SEC adopts three rules related to naked short selling

By Cydney Posner

The SEC has adopted three rules related to naked short selling: amendments to Reg SHO eliminating the options market maker exception; a new naked short- selling antifraud rule and another amendment to Reg SHO, identified as an "interim final temporary rule." (Does that mean there could be an interim final permanent rule? Can we expect a permanent final temporary rule? My head hurts already.) 

• The first amendments to Reg SHO are intended to further reduce the number of persistent "fails to deliver" in certain equity securities by eliminating the options market maker exception to the close-out requirement of Reg SHO. As a result of the amendments, fails to deliver in threshold securities (securities with a substantial level of persistent "fails to deliver") that result from hedging activities by options market makers will no longer be excepted from Reg SHO’s close-out requirement. The release also provides guidance regarding bona fide market making activities for purposes of the market maker exception to Reg SHO’s locate requirement. The effective date is October 17.
• The new anti-fraud rule, Rule 10b-21, is aimed at short sellers, including broker-dealers acting for their own accounts, who deceive specified persons, such as brokers or dealers, about their intention or ability to deliver securities in time for settlement and who fail to deliver securities by the 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 Reg SHO’s "locate" requirement. Rule 10b-21 will also apply to sellers who misrepresent to their broker-dealers that they own the shares being sold. This is a "we really mean it" rule: the release notes that abusive naked short selling as part of a manipulative scheme is always illegal under the general antifraud provisions of the federal securities laws, such as Rule 10b-5; however, new 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. This rule becomes effective on October 17.
• The "interim final temporary" amendment under Reg SHO is intended to address abusive naked short selling in all equity securities by requiring that participants in a clearing agency registered with the SEC deliver securities by the settlement date or, if the participants have not delivered shares by the settlement date, immediately purchase or borrow securities to close out the fail-to-deliver position by no later than the beginning of regular trading hours on the next settlement day. This close-out requirement requires that the participant take affirmative action to purchase or borrow securities. In addition, a participant that does not comply with this close-out requirement, and any broker-dealer from which it receives trades for clearance and settlement, will not be able to short sell the security either for itself or for the account of another, unless it has previously arranged to borrow or borrowed the security, until the fail-to-deliver position is closed out. This rule is essentially an extension (with some modifications to address operational and technical concerns) of the SEC's September emergency order that imposed enhanced delivery requirements on sales of all equity securities. This interim final temporary rule becomes effective on October 17 and will expire on July 31, 2009.

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