deemed to own'' the security being sold, as defined in Rules
200(a) through (f) of Regulation SHO \73\ or if the seller knows or
recklessly disregards that the security being sold is not, or cannot
reasonably be expected to be, in the broker-dealer's physical
possession or control by the date delivery is due, and the seller fails
to deliver the security by settlement date.
---------------------------------------------------------------------------
\71\ See Rule 10b-21.
\72\ See Proposing Release, 73 FR at 15379.
\73\ 17 CFR 242.200(a)-(f).
---------------------------------------------------------------------------
Broker-dealers acting for their own accounts will also be liable
under Rule 10b-21 for marking an order ``long'' if the broker-dealer
knows or recklessly disregards that it is not ``deemed to own'' the
security being sold or that the security being sold is not, or cannot
reasonably be expected to be, in the broker-dealer's physical
possession or control by the date delivery is due, and the broker-
dealer fails to deliver the security by settlement date.\74\
---------------------------------------------------------------------------
\74\ Such broker-dealers will also be liable under Regulation
SHO Rule 203(a).
---------------------------------------------------------------------------
However, a seller would not be making a representation at the time
it submits an order to sell a security that it can or intends to
deliver securities on the date delivery is due if the seller submits an
order to sell securities that are held in a margin account but the
broker-dealer has loaned out the shares pursuant to the margin
agreement. Under such circumstances, it would be reasonable for the
seller to expect that the securities will be in the broker-dealer's
physical possession or control by settlement date.
E. Rule 10b-21 and Other Antifraud Provisions of the Federal Securities
Laws
One commenter stated that it believes proposed Rule 10b-21 is
unnecessary ``because the Commission already has ample existing
authority, under Section 10(b) of the Exchange Act and Rule 10b-5
thereunder, to prosecute manipulative and/or fraudulent activity,
including the type of activity that proposed Rule 10b-21 seeks to
address.'' \75\ Other commenters urged us to use less formal means than
rulemaking to address our concerns regarding misrepresentations in the
order entry process.\76\ For
[[Page 61673]]
instance, these commenters suggested that the Commission or its staff
could convey this message through FAQs, staff bulletins, and
speeches.\77\ We have determined, however, that the negative effects of
abusive ``naked'' short selling on market confidence warrant formal
Commission action.
---------------------------------------------------------------------------
\75\ See letter from SIFMA; see also letter from Bingham
(stating that ``[t]he Firms agree that the illicit conduct the
Commission seeks to address through [proposed Rule 10b-21] is
already illegal''); letter from MFA.
\76\ See, e.g., letter from Bingham; letter from MFA; but, c.f.,
letter from Chamber of Commerce (noting that although the activity
covered by proposed Rule 10b-21 is already a violation of the
antifraud provisions of the federal securities laws, ``[e]mphasizing
that such deceit violates these laws may deter some of this activity
in the future'').
\77\ See, e.g., letter from Bingham.
---------------------------------------------------------------------------
While ``naked'' short selling as part of a manipulative scheme is
already illegal under the general antifraud provisions of the federal
securities laws, we believe that a rule further evidencing the
illegality of these activities will focus the attention of market
participants on such activities. Rule 10b-21 will also further evidence
that the Commission believes such deceptive activities are detrimental
to the markets and will provide a measure of predictability for market
participants.
Some commenters sought clarification as to how this rule was
different from Rule 10b-5.\78\ We note that the set of factors that
will serve as the basis for a violation of Rule 10b-21 as adopted are
not determinative of a person's obligations under the general antifraud
provisions of the federal securities laws. Accordingly, and in order to
clarify the continued applicability of the general antifraud provisions
outside of the strict context of Rule 10b-21, we have added a
preliminary note to the rule as adopted, which states: ``This rule is
not intended to limit, or restrict, the applicability of the general
antifraud provisions of the federal securities laws, such as section
10(b) of the Act and rule 10b-5 thereunder.'' We added this preliminary
note because we believe it is important to underscore that Rule 10b-21
is not meant, in any way, to limit the general antifraud provisions of
the federal securities laws. Additionally, this preliminary note
provides much needed public clarity in answer to the confusion voiced
by many commenters.
---------------------------------------------------------------------------
\78\ See, e.g., letter from MFA; see also letter from SIFMA
(seeking clarification as to whether the level of scienter in the
proposed rule differs from that of Rule 10b-5).
---------------------------------------------------------------------------
Similarly, we are modifying the proposed rule text slightly to add
the word ``also,'' as follows: ``It shall also constitute a
`manipulative or deceptive device or contrivance' as used in section
10(b) of this Act for any person to submit an order to sell an equity
security if such person deceives a broker or dealer, a participant of a
registered clearing agency, or a purchaser about its intention or
ability to deliver the security on or before the settlement date, and
such person fails to deliver the security on or before the settlement
date.''
We believe the adding the word ``also'' in the rule text further
clarifies that Rule 10b-21 does not affect the operation of Rule 10b-5
or other antifraud rules, but is instead intended to supplement the
existing antifraud rules.
Commenters also raised questions whether there would be a private
right of action for a violation of proposed Rule 10b-21.\79\ We note
that the courts have held that a private right of action exists with
respect to Rule 10b-5 provided the essential elements constituting a
violation of the rule are met.\80\ Thus, a private plaintiff able to
prove all those elements in a situation covered by Rule 10b-21 would be
able to assert a claim under Section 10(b) of the Exchange Act and Rule
10b-5 thereunder.
---------------------------------------------------------------------------
\79\ See, e.g., letter from SIFMA. Another commenter stated that
``[t]he Commission should make explicitly clear that the adoption of
Proposed Rule 10b-21 does not create a private right of action for
violations of the rule. * * *'' See letter from Bingham.
\80\ See, e.g., Superintendent of Insurance v. Bankers Life &
Cas. Co., 404 U.S. 6, 13, n. 9 (1971); Ernst & Ernst, 425 at 196
(citing prior cases).
---------------------------------------------------------------------------
F. Aiding and Abetting Liability
In the Proposing Release, we stated that ``[a]lthough the proposed
rule is primarily aimed at sellers that deceive specified persons about
their intention or ability to deliver shares or about their locate
source and ownership of shares, as with any rule, broker-dealers could
be liable for aiding and abetting a customer's fraud under the proposed
rule.'' \81\ One commenter stated that broker-dealers should not be
held responsible for policing their customer's compliance with their
own legal requirements.\82\ Another commenter urged us to specifically
state that reliance by a broker-dealer on a customer representation
regarding long/short status or receipt of a locate does not rise to the
level of scienter required for aiding and abetting liability.\83\ This
commenter also asked us to make clear that broker-dealers who merely
offer DMA or sponsored access to a customer who violates the new rule
would not be liable for aiding and abetting such violation.\84\
---------------------------------------------------------------------------
\81\ See Proposing Release, 72 FR at 15379.
\82\ See letter from SIFMA.
\83\ See letter from Bingham.
\84\ See id.
---------------------------------------------------------------------------
Rule 10b-21 as adopted does not impose any additional liability or
requirements on any person, including broker-dealers, beyond those of
any existing Exchange Act rule. As we stated in the Proposing Release,
broker-dealers would remain subject to liability under Regulation SHO
and the general antifraud provisions of the federal securities
laws.\85\
---------------------------------------------------------------------------
\85\ See Proposing Release, 72 FR at 15380.
---------------------------------------------------------------------------
G. Administrative Law Matters
The Administrative Procedure Act also generally requires that an
agency publish an adopted rule in the Federal Register 30 days before
it becomes effective.\86\ This requirement, however, does not apply if
the agency finds good cause for making the rule effective sooner.\87\
The Commission has determined that the rule should be effective in
fewer than 30 days because it addresses illegal conduct that can cause
market disruption. In addition, because the rule further evidences
conduct that is manipulative and deceptive under existing general
antifraud rules, market participants should not need time to adjust
systems or procedures to comply with the rule. Therefore, the
Commission finds good cause to make the rule effective on October 17,
2008.
---------------------------------------------------------------------------
\86\ See 5 U.S.C. Sec. 553(d).
\87\ Id.
---------------------------------------------------------------------------
IV. Paperwork Reduction Act
Rule 10b-21 does not contain a ``collection of information''
requirement within the meaning of the Paperwork Reduction Act of
1995.\88\
---------------------------------------------------------------------------
\88\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------
V. Cost-Benefit Analysis
We are sensitive to the costs and benefits of our rules and we have
considered the costs and benefits of Rule 10b-21. In order to assist us
in evaluating the costs and benefits, in the Proposing Release, we
encouraged commenters to discuss any costs or benefits that the rule
would impose. In particular, we requested comment on the potential
costs for any modification to both computer systems and surveillance
mechanisms and for information gathering, management, and recordkeeping
systems or procedures, as well as any potential benefits resulting from
the rule for issuers, investors, brokers or dealers, other securities
industry professionals, regulators, and other market participants.
Commenters were encouraged to provide analysis and data to support
their views on the costs and benefits associated with the rule.
A. Benefits
Rule 10b-21 is intended to address abusive ``naked'' short selling
and fails
[[Page 61674]]
to deliver. The rule is aimed at short sellers, including broker-
dealers acting for their own accounts, who deceive broker-dealers,
participants of a registered clearing agency, or purchasers about their
intention or ability to deliver securities in time for settlement and
that fail to deliver securities by settlement date. Among other things,
Rule 10b-21 targets short sellers who deceive their broker-dealers
about their source of borrowable shares for purposes of complying with
Regulation SHO's ``locate'' requirement.\89\ The rule also applies to
sellers who misrepresent to their broker-dealers that they own the
shares being sold.\90\
---------------------------------------------------------------------------
\89\ See 17 CFR 242.203(b)(1).
\90\ See Rule 10b-21.
---------------------------------------------------------------------------
A seller misrepresenting its short sale locate source or ownership
of shares may intend to fail to deliver securities in time for
settlement and, therefore, engage in abusive ``naked'' short selling.
As noted above, although abusive ``naked'' short selling is not defined
in the federal securities laws, it refers generally to selling short
without having stock available for delivery and intentionally failing
to deliver stock within the standard three-day settlement cycle.\91\
Such short selling may or may not be part of a scheme to manipulate the
price of a security. Although ``naked'' short selling as part of a
manipulative scheme is always illegal under the general antifraud
provisions of the federal securities laws, including Rule 10b-5 under
the Exchange Act,\92\ Rule 10b-21 will further evidence the specific
liability of persons that deceive specified persons about their
intention or ability to deliver securities in time for settlement,
including persons that deceive their broker-dealer about their locate
source or ownership of shares and that fail to deliver securities by
settlement date. We believe that a rule specifying the illegality of
these activities will focus the attention of market participants on
such activities. The rule will also further evidence that the
Commission believes such deceptive activities are detrimental to the
markets and will provide a measure of predictability for market
participants.
---------------------------------------------------------------------------
\91\ See supra note 2.
\92\ 17 CFR 240.10b-5.
---------------------------------------------------------------------------
All sellers of securities should promptly deliver, or arrange for
delivery of, securities to the respective buyer and all buyers of
securities have a right to expect prompt delivery of securities
purchased. Thus, the rule takes direct aim at an activity that may
create fails to deliver. Those fails can have a negative effect on
shareholders, potentially depriving them of the benefits of ownership,
such as voting and lending. They also may create a misleading
impression of the market for an issuer's securities. As noted above,
issuers and investors have expressed concerns about fails to deliver in
connection with ``naked'' short selling. For example, in response to
the 2006 Regulation SHO Proposed Amendments, we received a number of
comments that expressed concerns about ``naked'' short selling and
extended delivery failures.\93\ Commenters continued to express these
concerns in response to the 2007 Regulation SHO Proposed
Amendments,\94\ and in response to the Proposing Release.\95\
---------------------------------------------------------------------------
\93\ See supra note 36.
\94\ See supra note 37.
\95\ See supra note 38.
---------------------------------------------------------------------------
To the extent that fails to deliver might be indicative of
manipulative ``naked'' short selling, which could be used as a tool to
drive down a company's stock price,\96\ such fails to deliver may
undermine the confidence of investors.\97\ These investors, in turn,
may be reluctant to commit capital to an issuer they believe to be
subject to such manipulative conduct.\98\ In addition, issuers may
believe that they have suffered unwarranted reputational damage due to
investors' negative perceptions regarding fails to deliver in the
issuer's security.\99\ Any unwarranted reputational damage caused by
fails to deliver might have an adverse impact on the security's
price.\100\
---------------------------------------------------------------------------
\96\ See supra note 39.
\97\ See supra note 40.
\98\ See supra note 41.
\99\ See supra note 42 (discussing the fact that due to such
concerns some issuers have taken actions to attempt to make transfer
of their securities ``custody only,'' thus preventing transfer of
their stock to or from securities intermediaries such as the DTC or
broker-dealers).
\100\ See supra note 43.
---------------------------------------------------------------------------
Thus, to the extent that fails to deliver might create a misleading
impression of the market for an issuer's securities, the rule will
benefit investors and issuers by taking direct aim at an activity that
may create fails to deliver. In addition, to the extent that ``naked''
short selling and fails to deliver result in an unwarranted decline in
investor confidence about a security, the rule will improve investor
confidence about the security. In addition, the rule will lead to
greater certainty in the settlement of securities which should
strengthen investor confidence in that process.
We believe the rule will result in broker-dealers having greater
confidence that their customers have obtained a valid locate source
and, therefore, that shares are available for delivery on settlement
date. Thus, the rule will aid broker-dealers in complying with the
locate requirement of Regulation SHO and, thereby, potentially reduce
fails to deliver. In addition, to the extent that the rule results in
fewer sales of threshold securities resulting in fails to deliver, the
rule will reduce costs to broker-dealers because such broker-dealers
will have to close-out a lesser amount of fails to deliver under
Regulation SHO's close-out requirement.\101\ The rule should also help
reduce manipulative schemes involving ``naked'' short selling.
---------------------------------------------------------------------------
\101\ Rule 203(b)(3)(iii) of Regulation SHO contains a close-out
requirement that applies only to broker-dealers for securities in
which a substantial amount of fails to deliver have occurred, also
known as ``threshold securities.'' Specifically, Rule 203(b)(3)'s
close-out requirement requires a participant of a clearing agency
registered with the Commission to take immediate action to close out
a fail to deliver position in a threshold security in the CNS system
that has persisted for 13 consecutive settlement days by purchasing
securities of like kind and quantity; see also 2008 Interim Rule,
supra note 29 (temporarily enhancing Regulation SHO's delivery
requirements for sales of all equity securities).
---------------------------------------------------------------------------
In the Proposing Release, we solicited comment on any additional
benefits that could be realized with the proposed rule, including both
short-term and long-term benefits. We also solicited comment regarding
benefits to market efficiency, pricing efficiency, market stability,
market integrity and investor protection. In response, one commenter
stated that the ``rule will have a positive impact on liquidity and
market quality in securities traded.'' \102\ Another commenter stated
that ``the liquidity of the market and the market quality of securities
traded can be threatened or damaged if investors perceive that naked
short sales may artificially distort the price of securities, in ways
and instances unknown to honest investors, * * * in this regard, the
strict application of the rule * * * should enhance liquidity and the
market quality of securities traded.'' \103\ This commenter also noted
that, ``[b]y increasing the liability of naked short sellers, the
proposed rule should reduce the incidence of naked short sales and
thereby reduce the likelihood of short squeezes.'' \104\
---------------------------------------------------------------------------
\102\ See letter from Susanne Trimbath, PhD., CEO and Chief
Economist, STP Advisory Services, LLC, dated May 30, 2008
(``Trimbath'') (noting also a tax benefit to investors from
enforcing delivery on settlement date).
\103\ See letter from Shapiro.
\104\ See id.
---------------------------------------------------------------------------
B. Costs
Rule 10b-21 is intended to address abusive ``naked'' short selling
by further evidencing the liability of persons that deceive specified
persons about their intention or ability to deliver securities
[[Page 61675]]
in time for settlement, including persons that deceive their broker-
dealer about their locate source or ownership of shares and that fail
to deliver securities by settlement date. In the Proposing Release, we
sought data supporting any potential costs associated with the rule,
and specific comment on any systems changes to computer hardware and
software, or surveillance costs that might be necessary to implement
the rule. One commenter stated that ``the rule will have a positive
impact on liquidity and market quality in securities traded * * *
[w]ithout strict rules against settlement failures, a systemic crisis
could occur where investors are reluctant to engage in trades in U.S.
markets because settlement finality is in question. The markets and
investors need the assurance of Rule 10b-21 that securities
transactions will be settled.'' \105\ Another commenter stated that
``the liquidity of the market and the market quality of securities
traded can be threatened or damaged if investors perceive that naked
short sales may artificially distort the price of securities, in ways
and instances unknown to honest investors, * * * in this regard, the
strict application of the rule * * * should enhance liquidity and the
market quality of securities traded.'' \106\ This commenter also noted
that, ``[b]y increasing the liability of naked short sellers, the
proposed rule should reduce the incidence of naked short sales and
thereby reduce the likelihood of short squeezes. The prospect of short
squeezes is increased by the moral hazard that occurs when short
sellers believe there is little or no cost to carrying out abusive
naked short sales, and therefore rules that impose such costs reduce
this prospect.'' \107\ The commenter also noted that any costs
associated with purchasing or borrowing securities to deliver on a sale
instead of allowing the fail to deliver position to remain open ``would
not represent an additional cost, since a legitimate short sale
involves borrowing the security for delivery at the cost of such
borrowing. Therefore, it would reflect only the cost of complying with
the rules and laws that apply to all investors.'' \108\ This commenter
also noted that ``[s]trict liability for failing to deliver securities
in short sales is needed to offset the implicit savings of violating
the law and rules, and getting away with it.'' \109\
---------------------------------------------------------------------------
\105\ See letter from Trimbath.
\106\ See letter from Shapiro.
\107\ See id.
\108\ See id.
\109\ See id.
---------------------------------------------------------------------------
We recognize, however, that Rule 10b-21 may result in increased
costs to broker-dealers to the extent that the rule encourages or
results in broker-dealers limiting the extent to which they rely on
customer assurances in complying with the locate requirement of
Regulation SHO. In addition, the rule may result in increased costs to
sellers who inadvertently fail to deliver securities because such
sellers, in an attempt to avoid liability under the rule, might
purchase or borrow securities to deliver on a sale at a time when, but
for the rule, the seller would have allowed the fail to deliver
position to remain open.
One commenter stated that, ``unless Proposed Rule 10b-21 were
modified to eliminate aiding and abetting liability and allow reliance
upon customer assurances, the price discovery and liquidity provided
through short sales may be constrained.'' \110\ Although broker-dealer
concerns regarding aiding and abetting liability under Rule 10b-21 may
potentially impact liquidity and efficiency in the markets, we believe
that such an impact, if any, will be minimal. Rule 10b-21 as adopted
does not impose any additional liability or requirements on any person,
including broker-dealers, beyond those of any existing Exchange Act
rule. Aiding and abetting liability is a question of fact, determined
on a case-by-case basis. In addition, as we stated in the Proposing
Release, broker-dealers would remain subject to liability under
Regulation SHO and the general antifraud provisions of the federal
securities laws.\111\
---------------------------------------------------------------------------
\110\ See letter from Bingham.
\111\ See Proposing Release, 72 FR at 15377.
---------------------------------------------------------------------------
VI. Consideration of Burden on Competition and Promotion of Efficiency,
Competition, and Capital Formation
Section 3(f) of the Exchange Act requires the Commission, whenever
it engages in rulemaking and whenever it is required to consider or
determine if an action is necessary or appropriate in the public
interest, to consider whether the action would promote efficiency,
competition, and capital formation.\112\ In addition, Section 23(a)(2)
of the Exchange Act requires the Commission, when adopting rules under
the Exchange Act, to consider the impact such rules would have on
competition.\113\ Exchange Act Section 23(a)(2) prohibits the
Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.
---------------------------------------------------------------------------
\112\ 15 U.S.C. 78c(f).
\113\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
Rule 10b-21 is intended to address abusive ``naked'' short selling
and fails to deliver. The rule is aimed at short sellers, including
broker-dealers acting for their own accounts, who deceive specified
persons, such as a broker-dealer, about their intention or ability to
deliver securities in time for settlement and fail to deliver
securities by settlement date. Among other things, Rule 10b-21 targets
short sellers who deceive their broker-dealers about their source of
borrowable shares for purposes of complying with Regulation SHO's
``locate'' requirement.\114\ The rule also applies to sellers who
misrepresent to their broker-dealers that they own the shares being
sold.\115\
---------------------------------------------------------------------------
\114\ See 17 CFR 242.203(b)(1).
\115\ See Rule 10b-21.
---------------------------------------------------------------------------
Although ``naked'' short selling as part of a manipulative scheme
is always illegal under the general antifraud provisions of the federal
securities laws, including Rule 10b-5 under the Exchange Act,\116\ Rule
10b-21 will further evidence the liability of persons that deceive
specified persons about their intention or ability to deliver
securities in time for settlement, including persons that deceive their
broker-dealer about their locate source or ownership of shares and that
fail to deliver securities by settlement date. We believe that a rule
further evidencing the illegality of these activities will focus the
attention of market participants on such activities. The rule will also
provide a measure of predictability for market participants. We believe
Rule 10b-21 will have minimal impact on the promotion of price
efficiency.
---------------------------------------------------------------------------
\116\ 17 CFR 240.10b-5.
---------------------------------------------------------------------------
In the Proposing Release, we sought comment regarding whether Rule
10b-21 will adversely impact liquidity, disrupt markets, or
unnecessarily increase risks or costs to customers. In response, one
commenter noted that, ``the liquidity of the market and the market
quality of securities traded can be threatened or damaged if investors
perceive that naked short sales may artificially distort the price of
securities, in ways and instances unknown to honest investors, * * * in
this regard, the strict application of the rule * * * should enhance
liquidity and the market quality of securities traded.'' \117\ This
commenter also noted that, ``[b]y increasing the liability of naked
short sellers, the proposed rule should reduce the incidence of naked
short sales and
[[Page 61676]]
thereby reduce the likelihood of short squeezes. * * *'' \118\
---------------------------------------------------------------------------
\117\ See letter from Shapiro.
\118\ See id.
---------------------------------------------------------------------------
Another commenter stated that, ``unless Proposed Rule 10b-21 were
modified to eliminate aiding and abetting liability and allow reliance
upon customer assurances, the price discovery and liquidity provided
through short sales may be constrained.'' \119\ Although broker-dealer
concerns regarding aiding and abetting liability under Rule 10b-21 may
potentially impact liquidity and efficiency in the markets, we believe
that such an impact, if any, will be minimal. Rule 10b-21 as adopted
does not impose any additional liability or requirements on any person,
including broker-dealers, beyond those of any existing Exchange Act
rule. Aiding and abetting liability is a question of fact, determined
on a case-by-case basis. In addition, as we stated in the Proposing
Release, broker-dealers would remain subject to liability under
Regulation SHO and the general antifraud provisions of the federal
securities laws.\120\
---------------------------------------------------------------------------
\119\ See letter from Bingham.
\120\ See Proposing Release, 72 FR at 15377.
---------------------------------------------------------------------------
In addition, we believe that the rule will have minimal impact on
the promotion of capital formation. The perception that abusive
``naked'' short selling is occurring in certain securities can
undermine the confidence of investors. These investors, in turn, may be
reluctant to commit capital to an issuer they believe to be subject to
such manipulative conduct. For example, in response to the Proposing
Release, one commenter noted that, ``[c]onfidence in the securities
markets is diminished when investors and others cannot rely on the
receipt of securities in trades.'' \121\ Thus, we believe that
strengthening our rules against ``naked'' short selling by targeting
sellers who deceive their broker-dealers about their source of
borrowable shares and their share ownership will provide increased
confidence in the markets.
---------------------------------------------------------------------------
\121\ See letter from Trimbath.
---------------------------------------------------------------------------
In addition, we note that we have previously sought comment
regarding the impact on capital formation of other proposed amendments
aimed at reducing fails to deliver and addressing potentially abusive
``naked'' short selling, including whether the proposed increased short
sale restrictions would affect investors' decisions to invest in
certain equity securities.\122\ In response, commenters expressed
concern about the potential impact of ``naked'' short selling on
capital formation claiming that ``naked'' short selling causes a drop
in an issuer's stock price that may limit the issuer's ability to
access the capital markets.\123\ Thus, to the extent that ``naked''
short selling and fails to deliver result in an unwarranted decline in
investor confidence about a security, the rule is expected to improve
investor confidence about the security. We note, however, that
persistent fails to deliver exist in only a small number of securities
and may be a signal of overvaluation rather than undervaluation of a
security's price.\124\ In addition, we believe that the rule will lead
to greater certainty in the settlement of securities, which is expected
to strengthen investor confidence in the settlement process.
---------------------------------------------------------------------------
\122\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41710;
2007 Regulation SHO Proposed Amendments, 72 FR 45558.
\123\ See, e.g., supra note 41 (citing to comment letters
expressing concern regarding the impact of potential ``naked'' short
selling on capital formation).
\124\ Persistent fails to deliver may be symptomatic of an
inadequate supply of shares in the equity lending market. If short
sellers are unable to short sell due to their inability to borrow
shares, their opinions about the fundamental value of the security
may not be fully reflected in a security's price, which may lead to
overvaluation.
---------------------------------------------------------------------------
We also believe that Rule 10b-21 will not impose any burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act. By specifying that abusive ``naked'' short selling
is a fraud, the Commission believes the rule will promote competition
by providing the industry with guidance regarding the liability of
sellers that deceive specified persons about their intention or ability
to deliver securities in time for settlement, including persons that
deceive their broker-dealer about their locate sources or share
ownership and that fail to deliver securities by settlement date.
VII. Final Regulatory Flexibility Analysis
The Commission has prepared a Final Regulatory Flexibility Analysis
(``FRFA''), in accordance with the provisions of the Regulatory
Flexibility Act (``RFA''),\125\ regarding Rule 10b-21 under the
Exchange Act. An Initial Regulatory Flexibility Analysis (``IRFA'') was
prepared in accordance with the RFA and was included in the Proposing
Release. We solicited comments on the IRFA.
---------------------------------------------------------------------------
\125\ 5 U.S.C. 603.
---------------------------------------------------------------------------
A. Reasons for the Rule
Rule 10b-21 is intended to address fails to deliver associated with
abusive ``naked'' short selling. While ``naked'' short selling as part
of a manipulative scheme is already illegal under the general antifraud
provisions of the federal securities laws, Rule 10b-21 specifies that
it is unlawful for any person to submit an order to sell an equity
security if such person deceives a broker-dealer, participant of a
registered clearing agency, or purchaser about its intention or ability
to deliver securities on the date delivery is due, and such person
fails to deliver the security on or before the date delivery is due.
Thus, Rule 10b-21 will further evidence the liability of persons that
deceive specified persons about their intention or ability to deliver
securities in time for settlement, including persons that deceive their
broker-dealer about their locate source or ownership of shares.
B. Objectives
Rule 10b-21 is aimed at short sellers, including broker-dealers
acting for their own accounts, that deceive specified persons, such as
a broker or dealer, about their intention or ability to deliver
securities in time for settlement and that fail to deliver securities
by settlement date. We believe that a rule further evidencing the
illegality of these activities will focus the attention of market
participants on such activities. The rule will also underscore that the
Commission believes such deceptive activities are detrimental to the
markets and will provide a measure of predictability for market
participants.
All sellers of securities should promptly deliver, or arrange for
delivery of, securities to the respective buyer and all buyers of
securities have a right to expect prompt delivery of securities
purchased. Thus, Rule 10b-21 takes direct aim at an activity that may
create fails to deliver. Those fails can have a negative effect on
shareholders, potentially depriving them of the benefits of ownership,
such as voting and lending. They also may create a misleading
impression of the market for an issuer's securities. Rule 10b-21 will
also aid broker-dealers in complying with the locate requirement of
Regulation SHO and, thereby, potentially reduce fails to deliver. In
addition, the rule is expected to help reduce manipulative schemes
involving ``naked'' short selling.
C. Significant Issues Raised By Public Comment
The IRFA appeared in the Proposing Release. We requested comment on
any aspect of the IRFA. In particular, we requested comment on: (i) The
number of small entities that would be affected by the rule; and (ii)
the existence or nature of the potential impact of the rule on small
entities. We requested that the
[[Page 61677]]
comments specify costs of compliance with the rule, and suggest
alternatives that would accomplish the objectives of the rule. We did
not receive any comments that responded specifically to this request.
D. Small Entities Subject to the Rule
The entities covered by Rule 10b-21 will include small broker-
dealers, small businesses, and any investor who effects a short sale
that qualifies as a small entity. Although it is impossible to quantify
every type of small entity that may be able to effect a short sale in a
security, paragraph (c)(1) of Rule 0-10 under the Exchange Act \126\
states that the term ``small business'' or ``small organization,'' when
referring to a broker-dealer, means a broker or dealer that had total
capital (net worth plus subordinated liabilities) of less than $500,000
on the date in the prior fiscal year as of which its audited financial
statements were prepared pursuant to Sec. 240.17a-5(d); and is not
affiliated with any person (other than a natural person) that is not a
small business or small organization. As of 2007, the Commission
estimates that there were approximately 896 broker-dealers that
qualified as small entities as defined above.\127\
---------------------------------------------------------------------------
\126\ 17 CFR 240.0-10(c)(1).
\127\ These numbers are based on OEA's review of 2007 FOCUS
Report filings reflecting registered broker-dealers. This number
does not include broker-dealers that are delinquent on FOCUS Report
filings.
---------------------------------------------------------------------------
Any business, however, regardless of industry, could be subject to
the rule if it effects a short or long sale. The Commission believes
that, except for the broker-dealers discussed above, an estimate of the
number of small entities that fall under the rule is not feasible.
E. Reporting, Recordkeeping, and Other Compliance Requirements
Rule 10b-21 is intended to address abusive ``naked'' short selling
by further evidencing the liability of persons that deceive specified
persons about their intention or ability to deliver securities in time
for settlement, including persons that deceive their broker-dealer
about their locate source or ownership of shares and that fail to
deliver securities by settlement date. The Commission believes that the
rule may impose new or additional compliance costs on any affected
party, including broker-dealers, that are small entities. To comply
with Regulation SHO, small broker-dealers needed to modify their
systems and surveillance mechanisms to comply with Regulation SHO's
locate, marking and delivery requirements. Thus, any systems and
surveillance mechanisms necessary for broker-dealers to comply with the
rule should already be in place. We believe that any necessary
additional systems and surveillance changes, in particular changes by
sellers who are not broker-dealers, will be similar to the changes
incurred by broker-dealers when Regulation SHO was implemented.
F. Agency Action To Minimize Effect on Small Entities
The RFA directs the Commission to consider significant alternatives
that would accomplish the stated objective, while minimizing any
significant adverse impact on small entities. Pursuant to Section 3(a)
of the RFA,\128\ the Commission must consider the following types of
alternatives: (a) The establishment of differing compliance or
reporting requirements or timetables that take into account the
resources available to small entities; (b) the clarification,
consolidation, or simplification of compliance and reporting
requirements under the rule for small entities; (c) the use of
performance rather than design standards; and (d) an exemption from
coverage of the rule, or any part thereof, for small entities.
---------------------------------------------------------------------------
\128\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------
A primary goal of Rule 10b-21 is to address abusive ``naked'' short
selling. While ``naked'' short selling as part of a manipulative scheme
is always illegal under the general antifraud provisions of the federal
securities laws, Rule 10b-21 specifies that it is a fraud for any
person to submit an order to sell an equity security if such person
deceives a broker-dealer, participant of a registered clearing agency,
or purchaser about its intention or ability to deliver the security on
the date delivery is due and such person fails to deliver the security
on or before the date delivery is due. Rule 10b-21 is aimed at short
sellers, including broker-dealers acting for their own accounts, who
deceive specified persons, such as a broker or dealer, about their
intention or ability to deliver securities in time for settlement and
who do not deliver securities by settlement date. Among other things,
Rule 10b-21 targets short sellers who deceive their broker-dealers
about their source of borrowable shares for purposes of complying with
Regulation SHO's ``locate'' requirement.\129\ The rule also applies to
sellers who misrepresent to their broker-dealers that they own the
shares being sold.
---------------------------------------------------------------------------
\129\ See 17 CFR 242.203(b)(1).
---------------------------------------------------------------------------
We believe that imposing different compliance requirements, and
possibly a different timetable for implementing compliance
requirements, for small entities would undermine the Commission's goal
of addressing abusive ``naked'' short selling and fails to deliver. In
addition, we have concluded similarly that it is not consistent with
the primary goal of the rule to further clarify, consolidate, or
simplify the rule for small entities. Finally, the rule imposes
performance standards rather than design standards.
VIII. Statutory Authority
Pursuant to the Exchange Act and, particularly, Sections 2, 3(b),
6, 9(h), 10, 11A, 15, 15A, 17, 17A, 19 and 23(a) thereof, 15 U.S.C.
78b, 78c(b), 78f, 78i(h), 78j, 78k-1, 78o, 78o-3, 78q, 78q-1, 78s and
78w(a), the Commission is adopting a new antifraud rule, Rule 10b-21,
to address abusive ``naked'' short selling.
List of Subjects in 17 CFR Part 240
Brokers, Fraud, Reporting and recordkeeping requirements,
Securities.
0
For the reasons set out in the preamble, Title 17, Chapter II, of the
Code of Federal Regulations is amended as follows.
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
0
1. The authority citation for part 240 continues to read, in part, as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i,
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5,
78w, 78x, 78-ll, 78mm, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4,
80b-11, and 7201 et seq.; and 18 U.S.C. 1350, unless otherwise
noted.
0
2. Add Sec. 240.10b-21 to read as follows:
Sec. 240.10b-21 Deception in connection with a seller's ability or
intent to deliver securities on the date delivery is due.
Preliminary Note to Sec. 240.10b-21: This rule is not intended
to limit, or restrict, the applicability of the general antifraud
provisions of the federal securities laws, such as section 10(b) of
the Act and rule 10b-5 thereunder.
(a) It shall also constitute a ``manipulative or deceptive device
or contrivance'' as used in section 10(b) of this Act for any person to
submit an order to sell an equity security if such person deceives a
broker or dealer, a participant of a registered clearing agency, or a
purchaser about its intention or ability to deliver the security on or
before the settlement date, and such person fails to deliver the
[[Page 61678]]
security on or before the settlement date.
(b) For purposes of this rule, the term settlement date shall mean
the business day on which delivery of a security and payment of money
is to be made through the facilities of a registered clearing agency in
connection with the sale of a security.
By the Commission.
Dated: October 14, 2008.
Florence E. Harmon,
Acting Secretary.
[FR Doc. E8-24714 Filed 10-16-08; 8:45 am]
BILLING CODE 8011-01-P