Final Rules for Reg SHO

By: Cydney Posner

The SEC has posted the final rules relating to new Reg SHO.  Reg SHO is designed to regulate short sales, that is, the sale of a security that the seller does not own or any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. In order to deliver the security to the purchaser, the short seller will borrow the security, typically from a broker-dealer or an institutional investor. The short seller later closes out the position by purchasing equivalent securities on the open market or by using an equivalent security it already owned and returning the security to the lender. The new rules become effective 30 days after publication in the Federal Register.

The SEC had originally proposed a much broader overhaul of these rules, but decided instead to adopt certain provisions of proposed Reg SHO and to defer consideration of other provisions. The SEC adopted Rule 200, which provides ownership, aggregation and marking requirements. The SEC also established, under Rule 202T, a pilot program that would allow the SEC to temporarily suspend the operation of some of the short sale rules, including the "tick" test and the price test, for selected securities. The SEC decided not to proceed with the proposed uniform bid test until after the pilot results are in. The pilot is designed to allow the SEC to determine, among other things, the extent to which a price test is necessary to further the objectives of short sale regulation, to study the effects of relatively unrestricted short selling on market volatility, price efficiency and liquidity, and to obtain empirical data to help assess whether a short sale price test should be removed or extended for some or all securities.

Other parts of Reg SHO adopted include Rule 203, which creates a uniform SEC rule requiring broker-dealers, prior to effecting short sales in all equity securities, to "locate" securities available for borrowing, and which imposes additional delivery requirements on broker-dealers for securities that have been subject to a substantial level of "failures to deliver" ("threshold securities"). These requirements are designed to reduce short selling abuses by acting as a restriction on "naked" short selling.

The SEC also adopted amendments to Rule 105 of Reg M to eliminate the shelf exception. Rule 105 of Reg M prohibits a short seller from covering short sales with offering securities purchased from an underwriter or broker or dealer participating in the offering if the short sale occurred during the Rule’s restricted period, typically the five-day period prior to pricing. The reason for the prohibition is that pre-pricing short sales that are covered with offering shares artificially distort (lower) the market price for the security. Although the rule does not prohibit pre-pricing short sales, it does prohibit using offering shares to cover pre-pricing short sales. The SEC argues that a trader who sells short pre-pricing and knows that he will be able to obtain covering shares in the offering does not assume the same market risk as a short seller who intends to cover using open market shares, harms the issuer and distorts the market price.

Originally, the shelf exception in Rule 105 was created because shelf offerings were generally viewed to be less susceptible to manipulation than regular offerings. Now shelf offerings have many of the same characteristics of non-shelf offerings and are likely to utilize the same marketing efforts -- road shows and other special selling efforts -- that are used with non-shelf offerings. Accordingly, the SEC has now decided to eliminate the shelf exception.

However, the SEC is especially concerned with sham transactions that are structured to appear to comply with Rule 105 by giving the appearance that pre-pricing short sales are not covered with offering shares, but instead are covered with shares purchased in the open market. The SEC has therefore issued interpretive guidance, which furnishes examples of sham transactions that it believes violate Rule 105. These include:

• an arrangement by the short seller with a third party who acquires the securities in the primary offering;
• receiving offering shares, selling the offering shares into the open market, and then contemporaneously or nearly contemporaneously purchasing an equivalent number of the same class of shares as the offering shares, which are then used to cover the short sales (no legitimate economic purpose or substance to the contemporaneous purchase and sale, no genuine change in beneficial ownership, and/or little or no market risk).

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