[Federal Register Volume 68, Number 225 (Friday, November 21, 2003)]
[Rules and Regulations]
[Pages 65820-65822]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-29084]



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Part III





Securities and Exchange Commission





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17 CFR Part 241



Commission Guidance on Rule 3b-3 and Married Put Transactions; Final 
Rule

  Federal Register / Vol. 68, No. 225 / Friday, November 21, 2003 / 
Rules and Regulations  

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 241

[Release No. 34-48795]


Commission Guidance on Rule 3b-3 and Married Put Transactions

AGENCY: Securities and Exchange Commission.

ACTION: Interpretation.

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SUMMARY: The Securities and Exchange Commission is publishing 
interpretive guidance on calculating a ``net long'' position under the 
Securities Exchange Act of 1934 when using married put transactions as 
a part of certain trading strategies. A seller of securities is 
required to aggregate all of its positions in that security to 
determine the seller's ``net long'' position. Determining security 
ownership is an essential component to aggregating security positions 
under the Securities Exchange Act of 1934. The guidance we are 
publishing today clarifies the determination of security ownership when 
married puts transactions are used.

EFFECTIVE DATE: November 21, 2003.

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, and Elizabeth Sandoe, Special Counsels.

SUPPLEMENTARY INFORMATION:

I. Background

    A seller of securities must determine whether a sale is ``long'' or 
``short'' because of special provisions applying to short sales.\1\ 
This determination depends in significant measure on whether the seller 
owns the security to be sold and the seller's net position in the 
security. Rule 3b-3 under the Exchange Act provides, in part, that a 
person owns a security if he or his agent has title to a security or he 
has purchased or has entered into an unconditional contract to purchase 
it but has not yet received it.\2\
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    \1\ This interpretation discusses the operation of Rule 10a-1 
under the Securities Exchange Act of 1934 (``Exchange Act''), 17 CFR 
240.10a-1, and Rule 105 of Regulation M, 17 CFR 242.105. It does not 
address the operation of all provisions that apply to short sales, 
such as general anti-fraud and anti-manipulation provisions, e.g., 
Sections 17(a)(1) and 10b-5 of the Exchange Act, and self-regulatory 
organization rules, e.g., National Association of Securities 
Dealers, Inc. (``NASD'') Rule 3370, New York Stock Exchange 
(``NYSE'') Rule 440C.
    \2\ 17 CFR 240.3b-3(a)--(b). In addition, Rule 3b-3 provides 
that a person has a ``long'' position in a security if he holds 
convertible securities, options, rights, or warrants, and has 
tendered for conversion or exchange the convertible securities or 
exercised the options, rights, or warrants. 17 CFR 240.3b-3(c)-(e). 
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.
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    The seller's net position must be determined with reference to Rule 
3b-3. Rule 3b-3 requires a seller of an equity security to aggregate 
all of its positions in that security.\3\ If the seller has a ``net 
long'' position in the security after this aggregation process, then 
the sale may be effected as a ``long'' sale to the extent of the ``net 
long'' position. If the aggregation process results in a ``flat'' or 
``net short'' position, the sale must be effected as a ``short'' sale. 
All sell orders in any security registered on or admitted to unlisted 
trading privileges on a national securities exchange must be marked 
either ``long'' or ``short.'' \4\ A short sale of an exchange-listed 
security must comply with Rule 10a-1 under the Exchange Act.\5\ A sale 
of a ``long'' position is not subject to the price test of Rule 10a-1.
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    \3\ See 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).
    \4\ 17 CFR 240.10a-1(c).
    \5\ 17 CFR 240.10a-1. Rule 10a-1 (commonly referred as the 
``short sale rule'' or ``tick test'') prohibits, subject to certain 
narrow exceptions, short sales of any security registered on or 
admitted to unlisted trading privileges on a national securities 
exchange on minus or zero-minus ticks. Generally, the short sale 
rule is designed to prevent short selling from accelerating a 
declining market. Aggregation under Rule 3b-3 is also necessary to 
ensure compliance with the short sale ``bid test'' of NASD Rule 
3350. See Rule 3350(k)(1) and NASD Notice to Members 94-68, Question 
15.
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    Calculation of a seller's net position is also necessary for 
compliance with Rule 105 of Regulation M.\6\ Rule 105 prohibits 
covering a short sale with offering securities obtained from an 
underwriter or dealer if the short sale occurred during the period 5 
days prior to pricing until pricing or the period from filing the 
registration until pricing, whichever is shorter.\7\ Thus, a seller 
needs to know if any sales during the 5-day period prior to certain 
repeat or secondary offerings are short sales for which offering shares 
may not be used to cover such sales.
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    \6\ 17 CFR 242.105. Rule 105 prevents persons from covering 
short sales with offering securities purchased from an underwriter, 
broker, or dealer participating in the offering if the short sale 
was effected during the Rule's restricted period, which is typically 
five days prior to pricing and ending with pricing (``105 restricted 
period''.) Rule 105 is designed to ensure that ``secondary'' and 
``repeat'' offering prices are based on open market prices 
determined by supply and demand rather than influenced by artificial 
forces, and to prevent artificial depression of trading markets that 
may reduce an issuer's offering proceeds. See Short Sales in 
Connection with a Public Offering, Exchange Act Release No. 26028 
(August 25, 1988), 53 FR 33455 (August 31, 1988) (release adopting 
the predecessor to Rule 105, Rule 10b-21, which prohibited 
substantially the same conduct as Rule 105).
    \7\ 17 CFR 242.105(a)(1) and (a)(2). Rule 105 does not apply to 
offerings filed under Rule 415 of the Securities Act of 1933 (i.e., 
``shelf offerings'') or to offerings that are not conducted on a 
firm commitment basis. 17 CFR 242.105(b).
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    This release discusses the operation of Rule 3b-3 with respect to 
sellers who may claim to have a position in a security by virtue of 
having entered into a ``married put'' transaction.\8\
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    \8\ The Commission has proposed new Regulation SHO that, among 
other things, would apply a new uniform bid test to all exchange-
listed securities and Nasdaq National Market System (``NMS 
Security'') securities, wherever traded, allowing short sales to be 
effected at a price one cent above the consolidated best bid. The 
interpretive guidance we are issuing today on calculating a ``net 
long'' position applies regardless of whether the Commission adopts 
Regulation SHO.
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II. Discussion

    A married put is the purchase of an option to sell (i.e., a put 
option) a certain number of securities at a particular price by a 
specified time, bought contemporaneously with the same number of 
underlying securities.\9\ When used as a hedging vehicle, the married 
put is designed to provide protection to the holder of the stock 
against losses, i.e., if the price of the stock goes up, the put will 
not be exercised and will expire worthless, and if the price of the 
stock goes down, the put may be exercised by the holder to sell the 
underlying stock at the strike price.
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    \9\ The term ``married put'' is used to describe the underlying 
transaction, i.e., the linked purchase of securities and the put 
option to sell an equivalent number of securities. Several different 
terms have been used in the industry to describe various strategies 
involving married put transactions including, but not limited to, 
``bullets,'' ``ghost bullets,'' ``bullet trades,'' and ``slam 
dunks.'' All of these strategies involve the use of married put 
transactions.
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    The Securities and Exchange Commission (the ``Commission'') is 
concerned about the abusive use of married puts as a part of trading 
strategies designed to evade the application of Rule 10a-1 and Rule 
105.\10\ Some of these strategies appear to

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be designed to avoid possible trade execution delays associated with 
complying with the ``tick test'' of Rule 10a-1. Other strategies are 
intended to avoid aggregation obligations.\11\ Some strategies may 
involve the manipulative sale of securities underlying a married put as 
part of a scheme to drive the market price down and later profit by 
purchasing the securities at a depressed price.\12\
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    \10\ Traders may also be using married put transactions as part 
of a scheme to avoid the short sale ``bid test'' adopted by the 
NASD, Rule 3350. Although an NASD rule, a trader must calculate his 
``net long'' position pursuant to Commission Rule 3b-3 in order to 
comply with Rule 3350. See, supra n. 5. Rule 3350 provides that with 
respect to trades executed on or reported to Nasdaq no member shall 
effect a short sale, for the account of a customer or for its own 
account, in a Nasdaq NMS security at or below the current best 
(inside) bid displayed in the Nasdaq National Market Execution 
System when the current best (inside) bid is below the preceding 
best (inside) bid in the security. With respect to trades executed 
on or reported to the Alternative Display Facility, Rule 3350 
provides that no member shall effect a short sale, for the account 
of a customer or for its own account, in a NMS Security at or below 
the current national best (inside) bid when the current national 
best (inside) bid is below the preceding national best (inside) bid 
in the security.
    \11\ For example, day-trading firms, where traders generally 
attempt to derive a profit by executing many intra-day trades to 
take advantage of small price movements in a stock, may find it 
difficult to aggregate the positions held by each day trader in 
calculating the firm's ``net long'' position under Rule 3b-3. As 
part of an effort to avoid aggregation, day-trading firms may use 
married put transactions to execute sales in a stock in a 
coordinated attempt to maintain a firm-wide ``net long'' position.
    \12\ We have previously expressed concern about the use of 
married put transactions as a part of such strategies. See Exchange 
Act Release No. 42037 (October 20, 1999), 64 FR 57996 (October 28, 
1999) (Short Sale Concept Release). We noted that such strategies 
often involve the purchase of a married put just prior to, or 
simultaneous with, the sale of stock associated with the married put 
transaction. Soon after (i.e., later in the day), the transaction is 
unwound when the market participant allegedly returns the securities 
to the facilitator of the married put transaction. In expressing 
concern about such activity, we concluded ``a potential for abuse 
exists where the trader aggressively sells the ``long'' stock 
position, destabilizing the price of the stock, and soon after 
repurchases the stock in the market to return to the counter party. 
This type of strategy may present a heightened potential for 
manipulation.'' Id.
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    Most recently, we have become aware of certain strategies in which 
traders may acquire married puts as part of what may be an effort to 
circumvent the application of Rule 105. In these schemes traders enter 
into married put transactions during the restricted period 5 days 
before (or, sometimes, on the day of) pricing in a ``secondary'' or 
``repeat'' offering.\13\ Thereafter, the traders aggressively sell the 
stock portion of the married put as ``long'' sales, exercise the puts 
at the end of the day they are obtained, and then use securities 
obtained in the offering (sometimes obtained at a discount to the 
closing price) to cover their restricted period sales.
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    \13\ The first time an issuer conducts a public offering of its 
securities, the offering is referred to as an ``initial public 
offering.'' Subsequent offerings by the issuer are referred to as 
``repeat'' offerings. A ``secondary'' offering is an offering of 
securities held by shareholders.
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    This activity often enables the traders receiving offering shares 
to profit from the difference between the sales prices and the offering 
price, where the sales lowered the market price and, as a consequence, 
the market-based offering price. Not only is this manipulative conduct 
harmful to the market, but it also may have a substantial impact on the 
issuer and its shareholders that receive reduced offering proceeds as a 
result of the lower offering price.\14\
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    \14\ This activity impedes the markets from functioning as an 
independent pricing mechanism, undermines market integrity, and 
diminishes investor confidence.
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    We find the use of married put transactions as a part of these 
strategies particularly troubling because they represent an attempt to 
facilitate the very kind of abuse that Rules 10a-1 and 105 are designed 
to prevent. In light of this activity, we have determined that it is 
necessary to provide notice to traders that, under certain 
circumstances, the securities underlying married puts will not provide 
ownership (i.e., a ``long'' position) under Rule 3b-3.
    We are issuing this guidance to address married puts that are used 
as part of an attempt to create a ``long'' position for the purpose of 
circumventing Rules 10a-1 and 105.\15\ Such transactions usually have 
some or all of the following characteristics (or a variation of them):
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    \15\ The abusive use of married put transactions has also been 
discussed in the press. For example, see Torres, ``Are `Slam Dunks' 
on Troubled Stocks a Foul,'' Wall St. J., (February 1, 1991) 
(describing married puts as a ``new weapon to `raid' bad-news 
stocks.''); see also Pulliam, ``Bullet Strategy Makes Comeback as 
Trades Find a Way to Skirt Rules on Short Selling,'' Wall St. J., 
(October 14, 1998) (describing the married put strategy as a ``rapid 
fire sale of stock that is designed to build on a wave of selling . 
. . even though the trader may be selling the married-put stock at a 
loss, the theory is that he will make an even bigger profit on the 
put option as its value rises based partly on the market impact of 
the aggressive stock selling.'').

    [sbull] the purchase of an at- or in-the-money non-standardized put 
option with a brief (1 to 5 day) expiration period,
    [sbull] the contemporaneous purchase of an equivalent number of 
shares of the same security,
    [sbull] the contemporaneous sale of the stock acquired with a 
married put, in essence divorcing the stock position from the put 
option,\16\
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    \16\ Identifying a contemporaneous divorce of the stock position 
from the put option as an indication of a possible abusive use of 
married put transactions should not discourage legitimate hedging 
because such activity is inconsistent with hedging. Separating the 
securities underlying a married put transaction from the put option 
eliminates one of the legitimate economic reasons why an investor 
may enter into a married put transaction, i.e., its use to protect 
from any losses resulting from the stock price falling below the 
strike price of the option. Once the stock is divorced from the put 
option, a married put transaction is converted into a speculative 
``bearish'' position, with the put option used as a substitute for a 
short position in the stock. This is not consistent with legitimate 
hedging but rather aligned with a short strategy. Moreover, it is 
unlikely that a trader anticipating obtaining a ``long'' position by 
virtue of an expected allocation of ``repeat'' or ``secondary'' 
offering shares would use a married put transaction as a legitimate 
hedging instrument. In such an instance, a trader most likely would 
simply purchase put options in the offering stock rather than 
purchasing both the stock and the put options.
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    [sbull] the repeated use of a ``facilitator''\17\ that sells both 
the puts and the ``long'' position (often by selling the stock short to 
the counterparty),
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    \17\ Often, the married put transactions are structured so the 
facilitator sells the ``long'' position at a price equal to the 
strike price of the puts at the beginning of a trading day. At the 
end of the day the facilitator repurchases the security from the 
trader at the strike price charging a per share fee for the service. 
Other times, the facilitator may sell the put options with an in-
the-money strike price, i.e., the strike price is above the current 
market price, charging higher premiums as payment for the 
facilitating the married put transactions.
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    [sbull] the ``netting out'' of the transaction between the 
facilitator and the counterparty, often at the end of the day the 
married put was purchased, and
    [sbull] the payment of a standardized fee, not calculated in 
accordance with a standard options pricing model, to the facilitator 
for the transaction.\18\

    \18\ The options are not priced in accordance with a standard 
options pricing model, e.g., the Black-Scholes option pricing model, 
that takes into account volatility of a securities return, the level 
of interest rates, the relationship of the underlying stock's price 
to the strike price of the option, and the time remaining until the 
option expires. Instead, the options are priced to ensure that 
transaction is netted out between the parties with the payment of a 
flat fee to the facilitator for the service, i.e., a lending fee.
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    The net result of these transactions is that there is minimal or no 
economic risk to the married put purchaser or the party facilitating 
the married put.\19\ These married puts are distinguishable from other 
paired positions of stock and options where each component is intended 
to offset the risk of the other. In those cases, both sides of the 
position are held for a period of time, and the

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stock and options are priced at market levels.\20\
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    \19\ The Commission has previously indicated that where 
transactions involve no market risk and serve no purpose other than 
rendering a person an owner of a security in order to accomplish 
indirectly what was prohibited directly, the activity may violate 
the federal securities laws. See In the Matter of Shearson Lehman 
Brothers, Inc., Admin. Proc. File No. 3-7853, Exchange Act Release 
No. 31196 (September 17, 1992). See also In re Bevill, Bresler & 
Schulman Asset Management Corp., 67 B.R. 557 (D.N.J. 1986) (Whether 
a particular repurchase agreement is characterized as a securities 
transaction or as a loan can be determined by the objective intent 
of the parties. Intent of the parties may be reflected in the terms 
of the transaction as well as extrinsic evidence of intent, such as 
books and records of the parties, accounting practices, regulatory 
treatment of the transactions, and trade custom and usage).
    \20\ Even viewed in the most favorable light, these married put 
transactions appear to be nothing more than temporary stock lending 
agreements designed to give the appearance of a ``long'' position in 
order to effect sales of stock in a manner that would otherwise be 
prohibited. However, borrowed stock does not confer an ownership 
position under Rule 3b-3. Therefore, the sale of borrowed securities 
must be effected in compliance with short sale rules.
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    These married transactions have been used in connection with 
various trading strategies, including, but not limited to, the 
following:

    [sbull] contemporaneously with or shortly after the purchase of a 
married put, stock sales are made without regard to the ``tick test'' 
as part of a day trading strategy dependent on trading without short 
sale price test execution delays in order to profit from rapid intra-
day trades to take advantage of small price movements in stocks,
    [sbull] contemporaneously with or shortly after the purchase of a 
married put, aggressive, rapid stock sales on successive minus or zero-
minus ticks as part of a short-term momentum play in which a trader's 
strategy is aligned with a downward movement of the stock's price, or
    [sbull] contemporaneously with or shortly after the purchase of a 
married put, aggressive stock sales are made during the 5-day period 
prior to the pricing of a secondary or repeat offering where the 
trader's strategy is aligned with a downward movement of the stock's 
price in an effort to profit from the difference between the sales 
prices and the offering price.
    We believe it is important to disabuse traders of any notion that 
the use of married puts, as described above, complies with Commission 
rules. As such, we are issuing this interpretative release as a means 
of providing all market participants with guidance regarding the use of 
married put transactions when determining their net positions under 
Rule 3b-3. Married puts with the characteristics described above are 
sham transactions that do not give rise to security ownership under 
Rule 3b-3.\21\ Therefore, sellers who use these types of married puts 
may violate Rule 10a-1 and Rule 105.\22\ Moreover, if sham married puts 
are used as part of a fraudulent or manipulative scheme, the conduct 
may also violate the Commission's anti-fraud and anti-manipulation 
provisions, including, but not limited to, Sections 9(a) and 10(b) of 
the Exchange Act.\23\
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    \21\ A variation on the married put transaction used to 
facilitate day trading strategies that also may be problematic is a 
``conversion'' arrangement. In this arrangement, the trader that 
purchases the married put is long the stock, long a put option, and 
short a call option. The facilitator has the opposite side of the 
transaction, i.e., short the stock, short a put option, and long a 
call option. Often, the put and call options have the same strike 
prices. This arrangement provides the facilitator with the right to 
call the stock to cover its short position at a prearranged price in 
the event the counter party to the transaction does not exercise the 
put option. As with married put transactions, where these 
arrangements, or other similar arrangements, have the 
characteristics described above, they do not give rise to security 
ownership under Rule 3b-3.
    \22\ Scienter is not required to establish a violation of Rule 
10a-1. See U.S. v. Mandel, 296 F. Supp. 1038, 1039 (S.D.N.Y. 1969). 
Rule 105, as the successor to Rule 10b-21, does not require a 
showing of scienter. In adopting Rule 10b-21, the Commission made it 
clear that there was not a requirement to show a specific 
manipulative intent. See Exchange Act Release No. 26028, fn. 6, 
supra. See, e.g., Paul Giles et al., Exchange Act Release No. 36118 
(August 18, 1995), 1995 WL 509484.
    \23\ 15 U.S.C. 78e (a) and 78j (b). See also Securities Act 
Section 17(a), 15 U.S.C. 77q(a), and Exchange Act Section 15(c) and 
Rule 15c1-2 thereunder, 17 CFR 240.15c1-2.
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    In publishing this interpretative guidance, we recognize that 
married put transactions may be used as part of a legitimate hedging 
strategy, and we do not want to discourage their use for that purpose. 
Rather, we are calling attention to abusive married put transactions 
that have characteristics described above and are used in a scheme to 
create sham long positions in order to evade Commission rules.

III. Conclusion

    For the foregoing reasons, we find that this interpretation is 
consistent with Rule 3b-3 of the Exchange Act.\24\
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    \24\ 17 CFR 240.3b-3.
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List of Subjects in 17 CFR Part 241

    Securities.
Amendments to the Code of Federal Regulations.

0
For the reasons set forth above, the Commission is amending title 17, 
chapter II of the Code of Federal Regulations as set forth below:

PART 241--INTERPRETATIVE RELEASES RELATING TO THE SECURITIES 
EXCHANGE ACT OF 1934 AND GENERAL RULES AND REGULATIONS THEREUNDER

0
Part 241 is amended by adding Release No. 34-48795 and the release date 
of November 17, 2003 to the list of interpretative releases.

    Dated: November 17, 2003.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-29084 Filed 11-20-03; 8:45 am]
BILLING CODE 8010-01-P