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21 March 2008
[Federal Register: March 21, 2008 (Volume 73, Number 56)]
[Proposed Rules]
[Page 15375-15385]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr21mr08-27]
[[Page 15375]]
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Part IV
Securities and Exchange Commission
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17 CFR Part 240
Naked Short Selling Anti-Fraud Rule; Proposed Rule
[[Page 15376]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-57511; File No. S7-08-08]
RIN 3235-AK06
``Naked'' Short Selling Anti-Fraud Rule
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
proposing an anti-fraud 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 proposed rule is
intended to highlight 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.
DATES: Comments should be received on or before May 20, 2008.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
Send an e-mail to rule-comments@sec.gov. Please include
File Number S7-08-08 on the subject line; or
Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-08-08. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549, on official business days between the hours of 10 a.m. and 3
p.m. All comments received will be posted without change; we do not
edit personal identifying information from submissions. You should
submit only information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Associate
Director, Josephine J. Tao, Assistant Director, Victoria L. Crane,
Branch Chief, Joan M. Collopy, Special Counsel, Todd E. Freier and
Christina M. Adams, 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: The Commission is requesting public comment
on proposed Rule 10b-21 under the Exchange Act.
I. Introduction
The Commission is proposing an anti-fraud 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, proposed Rule 10b-21 would 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\ The proposed rule would also apply to sellers who
misrepresent to their broker-dealers that they own the shares being
sold.
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\1\ See 17 CFR 242.203(b)(1).
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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\
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\2\ See Exchange Act Release No. 56212 (Aug. 7, 2007), 72 FR
45544 (Aug. 14, 2007) (``2007 Regulation SHO Amendments''); Exchange
Act Release No. 54154 (July 14, 2006), 71 FR 41710 (July 21, 2006)
(``2006 Regulation SHO Proposed Amendments'').
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Although abusive ``naked'' short selling as part of a manipulative
scheme is always illegal under the general anti-fraud provisions of the
federal securities laws, including Rule 10b-5 under the Exchange
Act,\3\ proposed Rule 10b-21 would highlight 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.\4\ We believe that a rule highlighting the illegality of these
activities would focus the attention of market participants on such
activities. The proposed rule would also highlight that the Commission
believes such deceptive activities are detrimental to the markets and
would provide a measure of predictability for market participants.
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\3\ 17 CFR 240.10b-5.
\4\ This conduct is also in violation of other provisions of the
federal securities laws, including the anti-fraud provisions.
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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 proposal 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. Proposed Rule 10b-
21 would also aid broker-dealers in complying with the locate
requirement of Regulation SHO and, thereby, potentially reduce fails to
deliver. In addition, the proposed rule 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 and 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
[[Page 15377]]
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.
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\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).
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Although the majority of trades settle within the standard three-
day settlement period,\9\ the Commission adopted Regulation SHO \10\ in
part to address problems associated with persistent fails to deliver
securities and potentially abusive ``naked'' short selling.\11\ Rule
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: (1) Borrowed the security, or entered into a bona-fide arrangement
to borrow the security; or (2) Reasonable grounds to believe that the
security can be borrowed so that it can be delivered on the date
delivery is due; and (3) 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\
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\9\ According to the NSCC, 99% (by dollar value) of all trades
settle within T+3. Thus, on an average day, approximately 1% (by
dollar value) of all trades, including equity, debt, and municipal
securities fail to settle on time. 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 sales 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, thus causing a fail to deliver on a
long sale within the normal three-day settlement period. The
Commission's Office of Economic Analysis (``OEA'') estimates that,
on an average day between May 1, 2007 and January 31, 2008, 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 0.6% of dollar value of trading in all securities.
\10\ 17 CFR 242.200. Regulation SHO became effective on January
3, 2005.
\11\ See 2007 Regulation SHO 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).
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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\
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\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).
\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).
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Under Regulation SHO, the executing or order-entry 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. This 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 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, or otherwise engage
in abusive ``naked'' short selling. Commission enforcement actions have
contributed to our concerns about the extent of misrepresentations by
short sellers about their locate sources and ownership of shares. 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.\20\
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\20\ 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).
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[[Page 15378]]
As we have stated previously, we are concerned that fails to
deliver may have a negative effect on the market and shareholders.\21\
For example, fails to deliver may deprive shareholders of the benefits
of ownership, such as voting and lending.\22\ In addition, where a
seller of securities fails to deliver securities on settlement date, in
effect the seller unilaterally converts a securities contract (which
should 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.\23\ Moreover,
sellers that fail to deliver securities on settlement date may be
subject to fewer restrictions than sellers that are required to deliver
the securities by settlement date, and such sellers may attempt to use
this additional freedom to engage in trading activities that are
designed to improperly depress the price of a security.\24\ For
example, by not borrowing securities and, therefore, not making
delivery within the standard three-day settlement period, the seller
does not incur the costs of borrowing.
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\21\ See 2007 Regulation SHO Amendments, 72 FR at 45544; 2006
Regulation SHO Proposed Amendments, 71 FR at 41712; Exchange Act
Release No. 56213 (Aug. 7, 2007), 72 FR 45558, 45558-45559 (Aug. 14,
2007) (``2007 Regulation SHO Proposed Amendments'').
\22\ See id.
\23\ See id.
\24\ See id.
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In addition, issuers and investors have expressed concerns about
fails to deliver in connection with ``naked'' short selling. For
example, in response to proposed amendments to Regulation SHO in 2006
\25\ designed to further reduce the number of persistent fails to
deliver in certain equity securities by eliminating Regulation SHO's
``grandfather'' provision, and limiting the duration of the rule's
options market maker exception, the Commission received a number of
comments that expressed concerns about ``naked'' short selling and
extended delivery failures.\26\
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\25\ See 2006 Regulation SHO Proposed Amendments.
\26\ 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'').
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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,\27\ such fails to deliver may
undermine the confidence of investors.\28\ These investors, in turn,
may be reluctant to commit capital to an issuer they believe to be
subject to such manipulative conduct.\29\ 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.\30\ Any unwarranted reputational damage caused by
fails to deliver might have an adverse impact on the security's
price.\31\
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\27\ See supra, note 8 (discussing a case in which the
Commission 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. March 27,
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).
\28\ In response to the 2006 Regulation SHO Proposed Amendments,
the Commission received comment letters discussing the impact of
fails to deliver on investor confidence. See, e.g., letter from Mary
Helburn, Executive Director, National Coalition Against Naked
Shorting, dated Sept. 30, 2006 (``NCANS''); letter from Richard
Blumenthal, Attorney General, State of Connecticut, dated Sept. 19,
2006 (``Blumenthal'').
\29\ In response to the 2006 Regulation SHO Proposed Amendments,
the Commission 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 Congressman Tom Feeney--Florida,
U.S. House of Representatives, dated Sept. 25, 2006 (``Feeney'');
see also letter from Zix Corporation, dated Sept. 19, 2006 (``Zix'')
(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.'').
\30\ 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 Exchange Act Release No. 48709
(Oct. 28, 2003), 68 FR 62972, at 62975 (Nov. 6, 2003). 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 Securities
Exchange Act Release No. 47978 (June 4, 2003), 68 FR 35037 (June 11,
2003).
\31\ 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 (providing
additional discussion of the impact of fails to deliver on the
market); see also Exchange Act Release No. 48709 (Oct. 28, 2003), 68
FR 62972, 62975 (Nov. 6, 2003) (``2003 Regulation SHO Proposing
Release'') (discussing the impact of ``naked'' short selling on the
market).
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III. Discussion of Proposed Rule
A. Proposed Anti-Fraud Rule
To further address potentially abusive ``naked'' short selling and
fails to deliver, we are proposing a narrowly-tailored rule, Rule 10b-
21, which would 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, or purchaser \32\
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.\33\ Scienter would be a necessary
element for a violation of the proposed rule.\34\
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\32\ 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.
\33\ Proposed Rule 10b-21.
\34\ 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)).
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The proposed rule would 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. Proposed Rule 10b-21 would
apply to 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 proposed
Rule 10b-21 is to reduce fails
[[Page 15379]]
to deliver, violation of the proposed rule would occur only if a fail
to deliver results from the relevant transaction.
For purposes of the proposed rule, broker-dealers (including market
makers) acting for their own accounts would be considered sellers. For
example, a broker-dealer effecting short sales for its own account
would 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.\35\
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\35\ See 2007 Regulation SHO Amendments, 72 FR at 45544; 2006
Regulation SHO Proposed Amendments, 71 FR at 41712; 2007 Regulation
SHO Proposed Amendments, 72 FR at 45558-45559.
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As noted above, under Regulation SHO, the executing or order-entry
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.\36\ 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.\37\ 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 would be making a representation to a broker-dealer for purposes
of proposed Rule 10b-21.\38\
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\36\ See 17 CFR 242.203(b)(3)(1).
\37\ See 2004 Regulation SHO Adopting Release, 69 FR at 48014.
\38\ Broker-dealers may offer DMA to 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.
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If a seller deceives a broker-dealer about the validity of its
locate source, the seller would be liable under proposed Rule 10b-21 if
the seller also fails to deliver securities by the date delivery is
due. For example, a seller would be liable for a violation of proposed
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 would 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.
If, however, 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.'' \39\
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\39\ 2004 Regulation SHO Adopting Release, 69 FR at 48014.
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In addition, 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.\40\ 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.
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\40\ See 2004 Regulation SHO Adopting Release, 69 FR at 48015,
n. 67.
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Under proposed Rule 10b-21, a seller would 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. For
example, a seller would be liable for a violation of proposed 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 \41\ 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. Broker-dealers acting for their own
accounts would also be liable under the proposed rule 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.\42\
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\41\ 17 CFR 242.200(a)-(f).
\42\ Such broker-dealers would also be liable under Regulation
SHO.
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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.
Although the proposed rule is primarily aimed at sellers that
deceive specified persons about their intention or ability to deliver
shares or about their locate sources and ownership of shares, as with
any rule, broker-dealers could be liable for aiding and abetting a
[[Page 15380]]
customer's fraud under the proposed rule. In addition, broker-dealers
would remain subject to liability under Regulation SHO and the general
anti-fraud provisions of the federal securities laws.
Proposed Rule 10b-21 is narrowly tailored to apply when a seller,
including a broker-dealer trading for its own account, deceives
specified persons about its ability or intention to deliver securities
in time for settlement, or about its locate source or ownership of
shares and that fails to deliver securities by settlement date. While
``naked'' short selling as part of a manipulative scheme is already
illegal under the general anti-fraud provisions of the federal
securities laws, we believe that the proposed anti-fraud rule would
highlight 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. Proposed Rule 10b-21
would also aid broker-dealers in complying with the locate requirement
of Regulation SHO and, thereby, potentially reduce fails to
deliver.\43\
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\43\ The Commission would continue to monitor the effect of
``naked'' short selling practices to determine whether additional
rulemaking is warranted.
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Request for Comment
The Commission seeks comment generally on all aspects of proposed
Rule 10b-21. In addition, we seek comment on the following:
Proposed Rule 10b-21 would apply to sales in all equity
securities. Should we narrow the scope of the proposed rule to apply
only to sales of ``threshold securities'' as that term is defined in
Rule 203(c)(6) of Regulation SHO \44\ or to certain types of
securities? Why or why not? If so, to what types of securities should
the proposed rule apply? If we narrow the proposed rule to apply only
to certain types of securities, should exchange traded funds or other
basket securities be excluded? Why or why not?
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\44\ Rule 203(c)(6) defines ``threshold securities'' 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)).'' 17 CFR 242.203(c)(6).
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The proposed rule highlights the specific liability of
persons that deceive broker-dealers, participants of a registered
clearing agency, or purchasers about their intention or ability to
deliver securities in time for settlement. Are there other entities
that could be deceived about a seller's intention or ability to deliver
securities in time for settlement that should be included in the
proposed rule? As an alternative to listing who must be deceived,
should the proposed rule provide that a person would be liable if it
deceives ``another person'' about its intention or ability to deliver
securities in time for settlement? Please explain.
The proposed rule includes a person failing to deliver
securities when delivery is due as an element for a violation of the
proposed rule. What are the costs and benefits, including to broker-
dealers or customers, for including delivery as an element of the
violation? Would the inclusion of a fail to deliver as an element of
the proposed rule encourage broker-dealers, as a service to customers,
to deliver securities on behalf of customers to prevent customers from
failing to deliver securities by settlement date? Would broker-dealers
feel any additional obligation to purchase or borrow securities on
behalf of their customers to deliver on a customer's sale? What would
be the costs to broker-dealers if they were to take such actions,
particularly if the sale involves an expensive or hard to borrow
security? Would the inclusion of failing to deliver as an element for a
violation of the proposed rule increase costs for customers for
inadvertent fails? Should delivery be excluded as a required element
for a violation? For example, should the rule language instead be: ``It
shall 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 a security if such person deceives a broker or dealer, participant
of a registered clearing agency, or a purchaser about its intention or
ability to deliver the security on the date delivery is due''? What
would be the costs and benefits of excluding delivery as an element for
a violation of the proposed rule? Would excluding failing to deliver as
an element for liability under the proposed rule affect a self-
regulatory organization's ability to surveil for violations of the
rule?
In the 2004 Regulation SHO Adopting Release, the
Commission stated that a broker-dealer could satisfy the locate
requirement of Regulation SHO by obtaining an assurance from a customer
that the customer can obtain securities from another identified source
in time to settle the trade, provided the broker-dealer reasonably
believes the customer's assurance. Proposed Rule 10b-21 is aimed, in
part, at sellers who make misrepresentations to their broker-dealers
about their locate sources. Should we instead no longer permit a
broker-dealer to rely on such customer assurances in satisfying the
locate requirement of Regulation SHO? What would be the costs and
benefits of removing the ability of broker-dealers to rely on such
customer assurances? What would be the impact on market participants
(such as broker-dealers, stock lenders, investors)? Would smaller
entities be affected more or less adversely than larger entities?
What procedures do broker-dealers currently have in place
to assist in making the determination that there are reasonable grounds
to believe that customers' representations regarding a locate source
are accurate? How do those procedures help to provide confidence
regarding the accuracy of such representations?
What procedures do broker-dealers currently have in place
to determine the accuracy of a seller's representations that it owns
the securities being sold and that the securities are reasonably
expected to be in the broker-dealer's physical possession or control by
settlement?
Are there other types of transactions to which proposed
Rule 10b-21 should not apply?
Are there any issues with respect to the application of
the proposed rule in the context of the use of DMAs? If so, please
explain.
Are there any issues with respect to the application of
the proposed rule to trades submitted to, or effected on, electronic
communications networks?
To what extent, if any, would the proposed rule encourage
or result in fewer executing broker-dealers relying on customer
assurances to satisfy the locate requirement of Regulation SHO? To what
extent would such a result of the proposed rule impact prime brokerage
relationships? Please explain.
Although the type of activity that would be illegal under
the proposed rule is already prohibited by the general anti-fraud
provisions of the federal securities laws, to what extent, if any,
would the proposed rule impact liquidity and market quality in
securities traded? Please explain. To what extent, if any, might the
proposed rule result in short squeezes? What costs, if any, would the
potential for short squeezes have on the efficiency of the market?
To what extent, if any, would the proposed rule induce
short sellers to execute trades in overseas markets?
IV. General Request for Comment
The Commission seeks comment generally on all aspects of the
proposed rule. Commenters are requested to provide empirical data to
support their views and arguments related to
[[Page 15381]]
proposed Rule 10b-21. In addition to the questions posed above,
commenters are welcome to offer their views on any other matter raised
by the proposed rule. With respect to any comments, we note that they
are of the greatest assistance to our rulemaking initiative if
accompanied by supporting data and analysis of the issues addressed in
those comments and if accompanied by alternative suggestions to our
proposals where appropriate.
V. Paperwork Reduction Act
Proposed Rule 10b-21 does not contain a ``collection of
information'' requirement within the meaning of the Paperwork Reduction
Act of 1995.\45\ An agency may not conduct or sponsor, and a person is
not required to respond to, a collection of information unless it
displays a currently valid OMB control number.
---------------------------------------------------------------------------
\45\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------
VI. Consideration of Costs and Benefits of the Proposed Amendments
The Commission is considering the costs and benefits of proposed
Rule 10b-21. The Commission is sensitive to these costs and benefits,
and encourages commenters to discuss any additional costs or benefits
beyond those discussed here, as well as any reductions in costs. In
particular, the Commission requests 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
proposals for issuers, investors, brokers or dealers, other securities
industry professionals, regulators, and other market participants.
Commenters should provide analysis and data to support their views on
the costs and benefits associated with the proposed rule.
A. Benefits
Proposed Rule 10b-21 is intended to address abusive ``naked'' short
selling and fails to deliver. The proposed 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, proposed Rule 10b-21 would target short
sellers who deceive their broker-dealers about their source of
borrowable shares for purposes of complying with Regulation SHO's
``locate'' requirement.\46\ The proposed rule would also apply to
sellers who misrepresent to their broker-dealers that they own the
shares being sold.\47\
---------------------------------------------------------------------------
\46\ See 17 CFR 242.203(b)(1).
\47\ Proposed 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.\48\
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 anti-fraud
provisions of the federal securities laws, including Rule 10b-5 under
the Exchange Act,\49\ proposed Rule 10b-21 would highlight 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 would focus the attention of market participants on
such activities. The proposed rule would also highlight that the
Commission believes such deceptive activities are detrimental to the
markets and would provide a measure of predictability for market
participants.
---------------------------------------------------------------------------
\48\ See supra note 2.
\49\ 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 proposal 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
proposed amendments to Regulation SHO in 2006 \50\ designed to further
reduce the number of persistent fails to deliver in certain equity
securities by eliminating Regulation SHO's ``grandfather'' provision,
and limiting the duration of the rule's options market maker exception,
the Commission received a number of comments that expressed concerns
about ``naked'' short selling and extended delivery failures.\51\
---------------------------------------------------------------------------
\50\ See 2006 Regulation SHO Proposed Amendments.
\51\ See, e.g., letters from Overstock; TASER, Royce; Read;
DeVivo; Akhtar.
---------------------------------------------------------------------------
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,\52\ such fails to deliver may
undermine the confidence of investors.\53\ These investors, in turn,
may be reluctant to commit capital to an issuer they believe to be
subject to such manipulative conduct.\54\ 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.\55\ Any unwarranted reputational damage caused by
fails to deliver might have an adverse impact on the security's
price.\56\
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\52\ See supra note 27.
\53\ See supra note 28.
\54\ See supra note 29.
\55\ See supra note 30 (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).
\56\ See supra note 31.
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Thus, to the extent that fails to deliver might create a misleading
impression of the market for an issuer's securities, the proposed rule
would 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 proposed rule
should improve investor confidence about the security. In addition, the
proposed rule could lead to greater certainty in the settlement of
securities which should strengthen investor confidence in that process.
The proposed rule could 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 proposed rule would aid broker-dealers in complying
with the locate requirement of Regulation SHO and, thereby, potentially
reduce fails to deliver. The proposed rule also may provide additional
encouragement for broker-
[[Page 15382]]
dealers to deliver shares by settlement date and, therefore, result in
a reduction in fails to deliver. In addition, to the extent that sales
of threshold securities do not result in fails to deliver, the proposed
rule would reduce costs to broker-dealers because such broker-dealers
would have to close out a lesser amount of fails to deliver under
Regulation SHO's close-out requirement.\57\
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\57\ 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 Continuous
Net Settlement (CNS) system that has persisted for 13 consecutive
settlement days by purchasing securities of like kind and quantity.
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In addition, the proposed rule could help reduce manipulative
schemes involving ``naked'' short selling. We solicit comment on any
additional benefits that could be realized with the proposed rule,
including both short-term and long-term benefits. We solicit comment
regarding benefits to market efficiency, pricing efficiency, market
stability, market integrity and investor protection.
B. Costs
As an aid in evaluating costs and reductions in costs associated
with proposed Rule 10b-21, the Commission requests the public's views
and any supporting information.
The proposed rule is intended to address abusive ``naked'' short
selling by highlighting 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 recognizes that
the proposed rule might result in increased costs to broker-dealers to
the extent that the proposed 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. Because the
failure to deliver securities by the date delivery is due is an element
for a violation of the proposed rule, as a service to customers broker-
dealers could feel an additional obligation to borrow or purchase
securities to deliver on customer sales even though the broker-dealer
did not enter into an arrangement with the customer to do so. The
proposed rule could result in increased costs to customers who
inadvertently fail to deliver securities because such customers, in an
attempt to avoid liability under the proposed rule, might purchase or
borrow securities to deliver on a sale at a time when, but for the
proposed rule, the seller would have allowed the fail to deliver
position to remain open.
The Commission believes that the proposed rule would not compromise
investor protection. We seek data, however, supporting any potential
costs associated with the proposed rule. In addition, we request
specific comment on any systems changes to computer hardware and
software, or surveillance costs that might be necessary to implement
the proposed rule. Specifically:
What would be the costs and benefits of the proposed rule?
Would the proposed rule create any costs associated with
systems, surveillance, or recordkeeping modifications? Would these
costs justify the benefits of better ensuring compliance with the
federal securities laws?
How much would the proposed rule affect compliance costs
for small, medium, and large broker-dealers (e.g., personnel or system
changes)? We seek comment on the costs of compliance that may arise.
VII. 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.\58\ 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.\59\ 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.
---------------------------------------------------------------------------
\58\ 15 U.S.C. 78c(f).
\59\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
Proposed Rule 10b-21 is intended to address abusive ``naked'' short
selling and fails to deliver. The proposed 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,
proposed Rule 10b-21 would target short sellers who deceive their
broker-dealers about their source of borrowable shares for purposes of
complying with Regulation SHO's ``locate'' requirement.\60\ The
proposed rule would also apply to sellers who misrepresent to their
broker-dealers that they own the shares being sold.\61\
---------------------------------------------------------------------------
\60\ See 17 CFR 242.203(b)(1).
\61\ Proposed Rule 10b-21.
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Although ``naked'' short selling as part of a manipulative scheme
is always illegal under the general anti-fraud provisions of the
federal securities laws, including Rule 10b-5 under the Exchange
Act,\62\ proposed Rule 10b-21 would highlight 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 highlighting the illegality of these activities
would focus the attention of market participants on such activities.
The proposed rule would also provide a measure of predictability for
market participants. We believe proposed Rule 10b-21 would have minimal
impact on the promotion of price efficiency. We seek comment regarding
whether proposed Rule 10b-21 may adversely impact liquidity, disrupt
markets, or unnecessarily increase risks or costs to customers.
---------------------------------------------------------------------------
\62\ 17 CFR 240.10b-5.
---------------------------------------------------------------------------
In addition, we believe that the proposed rule would 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. We believe that any such effect on capital
formation is limited by the relatively few securities from corporate
issuers that persist on the Regulation SHO threshold list \63\ and the
fact that this persistence does not necessarily indicate abusive
``naked'' short selling
[[Page 15383]]
or a deleterious effect on the cost of capital for the issuer.
---------------------------------------------------------------------------
\63\ On an average day over a nine month period from May 1, 2007
to January 31, 2008, approximately 50 securities had persisted on
the threshold list for more than 17 days and had fails to deliver of
10,000 shares or more. However, the majority of these securities are
exchange traded funds which suggests that only a small number of
corporate issuers are potentially affected.
---------------------------------------------------------------------------
In the 2006 Proposing Release, we sought comment on whether the
proposed amendments to Regulation SHO would promote capital formation,
including whether the proposed increased short sale restrictions would
affect investors' decisions to invest in certain equity securities. 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.\64\ Thus, to the
extent that ``naked'' short selling and fails to deliver result in an
unwarranted decline in investor confidence about a security, the
proposed rule should 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.\65\ In addition, we believe that
the proposed rule could lead to greater certainty in the settlement of
securities which should strengthen investor confidence in the
settlement process.
---------------------------------------------------------------------------
\64\ See, e.g., letter from Feeney.
\65\ 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 proposed Rule 10b-21 would 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 proposed rule
would 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. The Commission requests specific comment
on whether the proposed rule would promote efficiency, competition, and
capital formation.
VIII. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \66\ we must advise the Office of
Management and Budget as to whether the proposed regulation constitutes
a ``major'' rule. Under SBREFA, a rule is considered ``major'' where,
if adopted, it results or is likely to result in:
---------------------------------------------------------------------------
\66\ Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
---------------------------------------------------------------------------
An annual effect on the economy of $100 million or more
(either in the form of an increase or a decrease);
A major increase in costs or prices for consumers or
individual industries; or
Significant adverse effect on competition, investment or
innovation.
If a rule is ``major,'' its effectiveness will generally be delayed
for 60 days pending Congressional review. We request comment on the
potential impact of the proposed rule on the economy on an annual
basis. Commenters are requested to provide empirical data and other
factual support for their view to the extent possible.
IX. Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (``IRFA''), in accordance with the provisions of the
Regulatory Flexibility Act (``RFA''),\67\ regarding the proposed rule.
---------------------------------------------------------------------------
\67\ 5 U.S.C. 603.
---------------------------------------------------------------------------
A. Reasons for the Proposed Action
Proposed 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 anti-fraud provisions of the federal securities laws, proposed
Rule 10b-21 would specify that it is a fraud for any person to submit
an order to sell a 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 securities on or before the date
delivery is due. Thus, the proposed rule would highlight 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
Proposed 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 that fail to deliver securities
by settlement date. We believe that a rule highlighting the illegality
of these activities would focus the attention of market participants on
such activities. The proposed rule would also underscore that the
Commission believes such deceptive activities are detrimental to the
markets and would 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, the proposal 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. Proposed Rule 10b-
21 would also aid broker-dealers in complying with the locate
requirement of Regulation SHO and, thereby, potentially reduce fails to
deliver. In addition, the proposed rule could help reduce manipulative
schemes involving ``naked'' short selling.
C. Legal Basis
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 proposing a new anti-fraud rule, Rule 10b-21,
to address fails to deliver associated with abusive ``naked'' short
selling.
D. Small Entities Subject to the Rule
The entities covered by the proposed rule would 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 \68\ 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
[[Page 15384]]
natural person) that is not a small business or small organization. As
of 2006, the Commission estimates that there were approximately 894
broker-dealers that qualified as small entities as defined above.\69\
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\68\ 17 CFR 240.0-10(c)(1).
\69\ These numbers are based on OEA's review of 2006 FOCUS
Report filings reflecting registered broker-dealers. This number
does not include broker-dealers that are delinquent on FOCUS Report
filings.
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Any business, however, regardless of industry, could be subject to
the proposed amendments 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
proposed rule is not feasible.
E. Reporting, Recordkeeping, and Other Compliance Requirements
The proposed rule is intended to address abusive ``naked'' short
selling by highlighting 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
proposed rule could impose new or additional reporting, recordkeeping,
or 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 proposed 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, would be
similar to the changes incurred by broker-dealers when Regulation SHO
was implemented.
We solicit comment on what new recordkeeping, reporting or
compliance requirements may arise as a result of this proposed rule.
F. Duplicative, Overlapping or Conflicting Federal Rules
The Commission believes that there are no federal rules that
duplicate or conflict with the proposed rule. ``Naked'' short selling
as part of a manipulative scheme is always illegal under the general
anti-fraud provisions of the federal securities laws, including Rule
10b-5 under the Exchange Act,\70\ and, therefore, overlap to a certain
extent with the proposed rule. Proposed Rule 10b-21 would highlight 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 highlighting the
illegality of these activities would focus the attention of market
participants on such activities. The proposed rule would also highlight
that the Commission believes such deceptive activities are detrimental
to the markets and would provide a measure of predictability for market
participants.
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\70\ 17 CFR 240.10b-5.
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G. Significant Alternatives
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,\71\ 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.
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\71\ 5 U.S.C. 603(c).
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A primary goal of proposed 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 anti-fraud
provisions of the federal securities laws, Rule 10b-21 would specify
that it is a fraud for any person to submit an order to sell a 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. The
proposed rule 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, proposed Rule 10b-21 would target
short sellers who deceive their broker-dealers about their source of
borrowable shares for purposes of complying with Regulation SHO's
``locate'' requirement.\72\ The proposed rule would also apply to
sellers who misrepresent to their broker-dealers that they own the
shares being sold.
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\72\ See 17 CFR 242.203(b)(1).
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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 would not be consistent
with the primary goal of the proposed rule to further clarify,
consolidate, or simplify the proposed rule for small entities. Finally,
the proposed rule would impose performance standards rather than design
standards.
H. Request for Comments
The Commission encourages the submission of written comments with
respect to any aspect of the IRFA. In particular, the Commission seeks
comment on (i) the number of small entities that will be affected by
the proposed rule; and (ii) the existence or nature of the potential
impact of the proposed rule on small entities. Those comments should
specify costs of compliance with the proposed rule, and suggest
alternatives that would accomplish the objective of the proposed rule.
X. 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 proposing a new anti-fraud 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.
Text of the Proposed Rule Amendments
For the reasons set out in the preamble, Title 17, Chapter II, of
the Code of Federal Regulations is proposed to be amended as follows.
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
1. The authority citation for part 240 continues to read, in part,
as follows:
[[Page 15385]]
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, 78ll, 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.
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.
It shall 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 a 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 the date
delivery is due, and such person fails to deliver the security on or
before the date delivery is due.
By the Commission.
Dated: March 17, 2008.
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E8-5697 Filed 3-20-08; 8:45 am]
BILLING CODE 8011-01-P