[Federal Register Volume 68, Number 215 (Thursday, November 6, 2003)]
[Proposed Rules]
[Pages 62972-63009]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-27660]



[[Page 62971]]

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Part V





Securities and Exchange Commission





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17 CFR Parts 240 and 242



Short Sales; Proposed Rule

  Federal Register / Vol. 68, No. 215 / Thursday, November 6, 2003 / 
Proposed Rules  

[[Page 62972]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 242

[Release No. 34-48709; File No. S7-23-03]
RIN 3235-AJ00


Short Sales

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (Commission) is 
publishing for public comment new Regulation SHO, under the Securities 
Exchange Act of 1934 (Exchange Act), which would replace Rules 3b-3, 
10a-1, and 10a-2. The Commission is also proposing amendments to Rule 
105 of Regulation M. Proposed Regulation SHO would, among other things, 
require short sellers in all equity securities to locate securities to 
borrow before selling, and would also impose strict delivery 
requirements on securities where many sellers have failed to deliver 
the securities. In part, this action is designed to address the problem 
of ``naked'' short selling. Proposed Regulation SHO would also 
institute a new uniform bid test allowing short sales to be effected at 
a price one cent above the consolidated best bid. This test would apply 
to all exchange-listed securities and Nasdaq National Market System 
Securities (NMS Securities), wherever traded.
    We are also seeking comment on a temporary rule that would suspend 
the operation of the proposed bid test for specified liquid securities 
during a two-year pilot period. The temporary suspension would allow 
the Commission to study the effects of relatively unrestricted short 
selling on market volatility, price efficiency, and liquidity.

DATES: Comments must be received on or before January 5, 2004.

ADDRESSES: To help us process and review your comments more 
efficiently, comments should be sent by hard copy or e-mail, but not by 
both methods. Comments sent by hard copy should be submitted in 
triplicate to Jonathan G. Katz, Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Comments 
also may be submitted electronically at the following E-mail address: 
[email protected]. All comment letters should refer to File No. S7-
23-03. Comments submitted by E-mail should include this file number in 
the subject line. Comment letters received will be available for public 
inspection and copying in the Commission's Public Reference Room, 450 
Fifth Street, NW., Washington, DC 20549. Electronically submitted 
comment letters will be posted on the Commission's Internet Web site 
(http://www.sec.gov).\1\
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    \1\ Personal identifying information, such as names or e-mail 
addresses, will not be edited from electronic submission. Submit 
only information that you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: Any of the following attorneys in the 
Office of Trading Practices, Division of Market Regulation, Securities 
and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-
1001, at (202) 942-0772: James Brigagliano, Assistant Director, or 
Gregory Dumark, Kevin Campion, Lillian Hagen, Elizabeth Sandoe and 
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Marla Chidsey, Special Counsels.

SUPPLEMENTARY INFORMATION: The Commission is publishing for comment 
proposed Regulation SHO and a proposed temporary rule, Rule 202 \2\, 
and proposed amendments to Regulation M, Rule 105 \3\ under the 
Exchange Act.
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    \2\ 17 CFR 242.202.
    \3\ 17 CFR 242.105.
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Table of Contents

I. Introduction
    A. Background and Current Short Sale Regulation
    B. Market Effects of Short Selling
    C. Market Developments
II. Naked Short Selling
    A. Background
    B. Current Regulatory Requirements
    C. Proposed Amendments
    1. Short Sales
    2. Long Sales
III. Current Market Structure and the Tick Test
IV. Proposed Bid Test
    A. Operation of the Uniform Bid Test
    B. Scope of the Uniform Bid Test
    1. Securities Subject to the Price Test
    2. Securities Not Subject to the Price Test
    C. Bid Test Flexibility in a Decimals Environment
    D. Bid Test Flexibility for Passive Pricing Systems
V. Pilot Program
VI. Rule 10a-1 Exceptions
    A. Exceptions Proposed to be Retained
    1. Long Seller's Delay in Delivery
    2. Error in Marking a Short Sale
    3. Odd Lot Transactions
    4. Domestic Arbitrage
    5. International Arbitrage
    6. Distribution Over-Allotment
    7. Equalizing Short Sales and Trade-Throughs
    B. Exception Proposed to Be Eliminated
VII. Prior Exemption Letters under Rule 10a-1
    A. Exchange Traded Funds

B. Short Sales Executed at the Closing Price

VIII. Market Maker Exception from Proposed Uniform Bid Test
IX. Proposed Changes to the Order Marking Requirement
    A. Marking Orders
    B. Marking Requirements for Riskless Principal Transactions
X. Rule 3b-3
    A. Unconditional Contracts to Purchase Securities
    B. Ownership of Securities Underlying Securities Futures 
Products
    C. Aggregation Units
    D. Block-Positioner Exception
    E. Liquidation of Index Arbitrage Positions
XI. Hedging Transactions
XII. Elimination of Current Subparagraphs 10a-1(a)(2) and (a)(3)
XIII. Exclusion of Bonds
XIV. After Hours Trading/Foreign Markets Issues
    A. After-Hours Trading
    B. Off-Shore Trading
XV. Limitations on Short Selling During Significant Market Declines
XVI. Rule 105 of Regulation M--Short Sales in Connection with a 
Public Offering
    A. Scope of Rule 105 of Regulation M
    B. Shelf Offerings
    C. Sham Transactions Designed to Give the Appearance of Covering 
with Open Market Securities
XVII. General Request for Comment
XVIII. Paperwork Reduction Act
XIX. Consideration of Proposed Regulation SHO's Costs and Benefits
XX. Consideration on Burden and Promotion of Efficiency, 
Competition, and Capital Formation
XXI. Consideration of Impact on the Economy
XXII. Initial Regulatory Flexibility Analysis
XXIII. Statutory Authority Text of Proposed Regulation SHO, 
Amendments and Temporary Rule

I. Introduction

    Congress, in 1934, directed the Commission to ``purge the market'' 
of short selling abuses, and in response, the Commission adopted 
restrictions that have remained essentially unchanged for over 60 
years. Originally adopted in 1938, the Commission's short sale rule, 
Rule 10a-1, is designed to restrict short sellers from effecting short 
sales in an exchange-traded security when the price of that security is 
declining.\4\
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    \4\ 17 CFR 240.10a-1.
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    Since its adoption, the Commission has engaged in studies, 
investigations, and reviews of the efficacy of the Rule.\5\

[[Page 62973]]

Most recently, in 1999, the Commission issued a release requesting 
public comment on the regulation of short sales of securities (Concept 
Release).\6\ The Concept Release examined ways to modernize our 
approach to short sale regulation. We received 2778 comment letters in 
response to the Release.\7\
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    \5\ See 2 Securities and Exchange Commission, Report of Special 
Study of Securities Markets, H.R. Doc. No. 95, 88th Cong., 1st Sess. 
247 (1963) (study to determine the relationships between changes in 
short positions and subsequent price trends); see also Short-Selling 
Activity in the Stock Market: Market Effects and the Need for 
Regulation (Part I)(House Report), H.R., Rep. No. 102-414 (1991), 
reprinted in CCH Federal Securities Law Reports Number 1483 Part II 
(1992).
    \6\ Securities Exchange Act Release No. 42037 (October 20, 
1999), 64 FR 57996 (October 28,1999).
    \7\ The comment letters and a comprehensive summary of the 
comments are available for inspection in the Commission's Public 
Reference Room in File No. S7-24-99.
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    Since the Concept Release was published, we have reviewed the 
comment letters and reexamined the structure and operation of Rule 10a-
1, and related Rules 10a-2 \8\ and 3b-3.\9\ We also considered the 
status of short sale regulation in the context of requests for relief 
from Rule 10a-1 submitted to the Commission for a wide range of short 
selling activities. Finally, we considered recent market changes, 
including increased instances of ``naked'' short selling, i.e., selling 
short without borrowing the necessary securities to make delivery; 
decimalization; the advent of security futures trading; and an 
increasing amount of Nasdaq securities being traded away from the 
Nasdaq market, and thus not subject to any short sale price test. As a 
result of this assessment, we are seeking comment on proposed 
Regulation SHO, which would replace Rules 3b-3, 10a-1, and 10a-2, and 
that would temporarily suspend the short sale price test for specified 
liquid stocks. We also propose to amend Rule 105 of Regulation M to 
eliminate the shelf offering exception. The comments we receive will 
assist us in determining whether to adopt the proposed changes to these 
rules and the nature and scope of such changes.
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    \8\ 17 CFR 240.10a-2.
    \9\ 17 CFR 240.3b-3.
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A. Background and Current Short Sale Regulation

    A short sale 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.\10\ 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. In general, 
short selling is used to profit from an expected downward price 
movement, to provide liquidity in response to unanticipated demand, or 
to hedge the risk of a long position in the same security or in a 
related security.
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    \10\ See Rule 3b-3 under the Exchange Act, 17 CFR 240.3b-3.
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    The following example illustrates a typical short sale transaction:

    XYZ stock is currently selling at $50 per share. An investor 
anticipates that the price of XYZ stock will decline and wants to 
sell short 100 shares. The investor's broker borrows 100 shares for 
the investor and executes the short sale. The $5,000 proceeds from 
the sale (plus, usually, an additional 2%) are posted as collateral 
with the lender and the investor must also post margin equal to 50% 
of the purchase price with his broker.\11\ At some point in the 
future the investor must purchase 100 shares to return to the 
lender. If the investor can purchase the XYZ shares at a price below 
$50, the investor can cover the short position at a profit. If the 
price of XYZ shares rises above $50, the investor may have to cover 
the short position at a loss.\12\
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    \11\ See, e.g., 12 CFR 220.12(c)(1) of Regulation T of the Board 
of Governors of the Federal Reserve System, which requires margin 
for a short sale of a nonexempted equity security of 150 percent of 
the current market value of the security. An investor may be 
required to deposit additional ``maintenance margin'' for 
transactions in short sales under margin requirements imposed by 
self regulatory organizations (SROs). See, e.g., NASD Rule 2520(c) 
and NYSE Rule 431(c). Further, broker-dealers may institute higher 
short sale margin requirements than those imposed by self-regulatory 
organization rules. See, e.g., NASD Rule 2520(d) and NYSE Rule 
431(d).
    \12\ This simple example does not include transaction and 
carrying costs. For a more complete discussion of equity lending and 
costs of borrowing equity see Securities Lending Transactions: 
Market Developments and Implications, Technical Committee of the 
International Organization of Securities Commissions (IOSCO) 
Committee on Payment and Settlement Systems (CPSS) (July, 1999). 
This paper can be accessed at www.iosco.org/pubdocs/pdf/IOSCOPD96.pdf. See also Geczy, Musto, and Reed, 2002, Stocks Are 
Special Too: An Analysis of the Equity Lending Market, Journal of 
Financial Economics, 66, 241-269.

    Section 10(a) of the Exchange Act gives the Commission plenary 
authority to regulate short sales of securities registered on a 
national securities exchange (listed securities), as necessary to 
protect investors. After conducting an inquiry into the effects of 
concentrated short selling during the market break of 1937, the 
Commission adopted Rule 10a-1 in 1938 in order to restrict short 
selling in a declining market.\13\ The core provisions of the Rule are 
largely the same today as when they were adopted.
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    \13\ Securities Exchange Act Release No. 1548 (January 24, 
1938), 3 FR 213 (January 26, 1938).
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    Paragraph (a) of Rule 10a-1 generally covers short sales in listed 
securities if trades of the security are reported pursuant to an 
``effective transaction reporting plan'' and information as to such 
trades is made available in accordance with such plan on a real-time 
basis to vendors of market transaction information.\14\ Paragraph (b) 
applies to short sales on national exchanges in securities that are not 
covered by paragraph (a).
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    \14\ Rule 10a-1 uses the term ``effective transaction reporting 
plan'' as defined in Rule 11Aa3-1 (17 CFR 240.11Aa3-1) under the 
Exchange Act. See 17 CFR 240.10a-1(a)(1)(i).
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    Rule 10a-1(a)(1) provides that, subject to certain exceptions, a 
listed security may be sold short (A) at a price above the price at 
which the immediately preceding sale was effected (plus tick), or (B) 
at the last sale price if it is higher than the last different price 
(zero-plus tick).\15\ Short sales are not permitted on minus ticks or 
zero-minus ticks, subject to narrow exceptions. The operation of these 
provisions, commonly described as the ``tick test,'' determines the 
minimum shortable price (MSP) \16\ at which a security can be sold 
short. The following transactions illustrate the operation of the tick 
test: \17\
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    \15\ The last sale price is the price reported pursuant to an 
effective transaction reporting plan, i.e., the Consolidated Tape 
Association, also generally referred to as the ``Tape.''
    \16\ The MSP is the lowest price that a stock can be sold short 
under current short sale regulation. If a stock is trading on a 
minus or zero-minus tick, a short sell order must be executed at a 
price higher than the last trade.
    \17\ The first execution at 47.04 is a plus tick since it is 
higher than the previous last trade price of 47.00. The next 
transaction at 47.04 is a zero-plus tick since there is no change in 
trade price but the last change was a plus tick. Short sales could 
be executed at 47.04 or above. The final two transactions at 47.00 
are minus and zero-minus transactions, respectively. Short sales 
would have to be effected at the next higher increment above 47.00 
in order to comply with Rule 10a-1.

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[GRAPHIC] [TIFF OMITTED] TP06NO03.005

    In adopting the tick test, the Commission sought to achieve three 
objectives:
    (i) allowing relatively unrestricted short selling in an advancing 
market;
    (ii) preventing short selling at successively lower prices, thus 
eliminating short selling as a tool for driving the market down; and
    (iii) preventing short sellers from accelerating a declining market 
by exhausting all remaining bids at one price level, causing 
successively lower prices to be established by long sellers.\18\
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    \18\ See Securities Exchange Act Release No. 13091 (December 21, 
1976), 41 FR 56530 (December 28, 1976).
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    In 1994, the Commission granted temporary approval to the NASD to 
apply its own short sale rule to Nasdaq NMS securities.\19\ NASD Rule 
3350 prohibits short sales by NASD members in Nasdaq NMS Securities 
\20\ at or below the current best (inside) bid when that bid is lower 
than the previous best (inside) bid (commonly referred to as the bid 
test).
    The operation of the bid test in NASD Rule 3350 is illustrated as 
follows:
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    \19\ See Securities Exchange Act Release No. 34277 (June 29, 
1994), 59 FR 34885 (July 7, 1994).
    \20\ Rule 11Aa2-1 under the Act sets forth the criteria and 
procedures by which certain over-the-counter (OTC) securities are 
designated as NMS Securities. 17 CFR 240.11Aa2-1.

----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
Bid Sequence..................     47   47.04............  47.04............  47..............  47
Current Bid Compared to the     ......  plus bid           zero-plus bid      minus bid         zero-minus bid
 previous bid.                           (compared to       (compared to       (compared to      (compared to
                                         last bid at 47).   last bid at        last bid at       last bid at 47)
                                                            47.04).            47.04).
MSP...........................  ......  any price........  any price........  47.01...........  47.01
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B. Market Effects of Short Selling

    Short selling provides the market with at least two important 
benefits: market liquidity and pricing efficiency.\21\ Market liquidity 
is generally provided through short selling by market professionals, 
such as market makers (including specialists) and block positioners, 
who offset temporary imbalances in the buying and selling interest for 
securities. Short sales effected in the market add to the selling 
interest of stock available to purchasers and reduce the risk that the 
price paid by investors is artificially high because of a temporary 
contraction of selling interest. Short sellers covering their sales 
also may add to the buying interest of stock available to sellers.
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    \21\ See Lamont, Owen A. and Thaler, Richard H, 2003, Can the 
Market Add and Subtract? Mispricing in Tech Stocks Carve-outs, 
University of Chicago and NBER.
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    Short selling also can contribute to the pricing efficiency of the 
equities markets. Efficient markets require that prices fully reflect 
all buy and sell interest. When a short seller speculates or hedges 
against a downward movement in a security, his transaction is a mirror 
image of the person who purchases the security based upon speculation 
that the security's price will rise or to hedge against such an 
increase. Both the purchaser and the short seller hope to profit, or 
hedge against loss, by buying the security at one price and selling at 
a higher price. The strategies primarily differ in the sequence of 
transactions. Market participants who believe a stock is overvalued may 
engage in short sales in an attempt to profit from a perceived 
divergence of prices from true economic values. Such short sellers add 
to stock pricing efficiency because their transactions inform the 
market of their evaluation of future stock price performance. This 
evaluation is reflected in the resulting market price of the 
security.\22\
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    \22\ Arbitrageurs also contribute to pricing efficiency by 
utilizing short sales to profit from price disparities between a 
stock and a derivative security, such as a convertible security or 
an option on that stock. For example, an arbitrageur may purchase a 
convertible security and sell the underlying stock short to profit 
from a current price differential between two economically similar 
positions.
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    Although short selling serves useful market purposes, it also may 
be used to illegally manipulate stock prices.\23\ One example is the 
``bear raid'' where an equity security is sold short in an effort to 
drive down the price of the security by creating an imbalance of sell-
side interest.\24\ Further, unrestricted short selling can exacerbate a 
declining market in a security by increasing pressure from the sell-
side, eliminating bids, and causing a further reduction in the price of 
a security by creating an appearance that the security price is falling 
for fundamental reasons.
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    \23\ See, e.g., 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 (2nd 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).
    \24\ Many people blamed ``bear raids'' for the 1929 stock market 
crash and the market's prolonged inability to recover from the 
crash. See 7 Louis Loss and Joel Seligman, Securities Regulation 
3203-04, note 213 (3d ed. 1989).
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    Short selling was one of the central issues studied by Congress 
before enacting the Exchange Act, but Congress did not directly 
prohibit short selling.\25\ Instead, Congress gave the Commission broad 
authority to regulate short sales in order to stop short selling 
abuses.\26\
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    \25\ See 2 Securities and Exchange Commission, Report of Special 
Study of Securities Markets, H.R. Doc. No. 95, 88th Cong., 1st Sess. 
247 (1963) (Special Study).
    \26\ Id.
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C. Market Developments

    Several significant developments in the securities markets, 
including, but not limited to, instances of abusive naked short 
selling, the increasing

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number of Nasdaq securities trading away from the Nasdaq market (and 
thus not subject to any price test), the advent of security futures 
trading, and decimalization have caused the Commission to reexamine 
short sale regulation. At a minimum, the Commission believes that 
adjustments to short sale regulation are required to keep pace with 
these market developments.

II. Naked Short Selling

A. Background

    Many issuers and investors have complained about alleged ``naked 
short selling,'' especially in thinly-capitalized securities trading 
over-the-counter.\27\ Naked short selling is selling short without 
borrowing the necessary securities to make delivery, thus potentially 
resulting in a ``fail to deliver'' securities to the buyer.
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    \27\ For example, see comment letters from John Henry Austin 
(2675), Bridget Thomas (2297), James McCaffery (492), Richard 
Ballard (507), and Ken Klaser (596).
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    Naked short selling can have a number of negative effects on the 
market, particularly when the fails to deliver persist for an extended 
period of time and result in a significantly large unfulfilled delivery 
obligation at the clearing agency where trades are settled.\28\ At 
times, the amount of fails to deliver may be greater than the total 
public float. In effect the naked short seller unilaterally converts a 
securities contract (which should settle in three days after the trade 
date) into an undated futures-type contract, which the buyer might not 
have agreed to or that would have been priced differently. The seller's 
failure to deliver securities may also adversely affect certain rights 
of the buyer, such as the right to vote. More significantly, naked 
short sellers enjoy greater leverage than if they were required to 
borrow securities and deliver within a reasonable time period, and they 
may use this additional leverage to engage in trading activities that 
deliberately depress the price of a security.\29\
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    \28\ ``Clearing agency'' is defined in Section 3(a)(23)(A) of 
the Exchange Act, 15 U.S.C. 78c(a)(23)(a).
    \29\ The Commission issued a prior statement cautioning broker-
dealers that where the broker-dealer has sold short, but did not, 
for a substantial period of time, effect the offsetting purchase 
transactions for purpose of delivery, this could generally involve 
violations of the anti-fraud provisions of the Federal securities 
laws. See Securities Exchange Act Release No. 6778 (April 16, 1962).
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    The Commission recently brought an enforcement action against 
certain parties, alleging manipulative naked short selling, in a scheme 
sometimes termed as a ``death spiral.'' These schemes generally involve 
parties arranging financings in public companies that are unable to 
obtain more conventional financing in the capital markets due to their 
precarious financial condition. The party providing financing receives 
from a public company debentures that are later convertible into the 
stock of the issuer. The terms typically provide that the conversion 
ratio will be tied to a fixed value of the aggregate underlying shares 
(typically a discount from the market price of the security at the time 
of the conversion rather than a conversion price per share).\30\ In 
some cases the parties providing financing have engaged in extensive 
naked short selling designed to lower the price of the issuer's stock, 
thus realizing profits when the debentures are converted to cover the 
short sales.\31\
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    \30\ For more information, see ``Convertible Securities'' on the 
Commission's Web site at www.sec.gov/answers/convertibles.htm
    \31\ The Commission recently settled a case against parties 
relating to allegations of manipulative short selling in the stock 
of Sedona Corporation, a Nasdaq Small Cap company. The action 
alleged that the defendants engaged in massive naked short selling 
that flooded the market with Sedona stock, and thus depressed its 
price. The defendants thereby profited by subsequently exercising 
the conversion rights under the debenture. See Rhino Advisors, Inc. 
and Thomas Badian, Lit. Rel. No. 18003 (February 27, 2003); see also 
SEC v. Rhino Advisors, Inc. and Thomas Badian, Civ. Action No. 03 
civ 1310 (RO) (Southern District of New York).
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    Naked short selling has sparked defensive actions by some issuers 
designed to combat the potentially negative effects on shareholders, 
broker-dealers, and the clearance and settlement system.\32\ 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. A number of 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.\33\ 
Withdrawing securities from DTC or requiring custody-only transfers 
undermine the goal of a national clearance and settlement system, 
designed to reduce the physical movement of certificates in the trading 
markets.\34\
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    \32\ There have been press reports concerning the actions of 
some issuers, and questioning whether the cause of declines in their 
stock prices can be attributed to naked short selling, or to 
fundamental problems with the company. See, e.g., Carol S. Remond, 
Universal Blames Shorts, But What of Dilution?, Dow Jones Newswires 
(October 6, 2003); Rob Wherry, Wall Street's Next Nightmare?, 
Forbes.com (October 6, 2003); see also Gretchen Morgenson, If Short 
Sellers Take Heat, Maybe It's Time to Bail Out, NY Times (January 
26, 2003) (citing a study by Professor Owen A. Lamont that analyzed 
returns at companies that waged public battles with short sellers, 
and found that their stocks lagged the market by 2.34 percent in 
each of the twelve months after the battles began). As a matter of 
practice, the Commission does not opine on the content or accuracy 
of such reports.
    \33\ The Commission recently 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) (File No. SR-DTC-2003-02).
    \34\ See Section 17A(e) of the Exchange Act. 15 U.S.C. 78q-1(e). 
The Commission noted in the order approving the DTC rule change that 
the use of certificates can result in significant delays and 
expenses in processing securities transactions and can raise safety 
concerns associated with lost, stolen, and forged certificates. See, 
supra n. 33.
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B. Current Regulatory Requirements

    The SROs have adopted rules generally requiring that, prior to 
effecting short sales, members must ``locate'' stock available for 
borrowing.\35\ For example, NYSE Rule 440C.10 states that no NYSE 
member or member organization should ``fail to deliver'' against a 
short sale of a security on a national securities exchange until a 
diligent effort has been made by such member or member organization to 
borrow the necessary securities to make delivery.\36\ An NYSE 
interpretation to the rule further states that member organizations 
effecting short sales for their own account or the accounts of 
customers must be in a position to complete the transaction. The 
interpretation states that no orders to sell short should be accepted 
or entered unless prior arrangements to borrow the stock have been made 
or other acceptable assurances that delivery can

[[Page 62976]]

be made on settlement date.\37\ These provisions apply to all NYSE 
member organizations, whether effecting transactions in exchange-listed 
securities on the NYSE, another national securities exchange, or in the 
over-the-counter market. Exceptions from the rule are provided for 
short sales by specialists, market makers, and odd lot dealers in 
fulfilling their market responsibilities.\38\
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    \35\ In 1976 the Commission proposed the adoption of Rule 10b-
11. Rule 10b-11 would have prohibited any person from effecting a 
short sale in any equity security (i.e., not just exchange-traded 
securities) for his own account or the account of any other person 
unless he, or the person for whose account the short sale is 
effected (i) borrowed the security, or entered into an arrangement 
for the borrowing of the security, or (ii) had reasonable grounds to 
believe that he could borrow the security so that, in either event, 
he would be capable of delivering the securities on the date 
delivery is due. Securities Exchange Act Release No. 13091 (December 
21, 1976), 41 FR 56530 (December 28, 1976). In 1988, the Commission 
withdrew proposed Rule 10b-11, noting that since the time the rule 
was proposed, the NYSE and the NASD had adopted interpretations 
specifying that members should not accept or enter a short sale 
order unless prior arrangements to borrow the stock have been made, 
or other acceptable assurances that delivery can be made on 
settlement date have been obtained. The Commission also stated that 
it believed the general antifraud provisions of the federal 
securities laws were applicable to activity addressed by proposed 
Rule 10b-11. Securities Exchange Act Release No. 26182 (October 14, 
1988), 53 FR 41206.
    \36\ See NYSE Rule 440C.10.
    \37\ Such assurances include knowledge that the security is 
available for borrowing, conversion privileges, rights exercise, and 
the like. One test of reasonableness in short sales against 
convertible securities, rights and merger securities is whether the 
security needed for delivery can be exchanged in normal transfer 
time. A firm that normally relies on the stock loan market without 
advance borrowing can demonstrate compliance by switching to prior 
borrowing whenever the stock borrowing market in a particular 
security becomes tight.'' NYSE Rule 440C.10 Interp. /01. See also 
NYSE Information Memo 91-41 (providing further information regarding 
compliance with Rule 440C.10).
    \38\ Id.
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    The comparable NASD Rule 3370 generally provides that no member, or 
person associated with a member, shall effect a short sale for a 
customer or for its own account unless the member makes an 
``affirmative determination'' that the member can borrow the securities 
or otherwise provide for delivery of the securities by settlement 
date.\39\ The affirmative determination must be annotated in writing, 
evidencing that the member firm will receive delivery of the security 
from the customer or, if the member firm locates the stock, the 
identity of the individual and firm contacted who offered assurance 
that the shares would be delivered or were available for borrowing.\40\ 
This requirement applies regardless of how a short sale order is 
received, e.g., by the telephone, an electronic transmission, the 
Internet, or otherwise.\41\ This requirement does not apply to 
transactions in corporate debt securities, to bona fide market making 
transactions by Nasdaq market makers,\42\ or to transactions that 
result in fully hedged or arbitraged positions.\43\
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    \39\ See NASD Rule 3370.
    \40\ According to the rule, the manner by which a member or 
person associated with a member annotates compliance with the 
affirmative determination requirement is to be decided by each 
member. Members may rely on ``blanket'' or standing assurances 
(i.e., ``Easy to Borrow'' lists) that securities will be available 
for borrowing on settlement date. For any short sales executed in 
Nasdaq National Market (``NNM'') or exchange-listed securities, 
members also may rely on ``Hard to Borrow'' lists indicating NNM or 
listed securities that are difficult to borrow or unavailable for 
borrowing on settlement date provided that: (i) Any securities 
restricted pursuant to NASD Rule 11830 must be included on such a 
list; and (ii) the creator of the list attests in writing on the 
document or otherwise that any NNM or listed securities not included 
on the list are easy to borrow or are available for borrowing. 
Members are permitted to use Easy to Borrow or Hard to Borrow lists 
provided: (i) The information used to generate the list is no less 
than 24 hours old; and (ii) the member delivers the security on 
settlement date. Should a member relying on an Easy to Borrow or 
Hard to Borrow fail to deliver the security on settlement date, the 
NASD deems such conduct inconsistent with the terms of Rule 3370, 
absent mitigating circumstances adequately documented by the member. 
See NASD Rule 3370(b)(4)(C).
    \41\ See NASD Notice to Members 99-98.
    \42\ NASD IM-3350 contains language specifying what type of 
activity does not constitute bona fide market making: ``Bona fide 
market making activity does not include activity that is unrelated 
to market making functions, such as index arbitrage and risk 
arbitrage that is independent from a member's market making 
functions. * * *'' IM-3350(a)(2). ``Similarly, bona fide market 
making would exclude activity that is related to speculative selling 
strategies of the member or investment decisions of the firm and is 
disproportionate to the usual market making patterns or practices of 
the member in that security. The Association does not anticipate 
that a firm could properly take advantage of its market maker 
exemption to effectuate such speculative or investment short selling 
decisions. Disproportionate short selling in a market making account 
to effectuate such strategies will be viewed by the Association as 
inappropriate activity that does not represent bona fide market 
making and would therefore be in violation of Rule 3350.'' IM-
3350(a)(3).
    The NASD has instituted disciplinary actions against broker-
dealers that the NASD found were abusing the exemption provided for 
bona-fide market making transactions. See, e.g., Hearing Panel 
Decision as to Respondents John Fiero and Fiero Brothers, Inc. 
(December 6, 2000) (decision affirmed by the National Adjudicatory 
Council on October 28, 2002); see also John Emshwiller, NASD Moves 
to Bar Short Seller Fiero, Citing Alleged Manipulation of Stocks, 
WSJ (January 9, 2001).
    \43\ NASD Rule 3370(b)(5) provides guidelines in determining the 
availability of the exemption for ``bona-fide fully hedged'' and 
``bona-fide fully arbitraged'' positions.
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    The NASD has also adopted several rules addressing failures to 
deliver. NASD Rule 3210 prevents a member, or person associated with a 
member, from selling a security for his own account, or buying a 
security as a broker for a customer if, with respect to domestic 
securities,\44\ he has a fail to deliver in that security that is 60 
days or older. NASD Rule 11830 imposes a mandatory close-out 
requirement for Nasdaq securities that have a clearing short position 
of 10,000 shares or more per security and that are equal to at least 
one-half of one percent of the issue's total shares outstanding. NASD 
Rule 11830 generally requires that a contract involving a short sale in 
these securities, for the account of a customer or for an NASD member's 
own account, which has not resulted in delivery by the broker-dealer 
representing the seller within 10 business days after the normal 
settlement date (currently transaction date + 3 business days), must be 
closed by the broker-dealer representing the seller by purchasing for 
cash or guaranteed delivery of securities of like kind and quality. 
This mandatory close-out requirement does not apply to bona-fide market 
making transactions and transactions that result in fully hedged or 
arbitraged positions.
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    \44\ With respect to foreign securities, if the member has a 
fail to deliver in that security 90 days or older (except American 
Depositary Receipt and Canadian securities, which shall be subject 
to the 60 day provision).
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C. Proposed Amendments

1. Short Sales
    The Commission believes that these SRO requirements have not fully 
addressed the problems of naked short selling and extended fails to 
deliver. We believe it would be beneficial to establish a uniform 
standard specifying the procedures for all short sellers to locate 
securities for borrowing.\45\ This would further the goals of 
regulatory simplification and avoidance of regulatory arbitrage, as 
well as address some areas not currently covered. We are therefore 
proposing to incorporate in proposed Regulation SHO a uniform 
``locate'' rule applicable to all equity securities, wherever they are 
traded.\46\ Proposed Rule 203 would prohibit a broker-dealer from 
executing a short sale order for its own account or the account of 
another person, unless the broker-dealer, or the person for whose 
account the short sale is executed (1) borrowed the security, or 
entered into an arrangement for the borrowing of the security, or (2) 
had reasonable grounds to believe that it could borrow the security so 
that it would be capable of delivering the securities on the date 
delivery is due.\47\ Consistent with the current SRO requirements, the 
proposed rule would require that the locate be made and annotated in 
writing prior to effecting any short sale, regardless of the fact that 
the seller's short position may

[[Page 62977]]

be closed out by purchasing securities the same day.\48\ The Commission 
is proposing an exception from these requirements for short sales 
executed by specialists or market makers but only in connection with 
bona-fide market making activities.\49\ We believe a narrow exception 
for market makers and specialists engaged in bona fide market making 
activities is necessary because they may need to facilitate customer 
orders in a fast moving market without possible delays associated with 
complying with the proposed ``locate'' rule. Moreover, we believe that 
most specialists and market makers seek a net ``flat'' position in a 
security at the end of each day and often ``offset'' short sales with 
purchases such that they are not required to make delivery under the 
security settlement system.
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    \45\ Some commenters to the Concept Release supported a single, 
workable approach to locating securities for borrowing before 
effecting short sales. See letter from Wilkie, Farr & Gallagher 
(488) (writing on behalf of Bear, Stearns & Co., Inc.; Credit Suisse 
First Boston Corp.; Deutsche Bank Securities, Inc.; JP Morgan 
Securities Inc.; PaineWebber Inc.; Prudential Securities Inc.; and 
Warburg Dillon Read LLC.).
    \46\ See paragraph (b), Rule 203 of proposed Regulation SHO.
    \47\ We are interested in receiving comment on the manner in 
which persons could satisfy the ``reasonable grounds'' determination 
in the proposed rule. As noted above, the current SRO rules 
generally defer to members to decide the manner of compliance, and 
permit members to rely on blanket assurances that stock is available 
for borrowing, i.e., ``hard to borrow'' or ``easy to borrow'' lists. 
See, supra n. 40. We specifically request comment on whether this 
present method of compliance provides an accurate assessment of the 
current lending market in a manner that would not impede liquidity 
and the ability of market participants to establish short positions, 
while at the same time guarding against the noted problems inherent 
with large extended settlement failures.
    \48\ See, e.g., Ko Securities, Inc. and Terrance Y. Yoshikawa, 
Securities Exchange Act Release No. 48550 (September 26, 2003) 
(holding that an affirmative determination must be made before the 
securities are sold short regardless of whether the short seller 
repurchases securities on the same day).
    \49\ The exemption for bona-fide market making activities would 
exclude activity that is related to speculative selling strategies 
or investment decisions of the broker-dealer or associated person 
and is disproportionate to the usual market making patterns or 
practices of the broker-dealer in that security.
---------------------------------------------------------------------------

    As an additional safeguard against some of the problems associated 
with naked short selling, we are proposing a delivery requirement 
targeted at securities where there is evidence of significant 
settlement failures. We are incorporating the same threshold currently 
used in NASD Rule 11830,\50\ i.e., any security where there are fails 
to deliver at a clearing agency registered with the Commission of 
10,000 shares or more per security, and that is equal to at least one-
half of one percent of the issue's total shares outstanding.\51\ We are 
incorporating this standard into proposed Rule 203 because we believe 
that the levels set in NASD Rule 11830 characterize situations where 
the ratio of unfulfilled delivery obligations at the clearing agency 
where trades are settled represents a significant number of shares 
relative to the company's total shares outstanding, thus requiring 
remedial action designed to address potential negative effects. The 
proposed rule would specify that for short sales of any security 
meeting this threshold, the selling broker-dealer must deliver the 
security no later than two days after the settlement date.\52\ We 
believe a two-day grace period is appropriate to allow for transfer 
delays or delays due to a variety of circumstances that prevent timely 
delivery.\53\ If for any reason such security was not delivered within 
two days after the settlement date, the rule would restrict the broker-
dealer, including market makers, from executing future short sales in 
such security for the person for whose account the failure to deliver 
occurred unless the broker-dealer or the person for whose account the 
short sale is executed borrowed the security, or entered into a bona 
fide arrangement to borrow the security, prior to executing the short 
sale and delivered on settlement date. This restriction would be in 
effect for a period of 90 calendar days.\54\ In addition, the rule 
would require the rules of the registered clearing agency that 
processed the transaction to include the following provisions: (A) A 
broker or dealer failing to deliver such securities shall be referred 
to the NASD and the designated examining authority for such broker-
dealer for appropriate action; \55\ and (B) The registered clearing 
agency shall withhold a benefit of any mark-to-market amounts or 
payments that otherwise would be made to the party failing to 
deliver,\56\ and take other appropriate action, including assessing 
appropriate charges against the party failing to deliver. Both of these 
requirements should assist the Commission in preventing abuses and 
promote the prompt and accurate clearance and settlement of securities 
transactions.
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    \50\ The National Securities Clearing Corporation (NSCC) 
currently tracks this information on fails to deliver and provides 
it to Nasdaq for purposes of administering NASD Rule 11830. Thus, we 
do not believe that the threshold proposed here would impose unduly 
burdensome data collection requirements.
    \51\ For example, if an issuer had 1,000,000 shares outstanding, 
one-half of one percent (.005) would be 5,000 shares. An aggregate 
fail to deliver position at a clearing agency of 10,000 shares or 
more would thus meet the threshold. If an issuer had 10,000,000 
shares outstanding, one-half of one percent would be 50,000 shares. 
An aggregate fail to deliver position at a clearing agency of 50,000 
shares or greater would meet the threshold.
    \52\ When the trade fails to settle on normal settlement date 
(i.e., T+3), the broker-dealer would have to take actions, such as 
borrowing the security or effecting a purchase in the cash market, 
so that actual delivery is made by T+5.
    \53\ Unlike NASD Rule 11830, which provides for delivery of 
securities meeting this threshold to be delivered within 10 business 
days after the normal settlement date, we propose a two-day period 
because we believe it is reasonable period to allow for transfer 
delays or delays due to some other characteristic of the security 
while preventing unfulfilled delivery obligations from extending for 
a period that we believe is characteristic of a more significant 
problem.
    \54\ In this context, we believe that a 90-day restricted period 
is an appropriate consequence for a failure to deliver and a 
deterrent to prevent failures to deliver in the future. The Federal 
Reserve Board has taken this approach with respect to transactions 
in cash accounts where the securities are sold before they have been 
fully paid for. See, 12 CFR 220.8(c), Regulation T.
    \55\ Referral to the designated examining authority would allow 
for monitoring of broker or dealers not complying with proposed Rule 
203 and allow for possible disciplinary action. In the case of any 
fail to deliver occurring at the Canadian Depository for Securities 
(CDS), the registered clearing agency would refer CDS to the Ontario 
Securities Commission for appropriate action.
    \56\ As part of its Continuous Net Settlement system (CNS) NSCC 
marks-to-market each day positions for which participants failed to 
make delivery. In situations where the value of a security that is 
the subject of a failure to deliver is increasing, NSCC collects the 
mark from the party that failed to deliver and passes it on to the 
party that failed to receive the securities. Conversely, in a 
situation where the value of the security is decreasing, NSCC 
collects the mark from the party that failed to receive the 
securities and passes it on to the party that failed to deliver. 
Under the CNS system, a participant does not receive the actual 
contract value of the securities (i.e., the proceeds from their 
sale) until actual delivery of securities is made. See National 
Securities Clearing Corporation Rules of Procedures Rule 11. 
Nevertheless, we believe that withholding the benefit of mark-to-
market amounts from the party failing to deliver in a security 
meeting the specified threshold would serve as a financial incentive 
to comply with the borrow and delivery requirements during the 90-
day restricted period.
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    These proposed requirements in Rule 203 would differ from the 
current SRO rules in several respects. First, the proposals require 
action two days after settlement, as opposed to the current ten days 
after settlement provided in Rule 11830.\57\ Further, the mandatory 
close-out provision in NASD Rule 11830 currently only applies to Nasdaq 
securities. We believe that securities with lower market capitalization 
may be more susceptible to abuse, and therefore believe that these 
additional delivery requirements should be extended to all equity 
securities registered under Section 12 of the Exchange Act. Finally, 
although market makers engaged in bona fide market making are currently 
exempted from NASD Rule 11830, we believe that extended failures to 
deliver appear characteristic of an investment or trading strategy, 
rather than being related to market making. We believe it is 
questionable whether a market maker carrying a short position in a 
heavily shorted security for an extended period of time is in fact 
engaged in providing liquidity for customers, or rather is engaged in a 
speculative trading strategy. Therefore, we are not proposing an 
exception from these additional delivery requirements for short sales 
in connection with market making.
---------------------------------------------------------------------------

    \57\ We solicit comment on any legitimate reasons why a short 
seller may be unable to deliver securities by at least T+5. We may 
then choose to except particular types of transactions, or add a 
specified grace period.
---------------------------------------------------------------------------

    In our view, these delivery requirements would protect and enhance 
the operation, integrity and stability of the markets and the clearance 
and settlement system. In

[[Page 62978]]

particular, we believe that they will protect buyers of securities by 
substantially curtailing naked short selling. We request comment on the 
---------------------------------------------------------------------------
extent to which the proposed rules will achieve these objectives.

    Q. What harms result from naked short selling? Conversely, what 
benefits accrue from naked short selling?
    Q. Are there negative tax consequences associated with naked 
short selling, in terms of dividends paid or otherwise?
    Q. What is the appropriate manner by which short sellers can 
comply with the requirement to have ``reasonable grounds'' to 
believe that securities sold short could be borrowed? Should short 
sellers be permitted to rely on blanket assurances that stock is 
available for borrowing, i.e., ``hard to borrow'' or ``easy to 
borrow'' lists? Is the equity lending market transparent enough to 
allow an efficient means of creating these lists?
    Q. Should short sales effected by a market maker in connection 
with bona fide market making be excepted from the proposed 
``locate'' requirements? Should the exception be tied to certain 
qualifications or conditions? If so, what should these 
qualifications or conditions be?
    Q. Should the proposed additional delivery requirements be 
limited to securities in which there are significant failures to 
deliver? If so, is the proposed threshold an accurate indication of 
securities with excessive fails to deliver? Should it be higher or 
lower? Should additional criteria be used?
    Q. Are the proposed consequences for failing to deliver 
securities appropriate and effective measures to address the abuses 
in naked short selling? If not, why not? What other measures would 
be effective? Should broker-dealers buying on behalf of customers be 
obligated to effect a buy-in for aged fails?
    Q. Is the restriction preventing a broker-dealer, for a period 
of 90 calendar days, from executing short sales in the particular 
security for his own account or the account of the person for whose 
account the failure to deliver occurred without having pre-borrowed 
the securities an appropriate and effective measure to address the 
abuses in naked short selling? Should this restriction apply to all 
short sales by the broker-dealer in this particular security? Should 
the restriction also apply to all further short sales by the person 
for whose account the failure to deliver occurred, effected by any 
broker-dealer?
    Q. Should short sales effected by a market maker in connection 
with bona-fide market making be exempted from the proposed delivery 
requirements targeted at securities in which there are significant 
failures to deliver? If so, what reasons support such an exemption, 
and how should bona-fide market making be identified?
    Q. Under what circumstances might a market maker need to 
maintain a fail to deliver on a short sale longer than two days past 
settlement date in the course of bona fide market making? Is two 
days the appropriate time period to use?
    Q. Are there any circumstances in which a party not engaging in 
bona-fide market making might need to maintain a fail to deliver on 
a short sale longer than two days past settlement? If so, can such 
positions be identified? Should they be excepted from the proposed 
borrow and delivery requirements, and if so, why, and for how long?
2. Long Sales
    Current Rule 10a-2 covers delivery requirements applicable to long 
sales of securities registered or admitted to unlisted trading 
privileges on a national securities exchange. We are proposing to adopt 
subparagraph (a) of Rule 203 in proposed Regulation SHO, which would 
replace and modify Rule 10a-2 to make it consistent with the new 
delivery requirements in the proposed short sale rule.
    Generally, Rule 10a-2 provides that if a broker-dealer knows or 
should know that a sale is marked long, the broker-dealer must make 
delivery when due and cannot lend securities to do so. If the broker-
dealer does not have the securities, it must make delivery with 
securities purchased for cash, i.e., effect a ``buy in,'' unless it 
knows that the seller either is in the process of forwarding the 
securities to the broker-dealer or will do so as soon as possible 
without undue inconvenience or expense. Broker-dealers are excused from 
the buy-in requirement in two cases. In sales between broker-dealers, 
loans are permitted in lieu of a buy-in. The rule also allows a broker-
dealer to fail to deliver, or to borrow securities in lieu of buying-
in, if, despite the broker-dealer's efforts to ensure that the sale was 
long, it was in fact short. This exemption is available only if the 
exchange or national securities association in whose market the sale 
was effected finds that the sale resulted from a good-faith mistake, 
the broker-dealer exercised due diligence, and either that requiring a 
buy-in would result in undue hardship or that the sale had been 
effected at a permissible price.
    Subparagraph (a) of Rule 203 of proposed Regulation SHO preserves 
the substance of current Rule 10a-2 regarding delivery of securities 
sold pursuant to orders marked ``long.'' Only two substantive changes 
have been made. First, Regulation SHO would extend the delivery 
requirements of Rule 10a-2 to all securities, including those traded 
over-the-counter. As with our proposal to apply borrow and delivery 
requirements for short sales in all equity securities, we believe it is 
equally important to apply long delivery requirements to securities 
with lower market capitalization that may be more susceptible to abuse.
    Second, proposed Regulation SHO would provide that a loan or 
failure to deliver is permitted if the seller has informed the broker-
dealer that the seller owns the security and will deliver it to the 
broker-dealer prior to settlement of the transaction, but fails to do 
so. The proposed modification tracks the proposed amendments to the 
order marking requirements, which would permit an order to be marked 
long if the seller owns the securities and the seller's broker-dealer 
will have physical possession or control of the security prior to 
settlement.\58\ The proposed rule would permit a broker-dealer to fail 
to deliver, or to deliver borrowed securities, if an exchange or 
national securities association found that the broker-dealer used due 
diligence in obtaining the seller's confirmation that the security 
would be in the broker-dealer's possession prior to settlement, and 
that either compelling a buy-in would result in undue hardship, or that 
the mistake was made by the seller's broker-dealer and the sale was at 
a permissible price under Proposed Rule 201(b) of Regulation SHO.\59\ 
We believe that this change would facilitate the process of clearance 
and settlement, while still achieving the goals of short sale 
regulation.
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    \58\ See, infra part IX for a further discussion of the proposed 
order marking requirements.
    \59\ This exception shall not apply where a broker-dealer knows 
or has reason to know that an order is incorrectly marked long. 
Knowledge may be inferred where a broker-dealer repeatedly accepts 
orders marked long from the same customer that requires borrowed 
shares for delivery or results in a ``fail to deliver'' on several 
occasions.

    Q. Are the delivery requirements in proposed Rule 203(a) 
appropriate?

III. Current Market Structure and the Tick Test

    The tick test was part of short sale regulation implemented in 
1938. The tick test has provided the markets with a generally effective 
means of regulating short sales for more than 60 years. Nonetheless, 
arguments have been made to allow greater flexibility in short selling. 
Indeed, substantial economic arguments have been made that short 
selling should be deregulated, at least in the case of the tick 
test.\60\ Some

[[Page 62979]]

commenters to the Concept Release took that position.\61\ A substantial 
number of other commenters disagreed and expressed support for a price 
test.\62\ We do not believe that proposing complete rescission of the 
short sale price test would be appropriate at this time, although we 
request comment about that approach. Instead, we propose a new, uniform 
price test that would apply to today's markets, and a pilot that would 
permit us to gather data about trading activity in the absence of a 
short sale price restriction.
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    \60\ See, e.g., Albert, Smaby, and Robison, 1997, Short Selling 
and Trading Abuses on Nasdaq, Financial Services Review, 6(1), 27-
39; Alexander and Peterson, 1999, Short Selling and the New York 
Stock Exchange and the Effects of the Uptick Rule, Journal of 
Financial Intermediation, 8, 90-116; Alexander and Peterson, 2002, 
Implications of a Reduction in Tick Size on Short-Sale Order 
Execution, Journal of Financial Intermediation, 11, 37-60; Angel, 
1997, Short Selling on the NYSE, working paper, Georgetown 
University; Jones, 2002, Shorting Restrictions, Liquidity, and 
Returns, working paper, Columbia University; Lamont, Owen A., 2003, 
Go Down Fighting: Short Sellers vs. Firms, working paper, University 
of Chicago and NBER.
    \61\ See, e.g., letters from The Chicago Board Options Exchange 
(32), Cornerstone Securities Corporation (324), Electronic Traders 
Association (ETA) (327), Interactive Brokers; The Timber Hill Group 
(329), Island ECN (Island) (431), Managed Funds Association (MFA) 
(427), Charles Schwab (Schwab) (310), Sierra Trading Group, L.P. 
(39), Trimark Securities (330).
    \62\ See, e.g., letters from the NASD (480), NYSE (467), Sherman 
and Sterling (424), North American Securities Administrators 
Association (NASAA)(321), Specialist Association (426).
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IV. Proposed Bid Test

    Current short sale regulation applies different price tests to 
securities trading in different markets. Rule 10a-1 applies only to 
short sale transactions in securities listed on a national securities 
exchange, whether the transaction is effected on an exchange or 
otherwise. The NASD's bid test applies to short sale transactions in 
Nasdaq NMS securities effected on either SuperMontage or the NASD's 
Alternative Display Facility (ADF), but not to Nasdaq SmallCap, OTCBB, 
and other securities traded over-the-counter. Moreover, no short sale 
price test applies to short sales of Nasdaq NMS securities executed 
away from SuperMontage and the ADF, unless the market on which the 
securities are being traded has adopted its own price test.\63\ The end 
result is disparate short sale regulation of Nasdaq securities, 
depending on the market where the securities are trading. This 
situation may lend itself to regulatory arbitrage.\64\
---------------------------------------------------------------------------

    \63\ Transactions in these securities are not subject to short 
sale regulation under Rule 10a-1. See Securities Exchange Act 
Release No. 22975 (March 6, 1986), 51 FR 8801 (March 14, 1986) (the 
Commission adopted amendments to Exchange Act Rule 10a-1 to exclude 
from application of the rule transactions in NMS securities that are 
traded on an exchange on a listed or unlisted trading privileges 
basis).
    \64\ The Commission recently issued a Concept Release seeking 
comment on this and other issues presented in a petition submitted 
by Nasdaq. Securities Exchange Act Release No. 47849 (May 14, 2003), 
68 FR 27722 (May 20, 2003).
---------------------------------------------------------------------------

    We note that Nasdaq has also applied to become a national 
securities exchange.\65\ If Nasdaq becomes an exchange, Rule 10a-1 
would apply to Nasdaq securities because they would be exchange-listed 
securities reported pursuant to an ``effective transaction reporting 
plan.'' Nasdaq has applied for relief from Rule 10a-1 in conjuction 
with the exchange registration.\66\ The Commission has not yet acted 
upon the application. If the Commission were to grant an exemption from 
Rule 10a-1 to allow Nasdaq to apply Rule 3350 to Nasdaq exchange-listed 
securities, the same securities quoted and traded on Nasdaq and other 
exchanges would be subject to two different short sale rules. This has 
the potential for confusion and compliance difficulties. We believe 
that these considerations, along with the other market developments 
discussed previously, make this an appropriate time to propose 
amendments that would provide for a more consistent approach to short 
sale regulation.
---------------------------------------------------------------------------

    \65\ See Securities Exchange Act Release No. 44396 (June 7, 
2001), 66 FR 31952 (June 13, 2001).
    \66\ See Letter to Jonathan G. Katz, Secretary, Commission, from 
Edward S. Knight, Executive Vice President and Chief Legal Officer, 
NASD (August 7, 2000).
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A. Operation of the Uniform Bid Test

    The current tick test uses the last trade price in a security as a 
reference point for determining permissible short sale prices under 
Rule 10a-1. The effectiveness of this test for exchange-listed 
securities depends on the centralized auction nature of most exchanges 
and the historical concentration on exchanges of transactions in 
exchange-listed securities, which helps produce a consistent sequence 
of trade reports. In 2002, for example, the NYSE accounted for 87.9% of 
share volume in NYSE listed equities.\67\
---------------------------------------------------------------------------

    \67\ See 2002 NYSE Annual Report.
---------------------------------------------------------------------------

    The tick test, however, may not be as effective a means of 
regulating dealer markets. Nasdaq, in contrast to the auction markets, 
has no single market center that concentrates trading in Nasdaq 
securities. During regular trading hours, order flow in Nasdaq 
securities is divided among many different market makers, ECNs, and 
regional exchanges.\68\ Trade reporting for Nasdaq securities involves 
multiple market makers reporting trades in the same stock from 
different locations using different means of reporting. Although trades 
are required to be reported within 90 seconds after execution, they are 
published in reporting sequence, not trade sequence.\69\ This reporting 
may create upticks and downticks that may not accurately reflect price 
movements in the security for the purposes of the tick test. To a 
lesser degree, this phenomenon occurs in exchange-listed securities 
that are traded in multiple venues.
---------------------------------------------------------------------------

    \68\ For example, in May 2003, there were an average of 73 
market makers per issue in the top 1% of Nasdaq stocks by trading 
volume, 40.5 market makers per issue in the next 9% of stocks, and 
an overall average of 15.4 market makers per issue. The majority of 
Nasdaq trading occurs primarily at dealer market centers. The agency 
markets operated by the seven ECNs in May 2003 accounted for 23.3% 
of Nasdaq share volume. In addition, the Archipelago Exchange and 
the Cincinnati Stock Exchange each account for 12.8% of the Nasdaq 
Share Volume for a total of 25.6% of Nasdaq Share Volume. See 
www.marketdata.nasdaq.com.
    \69\ NASD Rule 4632, Transaction Reporting, requires market 
makers to transmit through the Automated Confirmation Transaction 
Service or ``ACT'' all last sale reports of transactions in 
designated securities executed during normal market hours within 90 
seconds after execution. See NASD Rule 4632 (NMS securities) and 
Rule 4642 (Nasdaq SmallCap securities), and Rule 6420 (exchange-
listed securities).
---------------------------------------------------------------------------

    We are proposing Rule 201 of Regulation SHO, which would replace 
Rule 10a-1's tick test with a test using the consolidated best bid as 
the reference point for permissible short sales. Specifically, 
subparagraph (b) of proposed Rule 201 would require that all short 
sales in exchange-listed and Nasdaq NMS securities, wherever traded, be 
effected at a price at least one cent above the consolidated best bid 
at the time of execution.\70\ A bid test would apply a uniform rule to 
trades in the same securities that occur in multiple, dispersed, and 
diverse markets. Moreover, a bid test would provide greater flexibility 
in effecting short sales in a decimals environment, as discussed below. 
Finally, a bid test would better accommodate increasingly popular 
automated trading systems that utilize passive pricing and trading 
systems that offer price improvement based on the consolidated best bid 
and offer.\71\
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    \70\ To address the problem of locked and crossed markets, we 
have proposed an exception from the proposed bid test allowing a 
responsible broker or dealer, as defined in 17 CFR 240.11Ac1-
1(a)(21), to effect a short sale at a price equal to the 
consolidated best offer when the market for the covered security is 
locked or crossed, provided however, that the exception shall not 
apply to any broker or dealer who initiated the locked or crossed 
market. See, infra Part VI.A.7 for a further discussion of this 
exception.
    \71\ Passive pricing systems often effect trades at an 
independently-derived price, such as the midpoint of the bid-offer 
spread. Such pricing would often not satisfy the current tick test. 
However, midpoint pricing would generally satisfy a test requiring a 
short sale to be priced above the current best bid. We generally do 
not believe that such passive pricing systems present significant 
opportunities for short selling abuse. See infra, part IV.D, for a 
further discussion of passive pricing.
---------------------------------------------------------------------------

    The proposed bid test in Rule 201 would require that a short sale 
be effected at a price at least one cent above the best consolidated 
bid at the

[[Page 62980]]

time of execution.\72\ This would be a significant change from the 
current tick test, which is based on last sale prices. The bid test 
also would operate differently from the current rule for Nasdaq 
securities. NASD's Rule 3350 prohibits NASD members from effecting 
short sales in NMS securities at or below the best bid when the best 
bid displayed is below the preceding best bid in a security. However, 
if there is an ``upbid'' in a security, i.e., the best bid displayed is 
above the preceding best bid, there is no restriction on the price that 
a NASD member can sell an NMS security short.\73\
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    \72\ As stated in the Commission's approval of Nasdaq's penny 
short sale pilot, a $0.01 increment for a short sale price test is a 
reasonable increment in a decimals environment. See Securities 
Exchange Act Release No. 44030 (March 2, 2001), 66 FR 14235 (March 
8, 2001). However, the Commission may revisit this requirement upon 
the completion of its analysis of statistical data relating to 
quoting and trading activity in a decimals environment.
    \73\ Should the Commission adopt changes to existing short sale 
regulations, the SROs would need to update their rules to reflect 
our modifications.
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    Under the proposed uniform bid test, the price at which a short 
sale could be effected would move contemporaneously with the movement 
of the consolidated best bid.\74\ In contrast, compliance with the 
current short sale price tests require a comparison of the previous 
last sale in relation to the most recent last sale in listed securities 
or a comparison of the current bid with the previous bid for Nasdaq 
securities.
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    \74\ Under the proposed bid test, if the best bid in a security 
is $47.00, short selling would be allowed at $47.01 or higher, 
regardless of whether the immediately preceding bid was $46.99 or 
$47.01 (i.e., it does not matter whether the current bid is an upbid 
or downbid from the immediately preceding bid). Also, if the best 
bid in a security is $47.00, and the last trade price in the 
security was $47.05, short selling would be allowed at $47.01 or 
higher (i.e., the last sale price is irrelevant).
---------------------------------------------------------------------------

    We recognize that a quotation only proposes a transaction, whereas 
the last trade price reflects an actual trade. However, pursuant to 
Commission and SRO rules, quotations for all covered securities must be 
firm. Further, we believe that bids generally are a more accurate 
reflection of current prices for a security because last trade prices 
can be reported out-of-sequence within a 90 second window.
    We believe the proposed bid test would promote the fundamental 
goals of short sale regulation. First, the proposed bid test would 
facilitate relatively unrestricted short selling in an advancing 
market, because the short selling reference price would move with the 
current interest of the market.
    The proposed bid test also is designed to achieve the second and 
third objectives of the short sale rule, preventing short selling at 
successively lower prices and preventing short sellers from 
accelerating a decline in the market by exhausting all remaining bids 
at one price level. One of the negative uses of short selling is 
attempting to establish lower transaction prices in a security, hoping 
to induce others to liquidate their positions and lower prices 
further.\75\ A short seller may attempt to accomplish this by 
exhausting higher priced bids in a security, thus creating the 
appearance of a declining market.\76\ Barring short sales at prices 
equal to or below the consolidated best bid would prevent short sellers 
from exhausting the bids in a security and thus prevent short sellers 
from inducing a price decline. Since only long sellers could sell at 
the consolidated best bid, it is unlikely that short sellers could 
directly cause short selling at successively lower prices.\77\
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    \75\ See Securities Exchange Act Release No. 10668 (March 6, 
1974), 39 FR 10604 (March 21, 1974).
    \76\ Id.
    \77\ The Commission would view activity by market participants 
to alter the consolidated best bid solely for the purpose of 
facilitating short sales as a violation of proposed Regulation SHO, 
as well as potentially the anti-fraud and anti-manipulation 
provisions of the federal securities laws, including Sections 9(a), 
10(b), and 15(c) of the Exchange Act, and Rules 10b-5 and 15c1-2 
thereunder. For example, a broker-dealer may attempt to circumvent 
the rule by entering into an arrangement with a customer in which 
the customer would sell short to the dealer one cent above the bid, 
and the dealer would charge a higher commission to cover the price. 
The dealer would then sell ``long'' at the bid. An example of this 
is as follows: Assume that the best bid is $20.35. A broker-dealer 
could arrange with a customer to execute a short sale at $20.36, and 
include a mark-up or commission of 6 cents. The net to the customer 
would thus be $20.30. The broker-dealer could then sell long into 
the bid at $20.35, thus earning a profit on the transaction. Not 
only may such activity violate reporting rules (see NASD Rule 
6130(d)(3)), such activity could be viewed as fraudulent and/or 
manipulative by the Commission.
---------------------------------------------------------------------------

    While we believe the uniform bid test is the most flexible approach 
to modernizing the short sale rule while continuing to promote the 
goals of short sale regulation, we understand that some market 
participants may desire an even greater range of prices at which to 
effect short sales. One alternative would be a bid test allowing short 
selling at a price equal to or above the consolidated best bid if the 
current best bid is above the previous bid (i.e., an upbid). However, 
in this alternative, short selling would be restricted to a price at 
least one cent above the consolidated best bid (not equal to the best 
bid) if the current best bid is below the previous bid (i.e., a 
downbid).\78\ This alternative test would apply to the same securities 
as our uniform bid test.\79\ While we are not proposing this 
alternative test as part of Regulation SHO, we seek comment on this 
test as another possible approach to regulating short sales.
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    \78\ The following example demonstrates the operation of this 
alternative uniform short sale rule: If the consolidated best bid in 
a security is $47.00, and the immediately preceding bid was $46.99, 
short selling would be allowed at $47.00 or higher. If the 
consolidated best bid in a security is $47.00, and the immediately 
preceding bid was $47.01, short selling would only be allowed at 
$47.01 or higher.
    \79\ We note that, unlike the proposed bid test, this 
alternative test would incorporate the preceding bid into the 
calculation of the price at which a short sale could be executed. 
This would add a layer of complexity to the rule and could impose 
additional programming costs.
---------------------------------------------------------------------------

    We are aware that these proposals represent significant changes in 
the operation of Rule 10a-1. We request comment about the 
appropriateness of the proposed bid test and the alternative bid test.

    Q. Should short sales continue to be limited by a price test? If 
the Commission did not adopt a price test under Regulation SHO, 
should it also preclude the ability of the SROs to have price tests?
    Q. Would there be any benefits in eliminating a short sale price 
test? Would the elimination of a price test benefit the markets by 
allowing investors to more freely short sell potentially overvalued 
securities so that their price more accurately reflects their 
fundamental value? Are there other benefits to the removal of a 
price test, such as elimination of systems and surveillance costs?
    Q. Would the proposed ``bid test'' in Rule 201, allowing short 
sales above the best consolidated bid, effectively prevent short 
selling being used as a tool for driving the market down?
    Q. Would short sale regulation using the proposed bid test 
operate effectively in an auction market? If not, why not?
    Q. Would short sale regulation using the proposed bid test 
operate effectively in a dealer market? If not, why not?
    Q. Would there ever be a circumstance where there would not be a 
consolidated bid in an exchange-listed or Nasdaq NMS security? If 
so, please describe.
    Q. The proposed bid test likely would inhibit short sales in a 
declining market because there would be few execution opportunities 
above the best bid. Is this appropriate?
    Q. Is a one-cent increment an appropriate standard for allowing 
short sales above the best consolidated bid? If not, what is an 
appropriate increment?
    Q. Would short sale regulation using the proposed bid test 
present any automated systems problems for market participants?
    Q. Would the proposed bid test operate effectively in the 
current decimal environment, i.e., would bid flickering inhibit the 
operation of the test?

[[Page 62981]]

    Q. Would the proposed bid test fulfill the fundamental goals of 
short sale regulation?
    Q. Would the alternative test allowing short selling at a price 
equal to or above the consolidated best bid if it is an upbid better 
fulfill the goals of short sale regulation?

B. Scope of the Uniform Bid Test

1. Securities Subject to the Price Test
    The proposed bid test would apply to all securities currently 
subject to short sale price tests, i.e., exchange-listed and Nasdaq NMS 
securities, wherever they are traded. Specifically, the proposed bid 
test would apply to all national market system securities as defined in 
Sec.  240.11Aa2-1 of this chapter, but shall exclude Nasdaq Small Cap 
securities, as determined by NASD rules.
    Market information for securities, including quotes, is 
disseminated pursuant to a variety of different national market system 
plans. Generally, the SROs have developed networks or systems that 
disseminate market information.\80\ The NYSE, Amex, Nasdaq, and the 
regional exchanges are all required to make available to vendors the 
best bids in any common stock, long-term warrant, or preferred 
stock.\81\ This information is disseminated as a part of an effective 
transaction reporting plan pursuant to the Consolidated Tape 
Association Plan (CTA Plan) and the Consolidated Quotation Plan (CQ 
Plan). The NYSE, Amex, Nasdaq, and the regional exchanges all 
participate in the CTA Plan and CQ Plan.\82\ Finally, Nasdaq 
disseminates market information for securities in the two tiers of the 
Nasdaq market, i.e., NMS and SmallCap stocks, as well as certain other 
securities traded OTC. Information for NMS securities is collected and 
disseminated pursuant to NASD's rules and the Nasdaq/UTP plan.\83\
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    \80\ In relevant part, these networks can be categorized as 
follows: (1) Network A--securities listed on the NYSE; (2) Network 
B--securities listed on Amex or the regional exchanges; and (3) 
Nasdaq system--securities qualified for inclusion in the Nasdaq 
system and certain other securities traded in the OTC market.
    \81\ See Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1; Exchange 
Act Rule 11Ac1-4, 17 CFR 240.11Ac1-4.
    \82\ CTA Plan, Sections I(q) and VII(a)(i) for NYSE securities 
(Network A), CTA Plan, Sections I(q) and VII(a) for Amex and the 
regional exchanges (Network B). These plans were adopted pursuant to 
Rule 11Aa3-1, 17 CFR 240.11Aa3-1, which governs the dissemination of 
transaction reports and last trade price information in national 
market system securities (equity securities listed on national 
securities exchanges or included in the national market tier of 
Nasdaq). In general, this rule requires an SRO to file a transaction 
reporting plan for such securities, and it requires SRO members to 
transmit information required by the plans to the SROs.
    \83\ See Securities Exchange Act Release No. 42208 (December 9, 
1999) 64 FR 70613 (December 17, 1999) (concept release requesting 
comment on the regulation of market information fees and revenues).
---------------------------------------------------------------------------

    These networks are designed to ensure that consolidated bids from 
the various market centers that trade exchange-listed and Nasdaq NMS 
securities are continually collected and disseminated on a real-time 
basis, in a single stream of information. Thus, all market participants 
would have access to the consolidated bids for all the securities that 
would be subject to the proposed uniform bid test.
2. Securities Not Subject to the Price Test
    We are not proposing at this time to extend the uniform bid test to 
securities not currently covered by a short sale price test (i.e., 
Nasdaq SmallCap, OTCBB, and Pink Sheet securities) in part because 
these markets have not been subject to the rule in the past. More 
significantly, we believe that the proposed locate and deliver 
requirements may address many of the concerns regarding abusive short 
selling in thinly-capitalized securities trading over-the-counter. In 
particular, these proposals should significantly discourage efforts to 
deliberately depress the price of these securities by removing the 
leverage abusive short sellers enjoy through short selling without 
incurring the costs of borrowing and delivering. We recognize, however, 
that issuers of less actively traded securities believe that they are 
particularly vulnerable to ``abusive'' short selling, and we seek 
specific comment on whether the proposed bid test or other price test 
should be extended to these securities.

    Q. Should the proposed uniform bid test be extended to Nasdaq 
SmallCap and OTCBB Securities? Do these securities need the 
protection of the proposed uniform bid test?
    Q. Should the proposed uniform bid test be extended to other OTC 
securities, e.g., those quoted in the Pink Sheets? If so, are quotes 
in these securities disseminated in a manner that would allow for 
the use of the proposed uniform bid test? In addition, would the 
proposed bid test be workable due to the fact that the best bid in 
these securities could be outstanding for long periods of time? If 
not, could a last sale test or some other test be applied to these 
securities?

C. Bid Test Flexibility in a Decimals Environment

    The Commission is aware of concerns about the ability to effect 
short sales using the tick test in a decimals environment. In 
particular, with the increase in the number of price points from 16 to 
100 per dollar as a result of pricing in decimals, there has been an 
increase in price flickering, i.e., an increase in the number of times 
the last trade price in a security changes rapidly.
    As a result market participants have sought relief from the tick 
test provisions of Rule 10a-1. For example, some third market makers in 
exchange-listed securities offer trade execution for eligible customer 
orders at a price equal to or better than the consolidated best offer. 
However, if the consolidated best offer is below the previous last 
reported sale in a security and the third market maker or specialist 
has a short position, sales at the consolidated best offer would 
violate the tick test of Rule 10a-1. The Commission has granted an 
exemption from Rule 10a-1 to permit registered market makers and 
exchange specialists publishing two-sided quotes in a security to sell 
short to facilitate customer market and marketable limit orders at the 
consolidated best offer, regardless of the last trade price.\84\ The 
exemption provided relief in a decimals environment to market makers 
and specialists in instances where they would be providing liquidity in 
response to customer buy orders. Such relief would not be necessary 
with a bid test, since such sales (by any market participant) would 
always be effectuated above the best bid, specifically at the 
consolidated best offer or better.
---------------------------------------------------------------------------

    \84\ See Letter re: Bernard L. Madoff Investment Securities LLC 
(February 9, 2001) (exemption from Rule 10a-1 to allowing registered 
market makers and specialists to sell short to facilitate customer 
market and marketable limit orders at the consolidated best offer 
regardless of the last trade price). All such short sales effected 
pursuant to the exemption are required to be reported as ``sell 
short exempt.'' This relief is strictly limited to the facilitation 
of customer market and marketable limit orders and is not available 
as a means of soliciting customer orders. Moreover, the exemption 
letter notes that whether an execution at the consolidated best 
offer constitutes best execution of a customer's trade will depend 
on all the facts and circumstances.
---------------------------------------------------------------------------

    Permitting short sales above the best bid should alleviate other 
difficulties complying with the tick test in a decimals environment. 
The Commission's Office of Economic Analysis (OEA) conducted a study 
that found that the proposed bid test is considerably less restrictive 
than the current tick test.\85\ Specifically, OEA

[[Page 62982]]

compared the minimum shortable price (MSP) using the proposed bid test 
and the current tick test. Under the proposed bid test, the MSP is 
always a minimum increment above the bid. Under the tick test, if the 
last transaction was on an uptick or zero-plus uptick, the MSP is equal 
to the latest transaction price. If the latest transaction price was on 
a minus tick or a zero-minus tick, the MSP is equal to the latest 
transaction price plus one tick.\86\ OEA found that the tick test was 
more restrictive (the MSP was higher for the tick test than it was for 
the proposed bid test) 60.4% of the time, the proposed bid test and 
tick test were equally restrictive (the MSP for the tick test and the 
proposed bid test were the same) 15.5% of the time, and the proposed 
bid test was more restrictive (the MSP was at or below the bid) 24.1% 
of the time. As this study indicates, the proposed bid test should 
offer more short selling opportunities than the current tick test.
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    \85\ The study was conducted using stocks listed on the NYSE 
during the month of July, 2003. The study did not examine the 
proposed bid test relative to the current Nasdaq bid test. The study 
is available in the Commission's Public Reference Room. See also 
Alexander and Peterson, 1999, Short Selling on the New York Stock 
Exchange and the Effects of the Uptick Rule, Journal of Financial 
Intermediation (a study of, among other things, short selling 
opportunities under the current tick test in a declining market).
    \86\ In OEA's analysis, if the tick test MSP was greater than 
the MSP from the proposed bid test, then the tick test was more 
restrictive than the proposed bid test because the bid test allows 
lower execution prices, and, of course, the converse conclusion 
would be reached if the opposite was true.
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D. Bid Test Flexibility for Passive Pricing Systems

    We have granted limited exemptive relief from the tick test 
provisions of Rule 10a-1 in connection with short sale transactions 
executed on a volume-weighted average price (VWAP) basis.\87\ The 
relief is limited to VWAP transactions that are arranged or ``matched'' 
before the market opens at 9:30 a.m. but are not assigned a price until 
after the close of trading when the VWAP value is calculated.\88\ We 
granted the exemption based, in part, on the fact that these VWAP short 
sale transactions appear to pose little risk of facilitating the type 
of market effects that Rule 10a-1 was designed to prevent. In 
particular, the pre-opening VWAP short sale transactions do not 
participate in or affect the determination of the VWAP for a particular 
security. Moreover, the Commission stated that all trades used to 
calculate the day's VWAP would continue to be subject to Rule 10a-
1.\89\
---------------------------------------------------------------------------

    \87\ See e.g. Letter re: VWAP Trading System (March 24, 1999); 
Letter re: Jeffries and Company, Inc. (Jeffco) (December 7, 2000); 
Letter re: POSIT (March 30, 2001); Letter re: Morgan, Stanley & Co., 
Inc. (May 11, 2001); Letter re: Vie Institutional Services (February 
12, 2003).
    \88\ The VWAP for each security is generally determined by: (1) 
Calculating raw values for regular session trades reported by the 
Consolidated Tape during the regular trading day by multiplying each 
such price by the total number of shares traded at that price; (2) 
compiling an aggregate sum by adding each calculated raw value from 
step one above; and (3) dividing the aggregate sum by the total 
number of reported shares for that day in the security. See, e.g., 
Letter re: POSIT (March 30, 2001).
    \89\ The relief is subject to a number of conditions, including: 
limiting it to only those securities which would qualify as 
``actively-traded securities'' as defined in Regulation M (unless 
the security is part of a ``basket'') 17 CFR 242.100; that there be 
no pre-arranged matching sale and purchase orders; a 10% average 
daily volume limitation when acting as principal on the contra-side 
of a VWAP short sale transaction; and that no transactions are made 
for the purpose of creating actual, or apparent, active trading in 
or otherwise affecting the price of any security. See, supra n. 87.
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    There are also electronic trading systems that match and execute 
trades at other independently-derived prices, such as the midpoint of 
the consolidated best bid and offer. Limited short sale relief has been 
granted to certain systems that match customer orders at random times 
within specific time intervals.\90\ These systems had requested relief 
from Rule 10a-1 because matches could potentially occur at a price 
below the last reported sale price. Due to the passive nature of 
pricing and the lack of price discovery, trades executed through the 
systems generally do not appear to involve the types of abuses that 
10a-1 was designed to prevent.\91\
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    \90\ See e.g. Letter re: POSIT (April 23, 2003).
    \91\ The relief was also conditioned on the fact that none of 
the persons relying on the exemption would be represented in, or 
otherwise influence the primary market bid or offer, and that none 
of the transactions effected on the electronic system would be made 
for the purpose of depressing or manipulating the price of the 
security. Id.
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    We believe that the proposed bid test would accommodate the recent 
growth of matching systems that execute trades at an independently 
derived price above the consolidated best bid. Such executions would 
generally comply with the proposed bid test, while also enabling 
customer orders to seek executions that would provide price, and 
possibly size, improvement.
    We note, however, that there may be instances where the final 
execution price of VWAP short sale transactions could be at or below 
the closing best bid for that security, and thus would violate the 
proposed bid test. Nevertheless, we propose codifying an exception to 
the bid test provisions of proposed Rule 201 to permit short sales at 
the VWAP, subject to the same conditions included in the above 
exemptions.\92\ These would be the following: (1) All short sale orders 
will be received and matched before the regular trading session opens 
and the execution price of VWAP matched trades will be determined after 
the close of the regular trading session; (2) the VWAP for the covered 
security is calculated by: calculating the values for every regular way 
trade reported in the consolidated system, or on a primary market that 
accounts for 75% or more of the covered security's average daily 
trading volume for the security during the regular trading session, by 
multiplying each such price by the total number of shares traded at 
that price; compiling an aggregate sum of all values; and dividing the 
aggregate sum by the total number of reported shares for that day in 
the security; (3) the transactions are reported using a special VWAP 
trade modifier; (4) short sales used to calculate the VWAP will 
themselves be subject to the bid test; (5) the VWAP matched security 
qualifies as an ``actively-traded security'' (as defined under Rules 
101(c)(1) and 102(d)(1) of Regulation M).\93\ Where the subject listed 
security is not an ``actively-traded security'' or a S&P 500 Index 
security, the proposed short sale transaction would be permitted only 
if it is conducted as part of a basket transaction of 20 or more 
securities in which the subject security does not comprise more than 5% 
of the value of the basket traded; (6) the transaction is not effected 
for the purpose of creating actual, or apparent, active trading in or 
otherwise affecting the price of any security; (7) a broker or dealer 
shall be permitted to act as principal on the contra-side to fill 
customer short sale orders only if the broker or dealer's position in 
the subject security, as committed by the broker-dealer during the pre-
opening period of a trading day and aggregated across all of its 
customers who propose to sell short the same security on a VWAP basis, 
does not exceed 10% of the subject security's relevant average daily 
trading volume, as defined in Regulation M.\94\ Any VWAP short sale 
transaction that does not meet these conditions would need to comply 
with the bid test. In addition, all other provisions of Regulation SHO, 
including the marking requirements in Rule 201 and the locate and 
deliver requirements in Rule 203, would apply. We request comment on 
whether the proposed exception for VWAP executions, subject to these 
conditions, is appropriate.
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    \92\ We believe that these conditions have worked well in 
restricting the exemptive relief to situations that do not appear to 
raise the abuses that the short sale price test is designed to 
prevent, and should be incorporated in the proposed exception. We 
also note that market participants that have been granted these 
exceptions have designed their programming and surveillance systems 
in accordance with these conditions.
    \93\ At this time, securities that qualify as ``actively traded 
securities'' under Rule 101 of Regulation M and securities that 
comprise the S&P 500 index would qualify as ``actively traded 
securities'' for purposes of this exception.
    \94\ 17 CFR 242.100(b).


[[Page 62983]]


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    Q. Do VWAP transactions create perverse incentives for broker-
dealers, such that they should not be granted an exception? If an 
exception is included, are there ways to detect and limit the 
effects of these perverse incentives?
    Q. Are the proposed conditions for the VWAP exception 
appropriate? If not, why not? Should there be any additional 
conditions?

V. Pilot Program

    As a part of the Commission's review of short sale regulation, we 
are also proposing temporary Rule 202 of Regulation SHO that would 
suspend, on a pilot basis, the operation of the proposed bid test of 
proposed Rule 201 for specified liquid securities. We believe that the 
pilot is appropriate for several reasons. The pilot would enable us to 
study the effects of relatively unrestricted short selling on, among 
other things, market volatility, price efficiency, and liquidity. This 
would thus allow us to obtain empirical data to assess whether short 
sale regulation should be removed, in part or in whole, for actively 
traded securities. The pilot would also allow the Commission to 
determine the extent to which the proposed bid test achieves the three 
objectives of short sale regulation through the comparison of trading 
activity of similar stocks subject to the test and those not subject to 
the test.
    In 1976 the Commission proposed a suspension of the tick test as a 
part of a comprehensive review of short sale regulation that was 
designed to obtain statistical data regarding short selling.\95\ The 
pilot was never implemented due to concerns expressed by trading 
markets and listed companies.\96\ However, there have been significant 
developments in market surveillance since 1976 that now make a pilot 
more appropriate. Further, the Commission and SROs now have access to a 
wide range of trading data on potentially manipulative trading 
behavior.\97\ Access to this information greatly enhances the ability 
of the Commission and the SROs to monitor trading behavior during the 
proposed suspension of the bid test and surveil for manipulative short 
selling.
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    \95\ See Securities Exchange Act Release No. 13091 (December 21, 
1976), 41 FR 56530. We proposed three alternative temporary rules 
that would have suspended the tick test to varying degrees in order 
for critical data to be collected. The three alternative temporary 
rules would have: (1) Suspended the operation of the short sale rule 
for all securities registered, or admitted to unlisted trading 
privileges on a national securities exchange; (2) suspended the 
operation of the tick test only for equity securities (other than 
warrants, rights, or options) that are registered, or admitted to 
unlisted trading privileges, on more than one national securities 
exchange and for which transactions were reported in the 
consolidated system; and (3) suspended the operation of the tick 
test only for the fifty most active equity securities (other than 
warrants, rights, or options) during the 12 calendar months 
preceding the effective date of the rule. However, the Commission 
withdrew this and other short sale rule proposals largely because 
commenters did not support the changes. Securities Exchange Act 
Release No. 17347 (December 1, 1980), 45 FR 80834 (December 8, 
1980).
    \96\ One commenter expressed concern that removal of the tick 
test might accelerate market declines and increase volatility as 
well as create distortions in the market for secondary or tertiary 
stocks. See Letter from James E. Buck, Secretary, NYSE, to George A. 
Fitzsimmons, Secretary, SEC (March 17, 1977). Another commenter 
stated that the tick test should be retained to prevent manipulative 
short selling even though some arguments could be made that short 
selling helps adjust markets to their proper levels more quickly. 
The commenter stated that it was beneficial to retain Rule 10a-1 
until such time a rule could be devised that distinguished between 
manipulative and non-manipulative short sales. See Letter from Frank 
A. Hutson, Jr., Chairman, Securities Law Committee, American Society 
of Corporate Secretaries, Inc., to George A. Fitzsimmons, Secretary, 
SEC (May 3, 1977).
    \97\ For example, the NYSE has since implemented both on-line 
and off-line automated surveillance capability, and monitors trading 
on both a real-time and next day basis. Further, the NYSE also 
utilizes an audit trail through its Intermarket Surveillance 
Information System (ISIS) data base. Securities Exchange Act Release 
No. 22183 (June 28, 1985) 50 FR 27875 (July 8, 1985). Further, NYSE 
adopted a rule requiring all transactions in NYSE-listed stocks that 
are not reported to the Consolidated Tape to be reported to the 
Exchange in order to provide an accurate record of overall trading 
activity. In its filing with the Commission, NYSE stated that the 
information obtained pursuant to the rule will ``augment and enhance 
its ability to surveil for and investigate, among other matters, 
insider trading, frontrunning, and manipulative activities, * * *'' 
Securities Exchange Act Release No. 31358 (October 26, 1992) 57 FR 
49736 (November 3, 1992) (order approving NYSE Rule 410B).
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    We also believe that a pilot may be appropriate in light of the 
Commodity Futures Modernization Act of 2000 (CFMA) lifting the ban on 
security futures.\98\ Among other things, investors are now allowed to 
enter into futures contracts for the sale of individual securities at a 
fixed point in the future and at a set price. In authorizing single 
stock futures trading, Congress exempted transactions in security 
futures products from short sale regulation. Short security futures, 
i.e., obligating a person to make a future delivery of the underlying 
securities, may function as a substitute for short selling the 
underlying stock.\99\ We believe that to the extent possible, 
consistent with investor protection, one market should not benefit over 
another because of regulatory differences. Thus, we intend to include 
liquid securities subject to futures trading in our proposed pilot.
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    \98\ Pub. L. 106-554, 114 Stat. 2763 (2000). Futures involving 
single stocks are generally defined as futures contracts (or options 
thereon) on single non-exempt securities and narrow based groups or 
indices of non-exempt securities.
    \99\ We note that the CFMA exception was a departure from 
traditional short sale regulation, which is security-based rather 
than market-based (i.e., the tick test applies to a security 
irrespective of the market in which the short sale occurs.)
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    As a result, we believe it is appropriate to propose a rule that 
would establish procedures for a temporary suspension of the trading 
restrictions of the price test of the Commission's short sale rule, and 
any short sale price test of any exchange or national securities 
association, for a limited number of securities. The securities that 
could be included in the pilot could be comprised of a subset of the 
Russell 1000 index, or such other securities as the Commission 
designates by order as necessary or appropriate in the public interest 
and consistent with the protection of investors after giving due 
consideration to the security's liquidity, volatility, market depth and 
trading market. The relative weight given to these factors would vary. 
In particular, the Commission would consider including in the pilot 
one-third of the securities in the Russell 1000 Index.\100\ To select 
the stocks for the pilot if we were to use the Russell 1000, we would 
sort the Russell 1000 by average daily dollar volume over the calendar 
year prior to the start of the pilot and use an objective method that 
would create two samples that should be approximately similar in 
average market value and average volume.\101\ Of course, as noted 
above, the Commission might include different stocks in the pilot or 
base the pilot on a different broad-based index if it were necessary or 
appropriate in the public interest and consistent with the protection 
of investors.
---------------------------------------------------------------------------

    \100\ The Russell 1000 Index comprises the 1,000 largest 
companies in the Russell 3000 Index (approximately 92% of the total 
market capitalization of the Russell 3000 Index). Inclusion in the 
Russell 1000 index is based completely on objective criteria, i.e., 
market capitalization. A pilot containing stocks from the Russell 
1000 index would allow us to analyze the effects of removing price 
restrictions on a broad range of liquid securities. A narrower index 
of liquid securities might not provide the breadth of information 
necessary to make an accurate determination of these effects. 
Conversely, broader indexes may contain certain securities that 
could be considered less liquid, which may not be appropriate for a 
pilot that focuses on short selling in liquid securities.
    \101\ In addition, both samples should also contain Nasdaq and 
NYSE stocks, optionable stocks, stocks with associated security 
futures, and both value and growth stocks. We hope that both samples 
would have similar average short interest and similar expected 
volatility. Even if the two samples differ slightly along these 
dimensions, researchers can control for the variations using 
regression techniques.
---------------------------------------------------------------------------

    While we recognize that the price of any security can be 
manipulated, we believe that as trading volume increases, it becomes 
less likely that a trader would be able to cost-effectively

[[Page 62984]]

manipulate the price of a security.\102\ Further, the high levels of 
transparency and surveillance for actively-traded securities on 
exchanges and other regulated markets make it more likely that any 
manipulation would be detected and pursued.\103\
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    \102\ See Securities Exchange Act Release No. 37094 (April 11, 
1996), 61 FR 17108 (April 18, 1996) (proposing anti-manipulation 
rules including an exception to the rules for trading activity in 
high ADTV securities).
    \103\ Id.
---------------------------------------------------------------------------

    The proposed temporary Rule 202 would remain in effect for two 
years. We anticipate that a partial, two-year suspension of the short 
sale rule would allow the Commission to gather and analyze the data 
necessary to reach conclusions regarding trading behavior in the 
absence of short sale price restrictions. The sample period should 
provide data on advancing and declining markets, high volume and low 
volume, and different stages of volatility so that the suspension can 
be studied fully.\104\
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    \104\ The Commission would study data from the pilot to 
determine the effect that the removal of the proposed bid test has 
on trading in the pilot securities. By the end of the two year 
period, we would consider extending the pilot in light of trading 
data and whether to pursue rulemaking to permanently remove the 
proposed bid test for a segment of securities.
---------------------------------------------------------------------------

    The Commission notes that the general anti-fraud and anti-
manipulation provisions of the federal securities laws would continue 
to apply to trading activity in these securities, thus prohibiting 
trading activity designed to improperly influence the price of a 
security.\105\ Further, the pilot would only suspend the operation of 
the proposed bid test. All other provisions of proposed Regulation SHO, 
including the marking requirements of Rule 201 and the locate and 
deliver requirements of Rule 203, would continue in effect. Finally, 
the Commission could terminate the operation of the pilot, in whole or 
in part, prior to the end of the proposed two-year period as it 
determines necessary or appropriate in the public interest or to 
protect investors by removing all securities selected for inclusion in 
the pilot.

    \105\ See, e.g., Securities Act Section 17(a), Exchange Act 
Sections 9(a), 10(b), and 15(c) and Rules 10b-5 and 15c1-2 
thereunder.
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    Q. Is the proposed rule temporarily suspending the short sale 
price test for liquid stocks appropriate? Are liquid stocks more 
difficult to manipulate through short selling?
    Q. Is a two-year temporary suspension of the short sale price 
test a sufficient period to fully study the impact? If not, what 
time period should be selected? Commenters should provide specific 
reasons to support their view in favor of establishing another time 
period.
    Q. Is the proposed selection method for the pilot, including our 
contemplated use of the Russell 1000, appropriate? If not, what 
other selection method should be considered? Is it possible that one 
market could benefit over another market depending on the selection 
of stocks for the pilot?
    Q. Should the short sale price test be automatically 
reinstituted in extraordinary market conditions, for instance, if, 
on an intraday basis, the price of a security falls more than a 
certain percentage based on the day's opening price (e.g., if the 
price of a security falls 10% from the day's opening price short 
sale restrictions would be reinstituted)?
    Q. The pilot, in part, would allow the Commission to obtain data 
to assess whether the price test should be removed for some types of 
securities and to study trading behavior in the absence of the 
proposed bid test. After analyzing the results of the pilot, the 
Commission may propose that the bid test be removed for certain 
exchange-listed and NMS securities. Should the Commission await the 
results of the pilot before applying the uniform bid test to 
exchange-listed and Nasdaq NMS securities that may later have the 
bid test removed?
    Q. Should the pilot apply to existing short sale rules even if 
we do not adopt the new uniform bid test?
    Q. The securities included in the pilot would still be marked 
and specialists and market makers can observe this mark prior to 
executing the short sale. How would this affect the outcome and 
reliability of the pilot, if at all?

VI. Rule 10a-1 Exceptions

    Paragraph (e) of Rule 10a-1 currently contains 13 exceptions to the 
tick test designed to permit certain types of trading activities that 
were intended to benefit the markets or that were believed to carry 
little risk of the kind of manipulative or destabilizing trading that 
the Rule was designed to address. We have reviewed these exceptions in 
light of proposed Rule 201, and we propose modifying some exceptions 
for inclusion in Rule 201 and excluding other exceptions from the Rule.

A. Exceptions Proposed To Be Retained

1. Long Seller's Delay in Delivery
    Subsection (e)(1) of Rule 10a-1 has existed since the inception of 
the short sale rule in 1938. This exception allows short sales to be 
effected without regard to the current tick test if the seller owns the 
security sold and intends to deliver such security as soon as is 
possible without undue inconvenience or expense. It was created so that 
sellers who actually own a security will not be penalized in the event 
they are unable to deliver the security to their broker prior to 
settlement, despite every intention of doing so, or in the event the 
certificate turned in by the seller is not in a form appropriate for 
transferring.
    In the event that the seller's shares are not delivered to the 
broker-dealer prior to settlement, borrowed shares may be used to 
consummate the sale. By definition, when borrowed shares are delivered, 
the sale is a short sale. We believe that this exception continues to 
be necessary to facilitate those limited circumstances where the seller 
owned the securities at the time of sale, however delivery may be 
briefly delayed, as when an option, right or warrant has been exercised 
but the underlying security has not yet been received by the seller. We 
propose to retain this exception from the proposed bid test 
substantially unchanged.\106\
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    \106\ See subparagraph (d)(1) of proposed Rule 201 of Regulation 
SHO.

    Q. Should this exception be retained in its current form?
    Q. Is this exception outdated?
2. Error in Marking a Short Sale
    Subsection (e)(2) of Rule 10a-1 has also existed since the 
inception of the Rule. This exception protects brokers in the event 
they execute a sale already marked long by another broker-dealer, but 
the sale turns out to be a short sale. The broker-dealer that marks the 
order long must abide by the provisions of the marking requirement that 
dictates when an order may be marked long and the executing broker-
dealer may rely on this marking when executing the sell order. This 
exemption was created to avoid implicating a broker that has 
unknowingly participated in a violation of the Rule, and we believe the 
basis for including the exception still makes sense in the current 
environment.\107\ We propose to retain this exception substantially 
unchanged.\108\
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    \107\ This exception does not apply where a broker-dealer knows 
or has reason to know that an order is incorrectly marked long. 
Knowledge may be inferred where a broker-dealer repeatedly accepts 
orders marked long from the same counterparty but requires borrowed 
shares for delivery or results in a ``fail to deliver'' on several 
occasions.
    \108\ See subparagraph (d)(2) of proposed Rule 201 of Regulation 
SHO.

    Q. Should this exception be retained in its current form?
3. Odd Lot Transactions
    An exception for certain odd-lot transactions was created in an 
effort to reduce the burden and inconvenience that short sale 
restrictions would place on odd-lot transactions. In 1938, the 
Commission found that odd-lot transactions played a very minor role in 
potential manipulation by short selling. Initially, sales of odd-lots 
were not subject to the restrictions of Rule 10a-1.\109\ However, the 
Commission became

[[Page 62985]]

concerned over the volume of odd-lot transactions, which possibly 
indicated that the exception was being used to circumvent the Rule. As 
a result, the exception was changed to the present two exceptions.\110\
---------------------------------------------------------------------------

    \109\ The Commission initially adopted three exceptions for odd-
lot transactions. While the first one, excepting all odd-lot 
transactions, seemed to make other odd-lot exceptions unnecessary, 
the 1938 adopting release included all three exceptions without 
discussion. Securities Exchange Act Release No. 1548 (January 24, 
1938), 3 FR 213 (January 26, 1938).
    \110\ See Securities Exchange Act Release No. 11030 (September 
27, 1974), 39 FR 35570.
---------------------------------------------------------------------------

    Subparagraph (e)(3) is limited to odd-lot dealers registered in the 
security and third-market makers. The exception allows short sales by 
odd-lot dealers registered in the security and by third market-makers 
(of covered securities) to fill customer odd-lot orders. Subparagraph 
(e)(4) provides relief for any sale to liquidate an odd-lot position by 
a single round lot sell order that changes such broker-dealer's 
position by no more than a unit of trading. We understand the odd lot 
exception to still be of utility and not in conflict with the goals of 
the proposed bid test. We propose combining the two exceptions into one 
odd-lot exception under subparagraph (d)(3) of Rule 201 of proposed 
Regulation SHO.
    In addition, we propose extending these exceptions to all market 
makers acting in the capacity of an odd-lot dealer. When the Rule was 
adopted, odd-lot dealers dealt exclusively with odd-lot transactions, 
and were so registered. Today, specialists assigned to a security are 
typically the odd-lot dealer in that security. We propose to broaden 
the use of this exception to all brokers or dealers acting as ``market 
makers'' in odd-lots.\111\
---------------------------------------------------------------------------

    \111\ The definition of a ``market maker'' is found in Section 
3(a)(38) of the Exchange Act, and includes specialists. 15 U.S.C. 
78c(a)(38).
---------------------------------------------------------------------------

    Odd-lot transactions by market makers to facilitate customer trades 
are generally not of a size that could facilitate a downward movement 
in the market. Therefore, those acting in the capacity of a ``market 
maker'' should be able to off-set customer odd-lot orders and liquidate 
an odd-lot position by a single round lot sell order that changes such 
broker-dealer's position by no more than a unit of trading without 
regard to the restrictions of the current tick test or proposed bid 
test.

    Q. Are these exceptions relating to odd-lots appropriate in 
today's markets?
    Q. Should these exceptions apply to all market makers in odd-
lots or should the exception be more limited?
    Q. Are these odd-lot exceptions susceptible to abuse?
    Q. Should all odd-lot transactions have an exception from the 
Rule? Would providing an exception for all odd-lot transactions pose 
a risk of increased short sale manipulation, e.g., would traders 
break up trades into 99 share odd-lots in order to avoid the price 
test?
4. Domestic Arbitrage
    Current subsection (e)(7) of Rule 10a-1 was adopted in 1938 to 
allow short selling associated with certain bona fide domestic 
arbitrage transactions.\112\ In adopting this exception, we stated that 
it ``applies only to bona fide arbitrage transactions in a security 
effected, under certain circumstances described in the exception, by 
persons who own rights or privileges entitling them to acquire that 
security.'' \113\ The exception has remained unchanged since its 
adoption.
---------------------------------------------------------------------------

    \112\ Securities Exchange Act Release No. 1645 (April 8, 1938).
    \113\ Id.
---------------------------------------------------------------------------

    The term ``bona fide arbitrage'' generally describes an activity 
undertaken by market professionals in which essentially contemporaneous 
purchases and sales are effected in order to lock in a gross profit or 
spread resulting from a current differential in pricing of two related 
securities.\114\ The Commission continues to believe that bona fide 
arbitrage activities are beneficial to the markets because they tend to 
reduce pricing disparities between securities.\115\ These activities 
also carry limited risk of the kind of manipulative or destabilizing 
trading that Rule 10a-1 was designed to address.
---------------------------------------------------------------------------

    \114\ See Securities Exchange Act Release No. 15533 (January 29, 
1979), 44 FR 6084 (January 31, 1979) (interpretation concerning the 
application of Section 11(a)(1) to bona fide arbitrage).
    \115\ Id.
---------------------------------------------------------------------------

    We therefore propose that proposed Rule 201 of Regulation SHO would 
retain the general exception contained in (e)(7). Subparagraph (d)(5) 
of Rule 201 would continue to except short sales effected in bona fide 
arbitrage transactions involving convertible, exchangeable, and other 
rights to acquire the securities sold short, where such rights of 
acquisition were originally attached to or represented by another 
security, or were issued to all the holders of any such class of 
securities of the issuer. In addition, we have proposed adding language 
to the exception to require a person relying on the exception to 
subsequently acquire or purchase the security upon which the arbitrage 
is based.\116\ For example, if a person sells short securities to 
profit from a current price differential based upon a convertible 
security that entitles him to acquire an equivalent number of 
securities of the securities sold short, he must subsequently tender 
the instrument for conversion to obtain the underlying securities and 
complete the arbitrage in order to satisfy the terms of the exception. 
We have also proposed minor amendments to the language of the exception 
to make it more understandable.

    \116\ As discussed, the Commission has interpreted the term 
``bona fide arbitrage'' to involve the contemporaneous purchase and 
sale of securities effected to ``lock in'' a gross profit or spread 
from a current differential in pricing. Id. We believe requiring a 
person relying on the exception to subsequently acquire or purchase 
the security upon which the arbitrage is based is consistent with 
this interpretation.
---------------------------------------------------------------------------

    Q. Should the exception be retained for purposes of the proposed 
Rule 201? If not, state specific reasons why the exception should be 
removed from the Rule.
    Q. Minor changes have been made to the text of existing 
exception (e)(7) in the proposed rule to simplify its language. Are 
these changes helpful? Does the proposed amendment to the exception 
alter its meaning in a way that would affect its substance?
    Q. Is the proposed amended exception too narrow or too broad? If 
so, state specifically why, and how it should be restructured in 
relation to the purposes of Regulation SHO.
    Q. Should the requirement that the transactions be made in a 
separate domestic arbitrage account be eliminated? If so, should the 
exception permit domestic arbitrage to be effected in an arbitrage 
account in which international arbitrage could also be effected?
    Q. Should exception (e)(7) be combined with (e)(8), the 
international arbitrage exception? Would such a combination create 
compliance problems or other issues?

    Recently, Commission staff has received inquiries regarding the 
operation of (e)(7) in the context of a corporate merger. In 
particular, market participants have sought advice whether upon 
finalization of a merger agreement, wherein a date certain is 
determined for the merger, a party who is entitled to receive stock of 
the acquiring company under the terms of the merger agreement is 
entitled to sell short this stock without regard to the tick test 
pursuant to the domestic arbitrage exception. Unlike the arbitrage 
contemplated in (e)(7), the right to acquire another security in a 
merger scenario arises only by the terms of the merger agreement and 
not through a right vested in the security itself. We believe that this 
type of arbitrage is not within the scope of paragraph (e)(7), and 
therefore we are not proposing to include it.

    Q. Should short sales effected in connection with a merger be 
excepted from the provisions of Rule 201? If so, at what point in 
the merger process should a party be deemed entitled to acquire the 
acquiring company's stock?


[[Page 62986]]


5. International Arbitrage
    The international arbitrage exception in Rule 10a-1 (e)(8) has also 
remained unchanged since its adoption in 1939.\117\ The international 
arbitrage exception was added following an extended study of 
international arbitrage operations in their relation to short 
selling.\118\ The Commission concluded that the exception was necessary 
to facilitate ``transactions which are of a true arbitrage nature, 
namely, transactions in which a position is taken on one exchange which 
is to be immediately covered on a foreign market.'' \119\
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    \117\ Securities Exchange Act Release No. 2039 (March 10, 1939).
    \118\ Id.
    \119\ Id. We believe that the provision necessitating that the 
transaction be ``immediately'' covered on a foreign market requires 
the foreign market to be open for trading at the time of the 
transaction in order to qualify for this exception.
---------------------------------------------------------------------------

    The Commission proposes to retain the international arbitrage 
exception because we understand that the exception is still being used 
and does not conflict with the goals of the proposed bid test. As with 
the domestic arbitrage exception, we have proposed amendments to the 
language in the exception in order to make it more understandable. In 
addition, we have incorporated language from current exception (e)(12) 
of Rule 10a-1 that provides that, for the operation of the 
international arbitrage exception, a depositary receipt for a security 
shall be deemed to be the same as the security represented by the 
receipt. This language was originally included in the Commission's 1939 
release adopting the international arbitrage exception, but was 
incorporated separately in subparagraph (e)(12). We believe this 
provision should be moved from its current location to the 
international arbitrage exception because it directly pertains to the 
operation of that exception.

    Q. Should the international arbitrage exception be retained for 
purposes of the proposed Rule 201? If not, state specific reasons 
why the exception should be removed from the Rule.
    Q. Minor changes have been made to the proposed rule to simplify 
the language of the existing exception. Are these changes helpful? 
Do they alter the meaning of the exception in a way that diminishes 
its value or prohibits bona fide international arbitrage activity in 
relation to Rule 201?
    Q. Is the proposed amended exception too narrow? If so, state 
specifically why it is too narrow and how it should be restructured 
to allow beneficial international arbitrage activity that does not 
carry the kind of manipulative or destabilizing trading that 
proposed Rule 201 is designed to address.
    Q. Should the requirement that the transactions be made in a 
separate international arbitrage account be eliminated? If so, 
should the exception permit international arbitrage to be effected 
in an arbitrage account in which domestic arbitrage could also be 
effected, rather than in a separate international arbitrage account?
    Q. Should exception (e)(8) be combined with (e)(7), the domestic 
arbitrage exception? Would such a combination create compliance 
problems or other issues?

6. Distribution Over-Allotment
    Subsection (e)(10) generally excepts from Rule 10a-1 sales of 
securities by underwriters or syndicate members participating in a 
distribution in connection with an over-allotment, and any lay-off 
sales by such a person in connection with a distribution of securities 
through rights or a standby underwriting commitment.\120\ Proposed Rule 
201 would retain the over-allotment exception in substance, although 
minor changes have been made to simplify its language.\121\ Under the 
proposed bid test, the exception would permit short sales in connection 
with an over-allotment at or below the bid, thus enabling an 
underwriter to price an offering at or below the last bid. We propose 
including this exception in Rule 201 of Regulation SHO because these 
sales are all at the offering price and, therefore, do not implicate 
one of the goals of short sale regulation, i.e., preventing short 
sellers from accelerating a declining market by exhausting all 
remaining bids at one price level.
---------------------------------------------------------------------------

    \120\ See Securities Exchange Act Release No. 11030 (September 
27, 1974), 39 FR 35570 (October 2, 1974). Although the exception was 
not adopted until 1974, the Commission's approval of the concept of 
excepting over-allotments from the short sale rule is long-standing. 
See, e.g., Securities Exchange Act Release No. 3454 (July 6, 1946), 
in which the Commission approved the NYSE's special offering plan, 
which permitted short sales in the form of over-allotments to 
facilitate market stabilization.
    \121\ See subparagraph (d)(7) of proposed Rule 201 of Regulation 
SHO.

    Q. Is this exception necessary? Under what circumstances would 
an underwriter or syndicate member price an offering below the best 
bid? Would extending the exception to short sales below the bid have 
---------------------------------------------------------------------------
any negative market impact?

7. Equalizing Short Sales and Trade-Throughs
    Exceptions (e)(5)(ii) and (e)(11) were adopted in order to 
eliminate a potential conflict between Rule 10a-1 and Rule 11Ac1-1 
under the Exchange Act (Quote Rule).\122\ The (e)(5) equalizing 
exception, as discussed in further detail below, permits market makers 
to effect short sales on a zero-minus tick (i.e., at the same price as 
the last trade price), but does not permit short sales, either as a 
dealer or agent, at a price lower than the last trade price reported in 
the consolidated system (i.e., on a minus tick). As a result, there 
arose a potential conflict between the operation of Rule 10a-1 and the 
``firmness requirement'' \123\ of the Quote Rule in situations where 
execution of an offer quotation by a broker or dealer would be rendered 
unlawful because of a trade-through \124\ even though the offer had 
been at a price permitted under Rule 10a-1 at the time that broker or 
dealer had communicated it to its exchange or association for inclusion 
in the consolidated quotation system.\125\
---------------------------------------------------------------------------

    \122\ See Securities Exchange Act Release No. 17314 (November 
20, 1980), 45 FR 231 (November 28, 1980).
    \123\ 17 CFR 240.11Ac1-1(c)(1). The Quote Rule requires that, 
subject to certain exceptions, the broker or dealer responsible for 
communicating a quotation shall be obligated to execute any order to 
buy or sell presented to him, other than an odd lot order, at a 
price comprising the responsible broker or dealer's published bid or 
offer in any amount up to his published quotation size.
    \124\ A trade-through generally occurs when an Intermarket 
Trading System (ITS) participant purchases an ITS security at a 
price that is higher than the displayed price at which the security 
is being offered at another ITS participating market, or sells an 
ITS security at a price that is lower than the displayed price at 
which the security is being bid at another ITS participant.
    \125\ The following example from the release adopting the 
exception illustrates the potential conflict: A market maker who 
currently has a short position in XYZ stock communicates an offer 
which, if executed against at that time, would be in compliance with 
Rule 10a-1, e.g., at a price of 20\1/8\ when the last trade price 
reported in the consolidated system is also 20\1/8\. There is a 
``trade through'' of the market maker's offer on another market 
center that causes an up-tick to be reported in the consolidated 
system at 20\1/4\. Finally, a buy order is sent to the market maker 
after the trade through at 20\1/4\ has been reported. In order to 
ensure compliance with 10a-1, the market maker must refuse to 
execute the order at his offer of 20\1/8\ because doing so would 
result in a short sale being effected on an impermissible minus 
tick, however, in refusing to effect the trade, he would arguably 
violate the ``firmness requirement'' of the Quote Rule. In addition, 
when a market maker ``backs away'' from an order, he may, in effect 
be revealing that he had a short position in the security, thus 
making it more difficult to liquidate that position at favorable 
prices. See, supra n. 122.
---------------------------------------------------------------------------

    In order to resolve this potential conflict, the Commission adopted 
(e)(5)(ii) to permit market makers to execute transactions at their 
offer following a trade-through, and (e)(11) to permit non-market 
makers to effect a short sale at a price equal to the price associated 
with their most recently communicated offer up to the size of that 
offer \126\ so long as the offer was at

[[Page 62987]]

a price, when communicated, that was permissible under Rule 10a-1. The 
(e)(11) exception was added in response to several comments that, in 
addition to orders for their own account, specialists and other floor 
members also often represent as part of their displayed quotation 
orders of other market participants (e.g., public agency orders or 
proprietary orders of non-market makers) that also might be ineligible 
for execution under Rule 10a-1 following a trade-through in another 
market.\127\
---------------------------------------------------------------------------

    \126\ The Commission explained in the release that the scope of 
the exception in Rule 10a-1(e)(11) was limited to the size of the 
broker or dealer's displayed offer because the need for the 
exception only arises to the extent that the broker or dealer's 
obligations under the Quote Rule may conflict with Rule 10a-1. 
Because the firmness requirement of the Quote Rule only applies to a 
broker or dealer's displayed offer, it was deemed appropriate to 
limit the exception to the size of the displayed offer. See, supra 
n. 122 at n.20.
    \127\ This concern was illustrated with the following example: A 
specialist who is short XYZ stock quotes an offer for 1,000 shares 
at 20\1/8\ at a time when the last sale reported in the consolidated 
system was such that the offer, if executed at that time, would be 
in compliance with Rule 10a-1. This offer for 1,000 shares consists 
of 300 shares offered by the specialist, a 400-share limit order in 
the specialist's book, and an offer from the crowd at the 
specialist's post for 300 shares, all at 20\1/8\. A trade through of 
this offer occurs on another exchange and an up-tick is reported in 
the consolidated system at 20\1/4\. A buy order for 1,000 shares at 
20\1/8\ is then sent to the exchange--after the trade through at 
20\1/4\ is reported. Without (e)(11), filling the complete order for 
1,000 shares would not be permissible, since (e)(5)(ii), by its 
terms, applies only to a sale by a market maker for its own account. 
Id at n.18.
---------------------------------------------------------------------------

    We believe that the rationale for adopting exceptions (e)(5)(ii) 
and (e)(11), namely resolving a conflict between the short sale rule 
and the quote rule arising from a trade-through, would not exist under 
the proposed bid test. Under the proposed rule, the reference point for 
a market participant seeking to execute a short sale would not be the 
last trade price, which could be a down tick created by a trade 
through, but rather the current consolidated best bid.
    It appears that under the proposed bid test, a comparable situation 
as that envisioned under (e)(5)(ii) and (e)(11) would result in a 
locked or crossed market.\128\ Locking or crossing a quote temporarily 
frustrates trading in a particular security, and there are various 
rules and regulations that guard against such practices.\129\ We have 
stated in prior releases that continued locking and crossing of the 
market can negatively impact market quality, and have approved SRO 
rules aimed at reducing the frequency of locked and crossed markets and 
providing more informative quotation information, facilitating price 
discovery, and contributing to the maintenance of a fair and orderly 
market.\130\
---------------------------------------------------------------------------

    \128\ In a locked market, the best bid price equals the best ask 
price; in a crossed market, the best bid price exceeds the best ask 
price. For example, assume that the current consolidated best bid 
for a security is 10.00. A market participant who has a short 
position in a security posts an offer to sell at 10.05. The market 
participant would be able to execute its short sale so long as it 
was above the consolidated best bid. Any bid that was posted at 
10.05 would lock the market, and any bid posted above 10.05 would 
cross the market.
    \129\ See, e.g. NASD Rule 4613(e). NASD Rule 4613(e)(2) states 
that ``A market maker shall, prior to entering a quotation that 
locks or crosses another quotation, make reasonable efforts to avoid 
such locked and crossed market by executing transactions with all 
market makers whose quotations would be locked or crossed. Pursuant 
to the provisions of paragraph (b) of this Rule 4613, a market maker 
whose quotations are causing a locked or crossed market is required 
to execute transactions at its quotations as displayed through 
Nasdaq at the time of receipt of any order.''
    \130\ See Securities Exchange Act Release No. 43863 (January 19, 
2001), 66 FR 8020, 8046 (January 26, 2001); Securities Exchange Act 
Release No. 46410 (August 23, 2002), 67 FR 55897 (August 30, 2002) 
(File No. SR-NASD-2002-56). See also Securities Exchange Act Release 
No. 47735 (April 24, 2003), 68 FR 23787 (May 5, 2003) (File No. 
NASD-2003-38).
---------------------------------------------------------------------------

    However, we recognize that locked and crossed markets have not been 
eliminated entirely, and thus the same conflict between the firm quote 
rule and the short sale rule could arise under the proposed bid test. 
We believe that this situation would exist where a market participant 
posts an offer to sell short at a valid price, i.e., above the best 
bid, but the bid subsequently moves up and either locks or crosses the 
market participant's posted offer. A market participant in this 
situation could still be required to execute buy orders directed to its 
posted offer, which would be at or below the best bid.\131\ The 
Commission thus proposes to include an exception to Rule 201 of 
Regulation SHO permitting a responsible broker-dealer, as defined in 
Rule 11Ac1-1 under the Exchange Act \132\ to effect a short sale at a 
price equal to its posted offer when the market is locked or crossed, 
when consistent with best execution obligations, provided however, that 
the exception would not apply to any broker-dealer who initiated the 
locked or crossed market.
---------------------------------------------------------------------------

    \131\ See 17 CFR 240.11Ac1-1; see also supra n. 129. Paragraph 
(b) of Rule 4613 is the NASD Firm Quote Rule.
    \132\ Rule 11Ac1-1(a)(21) defines the term responsible broker or 
dealer to mean: (i) When used with respect to bids or offers 
communicated on an exchange, any member of such exchange who 
communicates to another member on such exchange, at the location (or 
locations) designated by such exchange for trading in a covered 
security, a bid or offer for such covered security, as either 
principal or agent; provided, however, That, in the event two or 
more members of an exchange have communicated on such exchange bids 
or offers for a covered security at the same price, each such member 
shall be considered a ``responsible broker or dealer'' for that bid 
or offer, subject to the rules of priority and precedence then in 
effect on that exchange; and further provided, That for a bid or 
offer which is transmitted from one member of an exchange to another 
member who undertakes to represent such bid or offer on such 
exchange as agent, only the last such member who undertakes to 
represent such bid or offer as agent shall be considered the 
``responsible broker or dealer'' with respect to that bid or offer; 
and (2) when used with respect to bids and offers communicated by a 
member of an association to another broker or dealer or to a 
customer otherwise than on an exchange, the member communicating the 
bid or offer (regardless of whether such bid or offer is for its own 
account or on behalf of another person).

    Q. Would an exception from the proposed bid test permitting a 
short sale to be effected at the consolidated best offer if the 
market is locked or crossed be useful or necessary to remedy 
problems associated with locked and crossed markets? If so, describe 
such circumstances and the market participants to whom the exception 
should apply.
    Q. Would such an exception be used appropriately to remedy the 
problem of locked and crossed markets, or could such an exception be 
susceptible to abuse? Is there another way to design an exception 
for locked and crossed markets?
    Q. Some market participants that provide their customers with 
guaranteed executions of their buy orders at a price equal to the 
consolidated best offer would be prevented from selling short to 
fill customer buy orders in a locked or crossed market, due to the 
fact that the short sale would be executed at a price equal to or 
below the best bid. Should there be an exception to allow these 
market participants to execute short sales at their offer to 
facilitate customer buy orders in locked or crossed markets?

B. Exception Proposed To Be Eliminated

    Exception (e)(6) of Rule 10a-1, the original ``equalizing 
exception,'' was adopted by the Commission in 1938 to allow a short 
sale of a security on a regional exchange at the same price as the then 
current price for the same security on the principal exchange, even 
though the short sale on the regional exchange would constitute a zero-
minus or minus tick in relation to the last preceding trade price on 
the principal exchange.\133\ The exception, limited to short sales 
effected on an exchange, permitted regional specialists to guarantee 
execution at a price at least as favorable to the customer as he would 
have obtained had his order been exposed to the principal exchange 
market.\134\ The Commission believed that unless the regional exchanges 
were

[[Page 62988]]

allowed to fill purchase orders at prices that would have been obtained 
on the principal exchanges, regional exchanges would be unable to 
attract sufficient order flow to remain viable.\135\
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    \133\ Securities Exchange Act Release No. 1579 (February 10, 
1938), 3 FR 382 (1938). At the time the exception was adopted (and 
until April 30, 1976) the permissibility of short sales under Rule 
10a-1 was determined for each particular exchange by comparing the 
price of the proposed short sale to the immediately preceding last 
trade price in the security to be sold short on that exchange.
    \134\ Pursuant to the Rule, such sales are excepted only with 
the approval of the exchange, and only if (1) trades in the security 
are not reported pursuant to an effective transaction reporting plan 
and (2) information as to such trades is not made available on a 
real-time basis.
    \135\ See Securities Exchange Act Release No. 11468 (June 12, 
1975), 40 FR 25442 (June 16, 1975) (adopting amendments to Rule 10a-
1 and discussing the operation of Rule 10a-1(e)(6) as in effect 
prior to and after amendment).
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    In 1975 the Commission adopted amendments to Rule 10a-1 in 
conjunction with the full implementation of the consolidated 
transaction reporting system (``consolidated system'').\136\ As 
amended, Rule 10a-1 applies a tick test referencing the last trade 
price reported in the consolidated system, however permits an exchange 
to make an election to use a tick test that references the last trade 
price reported in that exchange market.\137\
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    \136\ Id.
    \137\ 17 CFR 240.10a-1(a)(2). This aspect of the short sale 
rule, as amended, was designed to ameliorate potential regulatory 
and operational problems perceived by certain exchanges with a 
uniform short sale rule employing a tick test referenced to the 
consolidated system. Id.
---------------------------------------------------------------------------

    In addition to altering the reference point for determining the 
permissibility of short sales, the amendments also altered the 
reference point for the permissibility of equalizing short sales. 
Subsection (e)(5)(i) was added to provide an exception for short sales 
of certain securities effected by a registered specialist, exchange 
market maker, or third market maker at a price equal to the last price 
reported in the consolidated system.\138\ The exception applies to 
short sales of securities registered or admitted to unlisted trading 
privileges on an exchange, whether effected on an exchange or over-the-
counter, if transactions in the security are reported pursuant to an 
effective transaction reporting plan and made available on a real time 
basis to vendors of market transaction information.
---------------------------------------------------------------------------

    \138\ Rule 10a-1(e)(5)(i) exempts: Any sale of a security 
covered by paragraph (a) of this section (except a sale to a 
stabilizing bid complying with Sec.  242.104 of this chapter) by a 
registered specialist or registered exchange market maker for its 
own account on any exchange with which it is registered for such 
security, or by a third market maker for its own account over-the-
counter, (i) Effected at a price equal to or above the last sale, 
regular way, reported for such security pursuant to an effective 
transaction reporting plan.
---------------------------------------------------------------------------

    The exception is intended to permit market professionals to protect 
customer orders against transactions in other markets in the 
consolidated system by allowing them to sell short at a price equal to 
the last trade price reported in the consolidated system, even if that 
sale was on a minus tick (a so-called ``zero-minus tick'').\139\ 
Concurrent with the adoption of subsection (e)(5)(i), exception (e)(6) 
was amended to apply only to short sales of securities covered by Rule 
10a-1(b), i.e., to short sales of exchange-listed securities that are 
not reported to the consolidated system or made available on a real-
time basis.\140\
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    \139\ Securities Exchange Act Release No. 11030 (September 27, 
1974), 39 FR 35570.
    \140\ Paragraph (b) of Rule 10a-1 applies to any short sale 
effected on a national exchange of any security not covered by 
paragraph (a) of Rule 10a-1. Paragraph (a), in turn, covers any 
short sale effected on a national exchange of any security 
registered or admitted to unlisted trading privileges on a national 
exchange, if trades in the security are reported pursuant to an 
``effective transaction reporting plan'' and if information as to 
such trades is made available on a real-time basis to vendors of 
market transaction information.
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    We do not believe that the equalizing exceptions should be retained 
as part of proposed Regulation SHO. The rationale for exceptions (e)(6) 
and (e)(5)(i), i.e., allowing short selling at a price that matches a 
given security's last trade price on another market center, would not 
exist under our proposed short sale rule. The proposed rule would 
reference the real-time consolidated best bid rather than the last 
trade price, and would not depend on prices in individual markets.\141\ 
We therefore do not believe that a registered specialist or exchange 
market maker would need to ``equalize'' their price with a price on 
another market center.

    \141\ We have proposed eliminating Rule 10a-1(a)(2), and thus 
any market center would be prevented from relying on its own bid as 
a reference point for compliance with the rule. See, infra part XII.

    Q. Is there any reason why exception (e)(6) should be retained?
    Q. Is there any reason why exception (e)(5)(i) should be 
retained? For example, would broker-dealers that provide customers 
with executions at a price equal to transaction prices on a primary 
exchange require an exception to facilitate customer buy orders?

VII. Prior Exemption Letters Under Rule 10a-1

A. Exchange Traded Funds

    Exchange Traded Funds (ETFs) are designed to provide investment 
results that correspond generally to price and yield performance of 
securities included in a particular index or securities portfolio. In 
light of the composite and derivative nature of ETFs, the Commission 
found that trading in ETFs would not be susceptible to the practices 
that Rule 10a-1 is designed to prevent and granted an exemption from 
Rule 10a-1 for transactions in these securities.\142\ In particular, 
the Commission found that ETFs should rise or fall based on changes in 
the net asset value of the component stocks of the particular index and 
supply and demand.\143\
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    \142\ See, e.g., Letter re: SPDRs (January 27, 1993); Letter re: 
MidCap SPDRs (April 21. 1995); Letter re: Select Sector SPDRs 
(December 14, 1998); Letter re: Units of the Nasdaq-100 Trust (March 
3, 1999); Letter re: ETFs (August 17, 2001) (class letter).
    \143\ The Commission, however, did not provide any relief from 
the tick test for short selling of the individual component stocks 
underlying an ETF.
---------------------------------------------------------------------------

    The relief is subject to a number of specified conditions. In 
particular, the corresponding index or portfolio represented by the ETF 
must consist of a ``basket'' of twenty or more different component 
stocks, in which the most heavily weighted component stock cannot 
exceed 25% of the weight of the index or portfolio. Moreover, the 
component stocks that in the aggregate account for a least 85% of the 
weight of the underlying index or portfolio must have a minimum public 
float value of at least $150 million and, with certain exceptions, a 
minimum ADTV with a value of at least $1 million during each of the 
previous 2 months of trading prior to the formation of the ETF series. 
We believe that these conditions continue to be necessary to ensure the 
composition of the ETFs is such that short selling in the ETFs does not 
implicate the type of trading activity that short sale regulation was 
designed to prevent.
    The relief previously granted under Rule 10a-1 would continue to 
apply to cover exemptions from the price test provisions of Rule 201 of 
Regulation SHO.

    Q. Should the Commission provide relief from proposed Rule 201 
of Regulation SHO for transactions in ETFs? If so, are the 
conditions for relief appropriate? If not, please explain why.
    Q. Should the relief be codified as an exception to proposed 
Rule 201 of Regulation SHO?

B. Short Sales Executed at the Closing Price

    The Commission has granted conditional relief from the price test 
provisions of Rule 10a-1 to allow requesting exchanges \144\ and 
broker-dealers \145\ to execute short sales in after-hours crossing 
sessions at a price equal

[[Page 62989]]

to the closing price of the security.\146\ Absent relief, such short 
sales could violate Rule 10a-1, in that the matching price (the closing 
price) of a security could be on a minus or zero-minus tick with 
respect to the last sale in the consolidated transaction reporting 
system. In granting this conditional relief, we have noted that short 
sale transactions executed at the closing price generally do not 
represent the type of abusive practices that Rule 10a-1 is designed to 
prevent. In particular, short sale orders entered in the after-hours 
crossing sessions cannot influence the matching price, but rather are 
priced by unrelated order flow and transactions occurring during the 
primary trading session, which are subject to the tick test. The relief 
previously granted under 10a-1 would continue to apply to cover 
exemptions from the price test provisions of Rule 201 of Regulation 
SHO.

    \144\ See, e.g., Letter re: Off-Hours Trading by the Amex, 
[1991] Fed. Sec. L. Rep. (CCH) ] 79,802 (August 5, 1991); Letter re: 
Operation of Off-Hours Trading by the NYSE, [1991] Fed. Sec. L. Rep. 
(CCH) ] 79,736 (June 13, 1991).
    \145\ See, e.g., Letter re: Burlington Capital Markets (July 1, 
2003); Letter re: Bear, Stearns & Co., Inc. (January 19, 1996); 
Letter re: AZX, Inc. (November 15, 1995); Letter re: Instinet 
Corporation Crossing Network, [1992] Fed. Sec. L. Rep. (CCH) ] 
76,290 (July 1, 1992); Letter re: Portfolio System for Institutional 
Trading, [1991-1992] Fed. Sec. L. Rep. (CCH) ] 76,097 (December 31, 
1991).
    \146\ The relief is generally subject to the conditions that: 
(1) short sales of a security in the after-hours matching session 
shall not be effected a prices lower than the closing price of the 
security on its primary exchange; (2) persons relying on these 
exemptions shall not directly or indirectly effect any transactions 
designed to affect the closing price on the primary exchange for any 
security traded in the after-hours matching session; and (3) 
transactions effected in the after-hours matching session shall not 
be made for the purpose of creating actual, or apparent, active 
trading in or otherwise affecting the price of any security.

    Q. Do closing price transactions create perverse incentives for 
broker-dealers, such that they should not be granted an exception?
    Q. Should the relief be codified as an exception to proposed 
Rule 201 of Regulation SHO?

VIII. Market Maker Exception From Proposed Uniform Bid Test

    It has been argued that short selling by market makers helps offset 
imbalances in the supply and demand or gaps in the flow of buy and sell 
orders.\147\ NASD Rule 3350 exempts from operation of the NASD's bid 
test short sales executed by qualified market makers in connection with 
bona fide market making.\148\ There is currently no similar exception 
in Rule 10a-1, however, for the bona fide market making activities of 
specialists and third market makers in exchange-listed securities.
---------------------------------------------------------------------------

    \147\ See, e.g., Irving M. Pollack, Short Sale Regulation of 
NASDAQ Securities (1986), at 12.
    \148\ Rule 3350 (c) provides further that ``transactions 
unrelated to normal market making activity, such as index arbitrage 
and risk arbitrage that are independent from a member's market 
making functions, will not be considered bona fide market-making 
activity.'' See NASD Rule 3350. NASD IM-3350 also contains language 
specifying what type of activity does not constitute bona fide 
market making. See, supra n. 42.
---------------------------------------------------------------------------

    The chief reason advanced in support of the NASD market maker 
exception is that it enhances liquidity by permitting market makers to 
adjust inventory positions quickly.\149\ If market makers were required 
to wait for an upbid to make a short sale, it is asserted that their 
ability to satisfy their market making functions would be impaired. The 
NASD has also argued that market makers perform an important market 
stabilizing function. According to a 1997 study by NASD Economic 
Research, market makers provide immediate, stabilizing liquidity.\150\ 
If there is heavy selling pressure by investors and the market is 
moving down, market makers provide stability by standing ready to buy 
stock. According to the study, application of a short sale rule to 
market makers could reduce a market maker's ability to adjust inventory 
positions quickly, thereby reducing its supply of immediate liquidity 
to the marketplace.\151\ The NASD study also states that application of 
the short sale rule to market makers could increase market makers' 
costs, which would be passed on to investors in the form of wider 
spreads.\152\
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    \149\ See Securities Exchange Act Release No. 34277 (July 7, 
1994), 59 FR 34885 (July 29, 1994) (order granting temporary 
approval of Rule 3350 for an eighteen-month period (Temporary 
Approval Order)).
    \150\ See D. Timothy McCormick and Bram Zeigler, The Nasdaq 
Short Sale Rule: Analysis of Market Quality Effects and The Market 
Maker Exemption, NASD Economic Research, (August 7, 1997) at 22-23.
    \151\ Id. at 20.
    \152\ Id.
---------------------------------------------------------------------------

    We do not find these arguments persuasive in the context of the 
proposed uniform bid test. In providing liquidity to customers, a 
market maker primarily buys at the bid and sells at the offer, or in 
between the bid and offer. We believe that a market maker should rarely 
need to sell short at or below the bid in its market making 
capacity.\153\ The proposed rule permits unrestricted short sales at 
the offer or at any other price that is one cent or more above the bid, 
and thus the need for an exception to allow market makers to sell at or 
below the best bid seems limited.\154\
---------------------------------------------------------------------------

    \153\ The NASD's 1997 study indicates that during a sample month 
in 1997, market maker short sales at or below the inside bid 
accounted for only 2.41% of their total share volume. Id. at 27.
    \154\ In approving the market maker exception, the Commission 
noted that we would review the exception to determine whether the 
bid-test and exceptions are practicable and necessary on an ongoing 
basis. See Temporary Approval Order, supra, n. 149. Most recently, 
we extended the Rule 3350 pilot, including the market maker 
exemption, until December 15, 2003. See Securities Exchange Act 
Release No. 48035 (June 16, 2003), 68 FR 37183 (June 23, 2003). We 
noted that the extension was subject to modification or revocation 
should the Commission amend Rule 10a-1 in such a manner as to deem 
the extension unnecessary or in conflict with any adopted 
amendments.
---------------------------------------------------------------------------

    We are also concerned that the exception may be being used by 
entities that are not actually engaged in bona-fide market making.\155\ 
For example, some issuers and investors have argued that some market 
makers are relying on the exception to continuously sell short into the 
bid--an activity that, as mentioned above, we find inconsistent with 
bona fide market making. The Commission believes that for the rule to 
have its intended positive effect on the market, all market 
participants, including market makers, should be subject to the 
rule.\156\
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    \155\ As initially approved, only market makers that met the 
Primary Market Maker (PMM) standards set forth in NASD Rule 4612 
were eligible for an exception from the short sale rule. These PMM 
standards were subsequently suspended for all National Market 
Securities due to the potential impact of the Order Handling Rules. 
See Securities Exchange Act Release No. 38294 (February 14, 1997), 
62 FR 8289 (February 24, 1997). As such, all market makers are 
currently eligible to rely on the exception.
    \156\ When we first approved the NASD's bid test and market 
maker exception in 1994, we recognized that the exception could 
result in problems of the type that have been reported by 
commenters. The Commission stressed the importance of monitoring the 
need for and effect of the exception on an ongoing basis, stating 
that experience with the test ``may raise issues that require 
reconsideration of some or all elements of the proposal.'' See 
Temporary Approval Order, supra, note 149. In particular, the 
Commission noted concerns that the market maker exception could 
create opportunities for abusive short selling. Id.
---------------------------------------------------------------------------

    A market maker that is positioning inventory to profit from market 
moves would find it advantageous to be able to short into the bid, like 
any speculator. One of the historical goals of short sale regulation is 
to prevent short sellers from accelerating a declining market by 
exhausting all remaining bids at one price level, and causing 
successively lower prices to be established by long sellers.\157\ If 
such a seller is able to exhaust the existing bids in a security with 
short sales, and is able to attract long sellers to the market, the 
goal of accelerating the price decline of a particular security would 
be accomplished. Another goal of short sale regulation is that long 
sellers should have the right to sell first in a declining market.
---------------------------------------------------------------------------

    \157\ Securities and Exchange Commission, Special Study of 
Securities Markets, H.R. Doc. No. 95, 88th Cong., 1st Sess., at 251 
(1963).
---------------------------------------------------------------------------

    Nevertheless, we believe that the proposed exception that would 
allow broker-dealers to execute customer sales on a riskless principal 
basis by looking to the customer's position would provide broker-
dealers with additional flexibility to facilitate customer

[[Page 62990]]

orders.\158\ In addition, we are proposing an exception from Rule 201 
to allow broker-dealers to sell short at a price equal to the 
consolidated best bid, when consistent with best execution obligations, 
in order to fill customer orders it is required to execute pursuant to 
federal securities laws or SRO rules, such as NASD IM-2110-2 and the 
related interpretation of IM-2110-2 (Manning Interpretation). According 
to Nasdaq, the Manning Interpretation is designed to ensure that 
customer limit orders are executed in a fair manner and at similar 
prices at which a firm has traded for its own account.\159\ If a 
broker-dealer executed an incoming market sell order at the 
consolidated best bid, it would then be obligated to fill other 
customer limit orders it held at that price.\160\ However, if the 
broker-dealer had a net short position, it would be prohibited by 
proposed Rule 201 from filling the customer buy order at a price equal 
to the bid. We believe the proposed exception would remedy this 
conflict.
---------------------------------------------------------------------------

    \158\ See, infra part IX.B for a further discussion of the 
proposal regarding riskless principal trades.
    \159\ See, e.g., Securities Exchange Act Release No. 44030 
(March 2, 2001), 66 FR 14235 (March 9, 2001) (order granting 
approval of proposed rule change by the NASD regarding trading ahead 
of customer limit orders pursuant to decimal pricing in the Nasdaq 
market). See also NASD Rule 6440(f) (applying limit order protection 
rules to NASD members in exchange-listed securities).
    \160\ For example, a market maker receives an order to buy 1,000 
shares of XYZ stock at $20 from a customer and represents the order 
in its Nasdaq quote. Market maker buys 1,000 shares of XYZ at $20 
for its own account. Pursuant to the Manning Interpretation, the 
market maker would be obligated to sell to the customer to fill the 
customer's 1,000 share order.
---------------------------------------------------------------------------

    We seek comment on the importance of a market maker exception in 
the context of a market maker's role in providing liquidity. We also 
seek comment on the extent to which market makers might need to be able 
to short at the bid in order to facilitate a customer buy order, and 
inquire whether an exception limited to those situations would be 
necessary or appropriate.

    Q. Should the proposed uniform bid test include a bona-fide 
market making exception? If so, why? How important is it for a 
market maker to be able to profit from position trading? Could there 
potentially be negative consequences to the market if there is not 
an exception for bona-fide market making transactions? Please 
describe.
    Q. If a market making exception from the bid test is necessary, 
what should be done to limit its use to those engaged in bona-fide 
market making? Should the exception be tied to certain 
qualifications or conditions? If so, what should these 
qualifications or conditions be?
    Q. If inclusion of a bona-fide market making exception is 
necessary, would there be any circumstances where a market maker 
acting in his market making capacity would need to sell short below 
the bid?
    Q. How often do market makers or other broker-dealers sell short 
at the bid in response to customer buy orders? Would it be feasible 
to allow market makers or other broker-dealers to sell short at the 
bid to facilitate customer buy orders without undermining the 
purposes of the price test? If so, should there be limits on such 
short sales, for example to prevent a dominant market maker from 
filling customer orders at the bid in order to place downward 
pressure on the security's price?
    Q. What other type of transactions should qualify for a bona 
fide market making exception?

IX. Proposed Changes to the Order Marking Requirement

A. Marking Orders

    We propose combining current marking requirements in subsections 
(c) and (d) of Rule 10a-1 into new subsection (c) of Rule 201. New 
subsection (c) generally would differentiate between ``long,'' 
``short,'' and ``short exempt'' orders. The marking requirement would 
apply to all exchange-listed securities and over-the-counter 
securities. An order could only be marked ``long'' when the seller owns 
the security being sold and the security either is in the physical 
possession or control of the broker-dealer or will be prior to the 
settlement of the transaction. A sell order would be required to be 
marked ``short exempt'' if it were a short sale effected pursuant to an 
exception in Rule 201.
    We believe that the proposed change would eliminate the current 
discrepancy between how Rule 3b-3 defines a short sale and the marking 
provisions found in Rule 10a-1. There are circumstances where an order 
can be marked ``long,'' but is a short sale executed without regard to 
the current tick test. For example, a person placing a sell order may 
be deemed to own a security under current Rule 3b-3(b)-(e),\161\ but 
must borrow securities to consummate the delivery (e.g., because the 
securities due upon a conversion of a security have not been received). 
While borrowing to settle a sale constitutes a short sale under Rule 
3b-3, the seller would not be subject to the current tick test if at 
the time of the trade the seller owns the security and intends to 
deliver such security ``as soon as possible without undue inconvenience 
or expense.'' \162\ This sale would be marked ``long'' under the 
current marking provisions of Rule 10a-1(d).
---------------------------------------------------------------------------

    \161\ As discussed infra, Part X, Rule 3b-3 provides that a 
person is deemed to own a security if he or she: has entered into a 
binding, unconditional contract to purchase a security; own a 
security convertible into or exchangeable for it and has tendered 
such security for conversion or exchange; have an option to purchase 
or acquire it and has exercised such option; or have rights or 
warrants to subscribe to it and have exercised such rights. A person 
who is deemed to own a security may mark orders to sell such 
securities long.
    \162\ 17 CFR 240.10a-1(e)(1).
---------------------------------------------------------------------------

    Under our proposed amendment, the sell order described above would 
not be marked ``long'' because, while the above seller may own the 
security, the security is neither in the physical possession or control 
of the broker-dealer nor is it reasonably expected to be prior to the 
settlement of the transaction. The seller would thus have to borrow the 
stock in order to effectuate delivery to the buyer. Instead the seller, 
availing themselves of exception (d)(1) of Rule 201, would mark the 
order ``short exempt.'' Requiring the order to be marked ``short 
exempt'' promotes consistency among related rules and uniformity among 
markets and market participants in the manner in which short sales are 
marked.
    We believe that the proposed amendments would provide several 
benefits. The current marking requirements can lead to undetected 
violations of Rule 10a-1 because once the order is marked ``long,'' it 
is processed and executed as such, even though borrowed shares 
consummate the delivery on the sale. This complicates surveillance for 
violations of Rule 10a-1, as short sales executed under an exception 
from the rule can be masked as ``long'' sales. Further, under the 
current marking requirements there is no record of how short sellers 
are availing themselves of the various exceptions to Rule 10a-1. We 
believe that surveillance for compliance with proposed Rule 201 would 
be facilitated with accurate indications of when and under what 
circumstances the exceptions are utilized.
    The practice of designating an order as ``short exempt,'' as 
proposed, has already developed. Many broker-dealers are already 
required to mark short sales as short exempt if they are effected under 
one of the exceptions from Rule 10a-1. For example, ITS participants 
\163\ are required to designate commitment orders as ``short exempt'' 
when the short sale falls under an exception to the

[[Page 62991]]

application of Rule 10a-1.\164\ The NYSE has advised its members that 
it is ``appropriate'' to mark those short sale orders covered under 
exceptions to the rule as ``short exempt.''\165\ In addition, NASD Rule 
4991(i) requires all orders executed on Nasdaq be designated as 
``buy,'' ``sell long,'' ``sell short,'' or ``sell short exempt.''\166\ 
The proposed amendment would require orders to be marked as either 
``long,'' ``short,'' or ``short exempt,'' providing greater uniformity.
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    \163\ Current signatories to the ITS Plan include the American 
Stock Exchange LLC (Amex), Boston Stock Exchange, Inc. (BSE), 
Chicago Board Options Exchange, Inc. (CBOE), Chicago Stock Exchange, 
(CHX), Cincinnati Stock Exchange (CSE), NASD, NYSE, Pacific 
Exchange, Inc. (PCX), and Philadelphia Stock Exchange, Inc. (Phlx).
    \164\ See Restated Intermarket Trading Plan, 33 (May 30, 1997).
    \165\ See NYSE Rule 440B.20.
    \166\ See NASD Rule 4991(i)(2).
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    Further, we believe that requiring a broker dealer to have physical 
possession or control of the security at execution, or, in the 
alternative, that the broker dealer obtain physical possession or 
control of the security prior to settlement, before marking the order 
``long'' should facilitate the process of clearance and settlement in 
the current T + 3 environment. Disturbances in settlement processes can 
affect the stability and integrity of the financial system in general. 
Clearance and settlement systems are designed to preserve financial 
integrity and minimize the likelihood of systematic disturbances by 
instituting risk-management systems.\167\ Requiring a broker-dealer to 
have possession or control of the securities before the broker-dealer 
can mark an order long should help to reduce failures to deliver. We 
anticipate that this proposed amendment would not be burdensome to 
market participants because most customer securities are not held by 
investors in physical form, but rather are held indirectly through 
their broker-dealer, i.e., in ``street name.'' \168\

    \167\ See Exchange Act Section 17A, 15 U.S.C 78q-1.
    \168\ DTC holds approximately 83% of all NYSE-traded shares 
outstanding and 72% of all Nasdaq-traded shares outstanding for the 
benefit of its participants (i.e., broker-dealers and banks). See 
Securities Dematerialization White Paper, Securities Industry 
Association, at 17 (June 5, 2000).
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    Q. What type of additional costs and burdens, if any, would be 
associated with requiring orders to be marked ``short exempt?''
    Q. Does the requirement that a broker has physical possession or 
control of the security or will have physical possession or control 
prior to settlement place undue or unreasonable hardship on long 
sellers?
    Q. Should proposed Rule 200 require a broker or dealer marking a 
sell order ``short exempt'' to identify the specific exception that 
the broker or dealer is relying on in marking it ``short exempt?'' 
If not, state why not.

B. Marking Requirements for Riskless Principal Transactions

    Recently, some market makers have indicated that they would like 
exemptive relief from Rule 10a-1 to mark sell orders based on a 
customer's net position when a broker-dealer or market maker is 
effecting the execution of the customer's order on a riskless principal 
basis.\169\ For example, a customer who is net long 1,000 shares of XYZ 
security enters an order to sell those securities with a market maker, 
the market maker then seeks to sell 1,000 shares of XYZ from his 
proprietary account to facilitate the trade prior to obtaining the 
securities from the customer. In this situation, market makers acting 
as riskless principal have sought an exemption from Rule 10a-1 to mark 
the market maker's sale from its proprietary account as ``long'' based 
on the customer's long position, regardless of the market maker's 
proprietary position in the security.
---------------------------------------------------------------------------

    \169\ Riskless principal transactions are generally described as 
trades in which, after receiving an order to sell (or buy) from a 
customer, the broker-dealer sells (or purchases) the security to (or 
from) another person in a contemporaneous offsetting transaction. 
See Securities Exchange Act Release No. 44291 (May 18, 2001), 66 FR 
27760 (order adopting a de minimis exception to the definition of 
the term ``dealer'' solely for banks engaging in riskless principal 
transactions under 240.17 CFR 3a5-1); see also Securities Exchange 
Act Release No. 33743 (March 9, 1994), 59 FR 12767-01 (March 17, 
1994). More recently, the Commission modified its interpretation of 
Exchange Act Section 28(e), the ``safe harbor'' provision for money 
managers who use commission dollars of their advised accounts to 
obtain research and brokerage, so that it encompasses certain 
riskless principal transactions as defined by Nasdaq trade reporting 
rules. See Securities Exchange Act Release No. 45194 (December 17, 
2001), 67 FR 6 (January 2, 2002) (NASD's rules define a riskless 
principal trade as a transaction in which a member after having a 
received an order to buy a security, purchases the security as 
principal at the same price to satisfy the order to sell. See NASD 
Rules 4632(d)(3)(B), 4642(d)(3)(B), and 6420(d)(3)(B)).
---------------------------------------------------------------------------

    We believe that for the purposes of short sale regulation, the 
position of a broker-dealer should be deemed to be the same as a 
customer's position, regardless of whether the broker-dealer has a 
proprietary net ``long'' or ``short'' position, when the broker-dealer 
acts in a riskless principal capacity.\170\ We believe that in this 
context, the broker-dealer effects the sale in a manner analogous to an 
agency execution. A short sale effected on an agency basis is marked 
according to the customer's net position. We therefore propose adding 
an exception to the proposed bid test of Regulation SHO that would 
allow broker-dealers to mark such sell orders ``short exempt.'' \171\ 
Allowing a broker-dealer to mark an order in this manner does not 
implicate the stated concerns raised by short selling, i.e., where a 
customer is long, specialist or market maker principal transactions 
should not be restricted in the same manner as short sales.\172\
---------------------------------------------------------------------------

    \170\ For example, if the customer seeking to sell 1,000 shares 
of XYZ and the customer was net short in XYZ, a market maker 
engaging in a riskless principal transaction on behalf of the 
customer would have to mark the sell order from his principal 
account short regardless of his own net position.
    \171\ See subparagraph (d)(9) of proposed Rule 201 of Regulation 
SHO.
    \172\ See Securities Exchange Act Release No. 46994 (December 
13, 2002), 67 FR 78033 (December 20, 2002) (order approving NASD 
amendment to the Manning Interpretation establishing a riskless 
principal customer facilitation exemption).
---------------------------------------------------------------------------

    We are concerned, however, that this exception from proposed Rule 
201 not be used in an abusive or manipulative manner. Towards that 
goal, we would restrict this provision to riskless principal 
transactions as follows:
    [sbull] A transaction in which a broker or dealer, after having 
received an order to sell a security, sells the security as principal 
at the same price to satisfy the order to sell;
    [sbull] The sell order must be given the same per-share price at 
which the broker or dealer sold shares to satisfy the facilitated 
order, exclusive of any explicitly disclosed markup or markdown, 
commission equivalent or other fee;
    [sbull] The broker or dealer must have written policies and 
procedures in place to assure that, at a minimum: the customer order 
was received prior to the offsetting transaction; the offsetting 
transaction is allocated to a riskless principal account or customer 
account within 60 seconds of execution; the broker or dealer has 
supervisory systems in place to produce records that enable the broker 
or dealer to accurately and readily reconstruct, in a time-sequenced 
manner, all orders effected pursuant to this exception.
    We believe that these conditions would allow for the surveillance 
of the exception by linking the exception to specific incoming orders 
and executions, and by requiring the brokers and dealers to establish 
procedures for handling such transactions. Moreover, requiring the 
orders to be received prior to the offsetting transaction and the 
allocation of the offsetting transaction to the customer within 60 
seconds would help avoid the exception from being abused by brokers or 
dealers who may attempt to retroactively claim the exception for 
transactions that were not done on a riskless principal basis.\173\
---------------------------------------------------------------------------

    \173\ The requirement that an offsetting transaction be 
allocated to either a riskless principal or customer account within 
60 seconds is a condition that is consistent with previously stated 
Nasdaq policy regarding the handling of mixed capacity trades and 
compliance with the Manning Interpretation. See NASD Notice to 
Members 01-85, at Question 7 and Notice to Members 95-67, at 
Question 5.

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[[Page 62992]]

    In order to assess whether this proposed exception properly 
addresses the needs of specialists or market makers, we ask the 
---------------------------------------------------------------------------
following questions:

    Q. Does the proposed riskless principal exception allow brokers 
and dealers to facilitate customer orders handled on a riskless 
principal basis regardless of their proprietary net position? Are 
the conditions appropriate? In particular, is the requirement to 
allocate the offsetting transaction to the customer within 60 
seconds appropriate?
    Q. Is there any concern that this provision is not consistent 
with the goals of short sale regulation? If so, how?

X. Rule 3b-3

    Rule 3b-3 defines the term ``short sale'' as any sale of a security 
that the seller does not own or any sale that is consummated by the 
delivery of a security borrowed by, or for the account of, the seller. 
Rule 3b-3 also defines specific instances when a person shall be deemed 
to own a security, i.e., a long position, for the purposes of Rule 10a-
1.
    We are proposing new Rule 200 to replace Rule 3b-3 and include 
several amendments to Rule 3b-3. As discussed in further detail below, 
we seek comment on including a modified version of current subparagraph 
(b) of Rule 3b-3 in Rule 200 that would require that a person not only 
have entered into an unconditional contract, binding on both parties 
thereto, to purchase the security, but also that the contract specify 
the irrevocable price and amount of securities purchased and provides 
for present delivery. We also propose amending the Rule to allow 
broker-dealers to calculate net positions in a particular security 
within defined trading units. Additionally, we propose that the 
definition of a short sale include the block-positioner exception from 
the current Rule 10a-1(e)(13). We also propose codifying in Rule 200 
prior interpretations related to security futures products, and the 
unwinding of certain index arbitrage positions.

A. Unconditional Contracts To Purchase Securities

    Under Rule 3b-3, a person owns a security if 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.'' 
\174\ The staff has recently received inquiries about whether certain 
transactions qualify as an ``unconditional contract'' for the purposes 
of short sale regulation. In particular these inquiries focus on 
whether it is necessary for a contract to specify the price and amount 
of securities to be purchased in order to be considered an 
unconditional contract.
---------------------------------------------------------------------------

    \174\ 17 CFR 240.3b-3(b).
---------------------------------------------------------------------------

    In 1992 the Commission proposed to clarify that an ``unconditional 
contract'' must specify a fixed, currently ascertainable price, and the 
exact amount of securities to be obtained in order for a person to be 
deemed to own a security under subparagraph (b) of Rule 3b-3.\175\ The 
proposed amendments were intended to address potentially abusive 
trading practices associated with contracts for future purchases of 
securities where the price or volume was based on a formula or other 
contingent event. We were concerned about the potential for abuse 
associated with securities contracts where the purchase price is based 
on the next following closing price in the primary market for the stock 
or stocks. The concern was that a purchaser under such a contract may 
have incentive to sell the securities (long) that are subject to the 
contract prior to the close of trading on the primary market in a 
manner that would depress the closing price. Similarly, we expressed 
concern regarding shares expected to be received from dividend 
reinvestment plan purchases being considered in calculating a long 
position pursuant to Rule 3b-3 where the number of shares received 
under a plan was not known but only estimated based on a formula. The 
proposed amendments were never adopted or withdrawn.
---------------------------------------------------------------------------

    \175\ See Securities Exchange Act Release No. 30772 (June 3, 
1992), 57 FR 24415 (June 9, 1992). Three commenters supported the 
price provision while four opposed it. Those who opposed it believed 
that a fixed-price requirement would prevent large transactions from 
being effected in an orderly manner and would place an undue burden 
on market participants who enter into contracts to buy and sell 
securities at a price to be determined in the future. Five 
commenters favored the fixed quantity provision and one commenter 
opposed it.
---------------------------------------------------------------------------

    As stated, the language of subparagraph (b) of Rule 3b-3 may be 
subject to abuse by individuals seeking to claim a long position only 
to avoid application of the tick test provisions in Rule 10a-1. 
Further, it is possible that where a contract mandates that securities 
will be purchased at the closing price, there may be incentive to 
depress the market price of the security to obtain the security at a 
lower price.\176\ Moreover, there is the potential that contracts in 
which the amount of securities owned is not known until some later 
period may be designed to create a long position that would facilitate 
avoidance of the tick test. It appears to us that a fixed price and 
quantity of a contract to purchase securities, as well as present 
delivery of the securities, are essential elements in determining 
whether such a contract conveys ownership for purposes of short sale 
regulation,\177\ and requiring these elements would restrict certain 
activities designed to manipulate the market. Therefore, we are 
proposing that Rule 200, subparagraph (b)(2) require that the 
unconditional contract specify the price and amount of securities to be 
purchased in order for a person to claim ownership of the securities 
underlying the contract under proposed Regulation SHO.
---------------------------------------------------------------------------

    \176\ Id.
    \177\ The Commission notes that in a typical ``equity line'' 
financing arrangement, an investor and the company enter into a 
written agreement under which the company has the right to ``put'' 
its securities to the investor. Under this ``put,'' the company has 
the right to tell the investor when to buy securities from the 
company over a set period of time and the investor has no right to 
decline to purchase the securities. The dollar value of the equity 
line is set in the written agreement, but the number of shares that 
the company will actually issue may be determined by a formula tied 
to the market price of the securities at the time the company 
exercises its ``put.'' See Division of Corporation Finance, Current 
Issues Outline Quarterly Update (March 31, 2001). As such, equity 
line financing arrangements and convertible financing arrangements 
would generally not meet the requirements for an unconditional 
contract, due to the fact that such arrangements may not specify a 
fixed price and quantity of the securities to be purchased, nor 
would they contemplate present delivery of the securities upon 
conversion or exercise of the put. All sales executed by the 
investor prior to the company exercising its ``put,'' or the 
investor exercising its conversion right, would thus be short sales 
subject to all applicable regulations, including the borrow and 
delivery requirements in proposed Rule 203, and, if the security 
sold is a ``covered security,'' the bid test provisions of proposed 
Rule 201.

    Q. Should proposed Rule 200 provide that in order for a person 
to be deemed to own a security by virtue of the fact that he has 
entered into an unconditional contract to purchase the security, the 
contract must specify the price and amount of the security to be 
---------------------------------------------------------------------------
purchased? If not, state why not.

    In addition, questions have arisen about whether an unconditional 
contract must contemplate present delivery of securities in order for 
persons to claim ownership of securities under Rule 3b-3. In order for 
a person to claim ownership of a security, she should have title to the 
security or some other type of present or near-term ownership right to 
obtain the security. In the case of options, convertibles, rights, or 
warrants, the rule requires that a person exercise or convert the 
instrument in order to claim ownership of the underlying security. 
However, there is currently no express requirement that a person who 
has

[[Page 62993]]

entered into an unconditional, binding contract be expected to receive 
the securities imminently in order to claim ownership.
    We are concerned that, without an express requirement that the 
contract contemplate present delivery, there is a danger that contracts 
would be formed solely for the purposes of creating a long position to 
evade the short sale rule, although there is no real intention to 
actually acquire the securities pursuant to the contract. As a result, 
we are seeking comment on whether buyers of securities pursuant to a 
contract should be required to have a reasonable expectation of 
imminent receipt of the securities prior to considering themselves to 
own the securities pursuant to proposed Rule 200. We are not proposing 
a present or imminent delivery requirement in proposed Rule 200 but 
instead we are seeking comment on such a provision.

    Q. Should proposed Rule 200 require a definite time frame that 
limits when the buyer can consider themselves long, i.e., a buyer 
would be deemed to own the securities only if the contract 
contemplates the buyer will receive the securities within 30 days?
    Q. If so, what should the time frame be? Does industry practice 
provide some objective standard that is reasonable?

B. Ownership of Securities Underlying Securities Futures Products

    We propose that new Rule 200 include language consistent with 
existing Commission guidance defining when a person shall be deemed to 
own a security underlying a security futures contract.\178\ 
Specifically, we have stated that a person who holds a security future 
obligating him to take delivery of the underlying securities by 
physical settlement would not be considered long in these securities 
for the purposes of proposed Rule 100 until the security future 
terminates trading.\179\ This interpretation is consistent with the way 
current Rule 3b-3 addresses several instances where a person owns a 
security that entitles a person to acquire securities underlying the 
instrument, e.g., options, rights, warrants, and convertibles. In those 
instances, Rule 3b-3 requires the option, right, warrant, or 
convertible to be exercised, tendered, or converted before the person 
can be considered as having a long position in the underlying security. 
These provisions also implicitly contemplate that the person will 
shortly acquire the security being sold. For a physically-settled 
security future, the holder will obtain the underlying security only 
after the security future terminates trading. A security future settled 
by receipt of cash has no effect on a person's long position.
---------------------------------------------------------------------------

    \178\ Commission Guidance on the Application of Certain 
Provisions of the Securities Act of 1933, the Securities Exchange 
Act of 1934, and Rules Thereunder to Trading in Security Futures 
Products, Securities Exchange Act Release No. 46101 (June 21, 2002), 
67 FR 43234 (June 27, 2002).
    \179\ Termination of trading is the moment at which an open 
position in a security future, either a long or short position, can 
no longer be closed or liquidated either by buying or selling an 
opposite position. A person obligated to deliver would be considered 
short at the termination of trading, and a person entitled to 
receive securities at the termination of trading would be considered 
long. Id.
---------------------------------------------------------------------------

    We are proposing subparagraph (b)(6) of Rule 200 that provides that 
a person holding a long security futures position is not considered to 
own the underlying security for the purposes of Rule 3b-3 until the 
security terminates trading.

    Q. Should proposed Rule 200 require delivery of the securities 
underlying a futures contract before a person can consider himself 
long for the purposes of short sale regulation?

C. Aggregation Units

    Rule 3b-3 requires a seller of an equity security subject to Rule 
10a-1 to aggregate all of its positions in that security in order to 
determine whether the seller has a ``net long position'' in the 
security.\180\ Broker-dealer firms have represented that firm-wide 
netting is costly, burdensome, and potentially counterproductive for 
large, multi-service brokerage firms. Firm-wide netting is currently 
required at least once a day.\181\
---------------------------------------------------------------------------

    \180\ See 17 CFR 240.3b-3. See also Securities Exchange Act 
Release No. 20230 (September 27, 1983), 48 FR 45119, 45120 (October 
3, 1983) (to determine whether a person has a ``net long position'' 
in a security, all accounts must be aggregated).
    \181\ See Securities Exchange Act Release No. 27938 (April 23, 
1990), 55 FR 17949, 17950 (aggregation must be based on a listing of 
securities positions in all proprietary accounts as determined at 
least once each trading day). Allowing aggregation to be determined 
once per day was largely due to practical considerations arising 
from technological limitations at the time the interpretation was 
issued.
---------------------------------------------------------------------------

    Many large broker-dealers are divided into ``desks'' that pursue 
separate trading strategies. At times, the firm may have a net short 
position in a security, but a particular desk may have a net long 
position in that security. This situation may result in a desk not 
being able to pursue an investment strategy that calls for the desk to 
sell its long position. This result appears to be unwarranted where the 
sale is not made to benefit the positions of other firm trading units. 
While the firm could form separate broker-dealers for each trading 
unit's strategy to support the independence of each trading unit, this 
approach would be costly and elevate form over substance.
    In 1998, the staff issued a letter stating that the Division would 
not recommend that the Commission take enforcement action if a multi-
service broker-dealer calculated its net position in a particular 
security within defined trading units independently from the positions 
held by the other aggregation units within the firm (``aggregation unit 
letter'').\182\ We propose to incorporate aggregation unit netting into 
proposed Rule 200 because we believe that such netting allows 
aggregation units at multi-service broker-dealers to pursue different 
trading strategies, as well as provide liquidity to the market, without 
the restrictions of firm-wide netting.
    Specifically, we propose to allow trading unit aggregation if: (1) 
The broker or dealer has a written plan of organization that identifies 
each aggregation unit, specifies the trading objective of each, and 
supports its independent identity;\183\ (2) each aggregation unit 
within the firm continuously determines, on a real-time basis, its net 
position for every security that it trades that is subject to proposed 
Rule 201 of Regulation SHO;\184\ (3) each trader pursuing a particular 
trading objective or strategy is included in only one aggregation unit; 
and (4) individual traders are assigned to only one aggregation unit at 
a time. We believe that these conditions would help prevent potential 
coordinated manipulative activity amongst the aggregation units by 
ensuring they are separate and independent.\185\
---------------------------------------------------------------------------

    \182\ See Letter regarding Bear, Stearns & Co. Inc.; Credit 
Suisse First Boston Corporation; Deutsche Bank Securities Inc.; 
Donaldson, Lufkin & Jenrette Securities Corporation; Goldman, Sachs 
& Co.; J.P. Morgan Securities Inc.; Lehman Brothers Inc.; Merrill 
Lynch, Pierce, Fenner & Smith; Morgan Stanley & Co. Inc.; 
PaineWebber Inc.; Prudential Securities Inc.; Salomon Smith Barney 
Inc.; SG Cowen Securities Corporation; and Warburg Dillon Read LLC. 
(November 23, 1998), 1998 SEC No-Act LEXIS 1038.
    \183\ The independence of the units would be evidenced by a 
variety of factors, such as separate management structures, 
location, business purpose, and profit and loss treatment.
    \184\ This condition holds firms accountable for knowing the 
activities and positions of each aggregation unit.
    \185\ We believe that these conditions have worked well in 
restricting the exemptive relief to situations that do not appear to 
raise the abuses that the short sale price test is designed to 
prevent, and should be incorporated in the proposed exception. We 
also note that market participants that rely on the aggregation unit 
exception have designed their programming and surveillance systems 
in accordance with these conditions.
---------------------------------------------------------------------------

    We seek comment on our proposal to include the aggregation unit 
netting into Rule 200 of proposed Regulation SHO as well as firm-wide 
netting in general.

    Q. Is this relief necessary for multi-service firms? How easily 
can these firms estimate

[[Page 62994]]

their real time positions for individual trading units? What about 
for the entire firm?
    Q. Are the conditions included in proposed Rule 200 appropriate? 
Should there be additional conditions?
    Q. Can the utility of the aggregation unit provision to multi-
service firms be improved? If so, how? \186\ Are the designated 
conditions appropriate?
---------------------------------------------------------------------------

    \186\ One commenter to the Concept Release said that while the 
Aggregation Letter is sensible in concept, firms have expressed 
difficulty devising procedures to meet its requirements. See Letter 
from Willkie, Farr & Gallagher (WFG).
---------------------------------------------------------------------------

    Q. Should the aggregation unit provision be available to non-
broker-dealers, for example, to hedge funds?
    Q. On its face, Rule 3b-3 contemplates that a sale must be 
marked based on positions in all proprietary accounts in that 
security at the time of the sale. In light of the advances in 
technology since 1990, is it possible for firms or other entities to 
be able to determine their aggregate position in all proprietary 
accounts contemporaneously throughout the day? If not, why not?
    Q. If firms or other entities are unable to determine their 
aggregate position in all proprietary accounts contemporaneously 
throughout the day, is there a means of allocating a daily aggregate 
position within the firm that would be capable of surveillance?

D. Block-Positioner Exception

    The block-positioner exception is currently in subsection (e)(13) 
of Rule 10a-1.\187\ Because this exception directly relates to a 
broker-dealer's calculation of its net position under current Rule 3b-
3, we propose to incorporate the block-positioner exception without 
modification into Rule 200 of Regulation SHO.
---------------------------------------------------------------------------

    \187\ See Securities Exchange Act Release No. 20715 (March 6, 
1984), 49 FR 9414 (March 13, 1984). Block positioning is the 
facilitation of a large purchase or sale of securities for a 
customer by buying or selling as principal the amount of securities 
that cannot be immediately placed or obtained from third parties.
---------------------------------------------------------------------------

    Rule 3b-3 considers broker-dealers to have a short position in a 
security even though that position is fully offset by equivalent 
convertible securities, rights, warrants, or call options. Therefore, 
arbitrage activities may result in the block-positioner having a net 
short position. This short position would require compliance with the 
``tick'' restrictions of the Rule and may inhibit the efforts of 
broker-dealers who engage in both block-positioning and offset 
activities. If a broker-dealer seeks to dispose of a block of 
securities it bought as a principal while acting in the capacity of a 
block-positioner, it may be unnecessarily hindered in doing so if it 
simultaneously has an equal or larger short position in the same 
security, even though that short position is fully offset as a result 
of arbitrage or hedging activity.
    The block-positioner exception was created in order to facilitate 
the activities of broker-dealers who engage in both block positioning 
and arbitrage.\188\ The Commission has recognized the important role 
block-positioners play in providing liquidity for large securities and 
in maintaining a fair and orderly market. When adopting this exception, 
the Commission noted that when a block-positioning firm's other short 
positions are fully offsetting other instruments, the result is an 
economically neutral position. The Commission noted that these other 
positions provide no incentive to effect sales from the block-
positioning trading account in a manner that would cause or accelerate 
a decline in the market because gains in the short position would be 
offset by losses in the short position. The exception is limited in 
that it is available only to broker-dealers acting in the capacity of a 
block-positioner, and only if the short position is created in the 
course of bona fide arbitrage, risk arbitrage, or bona fide hedging 
activities. We are proposing to include in proposed Regulation SHO the 
block positioner exception as it currently exists.
---------------------------------------------------------------------------

    \188\ Id.

    Q. Does the block-positioner exception continue to be needed?
    Q. Does the block-positioner exception require any amendments? 
If so, what are alternatives to the way the rule currently operates?

E. Liquidation of Index Arbitrage Positions

    Index arbitrage generally involves the purchase or sale of a 
``basket'' of all stocks comprising a securities index or a smaller 
number of stocks designed to track day-to-day price movement of an 
index, and a contemporaneous offsetting sale or purchase of one or more 
commodity futures or options on a future or standardized option 
contracts on that index in an attempt to profit from price 
discrepancies between the stocks and the derivative index products. 
Index arbitrage often involves a liquidation (or ``unwinding'') 
transaction in order to realize arbitrage profits. Liquidation may 
consist of either simple elimination of each long or short stock 
position at expiration of the futures or option contract, or earlier 
termination of both the stock positions and the futures or option 
contract position.
    Pursuant to Rule 3b-3, a seller of an equity security subject to 
Rule 10a-1 must aggregate all of the seller's positions in that 
security in order to determine whether the seller has a ``net long 
position'' in the security. Therefore, if a person does not have a net 
long position in a security, any sale of that security must be 
designated as a short sale and must comply with the tick test 
provisions of current Rule 10a-1. A person liquidating an index 
arbitrage position involving a long basket of stocks may be unable to 
sell all the securities contemporaneously with closing out the 
derivative instrument position because of the requirement to net short 
security positions in other proprietary accounts, and as a consequence 
may not realize the expected arbitrage profit.
    In 1992 the Commission proposed codifying prior no-action relief 
from the tick test provisions of paragraphs (a) and (b) of Rule 10a-1 
relating to liquidations of certain index arbitrage positions.\189\ 
Specifically, we proposed a new exception from the tick test provisions 
of Rule 10a-1(a) and (b) for any sale by a person effected in 
connection with the liquidation of an index arbitrage position relating 
to a securities index that is the subject of a financial futures (or 
options on such futures) contract traded on a contract market 
designated by the Commodity Futures Trading Commission, or a 
standardized options contract as defined in Rule 9b-1(a)(4) under the 
Exchange Act,\190\ notwithstanding that such person may not have a net 
long position in that security. The proposed exception was limited, 
however, to contexts where: (1) such person's net short position is 
solely the result of one or more short positions created and maintained 
in the course of bona fide arbitrage, risk arbitrage, or bona fide 
hedge activities; and (2) the sale does not occur during a period 
commencing at the time that the Dow Jones Industrial Average (DJIA) had 
declined by 50 points or more from its closing value on the previous 
day and terminating upon the establishment

[[Page 62995]]

of the closing value of the DJIA on the next succeeding trading day. If 
the market decline restriction were in effect, each individual security 
would be required to be aggregated in the usual way with all of the 
seller's other positions in that security to determine whether the 
seller has a net long position.\191\ The amendments proposed in the 
1992 Release were never adopted.\192\
---------------------------------------------------------------------------

    \189\ Securities Exchange Act Release No. 30772 (June 3, 1992), 
57 FR 24415 (June 9, 1992). The release proposed codifying as Rule 
10a-1(g)(2) limited relief permitting the liquidation of certain 
existing index arbitrage positions involving long baskets of stock 
and short index futures or options without aggregating short stock 
positions in other proprietary accounts if those short stock 
positions are fully hedged. See Letter re: Merrill Lynch, Pierce, 
Fenner & Smith, Inc. (December 17, 1986); Securities Exchange Act 
Release No. 27938 (April 23, 1990), 55 FR 17949 (April 30, 1990) 
(release clarifying and emphasizing certain aspects of the limited 
relief granted in the Merrill Lynch letter).
    \190\ Rule 9b-1(a)(4) states: ``Standardized options are option 
contracts trading on a national securities exchange, an automated 
quotation system of a registered securities association, or a 
foreign securities exchange which relates to option classes the 
terms of which are limited to specific expiration dates and exercise 
prices, or such other securities as the Commission may, by order, 
designate.'' 17 CFR 240.9b-1(a)(4).
    \191\ This proposed market decline restriction substantially 
paralleled, and would be invoked simultaneously with, the operation 
of NYSE Rule 80A, which at the time of the proposal applied when the 
DJIA index moved 50 points or more from the previous day's close. 
Rule 80A was more restrictive, in that it required all NYSE index 
arbitrage stock transactions, whether undertaken by a short or long 
seller, to be effected on a plus or zero-plus tick. The proposed 
exception, however, would have operated for a longer period of time 
than 80A, which at that time terminated once the DJIA recovers 25 
points from the 80A trigger level. Instead, the exception would 
terminate upon the establishment of the closing value of the DJIA on 
the next succeeding trading day, in order to allow the markets to 
avoid incremental selling pressure at the close of trading on a 
volatile trading day and at the opening of trading on the following 
day, since trading activity at these times may have a substantial 
effect on the market's short-term direction.
    \192\ Commenters were generally in favor of codifying the 
exemption. However, the proposal was never acted upon.
---------------------------------------------------------------------------

    We propose to include in Rule 200 of Regulation SHO the relief for 
certain index arbitrage activities because we understand the relief is 
still being used and because codifying it would provide for ease of 
reference. We propose including it in Rule 200 with a minor change from 
the 1992 proposal. Namely Rule 200(f) would alter the second condition 
to specify that the relief would not be available during a period 
commencing at the time that the DJIA has declined below its closing 
value on the previous trading day by at least two percent and 
terminating upon the establishment of the closing value of the DJIA on 
the next succeeding trading day during which the DJIA has not declined 
by two percent or more from its closing value on the previous day. This 
change would keep the language in proposed Rule 200 consistent with the 
current language in NYSE Rule 80A.\193\
---------------------------------------------------------------------------

    \193\ Under Rule 80A, when the DJIA index moves two percent or 
more from the previous day's close, index arbitrage orders in 
component stocks of the S&P 500 stock price index are subject to a 
tick test. In down markets sell orders may be executed only on a 
plus or zero-plus tick (and be marked ``sell plus''); in up markets 
buy orders may be executed only on a minus or zero-minus tick (and 
be marked ``buy minus''). The test remains in effect for the 
remainder of the trading day once it has been activated, but shall 
be removed if the DJIA subsequently moves within one percent of the 
previous day's closing value.
---------------------------------------------------------------------------

    The Commission notes that levels of program trading have increased 
in recent years,\194\ and some have argued that this may be related to 
market volatility.\195\ It should be noted that index arbitrage is not 
the only type of program trading.\196\ The Commission requests comment 
on the usefulness and scope of the proposed amendment, including 
whether market participants believe that providing an exception from 
the proposed uniform bid test for some index arbitrage activity poses 
dangers for the markets.
---------------------------------------------------------------------------

    \194\ The NYSE publishes weekly program trading data on its 
website at www.nyse.com. The data shows that program trading over 
the past few years has increased as a percentage of the overall NYSE 
average daily volume. For example, during July 28 through August 1, 
2003, program trading amounted to 45.5% of the NYSE's average daily 
volume of 1,474.7 million shares, or 671.4 million shares a day.
    \195\ See David Henry, Whipsawed by Wall Street, Bus. Wk., 
(March 10, 2003); Karen Talley, Program Trading Grows as a Force in 
Stock Market, WSJ, (June 17, 2002).
    \196\ Program trading encompasses a wide range of portfolio-
trading strategies involving the purchase or sale of a basket of at 
least 15 stocks with a total value of $1million or more. Program 
trading is calculated as the sum of the shares bought, sold and sold 
short in program trades. The total of these shares is divided by 
total reported volume. The NYSE reported on its website that during 
July 28 through August 1, 2003, 13.3% of program volume executed by 
NYSE member firms related to index arbitrage. For the period from 
June 30 through July 3, 2003, when the program trading percentage 
reached 52% of NYSE average daily volume, the highest levels 
reported for the year to date, 8.5% of program volume executed by 
NYSE member firms related to index arbitrage.

    Q. Is the relief for certain index arbitrage activities proposed 
to be incorporated in Rule 200 necessary under proposed Regulation 
---------------------------------------------------------------------------
SHO? Are the conditions appropriate?

XI. Hedging Transactions

    In the Concept Release, the Commission requested comment on, among 
other things, exempting hedging transactions from short sale 
regulation. Currently, short sales related to hedges are treated the 
same under Rule 10a-1 as any other short sales. This is because Rule 
3b-3 only takes equity positions into account, and it does not consider 
derivative positions related to these equity positions.\197\ Some have 
suggested that bona fide hedging activity should be exempted from short 
sale regulation because such activity presents little threat of 
manipulation as gains from short hedging positions are offset by losses 
in a related security, i.e., they are economically neutral 
positions.\198\
---------------------------------------------------------------------------

    \197\ Under Rule 3b-3, holdings in convertible securities, 
options, rights and warrants are only considered to be long 
positions if they have been converted or exercised. See Rule 3b-
3(d).
    \198\ The CBOE submitted to the Commission a letter suggesting 
parameters of a possible hedging exception to Rule 10a-1. See Letter 
from CBOE (August 20, 2001). In particular, CBOE proposed a pilot 
program under which options market-makers and specialists would be 
exempt from the tick test provisions of the short sale rule when 
selling select listed stocks short to hedge positions in options 
that result from market-making obligations. Under the proposal, 
market makers and specialists would be able to sell CBOE pilot 
program stocks short on a minus or zero minus tick to hedge, on a 
delta equivalent basis only, pre-existing long exposure (stocks and 
options combined) or contemporaneous option transactions, subject to 
several provisions enumerated in their letter. The letter is 
available for review in the Commission's Public Reference Room (File 
No. S7-24-99).
---------------------------------------------------------------------------

    As discussed above, while the exceptions in the block-positioner 
and index arbitrage contexts do allow offsetting derivative positions 
to be considered, those exceptions provide limited aggregation relief 
for existing offsetting positions. They do not apply to short sales 
effected to establish an offsetting position. We have not included an 
exception for hedging short sales in our proposed Regulation SHO. We 
believe that a hedging exception is not necessary because the proposed 
bid test and pilot would provide market participants with additional 
flexibility in effecting short sales in order to hedge long exposure.

    Q. Should a hedging exception be added to proposed Rule 201? If 
so, how should such an exception be designed so that it can be 
monitored and is not subject to abuse?
    Q. Does the advent of trading in security futures absent short 
sale regulation, when combined with the proposed bid test and short 
sale pilot, address the concerns expressed by participants 
requesting an exception from Rule 201 for hedging? If not, why not?
    Q. Should a hedging exception be included in Rule 201 that only 
applies to a particular group of market participants, i.e., OTC 
market makers, option market makers, or specialists, that would 
allow short selling without regard to either a tick or bid test to 
offset the risk associated with their role in maintaining fair and 
orderly markets? Who should qualify for such an exception, what 
criteria would be used for determining whether short selling was 
part of maintaining fair and orderly markets, and how could the SROs 
and Commission surveil for compliance with such an exception?

 XII. Elimination of Current Subparagraphs 10a-1(a)(2) and (a)(3)

    One of the more significant changes in our proposal is the use of a 
bid test based on the consolidated best bid, which we believe would 
provide uniformity in short sale regulation for all markets in 
securities covered by proposed Rule 201. As a result, we are also 
proposing to eliminate the provision that markets currently have to use 
their own markets as a reference point for measuring the permissibility 
of short sales.

[[Page 62996]]

    This provision, currently subparagraph (a)(2) of Rule 10a-1, was 
added in response to operational difficulties associated with the tick 
test based on the last trade price reported in a security in the 
consolidated transaction reporting system.\199\ At the time the 
provision was added, certain SROs asserted that the last trade price in 
the consolidated system should not be the reference point for the tick 
test because last trade price data was not available in a timely manner 
and because the principal exchanges did not have adequate information 
retrieval systems on their floors to ensure adherence with the short 
sale rule.\200\
---------------------------------------------------------------------------

    \199\ See Securities Exchange Act Release No. 11276 (March 5, 
1975), 54 FR 12522 (March 19, 1975) (release proposing subparagraph 
(a)(2) in response to stated operational and other difficulties 
associated with complying with Rule 10a-1) (Proposing Release); see 
also Securities Exchange Act Release No. 11468 (June 12, 1975), 40 
FR 25442 (June 16, 1975) (adoption of proposed changes adding 
subparagraph (a)(2)) (Adopting Release).
    \200\ Id.
---------------------------------------------------------------------------

    We believe that this provision would no longer be needed in light 
of advances in the dissemination of market information and the proposed 
use of the consolidated bid for the price test. Currently, all 
participants in the markets have access to a consolidated, real-time 
stream of quotations for all the exchange and Nasdaq equity securities 
that would be subject to the bid test.\201\ Further, unlike the tick 
test, where the sequence of trade prices plays a crucial role in 
determining when short sales can be effected, the sequence of the bids 
under the proposed bid test is not a factor in determining the price at 
which a short sale can be effected; rather, the reference is the best 
bid at the time of the short sale transaction. We thus believe that the 
concerns that gave rise to the (a)(2) provision are no longer 
present.\202\ As a result, we propose to eliminate the ability of a 
market to use its own market information for purposes of the bid test 
of Regulation SHO.
---------------------------------------------------------------------------

    \201\ See, supra part IV.B.
    \202\ In adopting subparagraph (a)(2) the Commission noted that 
the ``modernization of exchange facilities may eliminate the need to 
structure short sale regulation in this manner and that it should be 
possible ultimately to utilize the kind of uniform rule'' originally 
proposed. See, supra n. 199.
---------------------------------------------------------------------------

    We also propose to eliminate current subparagraph (a)(3) of Rule 
10a-1. This subparagraph allows for an adjustment to the sale price of 
a security after a security goes ex-dividend, ex-right, or ex any other 
distribution when determining the price at which a short sale may be 
effected. Specifically, this provision allows for the reduction of all 
sale prices by the value of the distribution prior to the ``ex'' date. 
Under the proposed bid test, we do not believe (a)(3) is necessary 
because the last trade price would not be a factor in determining when 
a short sale can be effected, and the bid would immediately reflect the 
impact of the corporate action.

    Q. Are there any regulatory or operational reasons to allow 
markets to use their own bid information in regulating short sales 
under the proposed rule?
    Q. Would allowing markets to use their own bid information 
affect the operation or effectiveness of the proposed rule? If so, 
how?
    Q. Is there any reason to retain the requirements of existing 
subparagraph (a)(3) of Rule 10a-1, which allows for the adjustment 
to the sale price of a security after a security goes ex-dividend, 
ex-right, or ex any other distribution, under the proposed bid test? 
For example, do exchanges that match opening trades prior to the 
opening quotes require such a provision?

XIII. Exclusion of Bonds

    In 1992 the Commission proposed excluding from the application of 
Rule 10a-1 transactions in nonconvertible corporate bonds listed and 
effected on an exchange.\203\ This action was in response to a petition 
for rulemaking by the Amex that paragraph (b) of the Rule be amended to 
exclude corporate bonds from short sale regulation.\204\ Amex had noted 
that while paragraph 10a-1(a) of the Rule is not applied to bonds 
because transactions in corporate bonds are not required to be reported 
on a consolidated basis with other markets, bonds are covered under 
paragraph (b) regulating short sales of other securities on an 
exchange. According to the Amex, a competitive inequity was thus 
created between the exchanges and the over-the-counter market, where 
short selling is not regulated at all.\205\ Moreover, it was argued 
that, because the majority of corporate bond transactions occur in the 
OTC market, it would be difficult for a market participant to effect a 
manipulation of the primary bond market through short sales on an 
exchange.
---------------------------------------------------------------------------

    \203\ See Securities Exchange Act Release No. 30772 (June 3, 
1992), 57 FR 24415 (June 9, 1992).
    \204\ See Letters from Carrie E. Dwyer, Vice President and 
General Counsel, Amex, to John Wheeler, Secretary, SEC (December 30, 
1985 and January 22, 1986); and Letter from Scott L. Noah, Assistant 
Vice President and General Counsel, Amex, to Jonathan G. Katz, 
Secretary, SEC (November 22, 1989) (Amex Letters).
    \205\ The Commission noted the fact that the NASD had filed in 
April of 1992 a proposed rule change to implement its own short sale 
regulation, however this ``bid test'' would not relate to OTC 
transactions in bonds. See, supra n. 203 at n. 34.
---------------------------------------------------------------------------

    The Commission preliminarily concluded in the release that the 
application of Rule 10a-1 to bonds might impose an unnecessary 
regulatory burden on the exchange market because exchange trading of 
such bonds is not susceptible to the types of market abuse that the 
short sale rule is designed to prevent. Moreover, given the limited 
amount of bond trading effected on exchanges, there would appear to be 
little reason for concern over the effect of short selling of bonds on 
an exchange. Accordingly, the Commission proposed to exclude 
transactions in bonds from Rule 10a-1 by amending paragraph (b) to add 
the phrase ``except a bond or debenture.''\206\ It was also determined 
that up until the time that final action was taken on this proposed 
amendment, no-action relief would be provided under Rule 10a-1 with 
regard to short sales in exchange-listed bonds.\207\
---------------------------------------------------------------------------

    \206\ Convertible bonds were not proposed to be excluded from 
the Rule. The Commission noted that convertible bonds are defined as 
``equity securities'' in the Exchange Act (Section 3(a)(11), 15 
U.S.C. 78c(a)(11)). Further, it was argued that short selling of 
convertible bonds (at least in the much larger OTC market) might 
have an impact on the price of related exchange-traded equity 
securities. Id at n. 43.
    \207\ Id.
---------------------------------------------------------------------------

    Commenters were generally in favor of this proposed amendment and 
some also recommended that convertible bonds be excluded from Rule 10a-
1 as well.\208\ The amendments proposed in the 1992 release were never 
adopted or withdrawn. We believe that the same rationales that were 
cited in 1992 generally continue to apply today. In addition, as there 
is not currently a source for consolidated quote information on 
corporate bonds similar to what exists for equity securities, it is 
evident that our proposed bid test could not be applicable in the bond 
market.\209\ We have thus proposed that the uniform bid test in 
Regulation SHO would not apply to bonds.\210\

    \208\ See Letters from American Bar Association, Bear Stearns & 
Co., Inc., New York Stock Exchange, Securities Industry Association, 
and Sullivan & Cromwell.
    \209\ In 2001, the Commission approved a proposal by the NASD to 
establish a corporate bond reporting and transaction dissemination 
facility, TRACE. See Securities Exchange Act Release No. 43873 
(January 23, 2001), 66 FR 8131 (January 29, 2001) (SR-NASD-1999-65) 
(order approving TRACE).
    \210\ Should there in the future be a source for consolidated 
quote information on corporate bonds, we may decide to revisit the 
application of the bid test to bonds.

    Q. Should corporate bonds be excluded from proposed Rule 201?

XIV. After Hours Trading/Foreign Markets Issues

A. After-Hours Trading

    Trading in U.S. stocks outside of regular market hours is not a new

[[Page 62997]]

phenomenon.\211\ For years, institutional investors and market 
professionals have sent after-hours orders to broker-dealers for 
execution as principal on alternative broker-dealer trading systems, 
such as ECNs. However, technological advances have changed the 
securities markets, and trading has expanded beyond the regular trading 
hours of 9:30 a.m. to 4 p.m. Eastern Time (ET).
---------------------------------------------------------------------------

    \211\ See Division of Market Regulation, SEC, Market 2000: An 
Examination of Current Equity Market Developments (January 1994), at 
II-13 and II-14.
---------------------------------------------------------------------------

    We have supported investor choice in trading hours provided that 
essential protections for investors and the markets are not 
compromised. We have approved several SRO programs designed to further 
these goals, including extending consolidated last trade price and 
quotation information. We have also approved after hours and pre-
opening trading sessions for the Archipelago Exchange (ArcaEx).\212\ In 
addition, we have approved on a pilot basis a Nasdaq program to extend 
the operation of key trade and price reporting systems until 6:30 p.m. 
ET.\213\ However, the NASD has not extended its short sale bid test, 
Rule 3350, to the after-hours market.\214\ Nonetheless, NASD members 
are still required to make affirmative determinations that they will 
receive delivery of a security from their customers or that the member 
can borrow the security on behalf of the customer for delivery by 
settlement date before accepting short sale orders.\215\
---------------------------------------------------------------------------

    \212\ See Securities Exchange Act Release No. 44983 (October 25, 
2001), 66 FR 55225 (November 1, 2001). ArcaEx entered into an 
agreement with SIAC to extend the operation of the consolidated tape 
for exchange-listed stocks and Nasdaq NMS stocks from 8 a.m. to 8 
p.m. ET.
    \213\ See Securities Exchange Act Release No. 42003 (October 13, 
1999), 64 FR 56554 (October 20, 1999). Under the pilot, any Nasdaq 
market maker that chooses to post quotations and trade during these 
extended hours is obligated to post firm two-sided quotations when 
opening and making its market, but may enter or leave the market on 
the hour or half-hour up to 6:30 p.m. Regardless of an NASD's 
member's quotation activity, all transactions in Nasdaq National 
Market, Small Cap, Convertible Debt and OTC transactions in 
exchange-listed securities executed between the hours of 8 a.m. and 
6:30 p.m. must be reported within 90 seconds.
    \214\ See NASD Head Trader Alert 2000-55 (August 7, 
2000).
    \215\ See NASD Rule 3370.
---------------------------------------------------------------------------

    We currently interpret the tick test to apply to all trades in 
listed securities, whenever they occur. By its terms, Rule 10a-1 uses 
as a reference point the last trade price reported to the tape. Thus, 
after the tape ceases to operate, the rule prevents any person from 
effecting a short sale at a price that is lower than the last sale 
reported to the tape. Most of the comments received in response to the 
Concept Release supported applying the short sale rule to after-hours 
trading.\216\ We believe that the proposed uniform short sale rule 
should apply to after hours trades in all covered securities, requiring 
all short sales in covered securities to be effected at a price above 
the current best bid displayed as part of the consolidated best bid and 
offer. After the time the consolidated best bid ceases to be calculated 
and disseminated, the proposed rule would prevent short selling at a 
price at or below the last published consolidated best bid. We believe 
that applying the proposed bid test to after hours trades in all 
covered securities would extend the goals of short sale regulation to 
the after hours markets.
---------------------------------------------------------------------------

    \216\ The NYSE and the NASD were among those commentators who 
recommended extending the short sale rule to cover after hours 
trading. The NYSE stated that, ``With respect to after-hours 
trading, the Exchange believes that the Rule should apply given the 
potential for trading abuses in a market environment with lesser 
trading volume and greater volatility.'' See Letter from James E. 
Buck, Senior Vice President and Secretary, NYSE (February 3, 2000). 
The NASD recommended that short sale regulation be extended to all 
securities being traded in extended hours sessions, including 
National Market and SmallCap securities. ``The justifications for 
regulating short-sales--the threats of abusive short-selling, 
extreme volatility, and reduced liquidity due to the high risk to 
market-makers--apply with equal, if not greater, force during 
extended hours trading.'' See Letter from Richard G. Ketchum, 
President, NASD, Inc. (February 15, 2000). However, as noted, the 
NASD subsequently determined not to apply Rule 3350 after-hours, due 
to the belief that the volume of trading after hours was not 
sufficient to justify imposing short sale regulation.
---------------------------------------------------------------------------

    We solicit comment on this proposed operation of the rule, 
including, but not limited to, the following issues:

    Q. Does the consolidated quote information that is collected and 
published after hours provide sufficient information to allow short 
selling after hours at a price above the consolidated best bid, or 
should the rule impose a fixed reference point above which all short 
sales must be effected, such as the consolidated best bid at the 
close of the regular session?
    Q. Should the proposed short sale rule allow short selling above 
the best bid after the time that the consolidated best bid ceases to 
be collected and disseminated, if reliable quotes are still 
published? \217\ Would this approach, which would most likely have 
multiple reference points, be a feasible alternative?
---------------------------------------------------------------------------

    \217\ For example, in its comment letter in response to the 
Concept Release, one commenter urged the Commission to allow short 
sales to be effected on ATSs based on their respective systems' last 
trade price when the tape is not operating. It was noted that this 
option could only be extended to such ATSs that meet certain 
thresholds relative to the overall trading volume in the after-hours 
market. See Letter from Orrick, Herrington & Sutcliffe, counsel for 
MarketXT (December 30, 1999). Island also suggested allowing ATSs 
operating after-hours to rely on their own bid as a reference point. 
See Letter from The Island ECN, Inc. (January 21, 2000).
---------------------------------------------------------------------------

B. Off-Shore Trading

    In July 1992, the Commission announced that it was undertaking a 
study of the U.S. equity markets and of the regulatory environment in 
which those markets operate.\218\ As part of the study, the Commission 
addressed and sought comment on the practice of U.S. broker-dealers 
``booking'' trades through their foreign desks or foreign affiliates to 
avoid U.S. transparency requirements, off-board trading restrictions, 
transaction fees, or limits on short sales. In what is commonly 
referred to as the ``fax market,'' a U.S. broker-dealer acting as 
principal for its customer negotiates and agrees to the terms of a 
trade in the U.S., but transmits or faxes the terms overseas to be 
``printed'' on the books of a foreign office.\219\
---------------------------------------------------------------------------

    \218\ See Securities Exchange Act Release No. 30920 (July 14, 
1992), 57 FR 32587 (July 22, 1992).
    \219\ This practice of ``booking'' trades overseas was analyzed 
and dealt with in further depth in the Division of Market 
Regulation's Market 2000 Report. In the Report, the Division 
estimated that approximately 7 million shares a day in NYSE stocks 
are faxed overseas, and many of these trades are nominally 
``executed'' in the London over-the-counter market. The Report 
further stated that off-shore trades generally are not reported 
publicly. Rather, they are reported for regulatory purposes only to 
the NYSE and NASD pursuant to NYSE Rule 410 or to the NASD on Form 
T. See Division of Market Regulation, SEC, Market 2000: An 
Examination of Current Equity Market Developments (January 1994), 
Study VII, p. 2.
---------------------------------------------------------------------------

    Consistent with prior Commission action, we view short sale 
regulation as applying to trades in reported securities when the trade 
is agreed to in the United States, even if the trades are ``booked'' 
overseas.\220\ For example, a

[[Page 62998]]

U.S. money manager decides to sell a block of 500,000 shares in a NYSE 
security. The money manager negotiates a price with a U.S. broker-
dealer, who sends the order ticket to its foreign trading desk for 
execution. In our view, this trade occurred in the United States as 
much as if the trade had been executed by the broker-dealer at a U.S. 
trading desk. Under the proposed rule, if the sale agreed to is a short 
sale in an exchange-listed or Nasdaq NMS security, unless otherwise 
excepted, it must be effected at a price one cent above the current 
best bid displayed as part of the consolidated best bid and offer 
---------------------------------------------------------------------------
regardless of where it is executed.

    \220\ See, e.g., Securities Exchange Act Release No. 27938 
(April 23, 1990), 55 FR 17949 (April 30, 1990) (stating that the no-
action position exempting certain index arbitrage sales from the 
tick test provisions of Rule 10a-1 will not apply to an index 
arbitrage position that was established in an offshore transaction 
unless the holder acquired the securities from a seller that acted 
in compliance with Rule 10a-1 or other comparable provision of 
foreign law); see also Securities Exchange Act Release No. 21958 
(April 18, 1985), 50 FR 16302 (April 25, 1985) at n. 48 (stating 
that, ``Rule 10a-1 does not contain any exemption for short sales 
effected in international markets.''). The question of whether a 
particular transaction negotiated in the U.S. but nominally executed 
abroad by a foreign affiliate is a domestic trade for U.S. 
regulatory purposes was also addressed in the Commission's Order 
concerning Wunsch Auction Systems, Inc. (WASI). The Commission 
stated its belief that ``trades negotiated in the U.S. on a U.S. 
exchange are domestic, not foreign trades. The fact that the trade 
may be time-stamped in London for purposes of avoiding an SRO rule 
does not in our view affect the obligation of WASI and BT Brokerage 
to maintain a complete record of such trades and report them as U.S. 
trades to U.S. regulatory and self-regulatory authorities and, where 
applicable, to U.S. reporting systems.'' See Securities Exchange Act 
Release No. 28899 (February 20, 1991), 56 FR 8377 (February 28, 
1991).

    Q. What factors should be used to determine whether a trade in a 
covered security is agreed to in the U.S.? If a trade is agreed to 
by a broker-dealer located outside the U.S., should the trade be 
viewed as agreed to outside the U.S., regardless of the location of 
the seller? Would the requirement that trades agreed to in the U.S. 
be effected at a price above the current best bid disadvantage U.S. 
broker-dealers in favor of foreign broker-dealers? If so, please 
explain.
    Q. For trades agreed to in the United States and executed 
overseas, is the time of agreement a sufficient determinative event 
for the triggering of the rule?

XV. Limitations on Short Selling During Significant Market Declines

    To protect investors and the markets, the Commission has approved 
proposals to restrict trading if key market indexes fall by specified 
amounts. In response to the October, 1987 market break, the Commission 
approved various exchanges' circuit breaker proposals to permit these 
brief, coordinated cross-market halts to provide opportunities during a 
severe market decline to reestablish an equilibrium between buying and 
selling interests in an orderly fashion, and help to ensure that market 
participants have a reasonable opportunity to become aware of, and 
respond to, significant price movements.\221\ The coordinated cross-
market trading halts provided by circuit breaker procedures are 
designed to operate only during significant market declines and to 
substitute orderly, pre-planned halts for the ad hoc and destabilizing 
halts which can occur when market liquidity is exhausted.\222\ 
Currently, all stock exchanges and the NASD have rules or policies to 
implement coordinated circuit breaker halts.\223\ The options markets 
also have rules applying circuit breakers.\224\ The futures exchanges 
that trade futures on indexes have adopted circuit breaker halt 
procedures in conjunction with their price limit rules for index 
products.\225\ Finally, security futures products are required to have 
cross-market circuit breaker regulatory halt procedures in place.\226\
---------------------------------------------------------------------------

    \221\ See Securities Exchange Act Release No. 26198 (October 19, 
1988), 53 FR 41637 (October 24, 1988) (approving rules of the Amex, 
CBOE, NASD, NYSE).
    \222\ See Circuit Breaker Report by the Staff of the President's 
Working Group on Financial Markets (August 18, 1998) (Circuit 
Breaker Report), n. 33.
    \223\ See Securities Exchange Act Release No. 39846 (April 9, 
1998), 63 FR 18477 (April 15, 1998) (order approving proposals by 
Amex, BSE, CHX, NASD, NYSE, and Phlx). See also e.g., NYSE Rule 80B. 
The current circuit breaker procedures call for cross-market trading 
halts when the Dow Jones Industrial Average (DJIA) declines by 10 
percent, 20 percent, and 30 percent from the previous day's closing 
value.
    \224\ See Amex Rule 950 (applying Amex Rule 117, Trading Halts 
Due to Extraordinary Market Volatility, to options transactions); 
CBOE Rule 6.3B; ISE Rule 703; PCX Rule 4.22 (which applies to 
options contracts through Rules 6.1(a) and (e)); and Phlx Rule 133.
    \225\ See, e.g., CME Rule 4002.I. The CME will implement a 
circuit breaker trading halt in SPX Futures if the 10% circuit 
breaker halt has been imposed in the securities markets and the 
futures are ``locked'' at their 10% price limit. Trading will not 
reopen in SPX Futures until the circuit breaker halt has been lifted 
in the securities markets and trading has resumed in stocks 
comprising at least 50% of the index capitalization. The CME will 
implement another circuit breaker trading halt in SPX Futures if the 
20% circuit breaker halt has been imposed in the securities markets 
and the futures are locked at their 20% price limit. Once again, 
trading will not reopen in SPX Futures until the circuit breaker 
halt has been lifted in the securities markets and trading has 
resumed in stocks comprising at least 50% of the index 
capitalization.
    \226\ See Securities Exchange Act Release No. 45956 (May 17, 
2002), 67 FR 36740 (May 24, 2002).
---------------------------------------------------------------------------

    We note that current short sale regulation focuses on the prices of 
individual securities rather than market segments or market indexes. 
Nevertheless, we seek comment on whether short selling should be 
restricted in the future in response to a severe market decline.

    Q. Should short selling be restricted or prevented during a 
period of significant market decline, such as after circuit breakers 
have been lifted? If so, at what level should the restrictions take 
place, i.e., if the market declines 10%, 20% etc.? How long a period 
of time should the restrictions remain in effect?
    Q. Should short selling be restricted or prevented for any 
particular security if the price of that security declines 
significantly during the course of a trading day? If so, at what 
level should the restrictions take place, i.e., if the price of the 
security declines 10%, 20% etc.? How long a period of time should 
the restrictions remain in effect?

XVI. Rule 105 of Regulation M--Short Sales in Connection With a Public 
Offering

    The price of securities in an offering is generally based on a 
security's closing market price. When market prices are artificially 
distorted securities markets are prevented from functioning as 
independent pricing mechanisms and offering price integrity is eroded. 
Short sales of securities that depress the market price shortly before 
an offering is priced can cause (i) the postponement or abandonment of 
an offering, and (ii) the offering price to be lower than anticipated 
because artificial forces distort it.\227\ The pre-pricing short sales 
may exert downward pressure on a security's market price causing the 
market price to decline. Consequently, the offering price is set lower 
than anticipated because it is now based off an artificially depressed 
market price. Short sellers who anticipate and receive an offering 
allocation cover their short sales at the lower, fixed offering price 
generating a profit. Rule 105 of Regulation M addresses this market 
abuse.
---------------------------------------------------------------------------

    \227\ Concerned about losses in ``cold'' issues, investors may 
engage in schemes to guarantee ``cold'' issue profits by effecting 
short sales prior to the pricing of an offering (pre-pricing short 
sales) and covering the short sales with offering securities.
---------------------------------------------------------------------------

A. Scope of Rule 105 of Regulation M

    Rule 105 of Regulation M prohibits a short seller from covering 
short sales with offered securities purchased from an underwriter, 
broker or dealer participating in the offering if the short sale 
occurred within the period of five days prior to pricing of the 
offering securities. The Rule promotes offering prices that are based 
upon market prices determined by natural market forces instead of 
prices distorted by artificial forces. Rule 105 of Regulation M applies 
to offerings of securities for cash pursuant to a registration 
statement or a notification on Form 1-A filed under the Securities Act 
of 1933. The Rule prohibits covering a short sale with offering 
securities purchased from an underwriter or broker or dealer 
participating in the offering if the short sale occurred during the 
Rule 105 of Regulation M restricted period, which is the shorter of the 
period beginning (i) five business days before pricing of the offered 
securities and ending with such pricing, or (ii) with the initial 
filing of such registration statement or notification on Form 1-A and 
ending with the pricing. The Rule excepts shelf offerings filed under 
Rule 415 and offerings not conducted on a firm commitment basis as well 
as providing for exemptive relief. The Rule is prophylactic, and 
prohibits the conduct irrespective of the short seller's intent in 
effecting the short sale.

[[Page 62999]]

B. Shelf Offerings

    We believe that the use of shelf offerings (offerings filed under 
Sec.  230.415 of the Securities Act of 1933) is common today. If an 
individual with notice of a shelf offering takedown effects short sales 
during the five days prior to pricing and covers his short sale with 
shelf offering securities, his conduct may cause the same downward 
price pressure that occurs with pre-pricing short sales in connection 
with non-shelf offerings. The trading has the same manipulative 
potential, the same effect on offering price, and causes the same abuse 
that Rule 105 of Regulation M is designed to prevent. Accordingly, we 
propose eliminating the current shelf offering exception in Rule 105 of 
Regulation M. We solicit comment concerning the proposed elimination of 
the shelf offering exception. We also seek comments concerning other 
areas of the Rule.

    Q. In what manner are shelf offerings of equity securities 
marketed to potential investors? Include a discussion of the 
similarities and/or differences with respect to the marketing 
efforts of shelf and non-shelf offerings. Discuss the types of 
marketing efforts used and whether potential investors have notice 
of a shelf takedown before it occurs.
    Q. Should Rule 105 of Regulation M be applicable to only equity 
offerings? What is the Rule's relevance with respect to debt 
offerings and the potential for manipulation with debt offerings or 
other offering types?
    Q. Should the prohibitions of Rule 105 of Regulation M extend to 
derivative securities, i.e., should a person be prohibited from 
covering put options entered into within the period five days prior 
to pricing with securities purchased from an underwriter, broker or 
dealer participating in the offering?
    Q. Should the prohibitions of Rule 105 of Regulation M extend to 
short sales effected prior to the exercise of conversion rights 
under a debenture, or other security, and covering the short sales 
with securities issued in the conversion when the conversion 
consideration is based upon the security's market price during a 
certain time period prior to the conversion?
    Q. Should a person who executes short sales during the five day 
business period prior to the pricing of an offering be permitted to 
cover preexisting short positions held prior to that five day period 
with offering securities? Please provide a detailed analysis, 
including a discussion regarding the fungibility of securities. Can 
you trace offering shares in a person's account to show that they 
are used to cover the preexisting short position as opposed to the 
short sales executed five days prior to pricing?
    Q. Does the language ``cover a short sale'' provide the proper 
scope of prohibited activity? Is there additional or alternative 
language we should consider?
    Q. What is the manner in which firms, including prime brokerage 
firms, monitor compliance with Rule 105 of Regulation M, both 
manually and with computer systems?
    Q. Should Rule 105 apply to acquisitions from an issuer in a 
shelf takedown, such as a public equity line from an issuer or other 
direct purchase arrangement with an issuer?

C. Sham Transactions Designed To Give the Appearance of Covering With 
Open Market Securities

    Recently, the Commission has become aware of, and taken action, 
with respect to conduct designed to evade, but which violates Rule 105 
of Regulation M.\228\ This conduct may involve short sales within the 
restricted period of Rule 105, the purchase of offering shares, and the 
contemporaneous sale and purchase of the same class of shares as the 
offering shares. For example, an individual may sell the shares in the 
market and immediately purchase an equivalent number of shares. Where 
the transaction is structured such that there is 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, that transaction may be a sham transaction.
---------------------------------------------------------------------------

    \228\ See, Ascend Capital, LLC, Securities Exchange Act Release 
No. 48188 (July 17, 2003).
---------------------------------------------------------------------------

    The Commission would continue to consider enforcement action 
against those participating in sham transactions structured in a manner 
to give the appearance of compliance with Rule 105, but in fact, 
violate the rule. We are not proposing revisions to Rule 105 with 
respect to activities that violate the current rule. We seek comment, 
however, on criteria in addition to economic purpose or substance, 
change in beneficial ownership, and market risk, that may distinguish 
sham transactions from legitimate trading. The Commission also solicits 
comment regarding whether there should be additional language in the 
rule text of Rule 105 to address other transactions that cause the harm 
the Rule 105 is designed to prevent.

XVII. General Request for Comment

    The Commission seeks comment generally on all aspects of proposed 
Regulation SHO and the proposed amendment to Rule 105 of Regulation M 
under the Exchange Act. In addition to the specific requests for 
comment found throughout this release, the Commission asks commenters 
to address whether proposed Regulation SHO furthers the Commission's 
objectives to (1) allow relatively unrestricted short selling in an 
advancing market, (2) prevent short selling at successively lower 
prices, thus eliminating short selling as a tool for driving the market 
down, and (3) preventing short sellers from accelerating a declining 
market by exhausting all remaining bids at one price level, causing 
successively lower prices to be established by long sellers. Commenters 
are requested to provide empirical data to support their views and 
arguments related to the proposals herein. In addition to the questions 
posed above, commenters are welcome to offer their views on any other 
matter raised by the proposed Regulation SHO and Rule 105.

XVIII. Paperwork Reduction Act

    Proposed Regulation SHO would impose a new ``collection of 
information'' within the meaning of the Paperwork Reduction Act of 
1995,\229\ and the Commission has submitted them to the Office of 
Management and Budget (``OMB'') for review in accordance with 44 U.S.C. 
3507(d) and 5 CFR 1320.11. 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. OMB has not 
yet assigned a control number to the new collection of information 
imposed by Regulation SHO.
---------------------------------------------------------------------------

    \229\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

A. Summary of Collections of Information

    Proposed Regulation SHO, Rule 201 contains a requirement that all 
sell orders of securities registered under Section 12(g) of the 
Exchange Act be marked ``long,'' ``short,'' and ``short exempt.'' 
Currently, Rule 10a-1 prohibits the execution of a sell order for a 
security covered by Rule 10a-1 unless the order is marked either 
``long'' or ``short.'' Proposed Regulation SHO would be a new 
collection of information because the collection would cover a much 
larger number of securities. Proposed Regulation SHO, Rule 201 would 
add two elements to this marking requirement. First, a new category for 
``short exempt'' orders would be added. Second, the marking requirement 
would be extended to apply to all equity securities, including 
exchange-listed securities, Nasdaq NMS, Nasdaq SmallCap, OTCBB, and 
Pink Sheet securities. If the Commission adopts Proposed Regulation 
SHO, Rule 10a-1 would be repealed and any collection of information 
under Rule 10a-1 would be eliminated.
    Sell orders of exchange-listed and Nasdaq securities are already 
marked ``long,'' ``short,'' or ``short exempt'' pursuant to Rule 10a-1, 
NYSE Rule

[[Page 63000]]

440B.20, and the ITS Plan.\230\ Nasdaq NMS and Nasdaq SmallCap 
securities are also currently subject to marking requirement pursuant 
to NASD Rule 4991. Proposed Regulation SHO, Rule 201 would simply 
codify current industry practice for exchange-listed and Nasdaq 
securities into a uniform marking requirement.
---------------------------------------------------------------------------

    \230\ See Section IX.A regarding Marking Orders.
---------------------------------------------------------------------------

    Proposed Regulation SHO, Rule 201 would also apply to securities 
not currently covered under Rule 10a-1. Proposed Regulation SHO's 
marking requirement would apply to all sell orders of equity securities 
registered under Section 12(g) of the Exchnage Act, including, 
exchange-listed, Nasdaq NMS and SmallCap, OTCBB, Pink Sheets, and any 
other securities registered under 12(g).
    As a result, the collection of information under proposed 
Regulation SHO is the requirements that all sell orders of equity 
securities registered under the Exchange Act be marked ``long,'' 
``short,'' or ``short exempt.''

B. Proposed Use of Information

    The information required by proposed Regulation SHO is necessary 
for the execution of the Commission's mandate under the Exchange Act to 
prevent fraudulent, manipulative and deceptive acts and practices by 
broker-dealers. The purpose of the information collected is to enable a 
national securities exchange or national securities association to 
monitor whether a person effecting a short sale covered by proposed 
Regulation SHO is acting in accordance with Regulation SHO. In 
particular, requiring each order be marked either ``long,'' ``short,'' 
or ``short exempt'' would aid in ensuring compliance with proposed 
Rules 201 and 203. Moreover, the ``short exempt'' category would aid is 
surveillance for compliance with the proposed limited exception from 
the bid test for riskless principal transactions.

C. Respondents

    The marking provision in Rule 201 would apply to all 6,752 active 
brokers or dealers that are registered with the Commission. The 
Commission has considered each of these respondents for the purposes of 
calculating the reporting burden under proposed Regulation SHO.

D. Total Annual Reporting and Recordkeeping Burdens

    Proposed Rule 201 of Regulation SHO would require all brokers or 
dealers to mark all sell orders appropriately as ``long,'' ``short,'' 
or ``short exempt'' for all securities registered under Section 12(g) 
of the Exchange Act. We assume that all of the approximately 6,752 
registered broker-dealers effect sell orders in securities covered by 
proposed Regulation SHO. For purposes of the Paperwork Reduction Act, 
the Commission staff has estimated that a total of 1,164,755,007 trades 
are executed annually.\231\
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    \231\ In calendar year 2002 there were approximately 545,556,000 
trades on the NYSE, and 607,824,500 on Nasdaq NMS and Nasdaq 
SmallCap, and 11,374,507 in OTCBB, Pink Sheet, and other (gray 
market) securities.
---------------------------------------------------------------------------

    This is an average of approximately 172,505 annual responses by 
each respondent. Each response of marking orders ``long,'' ``short,'' 
or ``short exempt'' takes approximately .000139 hours (.5 seconds) to 
complete.\232\ Thus, the total approximate estimated annual hour burden 
per year is 161,900 burden hours (1,164,755,007 responses @ 0.000139 
hours/response). A reasonable estimate for the paperwork compliance for 
the proposed rules for each broker-dealer is approximately 24 burden 
hours (172,505 responses @ .000139 hours/response) or (a total of 
161,900 burden hours / 6,752 respondents).
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    \232\ We believe it is reasonable that it would only take 0.5 
seconds or .00039 hours to mark an order ``long,'' ``short,'' or 
``short exempt.''
---------------------------------------------------------------------------

E. Request for Comment

    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits 
comments to: (i) Evaluate whether the proposed collection of 
information is necessary for the proper performance of the functions of 
the agency, including whether the information shall have practical 
utility; (ii) evaluate the accuracy of the Commission's estimate of the 
burden of the proposed collection of information; (iii) determine 
whether there are ways to enhance the quality, utility, and clarity of 
the information to be collected; and (iv) evaluate whether there are 
ways to minimize the burden of the collection of information on those 
who are to respond, including through the use of automated collection 
techniques or other forms of information technology.
    Persons submitting comments on the collection of information 
requirements should direct them to the Office of Management and Budget, 
Attention: Desk Officer for the Securities and Exchange Commission, 
Office of Information and Regulatory Affairs, Washington, DC 20503, and 
should also send a copy of their comments to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609, with reference to File No. S7-23-03. 
Requests for materials submitted to OMB by the Commission with regard 
to this collection of information should be in writing, refer to File 
No. S7-23-03, and be submitted to the Securities and Exchange 
Commission, Records Management, Office of Filings and Information 
Services, 450 Fifth Street, NW., Washington, DC 20549-0609. As OMB is 
required to make a decision concerning the collections of information 
between 30 and 60 days after publication, a comment to OMB is best 
assured of having its full effect if OMB receives it within 30 days of 
publication.

XIX. Consideration of Proposed Regulation SHO's Costs and Benefits

    The Commission is considering the costs and the benefits of 
proposed Regulation SHO, which would replace Rules 3b-3, 10a-1, and 
10a-2, as well as proposed amendments to Rule 105 of Regulation M. The 
Commission is sensitive to these costs and benefits, and encourages 
commenters to discuss any additional costs or benefits beyond those 
discussed here. 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 registrants, issuers, investors, 
brokers or dealers, other securities industry professionals, 
regulators, and others. Commenters should provide analysis and data to 
support their views on the costs and benefits associated with proposed 
Regulation SHO and proposed amendments to Rule 105 of Regulation M.

A. Proposed Rule 201: Price Test and Marking Requirements

1. The Proposed Uniform Bid Test
a. Benefits
    We believe that the proposed bid test would simplify the 
application of the price test and provide flexibility to those seeking 
to sell short, especially in the current decimals environment. This 
increased ability to execute short sales in securities currently 
subject to Rule 10a-1 may lead to a reduction in transaction costs. 
Moreover, we believe that a uniform rule is preferable to applying 
different tests in different markets, which can require market 
participants to apply different rules to different securities, and thus 
may also reduce transaction costs. Also, there would be benefits 
associated with systems and surveillance mechanisms

[[Page 63001]]

that would only have to be programmed to consider a single test based 
on the consolidated best bid instead of two tests based on last sale 
and last bid information.
    In addition, the degree of restrictiveness of a price test may 
affect how well the stock price represents fundamental values. For 
example, a flexible price test may allow a trader to more freely sell 
short a stock that he or she believes is overvalued. The Commission 
seeks comments on whether the proposed bid test would affect stock 
prices and whether proposed Rule 201would result in prices that are a 
better reflection of the issuer's fundamental values.
    The Commission seeks estimates and views regarding the benefits to 
particular types of market participants as well as any other costs or 
benefits that may result from the adoption of proposed Regulation SHO. 
Please provide any specific data.
    Another potential benefit of the proposed bid test is that it 
should simplify surveillance systems in that proposed Rule 201 would 
look to the consolidated best bid at the time of execution as the 
reference price for short sales. This should be less complicated than 
comparing the immediately preceding sale or bid as the reference point 
for short sale compliance. In addition, we note that having only one 
short sale rule instead of two would mean that new staff (compliance 
personnel, traders, etc.) would only need to be trained regarding one 
rule. Over the long run, we believe this would likely lead to decreased 
costs for training and compliance.
    The Commission received approximately 35 formal requests for relief 
from Rule 10a-1 in 2002 in addition to approximately 340 phone calls. 
The Commission anticipates that a large percentage of the relief 
requested would no longer be necessary under the proposed uniform bid 
test. We expect that each request for relief requires a number of labor 
hours from traders and lawyers, both in-house and outside counsel, of a 
broker-dealer or exchange, when making informal (phone calls) or formal 
(letters) requests for exemptions from Rule 10a-1. The Commission 
requests empirical data to quantify this benefit.
b. Costs
    As an aid in evaluating costs and reductions in costs associated 
with the proposed Rule 201, the Commission requests the public's views 
and any supporting information regarding the costs associated with 
implementing the proposed uniform bid test. The Commission believes 
that the proposed uniform bid test requiring short sales in exchange-
listed and Nasdaq NMS securities to be effected at a price one cent 
above the consolidated best bid at the time of execution would impose 
costs on brokers or dealers, specialists, market makers, ECNs, 
Alternative Trading Systems (ATSs), and SROs. Adoption of the proposed 
uniform bid test in the various markets would require modifications to 
trading systems and surveillance systems. Under the proposal, systems 
trading exchange-listed securities and Nasdaq NMS securities would have 
to shift from Rule 10a-1's tick test and NASD Rule 3350's bid test, 
respectively, to the proposed uniform bid test. The Commission 
anticipates that these changes would result in immediate implementation 
costs associated with reprogramming trading and surveillance systems. 
One exchange informed us that reprogramming systems would take one 
month at a cost of approximately $100,000. A broker-dealer stated that 
it would take two months to reconfigure its systems to account for a 
new bid test but was unable to provide a cost estimate. These estimates 
do not include costs associated with training staff that would be 
effected by these systems modifications.
    The Commission seeks examples of all types of entities that would 
be affected by this proposal. The Commission seeks specific comments on 
the costs associated with system changes, including the type of system 
changes necessary and quantification of costs associated with changing 
the systems, including both start-up costs and maintenance. Comments 
are also requested on the types of jobs and staff that would be 
affected by systems modifications and training about the new rule, the 
number of labor hours that would be required to accomplish these 
matters, and the compensation rates of these staff members. The 
Commission also requests data to quantify the benefits of this proposal 
relating to ongoing compliance and surveillance of a uniform bid test. 
In addition, there may be costs associated with changing surveillance 
systems to monitor for compliance with the proposed bid test. We 
request specific comment on the costs for reprogramming systems to 
accommodate the proposed bid test in Rule 201.
2. Market Makers
a. Benefits
    NASD Rule 3350 currently exempts from operation of the NASD's short 
sale rule short sales executed by qualified market makers in connection 
with bona fide market making.\233\ We do not propose a market maker 
exception to Rule 201. We believe this would benefit the markets by 
subjecting all participants to the same regulation. We believe that the 
proposal would allow all market participants to establish short 
positions without being disadvantaged by an exception to the rule only 
available to certain participants. For example, there may be benefits 
in limiting the ability of a market maker to profit from position 
trading in anticipation of a market decline. The Commission also 
requests comment on any benefits that may result from adopting a price 
test absent a market maker exception. The Commission also seeks 
comments on the benefits of not allowing anyone to sell short at or 
below the best bid in a declining market.
---------------------------------------------------------------------------

    \233\ See supra part VIII for a further discussion.
---------------------------------------------------------------------------

b. Costs
    The absence of a market maker exception from Rule 201 may have 
implications for market makers' ability to supply liquidity. Some may 
argue that investors are harmed when market makers incur an increase in 
costs because market makers would pass the increased costs to 
investors. The Commission requests detailed comments on these, or any 
other, costs to market makers, investors or others associated with not 
adopting an exception from the proposed bid test for market makers.
    The Commission also recognizes that proposed Rule 201 may result in 
lost trading or business opportunities in the various markets. For 
example, there may be a cost in lost trading or business opportunities 
for those who trade Nasdaq NMS securities, in that the proposed bid 
test is more restrictive than the current Nasdaq bid test, and the 
market maker exemption has been eliminated. Please quantify, if 
possible, whether there would be any lost trading or business 
opportunity costs.
4. Use of the Consolidated Best Bid
a. Benefits
    Proposed Regulation SHO would use the consolidated best bid as a 
reference point for all short sales of exchange-listed or Nasdaq NMS 
securities wherever traded. The Commission believes that the use of the 
consolidated best bid is a benefit because it reflects the consolidated 
bids from the various market centers that trade exchange-listed and 
Nasdaq NMS securities and is continuously collected and disseminated on 
a real-time basis, in a single steam of information and would

[[Page 63002]]

be a more accurate depiction of the market's valuation of a security.
b. Costs
    The Commission is aware that this change may result in increased 
costs to traders, specialists, broker-dealers, and floor brokers on the 
NYSE or Amex who have heretofore used the last sale occurring in their 
own market as a reference point for short sales. For example, there 
would be a cost to market participants in gaining access to the 
consolidated best bid by subscribing to a vendor. We believe, however, 
that most, if not all, market participants already have access to this 
information. The Commission seeks information quantifying the cost of 
gaining access to the consolidated best bid.
    In addition, it is possible that the consolidated best bid may 
flicker more than an exchange's own best bid. Bid flickering may impede 
on the ability to execute short sales, which may result in increased 
costs. Please provide data to assist the Commission quantify these 
costs, if any.
5. Marking Orders
a. Benefits
    Proposed Rule 201 would permit broker-dealers to mark orders long 
only if the customer owns the securities and they are in the customer's 
account, or would be prior to settlement. Proposed Rule 201 also would 
require broker-dealers to differentiate between ``long,'' ``short,'' 
and ``short exempt'' sell orders. We believe these provisions would 
provide several benefits. The Commission notes that the current marking 
requirements can lead to undetected violations of proposed Rule 201 
because once the order is marked ``long,'' others handling the order 
execute the order as if it were a long sale, even though settlement on 
the sale may be effected by the delivery of borrowed securities. This 
can complicate surveillance for violations of the price test, as short 
sales executed under an exception from the price test can be masked as 
long sales. A benefit of this proposal is that surveillance for 
violations of proposed Rule 201 would be aided through accurate 
indications of when and under what circumstances these exceptions are 
utilized. An additional benefit is that the ``short exempt'' category 
would aid in surveillance for compliance with the proposed riskless 
principle exception to the bid test.
    Further, we believe the proposed requirement that a broker-dealer 
cannot mark a sale ``long'' unless it has physical possession or 
control of the security, either when the order is placed or prior to 
settlement, is a benefit because it would facilitate the process of 
clearance and settlement. Disturbances in settlement processes can 
affect the stability and integrity of the financial system in general. 
Clearance and settlement systems are designed to preserve financial 
integrity and minimize the likelihood of systematic disturbances by 
instituting risk-management systems. Requiring a broker-dealer to have 
possession or control of the securities before it can mark an order 
long would assist in reducing settlement and credit risks.
    The Commission proposes extending the marking requirements to all 
equity securities, including OTCBB and Pink Sheet securities. This 
proposal is designed to assist in surveillance for violations of the 
locate and delivery requirements proposed in Rule 203 of Regulation 
SHO.
b. Costs
    The Commission does not currently believe any costs would arise 
from the proposed requirement that sell orders be marked long only if 
the securities to be sold are owned by the customer and either 
presently, or prior to settlement, in the customer's account. Most 
customer securities are not held by investors in physical form, but 
rather are held indirectly through their broker-dealer, i.e., in 
``street name.''
    The Commission anticipates that any costs arising from the proposed 
requirement that certain sell orders be marked ``short exempt'' would 
be minimal because some self-regulatory organizations already either 
require or advise members to utilize the ``short exempt'' designation. 
We believe that the Commission's proposed amendment codifies current 
practice and provides the markets with a uniform practice. The 
Commission proposes extending the marking requirements to all equity 
securities, including OTCBB and Pink Sheet securities. The Commission 
recognizes that there is a paperwork burden cost associated with adding 
the ``short exempt'' category and extending the marking requirement to 
all equity securities. As discussed above in Section XVIII, the 
paperwork burden is estimated at approximately 24 burden hours for each 
broker-dealer registered with the Commission.\234\ The Commission does 
not believe there are any additional costs to this proposal, however we 
seek any data supporting any additional costs not mentioned.
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    \234\ For a full discussion of the paperwork burden associated 
with the marking requirements see Section XVIII.
---------------------------------------------------------------------------

6. Exceptions to the Rule
a. Benefits
    Proposed Regulation SHO would eliminate or alter exceptions to Rule 
10a-1's tick test and create certain exceptions to the proposed bid 
test, which we believe would result in benefits. Proposed Regulation 
SHO proposes eliminating the equalizing exception, which is based on 
the last sale concept and would have no utility under the proposed bid 
test. This would further the goal of regulatory simplification.
    In addition, the Commission believes that extension of the odd-lot 
exception to all market makers may reduce market makers' costs, since 
they would no longer need to register as odd-lot dealers or third 
market makers to avail themselves of the exception. Moreover permitting 
market makers to offset customer odd-lot orders and liquidate odd-lot 
positions without regard to the proposed uniform bid test would enhance 
market makers' ability to provide liquidity. To the extent that the 
benefits flowing from this increased liquidity can be quantified, we 
seek data and analysis on how to represent them accurately.
    Moreover, the benefit of the proposal to alter Rule 10a-1's 
domestic arbitrage exception to require that a person relying on the 
exception must subsequently acquire or purchase the security upon which 
the arbitrage is based is that it would help reduce pricing disparities 
between securities. In addition, the proposed language change would 
help with surveillance for compliance with the exception.
    In addition, the proposed limited exception to the bid test when 
the market is locked or crossed is beneficial because it increases 
liquidity by giving responsible broker-dealers flexibility to execute 
short sales in such situations. Moreover, the proposed exception 
permitting broker-dealers to sell short at the consolidated best bid to 
satisfy any obligations of a broker-dealer to customer limit orders, as 
determined by federal securities laws or rules of a self-regulatory 
organization, is a benefit because it ensures that customer limit 
orders are executed in a fair manner and at prices similar to the price 
at which a firm has traded for its own account. Finally, the proposed 
exception relating to pre-opening VWAP short sales would codify 
existing exemptive relief, thus providing the benefit of regulatory 
simplification, and may also promote a more liquid market for large 
traders.

[[Page 63003]]

b. Costs
    The Commission does not believe there would be any costs associated 
with altering the odd-lot and domestic arbitrage exceptions, 
eliminating the equalizing exception, creating new exceptions relating 
to locked or crossed markets and facilitating customer orders, and 
codifying existing VWAP exemptive relief. The Commission seeks comment, 
however, on whether any such costs exist, and if so, data to support 
such costs.

B. Proposed Rule 203: Locate and Delivery Requirements

1. Benefits
    Proposed Rule 203 would enhance locate and delivery requirements 
for short sales in all equity securities. These changes are proposed in 
response to complaints from many issuers and investors concerning 
allegations of abusive ``naked short selling.'' The Commission proposes 
to adopt safeguards to address the problems associated with large 
persistent failures-to-deliver. The Commission believes that this 
requirement would help curtail manipulative naked short selling.
    The Commission believes that it would be beneficial to establish 
uniform procedures to be utilized by short sellers to locate securities 
for borrowing, which could help promote and enhance the national 
clearance and settlement system. The Commission is proposing to 
prohibit a broker-dealer from executing a short sale order for its own 
account or the account of another person, unless the broker-dealer, or 
the person for whose account the short sale rule is executed: (1) 
Borrowed the security, or entered into an arrangement for the borrowing 
of the security, or (2) had reasonable grounds to believe that it could 
borrow the security so that it would be capable of delivering the 
securities on the delivery date it is due. This uniform rule would 
further the goals of regulatory simplification and avoidance of 
regulatory arbitrage. Please describe any additional benefits resulting 
from the proposed uniform locate requirements.
    The Commission is also proposing additional delivery requirements 
targeted at securities where there is evidence of large settlement 
failures. The proposal would specify that a short sale in any security 
that meets the threshold, i.e., any security where there are fails to 
deliver at a clearing agency registered with the Commission of 10,000 
shares or more, and that is equal to one-half of one percent of the 
issue's total shares outstanding, must be delivered, or the broker-
dealer would be required to enter into a contract to borrow the 
security, or effect a buy in so that, in either event, the security 
would be delivered within two days after the settlement date. If the 
securities are not delivered within two days after the settlement date, 
for a period of ninety calendar days the broker or dealer shall not 
execute a short sale in such security for his own account or the 
account of the person for whose account the failure to deliver occurred 
unless the broker or dealer or the person for whose account the short 
sale is executed has borrowed the security, or entered into a bona fide 
arrangement to borrow the security, and will deliver the security on 
the date delivery is due. The proposed Rule would also require the 
rules of the registered clearing agency to include the following 
provisions: (A) A broker or dealer failing to deliver securities as 
specified in subparagraph (3) above shall be referred to the NASD and 
the Examining Authority (as defined in 15c3-1(c)(12)) for such broker 
or dealer for appropriate action; and (B) The registered clearing 
agency shall withhold a benefit equal to any mark to market amounts or 
payments that otherwise would be made to the participant failing to 
deliver, and assess appropriate charges.
    The Commission believes that these additional delivery requirements 
would protect and enhance the operation, integrity, and stability of 
the markets. In particular, this requirement is targeted at securities 
with lower market capitalization that may be more susceptible to abuse. 
We also believe that clearly articulated rules restricting naked short 
selling would assist the Commission in its enforcement efforts.
    The Commission believes that a large amount of fails at the 
clearing level may impose costs on the clearing agency. For example, 
certain issuers have taken steps to make themselves either 
``certificate only,'' which require physical certification of company 
ownership for all share transfers, or ``custody only,'' which restricts 
ownership of their securities by depositories or financial 
intermediaries. The Commission believes these custody arrangements are 
highly costly to the clearing agencies, depositories and financial 
intermediaries. The Commission believes this proposed additional 
delivery requirement would provide a benefit because it would mitigate 
some of these costs. Please provide data supporting this, and any 
other, benefit that the proposal would provide in mitigating such 
costs, including benefits to clearing agencies, depositories and 
financial intermediaries in implementing and complying with this 
proposal.
    Proposed Rule 203 would also make two changes to existing long sale 
delivery rules. First, the rule would extend current delivery 
requirements for long sales of listed securities to all equity 
securities, including Nasdaq NMS, Nasdaq SmallCap, OTCBB, and Pink 
Sheet securities. The intended benefits of this change are uniformity 
across markets and a reduction in the number of fails to deliver on 
long sales. Moreover, the Commission believes that this modification 
would facilitate the process of clearance and settlement. The amended 
rule would also permit a broker-dealer effecting a long sale to fail to 
deliver, or to deliver borrowed securities, if prior to the sale, the 
seller told the broker-dealer he owned the security and would deliver 
it to the broker-dealer prior to settlement. This change is necessary 
to conform the proposed rule with proposed Rule 201(c), which would 
require an order to be marked long only if the seller informs his 
broker-dealer that he owns the security and the broker-dealer will have 
physical possession or control of the security prior to settlement. It 
is intended that this change would both reduce the number of over-the-
counter fails, and facilitate the process of clearance and settlement. 
The Commission requests data to quantify the value of the benefits 
identified.
2. Costs
    The Commission recognizes that the proposed locate and delivery 
requirement may increase costs for market participants who engage in 
short selling. However, we believe that these costs would be minimal, 
because the proposed rules largely incorporate existing SRO locate 
rules, such as NYSE Rule 440C.10 and NASD Rule 3370. The Commission is, 
however, proposing an exception from these requirements for short sales 
executed by specialists or market makers in connection with bona-fide 
market making activities. In addition, any costs that may be initially 
incurred would be mitigated over time because the uniform rule should 
lead to regulatory simplification with regard to training and 
surveillance. Please describe any additional costs resulting from the 
proposed uniform borrow requirements to market participants already 
subject to locate requirements by SROs. The Commission requests data to 
quantify the costs identified.
    This proposal would apply to all equity securities, including 
securities that have quotations published on the OTCBB and Pink Sheets. 
Issuers and investors have complained about

[[Page 63004]]

``naked short selling'' in these thinly-capitalized securities trading 
over-the-counter. The proposed locate and delivery requirements would 
address some of these concerns. There may be costs associated with 
implementing these borrowing requirements for OTCBB and Pink Sheets 
securities. The Commission requests comment on the costs of 
implementing these requirements, as well as costs associated with 
ongoing compliance and surveillance associated with this proposal. The 
Commission is also concerned with the impact this proposal may have on 
small issuers. Please provide data to quantify the costs to small 
issuers and potential investors in these small issuers, including 
whether reduced short selling opportunities may make the securities in 
these markets more susceptible to having overvalued stock prices. In 
addition, we request comment on the extent to which the recommended 
proposals may affect the ability of small issuers to secure financing 
through the issuance of convertible debentures. Please describe and 
analyze any other costs associated with this proposal.
    The Commission also recognizes that there would be costs to market 
participants in implementing and complying with the proposed additional 
delivery requirements targeted at securities with substantial 
settlement failures. The Commission seeks estimates and views regarding 
these costs for particular types of market participants, as well as any 
other costs or benefits that may result from adoption of the proposal.
    The Commission is not proposing any exception from the proposed 
additional delivery requirements for shorts sales in connection with 
bona-fide market making because we believe that extended fails to 
deliver appear characteristic of an investment or trading strategy, 
rather than one related to market making. The Commission believes that 
there may be costs to market makers that have open extended fail 
positions. We have requested comment on the need for market makers 
engaging in bona-fide market making to maintain extended fail 
positions. Please provide information detailing any costs that may be 
associated with not providing a market maker exception to the proposed 
additional delivery requirements. In particular, we request comment on 
any lost trading or business opportunity costs to market makers, any 
potential impact on investors, and a detailed description of any such 
costs.
    In general, the Commission acknowledges that the proposed 
additional delivery requirements may bring about new costs for market 
participants. The Commission requests data to quantify the costs 
identified. Broker-dealers, market makers, SROs, and clearance and 
settlement firms may incur costs in making initial system changes 
necessary to implement these new requirements, as well as maintain 
ongoing compliance and surveillance mechanisms. We request specific 
comment on the system changes to computer hardware and software, or 
surveillance costs necessary to implement this rule. If this rule 
requires additional labor, please indicate what type of jobs are 
affected, how many additional hours are required and the approximate 
costs of these additional hours.

C. Proposed Rule 202(T): Temporary Short Sale Rule Suspension

1. Benefits
    The proposed pilot program would suspend the operation of the 
proposed bid test provision for selected stocks that the Commission 
believes are less susceptible to manipulation because they are more 
liquid and have a high market capitalization. The proposed pilot 
program is intended to provide the Commission with empirical data to 
assess whether the proposed bid test should be removed for liquid 
securities. The empirical data collected would enable the Commission to 
study the effects of deregulated short selling on, among other things, 
market volatility, price efficiency, and liquidity. The proposed pilot 
program would assist the Commission in determining if, and to what 
extent, a price test inhibits the markets. The data would also be used 
to study the extent to which the proposed bid test achieves the stated 
objectives of the short sale rule by comparing trading activity in 
liquid securities that are subject to a price test with liquid 
securities that are not subject to a price test. The markets would 
benefit in the long run from the possibility of removing a rule that 
may weaken markets or, alternatively, by retaining a rule that may 
strengthen markets.
    In addition, the Commission recognizes that, in the presence of 
short sale restrictions in equity securities, the absence of short sale 
regulation for securities futures may make trading security futures an 
attractive hedging alternative to equities. The pilot is designed to 
remedy potentially unfair competition caused by disparate regulation 
between equities and security futures products. We believe that the 
proposed pilot program would give the Commission an opportunity to 
determine whether suspension of the proposed bid test would enhance 
competition among equities and securities futures in the most liquid 
securities. The Commission requests data to quantify the costs and the 
value of the benefits relating to security futures products and this 
proposal.
    The Commission anticipates that broker-dealers, including market 
makers, may be able to provide greater liquidity in securities included 
in the proposed pilot program, because the absence of the proposed bid 
test would make it easier to fill buy orders. The Commission believes 
that this could benefit investors, however, the Commission seeks 
comment on how to assess the potential benefits of short selling 
without a bid test restriction in these selected securities. In 
addition, the Commission seeks comment on the benefits of acquiring the 
potential empirical data gathered from the proposed pilot program. 
Would the proposed pilot program effectively allow the Commission to 
better understand short sales and short sale restrictions? Please 
provide estimates and views on these potential benefits.
2. Costs
    The Commission anticipates that the proposed pilot program may 
cause additional costs to brokers, dealers, SROs, and potentially 
issuers and investors. While we anticipate that SROs and broker-dealers 
would need to make system changes in order to exclude the selected 
securities from the proposed bid test, we do not know what these 
changes would cost. The Commission seeks detailed comment on the extent 
of required system changes and costs associated with implementation of 
the pilot program, and on any potential cost to investors due to the 
absence of a price test applied to these securities. In particular, the 
Commission seeks comment on whether the pricing of such securities is 
going to be more or less efficient, and whether manipulation of market 
prices (either upward or downward) is apt to be more or less prevalent.
    The Commission believes issuers may incur some costs associated 
with inclusion in the pilot program and seeks estimates and views on 
potential costs to those issuers selected for the pilot program.

D. Proposed Rule 200: Definition of a Short Sale

1. Unconditional Contracts
a. Benefits
    Proposed Rule 200 requires that unconditional contracts provide for 
present delivery, and specify the price

[[Page 63005]]

and number of securities to be sold. In addition, the proposal would 
require that persons who claim to be long actually receive a specified 
number of securities at a specified price and at a specified time. The 
benefit of this proposal is that it would prevent abuse by individuals 
seeking to claim a long position merely to avoid application of the 
price test provisions in proposed Rule 201. Specifically, if the price 
must be in the contract, there would be no incentive to attempt to 
depress the market price of security, such as depressing the price 
prior to closing where a contract mandates that the security be 
purchased at the closing price.
b. Costs
    The Commission does not anticipate any costs for this proposal. 
However, the Commission notes that some broker-dealers may claim that 
such a proposal would inhibit their trading strategy and increase the 
cost of doing business. The Commission seeks comment on how such a 
proposal would affect the trading of retail and institutional investors 
and the potential costs, if any, of limitations to the trading 
strategies of investors.
2. Securities Futures
a. Benefits
    Proposed Rule 200 would codify existing guidance issued by the 
Commission as to when a person is deemed to own a security underlying a 
security futures contract.\235\ Codifying this guidance would provide 
ease of reference for compliance with the short sale rule for those 
trading in security futures.
---------------------------------------------------------------------------

    \235\ Commission Guidance on the Application of Certain 
Provisions of the Securities Act of 1933, the Securities Exchange 
Act of 1934, and Rules thereunder to Trading in Security Futures 
Products, Securities Exchange Act Release No. 46101 (June 21, 2002), 
67 FR 43234 (June 27, 2002).
---------------------------------------------------------------------------

b. Costs
    The Commission acknowledges, however, that the existing 
interpretation may present costs associated with lost business 
opportunities for individuals who intended to use securities futures 
for trading strategies. In light of this, and in recognition that some 
participants may not have commented on the guidance when it was issued, 
the Commission requests data to quantify the costs and the value of the 
benefits identified.
3. Aggregation Units
a. Benefits
    We have also proposed to incorporate aggregation unit netting into 
Rule 200. This proposal would allow multi-service broker-dealers to 
calculate net positions in a particular security within defined trading 
units independently from the positions held by the other aggregation 
units within the firm, subject to certain conditions. This proposal is 
intended to allow multi-service firms to pursue different trading 
strategies under certain circumstances without being inhibited by the 
requirements of a price test when effecting short sales, which should 
increase efficiency and flexibility at large firms.
b. Costs
    The Commission does not believe there are any costs associated with 
this proposal because firms are not required to use aggregation units.

E. Proposed Amendments to Regulation M, Rule 105

1. Benefits
    The proposed amendment to Rule 105 of Regulation M would eliminate 
the exception for offerings filed under Sec.  230.415, commonly 
referred to as the shelf offering exception. We believe the elimination 
of the shelf offering exception would update Rule 105 of Regulation M 
and provide a uniform treatment of shelf offerings and non-shelf 
offerings in light of our belief that both shelf offerings and non-
shelf offerings are susceptible to the manipulative abuse that Rule 105 
of Regulation M is intended to prevent.
    We believe that the proposed amendment to Rule 105 of Regulation M 
would benefit issuers and investors by promoting shelf-offering prices 
that are based upon market prices that are not artificially influenced. 
We believe this should safeguard the integrity of the capital raising 
process with respect to shelf offerings and enhance investor confidence 
in our market. The proposal would also protect issuers conducting shelf 
offerings from receiving reduced offering proceeds as a result of 
manipulative conduct. These benefits are difficult to quantify. The 
Commission encourages commenters to provide data or other facts to 
support their views concerning these and any other benefits not 
mentioned here.
2. Costs
    We request comment as to whether the proposed elimination of the 
shelf offering exception would impose greater costs on market 
participants than the current rule. We recognize that the proposed 
elimination of the shelf offering exception would diminish a short 
seller's ability to effect a covering transaction by restricting the 
source of securities from which he may cover. Such costs are difficult 
to quantify and we solicit detailed description of the type and amount 
of any such costs from commenters. We believe, however, that any costs 
associated with restricting a short sellers' ability to cover with 
offering shares is balanced by the benefits derived from preventing the 
manipulative activity of effecting pre-pricing short sales and covering 
with offering shares. Additionally, we solicit comment concerning the 
costs to issuers, shareholders, and others of pre-pricing short sales 
prior to a shelf offering takedown and covering with shelf offering 
shares. Such costs may include costs associated with postponement or 
abandonment of an offering or a lower than anticipated offering price.

XX. Consideration on Burden and Promotion of Efficiency, Competition, 
and Capital Formation

    Section 3(f) of the Exchange Act requires the Commission, whenever 
it engages in rulemaking and must 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.\236\ In addition, Section 23(a)(2) of the Exchange Act 
requires the Commission, when making rules under the Exchange Act, to 
consider the impact such rules would have on competition.\237\ 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.
---------------------------------------------------------------------------

    \236\ 15 U.S.C. 78c(f).
    \237\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    Proposed Regulation SHO is intended to promote regulatory 
simplification by applying a uniform bid test to short sales in 
exchange-listed and Nasdaq NMS securities that occur in various markets 
and enhanced locate and delivery requirements to all equity securities. 
The Commission preliminarily believes that proposed Regulation SHO 
would promote efficiency because market participants would have to 
apply only one price test to exchange-listed and Nasdaq NMS securities, 
and the pilot program would give the Commission the opportunity to 
study how the new price test affects a broad range of securities in 
different markets. We also preliminarily believe that the locate and 
delivery requirements would promote efficiency by addressing large 
failures to deliver

[[Page 63006]]

securities that have the potential to disrupt market operations and 
pricing systems.
    The Commission preliminarily believes that Regulation SHO's uniform 
price test and enhanced locate and delivery requirements would promote 
capital formation because the proposed rules would reduce market 
volatility and the opportunities for market manipulation, thereby 
strengthening issuer and investor confidence in the markets. Applying 
the locate and delivery requirements to all equity securities would 
promote capital formation and especially help smaller issuers, whose 
securities may be more susceptible to the effects of naked short 
selling, enter into and remain in the marketplace and would promote 
capital efficiency in smaller, thinly capitalized securities that are 
more susceptible to manipulation.
    As discussed above, proposed Regulation SHO would apply a uniform 
bid test to covered securities and the locate and delivery requirements 
to all equity securities. The Commission preliminarily believes that 
Regulation SHO would promote competition among exchanges or other 
market centers in attracting issuers to list on a particular market, in 
that market participants would no longer be able to select a market on 
which to execute a short sale based on disparate regulation. In 
addition, the Commission preliminarily believes proposed Regulation SHO 
would level the playing field by applying uniform regulation.
    The Commission requests comment on whether the proposed amendments 
are expected to promote efficiency, competition, and capital formation.

XXI. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \238\ 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:
---------------------------------------------------------------------------

    \238\ 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).
---------------------------------------------------------------------------

    [sbull] An annual effect on the economy of $100 million or more 
(either in the form of an increase or a decrease);
    [sbull] A major increase in costs or prices for consumers or 
individual industries; or
    [sbull] 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 regulation 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.

XXII. 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),\239\ regarding the proposed Regulation SHO, 
Rules 200, 201, 202(T), and 203, replacing Rule 10a-1, Rule 10a-2, and 
Rule 3b-3, and proposed amendments to Rule 105 under the Exchange Act.
---------------------------------------------------------------------------

    \239\ 5 U.S.C. 603.
---------------------------------------------------------------------------

A. Reasons for the Proposed Action

    Based on recent developments, including but not limited to, 
increased instances of ``naked'' short selling, i.e., selling short 
without borrowing the necessary securities to make delivery; 
decimalization; the advent of security futures trading; and an 
increasing amount of Nasdaq securities being traded away from the 
Nasdaq market, and thus not subject to any short sale price test, the 
Commission is proposing Regulation SHO, Rules 200, 201, 202(T), and 
203, replacing Rules 10a-1, 10a-2, and 3b-3, along with amendments to 
Rule 105. The proposed rules, including a proposed uniform bid test 
Rule 201 that would apply to all exchange-listed and Nasdaq NMS 
securities wherever they are traded, enhanced locate and delivery 
requirements under proposed Rule 203, clarification of ownership under 
proposed Rule 200, as well as a temporary Rule 202(T) suspending the 
proposed bid test for certain securities during a two-year pilot, are 
designed to modernize short sale regulation in light of recent 
developments while providing simplification and uniformity to 
participants.

B. Objectives

    The proposed amendments are designed to fulfill several objectives. 
First, one of the prime objectives of the proposed amendments is to 
provide uniform short sale regulation applicable to trades in exchange-
listed and Nasdaq NMS securities occurring in multiple, dispersed, and 
diverse markets. Second, the proposed amendments provide greater 
flexibility in effecting short sales in a decimal environment as well 
as accommodating trading systems that utilize price improvement models 
that often conflict with existing short sale regulation. Third, the 
proposed amendments extend locate and delivery requirements to all 
equity securities, including the SmallCap, OTCBB, and Pink Sheet 
securities that have low market capitalization and may be more 
susceptible to manipulation. These locate and delivery requirements are 
designed to help prevent large fail positions, which may help 
facilitate some manipulative strategies.

C. Legal Basis

    Pursuant to the Exchange Act and, particularly, Sections 2, 3(b), 
9(h), 10, 11A, 15, 17(a), 19, 23(a) thereof, 15 U.S.C. 78b, 78c, 78i, 
78j, 78k-1, 78o, 78q, 78s, 78w(a), the Commission proposed to adopt 
Regulation SHO, Rules Sec.  240.200, 240.201, 240.202(T), and 240.203, 
replacing Sec.  240.3b-3, 240.10a-1, and 240.10a-2.

D. Small Entities Subject to the Rule

    Paragraph (c)(1) of Rule 0-10 240 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 2002, the Commission estimates 
that there were approximately 880 broker dealers that qualified as 
small entities as defined above.The Commission's proposed amendments 
would require all small entities to modify, and in some cases install, 
systems and surveillance mechanisms to ensure compliance with the 
uniform bid test, marking, and locate and delivery requirements.
---------------------------------------------------------------------------

    \240\ 17 CFR 240.0-10(c)(1).
---------------------------------------------------------------------------

E. Reporting, Recordkeeping, and Other Compliance Requirements

    The proposed amendments may impose some new compliance and marking 
requirements on broker-dealers that are small entities. Small broker 
dealers that only trade SmallCap, OTCBB, or Pink Sheet securities were 
not previously subject to marking and borrow and delivery requirements. 
Under the proposed amendments these broker-dealers would have an 
obligation to comply with the marking requirements and the borrow and 
delivery requirements imposed upon them by the proposals. Moreover, 
some small entities that trade securities that are subject to the pilot 
program may

[[Page 63007]]

have to make changes to exclude these securities from the uniform bid 
test.

F. Duplicative, Overlapping or Conflicting Federal Rules

    The Commission believes that there are no federal rules that 
duplicate, overlap or conflict with the proposed rules and the proposed 
temporary rule.

G. Significant Alternatives

    Pursuant to Section 3(a) of the RFA,\241\ 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.
---------------------------------------------------------------------------

    \241\ 5 U.S.C. 603 (c).
---------------------------------------------------------------------------

    The primary goal of the proposed amendments and the temporary rule 
is to promote uniformity in short sale regulation wherever trades in 
certain securities occur. As such, we believe that imposing different 
compliance or reporting requirements, and possibly a different 
timetable for implementing compliance or reporting requirements, for 
small entities would undermine the goal of uniformity. In addition, we 
have concluded similarly that it would not be consistent with the 
primary goal of the proposals to further clarify, consolidate or 
simplify the proposed amendments for small entities. The Commission 
also preliminarily believes that it would be inconsistent with the 
purposes of the Exchange Act to use performance standards to specify 
different requirements for small entities or to exempt broker-dealer 
entities from having to comply with the proposed rules and temporary 
rule.

H. Request for Comments

    The Commission encourages the submission of written comments with 
respect to any aspect of the IRFA. Those comments should specify costs 
of compliance with the proposed temporary rule, and suggest 
alternatives that would accomplish the objective of proposed amendments 
and temporary rule.

XXIII. Statutory Authority

    Pursuant to the Exchange Act and, particularly, Sections 2, 3(b), 
9(h), 10, 11A, 15, 17(a), 17A, 23(a) thereof, 15 U.S.C. 78b, 78c, 78i, 
78j, 78k-1, 78o, 78q, 78q-1, 78w(a), the Commission proposed to adopt 
Sec.  240.200, 240.201, 240.202(T), 203, along with amendments to 
Regulation M, Rule 105.

Text of Proposed Regulation SHO, Amendments and Temporary Rule

List of Subjects in 17 CFR Parts 240 and 242

    Brokers, Fraud, Reporting and recordkeeping requirements, 
Securities.

    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:

    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, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-
3, 80b-4, 80b-11, 7202, 7241, 7262, and 7263; and 18 U.S.C. 1350, 
unless otherwise noted.
* * * * *
    2. Sections 240.3b-3, 240.10a-1, and 240.10a-3 are removed and 
reserved.

PART 242--REGULATIONS M, SHO, ATS, AND AC AND CUSTOMER MARGIN 
REQUIREMENTS FOR SECURITY FUTURES

    3. The authority citation for part 242 continues to be read as 
follows:

    Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2), 
78i(a), 78j, 78k-1(c), 78l, 78m, 78mm, 78n, 78o(b), 78o(c), 78o(g), 
78q(a), 78q(b), 78g(h), 78w(a), 78dd-1, 80a-23, 80a-29, and 80a-37.

    4. The part heading for part 242 is revised as set forth above.
    5. Part 242 is amended by adding Sec. Sec.  242.200 through 242.203 
to read as follows:

Regulation SHO--Regulation of Short Sales

Sec.
242.200 Definition of ``short sale.''
242.201 Price test and marking requirements.
242.202(T) Temporary short sale rule suspension.
242.203 Borrowing and delivery requirements.

Regulation SHO--Regulation of Short Sales


Sec.  242.200  Definition of ``short sale.''

    (a) The term short sale shall mean any sale of a security which the 
seller does not own or any sale which is consummated by the delivery of 
a security borrowed by, or for the account of, the seller.
    (b) A person shall be deemed to own a security if:
    (1) He or his agent has title to it; or
    (2) He has purchased, or has entered into an unconditional 
contract, binding on both parties thereto, to purchase it, but has not 
yet received it, and the contract specifies the price and amount of the 
securities to be purchased; or
    (3) He owns a security convertible into or exchangeable for it and 
has tendered such security for conversion or exchange; or
    (4) He has an option to purchase or acquire it and has exercised 
such option; or
    (5) He has rights or warrants to subscribe to it and has exercised 
such rights or warrants; or
    (6) He holds a security futures contract to purchase it and has 
received notice that his position will be physically settled and is 
irrevocably bound to receive the underlying security.
    (c) A person shall be deemed to own securities only to the extent 
that he has a net long position in such securities.
    (d) A broker or dealer shall be deemed to own a security, even if 
it is not net long, if:
    (1) It acquired that security while acting in the capacity of a 
block positioner; and
    (2) To the extent that the broker or dealer's short position in the 
security is the subject of offsetting positions created in the course 
of bona fide arbitrage, risk arbitrage, or bona fide hedge activities.
    (e) In order to determine its net position, a broker or dealer 
shall aggregate all of its positions in a security unless it qualifies 
for independent trading unit aggregation, in which case each 
independent trading unit shall aggregate all of its positions in a 
security to determine its net position. Independent trading unit 
aggregation is available only if:
    (1) The broker or dealer has a written plan of organization that 
identifies each aggregation unit, specifies its trading objective, and 
supports its independent identity;
    (2) Each aggregation unit within the firm must continuously 
determine its net position for every security that it trades that is 
subject to Sec.  242.201;
    (3) Each trader pursuing a particular trading objective or strategy 
must be included in one aggregation unit; and
    (4) Individual traders must be assigned to only one aggregation 
unit at a time.
    (f) When unwinding index arbitrage positions involving long baskets 
of stock

[[Page 63008]]

and one or more short index futures traded on a board of trade or one 
or more standardized options contracts as defined in Sec.  240.9b-
1(a)(4) of this chapter, persons need not aggregate the long stock 
position with short stock positions in other proprietary accounts 
provided that:
    (1) The short stock positions have been created and maintained in 
the course of bona fide arbitrage, risk arbitrage, or bona fide hedge 
activities; and
    (2) The sale does not occur during a period commencing at the time 
that the Dow Jones Industrial Average has declined by two percent or 
more from its closing value on the previous day and terminating upon 
the establishment of the closing value of the Dow Jones Industrial 
Average on the next succeeding trading day.


Sec.  242.201  Price test and marking requirements

    (a) Definitions. For the purposes of this section:
    (1) The term actively traded security shall have the same meaning 
as in Sec.  242. 101(c)(1).
    (2) The term average daily trading volume shall have the same 
meaning as in Sec.  242.100(b).
    (3) The term consolidated best bid and offer shall have the same 
meaning as in Sec.  240.11Ac1-5(a)(7) of this chapter.
    (4) The term covered security shall mean all national market system 
securities as defined in Sec.  240.11Aa2-1 of this chapter, but shall 
exclude Nasdaq Small Cap securities, as determined by NASD rules.
    (5) The term odd lot shall mean an order for the purchase or sale 
of a covered security in an amount less than a round lot.
    (6) The term responsible broker or dealer shall have the same 
meaning as in Sec.  240.11Ac1-1(a)(21) of this chapter.
    (7) The term riskless principal shall mean a transaction in which a 
broker or dealer after having received an order to sell a security, 
sells the security as principal at the same price to satisfy the order 
to sell. The sell order must be given the same per-share price at which 
the broker or dealer sold shares to satisfy the facilitated order, 
exclusive of any explicitly disclosed markup or markdown, commission 
equivalent or other fee. In addition, for purposes of this section, a 
broker or dealer must have written policies and procedures in place to 
assure that, at a minimum: the customer order was received prior to the 
offsetting transaction; the offsetting transaction is allocated to a 
riskless principal or customer account within 60 seconds of execution; 
the broker or dealer has supervisory systems in place to produce 
records that enable the broker or dealer to accurately and readily 
reconstruct, in a time-sequenced manner, all orders which a broker or 
dealer relies pursuant to this exception.
    (b) All short sales of any covered security must be effected at a 
price at least one cent above the current best bid displayed as part of 
the consolidated best bid and offer at the time of execution.
    (c) A broker or dealer must mark all sell orders of any security as 
either ``long,'' ``short,'' or ``short exempt.'' A broker or dealer 
shall mark an order to sell a security ``long'' only if the seller owns 
the security being sold and either:
    (1) The security to be delivered is in the physical possession or 
control of the broker or dealer; or
    (2) The security will be in the physical possession or control of 
the broker or dealer no later than the settlement of the transaction. 
An order shall be marked ``short exempt'' if the sale is effected 
pursuant to one of the exceptions in paragraph (d) of this section.
    (d) The provisions of paragraph (b) of this section shall not apply 
to:
    (1) Any sale by any person of a covered security, for an account in 
which he has an interest, if such person owns the security and intends 
to deliver such security as soon as is possible without undue 
inconvenience or expense;
    (2) Any sale by a broker or dealer of a covered security for an 
account in which it has no interest, pursuant to an order marked long;
    (3) Any sale of a covered security by a market maker to off-set 
customer odd-lot orders or to liquidate an odd-lot position by a single 
round lot sell order which changes such broker or dealer's position by 
no more than a unit of trading;
    (4) Any sale of a covered security by a responsible broker or 
dealer effected at a price equal to the consolidated best offer when 
the market for the covered security is locked or crossed, provided 
however, that the exception shall not apply to any broker or dealer who 
initiated the locked or crossed market;
    (5) Any sale of a covered security for a special arbitrage account 
by a person who is presently entitled to acquire another security, 
provided that the security sold short is in the same class as the 
security he is entitled to acquire, the short sale is in an amount 
equivalent to the number of the securities that he is entitled to 
acquire, the sale is effected to profit from a current price difference 
between the security sold short and the security he is entitled to 
acquire, and the person subsequently acquires or purchases the security 
upon which the short sale was based. A person shall be deemed entitled 
to acquire a security if:
    (i) He has an unconditional right or option to acquire or purchase 
the security at a specific price and in a specific amount when the 
short sale is effected; and
    (ii) The right of acquisition was originally attached to or 
represented by another security, or was issued to all holders of the 
securities;
    (6) Any sale of a covered security for a special international 
arbitrage account effected to profit from a current price difference 
between a security on a foreign securities market and a security on a 
securities market subject to the jurisdiction of the United States, 
provided that the short seller has an offer to buy on a foreign market 
that allows him to immediately cover the short sale at the time it was 
made. For the purposes of this section, a depositary receipt of a 
security shall be deemed to be the same security as the security 
represented by such receipt;
    (7)(i) Any sale of a covered security by an underwriter or member 
of a syndicate or group participating in the distribution of a security 
in connection with an over-allotment of securities; or
    (ii) Any lay-off sale by an underwriter or member of a syndicate or 
group in connection with a distribution of securities through rights or 
a standby underwriting commitment;
    (8) Any sale of a covered security at the volume weighted average 
price (VWAP) that meets the following criteria:
    (i) The sale is entered into and matched before the regular trading 
session opens and the execution price of the VWAP matched trade will be 
determined after the close of the regular trading session; and
    (ii) The VWAP for the covered security is calculated by:
    (A) Calculating the values for every regular way trade reported in 
the consolidated system, or on a primary market that accounts for 
seventy-five percent or more of the covered security's average daily 
trading volume for the security during the regular trading session, by 
multiplying each such price by the total number of shares traded at 
that price;
    (B) Compiling an aggregate sum of all values; and
    (C) Dividing the aggregate sum by the total number of reported 
shares for that day in the security; and
    (iii) The transactions are reported using a special VWAP trade 
modifier; and

[[Page 63009]]

    (iv) Short sales used to calculate the VWAP will themselves be 
subject to the provisions of paragraph (b) this section, unless 
excepted or exempted, and Sec.  240.203 of this chapter; and
    (v) The VWAP matched security:
    (A) Qualifies as an ``actively-traded security''; or
    (B) The proposed short sale transaction is being conducted as part 
of a basket transaction of twenty or more securities in which the 
subject security does not comprise more than five percent of the value 
of the basket traded;
    (vi) The transaction is not effected for the purpose of creating 
actual, or apparent, active trading in or otherwise affecting the price 
of any security;
    (vii) A broker or dealer shall be permitted to act as principal on 
the contra-side to fill customer short sale orders only if the broker 
or dealer's position in the covered security, as committed by the 
broker-dealer during the pre-opening period of a trading day and 
aggregated across all of its customers who propose to sell short the 
same security on a VWAP basis, does not exceed 10% of the covered 
security's relevant average daily trading volume;
    (9) A sale of any covered security when the broker or dealer is 
effecting the execution of a customer ``long'' sale on a riskless 
principal basis, regardless of the broker or dealer's proprietary net 
position; and
    (10) A sale of any covered security at a price equal to the 
consolidated best bid by a broker or dealer to satisfy any obligations 
of the broker or dealer to a customer limit order, as determined by 
federal securities laws or the rules of a self-regulatory organization.
    (e) Upon written application or upon its own motion, the Commission 
may grant an exemption from the provisions of this section, either 
unconditionally or on specified terms and conditions, to any 
transaction or class of transactions, or to any security or class of 
securities, or to any person or class of persons.


Sec.  242.202(T)  Temporary short sale rule suspension.

    General rule. Short sales in specified securities constituting a 
subset of the Russell 1000 index, or such other securities as the 
Commission designates as permissible by order as necessary or 
appropriate in the public interest and consistent with the protection 
of investors after giving due consideration to the security's 
liquidity, volatility, market depth and trading market, may be effected 
without regard to the provisions of paragraph (b) of Sec.  242.201. All 
other provisions of Sec.  242.201 shall remain in effect.


Sec.  242.203  Borrowing and delivery requirements.

    (a) Long sales. (1) If a broker or dealer knows or has reasonable 
grounds to believe that the sale of a security was or will be effected 
pursuant to an order marked ``long,'' such broker or dealer shall not 
lend or arrange for the loan of any security for delivery to the broker 
for the purchaser after sale, or fail to deliver a security on the date 
delivery is due, unless the broker or dealer knows or has been informed 
by the seller that the seller owns the security and will deliver it to 
the clearing broker or dealer prior to the scheduled settlement of the 
transaction.
    (2) The provisions of paragraph (a)(1) of this section shall not 
apply to:
    (i) The loan of any security by a broker or dealer through the 
medium of a loan to another broker or dealer; or
    (ii) Any loan of, arrangement for the loan of, or failure to 
deliver any security, if, prior to such loan, arrangement or failure to 
deliver, a national securities exchange, in the case of a sale effected 
thereon, or a national securities association, in the case of a sale 
not effected on an exchange, finds:
    (A) That such sale resulted from a mistake made in good faith;
    (B) That due diligence was used to ascertain that the circumstances 
specified in Sec.  242.201(c) existed; and
    (C) Either that the condition of the market at the time the mistake 
was discovered was such that undue hardship would result from covering 
the transaction by a ``purchase for cash'' or that the mistake was made 
by the seller's broker and the sale was at a price permissible for a 
short sale under Sec.  242.201(b).
    (b) Short sales.
    (1) A broker or dealer may not execute a short sale order for its 
own account or the account of another person unless the broker or 
dealer, or the person for whose account the short sale is executed:
    (i) Borrowed the security, or entered into a bona-fide arrangement 
to borrow the security; or
    (ii) Had reasonable grounds to believe that it could borrow the 
security so that it would be capable of delivering the securities on 
the date delivery is due.
    (2) The provisions of paragraph (b)(1) of this section shall not 
apply to short sales executed by specialists or market makers in 
connection with bona-fide market making activities. Bona-fide market 
making activities shall not include activity that is related to 
speculative selling strategies or investment purposes of the broker or 
dealer or is disproportionate to the usual market making patterns or 
practices of the broker or dealer in that security.
    (3) For any security where there are fails to deliver at a clearing 
agency registered with the Commission of 10,000 shares or more, and 
that is equal to at least one-half of one percent of the issue's total 
shares outstanding, if a broker or dealer executes a short sale for its 
own account or the account of another person, and if for any reason 
whatever securities have not been delivered within two days after the 
settlement date:
    (i) For a period of ninety calendar days the broker or dealer shall 
not execute a short sale in such security for his own account or the 
account of the person for whose account the failure to deliver occurred 
unless the broker or dealer or the person for whose account the short 
sale is executed has borrowed the security, or entered into a bona fide 
arrangement to borrow the security, and will deliver the security on 
the date delivery is due; and
    (ii) The rules of a clearing agency registered pursuant to Section 
17A (15 U.S.C. 78q-1) of the Act shall include the following 
provisions:
    (A) A broker or dealer failing to deliver securities as specified 
in subparagraph (3) above shall be referred to the NASD and the 
Examining Authority (as defined in 15c3-1(c)(12)) for such broker or 
dealer for appropriate action; and
    (B) The registered clearing agency shall withhold a benefit equal 
to any mark to market amounts or payments that otherwise would be made 
to the participant failing to deliver, and assess appropriate charges.
    (c) Upon written application or upon its own motion, the Commission 
may grant an exemption from the provisions of this section, either 
unconditionally or on specified terms and conditions, to any 
transaction or class of transactions, or to any security or class of 
securities, or to any person or class of persons.

    Dated: October 28, 2003.
    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-27660 Filed 11-5-03; 8:45 am]
BILLING CODE 8010-01-P