[Federal Register Volume 69, Number 151 (Friday, August 6, 2004)]
[Rules and Regulations]
[Pages 48008-48031]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-17571]



[[Page 48007]]

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Part III





Securities and Exchange Commission





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17 CFR Parts 240, 241, and 242



Short Sales; Final Rule and Notice

  Federal Register / Vol. 69 , No. 151 / Friday, August 6, 2004 / Rules 
and Regulations  

[[Page 48008]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240, 241 and 242

[Release No. 34-50103; File No. S7-23-03]
RIN 3235-AJ00


Short Sales

AGENCY: Securities and Exchange Commission.

ACTION: Final rule; interpretation.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
adopting new Regulation SHO, under the Securities Exchange Act of 1934 
(``Exchange Act''). Regulation SHO defines ownership of securities, 
specifies aggregation of long and short positions, and requires broker-
dealers to mark sales in all equity securities ``long,'' ``short,'' or 
``short exempt.'' Regulation SHO also includes a temporary rule that 
establishes procedures for the Commission to suspend temporarily the 
operation of the current ``tick'' test and any short sale price test of 
any exchange or national securities association, for specified 
securities. Regulation SHO also requires short sellers in all equity 
securities to locate securities to borrow before selling, and also 
imposes additional delivery requirements on broker-dealers for 
securities in which a substantial number of failures to deliver have 
occurred. The Commission is also adopting amendments that remove the 
shelf offering exception, and issuing interpretive guidance addressing 
sham transactions designed to evade Regulation M.
    The Commission is deferring consideration of the proposal to 
replace the current ``tick'' test with a new uniform bid test 
restricting short sales to a price above the consolidated best bid, and 
also deferring consideration of the proposed exceptions to the uniform 
bid test. The Commission will reconsider any further action on these 
proposals after the completion of the pilot established by Regulation 
SHO.

DATES: Effective Date: September 7, 2004 except part 241 will be 
effective August 6, 2004 and Sec.  242.202T will be effective from 
September 7, 2004 to August 6, 2007.
    Compliance Date: The compliance date for Sec. Sec.  242.200 and 203 
is January 3, 2005. The compliance date for Sec.  242.202T is the same 
as its effective date, September 7, 2004.

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, Lillian 
Hagen, Alexandra Albright, and Elizabeth Sandoe, Special Counsels, or 
Peter Chepucavage, Attorney Fellow.

SUPPLEMENTARY INFORMATION: The Commission is adopting Rules 200, 202T, 
and 203 of Regulation SHO \1\ and amending Rule 105 of Regulation M,\2\ 
and Rule 10a-1\3\ under the Exchange Act.
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    \1\ 17 CFR 242.200 through 242.203.
    \2\ 17 CFR 242.105.
    \3\ 17 CFR 240.10a-1.
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Table of Contents

I. Introduction
II. Price Test--Proposed Rule 201
III. Rule 200--Definitions and Marking Requirements
IV. Rule 202T--Pilot Program
V. Rule 203--Locate and Delivery Requirements for Short Sales
VI. Rule 203(a)--Long Sales
VII. Rule 105 of Regulation M--Short Sales in Connection with a 
Public Offering
VIII. Paperwork Reduction Act
IX. Cost-Benefit Analysis
X. Consideration of Promotion of Efficiency, Competition, and 
Capital Formation
XI. Final Regulatory Flexibility Analysis
XII. Statutory Basis and Text of Adopted Amendments

I. Introduction

    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. 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.
    On October 28, 2003, the Commission proposed Regulation SHO, which 
would replace Rules 3b-3, 10a-1, and 10a-2 under the Exchange Act.\4\ 
As proposed, Regulation SHO contained the following rules:
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    \4\ Securities Exchange Act Release No. 48709 (October 28, 
2003), 68 FR 62972 (November 6, 2003) (``Proposing Release'').
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     Rule 200, which would replace Rule 3b-3 and: (1) Define 
the term ``short sale'' to allow multi-service broker-dealers to 
aggregate their positions by separate trading units; and (2) define 
ownership of a security to address security futures products and 
unconditional contracts to purchase securities;
     Rule 201, which would replace Rule 10a-1 and apply a 
uniform price test for exchange-listed and Nasdaq NMS securities based 
upon the consolidated best bid instead of the current tick test based 
upon the last reported sale;
     Rule 202T, which would establish a procedure for the 
Commission to suspend on a temporary basis the operation of Rule 10a-1 
and any short sale price test of any exchange or national securities 
association for specified securities; and
     Rule 203, which would replace current Rule 10a-2, 
incorporate provisions of the existing self-regulatory organization 
(``SRO'') ``locate'' rules into a uniform Commission rule applicable to 
all equity securities, wherever they are traded, and impose additional 
delivery requirements on broker-dealers for securities in which a 
substantial amount of failures to deliver have occurred.
    We also proposed revisions to Rule 105 of Regulation M (short 
selling in connection with a public offering) to eliminate the current 
shelf offering exception, and provide interpretive guidance addressing 
sham transactions designed to evade the rule.
    We received letters from 462 commenters in response to proposed 
Regulation SHO.\5\ The responses varied widely, with some commenters 
arguing for more stringent short sale regulation and others advocating 
the elimination of many or all short sale restrictions.
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    \5\ The comment letters and a comprehensive summary of the 
comments are available for inspection in the Commission's Public 
Reference Room in File No. S7-23-03, or may be viewed at http://www.sec.gov/rules/proposed/s72303.shtml. The 438 different letters 
from 462 commenters reflect the number of different letters 
received; thus form letters, referred to as ``letter types'' on the 
Commission's Web site (www.sec.gov), counted as one letter. For 
example, 18 individuals sent Letter Type A, 21 individuals sent 
Letter Type B, 18 individuals sent Letter Type C, 19 individuals 
sent Letter Type D, two individuals sent Letter Type E, two 
individuals sent Letter Type F, 15 individuals sent Letter Type G, 
two individuals sent Letter Type H, 15 individuals sent Letter Type 
I, and four individuals sent Letter Type J. In addition, although 
submitted under Regulation SHO, Letter Types H, I, and J 
substantively refer to amendments to NASD Rule 3370. See Securities 
Exchange Act Release No. 49285 (February 19, 2004), 69 FR 8717 
(February 25, 2004). They are included in the total here because 
commenters indicated that they were submitted in response to 
proposed Regulation SHO.
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    After considering the comments received, and upon further 
examination of current market practices and the purposes underlying 
short sale

[[Page 48009]]

regulation,\6\ we have decided to adopt certain provisions of proposed 
Regulation SHO and to defer consideration of other provisions. We are 
adopting proposed Rule 200, with some minor modifications. Rule 200, 
which incorporates Rule 3b-3, defines ownership for short sale 
purposes, and clarifies the requirement to determine a seller's net 
aggregate position. We have also decided to incorporate into Rule 200 
the proposed requirements to mark sales in all equity securities 
``long,'' ``short,'' or ``short exempt.'' \7\ We believe that the 
ownership, aggregation, and marking requirements are important for all 
short sale regulations.
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    \6\ 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. See Securities Exchange Act Release No. 13091 
(December 21, 1976), 41 FR 56530 (December 28, 1976). As we stated 
in the Proposing Release, short selling provides the market with at 
least two important benefits: market liquidity and pricing 
efficiency. Proposing Release, 68 FR at 62974.
    \7\ This marking requirement had been proposed in Rule 201(c). 
The marking requirements as adopted in Rule 200 apply to short sales 
in all equity securities, in contrast to paragraphs (c) and (d) of 
current Rule 10a-1, which only apply to exchange-listed securities.
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    We are also adopting Rule 202T, which creates a procedure for the 
Commission to establish, through a separate order, a pilot program 
pursuant to which the Commission may exclude designated securities from 
the operation of the tick test of Rule 10a-1 and any short sale price 
test rule of any exchange or national securities association 
(``pilot''). Concurrently with this release, we are issuing an order 
establishing a pilot program employing the procedures of Rule 202T.\8\ 
We have determined not to proceed with the uniform bid test of proposed 
Rule 201 until we have obtained the results of the pilot. Rule 10a-1, 
as well as all SRO price tests, will be maintained in present form for 
securities not included in the pilot.
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    \8\ Securities Exchange Act Release No. 50104 (July 28, 2004).
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    We believe that conducting a pilot pursuant to Rule 202T is an 
important component of evaluating the overall effectiveness of price 
test restrictions on short sales. The pilot will allow us to obtain 
data on the impact of short selling in the absence of a price test to 
assist in determining, among other things, the extent to which a price 
test is necessary to further the objectives of short sale regulation, 
to study the effects of relatively unrestricted short selling on market 
volatility, price efficiency, and liquidity, and to obtain empirical 
data to help assess whether a short sale price test should be removed, 
in part or in whole, for some or all securities, or if retained, should 
be applied to additional securities.
    The Commission's Office of Economic Analysis (``OEA'') will gather 
and analyze data during the pilot period to assess trading behavior in 
the absence of short sale price restrictions. Additionally, researchers 
are encouraged to provide the Commission with their own empirical 
analyses of the pilot.\9\
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    \9\ The Commission expects to make information obtained during 
the pilot publicly available.
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    We are adopting additional proposals in Regulation SHO, which we 
believe are necessary and appropriate regardless of whether short sales 
are subject to a price test, to clarify provisions and to address 
commenters' concerns. As adopted, Rule 203 creates a uniform Commission 
rule requiring broker-dealers, prior to effecting short sales in all 
equity securities, to ``locate'' securities available for borrowing, 
and imposes additional delivery requirements on broker-dealers for 
securities in which a substantial amount of failures to deliver have 
occurred (``threshold securities''). We believe that strong and uniform 
requirements in this area will reduce short selling abuses. The locate 
and delivery requirements will act as a restriction on so-called 
``naked'' short selling.\10\
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    \10\ ``Naked'' short selling, while not defined in the federal 
securities laws or SRO rules, generally refers to selling short 
without having borrowed the securities to make delivery.
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    We are also adopting amendments to Rule 105 of Regulation M in 
order to eliminate the shelf exception. In the Proposing Release we 
sought comment on how to address ``sham'' transactions that are 
structured to give the false appearance that short sales are being 
covered with open market shares, when in fact, the short seller has 
arranged to cover the short sale with offering shares, thereby 
violating Rule 105. We are issuing interpretive guidance relating to 
``sham'' transactions that violate Rule 105.

II. Price Test--Proposed Rule 201

    We proposed Rule 201 of Regulation SHO to replace Rule 10a-1's tick 
test with a price test using the consolidated best bid as the reference 
point for permissible short sales. Specifically, subparagraph (b) of 
proposed Rule 201 would have required that all short sales in covered 
securities be effected at a price at least one cent above the 
consolidated best bid at the time of execution.\11\
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    \11\ Additionally, the Commission sought comment on an 
alternative price test that would allow 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). Under this alternative, 
short selling would be restricted to a price at least one cent above 
the consolidated best bid if the current best bid is below the 
previous bid (i.e., a downbid).
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    The comments we received on the proposed price test varied widely. 
Some commenters (including the Investment Company Institute (``ICI''), 
North American Securities Administrators Association (``NASAA''), and 
many smaller investors) advocated more stringent short sale regulation. 
These commenters, favored extending the proposed bid test to smaller 
issuers and urged imposition of stricter locate and delivery 
requirements. Other commenters, despite supporting many of the 
initiatives, argued for maintaining the current ``tick'' test. The New 
York Stock Exchange (``NYSE''), a proponent of retaining the tick test, 
also contended that the NYSE should be allowed to maintain a tick test 
for short sales on the exchange even if the Commission determines to 
eliminate price restrictions on short sales.\12\ Additionally, the NYSE 
letter stated that it was representing the views of its issuers. None 
of these issuers submitted comments separately.\13\
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    \12\ The Specialist Association also argued for maintaining the 
current tick test on exchange-listed securities, and also opposed 
the proposed pilot program, arguing that it is likely to have 
unwarranted and unintended adverse effects on the securities 
included in the pilot, and could disadvantage these issuers compared 
to peer issuers that remain subject to the tick test.
    \13\ The letter from the American Society of Corporate 
Secretaries (``ASCS''), an organization of corporate issuers, did 
not opine on the pilot or the proposed bid test, but rather focused 
exclusively on the effects of short selling on proxy voting. The 
Commission expects to determine at a future date whether to take 
action with regard to that issue.
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    A number of commenters, including some of the largest broker-
dealers (e.g., J.P. Morgan, UBS Securities, Lehman Brothers), the 
Securities Industry Association (``SIA''), and one regional exchange, 
Chicago Stock Exchange (``CHX''), advocated that the Commission 
consider further the necessity of any price test (either the current 
tick test or the proposed bid test). Generally, these commenters 
supported the pilot as a good first step, but argued that the pilot 
should be shortened from the proposed two-year duration to one year to 
expedite this process. These commenters, and other broker-dealers 
(e.g., Goldman Sachs, Citigroup, Merrill Lynch, and Morgan Stanley), 
raised various concerns about the proposed price test, and opposed the 
Commission requiring market

[[Page 48010]]

participants to expend time and resources to re-program systems for the 
proposed bid test prior to the completion of a pilot, especially if a 
possible outcome following the completion of the pilot is the removal 
of a price test altogether based on the results of the pilot.\14\
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    \14\ See e.g., letter from The American Stock Exchange 
(``Amex''); letter from CHX. Amex estimated that it would take the 
exchange three and a half months to make the necessary surveillance 
changes and would cost roughly $125,000. CHX represented that the 
aggregate cost to the exchange and its floor members would amount to 
at least $500,000.
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    We have decided that the prudent course of action is to defer 
consideration of the proposed uniform bid test until after the 
conclusion of any pilot established pursuant to Rule 202T. As noted, 
the purpose of the pilot is to assist the Commission in considering 
alternatives, such as: (1) Eliminating a Commission-mandated price test 
for an appropriate group of securities, which may be all securities; 
(2) adopting a uniform bid test, and any exceptions, with the 
possibility of extending a uniform bid test to securities for which 
there is currently no price test; or (3) leaving in place the current 
price tests.\15\
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    \15\ As a result, all existing exceptions and exemptions from 
Rule 10a-1 remain in effect. In addition, at this time, because we 
are not adopting the proposed uniform bid test, we have deferred a 
decision on our proposal to codify prior exemptive relief. See 
Proposing Release, Section VII.
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III. Rule 200--Definitions and Marking Requirements

    We are adopting Rule 200 to incorporate Rule 3b-3 of the Exchange 
Act,\16\ with some amendments to the rule's current text. One of the 
key changes in Rule 200 is the requirement to mark sell orders in all 
equity securities ``long,'' ``short,'' or ``short exempt.'' 
Additionally, Rule 200 allows broker-dealers to calculate net positions 
in a particular security within defined trading units; incorporates the 
block-positioner exception from current Rule 10a-1(e)(13); and codifies 
prior interpretations related to the ownership of security futures 
products, and the unwinding of certain index arbitrage positions.\17\
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    \16\ Rule 3b-3 sets forth the definition of ``short sale'' and 
identifies the specific instances for determining a long position. 
17 CFR 240.3b-3.
    \17\ See Proposing Release, Section X.
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A. Ownership

1. Unconditional Contracts To Purchase Securities--Rule 200(b)(2)
    As proposed, paragraph (b) of Rule 200 would have amended the 
definition of unconditional contract to require the specification of a 
fixed price and amount of securities to be purchased in order for a 
person to claim ownership of the securities underlying the contract. 
Given our decision to maintain the status quo on the short sale price 
test in Rule 10a-1, we have determined not to amend the current 
definition of ``unconditional contract'' found in Rule 3b-3(b). Our 
decision primarily relates to our intent to preserve the operation of 
the current price test during the application of Rule 202T's pilot 
program. Amending qualifications for ownership of securities would 
affect net long positions, and thus have an impact on various trading 
strategies. However, we will continue to consider whether any future 
changes to the unconditional contract provision are appropriate, and 
may revisit our decision upon termination of any pilot that will be 
implemented pursuant to Rule 202T.
2. Ownership of Securities Underlying Securities Futures Products--Rule 
200(b)(6)
    We proposed Rule 200(b)(6) to achieve consistency with existing 
Commission guidance that defines when a person shall be deemed to own a 
security underlying a security futures contract.\18\ The proposed 
amendment provided that a person holding a long security futures 
position is not considered to own the underlying security, for Rule 200 
purposes, until the security future stops trading and the future will 
be physically settled. In the Proposing Release, we stated that 
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. 
At that point, the person obligated to deliver would be considered 
short, and a person entitled to acquire the securities would be 
considered long.\19\
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    \18\ See 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) (``Guidance Release'').
    \19\ Guidance Release at II.B.2.; Proposing Release at n. 179.
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    One commenter addressed the Rule 200 proposal and asserted that a 
person who holds a security future, which obligates the person to take 
delivery of the underlying securities by physical settlement, should be 
considered long the securities.\20\ Additionally, the commenter argued 
that securities futures products are ``materially different'' from 
options, rights, warrants, and convertibles, which merely give the 
holder the right, but not the obligation, to acquire the securities.
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    \20\ See letter from LEK Securities.
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    We believe that the ownership language in Rule 3b-3 implicitly 
contemplates that there is a high degree of certainty that the person 
presently will obtain possession of the security. The distant time 
element of a futures product is inconsistent with this position. 
Moreover, the sale of securities related to a future-dated delivery 
contract necessitates borrowing for delivery, thus rendering the sale 
of the related securities a short sale. Therefore, a futures contract 
is more analogous to other derivative products than to an unconditional 
contract.
    Therefore, we are adopting the proposed language relating to 
ownership of securities underlying a security futures contract. This 
interpretation is consistent with existing Commission guidance 
concerning the manner in which Rule 3b-3 addresses instances where a 
person owns a derivative instrument that entitles the person to acquire 
securities underlying the instrument, e.g., options, rights, warrants, 
convertibles, and security futures.\21\
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    \21\ See Guidance Release.
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3. Aggregation Units--Rule 200(f)
    We are adopting aggregation unit netting in Rule 200(f). 
Historically, a multi-service broker-dealer was considered one entity, 
so all of its positions were aggregated to determine the firm's net 
position.\22\ However, firm-wide aggregation often interfered with the 
trading of independent units within the broker-dealer. The staff of the 
Division of Market Regulation therefore issued a no-action letter 
allowing multi-service broker-dealers to aggregate their positions 
within defined trading units.\23\ We proposed to incorporate trading 
unit aggregation, for purposes of determining the trading unit's net 
position, into Regulation SHO.\24\
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    \22\ Under Rule 3b-3, a seller of an equity security subject to 
Rule 10a-1 must aggregate all of its positions in that security in 
order to determine whether the seller has a ``net long position'' in 
the security. 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); 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).
    \23\ 1998 SEC No-Act LEXIS 1038 (November 23, 1998) (aggregation 
unit netting no-action letter).
    \24\ For firms not relying on the aggregation unit exception, we 
understand that available technology allows firms to aggregate their 
firm-wide positions on a real-time basis. To the extent that a firm 
is unable to accomplish real-time aggregation on a firm-wide basis, 
it should be able to demonstrate why such aggregation is 
impracticable and that the alternative method employed (e.g., on a 
daily basis) accurately reflects firm ownership positions.

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    As proposed and adopted, Rule 200(f) permits trading unit 
aggregation if a registered broker-dealer meets the following 
requirements: (1) The broker-dealer has a written plan of organization 
that identifies each aggregation unit, specifies its trading 
objective(s), and supports its independent identity; \25\ (2) each 
aggregation unit within the firm determines at the time of each sale 
its net position for every security that it trades; (3) all traders in 
an aggregation unit pursue only the trading objectives or strategy(ies) 
of that aggregation unit; and (4) individual traders are assigned to 
only one aggregation unit at any time.\26\
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    \25\ As noted in the Proposing Release, 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.
    \26\ Two commenters focused on expanding aggregation unit 
netting to non-broker-dealers. See letters from LEK Securities; MFA. 
The Commission has determined not to extend aggregation unit netting 
to entities that lack self-regulatory oversight and are not subject 
to Commission examination. The lack of regulatory oversight may 
facilitate the creation of units that are not truly independent or 
separate.
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    We believe that these conditions are necessary to prevent potential 
abuses associated with establishing aggregation units within multi-
service broker-dealers. Specifically, we require a written plan of 
organization as a means to demonstrate that each unit is independent 
and engaged in separate trading strategies without regard to other 
trading units. Aggregation of the unit's net position prior to each 
sale limits the potential for abuse associated with coordination among 
units. The final two conditions, limiting traders to the pursuit of the 
trading strategies or objectives of the particular aggregation unit and 
the assignment to only one aggregation unit at a time, are both 
designed to maintain the independence of the units. Thus, if two or 
more traders or groups of traders (i.e., desks) within the same firm 
coordinate their trading activities, those traders or groups must be in 
the same aggregation unit.\27\
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    \27\ As with any rule, broker-dealers relying on this exception 
should be prepared to monitor for compliance with its conditions, 
and maintain records documenting such compliance.
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4. Block Positioners and Liquidation of Index Arbitrage Positions--Rule 
200(d) and (e)
    As proposed, we are incorporating the block positioner exception 
(currently found in subsection (e)(13) of Rule 10a-1) into Rule 200(d) 
because this provision directly relates to the calculation of a broker-
dealer's net position. Block positioning occurs when a broker-dealer 
acts as principal in taking all or part of a block order placed by a 
customer in order to facilitate a transaction that might otherwise be 
difficult to effect in the ordinary course of trading.\28\ The block 
positioner may then seek to sell the securities so acquired. The 
exemption for block positioners addresses the interaction between the 
price test under Rule 10a-1 and the determination of the seller's net 
position under Rule 3b-3.\29\ A broker-dealer that engages in block-
positioning will continue to be able to disregard economically neutral 
bona-fide arbitrage, risk arbitrage, and bona-fide hedge positions 
involving short stock components in determining its net position in the 
block-positioned security.
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    \28\ Securities Exchange Act Release No. 15533 (January 29, 
1979), 44 FR 6084 (January 31, 1979) (noting that the Commission has 
long recognized the important role that block positioning plays in 
providing liquidity for large securities transactions and in 
maintaining fair and orderly markets).
    \29\ See Securities Exchange Act Release No. 20230 (September 
27, 1983) 48 FR 45119 (October 3, 1983) (proposing the block 
positioner exception); see also Securities Exchange Act Release No. 
20715 (March 6, 1984), 49 FR 9414 (March 13, 1984) (adopting the 
block positioner exception).
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    Under subparagraph (e) of Rule 200, we are adopting relief for 
sales effected in connection with the unwinding of an index arbitrage 
position. Rule 200(e) provides a limited relaxation of the requirement 
that a person selling a security aggregate all of the person's 
positions in that security to determine whether he or she has a net 
long position. In a manner similar to that permitted under the block 
positioner exception in Rule 200(d), this provision allows market 
participants to liquidate (or unwind) certain existing index arbitrage 
positions involving long baskets of stocks and short index futures or 
options without aggregating short stock positions in other proprietary 
accounts if and to the extent that those short stock positions are 
fully hedged. To qualify for the relief, the liquidation of the index 
arbitrage position must relate to a securities index that is the 
subject of a financial futures contract (or options on such futures) 
traded on a contract market, or a standardized options contract,\30\ 
notwithstanding that such person may not have a net long position in 
that security.\31\
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    \30\ ``Standardized options contract'' is defined in Rule 9b-
1(a)(4) under the Exchange Act. 17 CFR 240.9b-1(a)(4).
    \31\ The Commission proposed to codify this relief in 1992, but 
the proposal was not adopted. See Securities Exchange Act Release 
No. 30772 (June 3, 1992), 57 FR 24415 (June 9, 1992).
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    Aggregation relief for index arbitrage positions was originally 
granted in a staff no-action letter.\32\ Proposed Rule 200(d) contained 
additional provisions that were not contained in the prior no-action 
letter. Three commenters supported the relief, but stated that the 
relief was too limited.\33\ Generally, these commenters preferred the 
relief as provided by the Merrill Lynch letter. We have carefully 
reviewed the comments and have determined to include the additional 
provisions in connection with the liquidation of an index arbitrage 
position. The Commission still believes that a market decline 
restriction is appropriate and in the public interest, and will 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.
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    \32\ 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) (clarifying and 
emphasizing certain aspects of the limited relief granted in the 
Merrill Lynch letter). The Merrill Lynch letter provided no-action 
relief if: (i) The firm has a long stock position as part of an 
index arbitrage position; (ii) the stock is being sold in the course 
of ``unwinding'' an index arbitrage position; and (iii) the sale 
would be a short sale, as defined in Rule 3b-3, solely as a result 
of the netting of the index arbitrage long position with one or more 
short positions created in the course of bona-fide hedge activities.
    \33\ See letters from LEK Securities; Willkie Farr & Gallagher, 
LLP (``Willkie Farr'') (sent on behalf of J.P. Morgan Securities and 
UBS Securities).
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    As proposed and adopted, the exception for unwinding index 
arbitrage positions provided in Rule 200(e) is limited to the following 
conditions: (1) The index arbitrage position involves a long basket of 
stock and one or more short index futures traded on a board of trade or 
one or more standardized options contracts; (2) 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 (3) the sale does not occur during a 
period commencing at the time that the Dow Jones Industrial Average 
(``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. If a market decline triggers the application 
of subparagraph (e)(2), a broker-dealer must aggregate all of its other 
positions in that security to

[[Page 48012]]

determine whether the seller has a net long position.\34\
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    \34\ We have adopted language that closely resembles the block 
positioner exception in Rule 200(d) since we believe that the 
economic rationale for and the operation of both exceptions are 
analogous. Securities Exchange Act Release No. 30772 (June 3, 1992), 
57 FR 24415 (June 9, 1992) at n. 60 (citing Securities Exchange Act 
Release No. 20230, 48 FR at 45119); Securities Exchange Act Release 
No. 20715 (March 6, 1984), 49 FR 9414 (March 13, 1984)).
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B. Order-Marking Requirements--Rule 200(g)

    We are adopting the new order-marking requirements proposed in Rule 
201(c) and incorporating them into Rule 200(g). Since the new marking 
requirements apply to all equity securities, not just exchange-listed 
securities, we are removing them from current Rule 10a-1. The new 
order-marking requirements differentiate between ``long,'' ``short,'' 
and ``short exempt'' orders for all exchange-listed and over-the-
counter equity securities.
    Under the former marking requirements in Rule 10a-1(d), a broker-
dealer could only mark an order to sell a security ``long'' if the 
security was carried in the account for which the sale is to be 
effected, or the broker-dealer is informed that the seller owns the 
security to be sold, and will deliver the security to the account for 
which the sale is effected as soon as possible without undue 
inconvenience or expense.\35\ We had proposed changing the marking 
requirement so that a sale could only be marked ``long'' if the seller 
owns the security being sold and either the security to be delivered is 
in the physical possession or control of the broker-dealer, or will be 
in the physical possession or control of the broker-dealer prior to 
settlement of the transaction.
---------------------------------------------------------------------------

    \35\ 17 CFR 240.10a-1(d).
---------------------------------------------------------------------------

    As adopted, an order can 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 it is reasonably 
expected that the security will be in the physical possession or 
control of the broker or dealer no later than settlement. We added the 
language ``reasonably expected'' because we acknowledge that it may be 
difficult for a person to know with certainty at the time of sale that 
a security will be in the possession or control of the broker-dealer 
prior to settlement. However, if a person owns the security sold and 
does not reasonably believe that the security will be in the possession 
or control of the broker-dealer prior to settlement, the sale should be 
marked ``short.'' The sale could be marked ``short exempt'' if the 
seller is entitled to rely on an exception from the tick test of Rule 
10a-1, or the price test of an exchange or national securities 
association.\36\ Short sales of pilot securities effected during any 
pilot period should be marked ``short exempt.''
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    \36\ In this situation, the seller may be entitled to rely on an 
exception if the seller ``owns the security sold and intends to 
deliver such security as soon as possible without undue 
inconvenience or expense.'' 17 CFR 240.10a-1(e)(1). Additionally, 
the seller may be entitled to rely on an exception from Rule 
203(b)(2)(ii), as adopted, if the seller owns the security sold 
pursuant to Rule 200, and the seller intends to deliver the security 
as soon as all restrictions on delivery have been removed, and no 
later than 35 days after trade date. See Rule 203(b)(2)(ii), 
discussed further in Part V.A.1.c., infra. However, without an 
exception to the price test, this sale should be marked ``short.''
---------------------------------------------------------------------------

    The new marking requirements will eliminate the prior discrepancy 
between how Rule 3b-3 defined a short sale and the marking provisions 
previously found in Rule 10a-1. In addition, the new marking 
requirements should facilitate the surveillance and monitoring of 
compliance with Rule 10a-1. The change to the marking requirements will 
provide information that shows when exceptions from Rule 10a-1 are 
used.

IV. Rule 202T--Pilot Program

A. General

    We proposed Rule 202T to provide a procedure for the Commission to 
suspend, on a pilot basis, the trading restrictions of the Commission's 
short sale price test, as well as any short sale price test of any 
exchange or national securities association, for short sales in such 
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.\37\ We stated 
our belief that temporary suspension of Commission and SRO price tests 
is an essential component of evaluating the overall effectiveness of 
such restrictions, and would permit the collection of data on the 
impact of short selling in the absence of a price test.
---------------------------------------------------------------------------

    \37\ See Proposing Release, Section V.
---------------------------------------------------------------------------

    Overall, thirty-eight commenters expressed support for a pilot 
program.\38\ Some commenters opposed any suspension of a price test for 
short sales, and expressed concern about possible pricing anomalies and 
disparate trading activity in securities within the same industry where 
one security is subject to a price test and another is not.\39\ We 
considered these suggestions together with other comments that not only 
supported the pilot, but recommended that the pilot criteria be 
expanded to include, among other things, less liquid securities; 
securities with position limit tiers for listed options; and stocks 
that currently qualify for the Regulation M exception for actively-
traded securities.\40\
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    \38\ See letters from James Angel; Archipelago Holdings 
(``ARCA''); Yuseff J. Burgess; Chicago Board Options Exchange 
(``CBOE''); Dario Cosic; Davis Polk; Timothy K. Dolnier; Tolga 
Erman; Chris Freddo; Kristopher Goldhair; Chris Gregg; Marc Griffin; 
Charles W. Hansford; Zachary Hepner; ICI; Mike Ianni; Brian Ingram; 
Kevin Karlberg; Gregory Kleiman; LEK Securities; Michael Lucarello; 
Hal Lux and Leon M. Metzger; Managed Funds Association (``MFA''); 
Raymond J. Murphy; Nasdaq Stock Market (``Nasdaq''); 
[email protected]; Tal Plotkin; David Schwarz; Sinan Selcuk; 
Theodore J. Siegel; Todd Sherman; SIA; Dan Solomon; The Securities 
Traders Association (``STA''); Securities Traders Association of New 
York (``STANY''); Jimmie E. Williams; Willkie Farr.
    \39\ See, e.g., letters from Anthony Gentile; Robert Morrow; 
NYSE; The Specialists Association. The NYSE asserted that a pilot 
will create a confusing system that will ``slow trading, lead to 
errors and baffle market participants'' as well as create 
``artificially anomalous price situations, particularly for 
securities within the same industry where some are subject to a 
`tick' or `bid' test and others are not.''
    \40\ Some commenters suggested expanding the scope of stocks 
that may be included in a pilot. See letters from CBOE; Coreina 
Chan; Timothy K. Dolnier; Charles W. Hansford; Zachary Hepner; 
Gregory Kleiman; Michael Lucarello; Nasdaq; [email protected]; 
Tal Plotkin; David Schwarz; Dan Solomon; STA; STANY; Hiro Shinohara; 
Daniel C. Sweeney. Additionally, some advocated including less 
liquid Nasdaq NMS and listed securities, while others argued for 
including groups of stocks with the two highest position limit tiers 
for listed options. See letters from STA; STANY; CBOE. SIA's letter 
suggested using stocks that currently qualify for the Regulation M 
exception for actively-traded securities because they are less 
susceptible to market manipulation and because programming costs may 
be less as many broker-dealers already have systems in place to 
identify such stocks.
---------------------------------------------------------------------------

    A number of commenters stated that the proposed two-year time span 
for the pilot would be too long.\41\ For example, Nasdaq asserted that 
the pilot should only last as long as absolutely necessary, to minimize 
the impact on issuers and the market, and suggested a six-month or 
twelve-month pilot. The NYSE expressed concern that a two-year pilot is 
``an exceptionally long time,'' especially if there were no quick 
mechanism to shorten or end the pilot if it proves to dislocate market 
prices. The STA favored a six-month pilot.
---------------------------------------------------------------------------

    \41\ See letters from James Angel; Charles Schwab Capital 
Markets (``Charles Schwab''); Nasdaq; NYSE; STA; STANY.
---------------------------------------------------------------------------

    After careful consideration of the comments received, we are 
adopting a modified version of proposed Rule 202T. As adopted, Rule 
202T provides procedures for the Commission to suspend any short sale 
price test for such securities and for such time periods as the 
Commission deems

[[Page 48013]]

necessary or appropriate, in the public interest and consistent with 
the protection of investors after giving due consideration to the 
securities' liquidity, volatility, market depth and trading market. Any 
such pilot would commence by separate order of the Commission, which 
would allow the Commission to act quickly should adverse findings 
result from any pilot. As part of that process, we would consider the 
concerns expressed by some commenters that any pilot last only as long 
as absolutely necessary to allow the Commission to gather sufficient 
data. The order establishing any such pilot would identify the pilot 
stocks and set forth the methodology we would use in selecting pilot 
and control group stocks. Any such order would also indicate the 
factors we plan to analyze in the pilot, such as the impact on market 
quality, price changes caused by short selling, costs imposed by the 
tick test, and the use of alternative means to establish short 
positions.
    By separate order, the Commission is establishing a pilot that 
includes a subset of securities from a broad-based index. The order 
identifies the pilot stocks and sets forth the methodology we used in 
selecting pilot and control group stocks.\42\ We believe that a pilot 
established under Rule 202T using a subset of securities from a broad-
based index will provide a balanced and targeted approach to assessing 
the efficacy of a price test for short sales. There is the potential 
that prices and trading activity may vary between securities included 
in a pilot and similar securities subject to the price test.\43\ 
However, to the extent there are price and trading activity variations, 
this is precisely the empirical data that the Commission seeks to 
obtain and analyze as part of our assessment as to whether the price 
test should be removed or modified, in part or whole, for actively-
traded securities or other securities. \44\
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    \42\ The Commission may in the future issue other orders 
adopting other pilot programs.
    \43\ See, e.g., letter from SONECON, LLC.
    \44\ No individual issuers submitted comment letters opposing a 
pilot or expressing concern about the possible disparate trading of 
securities subject to a pilot or about the possible adverse impact 
on their securities should the price test be removed from short 
selling in their stock on a temporary basis. However, the NYSE 
submitted a letter expressing concern ``on behalf of its members and 
its listed companies'' that strongly supported continuing price 
restrictions and expressed concern about unscrupulous market 
participants forcing prices lower in stocks not subject to a price 
test.
---------------------------------------------------------------------------

    We appreciate the concerns expressed by some commenters that 
issuers subject to a pilot could be unfairly disadvantaged because of 
potentially abusive or manipulative behavior. We note, however, that 
most of the more liquid securities that will be appropriate for a pilot 
are traded on exchanges or other organized markets with high levels of 
transparency and surveillance. This would enhance the ability of the 
Commission and SROs to monitor trading behavior during the operation of 
any pilot and to surveil for manipulative short selling. Moreover, the 
general anti-fraud and anti-manipulation provisions of the federal 
securities laws will continue to apply to trading activity in these 
securities, thus prohibiting trading activity designed to improperly 
influence the price of a security.\45\ In addition, a pilot would 
suspend only the operation of the price test, while the other 
requirements of Regulation SHO, including the order-marking, locate and 
delivery requirements, would remain in effect.\46\
---------------------------------------------------------------------------

    \45\ See, e.g., Securities Act of 1933 (``Securities Act'') 
Section 17(a), and Exchange Act Sections 9(a), 10(b), and 15(c) and 
Rules 10b-5 and 15c1-2 thereunder.
    \46\ Also, the order permits the Commission to act quickly to 
modify the pilot to address any adverse results, should we determine 
that continued operation of an established pilot would not be 
necessary or appropriate in the public interest or inconsistent with 
the protection of investors.
---------------------------------------------------------------------------

    Further, as adopted, Rule 202T makes explicit that no SRO ``shall 
have a rule that is not in conformity with or conflicts with'' the 
suspension of a price test for the securities selected for the pilot. 
Although a few commenters asserted that SRO price tests should remain 
in effect even if the Commission determined to eliminate price 
restrictions on short sales,\47\ as we noted in the Proposing Release, 
we believe it would be inconsistent with, and detrimental to the goals 
of, Rule 202T and any pilot to allow SRO price tests to continue to 
apply to securities subject to the pilot. A pilot would be intended to 
allow the Commission to, among other things, study the effects of 
relatively unrestricted short selling on trading behavior for a select 
group of stocks. If pilot stocks remained subject to SRO price tests, 
the empirical data would be compromised and the value of the study 
undermined. As a result, Rule 202T, as adopted, prohibits the SROs from 
applying a price test for short sales in securities selected for a 
pilot during the operation of any pilot.
---------------------------------------------------------------------------

    \47\ The NYSE asserted that it should be allowed to maintain a 
tick test for short sales on the NYSE even if the Commission 
determines to eliminate price restrictions on short sales. The 
Specialist Association also argued for maintaining the current tick 
test on exchange-listed securities.
---------------------------------------------------------------------------

B. After-Hours Trading

    We included in the Proposing Release our interpretation that the 
tick test applies to all trades in listed securities, whenever they 
occur, including in the after-hours market and after the consolidated 
transaction reporting system ceases to operate.\48\ A significant 
number of commenters objected to this position, arguing that there is 
limited liquidity after regular trading hours, and that the trades do 
not generate price effects associated with the abusive practices that 
the short sale rule is designed to prevent.\49\ These commenters 
further argued that many short sales that are executed after-hours are 
facilitating trades that are provisionally agreed to during regular 
trading hours, and accordingly provide liquidity to investors.\50\
---------------------------------------------------------------------------

    \48\ Proposing Release, Section XIV.A. After the consolidated 
tape ceases to operate, the tick test rule prevents any person from 
effecting a short sale at a price that is lower than the last sale 
reported to the tape.
    \49\ See, e.g., letters from James Angel; Charles Schwab; Davis 
Polk; Goldman; Citigroup; Merrill Lynch; Morgan Stanley; LEK 
Securities; MFA; SIA; Susquehanna International Group, LLP; Willkie 
Farr.
    \50\ See, e.g., letters from Goldman, Citigroup, Merrill Lynch, 
Morgan Stanley.
---------------------------------------------------------------------------

    Moreover, some commenters asserted that many after-hours trades are 
currently executed overseas due to the operation of Rule 10a-1.\51\ 
Excepting short sales executed after-hours on a pilot basis may result 
in these trades being executed in the United States, thus allowing for 
increased surveillance of these trades and providing increased 
liquidity to potential U.S. buyers.
---------------------------------------------------------------------------

    \51\ See, e.g., letter from SIA.
---------------------------------------------------------------------------

    In response to the comments received, Rule 202T, as adopted, 
establishes a procedure by which we may suspend on a pilot basis the 
tick test of Rule 10a-1(a) and any SRO short sale price test during 
such time periods as the Commission finds necessary or appropriate and 
consistent with the protection of investors. Any such pilot would 
commence by order of the Commission.\52\ The order described above 
establishes a pilot removing any price test for short sales of certain 
securities effected during certain after-hours periods.
---------------------------------------------------------------------------

    \52\ The order that is being issued concurrently with this 
release includes a pilot for short sales occurring after hours. See, 
n. 8, supra.
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V. Rule 203--Locate and Delivery Requirements for Short Sales

A. ``Locate'' Requirement

    We are adopting proposed Rule 203, with some modifications, after 
considering the comments received.\53\

[[Page 48014]]

As adopted, Rule 203(b) creates a uniform Commission rule requiring a 
broker-dealer, prior to effecting a short sale in any equity security, 
to ``locate'' securities available for borrowing. For covered 
securities, Rule 203 supplants current overlapping SRO rules. 
Specifically, the rule prohibits a broker-dealer from accepting a short 
sale order in any equity security from another person, or effecting a 
short sale order for the broker-dealer's own account unless the broker-
dealer has (1) borrowed the security, or entered into an arrangement to 
borrow the security, or (2) has reasonable grounds to believe that the 
security can be borrowed so that it can be delivered on the date 
delivery is due.\54\ The locate must be made and documented prior to 
effecting a short sale, regardless of whether the seller's short 
position may be closed out by purchasing securities the same day.\55\ 
The rule provides for some limited exceptions, including for short 
sales effected in connection with bona-fide market making, as discussed 
in further detail below.
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    \53\ Most commenters welcomed the Commission's proposal as a 
means to address potential manipulation through so called ``naked'' 
short selling, and additionally welcomed replacing the current 
disparate SRO requirements with a uniform Commission rule. See, 
e.g., letters from NYSE; Nasdaq; SIA.
    \54\ Any broker-dealer using the United States jurisdictional 
means to effect short sales in securities traded in the United 
States would be subject to Regulation SHO, regardless of whether the 
broker-dealer is registered with the Commission or relying on an 
exemption from registration. In addition, Commission staff members 
have engaged in discussions with staff of The Investment Dealers 
Association of Canada (``IDA''), who have confirmed that the IDA 
intends to issue an interpretation that failure of IDA members to 
comply with the requirements of Regulation SHO may be considered a 
breach of IDA rules. This would be consistent with an interpretation 
that the IDA recently issued regarding an amendment to NASD Rule 
3370, noting that IDA members would be required to make an 
affirmative determination that the member will receive delivery of 
the security from its customer or that the member can borrow the 
security on behalf of the customer by settlement date. It was stated 
that failure of IDA members to make such an affirmative 
determination may be considered a breach of IDA rules. Investment 
Dealers Association of Canada Member Regulation Notice MR0282 (April 
13, 2004). The NASD amendment had extended the affirmative 
determination requirements to short sale orders that NASD members 
receive from non-member broker-dealers. Securities Exchange Act 
Release No. 48788 (November 14, 2003), 68 FR 65978 (November 24, 
2003); NASD Notice to Members 04-03 (January, 2004); NASD Notice to 
Members 04-21.
    \55\ This is consistent with the current practice under NASD 
Rule 3370. See, e.g., Ko Securities, Inc. and Terrance Y. Yoshikawa, 
Securities Exchange Act Release No. 48550 (September 26, 2003) 
(holding that an affirmative determination, i.e., a ``locate,'' must 
be made before the securities are sold short regardless of whether 
the short seller repurchases securities on the same day).
---------------------------------------------------------------------------

    As proposed, Rule 203(b) would have allowed the ``person for whose 
account the short sale is executed'' to perform a locate.\56\ We agree 
with commenters that the locate requirement should apply to a regulated 
entity--the broker-dealer effecting the sale--and have modified the 
adopted rule accordingly.\57\ Therefore, the rule as adopted makes 
clear that the broker-dealer effecting the short sale has the 
responsibility to perform the locate.\58\
---------------------------------------------------------------------------

    \56\ Several commenters addressed this issue. See, e.g., letters 
from NYSE; SIA.
    \57\ See, e.g., letter from NYSE.
    \58\ A broker-dealer may obtain an assurance from a customer 
that such party can obtain securities from another identified source 
in time to settle the trade. This may provide the ``reasonable 
grounds'' required by Rule 203(b)(1)(ii). However, where a broker-
dealer knows or has reason to know that a customer's prior 
assurances resulted in failures to deliver, assurances from such 
customer would not provide the ``reasonable grounds'' required by 
203(b)(1)(ii). The documentation required by Rule 203(b)(1)(iii) 
should include the source of securities cited by the customer. The 
broker-dealer also should be able to demonstrate that there are 
``reasonable grounds'' to rely on the customer's assurances, e.g., 
through documentation showing that previous borrowings arranged by 
the customer resulted in timely deliveries in settlement of the 
customer's transactions.
---------------------------------------------------------------------------

    We requested comment in the Proposing Release on the manner in 
which persons could satisfy the ``reasonable grounds'' determination in 
the proposed rule. In particular, we asked whether blanket assurances 
that stock is available for borrowing, i.e., ``Easy to Borrow'' or 
``Hard to Borrow'' lists, provide 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 potential problems inherent with large 
extended settlement failures.\59\ After considering the comments 
received, we believe that, absent countervailing factors, ``Easy to 
Borrow'' lists may provide ``reasonable grounds'' for a broker-dealer 
to believe that the security sold short is available for borrowing 
without directly contacting the source of the borrowed securities.\60\ 
In order for it to be reasonable that a broker-dealer rely on such 
lists, the information used to generate the ``Easy to Borrow'' list 
must be less than 24 hours old, and securities on the list must be 
readily available such that it would be unlikely that a failure to 
deliver would occur.\61\ Therefore, absent adequately documented 
mitigating circumstances, repeated failures to deliver in securities 
included on an ``Easy to Borrow'' list would indicate that the broker-
dealer's reliance on such a list did not satisfy the ``reasonable 
grounds'' standard of Rule 203.\62\
---------------------------------------------------------------------------

    \59\ According to the current NASD ``affirmative determination'' 
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 short sales executed in Nasdaq National Market (``NNM'') or 
exchange-listed securities, members also may rely on ``Hard to 
Borrow'' lists identifying 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 that: (i) The information 
used to generate the list, is no more 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 list 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).
    \60\ In its comment letter, the SIA noted that in developing 
``Easy to Borrow'' lists, broker-dealer stock loan desks use 
information from a number of sources, including institutional 
lenders that have sophisticated systems for estimating borrow 
supply. Broker-dealer stock loan desks also consider the 
availability of inventory at their own firms and potential 
availability from other broker-dealers that act as conduit lenders. 
Much of this information is available through electronic feeds and 
is updated frequently. See letter from SIA.
    \61\ A broker-dealer could look to a lender's statement to the 
broker-dealer regarding the amount of securities available to lend 
on an ``Easy to Borrow'' list.
    \62\ Of course, securities that are ``threshold securities'' 
pursuant to Rule 203(c) should generally not be included on ``Easy 
to Borrow'' lists.
---------------------------------------------------------------------------

    Broker-dealers create ``Hard to Borrow'' lists to identify 
securities that are in limited supply. Thus, locates for securities on 
``Hard to Borrow'' lists are likely to be difficult. However, the fact 
that a particular lender placed certain securities on a ``Hard to 
Borrow'' list cannot be taken to mean that the lender represents that 
securities that are not on the ``Hard to Borrow'' list are easy to 
borrow. Commenters viewed ``Hard to Borrow'' lists with 
circumspection,\63\ and we understand that such lists are not widely 
used by broker-dealers. Therefore, the fact that a security is not on a 
hard to borrow list cannot satisfy the ``reasonable grounds'' test of 
Rule 203(b)(1)(ii).
---------------------------------------------------------------------------

    \63\ See, e.g., letter from NYSE. In particular, the NYSE stated 
that, ``We believe that the use of `easy to borrow' lists, together 
with an industry-wide list of securities where there is evidence of 
significant settlement failures (i.e., those for which there are 
fails to deliver at a clearing agency 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) prepared daily by the National Securities 
Clearing Corporation (`NSCC') as proposed, would be a more 
appropriate means of determining whether a security sold short could 
be borrowed. Consequently, the Exchange believes that broker-dealers 
should be required to make an affirmative determination for those 
securities that are not on the `easy to borrow' list.''

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[[Page 48015]]

1. Exceptions From the Locate Requirement
a. Broker-Dealer Accepting Short Sale Order From Another Broker-
Dealer--Rule 203(b)(2)(i)
    Rule 203(b)(2)(i) provides a new exception from the uniform locate 
requirement of Rule 203(b)(1) for a registered broker or dealer that 
receives a short sale order from another registered broker or dealer 
that is required to comply with 203(b)(1). For example, where an 
introducing broker-dealer submits a short sale order for execution, 
either on a principal or agency basis, to another broker-dealer,\64\ 
the introducing broker-dealer has the responsibility of complying with 
the locate requirement. The broker-dealer that received the order from 
the introducing broker-dealer would not be required to perform the 
locate. However, a broker or dealer would be required to perform a 
locate where it contractually undertook to do so or the short sale 
order came from a person that is not a registered broker-dealer.\65\
---------------------------------------------------------------------------

    \64\ This could include an electronic communications network 
(ECN).
    \65\ Of course, an executing broker-dealer who executes a short 
sale pursuant to an order from an introducing broker as part of a 
scheme to manipulate the security, or where, for example, it knows 
that the introducing broker did not perform the locate, could be 
liable under the securities laws, for, among other violations, 
committing or aiding and abetting a violation of Rule 203(b)(1). 
See, e.g., Sections 15(b)(4)(e) and 20(e) of the Exchange Act. 15 
U.S.C. 78t.
---------------------------------------------------------------------------

b. Bona-Fide Market Making
    We are adopting the proposed exception from the uniform ``locate'' 
requirement, as Rule 203(b)(2)(iii), for short sales executed by market 
makers, as defined in Section 3(a)(38) of the Exchange Act,\66\ 
including specialists and options market makers, but only in connection 
with bona-fide market making activities.\67\ Bona-fide market making 
does not include activity that is related to speculative selling 
strategies or investment purposes of the broker-dealer and is 
disproportionate to the usual market making patterns or practices of 
the broker-dealer in that security. In addition, where a market maker 
posts continually at or near the best offer, but does not also post at 
or near the best bid, the market maker's activities would not generally 
qualify as bona-fide market making for purposes of the exception.\68\ 
Further, bona-fide market making does not include transactions whereby 
a market maker enters into an arrangement with another broker-dealer or 
customer in an attempt to use the market maker's exception for the 
purpose of avoiding compliance with Rule 203(b)(1) by the other broker-
dealer or customer.\69\
---------------------------------------------------------------------------

    \66\ Section 3(a)(38) states: ``The term `market maker' means 
any specialist permitted to act as a dealer, any dealer acting in 
the capacity of a block positioner, and any dealer who, with respect 
to a security, holds himself out (by entering quotations in an 
inter-dealer quotation system or otherwise) as being willing to buy 
and sell such security for his own account on a regular or 
continuous basis.'' 15 U.S.C. 78c(a)(38).
    \67\ As noted in the Proposing Release, we believe that a narrow 
exception for market makers 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 ``locate'' requirement.
    \68\ Moreover, a market maker that continually executed short 
sales away from its posted quotes would generally be unable to rely 
on the bona-fide market making exception.
    \69\ See also NASD IM-3350(c)(2) (``A market maker would be 
deemed in violation of the Rule if it entered into an arrangement 
with a member or a customer whereby it used its exemption from the 
rule to sell short at the bid at successively lower prices, 
accumulating a short position, and subsequently offsetting those 
sales through a transaction at a prearranged price, for the purpose 
of avoiding compliance with the Rule, and with the understanding 
that the market maker would be guaranteed by the member or customer 
against losses on the trades.''). Although the IM-3350 
interpretation applies expressly to the bid test in NASD Rule 3350, 
the NASD previously found that the standards set forth are equally 
applicable to the market maker exemption in NASD Rule 3370. See NASD 
Hearing Panel Decision as to Respondents John Fiero and Fiero 
Brothers, Inc. (December 6, 2000); See also Section 20(b) of the 
Exchange Act, 15 U.S.C. 78t.
---------------------------------------------------------------------------

c. Additional Exception From the Locate Requirement--Rule 203(b)(2)(ii)
    Pursuant to the suggestions of other commenters, we are including 
an additional exception from the uniform locate requirement of Rule 
203(b)(1) for situations where a broker-dealer effects a sale on behalf 
of a customer that is deemed to own the security pursuant to Rule 200, 
although, through no fault of the customer or the broker-dealer, it is 
not reasonably expected that the security will be in the physical 
possession or control of the broker-dealer by settlement date, and is 
thus a ``short'' sale under the marking requirements of Rule 200(g) as 
adopted.\70\ Such circumstances could include the situation where a 
convertible security, option, or warrant has been tendered for 
conversion or exchange, but the underlying security is not reasonably 
expected to be received by settlement date.\71\ Rule 203(b)(2)(ii) as 
adopted provides that in all situations, delivery should be made on the 
sale as soon as all restrictions on delivery have been removed, and in 
any event no later than 35 days after trade date, at which time the 
broker-dealer that sold on behalf of the person must either borrow 
securities or close out the open position by purchasing securities of 
like kind and quantity.\72\
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    \70\ Pursuant to Rule 200(g), a broker or dealer shall mark an 
order to sell a security ``long'' only if the seller is deemed to 
own the security being sold pursuant to 17 CFR 242.200 and either: 
(i) The security to be delivered is in the physical possession or 
control of the broker or dealer; or (ii) it is reasonably expected 
that the security will be in the physical possession or control of 
the broker or dealer no later than the settlement of the 
transaction. See, supra Part III.B. for a further discussion of the 
order marking requirements.
    \71\ Another situation could be where a customer owns stock that 
was formerly restricted, but pursuant to Rule 144 under the 
Securities Act of 1933, the securities may be sold without 
restriction. In connection with a sale of such security, the 
security may not be capable of being delivered on settlement date, 
due to processing to remove the restricted legend. See, e.g., letter 
from Feldman Weinstein, LLP (``Feldman'').
    \72\ We believe that 35 days is a reasonable outer limit to 
allow for restrictions on a security to be removed if ownership is 
certain. We note that Section 220.8(b)(2) of Regulation T of the 
Federal Reserve Board allows 35 days to pay for securities delivered 
against payment if the delivery delay is due to the mechanics of the 
transaction. 12 CFR 220.8(b)(2).
---------------------------------------------------------------------------

    Two commenters advocated maintaining the current exception from the 
``affirmative determination'' requirements of NASD Rule 3370 for short 
sales that result in fully hedged or arbitraged positions.\73\ One 
comment letter requested an exception from the proposed locate and 
delivery requirements of Rule 203 in a situation where a market 
participant has a long position in warrants or rights which are 
exercisable within 90 days and are subject to a fixed price per share 
conversion ratio.\74\ The other comment letter requested an exception 
from the proposed locate and delivery requirements in the situation 
where a market participant is long in-the-money call options.\75\ The 
commenter argued

[[Page 48016]]

that excepting short sales in such situations promotes the ability of 
smaller issuers to acquire financing.
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    \73\ See NASD Rule 3370(b)(2)(B), which states in pertinent part 
that, ``[n]o member shall effect a `short' sale for its own account 
in any security unless the member or person associated with a member 
makes an affirmative determination that the member can borrow the 
securities or otherwise provide for delivery of the securities by 
settlement date. This requirement will not apply to * * * 
transactions that result in fully hedged or arbitraged positions.'' 
Rule 3370(b) provides guidelines in determining the availability of 
the exception.
    \74\ See first and fourth letters from Saul Ewing, LLP., on 
behalf of Greenwood Partners. The commenter noted the situation 
where a market participant views the issuer's warrants as being 
overly rich in comparison to the pricing of the warrants, and will 
thus sell the underlying stock short and purchase the warrants. It 
also stated that, because the stock borrow programs for many smaller 
issuers are virtually non-existent, the market participant engaging 
in this activity may be required to sell short naked. In order to 
guard against potential ``death spiral'' activity, it was requested 
that the exception be limited to warrants with a fixed price per 
share conversion ratio.
    \75\ See third letter from Saul Ewing, LLP. Specifically, the 
commenter, writing on behalf of an unnamed private equity fund, 
argued that the fund provides financing to smaller issuers, with a 
typical transaction generally involving a private placement of 
restricted stock in a company at a fixed price in exchange for an 
agreement to provide cash for such shares upon the closing of the 
transaction. In order to hedge the risk of market price changes in 
the restricted shares, the fund would buy over-the-counter put 
options from a counterparty. It was argued, however, that the 
counterparty would want to hedge its risk by purchasing an in-the-
money call option, and shorting the underlying stock. It was 
similarly argued that due to the dearth of borrowable shares in some 
smaller issuers, the sales could be naked short sales.
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    We have decided not to incorporate an exception from the locate and 
delivery requirements of Rule 203 for short sales that result in bona-
fide fully hedged or arbitraged positions. Because ``bona-fide'' 
hedging and arbitrage can be difficult to ascertain, we are concerned 
about including a blanket exception for some activity that may have the 
potential to harm issuers and shareholders.\76\ During the period of 
the pilot, we prefer instead to address the situations noted by the 
commenters, and other similarly situated entities, through the 
exemptive process, to the extent warranted.\77\ This will allow us to 
consider the particular facts and circumstances relevant to each 
request, as well as any potentially negative ramifications, and, should 
we gain comfort with the described transaction(s), fashion appropriate 
relief.
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    \76\ In a recent matter, the Commission accepted offers of 
settlement from Rhino Advisors and Thomas Badian, Rhino's president, 
in connection with trading in the common stock of Sedona Corporation 
by Rhino on behalf of certain foreign entities. The Commission 
alleged that Rhino and Badian, acting in their capacities as 
investment advisors, manipulated Sedona's stock price downward by 
engaging in naked short selling of Sedona's stock in accounts 
maintained in the names of others. In the complaint filed in the 
action, the Commission alleged that Rhino manipulated Sedona's stock 
price to enhance an offshore entity's economic interests in a $3 
million convertible debenture issued by Sedona and that, by 
depressing Sedona's stock price, Rhino increased the number of 
shares that the offshore entity received when it exercised its 
conversion rights under the debenture. See Rhino Advisors, Inc. and 
Thomas Badian, Litigation Release No. 18003 (February 27, 2003); see 
also SEC v. Rhino Advisors, Inc. and Thomas Badian, Civ. Action No. 
03 Civ 1310 (SDNY March 5, 2003).
    \77\ See Section 203(d) of Regulation SHO, 17 CFR 242.203(d), 
and Section 36 of the Exchange Act. 15 U.S.C. 78mm.
---------------------------------------------------------------------------

    Additionally, we have declined at this time to include an express 
exception from the locate requirements of Rule 203(b)(1) for 
transactions in exchange traded funds (``ETFs'').\78\ We have observed 
high levels of fails in some ETFs. Rather than providing a blanket 
exception from the requirements of Rule 203, we would prefer instead to 
address the treatment of ETFs through the exemptive process, which 
would be consistent with the prior treatment of ETFs.\79\ In 
considering any exemptive request, the Commission would evaluate the 
causes of large fails in certain ETFs, as well as potential remedies to 
resolve such fails, if necessary.
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    \78\ Two commenters requested an exception to the locate and 
delivery requirements for ETFs. The commenters maintain that ETFs 
should not be subject to the requirements of Rule 203 because ETFs 
have the ability to continuously create and redeem shares. See 
letters from Amex; Nasdaq.
    \79\ Prior exemptions from Rule 10a-1 have been granted for 
transactions in certain ETFs. 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).
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B. Short Sales in Threshold Securities--Rule 203(b)(3)

1. Threshold Securities
    The Commission has decided to adopt, with certain modifications 
from what was proposed, additional requirements targeted at stocks that 
have a substantial amount of failures to deliver. As adopted, Rule 
203(b)(3) requires any participant of a registered clearing agency 
(``participant'') \80\ to take action on all failures to deliver that 
exist in such securities ten days after the normal settlement date, 
i.e., 13 consecutive settlement days.\81\ Specifically, the participant 
is required to close out the fail to deliver position by purchasing 
securities of like kind and quantity.
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    \80\ ``Participant'' is defined in Section 3(a)(24) of the 
Exchange Act. 15 U.S.C. 78c(a)(24). A ``registered clearing agency'' 
is a clearing agency, as defined in Section 3(a)(23)(A) of the 
Exchange Act, (15 U.S.C. 78c(a)(23)(A)), that is registered with the 
Commission pursuant to Section 17A of the Exchange Act, 15 U.S.C. 
78q-1.
    \81\ Rule 203(c)(5) defines ``settlement day'' to mean any 
business day on which deliveries of securities and payments of money 
may be made through the facilities of a registered clearing agency.
---------------------------------------------------------------------------

    With slight modification from the proposal, a ``threshold 
security'' is defined in Rule 203(c)(6) as any equity security of an 
issuer that is registered under Section 12, or that is required to file 
reports pursuant to Section 15(d) of the Exchange Act \82\ where, for 
five consecutive settlement days: there are aggregate fails to deliver 
at a registered clearing agency of 10,000 shares or more per security; 
that the level of fails is equal to at least one-half of one percent of 
the issuer's total shares outstanding; and the security is included on 
a list published by an SRO.\83\ We believe this threshold characterizes 
situations where the ratio of unfulfilled delivery obligations at the 
clearing agency at which trades are settled represents a significant 
number of shares relative to the company's total shares outstanding. We 
believe that such circumstances warrant action designed to address 
potential negative effects.\84\ This narrowly targeted threshold will 
not burden the vast majority of securities where there are not similar 
concerns regarding settlement.\85\ Our OEA analyzed recent data from 
NSCC on fails to deliver and calculated that approximately 3.9% of all 
exchange-listed and Nasdaq securities, and 4.0%

[[Page 48017]]

of all securities, would meet this threshold.\86\
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    \82\ As proposed, the restrictions of Rule 203 would have 
covered equity securities registered under Section 12 of the 
Exchange Act. We are also extending the delivery restrictions to 
equity securities of issuers subject to Exchange Act reporting 
pursuant to Section 15(d). This would thus mandate coverage of those 
companies that are required to provide ongoing public disclosure 
about the company, its actions, and its performance. As the 
calculation of the threshold that would trigger the delivery 
requirements of Rule 203 depends on identifying the aggregate fails 
to deliver as a percentage of the issuer's total shares outstanding, 
it is necessary to limit the requirement to companies that are 
subject to the reporting requirements of the Exchange Act.
    \83\ 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 exceed the specified level of fails. 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 exceed the specified level 
of fails.
    \84\ We are incorporating the same threshold that is currently 
used in NASD Rule 11830. Because of this, it is our belief that 
implementation will not impose excessive programming costs on the 
industry, although we note that some programming modifications will 
be necessary to extend the current calculation beyond the current 
universe of Nasdaq securities.
    \85\ As noted by some commenters, there may be many different 
causes of fails to deliver that could be unrelated to a market 
participant engaging in naked short selling. Thus, imposing a lower 
threshold or, as suggested by some commenters, prohibiting all 
fails, might be impracticable or an overly-broad method of 
addressing any potential abuses, and could also disrupt the 
efficient functioning of the Continuous Net Settlement system 
(``CNS'') operated by the National Securities Clearing Corporation 
(``NSCC''). For example, one commenter noted that some fails are 
caused by custodian banks failing to deliver on behalf of their 
customers for a number of reasons, such as where a foreign domiciled 
customer engages in arbitrage involving American Depositary Receipts 
(``ADRs'') and operates under the international arbitrage exemption 
provided in Rule 10a-1(e)(8). See letter from LEK Securities.
    Additionally, some commenters addressed NSCC's securities 
lending program. See, e.g., letter from NASAA at 3. In responding to 
comments on the stock borrow program, NSCC noted that the program 
can reduce fails and give purchasers an increased chance of 
receiving those securities on settlement date. See letter from NSCC 
at 6-7. The Commission notes that NSCC's stock borrow program, as 
approved by the Commission, permits NSCC to borrow securities for 
the purpose of completing settlements only if participants have made 
those securities available to NSCC for this purpose and those 
securities are on deposit in the participant's account at The 
Depository Trust Company (``DTC''). See Securities Exchange Act 
Release No. 17422 (December 29, 1980), 46 FR 3104 (January 13, 
1981).
    \86\ Some stocks that are quoted in the Pink Sheets are not 
reporting issuers, and thus there is not a readily available means 
to determine the total shares outstanding in such securities. If, 
however, we incorporate non-reporting issuers that have aggregate 
fails in excess of 10,000 shares, only an additional 1% of all 
securities would be added. These securities will not be subject to 
the additional requirements imposed upon threshold securities, 
although broker-dealers effecting short sales in these securities 
are subject to the locate requirements of Rule 203(b)(1).
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    In order to be deemed a threshold security, and thus subject to the 
restrictions of Rule 203(b)(3), a security must exceed the specified 
fail level for a period of five consecutive settlement days. Similarly, 
in order to be removed from the list of threshold securities, a 
security must not exceed the specified level of fails for a period of 
five consecutive settlement days.\87\ This five-day requirement will 
address the potential situation where a security exceeds the fails 
level on one day, based on an aberrant fail to deliver that may not be 
indicative of the usual pattern of that particular security, and thus 
would prevent potential ``flickering'' of securities in and out of the 
list of threshold securities.\88\ Rule 203(b)(3) is intended to address 
potential abuses that may occur with large, extended fails to 
deliver.\89\ We believe that the five-day requirement will facilitate 
the identification of securities with extended fails.
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    \87\ For example, an issuer that had 10,000,000 shares 
outstanding and an aggregate fail to deliver position greater than 
50,000 shares for at least five consecutive settlement days, would 
be a threshold security, and would no longer be a threshold security 
after the aggregate fail to deliver position was less than 50,000 
shares for at least five consecutive settlement days.
    \88\ For example, we note the situation involving ADR arbitrage 
as described in n. 85, supra.
    \89\ A person that sells a security and fails to deliver, with 
the intent of triggering the close-out requirement of Rule 203(b)(3) 
and creating a short squeeze that could benefit a person's long 
position, could be deemed to be engaging in manipulative behavior.
---------------------------------------------------------------------------

    As is currently the practice for Nasdaq securities that exceed the 
threshold designated in NASD Rule 11830, the pertinent SRO will be 
responsible for publishing a daily list of the threshold securities 
that are listed on their markets, or for which the SRO bears the 
primary surveillance responsibility.\90\ The SROs derive the 
information necessary to calculate the list of threshold securities 
from data on fails to deliver currently received from NSCC.\91\
---------------------------------------------------------------------------

    \90\ It is expected that the NYSE will calculate and disseminate 
a list of NYSE-listed securities that exceed the specified fails 
level for at least five consecutive settlement days. Amex will 
calculate and disseminate a list of Amex-listed securities that 
exceed the specified fails level for at least five consecutive 
settlement days, in addition, the NASD will calculate and 
disseminate a list of all over-the-counter securities, including 
Nasdaq, OTCBB, and Pink Sheet securities that exceed the specified 
fails level for at least five consecutive settlement days. It is 
expected that the lists of threshold securities will be disseminated 
prior to the commencement of each trading day.
    \91\ As NSCC noted in its comment letter, it is providing the 
Commission, the NYSE, the NASD, and Amex with a daily report listing 
information on all participant short obligations for all equity 
securities with aggregate clearing short positions greater than 
10,000 shares. The SROs will calculate whether the aggregate fails 
at NSCC exceed 0.5% of the issuer's total shares outstanding.
---------------------------------------------------------------------------

2. Close-out Requirement
    As proposed, the rule would have specified 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. 
If for any reason such security were not delivered within two days 
after the settlement date, the rule would have restricted the broker-
dealer, including market makers, from executing additional short sales 
for the next 90 days 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. In addition, the rule would have required the 
registered clearing agency that processed the transaction to refer the 
party failing to deliver to the NASD and the designated examining 
authority for such broker-dealer for appropriate action; and to 
withhold a benefit of any mark-to-market amounts or payments that 
otherwise would be made to the party failing to deliver.
    Some commenters argued that under the confines of current 
settlement practices and procedures, it is not practical to assign 
delivery failures to a particular clearing firm customer account. It 
was noted that because NSCC's continuous net settlement (``CNS'') 
system nets all buys and sells in each security for each NSCC 
participant, broker-dealers cannot determine which customer's 
transaction or account gave rise to a failure to deliver.\92\ We note 
that while this may be the current situation in the industry, if the 
Commission believes that the rules as adopted are not having the 
intended effects of reducing potentially manipulative behavior, we may 
consider additional rulemaking that could require broker-dealers to 
identify individual accounts that are causing fails to deliver.
---------------------------------------------------------------------------

    \92\ See, e.g., letter from SIA. The SIA, as well as several 
other commenters, stated the belief that buy-ins were more practical 
since it is possible to allocate the costs of a buy-in among 
multiple short sellers, whereas application of the proposed account 
trading restriction is not feasible. Other commenters stated that 
the fear of a mandatory buy-in and threat of a market loss would be 
a greater deterrent than the proposed restriction and withholding of 
the mark. See, e.g., letter from H. Glenn Bagwell, Jr.
---------------------------------------------------------------------------

    We have considered the comments received, and have adopted a rule 
that differs in the mechanics from the proposed rule, but continues to 
preserve the goal of limiting failures to deliver in threshold 
securities. As adopted, Rule 203(b)(3) requires action if a fail in a 
threshold security remains open ten days after the settlement date, 
i.e., for thirteen consecutive settlement days.\93\ Specifically, Rule 
203(b)(3) requires a participant of a clearing agency registered with 
the Commission \94\ to take action to close out the fail to deliver 
that has remained for thirteen consecutive settlement days by 
purchasing securities of like kind and quantity.\95\ In addition, Rule

[[Page 48018]]

203(b)(3)(iii) states that the participant, and any broker-dealer for 
which it clears transactions, including any market maker that would 
otherwise be entitled to rely on the bona-fide market making exception, 
is prohibited from effecting further short sales in the particular 
threshold security without borrowing, or entering into a bona-fide 
arrangement to borrow, the security until the fail to deliver position 
is closed out. To the extent that the participant can identify the 
broker-dealer(s) or account(s) that have contributed to the fail to 
deliver position, the requirement to borrow or arrange to borrow prior 
to effecting further short sales should apply to only those particular 
broker-dealer(s) or account(s). Rule 203(b)(3)(v) states that where a 
participant enters into an arrangement with a counterparty to purchase 
securities as required by Rule 203(b)(3), and the broker or dealer 
knows or has reason to know that the counterparty will not deliver the 
securities, the broker or dealer will not have fulfilled the 
requirements of the rule.\96\
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    \93\ We note that some commenters believed that imposing the 
delivery requirements two days after settlement, i.e., after five 
settlement days, would capture many instances of ordinary course 
settlement delays, rather than address potentially abusive activity. 
See, e.g., letters from CBOE; SIA; Willkie Farr. OEA took a snapshot 
of fails data received from NSCC from April 19 through April 30, 
2004, which confirmed a rate of decline over a course of settlement 
days. Similar rates of decline were found using data obtained from 
NSCC for other periods during the past six months. In addition, 
because Rule 203(b)(3) would require a participant to close out all 
fails to deliver in threshold securities, whether resulting from 
short sales or long sales, extending the time period to ten days 
after settlement would make the close-out requirement consistent 
with 17 CFR 240.15c-3-3(m). Ten days after settlement is also the 
timeframe currently identified in NASD Rule 11830.
    \94\ A participant of a registered clearing agency includes 
registered broker-dealers, and entities that may not be registered 
broker-dealers, but are responsible for the settlement of 
transactions at a registered clearing agency, such as the Canadian 
Depository for Securities (``CDS'').
    \95\ The following examples illustrate potential scenarios 
involving threshold security XYZ: (i) If a participant has a 100 
share fail to deliver position in XYZ for 13 consecutive settlement 
days, the participant is required to purchase 100 shares; (ii) If a 
participant has a 100 share fail to deliver position in XYZ, and the 
fail to deliver position increases by 100 shares each day for 13 
consecutive settlement days, yielding a 1300 share fail to deliver 
position, then the participant is required to purchase 100 shares at 
the end of the 13th day, 100 shares the next day, etc., until the 
entire fail to deliver position is closed out; (iii) If a 
participant has a 100 share fail to deliver position in XYZ, which 
is then reduced to a 50 share fail to deliver position during the 
following 13 consecutive settlement days, then the participant is 
required to close out 50 shares; or (iv) If a participant has a 100 
share fail to deliver position in XYZ, which is netted to zero five 
settlement days later, and then a new 100 share position is 
established the following day, the participant would not be required 
to close out the initial 100 shares, but would be required to close 
out the subsequent 100 share fail to deliver position if it remained 
for 13 consecutive settlement days.
    \96\ This includes the situation where a broker-dealer that was 
required to close out a fail to deliver in a security exceeding the 
threshold entered into an arrangement to buy from a counterparty, 
and thus net out the broker-dealer's position at CNS, but the 
broker-dealer knew or had reason to know that the counterparty did 
not intend to deliver the security, which thus created another fail 
in the CNS system.
---------------------------------------------------------------------------

    The requirement to close out fail to deliver positions in threshold 
securities that remain for thirteen consecutive settlement days does 
not apply to any positions that were established prior to the security 
becoming a threshold security.\97\ However, if a participant's fail to 
deliver position is subsequently reduced below the pre-existing 
position, then the fail to deliver position excepted by this 
subparagraph shall be the lesser amount.\98\ Rule 203(b)(3)(iv) also 
provides that a participant may reasonably allocate its responsibility 
to close out open fail positions in threshold securities to another 
broker-dealer for which the participant is responsible for settlement. 
Thus, participants that are able to identify the accounts of broker-
dealers for which they clear may allocate the responsibility to close 
out open fail to deliver positions to the particular account(s) whose 
trading activities have caused the fail to deliver position. Absent 
such identification, however, the participant would remain subject to 
the close out requirement.
---------------------------------------------------------------------------

    \97\ Rule 203(b)(3)(i). This is consistent with the current 
operation of NASD Rule 11830.
    \98\ For example, if a participant had a 100 share fail to 
deliver position in XYZ security prior to XYZ becoming a threshold 
security, and if XYZ subsequently became a threshold security, the 
participant would not be required to close out the 100 share fail, 
even if it remained for 13 consecutive settlement days. Therefore, 
if after becoming a threshold security the fail to deliver position 
in XYZ increased to 200 shares, and remained for 13 consecutive 
settlement days, the participant would be required to close out 100 
shares. If, after becoming a threshold security, the participant's 
total fail to deliver position in XYZ fell to 50 shares, and then 
rose to 150 shares and remained for 13 consecutive settlement days, 
the participant would be required to close out 100 shares, rather 
than only 50 shares.
---------------------------------------------------------------------------

3. Other Proposed Requirements
    We are not adopting the additional requirements of proposed Rule 
203(b)(3)(ii), which would have required a registered clearing agency 
that processed the transaction to refer the party failing to deliver to 
the NASD and the designated examining authority for such broker-dealer 
for appropriate action; and withhold a benefit of any mark-to-market 
amounts or payments that otherwise would be made to the party failing 
to deliver. Since the Proposing Release was issued, Commission staff 
and the SROs have developed new procedures to identify and inquire 
regarding failures to deliver that achieve the goals of the proposed 
notification requirement. This includes the daily dissemination by NSCC 
to the Commission and the SROs of a report listing information on all 
participant short obligations for all equity securities with aggregate 
clearing short positions greater than 10,000 shares, which is being 
used by the SROs to initiate inquiries with members concerning the 
cause of the fails and whether there was compliance with regulatory 
requirements.
    In addition, NSCC and other commenters noted that, due to the 
manner in which the CNS system currently calculates each participant 
net position in a security, it is not possible to distinguish between 
obligations to deliver that are the result of short sales as opposed to 
long sales.\99\ As such, it is not possible to determine whether a mark 
paid to a participant is a ``benefit'' received in connection with a 
fail to deliver position resulting from a short sale.
---------------------------------------------------------------------------

    \99\ See letter from NSCC at p. 5 for further discussion 
regarding the operation of the CNS system.
---------------------------------------------------------------------------

    We are not adopting at this time the proposal that would require 
NSCC to withhold mark-to-market amounts paid to individuals. However, 
the Commission intends to pay close attention to the operation and 
efficacy of the provisions we are adopting in Rule 203, and will 
consider whether any further action is warranted.
4. Market Makers
    We received a number of comments from market makers, including 
options market makers, on the proposal not to provide an exception for 
market makers from the special delivery requirements applicable to 
securities that meet the designated threshold.\100\ Some of these 
commenters stated that the effect of not including such an exception 
would be to cease altogether options trading in securities that are 
difficult to borrow, as it was argued that no options market maker 
would make markets without the ability to hedge by selling short the 
underlying security.\101\ In addition, another commenter stated that 
the heightened delivery requirements for threshold securities could 
drain liquidity in other securities where there is no current 
indication of significant settlement failures.\102\ The commenter 
believed that, while a blanket exception from the heightened delivery 
requirements would be preferable, at a minimum the implementation of 
any such provision should not apply to market maker positions acquired 
prior to the effective date of the rule, and likewise should not apply 
to any short position acquired prior to the time that the subject 
security meets the designated threshold.
---------------------------------------------------------------------------

    \100\ See, e.g., letters from Knight; Susquehanna; Pacific 
Exchange (``PCX''); Amex; and joint letter from Amex, CBOE, 
International Securities Exchange (``ISE''); The Options Clearing 
Corporation (``OCC''), PCX, Philadelphia Stock Exchange (``PHLX'') 
(``Joint Options Letter'').
    \101\ See Joint Options Letter.
    \102\ See letter from Susquehanna. In particular, this commenter 
believed that market makers would need to assess for each assigned 
security the probability that it would become a threshold security 
at some point in the future, and in circumstances in which this is 
thought to be a realistic possibility, the market maker would need 
to decide whether to incorporate the added risks into pricing or 
relinquish market maker status in the particular security.
---------------------------------------------------------------------------

    We note that the close out requirements of Rule 203(b)(3) will only 
apply to fail to deliver positions in threshold securities, and will 
not apply to any fail to deliver positions established prior to the 
security meeting the threshold.\103\ As such, we believe that this 
addresses in part the commenters' concerns that market makers would 
need to assess the probability of a security meeting the threshold at 
some point in the future. Moreover, we expect that a small percentage 
of securities for which there are associated options will exceed the 
threshold.\104\ In light of this, we believe that the effects of not 
including a market

[[Page 48019]]

maker exception from the heightened delivery requirement will not be as 
severe as some of the commenters have described. Moreover, while some 
of these commenters have opined that options market makers are not 
responsible for significant failures to deliver,\105\ other commenters 
and academics have questioned this assertion.\106\
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    \103\ See Rule 203(b)(3)(i).
    \104\ OEA has estimated that approximately 4.1% of all 
securities that have options traded on them would meet the 
threshold.
    \105\ See Joint Options Letter.
    \106\ See letter from SIA (which noted in pertinent part, 
``[t]he SEC and SROs may also want to consider whether to utilize 
their existing authority to determine to what extent non-bona-fide 
market making trading activities by market makers does or does not 
contribute to extended fails.''); see also Evans, Geczy, Musto & 
Reed, Failure Is an Option: Impediments to Short Selling and Options 
Prices, Working Paper, The Wharton School at the University of 
Pennsylvania and the University of North Carolina (March 1, 2003) 
(finding that the options market maker exemption from the 
requirement to locate stock to borrow on short sales may create 
significant profits for the market makers).
---------------------------------------------------------------------------

    Therefore, while market makers (including options market makers) 
engaged in bona-fide market making will continue to be excepted from 
the locate requirement of Rule 203(b)(1), even when effecting short 
sales in threshold securities, we have decided at this time not to 
extend an exception to market makers from the requirements to close out 
fails to deliver in such securities that remain for thirteen 
consecutive settlement days. Moreover, as discussed previously, Rule 
203(b)(3)(iii) provides that until the market maker, or the participant 
that clears for the market maker, takes action to close out any such 
fails to deliver that remain ten days after the normal settlement date, 
the market maker shall be unable to rely on the exception in Rule 
203(b)(2)(iii) from the requirement to ``borrow or arrange to borrow'' 
for further short sales in such security.
    We have, however, included a limited exception from the close out 
requirement to allow registered options market makers to sell short 
threshold securities in order to hedge options positions, or to adjust 
such hedges, if the options positions were created prior to the time 
that the underlying security became a threshold security. Any fails to 
deliver from short sales that are not effected to hedge pre-existing 
options positions, and that remain for thirteen consecutive settlement 
days, are subject to the mandatory close out requirement. We will, 
however, take into consideration information that shows that this 
provision operates significantly differently from our expectations.

VI. Rule 203(a)--Long Sales

    We are adopting subparagraph (a) of Rule 203, which covers delivery 
requirements applicable to long sales of securities, largely as 
proposed. Rule 203(a) incorporates current Rule 10a-2.
    As proposed, Rule 203(a) would have provided that if a broker-
dealer knows or should know that a sale was marked long, the broker-
dealer must make delivery when due and cannot use borrowed securities 
to do so. The proposed rule would have provided that the delivery 
requirements would not apply in three situations: to the loan of a 
security through the medium of a loan to another broker or dealer; 
where the broker or dealer knows or has been reasonably informed by the 
seller that the seller owns the security and will deliver it to the 
broker or dealer prior to the scheduled settlement of the transaction; 
or where an exchange or securities association finds, prior to the loan 
or fail, 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. The proposed requirements would have extended to all 
securities, not just to those registered on an exchange.
    Three commenters supported the proposed changes, believing that 
they would ensure greater consistency across markets and 
securities.\107\ One commenter requested that the rule except long 
sales that fail, through no fault of the seller, because of processing 
delays.\108\ In addition, two commenters suggested that the proposed 
Rule did not adequately address long sale delivery fails.\109\
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    \107\ See letters from H. Glenn Bagwell, Jr.; Feldman; LEK 
Securities.
    \108\ See letter from Feldman. We have addressed this situation 
by providing an exception in Rule 203(b)(2)(ii) for situations where 
a broker effects a sale on behalf of a customer that is deemed to 
own the security pursuant to Rule 200, although, through no fault of 
the customer or the broker-dealer, it is not reasonably expected 
that the security will be in the physical possession or control of 
the broker-dealer by settlement date, and is thus a ``short'' sale 
under the marking requirements of Rule 200(g) as adopted.
    \109\ See Letter Type A; SIA. The Commission disagrees with 
these comments. We believe that the provisions of Rule 203(a) are 
appropriate to guard against fails to deliver on long sales, in that 
a broker may fail to deliver borrowed shares on long sale fails only 
in the limited circumstances set forth in the rule. In addition, 
Rule 203(b)(3) requires a participant to close out all fails to 
deliver that remain in threshold securities for 13 consecutive 
settlement days. 17 CFR 240.15c-3-3(m) also addresses fails to 
deliver on long sales.
---------------------------------------------------------------------------

    After considering comments received, we are adopting the changes 
proposed, with one modification. Pursuant to proposed Rule 203(a), one 
of the circumstances in which a fail or delivery of borrowed shares 
would have been permitted was where, prior to the sale, the broker or 
dealer knew that the seller owned the securities and the seller had 
represented that he or she would deliver them to the broker in time for 
settlement. Although we believe it was implicit in the proposed rule 
text (and in current Rule 10a-2), we are including in the rule text the 
predicate that the seller fails to make such delivery after advising 
the broker-dealer that he or she would deliver the securities in time 
for settlement.\110\
---------------------------------------------------------------------------

    \110\ See Rule 203(a)(2)(ii).
---------------------------------------------------------------------------

    As adopted, Rule 203(a) requires that if a broker-dealer knows or 
should know that a sale of an equity security is marked long, the 
broker-dealer must make delivery when due and cannot use borrowed 
securities to do so. This delivery obligation does not apply in three 
circumstances: (1) The loan of a security through the medium of a loan 
to another broker or dealer; (2) where the broker or dealer knows or 
has been reasonably informed by the seller that the seller owns the 
security and will deliver it to the broker or dealer prior to the 
scheduled settlement of the transaction and the seller fails to make 
such delivery;\111\ or (3) where an exchange or securities association 
finds, prior to the loan or arrangement to loan any security for 
delivery, or failure to deliver, 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.\112\
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    \111\ It may be unreasonable for a broker-dealer to treat a sale 
as long where orders marked ``long'' from the same customer 
repeatedly require borrowed shares for delivery or result in ``fails 
to deliver.'' A broker-dealer also may not treat a sale as long if 
the broker-dealer knows or has reason to know that the customer 
borrowed the shares being sold.
    \112\ As with other provisions of Regulation SHO, this provision 
requires good faith conduct by the broker-dealer. Therefore, where 
the broker-dealer did not in good faith believe that the customer 
would deliver the securities in time for settlement, the broker-
dealer cannot borrow or lend securities to deliver when the customer 
fails.
---------------------------------------------------------------------------

    The new rule is consistent with the Commission's view that delivery 
requirements are important for all securities, particularly those with 
a lower market capitalization that may be more susceptible to abuse. 
Moreover, Rule 203(a) provides that on a long sale, a broker-dealer 
cannot fail or loan shares unless, in advance of the sale, it 
ascertained that the customer owned the shares, and had been reasonably 
informed that the seller would deliver the security prior to settlement 
of the transaction. This requirement is consistent with changes being 
made to the order marking requirements, which require that for an order 
to be marked

[[Page 48020]]

long, the seller must own the security.\113\
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    \113\ See, supra part III.B. for a discussion of the order 
marking requirements.
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VII. Rule 105 of Regulation M--Short Sales in Connection with a Public 
Offering

A. Generally

    Rule 105 of Regulation M prohibits a short seller from covering 
short sales with offering securities purchased from an underwriter or 
broker or dealer participating in the offering, if the short sale 
occurred during the Rule's restricted period, typically the five-day 
period prior to pricing.\114\ The reason for the prohibition is that 
pre-pricing short sales that are covered with offering shares 
artificially distort the market price for the security, preventing the 
market from functioning as an independent pricing mechanism and eroding 
the integrity of the offering price.\115\ Prices of ``follow-on 
offerings''\116\ are typically based on a stock's closing price prior 
to the time of pricing, and thus short sales during the period 
immediately preceding pricing that reduce the market price can result 
in a lower offering price. The goal of Rule 105 is to promote offering 
prices that are based upon open market prices determined by supply and 
demand rather than artificial forces.
---------------------------------------------------------------------------

    \114\ 17 CFR 242.105.
    \115\ As noted in the Proposing Release, 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.
    \116\ A ``follow-on offering'' is an issuance of additional 
securities by an issuer that is subject to the reporting 
requirements pursuant to Sections 13 or 15(d) of the Exchange Act. 
15 U.S.C. 78m, 78o(d).
---------------------------------------------------------------------------

    Rule 105 does not prohibit pre-pricing short sales, in recognition 
of the fact that if such sales are motivated by a short seller's 
evaluation of the stock's future performance, they can contribute to 
pricing efficiency and the creation of a correct market price. Rule 105 
does, however, prohibit using offering shares to cover any such pre-
pricing short sales. A trader who sells short pre-pricing and knows or 
has a high degree of assurance that he will be able to obtain covering 
shares in the offering does not assume the same market risk as a short 
seller who intends to cover using open market shares, and may not be 
contributing to pricing efficiency and true price discovery. Therefore, 
the rule prohibits pre-pricing short sales, effected within five days 
of pricing of an offering, from being covered with offering securities 
acquired from an underwriter or other broker-dealer participating in 
the offering. Moreover, this manipulative conduct can negatively affect 
the issuer, which receives reduced offering proceeds as a result of the 
lower offering price, and harms the market by inhibiting the capital 
raising process. In addition, the presence of such shorting activity 
can lead other investors, who believe that the short selling is the 
result of an evaluation of the stock's value, to sell short as well. By 
prohibiting such artificial selling activity, the Rule contributes to 
the integrity of the capital raising process.

B. Shelf Offerings

    In the Proposing Release, we proposed to amend Rule 105 to 
eliminate the shelf offering exception.\117\ We are adopting the 
amendment as proposed.
---------------------------------------------------------------------------

    \117\ See Proposing Release, Section XVI.
---------------------------------------------------------------------------

    When the Commission initially adopted the shelf exception in Rule 
105, it stated that it might be necessary for the Commission to 
reevaluate the exception in the event such offerings became more 
common.\118\ One of the reasons for the adoption of the shelf offering 
exception was the generally accepted view that shelf offerings were not 
as susceptible to manipulation as non-shelf offerings.\119\ At the time 
Regulation M was adopted, it was our understanding that potential 
investors generally were not aware of a takedown from a shelf 
registration until immediately prior to its occurrence, and thus pre-
pricing short sales were arguably not focused on the prospective 
offering. Today, however, shelf offerings can have many characteristics 
of non-shelf offerings. They are likely to utilize the same marketing 
efforts--road shows and other special selling efforts--that are used 
with non-shelf offerings, and thus investors often have notice of a 
shelf offering before it occurs. Moreover, since the initial adoption 
of Rule 105, equity shelf offerings have become commonplace.
---------------------------------------------------------------------------

    \118\ See Anti-Manipulation Rules Concerning Securities 
Offerings; Final Rule, Securities Exchange Act Release No. 38067, 62 
FR 520, 538 (January 3, 1997) (``Regulation M Release''), where the 
Commission stated ``it may be necessary for the Commission to 
reevaluate this exclusion if the availability of shelf registration 
is further expanded or offerings of shelf-registered equity become 
more common-place.''
    \119\ See Short Sales in Connection With a Public Offering, 
Securities Exchange Act Release No. 26028, 53 FR 33455, 33458 
(August 25, 1988) (``Rule 10b-21(T) Release''), adopting Rule 10b-
21(T).
---------------------------------------------------------------------------

    We believe that using offering shares to cover short sales effected 
prior to pricing of a shelf offering has the same negative effect as in 
non-shelf offerings. In light of the increased use of shelf offerings, 
we believe that the shelf exception presents an increased potential for 
the type of manipulative conduct that Regulation M is designed to 
prevent.
    We received three comment letters on Rule 105. \120\ One commenter 
argued that the exception should be retained because allowing offerees 
to act on their conviction that the proposed offering is overpriced by 
shorting in advance of pricing, leads to the creation of a ``true'' 
market price.\121\ As noted above, Rule 105 does not prevent short 
sellers from contributing to pricing efficiency by short selling in 
advance of an offering. Another commenter urged the Commission to 
retain the exception for shelf offerings that occur on an ``overnight'' 
or ``bought deal basis'' where no red herring or preliminary prospectus 
is distributed.\122\ The Commission believes that even though no 
preliminary prospectus is issued in these takedowns, manipulative pre-
pricing short sales could take place if other marketing efforts prior 
to the offering put investors on notice of the offering. We therefore 
believe that granting a blanket exception for these offerings is not 
appropriate.
---------------------------------------------------------------------------

    \120\ See letters from The Bond Market Association (``TBMA''); 
Feldman; SIA.
    \121\ See letter from Feldman, at 5.
    \122\ See letter from SIA.
---------------------------------------------------------------------------

    By providing that shelf offering prices will be based upon market 
prices that are not artificially influenced, the amendment will benefit 
both issuers and investors. It will promote the integrity of the 
capital raising process, enhance investor confidence in our markets, 
and help protect issuers conducting shelf offerings from receiving 
reduced offering proceeds as a result of manipulative conduct.\123\
---------------------------------------------------------------------------

    \123\ One commenter asked the Commission to consider excluding 
non-equity securities offerings from the scope of Rule 105, claiming 
that the type of manipulative activity with which Rule 105 is 
concerned is less likely to occur in debt offerings than in equity 
offerings. See TBMA letter. We continue to believe that bond 
offerings present a potential for manipulation, and we have 
therefore determined that non-equity offerings will continue to be 
subject to the prohibitions of Rule 105. The Commission will 
consider granting exemptive relief on a case-by-case basis where 
warranted.
---------------------------------------------------------------------------

C. Sham Transactions

    In the Proposing Release, the Commission noted its concern with 
sham transactions that are structured to appear to comply with Rule 
105, but which in fact violate the Rule. Such transactions are 
undertaken to give the appearance that pre-pricing short sales are not 
covered with offering shares, but instead are covered with shares 
purchased in the open market. We sought comment on how to address

[[Page 48021]]

these transactions. We did not receive any comments on this issue. We 
have decided to issue interpretive guidance to address transactions 
that violate Rule 105 by utilizing offering-shares to cover short sales 
made in the pre-pricing restricted period, while structuring the 
transactions so as to falsely give the appearance that the short sale 
has been covered using shares purchased in the open market. 
Transactions structured in this way violate Rule 105. Some examples of 
sham transactions that would violate Rule 105 follow. These examples 
are illustrative, and are not meant to be exhaustive.
1. Arrangements To Purchase
    In the first example of a sham transaction, short sales are 
effected during the pre-pricing restricted period and are covered using 
offering securities obtained through an arrangement with a third party 
who acquires the securities in the primary offering.\124\ In this 
transaction, the trader is attempting to accomplish indirectly what he 
or she cannot do directly, i.e., a type of short sale transaction 
prohibited by Rule 105.\125\
---------------------------------------------------------------------------

    \124\ The Commission has previously stated its concern with 
transactions where an intermediary is used to purchase covering-
shares from the offering. See Rule 10b-21(T) Release, 53 FR at 
33460.
    \125\ See also Exchange Act Section 20(b), 15 U.S.C. 78t.
---------------------------------------------------------------------------

2. Sell/Buy and Buy/Sell
    In the second example of a sham transaction, a trader effects pre-
pricing short sales during the Rule 105 restricted period, receives 
offering shares, sells the offering shares into the open market, and 
then contemporaneously or nearly contemporaneously purchases an 
equivalent number of the same class of shares as the offering shares, 
which are then used to cover the short sales. 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,\126\ and/or little or no market risk, that 
transaction may be a sham transaction that violates Rule 105.
---------------------------------------------------------------------------

    \126\ See also Exchange Act Section 9(a )(1), 15 U.S.C. 
78i(a)(1). For example, an individual places limit orders to sell 
and buy the same amount of shares, and the transaction is crossed in 
the individual's brokerage account. There is no change in beneficial 
ownership and no market risk associated with the transaction, i.e., 
these are ``wash sales.'' Although the individual has attempted to 
disguise the fact that the offering shares are being used to cover 
the short sale, in fact, he is covering his pre-pricing short sale 
with shares obtained in the offering. See, e.g., Ascend Capital, 
LLC, Securities Exchange Act Release No. 48188 (July 17, 2003).
---------------------------------------------------------------------------

    We do not believe it necessary or desirable to add rule language to 
address these kinds of trading, as this activity violates the current 
rule and can vary in its details. The Commission will continue to 
enforce Rule 105 in the face of sham transactions designed to evade the 
Rule. In addition, if such sham transactions 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.\127\
---------------------------------------------------------------------------

    \127\ 15 U.S.C. 78i(a), 78j(b).
---------------------------------------------------------------------------

VIII. Paperwork Reduction Act

    The adopted amendments to Regulation SHO contain collection of 
information requirements within the meaning of the Paperwork Reduction 
Act of 1995.\128\ We published a notice requesting comment on the 
collection of information requirements in the Proposing Release, and 
submitted these requirements to the Office of Management and Budget 
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 
1320.11. OMB has approved these requests. We did not receive comments 
on the proposed collection of information requirements.
---------------------------------------------------------------------------

    \128\ 44 U.S.C. 3501.
---------------------------------------------------------------------------

    Compliance with the adopted amendments to Regulation SHO and Rule 
105 of Regulation M will be mandatory. The Commission will not keep the 
information required by the amendments confidential. An agency may not 
conduct or sponsor, and a person is not required to respond to, an 
information collection unless it displays a currently valid OMB control 
number. The title of the affected collection is ``Regulation SHO'' 
under OMB control number 3235-0589.

A. Summary of Collections of Information

    Rule 200(g) contains a requirement that all sell orders in equity 
securities be marked ``long,'' ``short,'' and ``short exempt.'' 
Currently, Rule 10a-1(c) prohibits the execution of a sell order for a 
security covered by Rule 10a-1 unless the order is marked either 
``long'' or ``short.'' Regulation SHO contains a new collection of 
information because the collection would cover a much larger number of 
securities. Rule 200(g) of Regulation SHO adds two elements to the 
existing marking requirement. First, a new category for ``short 
exempt'' orders is being added. Second, the marking requirement is 
being extended to apply to all equity securities, including exchange-
listed securities, Nasdaq NMS, Nasdaq SmallCap, OTCBB, and Pink Sheet 
securities. By adopting Rule 200(g) of Regulation SHO, Rule 10a-1(c) is 
being repealed and any collection of information under Rule 10a-1 is 
being eliminated.
    Sell orders of exchange-listed and Nasdaq securities are already 
marked ``long,'' ``short,'' or ``short exempt'' pursuant to Rule 10a-1, 
NYSE Rule 440B.20, and the ITS Plan. Nasdaq NMS and Nasdaq SmallCap 
securities are also currently subject to a marking requirement pursuant 
to NASD Rule 4991. Rule 200(g) of Regulation SHO simply codifies 
current industry practice for exchange-listed and Nasdaq securities 
into a uniform marking requirement.
    Rule 203(b)(1) contains a requirement that broker-dealer must 
locate securities available for borrowing prior to effecting a short 
sale transaction. Subparagraph (iii) of Rule 203(b)(1) requires 
documentation of compliance with Rule 203(b)'s locate requirement. We 
note, however, that current SRO rules already require a written record 
documenting compliance with their locate rules.\129\
---------------------------------------------------------------------------

    \129\ NASD Rule 3370(b)(4)(B).
---------------------------------------------------------------------------

B. Use of Information

    The information required by 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 the 
Commission, 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 to be marked either ``long,'' 
``short,'' or ``short exempt'' would aid in ensuring compliance with 
Rule 203 and current Rule 10a-1. Moreover, the ``short exempt'' 
category will aid in surveillance for compliance with the exceptions 
from these rules.

C. Respondents

    The marking provision in Rule 200(g) will apply to all 6,553 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

    Rule 200(g) of Regulation SHO requires all brokers or dealers to 
mark

[[Page 48022]]

all sell orders appropriately as ``long,'' ``short,'' or ``short 
exempt'' for all equity securities. We estimate that all of the 
approximately 6,553 active registered broker-dealers \130\ 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 1,465,563,860 trades are executed annually.\131\
---------------------------------------------------------------------------

    \130\ This number is based on 2003 FOCUS Report filings 
reflecting registered broker-dealers. This number does not include 
broker-dealers that are delinquent on FOCUS Report filings.
    \131\ In calendar year 2003, there were approximately 
722,753,000 trades on the NYSE, 733,410,000 on Nasdaq NMS and Nasdaq 
SmallCap, and over 9,400,860 in OTCBB, Pink Sheet, and other (gray 
market) securities.
---------------------------------------------------------------------------

    Currently, under both Commission and SRO rules, broker-dealers are 
obligated to document certain order information. Rule 10a-1 requires 
sell orders of exchange-listed and Nasdaq securities to be marked 
``long,'' ``short,'' or ``short exempt.'' NYSE Rule 440B.20, the ITS 
Plan, and NASD Rule 4991 \132\ additionally impose a marking 
requirement. Rule 200(g) of Regulation SHO simply codifies the current 
practice for exchange-listed and Nasdaq securities into a uniform 
marking requirement.
---------------------------------------------------------------------------

    \132\ For Nasdaq NMS and Nasdaq SmallCap securities.
---------------------------------------------------------------------------

    Based on the number of annual trades and number of active 
registered broker-dealers, the average annual responses by each 
respondent is approximately 223,647. Each response of marking orders 
``long,'' ``short,'' or ``short exempt'' takes approximately .000139 
hours (.5 seconds) to complete.\133\ Thus, the total estimated annual 
hour burden per year is 203,713 burden hours (1,465,563,860 responses @ 
0.000139 hours/response). A reasonable estimate for the paperwork 
compliance for the proposed rules for each broker-dealer is 
approximately 31 burden hours (223,647 responses @ .000139 hours/
response) or a total of 203,713 burden hours/6,553 respondents.
---------------------------------------------------------------------------

    \133\ As stated in the Proposing Release, we believe it is 
reasonable that it would take 0.5 seconds (or .000139 hours) to mark 
an order ``long,'' ``short,'' or ``short exempt.''
---------------------------------------------------------------------------

IX. Cost-Benefit Analysis

    We are sensitive to the costs and benefits of our rules and we have 
considered the costs and benefits of our adopted rules. To assist us in 
evaluating the costs and benefits, in the Proposing Release, we 
encouraged commenters to discuss any costs or benefits that the rules 
might impose. In particular, we requested 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 were requested to 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. We received very 
few comments providing cost or benefit estimates.

A. Costs and Benefits of the Adopted Amendments in Regulation SHO

    We believe that Regulation SHO simplifies and updates short sale 
regulation in light of numerous market developments since short sale 
regulation was first adopted in 1938. First, Rule 200 incorporates 
current Rule 3b-3 to provide ownership definitions for short sale 
purposes, clarifies the requirement to determine a seller's net 
aggregate position, and requires sales in all equity securities to be 
marked ``long,'' ``short,'' or ``short exempt.'' Second, Rule 202T 
establishes procedures for the Commission to exclude designated 
securities from the operation of the tick test of Rule 10a-1 and any 
short sale price test rule of any exchange or national securities 
association. Third, Rule 203 incorporates current provisions applicable 
to long sales under current Rule 10a-2. Rule 203 additionally creates a 
uniform Commission rule requiring broker-dealers to ``locate'' 
securities available for borrowing prior to effecting short sales in 
all equity securities, and imposes additional requirements on 
securities that have a substantial amount of failures to deliver. 
Finally, the amendments to Rule 105 of Regulation M, eliminate the 
current shelf offering exception, such that short sales may not be 
covered with offering securities purchased from an underwriter or other 
broker-dealer participating in the shelf offering.
1. Rule 200: Definitions
a. Ownership of Securities Underlying Securities Futures Products
i. Benefits
    The codification of existing Commission guidance regarding when a 
person is deemed to own a security underlying a securities futures 
contract provides important compliance benefits. The interpretation is 
designed to ensure consistency 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. Additionally, by codifying existing 
guidance, Regulation SHO clarifies and facilitates compliance with the 
short sale rule for persons trading in securities futures.
ii. Costs
    We do not believe that codifying existing guidance will impose 
costs or result in lost business opportunities. Although the Commission 
did not receive comments quantifying the costs related to the 
codification, we note that the guidance is well established and has 
been adhered to by the industry.\134\
---------------------------------------------------------------------------

    \134\ See Guidance Release, at n. 18, supra.
---------------------------------------------------------------------------

b. Aggregation Units
i. Benefits
    Permitting aggregation unit netting provides enhanced flexibility 
and liquidity to both broker-dealers and the market as a whole. Subject 
to four expressed conditions, Rule 200(f) permits multi-service broker-
dealers to calculate net positions in a particular security within 
defined trading units apart from the positions held by other 
aggregation units within the firm. This allows multi-service firms to 
pursue different trading strategies, within certain parameters, without 
being restricted by limitations associated with firm-wide aggregation. 
The greater trading flexibility, through use of aggregation unit 
netting, should improve the liquidity provided by these firms.
ii. Costs
    We believe that there are no costs associated with aggregation unit 
netting since firms are not required to use aggregation units. 
Aggregation of net positions within defined trading units is entirely 
optional and will likely be used by firms that believe it is cost 
effective to do so. However, firms that choose to make use of 
aggregation unit netting must comply with requirements set forth in 
Rule 200(f).\135\ Compliance with aggregation unit netting requirements 
may impose fewer costs to broker-dealers than if the firms use 
alternative means, such as establishing separate broker-dealers for 
each trading desk's strategy to ensure the independence of each trading 
desk. Industry sources maintain that the costs associated with 
aggregation unit netting are nominal. Furthermore, the technology to 
facilitate

[[Page 48023]]

aggregation unit netting is widely available.
---------------------------------------------------------------------------

    \135\ Firms that find difficulty in complying with the 
aggregation unit netting conditions in Rule 200(f) may submit 
requests for exemptive relief.
---------------------------------------------------------------------------

c. Liquidation of Index Arbitrage Position
i. Benefits
    Codifying the liquidation index arbitrage relief, in Rule 200(e), 
facilitates pricing efficiency while preserving the fundamental 
objectives of short sale price regulation. By focusing on the timing of 
the liquidation of all the index arbitrage positions, rather than on 
the timing of the establishment of individual index arbitrage 
positions,\136\ Rule 200(e) relieves firms from the compliance burdens 
of tracking different positions of fungible securities according to the 
timing or circumstances related to their acquisition. Additionally, it 
reduces the possibility of unintended effects that may penalize buy-
side index arbitrage strategies involving the purchase of stocks during 
times of market stress.
---------------------------------------------------------------------------

    \136\ As provided in the Merrill Lynch Letter. See Securities 
Exchange Act Release No. 27938, n. supra.
---------------------------------------------------------------------------

    Subparagraph (e)(3) of Rule 200 provides a 2% market decline 
restriction \137\ so that markets can avoid incremental selling 
pressure during volatile trading days. The safeguard benefits all 
market participants by limiting 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. Lastly, 
inclusion of the 2% safeguard provides consistency within the equities 
markets. In 1999, the NYSE amended its rules on index arbitrage 
restrictions to include the 2% trigger.\138\ The Commission's adoption 
of the same trigger provides a uniform protective measure.
---------------------------------------------------------------------------

    \137\ For Rule 200(e)(3) relief, the sale does not occur during 
a period commencing at the time that the Dow Jones Industrial 
Average (``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.
    \138\ Securities Exchange Act Release No. 41041 (February 11, 
1999) 64 FR 8424 (February 19, 1999) (approval of amendments to NYSE 
Rule 80A). We note that NYSE 80A removes the stabilizing requirement 
if the DJIA moves within 2% of the previous day's close.
---------------------------------------------------------------------------

ii. Costs
    If the unwinding of the index arbitrage position occurs during a 
period when the DJIA has declined by 2%, short sellers will not be 
permitted to use the price test exemption, and thus will incur 
additional costs.\139\ Therefore, Rule 200(e)(3) may increase costs for 
short sellers during certain times of market decline. We estimate that 
any costs incurred will be limited to compliance with Rule 10a-1's tick 
test. The safeguard simply limits the relief from the price test for 
short sales of securities held in an index arbitrage position. The 
Commission did not adopt a blanket prohibition of short sales during a 
market decline; rather, the effect of subparagraph (e)(2) is to require 
such sales to comply with the short sale price test.
---------------------------------------------------------------------------

    \139\ Short sellers would have to aggregate 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.
---------------------------------------------------------------------------

d. Order Marking Requirement
i. Benefits
    The new order marking requirements provide important benefits for 
investors and the market as a whole. First, because the new order-
marking requirements extend beyond exchange-listed equity securities to 
include over-the-counter equity securities, i.e., OTCBB and Pink Sheet 
securities, they provide a uniform practice designed to ensure 
consistency within the equity markets. Second, the marking requirement 
will generate information identifying when and under what circumstances 
certain exceptions to the price test are used. Third, the new marking 
requirements benefit the surveillance of previously undetected 
violations of Rule 10a-1. Under the prior requirements, orders marked 
``long,'' despite having to borrow shares to consummate delivery, were 
handled and executed as long sales.
    Furthermore, the requirement of physical possession or control, or 
the reasonable expectation that the security will be in the possession 
or control of the broker-dealer no later than settlement, in order to 
mark an order ``long,'' benefits the clearance and settlement process. 
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, assists in mitigating settlement and credit risks that can affect 
the stability and integrity of the financial system as a whole.
ii. Costs
    The addition of the classification of ``short exempt'' to the 
marking requirements will impose certain nominal costs on broker-
dealers. According to industry sources, some broker-dealers already use 
the short exempt classification when marking certain sell orders. 
Additionally, SRO rules already either require or advise members to 
utilize the ``short exempt'' designation on such sell orders. However, 
broker-dealers not already using the ``short exempt'' classification 
will incur a one-time cost associated with programming. Industry 
sources estimated that implementation costs would be approximately 
$100,000 to $125,000.
    The Commission recognizes that there is an ongoing paperwork burden 
cost associated with adding the ``short exempt'' category and extending 
the marking requirement to all equity securities. The paperwork burden 
is estimated to be approximately 31 burden hours for each active 
broker-dealer registered with the Commission.\140\
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    \140\ This is an average of approximately 223,647 annual 
responses by each respondent. Each response of marking orders 
``long,'' ``short,'' or ``short exempt'' takes approximately .000139 
hours (.5 seconds) to complete. Thus, the total approximate 
estimated annual hour burden per year is 203,713 burden hours 
(1,465,563,860 responses at 0.000139 hours per response). A 
reasonable estimate for the paperwork compliance for the proposed 
rules for each broker-dealer is approximately 31 burden hours 
(223,647 responses at .000139 hours per response) or a total of 
203,713 burden hours between 6,553 respondents.
---------------------------------------------------------------------------

    We do not believe the new order marking requirements will impose 
additional monitoring or surveillance costs for registered broker-
dealers. Registered broker-dealers already have established systems in 
place to comply with current SRO rules.
    The Commission estimates that little to no costs will arise from 
the requirement that sell orders be marked long only in cases where the 
securities to be sold are owned by the customer and either are 
presently, or reasonably expected to be, in the customer's account 
prior to settlement. Most customer securities are not held by investors 
in physical form, but rather are held indirectly through their broker-
dealer in ``street name.'' Furthermore, commenters did not indicate any 
significant burden associated with the requirement.
2. Rule 202T: Pilot
    Rule 202T establishes procedures for the Commission to temporarily 
suspend the trading restrictions of the Commission's short sale price 
test, as well as any short sale price test of any exchange or national 
securities association, for short sales in such securities as the 
Commission designates

[[Page 48024]]

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.
a. Benefits
    We believe establishing procedures for the Commission to adopt a 
pilot pursuant to Rule 202T is an essential component of evaluating the 
overall effectiveness of price test restrictions on short sales. Any 
such pilot would be intended to: provide data on the impact of short 
selling in the absence of a price test; study the effects of relatively 
unrestricted short selling on market volatility, price efficiency, and 
liquidity; and obtain empirical data to help us assess whether a price 
test is necessary to further the objectives of short sale regulation 
and whether short sale price tests should be removed, in part or in 
whole, for actively traded securities or for all securities, or if 
retained, whether it should be extended to securities for which there 
currently is no price test.
    We believe that there will be both short-term and long-term 
benefits from any such pilot. In the short-term, the removal of the 
price test for a specified period would immediately ease restrictions 
on short sales and might benefit investors and the markets without 
necessarily compromising the policy goals that a prophylactic price 
test is designed to address. Removing such restrictions could 
facilitate market participants' hedging activities in the securities 
included in the pilot, and might facilitate short selling that 
increases market liquidity and pricing efficiency. Short selling in the 
absence of a price test might increase the number of shares available 
to purchasers and reduce the risk that the price paid by investors is 
artificially high because of a temporary contraction of selling 
interest due to short sale price restrictions.
    In the long-term, a pilot would allow the Commission to obtain 
empirical data necessary to consider alternatives, such as eliminating 
a Commission mandated price test for an appropriate group of 
securities, which may be all securities; adopting a uniform bid test, 
possibly extended to securities for which there is currently no price 
test; or leaving in place the current price tests. Historically, the 
possibility of considering such alternatives has been hampered by a 
lack of data concerning short selling, particularly with regard to 
listed-securities. Without empirical data relating to short selling in 
the absence of a price test in today's market, we believe that only 
broad conclusions could be derived with respect to the general impact 
of such short selling. Consequently, we believe that it is beneficial 
to establish a pilot to obtain empirical data in order to assist us in 
ascertaining whether to implement a price test, in whole or in part, 
for short sales in some or all securities, including securities not 
currently subject to any price test.
b. Costs
    As an aid in evaluating costs, we sought comment in the Proposing 
Release concerning the public's views as well as any supporting 
information. Specifically, we sought detailed comment on the extent of 
required system changes and costs associated with implementation of a 
pilot program. Many industry commenters favored the creation of a 
pilot.\141\ Operation of the pilot could cause additional costs to 
brokers, dealers, SROs, and potentially to issuers and investors. SROs 
and broker-dealers might need to make system changes in order to 
exclude the selected securities from the Commission's tick test as well 
as any SRO price test.
---------------------------------------------------------------------------

    \141\ See letters from James Angel; ARCA; Yuseff J. Burgess; 
CBOE; Dario Cosic; Davis Polk; Timothy K. Dolnier; Tolga Erman; 
Chris Freddo; Kristopher Goldhair; Chris Gregg; Marc Griffin; 
Charles W. Hansford; Zachary Hepner; ICI; Mike Ianni; Brian Ingram; 
Kevin Karlberg; Gregory Kleiman; LEK Securities; Michael Lucarello; 
Lux & Metzger; MFA; Raymond J. Murphy; Nasdaq; 
[email protected]; Tal Plotkin; David Schwarz; Sinan Selcuk; 
Theodore J. Siegel; Todd Sherman; SIA; Dan Solomon; STA; STANY; 
Jimmie E. Williams; Willkie Farr.
---------------------------------------------------------------------------

    Based on comments from the industry, we estimate that a pilot 
established under Rule 202T could require broker-dealer firms to 
reconfigure systems that currently set price test restrictions on short 
sales, which could impose modest costs. We anticipate that firms would 
have to remove existing price test restrictions for short sales of 
specified securities. The implementation of these modifications would 
require a readily identifiable, one-time adjustment. Market 
participants already remove the NASD's short sale rule, Rule 3350, 
after traditional market hours, as it is not applicable during that 
time,\142\ so application of any pilot to Nasdaq securities would not 
likely require the development of any new programs or surveillance 
systems.
---------------------------------------------------------------------------

    \142\ See NASD Head Trader Alert 2000-55 (August 7, 
2000).
---------------------------------------------------------------------------

    Some commenters expressed a concern about pilot-related costs borne 
by issuers. According to these commenters, these costs could arise from 
possible manipulative short selling in the absence of price 
restrictions or pricing anomalies between securities in the same 
industry subject to a pilot and similar securities not subject to the 
price test. These commenters also asserted that a pilot might create a 
confusing system that will slow trading, lead to errors and confound 
market participants.
    Most of the more liquid securities that would be appropriate for a 
pilot are traded on exchanges or other organized markets with high 
levels of transparency and surveillance. This would enhance the ability 
of the Commission and SROs to monitor trading behavior during the 
operation of any pilot and to surveil for manipulative short 
selling.\143\ Moreover, 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.\144\ To the 
extent there are price and trading activity variations, this is 
precisely the empirical data that the Commission seeks to obtain and 
analyze as part of our assessment as to whether the price test should 
be removed, in part or whole, for pilot securities or other securities. 
In addition, a pilot would suspend only the operation of the price 
test, while the other requirements of Regulation SHO, including the 
order marking, locate and delivery requirements, would remain in 
effect.
---------------------------------------------------------------------------

    \143\ No individual issuers submitted comment letters opposing 
the pilot or expressing concern about the possible disparate trading 
of securities subject to the pilot or about the possible adverse 
impact on their securities should the price test be removed from 
short selling in their stock on a temporary basis. The NYSE 
submitted a letter expressing concern, ``on behalf of its members 
and its listed companies'' strongly supporting continued price 
restrictions and expressing concern about unscrupulous market 
participants forcing prices lower in stocks not subject to a price 
test.
    \144\ See, e.g., Securities Act Section 17(a), and Exchange Act 
Sections 9(a), 10(b), and 15(c) and Rules 10b-5 and 15c1-2 
thereunder.
---------------------------------------------------------------------------

    The Commission, by further order, can terminate or extend the 
period of a pilot, remove or add some or all securities selected for a 
pilot as it determines necessary or appropriate in the public interest 
or to protect investors. Thus, costs associated with any manipulative 
short selling or price variations may be ameliorated through the 
termination of the pilot or removal of affected securities.
3. Rule 203: Locate and Delivery Requirements for Short Sales
a. Benefits
    As adopted, Rule 203(b) creates a uniform Commission rule requiring

[[Page 48025]]

broker-dealers to follow specified procedures for short sellers in all 
equity securities, wherever traded. Rule 203(b) requires that, prior to 
effecting short sales in all equity securities, broker-dealers must 
``locate'' securities available for borrowing. This uniform rule 
furthers the goals of regulatory simplification and avoidance of 
regulatory arbitrage. Specifically, Rule 203(b) prohibits a broker-
dealer from executing a short sale in any equity security, for the 
broker-dealer's own account or the account of another person, unless 
the broker-dealer has (1) borrowed the security, or entered into an 
arrangement to borrow the security, or (2) has reasonable grounds to 
believe that the security can be borrowed so that it can be delivered 
on the date delivery is due. Rule 203 requires that the locate be made 
and documented prior to effecting any short sale, regardless of whether 
the seller's short position may be closed out by purchasing securities 
the same day. The Commission has also adopted additional requirements 
targeted at ``threshold securities'' that have a substantial amount of 
failures to deliver, i.e., any equity security of an issuer registered 
under Section 12 or required to file reports under Section 15 of the 
Exchange Act where there are fails to deliver at a registered clearing 
agency of 10,000 shares or more per security; that the level of fails 
is equal to at least one-half of one percent of the issue's total 
shares outstanding; and the security is included on a list published by 
an SRO. In order to be subject to the restrictions of Rule 203, a 
security must exceed the designated level of fails for a period of five 
consecutive settlement days. Similarly, in order to be removed from the 
list of threshold securities, a security must not exceed the threshold 
for a period of five consecutive settlement days.
    A broker-dealer is required to take additional steps should a fail 
in a threshold security remain 10 days after the normal settlement 
date, i.e., for 13 consecutive settlement days. Specifically, Rule 
203(b)(3) requires the participant of a registered clearing agency to 
take action to close out the fail to deliver by purchasing securities 
of like kind and quantity.
    The new locate and delivery requirements will protect and enhance 
the operation, integrity, and stability of the markets. For example, 
the requirements of Rule 203 include securities with lower market 
capitalization that may be more susceptible to abuse. Also, adopting 
uniform rules will further the goals of regulatory simplification and 
avoidance of regulatory arbitrage, as well as assist the Commission in 
its enforcement efforts regarding naked short selling activity. Certain 
issuers have taken steps to make their securities 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, which 
they assert has been done to avoid the effects of naked short selling 
of their securities. These custody arrangements are highly costly to 
the clearing agencies, depositories and financial intermediaries. 
Imposing a requirement to close-out large fails at the clearing level 
may decrease costs on the clearing agency by reducing the requests for 
``certificate only'' issues.\145\
---------------------------------------------------------------------------

    \145\ The Commission approved a rule change filed by DTC that 
clarified that DTC's rules permit only its participants to withdraw 
securities from the depository. See Securities Exchange Act Release 
No. 47978 (June 4, 2003), 68 FR 35037 (June 11, 2003). In addition, 
the Commission recently proposed a rule, ``Issuer Restrictions or 
Prohibitions on Ownership by Securities Intermediaries,'' which 
would prohibit a registered transfer agent from transferring any 
equity security registered pursuant to Section 12 of the Exchange 
Act, or any equity security that subjects an issuer to reporting 
under Section 15(d) of the Exchange Act, if such security is subject 
to any restriction or prohibition on transfer to or from a 
securities intermediary. See Securities Exchange Release No. 49804 
(June 4, 2004), 69 FR 32783 (June 10, 2004).
---------------------------------------------------------------------------

b. Costs
    The Commission recognizes that locate and delivery requirements may 
increase costs for some market participants who engage in short 
selling. The Commission is, however, including an exception from the 
locate requirements of Rule 203(b)(1) for short sales executed by 
market makers in connection with bona-fide market making activities. In 
addition, any costs that initially may be incurred should be mitigated 
over time because the uniform rule should lead to regulatory 
simplification with regard to training and surveillance.
    The rule includes certain exceptions from the locate requirement, 
which mitigate many associated cost burdens. The rule provides an 
exception for bona-fide market making. This exception covers short 
sales executed by market makers, including specialists and options 
market makers, in connection with bona-fide market making activities. 
Excepting bona-fide market making activity from the locate requirement 
will benefit investors and the market by preserving necessary market 
liquidity.
    A second exception is for broker-dealers that receive a short sale 
order from another registered broker-dealer that is required to have 
already complied with Rule 203(b)(1). This exception relieves the 
executing broker-dealer from engaging in a second locate for the 
transaction. This exception limits the possibility of over borrowing as 
well as any delay in execution.
    A third exception to the locate requirement covers situations where 
a broker effects a sale on behalf of a customer who owns the security 
pursuant to Rule 200, but through no fault of the customer or broker-
dealer, it is not reasonably expected that the security will be in the 
possession or control of the broker-dealer by settlement date. Under 
the newly adopted marking requirement, this sale would be marked 
``short.'' Such situations could include where a convertible security, 
option, or warrant has been tendered for conversion, but the underlying 
security is not reasonably expected to be received by settlement date.
    There may be costs associated with implementing these locate 
requirements for OTCBB and Pink Sheet securities. For example, a number 
of commenters noted that there might not be a broad pool of lendable 
securities in such issuers, due to the inability of firms to 
hypothecate shares bought on margin, and due to the absence of 
institutional lenders in these securities. This could affect the 
ability of these small issuers to obtain financing through the issuance 
of convertible debentures, in that market participants that buy these 
convertible debentures may not be able to sell short for hedging 
purposes if they are unable to locate the issuer's securities.
    In addition, other commenters also noted that, due to the absence 
of stock available for borrowing in these issuers, requiring short 
sellers to locate such securities could essentially remove the ability 
to take short positions in these stocks, and would help to facilitate 
issuers, promoters, or other shareholders that may be attempting to 
manipulatively push up the company's stock price. These commenters 
noted their belief that some issuers and their associated stock 
promoters may also be using the recent controversy over naked short 
selling to engage in fraud, or otherwise distract investors from 
fundamental problems with the company.
    It is the Commission's belief that removing all restrictions on the 
ability to effect naked short sales is not the proper recourse against 
potential issuer fraud, as it may simply encourage another type of 
manipulation or exacerbate other potentially negative consequences 
associated with large failures to deliver. Nevertheless, the

[[Page 48026]]

Commission is cognizant of these concerns and is taking action to 
combat such activities. For example, the Commission continues to bring 
enforcement actions for issuer fraud, including actions against some of 
the companies that have claimed to be ``victims'' of naked short 
selling.\146\ In addition, the Commission recently proposed other steps 
to protect investors by deterring fraud and abuse in the securities 
markets through the use of ``shell companies.'' \147\
---------------------------------------------------------------------------

    \146\ See, e.g., SEC vs. Universal Express, Inc., et. al., 
Litigation Release No. 18636 (March 24, 2004). Securities Exchange 
Act Release No. 49566 (April 15, 2004).
    \147\ Securities Exchange Act Release No. 49566 (April 15, 
2004). The proposal would prohibit the use of Form S-8, under the 
Securities Act, by a shell company. In addition, the release 
proposes amendments to Form 8-K, under the Exchange Act, to require 
a shell company, when reporting an event that causes it to cease 
being a shell company, to file with the Commission the same type of 
information that it would be required to file to register a class of 
securities under the Exchange Act. The provisions in this release 
target regulatory problems that the Commission has identified where 
shell companies have been used as vehicles to commit fraud and abuse 
the regulatory processes.
---------------------------------------------------------------------------

    The greatest costs associated with Rule 203's requirements relate 
to controlling failures in threshold securities.\148\ Participants of a 
registered clearing agency, broker-dealers, market makers, and SROs may 
incur costs in making initial system changes necessary to implement 
these new requirements, as well as maintaining ongoing compliance and 
surveillance mechanisms. Comments from the industry maintained that any 
one-time programming costs would be ``manageable'' or ``nominal.'' 
\149\ Since NSCC already provides to the SROs information on all 
issuers that have failed to deliver in excess of 10,000 shares, this 
will mitigate any cost burdens on accessing the information. 
Furthermore, this information can be matched with the readily available 
information on an issuer's total shares outstanding to determine 
whether the security meets the definition of a threshold security under 
Regulation SHO.
---------------------------------------------------------------------------

    \148\ The general locate requirement for short sales will not 
impose additional costs on broker-dealers, since current SRO rules 
require broker-dealers to effect such a locate.
    \149\ Industry participants appeared more concerned with having 
enough time to make the necessary programming and systems upgrades 
than the actual costs related to such upgrades.
---------------------------------------------------------------------------

    However, some industry sources argued that the ongoing cost of 
requiring broker-dealers, including market makers,\150\ to borrow or 
arrange to borrow for future short sales if there was not compliance 
with the requirement to close-out fails to deliver in threshold 
securities would decrease liquidity, impose large borrowing costs and 
execution delay. Also, some commenters, including options market makers 
and options exchanges, noted that if we do not include such an 
exception would be to cease altogether options trading in securities 
that are difficult to borrow, as it was argued that no options market 
maker would make markets without the ability to hedge.
---------------------------------------------------------------------------

    \150\ We have decided at this time not to extend to market 
makers an exception from the additional requirements to close out 
fails to deliver in securities exceeding the threshold that remain 
ten days after settlement date.
---------------------------------------------------------------------------

    We note that the close out requirements of Rule 203(b)(3) will only 
apply to short sales in securities that meet the designated threshold 
level of fails, and similar to the current operation of NASD Rule 
11830, will not apply to any short sales effected prior to the security 
meeting the threshold. We have noted the above concerns, but believe 
that they may be exaggerated, especially considering that OEA has 
estimated that threshold securities represent approximately 4% of the 
equities markets.\151\ Also, any cost estimates related to the narrowly 
applied borrowing requirement appear extremely speculative.\152\ In 
light of this, we do not expect that excluding a market maker exception 
from the close out requirement of Rule 203(b)(3) would have such 
adverse consequences.
---------------------------------------------------------------------------

    \151\ OEA has also estimated that approximately 4% of all 
securities that have options traded on them would be threshold 
securities.
    \152\ Industry participants could not produce a quantifiable 
estimate for the cost related to the ``borrow or arrange to borrow'' 
requirement for failing to close-out deliveries in threshold 
securities that remain open for ten days past the settlement date. 
Additionally, some industry participants provided inconsistent 
statements regarding the amount of securities for which a locate is 
given, compared to whether a short sale execution actually occurs. 
The estimated range is anywhere from 10% to 80%.
---------------------------------------------------------------------------

4. Rule 203: Requirements for Long Sales
    Rule 203(a) incorporates Rule 10a-2, which covered delivery 
requirements applicable to long sales of securities registered or 
admitted to unlisted trading privileges on a national securities 
exchange. As adopted, Rule 203(a) generally 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 use borrowed securities 
to do so.\153\ Rule 203(a) extends these delivery requirements to all 
securities, including those not registered on an exchange. In addition, 
Rule 203(a) makes clear that a broker or dealer may not fail to 
deliver, nor may it loan securities for delivery on a sale marked 
``long,'' unless, prior to the sale, the broker or dealer knew that the 
seller owned the securities and the seller represented that he would 
deliver them to the broker in time for settlement but failed to do so.
---------------------------------------------------------------------------

    \153\ As in former Rule 10a-2, these prohibitions do not apply 
to the loan of a security that occurs by way of a loan to another 
broker or dealer, or where an exchange or securities association 
finds, prior to the loan or fail, 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.
---------------------------------------------------------------------------

a. Benefits
    Extending the long sale delivery requirements to all securities 
will benefit investors and the markets, because as with short sales, 
delivery requirements are important in securities with lower market 
capitalization that may be more susceptible to abuse. Moreover, Rule 
203(a) states that a broker-dealer cannot fail or loan shares on a long 
sale unless, in advance of the sale, the broker-dealer ascertains that 
the customer owned the shares. This change, together with changes being 
made to the long sale order marking requirements, provide an important 
benefit to the market by making clear a broker's obligation to confirm 
the long seller's ownership of the shares prior to executing the sale.
b. Costs
    Although we sought public comment on costs, we did not receive any 
comments relating to Rule 203(a). We recognize that there may be some 
costs associated with extending the delivery requirements to all 
securities, including costs related to system changes and surveillance. 
However, since market participants already must comply with the current 
language of Rule 10a-2, we expect any costs will be nominal. The 
benefit of a uniform delivery scheme for long sales justifies any costs 
that will be incurred by market participants.
5. Rule 105 of Regulation M
    Rule 105 of Regulation M prohibits a short seller from covering 
short sales with offering securities purchased from an underwriter, 
broker or dealer participating in the offering if the short sale 
occurred during the Rule's restricted period, typically the five-day 
period prior to pricing. The reason for the prohibition is that pre-
pricing short sales that are covered with offering shares artificially 
distorts the market price for the security, preventing the market from 
functioning as an independent pricing mechanism and eroding the 
integrity of the offering

[[Page 48027]]

price. The goal of Rule 105 is to promote offering prices that are 
based upon open market prices determined by supply and demand rather 
than artificial forces. The Rule is prophylactic, and prohibits the 
conduct irrespective of the short seller's intent in effecting the 
short sale.
    Typically, follow-on offering prices are based on a stock's closing 
price prior to pricing, and thus short sales during the period 
immediately preceding pricing that reduce the market price can result 
in a lower offering price. Rule 105 does not prohibit pre-pricing short 
sales, but it does prevent short sellers from covering the short sales 
with offering shares. A trader who sells short pre-pricing because the 
trader knows or has a high degree of certainty that he or she will be 
able to obtain covering shares in the offering at a lower price does 
not assume the same market risk as a short seller who intends to cover 
with open market shares and is not engaged in an evaluation of the 
stock's ``true value.'' This manipulative conduct can negatively impact 
the issuer, which receives reduced offering proceeds as a result of the 
lower offering price, and harms the market by inhibiting the capital 
raising process.
    The adopted amendments to Rule 105 eliminate the shelf offering 
exception. At the time of adoption of the exception, the Commission 
viewed shelf offerings as uncommon and generally less susceptible to 
manipulation than non-shelf offerings.\154\ Today, shelf offerings are 
common, and investors generally have notice of them before they occur 
because they are likely to utilize the same marketing efforts--road 
shows and other selling efforts--that are used with non-shelf 
offerings.
---------------------------------------------------------------------------

    \154\ Potential investors generally were not aware of a takedown 
until immediately prior to its occurrence, and thus their pre-
pricing short sales were arguably non-manipulative.
---------------------------------------------------------------------------

a. Benefits
    Eliminating the shelf exception from Rule 105 will provide a number 
of important benefits to issuers, investors, and the market as a whole. 
The amendment updates Rule 105 by adopting a uniform standard for shelf 
and non-shelf offerings, which are much more similar today than when 
the exception was adopted because of changes in the way most shelf 
offerings are sold. Both shelf and non-shelf offerings are susceptible 
to the manipulation that Rule 105 is intended to prevent. In both 
cases, pre-pricing short sales that are covered with offering shares 
exert downward pressure on pricing that is not connected to any 
evaluation of the stock's future performance.
    Elimination of the shelf exception will benefit issuers and 
investors by promoting shelf-offering prices that are based upon market 
prices that are not artificially influenced. This will safeguard the 
integrity of the capital raising process with respect to shelf 
offerings and enhance investor confidence in our markets. The amended 
rule will also protect issuers conducting shelf offerings from 
receiving reduced offering proceeds as a result of manipulative 
conduct.
b. Costs
    We recognize that the amendments to Rule 105 may result in some 
costs to certain market participants. Eliminating the shelf exception 
may impair a short seller's ability to effect a covering transaction 
because there are fewer shares available with which one may cover. It 
may also impact traders and firms that derive significant revenue from 
covering pre-pricing shorts with shelf offering shares.
    We anticipate these changes to Rule 105 may impose compliance 
costs, in the form of increased surveillance, on broker-dealers. 
However, we do not expect the change to result in a major increase in 
costs or prices for consumers or individual industries. Rather, the 
change will curtail the potential for manipulative activity that might 
otherwise create a temporary mispricing of securities and reduce 
offering proceeds. The change will provide a protective measure against 
abusive conduct that hampers the capital raising process and negatively 
impacts issuers.
    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. Moreover, although the 
Commission recognizes that the amendments may diminish a short seller's 
ability to effect a covering transaction by restricting the sources 
from which he may cover, Rule 105 will continue to allow the beneficial 
effects of short selling to reach the market. Short selling in advance 
of a shelf offering will remain available to enhance pricing 
efficiency.
    Lastly, the amendments to Rule 105 of Regulation M do not impose a 
ban on pre-pricing short sales. Rather, the amendments prohibit short 
sellers from covering the short sales with offering shares. The 
amendments will prevent a trader who sells short pre-pricing because 
the trader knows he or she will obtain offering shares to cover the 
short position at a lower price in order to generate a risk-free 
profit.

X. Consideration of Promotion of Efficiency, Competition, and Capital 
Formation

    Section 3(f) of the Exchange Act \155\ requires us, when engaging 
in rulemaking and where we are required to consider or determine 
whether an action is necessary or appropriate in the public interest, 
to consider, in addition to the protection of investors, whether the 
action will promote efficiency, competition, and capital formation. 
Section 23(a)(2) of the Exchange Act \156\ requires the Commission in 
adopting rules under the Exchange Act, to consider the anticompetitive 
effects of any rules it adopts under the Exchange Act. Section 23(a)(2) 
prohibits us from adopting any rule that would impose a burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Exchange Act. In the Proposing Release, we solicited comment on 
the proposals' effects on efficiency, competition, and capital 
formation. Additionally we requested, but did not receive, comments 
regarding the impact of the proposed amendments on the economy 
generally pursuant to the Small Business Regulatory Enforcement 
Fairness Act of 1996.\157\
---------------------------------------------------------------------------

    \155\ 15 U.S.C. 78c(f).
    \156\ 15 U.S.C. 78w(a)(2).
    \157\ Pub. L. 104-121, tit. II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------

    We have considered the proposed amendments in Regulation SHO in 
light of the standards of Section 23(a)(2) of the Exchange Act and 
believe the adopted amendments should not impose any burden on 
competition not necessary or appropriate in furtherance of the Exchange 
Act. We note, however, that there are several areas in Regulation SHO 
where issuers may be treated differently.
    First, in any pilot created pursuant to Rule 202T, the price test 
could be suspended for issuers selected, while the price test would 
continue to apply to issuers in the same industry that are not selected 
for the pilot. Some commenters expressed a concern about the pilot 
imposing costs on issuers selected, relative to possible manipulative 
short selling in the absence of price restrictions or pricing 
anomalies. These commenters also asserted that the pilot would create a 
confusing system that would slow trading, lead to errors, and confound 
market participants.
    We believe that most of the more liquid securities that would be 
appropriate for a pilot are traded on exchanges or other organized 
markets

[[Page 48028]]

with high level of transparency and surveillance. The Commission and 
SROs would monitor trading behavior during the operation of any pilot 
and surveil for manipulative short selling activity. Furthermore, the 
general anti-fraud and anti-manipulation provisions of the federal 
securities laws will continue to apply to trading activity in these 
securities, thus prohibiting trading activity designed to improperly 
influence the price of a security.\158\ Moreover, to the extent there 
are price and trading activity variations, this is precisely the 
empirical data that the Commission seeks to obtain and analyze as part 
of our assessment as to whether the price test should be removed, in 
part or whole, for the pilot securities or other securities.
---------------------------------------------------------------------------

    \158\ See, e.g., Securities Act Section 17(a), and Exchange Act 
Sections 9(a), 10(b), and 15(c) and Rules 10b-5 and 15c1-2 
thereunder.
---------------------------------------------------------------------------

    By further order, the Commission can terminate or extend the period 
of the pilot as it determines necessary or appropriate in the public 
interest or to protect investors or to remove or add some or all 
securities selected for the pilot, any costs associated with 
manipulative short selling or price variations may be ameliorated 
through the termination of the pilot or removal of affected securities.
    Secondly, the additional requirements of Rule 203(b)(3) will apply 
to any equity security of an issuer registered under Section 12 or 
required to file reports pursuant to Section 15 of the Exchange Act 
where, for five consecutive settlement days, there are fails to deliver 
at a registered clearing agency 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. The additional requirements will not apply to 
any issuers that are not registered under Section 12 or required to 
file reports pursuant to Section 15 of the Exchange Act, and are thus 
not required to provide ongoing public disclosure about the company, 
its actions, and its performance. As the calculation of the threshold 
that would trigger the requirements of Rule 203(b)(3) depends on 
identifying the aggregate fails to deliver as a percentage of the 
issuer's total shares outstanding, it is necessary to limit the 
requirement to companies that are subject to the reporting requirements 
of the Exchange Act.

XI. Final Regulatory Flexibility Analysis

    The Final Regulatory Flexibility Analysis (``FRFA'') has been 
prepared in accordance with the Regulatory Flexibility Act.\159\ This 
FRFA relates to new Regulation SHO, adopted under the Exchange Act, 
which replaces Rules 3b-3 and 10a-2, and amends Rule 105 of Regulation 
M.
---------------------------------------------------------------------------

    \159\ 5 U.S.C. 603.
---------------------------------------------------------------------------

    Rule 200 of Regulation SHO defines ownership of securities, 
specifies aggregation of long and short positions, and also includes 
the requirement that sales in all equity securities be marked ``long,'' 
``short,'' or ``short exempt.'' Regulation SHO includes a temporary 
rule, Rule 202T, that establishes procedures to allow the Commission to 
suspend the operation of the current ``tick'' test in Rule 10a-1, and 
any short sale price test for any exchange or national securities 
association, for specified securities. Rule 203 of Regulation SHO 
requires short sellers in all equity securities to locate securities to 
borrow before selling, and also imposes heightened delivery 
requirements on securities that have fails to deliver at a registered 
clearing agency of 10,000 shares or more per security, and that is 
equal to at least one-half of one percent of the issues total shares 
outstanding. The Commission is also adopting amendments to Rule 105 of 
Regulation M to remove the shelf offering exception.

A. Need for and Objectives of the Amendments

    Regulation SHO and the amendments to Rule 105 of Regulation M are 
designed, in part, to fulfill several objectives, including: (1) 
Establish uniform locate and delivery requirements in order to address 
potentially abusive naked short selling and other problems associated 
with failures to deliver; (2) clarify marking requirements for short 
sales in all equity securities; (3) establish a procedure to 
temporarily suspend Commission and SRO short sale price tests in order 
to evaluate the overall effectiveness and necessity of such 
restrictions; and (4) prohibit certain short sales from being covered 
with securities obtained from shelf offerings.
    Moreover, the rules are consistent with the objective of 
simplifying and modernizing short sale regulation, providing controls 
where they are most needed, and temporarily removing restrictions where 
they may be unnecessary. Rule 203(b) of Regulation SHO provides 
stronger locate and delivery requirements designed to address abusive 
naked short selling, i.e., a security could only be sold short to the 
extent that there was stock available to borrow. Rule 203 is a targeted 
approach that incorporates the provisions of existing SRO rules while 
imposing additional restrictions where we believe appropriate to 
address naked short selling while protecting and enhancing the 
operation, integrity, and stability of the markets. As a part of this 
effort to improve locate and delivery requirements, Rule 200 clarifies 
marking requirements and thus clarifies when a participant must locate 
stocks for delivery. Rule 202T establishes procedures for the 
Commission to temporarily remove price restrictions for short sales 
from certain securities so that we can obtain empirical data on the 
impact of short selling in the absence of a price test and to assess 
whether a short sale price test should be removed, in part or in whole, 
for some or all securities.
    The amendments to Rule 105 of Regulation M prohibit covering 
certain short sales with securities acquired in a shelf offering. The 
amendments are in response to the recognition that shelf offerings are 
much more common in today's markets and with increased transparency 
they are susceptible to the same potential for manipulation and abuse 
as non-shelf offerings. The elimination of the shelf offering exception 
in Rule 105 is designed to reduce the potential that pre-pricing short 
sales will exert downward price pressure on the market price of a shelf 
offering.

B. Significant Issues Raised by Public Comments

    The Initial Regulatory Flexibility Analysis (``IRFA'') appeared in 
the Proposing Release.\160\ We requested comment in the IRFA on the 
impact the proposals would have on small entities and how to quantify 
the impact. We did not receive any comment letters addressing the IRFA; 
however, a few commenters discussed certain costs that would be 
incurred by small broker-dealers and issuers if some or all of the 
proposals in Regulation SHO were adopted.\161\
---------------------------------------------------------------------------

    \160\ See Proposing Release, Section XXII.
    \161\ For example, one commenter expressed concern about the 
Commission's proposal for firms to aggregate their positions in 
securities on a contemporaneous basis throughout the day. The 
commenter claimed such a requirement would require system changes 
for those broker-dealers who have not implemented the aggregation 
units, i.e., smaller broker-dealers, and would be significantly 
expensive without the attenuating benefits. See letter from SIA. 
Also, other commenters were concerned about the impact of Regulation 
SHO on small issuers, claiming it would increase the cost of capital 
to them by imposing locate and delivery requirements in the absence 
of a hedging exemption. See letters from Saul Ewing and Feldman.

---------------------------------------------------------------------------

[[Page 48029]]

C. Small Entities Subject to the Amendments

    Paragraph (c)(1) of Rule 0-10\162\ 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 that is not affiliated 
with any person (other than a natural person) that is not a small 
business or small organization. In the IRFA of the Proposing Release, 
we estimated that as of 2002 there were approximately 880 broker 
dealers that qualified as small entities, as defined above. Presently, 
we estimate that as of 2003 there are approximately 906 broker-dealers 
that qualify as small entities, as defined above.
---------------------------------------------------------------------------

    \162\ 17 CFR 240.0-10(c)(1).
---------------------------------------------------------------------------

    In the Proposing Release, we sought comment on the costs on small 
entities to modify, and in some cases install, systems and surveillance 
mechanisms to ensure compliance with the new rules, including 
implementing the pilot, marking, and locate and delivery requirements. 
No commenters responded with cost estimates pertaining to the requested 
data listed above. Nevertheless, we estimate the costs related to 
upgrades of systems and surveillance mechanisms will be minimal. 
Industry sources stated that most broker-dealers, including small 
broker-dealers, already have the necessary systems in place. Therefore, 
such entities will only be required to modify their systems for 
compliance.

D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

    Regulation SHO may impose some new compliance and marking 
requirements on broker-dealers that are small entities. Some small 
entities that trade securities that may be subject to the pilot program 
will have to make changes to exclude these securities from Commission 
and SRO price test restrictions. Moreover, small entities may have to 
make systems changes for additional marking requirements for short 
sales in listed securities, i.e., adding a ``short exempt'' 
designation.\163\
---------------------------------------------------------------------------

    \163\ We believe this cost should be minimal because some self-
regulatory organizations already either require or advise members to 
utilize the ``short exempt'' designation.
---------------------------------------------------------------------------

    We sought comment on the reporting, recordkeeping, and compliance 
costs on small entities with regard to, among other things, 
implementing the pilot and the marking requirements. We estimate that 
the greatest cost associated with such requirements is related to 
implementation time and training.

E. Agency Action To Minimize the Effect on Small Entities

    As required by the Regulatory Flexibility Act, we have considered 
alternatives that would accomplish our stated objectives, while 
minimizing any significant adverse impact on small entities. Several 
alternatives were considered but rejected, while other alternatives 
were taken into account in the adoption of Regulation SHO and the 
amendments to Rule 105 of Regulation M. The final rules and rule 
amendments meet the Commission's stated goals by applying short sale 
restrictions where they are most needed and easing them, on a temporary 
basis to obtain greater empirical data, where they may be unnecessary.
    Regulation SHO and the amendments to Rule 105 of Regulation M 
should not adversely affect small entities because they impose minimal 
new reporting, record keeping or compliance requirements. Moreover, it 
is not appropriate to develop separate requirements for small entities 
with respect to Regulation SHO and the adopted amendments to Rule 105 
of Regulation M, because we think all issuers, including issuers that 
are small entities, should be subject to short sale locate and delivery 
requirements, marking requirements, and the easing of restrictions on 
short sales subject of the pilot. As stated in the Proposing Release, 
we believe that it is beneficial to establish uniform standards 
specifying procedures for all short selling.

XII. Statutory Basis and Text of Adopted Amendments

    Pursuant to the Exchange Act and, particularly, Sections 2, 3(b), 
9(h), 10, 11A, 15, 17(a), 17A, 23(a), and 36 thereof, 15 U.S.C. 78b, 
78c(b), 78i(h), 78j, 78k-1, 78o, 78q(a), 78q-1, 78w(a), and 78mm, the 
Commission is adopting Sec. Sec.  242.200, 242.202T, 242.203, along 
with amendments to Regulation M, Rule 105, and interpretative guidance 
set forth in part 241.

List of Subjects

17 CFR Parts 240 and 242

    Brokers, Fraud, Reporting and recordkeeping requirements, 
Securities.

17 CFR Part 241

    Securities.


0
For the reasons set out in the preamble, Title 17, Chapter II, of the 
Code of Federal Regulations is amended as follows.

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

0
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, 78q-1, 78s, 
78u-5, 78w, 78x, 78ll, 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-
37, 80b-3, 80b-4, 80b-11, and 7201 et seq.; and 18 U.S.C. 1350, 
unless otherwise noted.
* * * * *


Sec.  240.3b-3  [Removed]


Sec.  240.10a-2  [Removed]

0
2. Sections 240.3b-3 and 240.10a-2 are removed and reserved.


Sec.  240.10a-1  [Amended]

0
3. Section 240.10a-1 is amended by:
0
a. Removing the authority citations following the section;
0
b. Removing and reserving paragraphs (c) and (d); and
0
c. Removing paragraph (e)(13).

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

0
4. Part 241 is amended by adding Release No. 34-50103 and the release 
date of July 28, 2004 to the list of interpretive releases.

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

0
5. The authority citation for part 242 continues to 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.


0
6. The part heading for part 242 is revised as set forth above.


Sec.  242.105  [Amended]

0
7. Section 242.105, paragraph (b) is amended by removing the phrase 
``offerings filed under Sec.  230.415 of this chapter or to''.

0
8. Part 242 is amended by adding a new subject heading and Sec. Sec.  
242.200 through 242.203 to read as follows:

[[Page 48030]]

Regulation SHO--Regulation of Short Sales

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

Regulation SHO--Regulation of Short Sales


Sec.  242.200  Definition of ``short sale'' and marking requirements.

    (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) The person or his agent has title to it; or
    (2) The person has purchased, or has entered into an unconditional 
contract, binding on both parties thereto, to purchase it, but has not 
yet received it; or
    (3) The person owns a security convertible into or exchangeable for 
it and has tendered such security for conversion or exchange; or
    (4) The person has an option to purchase or acquire it and has 
exercised such option; or
    (5) The person has rights or warrants to subscribe to it and has 
exercised such rights or warrants; or
    (6) The person holds a security futures contract to purchase it and 
has received notice that the position will be physically settled and is 
irrevocably bound to receive the underlying security.
    (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) The broker or dealer acquired that security while acting in the 
capacity of a block positioner; and
    (2) If and 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) A broker-dealer shall be deemed to own a security even if it is 
not net long, if:
    (1) The broker-dealer is unwinding index arbitrage position 
involving a long basket of stock and one or more short index futures 
traded on a board of trade or one or more standardized options 
contracts as defined in 17 CFR 240.9b1(a)(4); and
    (2) If and to the extent that the broker-dealer's short position in 
the security is the subject of offsetting positions created and 
maintained in the course of bona-fide arbitrage, risk arbitrage, or 
bona fide hedge activities; and
    (3) 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.
    (f) 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(s), 
and supports its independent identity;
    (2) Each aggregation unit within the firm determines, at the time 
of each sale, its net position for every security that it trades;
    (3) All traders in an aggregation unit pursue only the particular 
trading objective(s) or strategy(s) of that aggregation unit and do not 
coordinate that strategy with any other aggregation unit; and
    (4) Individual traders are assigned to only one aggregation unit at 
any time.
    (g) A broker or dealer must mark all sell orders of any equity 
security as ``long,'' ``short,'' or ``short exempt.''
    (1) An order to sell shall be marked ``long'' only if the seller is 
deemed to own the security being sold pursuant to paragraphs (a) 
through (f) of this section and either:
    (i) The security to be delivered is in the physical possession or 
control of the broker or dealer; or
    (ii) It is reasonably expected that the security will be in the 
physical possession or control of the broker or dealer no later than 
the settlement of the transaction.
    (2) A short sale order shall be marked ``short exempt'' if the 
seller is relying on an exception from the tick test of 17 CFR 240.10a-
1, or any short sale price test of any exchange or national securities 
association.
    (h) 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.  242.201  Price test [Reserved].


Sec.  242.202T  Temporary short sale rule suspension.

    (a) The provisions of 17 CFR 240.10a-1(a) and any short sale price 
test for any exchange or national securities association shall not 
apply to short sales in such securities, or during such time periods, 
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. All other provisions of 17 CFR 
240.10a-1, Sec.  242.200, and Sec.  242.203 shall remain in effect.
    (b) No self-regulatory organization shall have a rule that is not 
in conformity with or conflicts with any order issued pursuant to 
paragraph (a) of this section.
    (c) This temporary section will expire on August 6, 2007.


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 an equity 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 purchaser's broker after the sale, or fail to deliver a security on 
the date delivery is due.
    (2) The provisions of paragraph (a)(1) of this section shall not 
apply:
    (i) To the loan of any security by a broker or dealer through the 
medium of a loan to another broker or dealer;
    (ii) If the broker or dealer knows, or has been reasonably informed 
by the seller, that the seller owns the security, and that the seller 
would deliver the security to the broker or dealer prior to the 
scheduled settlement of the transaction, but the seller failed to do 
so; or
    (iii) If, prior to any loan or arrangement to loan any security for 
delivery, 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.  242.200(g) existed; and

[[Page 48031]]

    (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 permissible price under 
any applicable short sale price test.
    (b) Short sales. (1) A broker or dealer may not accept a short sale 
order in an equity security from another person, or effect a short sale 
in an equity security for its own account, unless the broker or dealer 
has:
    (i) Borrowed the security, or entered into a bona-fide arrangement 
to borrow the security; or
    (ii) Reasonable grounds to believe that the security can be 
borrowed so that it can be delivered on the date delivery is due; and
    (iii) Documented compliance with this paragraph (b)(1).
    (2) The provisions of paragraph (b)(1) of this section shall not 
apply to:
    (i) A broker or dealer that has accepted a short sale order from 
another registered broker or dealer that is required to comply with 
paragraph (b)(1) of this section, unless the broker or dealer relying 
on this exception contractually undertook responsibility for compliance 
with paragraph (b)(1) of this section;
    (ii) Any sale of a security that a person is deemed to own pursuant 
to Sec.  242.200, provided that the broker or dealer has been 
reasonably informed that the person intends to deliver such security as 
soon as all restrictions on delivery have been removed. If the person 
has not delivered such security within 35 days after the trade date, 
the broker-dealer that effected the sale must borrow securities or 
close out the short position by purchasing securities of like kind and 
quantity;
    (iii) Short sales effected by a market maker in connection with 
bona-fide market making activities in the security for which this 
exception is claimed; and
    (iv) Transactions in security futures.
    (3) If a participant of a registered clearing agency has a fail to 
deliver position at a registered clearing agency in a threshold 
security for thirteen consecutive settlement days, the participant 
shall immediately thereafter close out the fail to deliver position by 
purchasing securities of like kind and quantity:
    (i) The provisions of this paragraph (b)(3) shall not apply to the 
amount of the fail to deliver position that the participant of a 
registered clearing agency had at a registered clearing agency on the 
settlement day immediately preceding the day that the security became a 
threshold security; provided, however, that if the fail to deliver 
position at the clearing agency is subsequently reduced below the fail 
to deliver position on the settlement day immediately preceding the day 
that the security became a threshold security, then the fail to deliver 
position excepted by this paragraph (b)(3)(i) shall be the lesser 
amount;
    (ii) The provisions of this paragraph (b)(3) shall not apply to the 
amount of the fail to deliver position in the threshold security that 
is attributed to short sales by a registered options market maker, if 
and to the extent that the short sales are effected by the registered 
options market maker to establish or maintain a hedge on options 
positions that were created before the security became a threshold 
security;
    (iii) If a participant of a registered clearing agency has a fail 
to deliver position at a registered clearing agency in a threshold 
security for thirteen consecutive settlement days, the participant and 
any broker or dealer for which it clears transactions, including any 
market maker that would otherwise be entitled to rely on the exception 
provided in paragraph (b)(2)(iii) of this section, may not accept a 
short sale order in the threshold security from another person, or 
effect a short sale in the threshold security for its own account, 
without borrowing the security or entering into a bona-fide arrangement 
to borrow the security, until the participant closes out the fail to 
deliver position by purchasing securities of like kind and quantity;
    (iv) If a participant of a registered clearing agency reasonably 
allocates a portion of a fail to deliver position to another registered 
broker or dealer for which it clears trades or for which it is 
responsible for settlement, based on such broker or dealer's short 
position, then the provisions of this paragraph (b)(3) relating to such 
fail to deliver position shall apply to the portion of such registered 
broker or dealer that was allocated the fail to deliver position, and 
not to the participant; and
    (v) A participant of a registered clearing agency shall not be 
deemed to have fulfilled the requirements of this paragraph (b)(3) 
where the participant enters into an arrangement with another person to 
purchase securities as required by this paragraph (b)(3), and the 
participant knows or has reason to know that the other person will not 
deliver securities in settlement of the purchase.
    (c) Definitions. (1) For purposes of this section, the term market 
maker has the same meaning as in section 3(a)(38) of the Securities 
Exchange Act of 1934 (``Exchange Act'') (15 U.S.C. 78c(a)(38)).
    (2) For purposes of this section, the term participant has the same 
meaning as in section 3(a)(24) of the Exchange Act (15 U.S.C. 
78c(a)(24)).
    (3) For purposes of this section, the term registered clearing 
agency means a clearing agency, as defined in section 3(a)(23)(A) of 
the Exchange Act (15 U.S.C. 78c(a)(23)(A)), that is registered with the 
Commission pursuant to section 17A of the Exchange Act (15 U.S.C. 78q-
1).
    (4) For purposes of this section, the term security future has the 
same meaning as in section 3(a)(55) of the Exchange Act (15 U.S.C. 
78c(a)(55)).
    (5) For purposes of this section, the term settlement day means any 
business day on which deliveries of securities and payments of money 
may be made through the facilities of a registered clearing agency.
    (6) For purposes of this section, the term threshold security means 
any equity security of an issuer that is registered pursuant to section 
12 of the Exchange Act (15 U.S.C. 78l) or for which the issuer is 
required to file reports pursuant to section 15(d) of the Exchange Act 
(15 U.S.C. 78o(d)):
    (i) For which there is an aggregate fail to deliver position for 
five consecutive settlement days at a registered clearing agency of 
10,000 shares or more, and that is equal to at least 0.5% of the 
issue's total shares outstanding;
    (ii) Is included on a list disseminated to its members by a self-
regulatory organization; and
    (iii) Provided, however, that a security shall cease to be a 
threshold security if the aggregate fail to deliver position at a 
registered clearing agency does not exceed the level specified in 
paragraph (c)(6)(i) of this section for five consecutive settlement 
days.
    (d) Exemptive authority. 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.

    By the Commission.

    Dated: July 28, 2004.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 04-17571 Filed 8-5-04; 8:45 am]
BILLING CODE 8010-01-P