[Federal Register Volume 72, Number 156 (Tuesday, August 14, 2007)]
[Proposed Rules]
[Pages 45558-45590]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-15709]



  Federal Register / Vol. 72, No. 156 / Tuesday, August 14, 2007 / 
Proposed Rules  

[[Page 45558]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 242

[Release No. 34-56213; File No. S7-19-07]
RIN 3235-AJ57


Amendments to Regulation SHO

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is re-
proposing amendments to Regulation SHO under the Securities Exchange 
Act of 1934 (``Exchange Act''). The proposed amendments are intended to 
further reduce the number of persistent fails to deliver in certain 
equity securities by eliminating the options market maker exception. In 
addition, we are requesting comment regarding specific alternatives to 
our proposal to eliminate the options market maker exception.
    We are also proposing an amendment to the long sale marking 
provisions of Regulation SHO that would require that brokers and 
dealers marking a sale as ``long'' document the present location of the 
securities being sold.

DATES: Comments should be received on or before September 13, 2007.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number S7-19-07 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549.

All submissions should refer to File Number S7-19-07. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments 
are also available for public inspection and copying in the 
Commission's Public Reference Room, 100 F Street, NE., Washington, DC 
20549. All comments received will be posted without change; we do not 
edit personal identifying information from submissions. You should 
submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Associate 
Director, Josephine J. Tao, Assistant Director, Victoria L. Crane, 
Branch Chief, Elizabeth A. Sandoe, Branch Chief, Joan M. Collopy, 
Special Counsel, and Lillian S. Hagen, Special Counsel, Office of 
Trading Practices and Processing, Division of Market Regulation, at 
(202) 551-5720, at the Securities and Exchange Commission, 100 F 
Street, NE., Washington, DC 20549-6628.

SUPPLEMENTARY INFORMATION: The Commission is requesting public comment 
on proposed amendments to Rules 200 and 203 of Regulation SHO [17 CFR 
242.200 and 242.203] under the Exchange Act.

I. Introduction

    Regulation SHO, which became fully effective on January 3, 2005, 
sets forth the regulatory framework governing short sales.\1\ Among 
other things, Regulation SHO imposes a close-out requirement to address 
failures to deliver stock on trade settlement date\2\ and to target 
potentially abusive ``naked'' short selling\3\ in certain equity 
securities.\4\ While the majority of trades settle on time,\5\ 
Regulation SHO is intended to address those situations where the level 
of fails to deliver for the particular stock is so substantial that it 
might impact the market for that security.\6\ Although high fails 
levels exist only for a small percentage of issuers,\7\ we are 
concerned that large and persistent fails to deliver may have a 
negative effect on the market in these securities. For example, large 
and persistent fails to deliver may deprive shareholders of the 
benefits of

[[Page 45559]]

ownership, such as voting and lending. In addition, where a seller of 
securities fails to deliver securities on settlement date, in effect 
the seller unilaterally converts a securities contract (which should 
settle within the standard 3-day settlement period) into an undated 
futures-type contract, to which the buyer might not have agreed, or 
that might have been priced differently. Moreover, sellers that fail to 
deliver securities on settlement date may enjoy fewer restrictions than 
if they were required to deliver the securities within a reasonable 
period of time, and such sellers may attempt to use this additional 
freedom to engage in trading activities that are designed to improperly 
depress the price of a security.
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    \1\ 17 CFR 242.200. See also Securities Exchange Act Release No. 
50103 (July 28, 2004), 69 FR 48008 (Aug. 6, 2004) (``Adopting 
Release''), available at http://www.sec.gov/rules/final/34-50103.htm.
    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 may 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 owns, 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.
    \2\ Generally, investors must complete or settle their security 
transactions within three business days. This settlement cycle is 
known as T+3 (or ``trade date plus three days''). T+3 means that 
when the investor purchases a security, the purchaser's payment must 
be received by its brokerage firm no later than three business days 
after the trade is executed. When the investor sells a security, the 
seller must deliver its securities, in certificated or electronic 
form, to its brokerage firm no later than three business days after 
the sale. The three-day settlement period applies to most security 
transactions, including stocks, bonds, municipal securities, mutual 
funds traded through a brokerage firm, and limited partnerships that 
trade on an exchange. Government securities and stock options settle 
on the next business day following the trade. Because the Commission 
recognized that there are many legitimate reasons why broker-dealers 
may not deliver securities on settlement date, it adopted Rule 15c6-
1, which prohibits broker-dealers from effecting or entering into a 
contract for the purchase or sale of a security that provides for 
payment of funds and delivery of securities later than the third 
business day after the date of the contract unless otherwise 
expressly agreed to by the parties at the time of the transaction. 
17 CFR 240.15c6-1. However, failure to deliver securities on T+3 
does not violate the rule.
    \3\ We have previously noted that abusive ``naked'' short 
selling, while not defined in the federal securities laws generally 
refers to selling short without having stock available for delivery 
and intentionally failing to deliver stock within the standard three 
day settlement cycle. See Securities Exchange Act Release No. 54154 
(July 14, 2006), 71 FR 41710 (July 21, 2006) (``2006 Proposing 
Release'').
    \4\ In 2003, the Commission settled a case against certain 
parties relating to allegations of manipulative short selling in the 
stock of Sedona Corporation. The Commission alleged that the 
defendants profited from engaging in massive naked short selling 
that flooded the market with Sedona stock, and depressed its price. 
See Rhino Advisors, Inc. and Thomas Badian, Lit. Rel. No. 18003 
(Feb. 27, 2003); see also, SEC v. Rhino Advisors, Inc. and Thomas 
Badian, Civ. Action No. 03 civ 1310 (RO) (S.D.N.Y). See also, 
Securities Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR 
62972, 62975 (Nov. 6, 2003) (``2003 Proposing Release'') (describing 
the alleged activity in the case involving stock of Sedona 
Corporation); Adopting Release, 69 FR at 48016, n.76.
    \5\ According to the National Securities Clearing Corporation 
(``NSCC''), 99% (by dollar value) of all trades settle on time. 
Thus, on an average day, approximately 1% (by dollar value) of all 
trades, including equity, debt, and municipal securities fail to 
settle. The vast majority of these fails are closed out within five 
days after T+3.
    \6\ These fails to deliver may result from either short or long 
sales of stock. There may be many reasons for a fail to deliver. For 
example, human or mechanical errors or processing delays can result 
from transferring securities in physical certificate rather than 
book-entry form, thus causing a failure to deliver on a long sale 
within the normal three-day settlement period. Also, broker-dealers 
that make a market in a security (``market makers'') and who sell 
short thinly-traded, illiquid stock in response to customer demand 
may encounter difficulty in obtaining securities when the time for 
delivery arrives.
    \7\ The average daily number of securities on a threshold list 
(as defined infra note 13) in March 2007 was approximately 311 
securities, which comprised 0.39% of all equity securities, 
including those that are not covered by Regulation SHO. Regulation 
SHO's current close-out requirement applies to any equity security 
of an issuer that is registered under Section 12 of the Exchange 
Act, or that is required to file reports pursuant to Section 15(d) 
of the Exchange Act.
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    In addition, many issuers and investors continue to express 
concerns about extended fails to deliver in connection with ``naked'' 
short selling.\8\ To the extent that large and persistent fails to 
deliver might be indicative of manipulative ``naked'' short selling, 
which could be used as a tool to drive down a company's stock price, 
such fails to deliver may undermine the confidence of investors.\9\ 
These investors, in turn, may be reluctant to commit capital to an 
issuer they believe to be subject to such manipulative conduct.\10\ In 
addition, issuers may believe that they have suffered unwarranted 
reputational damage due to investors' negative perceptions regarding 
large and persistent fails to deliver in the issuer's security.\11\ Any 
unwarranted reputational damage caused by large and persistent fails to 
deliver might have an adverse impact on the security's price.\12\
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    \8\ See, e.g., letter from Patrick M. Byrne, Chairman and Chief 
Executive Officer, Overstock.com, Inc., dated Sept. 11, 2006 
(``Overstock''); letter from Daniel Behrendt, Chief Financial 
Officer, and Douglas Klint, General Counsel, TASER International, 
dated Sept. 18, 2006 (``TASER''); letter from John Royce, dated 
April 30, 2007; letter from Michael Read, dated April 29, 2007; 
letter from Robert DeVivo, dated April 26, 2007; letter from Ahmed 
Akhtar, dated April 26, 2007.
    \9\ See, e.g., letter from Mary Helburn, Executive Director, 
National Coalition Against Naked Shorting, dated Sept. 30, 2006 
(``NCANS''); letter from Richard Blumenthal, Attorney General, State 
of Connecticut, dated Sept. 19, 2006 (``State of Connecticut'') 
(discussing the impact of fails to deliver on investor confidence).
    \10\ See, e.g., letter from Congressman Tom Feeney--Florida, 
U.S. House of Representatives, dated Sept. 25, 2006 (``Feeney'') 
(expressing concern about the impact of potential ``naked'' short 
selling on capital formation, claiming that ``naked'' short selling 
causes a drop in an issuer's stock price and may limit the issuer's 
ability to access the capital markets); letter from Zix Corporation, 
dated Sept. 19, 2006 (``Zix'') (stating that ``[m]any investors 
attribute the Company's frequent re-appearances on the Regulation 
SHO list to manipulative short selling and frequently demand that 
the Company ``do something'' about the perceived manipulative short 
selling. This perception that manipulative short selling of the 
Company's securities is continually occurring has undermined the 
confidence of many of the Company's investors in the integrity of 
the market for the Company's securities'').
    \11\ Due, in part, to such concerns, issuers have taken actions 
to attempt to make transfer of their securities ``custody only,'' 
thus preventing transfer of their stock to or from securities 
intermediaries such as the Depository Trust Company (``DTC'') or 
broker-dealers. A number of issuers have attempted to withdraw their 
issued securities on deposit at DTC, which makes the securities 
ineligible for book-entry transfer at a securities depository. We 
note, however, that in 2003 the Commission approved a DTC rule 
change clarifying that its rules provide that only its participants 
may withdraw securities from their accounts at DTC, and establishing 
a procedure to process issuer withdrawal requests. See Securities 
Exchange Act Release No. 47978 (June 4, 2003), 68 FR 35037 (June 11, 
2003).
    \12\ See also 2006 Proposing Release, 71 FR at 41712 (discussing 
the impact of large and persistent fails to deliver on the market). 
See also 2003 Proposing Release, 68 FR at 62975 (discussing the 
impact of ``naked'' short selling on the market).
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    The close-out requirement, which is contained in Rule 203(b)(3) of 
Regulation SHO, applies only to securities in which a substantial 
amount of fails to deliver have occurred (also known as ``threshold 
securities'').\13\ As adopted in August 2004, Rule 203(b)(3) of 
Regulation SHO included two exceptions to the mandatory close-out 
requirement. The first was the ``grandfather'' provision, which 
excepted fails to deliver established prior to a security becoming a 
threshold security.\14\ The second was the ``options market maker 
exception,'' which excepted any fail to deliver in a threshold security 
resulting from short sales effected by a registered options market 
maker to establish or maintain a hedge on options positions that were 
created before the underlying security became a threshold security.\15\
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    \13\ A threshold security is defined in Rule 203(c)(6) as 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; and 
(ii) that is included on a list (``threshold securities list'') 
disseminated to its members by a self-regulatory organization 
(``SRO''). See 17 CFR 242.203(c)(6). Each SRO is responsible for 
providing the threshold securities list for those securities for 
which the SRO is the primary market.
    \14\ See Adopting Release, 69 FR at 48031. The ``grandfathered'' 
status applied in two situations: (i) to fail to deliver positions 
occurring before January 3, 2005, Regulation SHO's effective date; 
and (ii) to fail to deliver positions that were established on or 
after January 3, 2005 but prior to the security appearing on a 
threshold securities list.
    \15\ See Adopting Release, 69 FR at 48031.
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    At the time of Regulation SHO's adoption, the Commission stated 
that it would monitor the operation of Regulation SHO to determine 
whether grandfathered fail to deliver positions were being cleared up 
under the existing delivery and settlement guidelines or whether any 
further regulatory action with respect to the close out provisions of 
Regulation SHO was warranted.\16\ In addition, with respect to the 
options market maker exception, the Commission noted that it would take 
into consideration any indications that this provision was operating 
significantly differently from the Commission's original 
expectations.\17\
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    \16\ See id. at 48018.
    \17\ See id. at 48019.
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    Based, in part, on the results of examinations conducted by the 
Commission's staff and the SROs since Regulation SHO's adoption, as 
well as the persistence of certain securities on threshold securities 
lists, on July 14, 2006, the Commission published proposed amendments 
to Regulation SHO,\18\ which were intended to reduce the number of 
persistent fails to deliver in certain equity securities by eliminating 
the grandfather provision and narrowing the options market maker 
exception contained in that rule. In addition, in March 2007, the 
Commission re-opened the comment period to the 2006 Proposing Release 
for thirty days to provide the public with an opportunity to comment on 
a summary of the National Association of Securities Dealers, Inc.'s 
(``NASD's'') analysis that the NASD had submitted to the public file on 
March 12, 2007. In addition, the notice regarding the re-opening of the 
comment period directed the public's attention to summaries of data 
collected by the Commission's Office of Compliance Inspections and 
Examinations and the New York Stock Exchange LLC (``NYSE'').\19\
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    \18\ See 2006 Proposing Release, 71 FR 41719.
    \19\ In formulating its proposal to eliminate the grandfather 
provision and narrow the options market maker exception of 
Regulation SHO, the Commission relied in part on data collected by 
the NASD. In response to commenters' concerns regarding the public 
availability of data relied on by the Commission, we re-opened the 
comment period to the 2006 Proposing Release for thirty days to 
provide the public with an opportunity to comment on a summary of 
the NASD's analysis that the NASD had submitted to the public file 
on March 12, 2007. See Securities Exchange Act Release No. 55520 
(March 26, 2007), 72 FR 15079 (March 30, 2007) (``Regulation SHO Re-
Opening Release'').
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    On June 13, 2007, in a companion rule to this proposal, after 
careful consideration of public comments, we approved the adoption of 
the amendment, as proposed, to eliminate the grandfather provision of 
Regulation

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SHO.\20\ With respect to the options market maker exception, however, 
in response to comments to the 2006 Proposing Release, we are re-
proposing amendments to the current options market maker exception that 
would eliminate the exception.
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    \20\ See Securities Exchange Act Release No. 56212 (Aug. 7, 
2007).
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    We are concerned that persistent fails to deliver will continue in 
certain equity securities unless the options market maker exception is 
eliminated entirely. Thus, as discussed more fully below, our proposal 
would modify Rule 203(b)(3) by eliminating the exception. In addition, 
we are requesting comment regarding alternatives to eliminating the 
options market maker exception that would require fails to deliver in 
threshold securities underlying options to be closed out within 
specific time-frames.
    We are also proposing an amendment to the long sale marking 
provisions of Rule 200(g)(1) of Regulation SHO that would require that 
brokers and dealers marking a sale as ``long'' document the present 
location of the securities.

II. Background

A. Rule 203(b)(3)'s Close-out Requirement

    One of Regulation SHO's primary goals is to reduce fails to deliver 
in those securities with a substantial amount of fails to deliver by 
imposing additional delivery requirements on participants of a 
registered clearing agency with fails to deliver in these 
securities.\21\ As discussed above, we believe that additional delivery 
requirements help protect and enhance the operation, integrity and 
stability of the markets, as well as reduce short selling abuses.
    Thus, Rule 203(b)(3)'s close-out requirement requires a participant 
of a clearing agency registered with the Commission \22\ to take 
immediate action to close out a fail to deliver position in a threshold 
security in the Continuous Net Settlement (``CNS'') \23\ system that 
has persisted for 13 consecutive settlement days by purchasing 
securities of like kind and quantity.\24\ In addition, if the failure 
to deliver has persisted for 13 consecutive settlement days, Rule 
203(b)(3)(iv) prohibits the participant, and any broker-dealer for 
which it clears transactions, including market makers, from accepting 
any short sale orders or effecting further short sales in the 
particular threshold security without borrowing, 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.\25\
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    \21\ See Adopting Release, 69 FR at 48009.
    \22\ For purposes of Regulation SHO, the term ``participant'' 
has the same meaning as in section 3(a)(24) of the Exchange Act. See 
15 U.S.C. 78c(a)(24). The term ``registered clearing agency'' means 
a clearing agency, as defined in section 3(a)(23) of the Exchange 
Act, that is registered as such pursuant to section 17A of the 
Exchange Act. See 15 U.S.C. 78c(a)(23)(A), 78q-1 and 15 U.S.C. 78q-
1(b), respectively. See also, Adopting Release, 69 FR at 48031. As 
of May 2007, approximately 90% of participants of the NSCC, the 
primary registered clearing agency responsible for clearing U.S. 
transactions, were registered as broker-dealers. Those participants 
not registered as broker-dealers include such entities as banks, 
U.S.-registered exchanges, and clearing agencies. Although these 
entities are participants of a registered clearing agency, generally 
these entities do not engage in the types of activities that would 
implicate the close-out requirements of Regulation SHO. Such 
activities of these entities include creating and redeeming Exchange 
Traded Funds, trading in municipal securities, and using NSCC's 
Envelope Settlement Service or Inter-city Envelope Settlement 
Service. These activities rarely lead to fails to deliver and, if 
fails to deliver do occur, they are small in number and are usually 
closed out within a day. Thus, such fails to deliver would not 
trigger the close-out provisions of Regulation SHO.
    \23\ The majority of equity trades in the United States are 
cleared and settled through systems administered by clearing 
agencies registered with the Commission. The National Securities 
Clearing Corporation (``NSCC'') clears and settles the majority of 
equity securities trades conducted on the exchanges and over the 
counter. NSCC clears and settles trades through the CNS system, 
which nets the securities delivery and payment obligations of all of 
its members. NSCC notifies its members of their securities delivery 
and payment obligations daily. In addition, NSCC guarantees the 
completion of all transactions and interposes itself as the 
contraparty to both sides of the transaction. While NSCC's rules do 
not authorize it to require member firms to close out or otherwise 
resolve fails to deliver, NSCC reports to the SROs those securities 
with fails to deliver of 10,000 shares or more. The SROs use NSCC 
fails data to determine which securities are threshold securities 
for purposes of Regulation SHO.
    \24\ 17 CFR 242.203(b)(3).
    \25\ Id. at (b)(3)(iv). It is possible under Regulation SHO that 
a close out by a participant of a registered clearing agency may 
result in a fail to deliver position at another participant if the 
counterparty from which the participant purchases securities fails 
to deliver. However, Regulation SHO prohibits a participant of a 
registered clearing agency, or a broker-dealer for which it clears 
transactions, from engaging in ``sham close outs'' by entering into 
an arrangement with a counterparty to purchase securities for 
purposes of closing out a fail to deliver position and the purchaser 
knows or has reason to know that the counterparty will not deliver 
the securities, and which thus creates another fail to deliver 
position. See id. at (b)(3)(vii); Adopting Release, 69 FR at 48018 
n.96. In addition, we note that borrowing securities, or otherwise 
entering into an arrangement with another person to create the 
appearance of a purchase would not satisfy the close-out requirement 
of Regulation SHO. For example, the purchase of paired positions of 
stock and options that are designed to create the appearance of a 
bona fide purchase of securities but that are nothing more than a 
temporary stock lending arrangement would not satisfy Regulation 
SHO's close-out requirement.
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B. Regulation SHO's Options Market Maker Exception

1. Current Options Market Maker Exception
    Regulation SHO's options market maker exception excepts from the 
close-out requirement of Rule 203(b)(3) any fail to deliver position in 
a 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.\26\ The options market maker 
exception was created to address concerns regarding liquidity and the 
pricing of options.\27\ The exception does not require that such fails 
to deliver be closed out.
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    \26\ 17 CFR 242.203(b)(3)(iii).
    \27\ In response to the proposal to adopt Regulation SHO and the 
Commission's determination at that time not to provide an exception 
for market makers, including options market makers, from the 
delivery requirements of proposed Regulation SHO, the Commission 
received letters that 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 makers would make markets without the ability to 
hedge by selling short the underlying security. In addition, one 
commenter stated that the heightened delivery requirements of 
proposed Regulation SHO for threshold securities could drain 
liquidity in other securities where there is no current indication 
of significant settlement failures. The commenter believed that, 
while a blanket exception 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. See Adopting Release, 69 FR at 48019 (discussing the 
comment letters received in response to the delivery requirements of 
proposed Regulation SHO). In part, in response to these comments, we 
adopted a limited options market maker exception to the close-out 
requirement of Regulation SHO. As discussed in more detail in this 
release and, in particular, in Section II.B.3. below, we no longer 
believe that the current options market maker exception is 
necessary.
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    Since Regulation SHO's effective date in January, 2005, the Staff 
and the SROs have been examining firms for compliance with Regulation 
SHO, including the close-out provisions. We have received preliminary 
data that indicates that Regulation SHO appears to be significantly 
reducing fails to deliver without disruption to the market.\28\ 
However, despite this positive

[[Page 45561]]

impact, we continue to observe a small number of threshold securities 
with substantial and persistent fail to deliver positions that are not 
being closed out under existing delivery and settlement requirements.
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    \28\ For example, in comparing a period prior to the effective 
date of the current rule (April 1, 2004 to December 31, 2004) to a 
period following the effective date of the current rule (January 1, 
2005 to March 31, 2007) for all stocks with aggregate fails to 
deliver of 10,000 shares or more as reported by NSCC:
     The average daily aggregate fails to deliver declined 
by 29.5%;
     The average daily number of securities with aggregate 
fails to deliver of at least 10,000 shares declined by 5.8%;
     The average daily number of fails to deliver declined 
by 15.1%;
     The average age of a fail to deliver position declined 
by 25.5%;
     The average daily number of threshold securities 
declined by 39.0%; and
     The average daily fails to deliver of threshold 
securities declined by 52.9%.
    See also supra note 7.
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    Based on the examinations and our discussions with the SROs and 
market participants, we believe that these persistent fail to deliver 
positions may be attributable, in part, to reliance on the options 
market maker exception.\29\ Accordingly, on July 14, 2006, the 
Commission published the 2006 Proposing Release that included proposed 
amendments to limit the duration of the options market maker 
exception.\30\
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    \29\ As noted in the 2006 Proposing Release and the Regulation 
SHO Re-Opening Release, we believe that the persistent fails to 
deliver may be attributable primarily to the grandfather provision 
and, secondarily, to reliance on the options market maker exception. 
See 2006 Proposing Release, 71 FR at 41712; Regulation SHO Re-
Opening Release, 72 FR at 15079 (providing a summary of data 
received from certain SROs regarding reasons for the extended fails 
to deliver).
    \30\ See 2006 Proposing Release, 71 FR at 41722.
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    The Commission, in the 2006 Proposing Release, proposed that for 
securities that are threshold securities on the effective date of the 
amendment, any previously excepted fail to deliver position in the 
threshold security that resulted from short sales effected by a 
registered options market maker to establish or maintain a hedge on an 
options position that existed before the security became a threshold 
security, but that has expired or been liquidated on or before the 
effective date of the amendment, would be required to be closed out 
within 35 consecutive settlement days of the effective date of the 
amendment. In addition, if the fail to deliver position persisted for 
35 consecutive settlement days, the proposal would have prohibited a 
participant of a registered clearing agency, and any broker-dealer for 
which it clears transactions, including market makers, from accepting 
any short sale orders or effecting further short sales in the 
particular threshold security without borrowing, or entering into a 
bona-fide arrangement to borrow, the security until the participant 
closed out the entire fail to deliver position by purchasing securities 
of like kind and quantity.
    If the security became a threshold security after the effective 
date of the amendment, all fail to deliver positions in the security 
that result or resulted from short sales effected by a registered 
options market maker to establish or maintain a hedge on an options 
position that existed before the security became a threshold security 
would have to be closed out within 13 consecutive settlement days of 
the security becoming a threshold security or of the expiration or 
liquidation of the options position, whichever was later. In addition, 
if the fail to deliver position persisted for 13 consecutive settlement 
days from the date on which the security became a threshold security or 
the options position had expired or was liquidated, whichever was 
later, the proposal would have prohibited a participant of a registered 
clearing agency, and any broker-dealer for which it clears 
transactions, including market makers, from accepting any short sale 
orders or effecting further short sales in the particular threshold 
security without borrowing, or entering into a bona-fide arrangement to 
borrow, the security until the participant closed out the entire fail 
to deliver position by purchasing securities of like kind and quantity.
    Thus, under the 2006 Proposing Release, registered options market 
makers would still have been able to continue to keep open fail to 
deliver positions in threshold securities that resulted from short 
sales to hedge an options position created prior to the time the 
underlying security became a threshold security, provided the options 
position had not expired or been liquidated. Once the underlying 
security became a threshold security and the specific options position 
being hedged had expired or been liquidated, however, such fails to 
deliver would have been subject to a 13 consecutive settlement day 
close-out requirement.
2. Comments to the 2006 Proposing Release
    We received a number of comment letters on the proposed narrowing 
of the options market maker exception from a variety of entities 
including options market makers, SROs, associations, issuers, an 
academic, and individual retail investors.\31\
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    \31\ See, e.g., letter from Overstock, supra note 8; letter from 
NCANS, supra note 9; letter from Joseph P. Borg, Esq., President, 
North American Securities Administrators Association, Inc., dated 
Oct. 4, 2006 (``NASAA''); letter from TASER, supra note 8; letter 
from James J. Angel, PhD, CFA, dated July 18, 2006 (``Angel''); 
letter from Margaret Wiermanski, Chief Operations Officer and 
Matthew Abraham, Compliance Officer, CTC LLC, dated Sept. 28, 2006 
(``CTC LLC''); letter from Timothy D. Lobach, Keystone Trading 
Partners, dated Sept. 19, 2006 (``Keystone''); letter from Steve 
Keltz, General Counsel, Citigroup Derivatives Markets, Inc., dated 
Sept. 29, 2006 (``Citigroup''); letter from Robert Bellick, Managing 
Director, Chris Gust, Managing Director, and Megan Flaherty, 
Director of Compliance and Chief Legal Counsel, Wolverine Trading 
LLC, dated Sept. 25, 2006 (``Wolverine''); letter from Edward J. 
Joyce, President and Chief Operating Officer, Chicago Board Options 
Exchange, dated October 11, 2006 (``CBOE''); letter from The 
American Stock Exchange, Boston Options Exchange, Chicago Board 
Options Exchange, International Securities Exchange, NYSE/Arca, The 
Options Clearing Corporation, Philadelphia Stock Exchange, dated 
Sept. 22, 2006 (``Options Exchanges''); letter from Ira D. 
Hammerman, Senior Vice President and General Counsel, Securities 
Industry Association, dated Sept. 19, 2006 (``SIA''); letter from 
Keith F. Higgins, Chair, Committee on Federal Regulation of 
Securities, American Bar Association Section of Business Law, dated 
Sept. 27, 2006 (``ABA''); letter from Gerard S. Citera, Executive 
Director, U.S. Equities, UBS Securities LLC, dated Sept. 22, 2006 
(``UBS'').
---------------------------------------------------------------------------

    Several commenters supported the proposal to narrow the options 
market maker exception. For example, one commenter stated that 13 
consecutive settlement days was more than a sufficient amount of time 
in which to close out a fail to deliver position relating to an options 
position.\32\ Another commenter stated that it believes the current 
``exemption can be exploited to manipulate prices downward by 
manipulators buying large numbers of put options in already heavily-
shorted securities.'' \33\ Some of these commenters recommended that 
the Commission eliminate the options market maker exception 
altogether,\34\ or, reduce the close-out requirement to five 
consecutive settlement days.\35\ In addition, commenters that supported 
the proposal to narrow the options market maker exception also urged 
the Commission to enhance the documentation requirements for 
establishing eligibility for the exception.\36\
---------------------------------------------------------------------------

    \32\ See letter from Overstock, supra note 8.
    \33\ See letter from NCANS, supra note 9.
    \34\ See, e.g., id.
    \35\ See letter from NASAA, supra note 31.
    \36\ See, e.g., id.; TASER, supra note 8.
---------------------------------------------------------------------------

    Commenters who opposed the proposal to narrow the options market 
maker exception stated that the proposed amendments would disrupt the 
markets because they would not provide sufficient flexibility to permit 
efficient hedging by options market makers, would unnecessarily 
increase risks and costs to hedge, and would adversely impact liquidity 
and result in higher costs to customers.\37\ These commenters stated 
that they believe the proposed amendments would likely

[[Page 45562]]

discourage options market makers from making markets in illiquid 
securities since the risk associated in maintaining the hedges in these 
option positions would be too great.\38\ Moreover, these commenters 
claimed that the reluctance of options market makers to make markets in 
threshold securities would result in wider spreads in such securities 
to account for the increased costs of hedging, to the detriment of 
investors.\39\
---------------------------------------------------------------------------

    \37\ See, e.g., letter from CBOE, supra note 31.
    \38\ See id.
    \39\ See letter from Citigroup, supra note 31.
---------------------------------------------------------------------------

    Many of the commenters who opposed the proposal to narrow the 
options market maker exception argued that the requirement that fail to 
deliver positions be closed out upon liquidation or expiration of a 
specifically hedged options position was impracticable, given that the 
industry practice is to use hedges to manage risk of an entire 
inventory, not just a specific options position.\40\ These commenters 
noted that options market makers typically facilitate an investor's 
rolling of an existing options position to either a different strike 
price within the same expiration month or to a future month as 
expiration approaches, and retain the short position to hedge the new 
options position.\41\ These commenters argued that the amendment would 
require the options market maker to buy in the short position and/or 
pre-borrow to maintain a hedge, even though the overall position may 
have changed very little from a risk perspective, which, they argued, 
could potentially be a costly and time consuming measure.\42\
---------------------------------------------------------------------------

    \40\ For example, CBOE stated that options market makers hedge 
on a class basis and, therefore, as options positions are rolled to 
forward months, the options market maker may need to maintain the 
hedge. Thus, the stock position would need to be maintained not 
because it hedges a particular series, but because it maintains a 
delta of an overall position. See letter from CBOE, supra note 31. 
See, also, letters from CTC LLC, supra note 31; Citigroup, supra 
note 31; Wolverine, supra note 31.
    \41\ See, e.g., letters from Citigroup, supra note 31; 
Wolverine, supra note 31; Options Exchanges, supra note 31.
    \42\ See, e.g., letters from Wolverine, supra note 31; 
Citigroup, supra note 31.
---------------------------------------------------------------------------

    Commenters who opposed the proposed amendments to the options 
market maker exception favored maintaining the current exception, which 
they believe is already narrowly tailored.\43\ For example, one 
commenter stated that it believes the current exception preserves the 
integrity of legitimate hedging practices and prevents manipulative 
short squeezes.\44\ Another commenter stated that the current exception 
enables it to better service market participants by allowing it to 
continuously quote and disseminate bids and offers even where it may be 
difficult to borrow certain stock.\45\ Another commenter stated that it 
is unaware of any statistics establishing that fails to deliver 
attributable to legitimate options market making activity are 
correlated to abusive short selling practices, and cautioned that ``the 
possible detrimental effects on options markets in threshold securities 
should first be quantified to guard against an unanticipated, 
significant peril to another facet of the capital markets.'' \46\
---------------------------------------------------------------------------

    \43\ See id.
    \44\ See letter from Keystone, supra note 31.
    \45\ See letter from Citigroup, supra note 31.
    \46\ See letter from CTC LLC, supra note 31. Statistical 
evidence of options market maker failing practices can be found in 
Failure is an Option: Impediments to Short Selling and Options 
Prices by Evans, Geczy, Musto, and Reed, forthcoming in the Review 
of Financial Studies. See http://finance.wharton.upenn.edu/~musto/
papers/egmr.pdf.
---------------------------------------------------------------------------

3. Response to Comments to the 2006 Proposing Release
    We proposed to narrow the options market maker exception in 
Regulation SHO because we are concerned about large and persistent 
fails to deliver in threshold securities attributable, in part, to the 
options market maker exception, and our concerns that such fails to 
deliver might have a negative effect on the market in these 
securities.\47\
---------------------------------------------------------------------------

    \47\ See 2006 Proposing Release, 71 FR at 41711-41712; see also, 
Regulation SHO Re-Opening Release, 72 FR 15079-15080. See also, 
discussion above in Section I. Introduction.
---------------------------------------------------------------------------

    Regulation SHO's options market maker exception does not require 
fails to deliver to be closed out if they resulted from short sales 
effected by registered options market makers to establish or maintain a 
hedge on options positions established before the underlying security 
became a threshold security. For the reasons discussed below, although 
we recognize commenters' concerns that a mandatory close-out 
requirement for fails to deliver in threshold securities underlying 
options positions could potentially impact options market makers' 
willingness to provide liquidity in threshold securities, make it more 
costly for options market makers to accommodate customer buy orders, or 
result in wider bid-ask spreads or less depth, we believe that such an 
impact, if any, would be minimal.
    First, we believe that the potential effects, if any, of a 
mandatory close-out requirement would be minimal because the number of 
securities that would be impacted by a mandatory close-out requirement 
would be relatively small. Regulation SHO's close-out requirement is 
narrowly tailored in that it targets only those securities where the 
level of fails to deliver is high (0.5% of total shares outstanding and 
10,000 shares or more) for a continuous period (five consecutive 
settlement days).\48\ Requiring close-out only for securities with 
large and persistent fails to deliver limits the overall market impact. 
In addition, as noted by one commenter, a small number of securities 
that meet the definition of a ``threshold security'' have listed 
options, and those securities form a very small percentage of all 
securities that have options traded on them.\49\ Moreover, the current 
options market maker exception only excepts from Regulation SHO's 
mandatory 13 consecutive settlement day close-out requirement those 
fail to deliver positions that result from short sales effected by 
registered options market makers to establish or maintain a hedge on 
options positions established before the underlying security became a 
threshold security. Thus, it does not apply to fails to deliver 
resulting from short sales effected to establish or maintain a hedge on 
options positions established after the underlying security became a 
threshold security. Because the current options market maker exception 
has a very limited application, the overall impact of its removal on 
liquidity, hedging costs, spreads, and depth, should be relatively 
small.
---------------------------------------------------------------------------

    \48\ See supra note 7 (discussing the number of threshold 
securities as of March 31, 2007).
    \49\ See letter from Options Exchanges, supra note 31 (noting 
that as of the date of the 2006 Proposing Release, approximately 84 
of the approximately 300 threshold securities had options traded on 
them). This commenter also noted that ``options on a number of these 
threshold securities are very actively traded as are the securities 
themselves. Among the actively traded threshold securities with 
active options trading are iShares Russell 2000 ETF, Avanir 
Pharmaceuticals, Krispy Kreme Donuts, Martha Stewart Living 
Omnimedia, Mittal Steel, Navarre Corp., and Novastar Financial.'' 
See id.
---------------------------------------------------------------------------

    Second, to the extent that a mandatory close-out requirement could 
potentially impact options market makers' willingness to provide 
liquidity in threshold securities, make it more costly for options 
market makers to accommodate customer buy orders, or result in wider 
bid-ask spreads or less depth, we believe that any such potential 
effects would likely be mitigated by the fact that even though fails to 
deliver that were previously-excepted from the close-out requirement of 
Regulation SHO would not be permitted to continue indefinitely, such 
fails to deliver would not have to be closed out immediately, or even 
within the standard 3-day settlement period. Instead, under a mandatory 
close-out requirement, such as that imposed

[[Page 45563]]

currently by the 13 consecutive settlement day requirement of Rule 
203(b)(3) of Regulation SHO, fails to deliver in threshold securities 
would have an extended period of time within which to be closed out. An 
extended close-out requirement would provide options market makers with 
some flexibility in conducting their hedging activities in that it 
would allow them to not buy-in a fail to deliver position or pre-borrow 
to maintain a hedge for the time that the fail to deliver position can 
remain open.
    Third, as noted above, Regulation SHO's current options market 
maker exception is limited to only those fail to deliver positions that 
result from short sales effected by registered options market makers to 
establish or maintain a hedge on options positions established before 
the underlying security became a threshold security. Thus, it does not 
apply to fails to deliver resulting from short sales effected to 
establish or maintain a hedge on options positions established after 
the underlying security became a threshold security. In examining the 
application of the current mandatory close-out requirement of 
Regulation SHO for all non-excepted fail to deliver positions, we have 
not become aware of any evidence that the current close-out requirement 
for non-excepted fails to deliver in threshold securities has impacted 
options market makers' willingness to provide liquidity in threshold 
securities, made it more costly for options market makers to 
accommodate customer orders, or resulted in wider bid-ask spreads or 
less depth.
    Similarly, all fails to deliver in threshold securities resulting 
from long or short sales of securities in the equities markets must be 
closed out in accordance with Regulation SHO's mandatory 13 consecutive 
settlement day close-out requirement, and we are not aware that such a 
requirement has impacted the willingness of market makers to make 
markets in securities subject to the close-out requirement, or led to 
decreased liquidity, wider spreads, or less depth in these securities. 
Thus, we believe that the impact of requiring that fails to deliver in 
threshold securities resulting from short sales to hedge options 
positions created before the security became a threshold security be 
closed out would similarly be minimal, if any.
    Fourth, to the extent that a mandatory close-out requirement for 
all fails to deliver resulting from hedging activity in the options 
markets could potentially impact liquidity, hedging costs, depth, or 
spreads, or impact the willingness of options market makers to make 
markets in certain securities, we believe that such effects are 
justified by our belief, as discussed in more detail below, that fails 
to deliver resulting from hedging activities by options market makers 
should be treated similarly to fails to deliver resulting from sales in 
the equities markets so that market participants trading threshold 
securities in the options markets do not receive an advantage over 
those trading such securities in the equities markets.
    Fifth, to the extent that a mandatory close-out requirement for all 
fails to deliver resulting from hedging activity in the options markets 
could potentially impact liquidity, hedging costs, depth, or spreads, 
or impact the willingness of options market makers to make a market in 
certain securities, we believe that these potential effects are 
justified by the benefits of requiring that fails to deliver in all 
threshold securities be closed out within specific time-frames rather 
than being allowed to continue indefinitely. As discussed above, large 
and persistent fails to deliver can deprive shareholders of the 
benefits of ownership, such as voting and lending. They can also be 
indicative of potentially manipulative conduct, such as abusive 
``naked'' short selling. The deprivation of the benefits of ownership, 
as well as the perception that abusive ``naked'' short selling is 
occurring in certain securities, can undermine the confidence of 
investors. These investors, in turn, may be reluctant to commit capital 
to an issuer they believe to be subject to manipulative conduct.
    In the 2006 Proposing Release, we sought comment on whether the 
proposed amendments would promote capital formation, including whether 
the proposed increased short sale restrictions would affect investors' 
decisions to invest in certain equity securities. Commenters expressed 
concern about ``naked'' short selling causing a drop in an issuer's 
stock price and that it may limit an issuer's ability to access the 
capital markets.\50\ We believe that, by requiring that all fails to 
deliver in threshold securities be closed out within specific time-
frames rather than allowing them to continue indefinitely, there would 
be a decrease in the number of threshold securities with persistent and 
high levels of fails to deliver. If persistence on the threshold 
securities lists leads to an unwarranted decline in investor confidence 
about the security, the proposed amendments should improve investor 
confidence about the security. We also believe that the proposed 
amendments should lead to greater certainty in the settlement of 
securities which should strengthen investor confidence in the 
settlement process. The reduction in fails to deliver and the resulting 
reduction in the number of securities on the threshold securities lists 
could result in increased investor confidence, and the promotion of 
price efficiency and capital formation.
---------------------------------------------------------------------------

    \50\ See, e.g., letter from Feeney, supra note 10.
---------------------------------------------------------------------------

    Due to our concerns about the potentially negative market impact of 
large and persistent fails to deliver, and the fact that we continue to 
observe a small number of threshold securities with fail to deliver 
positions that are not being closed out under existing delivery and 
settlement requirements, we adopted amendments to eliminate Regulation 
SHO's grandfather provision that allowed fails to deliver resulting 
from long or short sales of equity securities to persist indefinitely 
if the fails to deliver occurred prior to the security becoming a 
threshold security.\51\ We believe that once a security becomes a 
threshold security, fails to deliver in that security must be closed 
out, regardless of whether or not the fails to deliver resulted from 
sales of the security in connection with the options or equities 
markets.
---------------------------------------------------------------------------

    \51\ See Securities Exchange Act Release No. 56212 (Aug. 7, 
2007); see also, 2006 Proposing Release, 71 FR at 41711-41712.
---------------------------------------------------------------------------

    Moreover, we believe that fails to deliver resulting from hedging 
activities by options market makers should be treated similarly to 
fails to deliver resulting from sales in the equities markets so that 
market participants trading threshold securities in the options markets 
do not receive an advantage over those trading such securities in the 
equities markets. We are also concerned that the current options market 
maker exception might allow for a regulatory arbitrage not permitted in 
the equities markets. For example, an options market maker who sells 
short to hedge put options purchased by a market participant unable to 
locate shares for a short sale in accordance with Rule 203(b)(2) of 
Regulation SHO may not have to close out any fails to deliver that 
result from such short sales under the current options market maker 
exception. The ability of options market makers to sell short and never 
have to close out a resulting fail to deliver position, provided the 
short sale was effected to hedge options positions created before the 
security became a threshold security, runs counter to the goal of 
similar treatment for fails to deliver resulting from sales of 
securities in the options and equities markets, because

[[Page 45564]]

no such ability is available in the equity markets.\52\
---------------------------------------------------------------------------

    \52\ See Securities Exchange Act Release No. 56212 (Aug. 7, 
2007).
---------------------------------------------------------------------------

    Although commenters who opposed the proposed amendments to the 
options market maker exception favored maintaining Regulation SHO's 
current options market maker exception, it has become apparent to us 
during the comment process that the language of the current exception 
is being interpreted more broadly than the Commission intended, such 
that the exception seems to be operating significantly differently from 
our original expectations.\53\ Thus, we are concerned that options 
market makers are claiming the exception even where options positions 
are created after the underlying security becomes a threshold security. 
For example, options market makers' practice of ``rolling'' positions 
from one expiration month to the next potentially allows these options 
market makers to not close out fail to deliver positions as required by 
the close-out requirements of Regulation SHO. According to commenters, 
when the options that allow an options market maker to be exempt from 
the close-out requirement expire or are closed out, investors on the 
opposite side may roll their long put or short call positions to a new 
expiration month.\54\ It appears that options market makers are not 
treating the rolling of options positions to a new expiration month as 
creating new options positions for purposes of the current options 
market maker exception even though the current options position 
typically is closed out and the same position is opened in the next 
expiration month.\55\
---------------------------------------------------------------------------

    \53\ The Commission noted in the Adopting Release that it would 
monitor the operation of Regulation SHO and, in so doing, would take 
into consideration any indications that the options market maker 
exception was operating significantly differently from the 
Commission's original expectations. See Adopting Release, 69 FR at 
48018-48019.
    \54\ See, e.g., letters from ABA, supra note 31; Wolverine, 
supra note 31.
    \55\ See, e.g., letter from Wolverine, supra note 31.
---------------------------------------------------------------------------

    Thus, options market makers providing liquidity to customers who 
are ``rolling'' positions from one expiration month to the next appear 
to use the original short sale to maintain the hedge on these new 
options positions, rather than closing out that original short sale and 
any fails to deliver that resulted from the short sale and establishing 
a new hedge. Regulation SHO's current options market maker exception 
provides that a fail to deliver position does not have to be closed out 
if it results from a short sale effected to establish or maintain a 
hedge on options positions created before the underlying security 
became a threshold security. Options market makers also may not be 
closing out fails to deliver that result from short sales effected to 
maintain or establish a hedge on options positions created after the 
underlying security became a threshold security. Such conduct would not 
be in compliance with the current options market maker exception and 
would allow options market makers to avoid improperly Regulation SHO's 
close-out requirement.\56\
---------------------------------------------------------------------------

    \56\ In addition, we are concerned that options market makers 
may not have systems in place to determine whether or not fails to 
deliver resulted from short sales effected to establish or maintain 
a hedge on options positions created before or after the underlying 
security became a threshold security, and, therefore, may not be 
complying with the requirements of the current exception.
---------------------------------------------------------------------------

    In addition, as a practical matter, we note that the cost of 
maintaining a fail to deliver position may change over time and, in 
particular, when a security becomes a threshold security. Thus, if 
options market makers, in accommodating their customers' rolling of 
options positions from one expiration month to the next, use the 
original short sale to maintain the hedge on these new options 
positions rather than closing out that short sale and any fails to 
deliver that resulted from the short sale and establishing a new hedge, 
any additional cost of maintaining a fail to deliver in the underlying 
security would not be properly transferred to the options positions.
    Despite our concerns noted above regarding the application of 
Regulation SHO's current options market maker exception, we credit 
commenters' statements that the amendments proposed in 2006 to narrow 
the current options market maker exception would be costly and 
difficult to implement, or even possibly unworkable, because they do 
not reflect how options market makers hedge their options positions. 
According to commenters, options market makers usually hedge their 
options positions on a portfolio basis.\57\ Thus, an options market 
maker typically does not assign a particular short or long position to 
a particular options position as would be required if the Commission 
were to adopt the 2006 amendments, as proposed. Only one commenter 
asked that the Commission be sensitive to the time necessary to make 
systems changes to track the requirements of the proposed 
amendments.\58\ Most commenters simply stated that the amendments 
proposed in 2006 would be difficult and costly to implement or possibly 
unworkable.
---------------------------------------------------------------------------

    \57\ See, e.g., letters from CBOE, supra note 31; Options 
Exchanges, supra note 31; Wolverine, supra note 31; UBS, supra note 
31; Angel, supra note 31.
    \58\ See letter from UBS, supra note 31.
---------------------------------------------------------------------------

    Based on commenters' concerns that they would be unable to comply 
with the amendments to the options market maker exception as proposed 
in the 2006 Proposing Release, and statements indicating that options 
market makers might be violating the current exception, we have 
determined to re-propose amendments to the options market maker 
exception.

III. Proposed Amendments to the Options Market Maker Exception

A. Elimination of the Options Market Maker Exception

    We propose to eliminate the options market maker exception in Rule 
203(b)(3) of Regulation SHO. In particular, the proposed amendment 
would require that any previously excepted fail to deliver position in 
a threshold security on the effective date of the amendment, including 
any adjustments to that fail to deliver position, be closed out within 
35 consecutive settlement days \59\ of the effective date of the 
amendment. This 35 consecutive settlement day requirement would be a 
one-time phase-in period. Thus, after 35 consecutive settlement days 
from the effective date of the amendment this phase-in period would 
expire and any additional fails to deliver in the threshold security 
would be subject to the current mandatory 13 consecutive settlement day 
close-out requirement of Rule 203(b)(3) of Regulation SHO.\60\
---------------------------------------------------------------------------

    \59\ If the security is a threshold security on the effective 
date of the amendment, participants of a registered clearing agency 
would have to close out that position within 35 consecutive 
settlement days, regardless of whether the security becomes a non-
threshold security after the effective date of the amendment.
    We chose 35 settlement days because 35 days was used in 
Regulation SHO as adopted in August 2004, and in Regulation SHO, as 
amended. See Adopting Release, 69 FR at 48031; Securities Exchange 
Act Release No. 56212 (Aug. 7, 2007). In addition, we believe that 
35 settlement days would allow participants time to close out their 
previously-excepted fail to deliver positions given that some 
participants may have large previously-excepted fails with respect 
to a number of securities.
    \60\ For example, assume that on the effective date of the 
amendment XYZ security is a threshold security and a participant of 
a registered clearing agency has fails to deliver in XYZ security 
that resulted from short sales by a registered options market maker 
to hedge options positions that were created before XYZ security 
became a threshold security. The participant must close out the 
fails to deliver in XYZ security within 35 consecutive settlement 
days of the effective date of the amendment, including any 
additional fails to deliver during that 35-day period that result 
from short sales by the registered options market maker to hedge 
options positions that were created before XYZ security became a 
threshold security. After the 35-day period has expired, if XYZ 
security remains a threshold security, any additional fails to 
deliver in XYZ security must be closed out in accordance with 
Regulation SHO's 13 consecutive settlement day close-out 
requirement, regardless of whether or not the fails to deliver 
resulted from short sales by a registered options market maker to 
hedge options positions that were created before XYZ security became 
a threshold security.

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

[[Page 45565]]

    In addition, similar to the pre-borrow requirement of Rule 
203(b)(3)(iv) of Regulation SHO, if the fail to deliver position 
persists for 35 consecutive settlement days from the effective date of 
the amendment, the proposed amendment would prohibit a participant, and 
any broker-dealer for which it clears transactions, including market 
makers, from accepting any short sale orders or effecting further short 
sales in the particular threshold security without borrowing, or 
entering into a bona-fide arrangement to borrow, the security until the 
participant closes out the entire fail to deliver position by 
purchasing securities of like kind and quantity. Any fails to deliver 
that were not previously-excepted from the close-out requirement of 
Rule 203(b)(3) of Regulation SHO as of the effective date of the 
amendment and, therefore, not subject to the one-time 35 consecutive 
settlement day phase-in period, would be subject to the pre-borrow 
requirement of Rule 203(b)(3)(iv) of Regulation SHO.
    If a security becomes a threshold security after the effective date 
of the amendment, any fails to deliver that result or resulted from 
short sales effected by a registered options market maker to establish 
or maintain a hedge on options positions that were created before the 
security became a threshold security would be subject to Rule 
203(b)(3)'s mandatory 13 consecutive settlement day close-out 
requirement, similar to any other fail to deliver position in a 
threshold security.
    For the reasons discussed above and in the 2006 Proposing Release, 
we believe that no fail to deliver position should be left open 
indefinitely. Although we included in Rule 203 of Regulation SHO 
exceptions to the close-out requirement of the rule, we also stated 
that we would pay close attention to the operation and efficacy of the 
provisions adopted in Rule 203, and would consider whether any further 
action was warranted.\61\ As discussed above, we continue to see a 
small number of threshold securities with large and persistent fails to 
deliver that are not being closed out under existing delivery and 
settlement requirements. We are concerned that these fails to deliver 
may have a potentially negative impact on the market for these 
securities by impeding the orderly functioning of the markets for these 
securities, depriving investors of ownership rights, undermining 
investor and issuer confidence in the markets, and being indicative of 
potentially manipulative trading activities. In addition, a seller that 
fails to deliver securities on trade settlement date effectively 
unilaterally converts a securities contract (that should settle within 
the standard 3-day settlement period) into an undated futures-type 
contract, to which the buyer might not have agreed, or that might have 
been priced differently.
---------------------------------------------------------------------------

    \61\ See Adopting Release, 69 FR at 48019.
---------------------------------------------------------------------------

    Thus, by proposing to eliminate the current options market maker 
exception of Regulation SHO so that all fails to deliver in threshold 
securities that result from short sales effected to maintain or 
establish a hedge on options positions would have to be closed out 
within Regulation SHO's current mandatory 13 consecutive settlement day 
close-out requirement similar to all other fails to deliver in 
threshold securities, we hope to reduce the number of threshold 
securities with large and persistent fails to deliver and, thereby, 
limit any potential negative impact of such fails to deliver on the 
market for these securities.
    In addition, the overly-broad interpretation of the current options 
market maker exception, as discussed above, could be contributing to 
some securities with listed options having large and persistent fails 
to deliver and remaining on the threshold securities list. Thus, we 
further believe it would be appropriate to eliminate the current 
exception.
    By proposing to eliminate the current options market maker 
exception, fails to deliver from hedging activities by options market 
makers would be treated similarly to fails to deliver resulting from 
sales in the equities markets so that market participants trading 
threshold securities in the options market would not receive an 
advantage over those trading such securities in the equities markets.
    In addition, we believe the proposed amendment would be warranted 
because it strikes the appropriate balance between reducing large and 
persistent fails to deliver in threshold securities while still 
allowing participants some flexibility in conducting their hedging 
activities. Under the proposed amendment, other than those previously-
excepted fails to deliver that would be subject to the one-time 35-day 
phase-in period, all fails to deliver in threshold securities would be 
subject to the current mandatory 13 consecutive settlement day close-
out requirement of Rule 203(b)(3) of Regulation SHO. Thus, the proposed 
amendment would provide flexibility because it would allow an extended 
period of time (i.e., 13 consecutive settlement days) within which to 
close out all fails to deliver in threshold securities, rather than, 
for example, requiring that such fails to deliver be closed out 
immediately, or even within the standard 3-day settlement period. 
During the period of time that the fail to deliver position could 
remain open, options market makers would be able to continue any 
hedging activity without having to close out the fail to deliver 
position or pre-borrow to maintain the hedge.
    In addition, we note that the one-time 35 consecutive settlement 
day phase-in period would help reduce any potential for market 
disruption, such as increased volatility or short squeezes, from having 
to close-out previously-excepted fail to deliver positions particularly 
as participants would be able to begin to close out such positions at 
anytime before the 35-day phase-in period.

Request for Comment

    The Commission seeks comment generally on all aspects of this 
proposed amendment to Regulation SHO. In addition, we seek comment on 
the following:
     The proposed amendment to eliminate the options market 
maker exception would require that fails to deliver that result from 
short sales effected to maintain or establish a hedge on options 
positions be closed out within Regulation SHO's current mandatory 13 
consecutive settlement day close-out requirement similar to other fails 
to deliver in any threshold security. We believe that fails to deliver 
in threshold securities should not last indefinitely. Thus, we proposed 
and adopted amendments to eliminate the grandfather provision in 
Regulation SHO so that fails to deliver resulting from long or short 
sales in the equities markets must be closed out within 13 consecutive 
settlement days. Should fails to deliver that result from short sales 
effected to maintain or establish a hedge on options positions be 
treated differently from fails to deliver that result from short or 
long sales of threshold securities in the equities markets? If so, why? 
Should market makers in the options markets be permitted to maintain a 
fail to deliver position in a threshold security for an extended period 
of time or indefinitely when market makers in the equities markets are 
not able to do so? If so, why? If not, why not?

[[Page 45566]]

     The options market maker exception was created to provide 
options market makers with flexibility in establishing and maintaining 
hedges on options positions created before the underlying security 
became a threshold security. Would elimination of the options market 
maker exception be appropriate? If so, why? If not, why not? Would 
elimination of the options market maker exception result in fewer 
options on threshold securities and what effect would this have on 
market efficiency and capital formation? Would eliminating the 
exception reduce the willingness of options market makers to make 
markets in securities that might become threshold securities or that 
are threshold securities? Would eliminating the exception result in 
increased costs to investors? Would options investors bear any 
additional costs that are not borne by the equivalent equity investors? 
Would eliminating this exception reduce liquidity in securities that 
might become threshold securities or that are threshold securities? How 
significant would such an impact be, if any, given that fails to 
deliver would be subject to Regulation SHO's current 13 consecutive 
settlement days close-out requirement similar to all other fails to 
deliver in threshold securities and that we are not aware that 
compliance with the current mandatory close-out requirement of 
Regulation SHO for non-excepted fails to deliver has resulted in market 
disruption? What other measures or time-frames would be effective in 
fostering Regulation SHO's goal of reducing fails to deliver while at 
the same time allowing market making by options market makers?
     Based on current experience with Regulation SHO, what have 
been the costs and benefits of the current options market maker 
exception?
     What are the costs and benefits of the proposed amendment 
to eliminate the options market maker exception?
     What technical or operational challenges would options 
market makers face in complying with the proposed amendment?
     Would the proposed amendment create additional costs, such 
as costs associated with systems, surveillance, or recordkeeping 
modifications that may be needed for participants to track fails to 
deliver subject to the 35 consecutive settlement day phase-in period 
from fails to deliver that are not eligible for the phase-in period? If 
there are additional costs associated with tracking fails to deliver 
subject to the 35 versus 13 consecutive settlement day requirements, 
would these additional costs justify the benefits of providing firms 
with a 35 consecutive settlement day phase-in period? Would a 35 
consecutive settlement day phase-in period be necessary given that 
firms would have been on notice that they would have to close out these 
fail to deliver positions following the effective date of the 
amendment?
     Should we consider changing the proposed phase-in period 
to 35 calendar days? If not, why not? If so, would this create systems 
problems or other costs? Would a phase-in period create examination or 
surveillance difficulties?
     Please provide specific comment as to what length of 
implementation period would be necessary such that participants would 
be able to meet the requirements that fail to deliver positions in 
threshold securities be closed out within the applicable time-frames, 
if adopted.

B. Alternatives To Eliminating the Options Market Maker Exception

    As discussed above, due to the fact that large and persistent fails 
to deliver are not being closed out under existing delivery and 
settlement requirements and because we are concerned that these fails 
to deliver may have a negative impact on the market for those 
securities, we believe that the options market maker exception to the 
mandatory close-out requirement of Rule 203(b)(3) of Regulation SHO 
should be eliminated. In addition, we believe that the options market 
maker exception should be eliminated because we believe that fails to 
deliver resulting from hedging activities by options market makers 
should be treated similarly to fails to deliver resulting from sales in 
the equities markets so that market participants trading threshold 
securities in the options markets do not receive an advantage over 
those trading such securities in the equities market.
    We anticipate, however, that in response to our request for comment 
on the proposed amendments to eliminate the options market maker 
exception, we will receive comment that an options market maker 
exception, similar to the current exception in Regulation SHO, is 
necessary. It has become apparent to us, however, that the current 
exception is being interpreted in such a way that the exception seems 
to be operating significantly differently from our original 
expectations, and that options market makers might be using the current 
exception to improperly avoid closing out certain fails to deliver in 
threshold securities. In addition, commenters stated that the proposed 
amendments to the options market maker exception set forth in the 2006 
Proposing Release would be impractical given the industry practice of 
using hedges to manage the risk of an entire inventory, not just a 
specific options position.\62\ Thus, in conjunction with our proposal 
to eliminate the options market maker exception, we have determined to 
solicit comment regarding two narrowly-tailored alternatives to the 
current options market maker exception and to our proposed elimination 
of that exception.
---------------------------------------------------------------------------

    \62\ See, e.g., letters from CBOE, supra note 31; CTC LLC, supra 
note 31; Citigroup, supra note 31; Wolverine, supra note 31.
---------------------------------------------------------------------------

    Because we are concerned that any exception to Regulation SHO's 
close-out requirement for fails to deliver resulting from short sales 
effected to establish or maintain a hedge on options positions might 
result in continued large and persistent fails to deliver in securities 
with options traded on them, the proposed alternatives would provide 
very limited exceptions to the close-out requirement of Regulation SHO 
so that all fails to deliver in threshold securities underlying options 
would eventually have to be closed out. Similar to elimination of the 
options market maker exception, by proposing to require that all fails 
to deliver be closed out within specific time-frames, the proposed 
alternatives should reduce large and persistent fails to deliver. The 
proposed alternatives, however, would provide participants of a 
registered clearing agency, or options market makers for which they 
clear transactions, longer periods of time than Regulation SHO's 
current mandatory 13 consecutive settlement day close-out requirement, 
within which to close out such fails to deliver.
    Also, similar to the proposed amendment to eliminate the options 
market maker exception, by proposing to require that fails to deliver 
be closed out within specific time-frames, the proposed alternatives 
would be more likely to result in shareholders receiving the benefits 
of ownership than under the current options market maker exception. 
Sellers would also be less able to unilaterally convert securities 
contracts into undated futures-type contracts to which the buyer may 
not have agreed, or that would have been priced differently. In 
addition, the delivery requirements of the proposed alternatives could 
enhance investor confidence as they make investment decisions by 
providing investors with greater assurance that securities would be 
delivered as expected. An increase in investor confidence in the market 
could facilitate investment.
    The proposed alternatives could benefit issuers because investors 
may be

[[Page 45567]]

more willing to commit capital where fails levels are lower. In 
addition, some issuers could believe that a reduction in fails to 
deliver could reverse unwarranted reputational damage potentially 
caused by large and persistent fails to deliver and what they believe 
might be an indication of manipulative trading activities, such as 
``naked'' short selling.\63\ Thus, the proposed requirement that all 
fails to deliver be closed out within specific time-frames, as proposed 
to be required by the alternatives, could decrease the possibility of 
artificial market influences and, therefore, could contribute to price 
efficiency.
---------------------------------------------------------------------------

    \63\ See, e.g., supra note 8 (citing to comment letters from 
issuers and investors discussing extended fails to deliver in 
connection with ``naked'' short selling).
---------------------------------------------------------------------------

    Although the proposed alternatives could lessen the potential 
negative impact of large and persistent fails to deliver similar to the 
proposed elimination of the options market maker exception because the 
proposed alternatives would require that fails to deliver in threshold 
securities eventually be closed out, we believe that complete 
elimination of the options market maker exception would achieve this 
goal more effectively. Under the proposed elimination of the options 
market maker exception, all fails to deliver in threshold securities 
would have to be closed out within Regulation SHO's mandatory 13 
consecutive settlement day close-out requirement. The proposed 
alternatives, however, would each allow a longer period of time for 
fail to deliver positions to be closed out. Specifically, the first 
alternative would allow certain fails to deliver to be closed out 
within 35 consecutive settlement days of the security becoming a 
threshold security. Under the second alternative, although some fails 
to deliver would be required to be closed out in less than 35 
consecutive settlement days, other fails to deliver would not have be 
closed out until 35 consecutive settlement days from the security 
becoming a threshold security.
    Similar to our discussions above in connection with our response to 
comments regarding the proposed amendment in the 2006 Proposing Release 
to limit the duration of the current options market maker exception and 
regarding the proposed amendment to eliminate the options market maker 
exception, we believe the mandatory close-out requirements of each of 
the proposed alternatives would similarly minimally impact, if at all, 
liquidity, hedging costs, spreads, or depth in the securities subject 
to the close-out requirements of the proposed alternatives, or the 
willingness of options market makers to make markets in such 
securities.
    We believe that these potential effects of the close-out 
requirements of the proposed alternatives would be minimal, if any, 
because the number of securities that would be impacted by the close-
requirements would be relatively small. The proposed alternatives would 
apply only to those threshold securities with listed options \64\ and 
would only impact fails to deliver in those securities that resulted 
from short sales by registered options market makers to hedge options 
series that were created before, rather than after, the security became 
a threshold security because all other fails to deliver in threshold 
securities are subject to Regulation SHO's current mandatory 13 
consecutive settlement day close-out requirement.
---------------------------------------------------------------------------

    \64\ See letter from Options Exchanges, supra note 49 
(discussing the number of threshold securities with listed options).
---------------------------------------------------------------------------

    In addition, the proposed alternatives would provide options market 
makers with flexibility in conducting their hedging activities because 
they would each allow an extended period of time (i.e., 35 consecutive 
settlement days for purposes of proposed Alternative 1 and 13 or 35 
consecutive settlement days for purposes of proposed Alternative 2) 
within which to close out all fails to deliver in threshold securities. 
As discussed above in connection with the proposed amendment to 
eliminate the options market maker exception, we believe that even a 13 
consecutive settlement day close-out requirement would result in 
minimal impact on the willingness of options market makers to make 
markets, liquidity, hedging costs, depth, and spreads because it would 
allow options market makers flexibility in conducting their hedging 
activities by permitting fails to deliver to remain open for an 
extended period of time (i.e., 13 consecutive settlement days) rather 
than, for example, requiring that such fails to deliver be closed out 
immediately, or even within the standard 3-day settlement period. 
During the period of time that the fail to deliver position can remain 
open, options market makers would be able to continue any hedging 
activity without having to close out the fail to deliver position or 
pre-borrow to maintain the hedge.
    The extended close-out requirements of the proposed alternatives 
would expire, however, after 35 consecutive settlement days of the 
security becoming a threshold security. In each of the proposed 
alternatives, after the excepted period expires, any additional fails 
to deliver that result from short sales in the threshold security, 
whether or not effected to establish or maintain a hedge on options 
series in the portfolio that were created before the security became a 
threshold security, would have to be closed within Rule 203(b)(3)'s 
mandatory 13 consecutive settlement day close-out requirement.
    The proposed alternatives are narrowly tailored in response to our 
concerns that options market makers are interpreting the current 
exception more broadly than the Commission intended and in response to 
comments that options market makers manage their risk based on an 
assessment of the entire portfolio rather than of a specific options 
position. Based on comments that portfolio hedging is the industry 
practice, the proposed alternatives refer to the hedging of options 
series in a portfolio rather than an options position. In addition, the 
proposed alternatives would permit options market makers to adjust 
their hedges on options series created before the underlying security 
became a threshold security provided any resulting fails to deliver are 
closed out within the applicable time-frames.
    The proposed alternatives would also require that participants of a 
registered clearing agency and options market makers document that any 
fails to deliver in threshold securities that have not been closed out 
in accordance with the 13 consecutive settlement days close-out 
requirement of Rule 203(b)(3) of Regulation SHO are eligible for the 
options market maker exception.\65\ The current exception does not set 
forth a specific documentation requirement, although some options 
market makers may in fact keep records that relate to their compliance 
with the exception. In the absence of such a requirement, we are 
concerned that many options market makers are not preparing or 
retaining records with regard to their eligibility for the exception. 
Without such a documentation requirement, it may be difficult for the 
Commission and SROs to monitor whether the options market maker 
exception is being applied consistently with the rule.
---------------------------------------------------------------------------

    \65\ Commenters to the 2006 Proposing Release urged the 
Commission to add specific documentation requirements for 
establishing eligibility for the options market maker exception. 
See, e.g., letters from NASAA, supra note 31; TASER, supra note 8.
---------------------------------------------------------------------------

    Thus, to the extent we retain an options market maker exception, we 
believe it would be necessary to add a provision to Regulation SHO that 
would

[[Page 45568]]

require both options market makers and participants of a registered 
clearing agency that rely on the options market maker exception to not 
close out a fail to deliver position in accordance with the mandatory 
close-out requirement of Rule 203(b)(3) of Regulation SHO to obtain, 
prepare, and keep documentation demonstrating that a fail to deliver 
position has not been closed out because it qualified for the 
exception. Such documentation could indicate, among other things, when 
the series being hedged was created, when the underlying security 
became a threshold security, and the age of the fail to deliver 
position that is not being closed out.
    A documentation requirement would enable the Commission and the 
SROs to monitor more effectively whether or not the options market 
maker exception is being applied correctly. In addition, the 
information would provide a record that would aid surveillance for 
compliance with this limited exception to Regulation SHO's close-out 
requirement.
The Alternatives
    We are requesting comment regarding specific alternatives, as 
described below, to eliminating the options market maker exception. 
Each of the proposed alternatives would provide for a 35 consecutive 
settlement day phase-in period similar to the phase-in period discussed 
above for securities that are threshold securities on the effective 
date of the amendment and that have previously excepted fail to deliver 
positions.\66\ In addition, as explained in more detail below, these 
alternatives would apply only to fails to deliver resulting from short 
sales effected by a registered options market maker to establish or 
maintain a hedge on any options series created before an underlying 
security became a threshold security. These alternatives would also 
require such fails to deliver to be closed out within specific time-
frames so that the fails to deliver would not last indefinitely.
---------------------------------------------------------------------------

    \66\ This 35 consecutive settlement day phase-in period would 
operate in the same manner as that outlined above in the discussion 
of the elimination of the options market maker exception.
---------------------------------------------------------------------------

i. Alternative 1
    We request comment regarding an options market maker exception that 
would require a participant of a registered clearing agency that has a 
fail to deliver position in a threshold security that results or 
resulted from a short sale by a registered options market maker to 
establish or maintain a hedge on any options series within a portfolio 
that were created before the security became a threshold security to 
close out the entire fail to deliver position, including any 
adjustments to that position, within 35 consecutive settlement days of 
the security becoming a threshold security. After the 35 consecutive 
settlement days has expired, any additional fails to deliver would be 
subject to the mandatory 13 consecutive settlement day close-out 
requirement of Rule 203(b)(3) of Regulation SHO.
    We propose 35 consecutive settlement days for purposes of proposed 
Alternative 1 because 35 days was used in Regulation SHO as adopted in 
August 2004, and in Regulation SHO, as amended and, therefore, is a 
period of time with which market participants subject to Regulation SHO 
are familiar.\67\ In addition, because we believe that all fails to 
deliver should be closed out within specific time-frames we did not 
want to propose an alternative that would allow fails to deliver to 
continue indefinitely, or for a period of time that would undermine the 
goal of requiring that all fails to deliver be closed out within a 
reasonable time period. We believe that 35 consecutive settlement days 
would allow participants time to close out their excepted fail to 
deliver positions without extending the close-out requirement beyond 
what we believe would be a reasonable period of time within which fails 
to deliver should be closed out.
---------------------------------------------------------------------------

    \67\ See Adopting Release, 69 FR at 48031; Securities Exchange 
Act Release No. 56212 (Aug. 7, 2007).
---------------------------------------------------------------------------

    In addition, similar to the pre-borrow requirement of Rule 
203(b)(3)(iv) of Regulation SHO, if the fail to deliver position 
persists for 35 consecutive settlement days, the proposed alternative 
would prohibit a participant, and any broker-dealer for which it clears 
transactions, including market makers, from accepting any short sale 
orders or effecting further short sales in the particular threshold 
security without borrowing, or entering into a bona-fide arrangement to 
borrow, the security until the participant closes out the entire fail 
to deliver position by purchasing securities of like kind and quantity.

    Example: The following is an example of how proposed Alternative 
1 would work if it were effective in February. XYZ security becomes 
a threshold security in March. On the date on which XYZ security 
becomes a threshold security, a participant of a registered clearing 
agency has fails to deliver in XYZ security that resulted from short 
sales by a registered options market maker to hedge options series 
in XYZ portfolio that were created before XYZ security became a 
threshold security. The participant must close out the entire fail 
to deliver position in XYZ security, including any additional fails 
that result from short sales to hedge options series in XYZ 
portfolio that were created before XYZ security became a threshold 
security, within 35 consecutive settlement days of the date on which 
XYZ security became a threshold security in March. After the 35 
consecutive settlement days, any additional fails to deliver in XYZ 
security, whether or not they result or resulted from short sales by 
a registered options market maker to hedge options series in XYZ 
portfolio that were created before XYZ security became a threshold 
security, must be closed out in accordance with Regulation SHO's 
mandatory 13 consecutive settlement day close-out requirement.
ii. Alternative 2
    As another alternative to eliminating the options market maker 
exception, we request comment regarding a proposed options market maker 
exception that would require a participant of a registered clearing 
agency that has a fail to deliver position in a threshold security that 
results or resulted from a short sale by a registered options market 
maker to establish or maintain a hedge on any options series in a 
portfolio that were created before the security became a threshold 
security to close out the entire fail to deliver position, including 
any adjustments to that position, within the earlier of: (i) 35 
Consecutive settlement days from the date on which the security became 
a threshold security, or (ii) 13 consecutive settlement days from the 
last date on which all options series within the portfolio that were 
created before the security became a threshold security expire or are 
liquidated. After the 35 or 13 consecutive settlement days has expired, 
any additional fails to deliver would be subject to the mandatory 13 
consecutive settlement day close-out requirement of Rule 203(b)(3) of 
Regulation SHO.
    We propose to require in Alternative 2 that fails to deliver be 
closed out within 13 consecutive settlement days if all options series 
within the portfolio that were created before the security became a 
threshold security expire or are liquidated because, at that point, 
there would be nothing in the portfolio for the original short sale and 
resulting fail to deliver position to hedge. We chose a proposed close-
out requirement of 13 consecutive settlement days for such situations 
because it is a time-frame currently used in the mandatory close-out 
requirement of Rule 203(b)(3) of Regulation SHO \68\ and, therefore, is 
a time-frame with which market

[[Page 45569]]

participants subject to the close-out requirement of Regulation SHO are 
currently familiar and with which such entities appear able to comply.
---------------------------------------------------------------------------

    \68\ See 17 CFR 242.203(b)(3).
---------------------------------------------------------------------------

    In addition, as discussed above for proposed Alternative 1, we 
chose 35 consecutive settlement days for purposes of proposed 
Alternative 2 because this is also a time-frame already used in 
Regulation SHO as adopted in August 2004, and in Regulation SHO, as 
amended and, therefore, is a time-frame with which market participants 
subject to Regulation SHO are already familiar.\69\ In addition, 
because we believe that all fails to deliver should be closed out 
within specific time-frames we did not want to propose an alternative 
that would allow fails to deliver to continue indefinitely, or for a 
period of time that would undermine the goal of requiring that all 
fails to deliver be closed out within a reasonable time period. We 
believe that a close-out requirement that provides that fails to 
deliver must be closed out within the time-frames specified by proposed 
Alternative 2 would allow participants time to close out their excepted 
fail to deliver positions without extending the close-out requirement 
beyond what we believe would be a reasonable period of time within 
which fails to deliver should be closed out.
---------------------------------------------------------------------------

    \69\ See Adopting Release, 69 FR at 48031; Securities Exchange 
Act Release No. 56212 (Aug. 7, 2007).
---------------------------------------------------------------------------

    In addition, similar to the pre-borrow requirement of Rule 
203(b)(3)(iv) of Regulation SHO, if the excepted fail to deliver 
position has persisted for longer than the earlier of: (i) 35 
Consecutive settlement days from the date on which the security became 
a threshold security, or (ii) 13 consecutive settlement days from the 
last date on which all options series within the portfolio that were 
created before the security became a threshold security expire or are 
liquidated, the proposal would prohibit a participant, and any broker-
dealer for which it clears transactions, including market makers, from 
accepting any short sale orders or effecting further short sales in the 
particular threshold security without borrowing, or entering into a 
bona-fide arrangement to borrow, the security until the participant 
closes out the entire excepted fail to deliver position by purchasing 
securities of like kind and quantity.

    Example 1. The following is an example of how proposed 
Alternative 2 would work if it were effective in February. XYZ 
security becomes a threshold security in March. On the date on which 
XYZ security becomes a threshold security, a participant of a 
registered clearing agency has fails to deliver in XYZ security that 
resulted from short sales by a registered options market maker to 
hedge its XYZ portfolio that were created before XYZ security became 
a threshold security. On the date on which XYZ security becomes a 
threshold security, XYZ portfolio consists of XYZ April 50 Calls and 
XYZ July 50 Calls. The last date on which the options within XYZ 
portfolio expire is July, which is later than 35 consecutive 
settlement days from the date on which XYZ security became a 
threshold security. In addition, none of the options series within 
XYZ portfolio have been exercised. Thus, the participant must close 
out the entire fail to deliver position in XYZ security, including 
any additional fails that result from short sales to hedge options 
series in XYZ portfolio that were created before XYZ security became 
a threshold security, within 35 consecutive settlement days of the 
date on which XYZ security became a threshold security in March. 
After the 35 consecutive settlement days, any additional fails to 
deliver in XYZ security, whether or not they result or resulted from 
short sales by a registered options market maker to hedge options 
series in XYZ portfolio that were created before XYZ security became 
a threshold security, must be closed out in accordance with 
Regulation SHO's mandatory 13 consecutive settlement day close-out 
requirement.
    Example 2. The following is another example of how proposed 
Alternative 2 would work if it were effective in February. XYZ 
security becomes a threshold security in March. On the date on which 
XYZ security becomes a threshold security, a participant of a 
registered clearing agency has fails to deliver in XYZ security that 
resulted from short sales by a registered options market maker to 
hedge options series in its XYZ portfolio that were created before 
XYZ security became a threshold security. On the date on which XYZ 
security becomes a threshold security, XYZ portfolio consists of XYZ 
April 50 Calls and XYZ July 50 Calls. Options market maker firm 
exercises both call options in March, shortly after XYZ security 
became a threshold security. Because options market maker firm 
liquidated the entire XYZ portfolio prior to the expiration of 35 
consecutive settlement days from the date on which XYZ security 
became a threshold security, or the last expiration date for the 
options comprising the XYZ portfolio, the participant must close out 
the entire fail to deliver position in XYZ security, including any 
additional fails to deliver that result from short sales by a 
registered options market maker to hedge options series in XYZ 
portfolio that were created before XYZ security became a threshold 
security, within 13 consecutive settlement days of the date on which 
the options series within XYZ portfolio were exercised.

Request for Comment

    The Commission seeks comment generally on all aspects of the 
proposed alternatives to elimination of the options market maker 
exception. In addition, we seek comment on the following:
     As set forth in proposed Alternative 1, should 
participants of a registered clearing agency, or options market makers 
that have been allocated the close-out requirement under Regulation 
SHO, have a limited exception to the close-out requirement that would 
allow 35 consecutive settlement days from the security becoming a 
threshold security for the fail to deliver position to be closed out? 
If so, why? If not, why not? Alternatively, as set forth in proposed 
Alternative 2, should the limited exception allow the earlier of: (i) 
35 Consecutive settlement days from the date on which the security 
becomes a threshold security, or (ii) 13 consecutive settlement days 
from the last date on which all options series within the portfolio 
that were created before the security became a threshold security 
expire or are liquidated, for the fail to deliver position to be closed 
out? If so, why?
     In our discussion above regarding the impact of the 
proposed amendment to eliminate Regulation SHO's current options market 
maker exception on liquidity, spreads, depth, and hedging costs, we 
stated that we believe that such an impact would be minimal, if any. 
For similar reasons, we believe that the impact of the mandatory close-
out requirements in the proposed alternatives on liquidity, spreads, 
depth, and hedging costs would be minimal, if any. To what extent would 
an options market maker exception as set forth in the proposed 
alternatives, rather than eliminating the exception, impact liquidity 
in securities that might become threshold securities or in threshold 
securities? To what extent would an options market maker exception as 
set forth in the proposed alternatives, rather than eliminating the 
exception, impact the willingness of options market makers to make 
markets in securities that might become threshold securities or in 
threshold securities? What other measures or time-frames would be 
effective in fostering Regulation SHO's goal of reducing fails to 
deliver while at the same time not discouraging market making by 
options market makers?
     In the proposed alternatives to eliminating the options 
market maker exception, fails to deliver would only be excepted from 
the close out requirement of Regulation SHO if the fail to deliver 
position results or resulted from a short sale effected to establish or 
maintain a hedge on options series created before the security became a 
threshold security. Is the reference to ``options series'' appropriate? 
Please explain.

[[Page 45570]]

     Are the terms ``expiration'' and ``liquidation'' of an 
options series sufficiently inclusive to prevent participants from 
evading the close-out requirements in the proposed alternatives? Are 
these terms understandable for compliance purposes? If not, what terms 
would be more appropriate? What difficulties, if any, could arise from 
having to determine the last date on which all options series within a 
portfolio that were created before the security became a threshold 
securities have expired or been liquidated?
     We provide examples of how the proposed alternatives would 
be applied. We request comment regarding these examples, and 
suggestions regarding additional examples that would be helpful in 
understanding how the proposed alternatives would work that could be 
incorporated by the Commission into any future releases, if the 
Commission were to adopt either of the proposed alternatives.
     What types of costs would be incurred in complying with 
the proposed alternatives? For example, what types of costs, if any, 
could be incurred for tracking the 35 or 13 consecutive settlement day 
close-out requirements? What types of costs, if any, could be incurred 
in determining whether or not options series were created before the 
security became a threshold security? What types of costs could be 
incurred in determining whether or not a fail to deliver position 
resulted from a short sale to establish or maintain a hedge on options 
series created before the security became a threshold security? How 
would these costs differ from costs incurred to comply with the current 
options market maker exception in Regulation SHO? Would the costs 
relating to the alternative proposals justify the benefits of allowing 
for a limited exception to the close-out requirement for options market 
makers?
     What would be the costs and benefits of the proposed 
alternatives to eliminating the options market maker exception?
     Under the proposed alternatives, after the specific time-
frames have expired, fails to deliver would be required to be closed 
out in compliance with the 13 consecutive settlement day close-out 
requirement of Rule 203(b)(3) of Regulation SHO regardless of whether 
or not the fails to deliver result or resulted from short sales 
effected by a registered options market maker to establish or maintain 
a hedge on options series created before the security became a 
threshold security. Under the proposed alternatives, might an options 
market maker need to maintain such fail to deliver positions beyond the 
13 consecutive settlement days allowed by the close-out requirement of 
Rule 203(b)(3) of Regulation SHO? What might be the impact, if any, of 
requiring such fails to deliver to be closed out?
     What technical or operational challenges would options 
market makers face in complying with the proposed alternatives?
     Should we consider changing the proposed alternatives to 
35 calendar days from the date on which the security becomes a 
threshold security? If so, would this create systems problems or other 
costs?
     The proposed alternatives would require that options 
market makers document eligibility for the exception. What should 
options market makers and participants of a registered clearing agency 
be required to include in the documentation? Should we specify in 
detail what would be required to be retained? For example, should we 
require that such documentation include, at a minimum, documentation 
evidencing when the series being hedged was created, when the 
underlying security became a threshold security, and the age of the 
fail to deliver position that is not being closed out?
     The proposed alternatives would require that participants 
of a registered clearing agency maintain documentation to demonstrate 
that a fail to deliver position has not been closed out due to the 
options market maker exception. Would this documentation requirement 
raise compliance concerns or any other concerns for participants? If 
so, please explain.
     The proposed alternatives would allow for a 35 consecutive 
settlement day phase-in period for previously excepted fails to deliver 
to be closed out. Is 35 consecutive settlement days from the effective 
date of the amendment a long enough period of time, or too long, for 
fails to deliver that were previously excepted from the close-out 
requirement of Regulation SHO to be closed out? If so, what would be an 
appropriate period of time?
     Would the proposed phase-in period create additional 
costs, such as costs associated with systems, surveillance, or 
recordkeeping modifications that could be needed for participants to 
track fails to deliver subject to the 35 consecutive settlement day 
phase-in period from fails to deliver that are not eligible for the 
phase-in period? If there were additional costs associated with 
tracking fails to deliver subject to the phase-in period, would these 
additional costs justify the benefits of providing firms with a 35 
consecutive settlement day phase-in period? Is a 35 consecutive 
settlement day phase-in period necessary given that firms would have 
been on notice that they would have to close out these fail to deliver 
positions following the effective date of the amendment? Please provide 
estimates of these costs.
     Please provide specific comment as to what length of 
implementation period would be necessary such that participants would 
be able to meet the requirements that fail to deliver positions in 
threshold securities be closed out within the applicable time-frames, 
if adopted.

IV. Proposed Amendment to Rule 200(g)(1) of Regulation SHO

    We are proposing an amendment to the long sale marking provisions 
of Rule 200(g)(1) of Regulation SHO that would require that brokers-
dealers marking orders as ``long'' sales document the present location 
of the securities.
    Prior to the adoption of Regulation SHO in August 2004, broker-
dealers that were members of the NASD were obligated to comply with 
former NASD Rule 3370(b). Former NASD Rule 3370(b) required a broker-
dealer making an affirmative determination that a customer was long to 
notate on the order ticket at the time an order was taken, the 
conversation with the customer as to the present location of the 
securities, whether they were in good deliverable form, and the 
customer's ability to deliver them to the member within three business 
days.\70\
---------------------------------------------------------------------------

    \70\ NASD repealed NASD Rule 3370(b), the ``affirmative 
determination'' for long sales, following the adoption of Regulation 
SHO. The repeal of NASD Rule 3370(b) was effective on January 3, 
2005, the effective date of Regulation SHO. See NASD Notice to 
Members 04-93. See also, Securities Exchange Act Release No. 50822 
(Dec. 8, 2004), 69 FR 74554 (Dec. 14, 2004).
---------------------------------------------------------------------------

    Regulation SHO does not contain a similar provision to former NASD 
Rule 3370(b) regarding documentation of long sales.\71\ Rule 200(g)(1) 
of

[[Page 45571]]

Regulation SHO, however, provides that a broker-dealer may mark an 
order to sell ``long'' only if the seller is deemed to own the security 
being sold pursuant to paragraphs (a) through (f) of Rule 200,\72\ and 
either the security is in the physical possession or control of the 
broker or 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 the settlement of the transaction.\73\ Thus, in marking a sell 
order ``long,'' a broker-dealer must determine whether the customer is 
``deemed to own'' the securities being sold.
---------------------------------------------------------------------------

    \71\ Because Regulation SHO does not include a similar provision 
to former NASD Rule 3370(b) regarding documentation of long sales, 
on July 20, 2005, the NASD filed with the Commission, pursuant to 
Section 19(b)(3)(A) of the Exchange Act, a rule filing to amend NASD 
Rule 3370 to clarify that members must make an affirmative 
determination and document compliance when effecting long sale 
orders. In the filing, the NASD stated that it proposed to amend 
NASD Rule 3370 ``to re-adopt expressly the affirmative determination 
requirements as they now relate to member obligations with respect 
to long sales under Regulation SHO.'' The NASD designated the rule 
change as ``non-controversial.'' In response to the proposed rule 
change, the Commission received three comment letters, the substance 
of which called into question the ``non-controversial'' designation 
of the proposal. The Commission found that it was appropriate in the 
public interest, for the protection of investors, and otherwise in 
furtherance of the purposes of the Exchange Act, to abrogate the 
proposed rule change. See Securities Exchange Act Release No. 52426 
(Sept. 14, 2005); Securities Exchange Act Release No. 52131 (July 
27, 2005), 70 FR 44707 (Aug. 3, 2005). The NASD took no further 
action with respect to the proposed rule change.
    \72\ Rule 200(a) defines the term ``short sale,'' while Rules 
200(b) through 200(f) set forth circumstances in which a seller is 
deemed to own securities. See 17 CFR 242.200(a)-(f).
    \73\ 17 CFR 242.200(g)(1).
---------------------------------------------------------------------------

    In the 2006 Proposing Release we requested comment regarding 
whether we should consider amending Regulation SHO to include 
documentation requirements for long sales similar to those required by 
former NASD Rule 3370(b).\74\ We received approximately 8 comment 
letters in response to the request for comment.\75\
---------------------------------------------------------------------------

    \74\ See 2006 Proposing Release, 71 FR at 41714. Specifically we 
stated: ``Current Rule 203(a) provides that on a long sale, a 
broker-dealer cannot fail or loan shares unless, in advance of the 
sale, it has demonstrated that it has 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. 
Former NASD Rule 3370 required that a broker making an affirmative 
determination that a customer was long must make a notation on the 
order ticket at the time an order was taken which reflected the 
conversation with the customer as to the present location of the 
securities, whether they were in good deliverable form, and the 
customer's ability to deliver them to the member within three 
business days. Should we consider amending Regulation SHO to include 
these additional documentation requirements? If so, should any 
modifications be made to these additional requirements? In the prior 
SRO rules, brokers did not have to document long sales if the 
securities were on deposit in good deliverable form with certain 
depositories, if instructions had been forwarded to the depository 
to deliver the securities against payment (``DVP trades''). Under 
Regulation SHO, a broker may not lend or arrange to lend, or fail, 
on any security marked long unless, among other things, the broker 
knows or has been reasonably informed by the seller that the seller 
owns the security and that the seller would deliver the security 
prior to settlement and failed to do so. Is it generally reasonable 
for a broker to believe that a DVP trade will settle on time? Should 
we consider including or specifically excluding an exception for DVP 
trades or other trades on any rule requiring documentation of long 
sales?''
    \75\ See, e.g., letters from NASAA, supra note 31; UBS, supra 
note 31; SIA, supra note 31. See also, letter from Leonard J. 
Amoruso, Compliance and Regulatory Affairs, Knight Capital Group, 
Inc., dated Sept. 20, 2006 (``Knight''); letter from John G. Gaine, 
President, Managed Funds Association, dated Sept. 19, 2006 
(``MFA''); letter from Martin Schwartz, Chief Compliance Officer, 
Millennium Partners, LP, Oct. 10, 2006 (``Millennium''); letter from 
Susan Trimbath, Ph.D., CEO and Chief Economist, STP Advisory 
Services, LLC, Aug. 29, 2006 (``Trimbath''); letter from Wayne 
Klein, Director, Division of Securities, State of Utah Department of 
Commerce, Sept. 13, 2006 (``Utah Department of Commerce'').
---------------------------------------------------------------------------

    Commenters that supported documentation requirements for long sales 
argued that the ``volume of outstanding fails is too large to permit 
the execution of trades where there is doubt about delivery.'' \76\ 
Commenters opposing documentation requirements for long sales stated 
that pre-trade documentation would unnecessarily impair efficiency, as 
broker-dealers already have procedures to ensure orders are marked 
properly based on information provided by customers and their own books 
and records, and the documentation requirements would add substantial 
cost.\77\ One commenter stated that compliance with such pre-trade 
documentation requirements would require a complete revamping of front 
end systems.\78\ Another commenter stated that the requirements would 
be inconsistent with the goal of fostering liquidity.\79\
---------------------------------------------------------------------------

    \76\ See, e.g., Letters from NASAA, supra note 31; Utah 
Department of Commerce, supra note 75.
    \77\ See letters from MFA, supra note 75; UBS, supra note 31; 
Knight, supra note 75.
    \78\ See letter from SIA, supra note 31.
    \79\ See letter from Millennium, supra note 75.
---------------------------------------------------------------------------

    Commenters also argued that the Commission has not presented 
evidence that long sales are contributing to a troublesome level of 
fails \80\ or abusive or manipulative activity,\81\ and that lack of 
documentation is related to those fails.\82\ One commenter stated that 
there is no valid purpose to put this additional burden on the 
industry.\83\ Another commenter argued that requiring this additional 
documentation should be considered only where the benefits clearly 
outweigh the burdens.\84\ Commenters also suggested that if the 
Commission did adopt additional long sale documentation requirements, 
it should except prime broker and DVP trades, ``done with'' trades, and 
orders submitted electronically,\85\ or where settlement instructions 
are on file with the executing broker.\86\
---------------------------------------------------------------------------

    \80\ See letter from MFA, supra note 75. See also, letter from 
Millennium, supra note 75.
    \81\ See letter from SIA, supra note 31 .
    \82\ See letter from MFA, supra note 75.
    \83\ See letter from UBS, supra note 31.
    \84\ See letter from MFA, supra note 75.
    \85\ See letters from SIA, supra note 31; Knight, supra note 75. 
The SIA commented that ``a broker-dealer should be provided an 
exception from such long sale annotation requirements if the broker-
dealer has information regarding the client's custodial 
relationship. Providing such an exception would be consistent with 
the Commission's long-standing policy of allowing broker-dealers to 
enter into bona-fide agreements with their customers regarding 
marking of orders.'' See letter from SIA, supra note 31.
    \86\ See letter from Knight, supra note 75.
---------------------------------------------------------------------------

    Although some commenters stated that pre-trade documentation for 
long sales would be inconsistent with the goal of fostering liquidity, 
would unnecessarily impair efficiency, and would add substantial 
cost,\87\ we believe that such costs, to the extent that there are any, 
would be justified by the benefits of a documentation requirement, as 
described below. In addition, we note that under former NASD Rule 
3370(b), NASD member firms making an affirmative determination that a 
customer was long were required to make a notation on the order ticket 
at the time an order was taken which reflected the conversation with 
the customer as to the present location of the securities, whether they 
were in good deliverable form, and the customer's ability to deliver 
them to the member within three business days.\88\ Thus, many broker-
dealers should already be familiar with a documentation requirement and 
one method that could be used to comply with such a requirement. Such 
familiarity should help reduce any costs associated with implementing 
the proposed documentation requirement. In addition, unlike with former 
NASD Rule 3370(b), the proposed amendment would not specify the format 
or methodology of the proposed documentation requirement. The absence 
of such specifications should help reduce costs to broker-dealers that 
would have to comply with this proposal because broker-dealers would be 
able to determine the most cost effective format and methodology for 
meeting the proposed documentation requirement.
---------------------------------------------------------------------------

    \87\ See, e.g., letters from MFA, supra note 75; UBS, supra note 
31; Knight, supra note 75; SIA, supra note 31; Millenium, supra note 
75.
    \88\ Brokers and dealers that were members of the NASD were 
obligated to comply with former NASD Rule 3370(b) prior to the 
adoption of Regulation SHO.
---------------------------------------------------------------------------

    We are proposing for further comment a documentation requirement 
for broker-dealers marking orders to sell ``long'' pursuant to 
Regulation SHO that would require such broker-dealers to document the 
present location of the securities being sold. First, we believe that 
such a proposed documentation requirement would aid in ensuring the 
correct marking of sell orders. To the extent that the seller is unable 
to provide the present location of the securities being sold, the 
broker-dealer

[[Page 45572]]

would have reason to believe that the seller is not ``deemed to own'' 
the securities being sold and that the securities would not be in its 
physical possession or control no later than settlement of the 
transaction and, therefore, that the broker-dealer would be required to 
mark the sale ``short'' rather than ``long.'' \89\ We believe that this 
proposed documentation requirement could also reduce the number of 
fails to deliver because, after making the inquiry into the present 
location of the securities being sold, a broker-dealer would know 
whether or not it needed to obtain securities for delivery.
---------------------------------------------------------------------------

    \89\ See 17 CFR 242.200(g).
---------------------------------------------------------------------------

    Second, we are concerned that broker-dealers marking orders 
``long'' may not be making a determination prior to marking the order 
that the seller is ``deemed to own'' the security being sold.\90\ Rule 
200(g)(1) currently requires that broker-dealers ascertain whether the 
customer is ``deemed to own'' the securities being sold before marking 
a sell order ``long.'' \91\ We believe that a proposed documentation 
requirement would help ensure that the broker-dealer marking the sale 
``long'' has inquired into, and determined that, the seller is ``deemed 
to own'' the securities being sold because the broker-dealer would be 
required to document the present location of the securities being sold.
---------------------------------------------------------------------------

    \90\ See id. at 242.200(g)(1).
    \91\ In the Adopting Release, we stated that ``* * * 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 long, the seller must own the security.'' See Adopting 
Release, 69 FR at 48021.
---------------------------------------------------------------------------

    Third, we believe that the proposed documentation requirement would 
enable the Commission and SROs to examine for compliance with the long 
sale marking provisions of Rule 200(g) more effectively because this 
proposed documentation requirement would provide a record that the 
seller is ``deemed to own'' the securities being sold in compliance 
with that rule. We also believe that the proposed documentation 
requirement would aid the Commission and SROs in reviewing for 
mismarking designed to avoid compliance with other rules and 
regulations of the federal securities laws, such as the ``locate'' 
requirement of Regulation SHO,\92\ and Rule 105 of Regulation M.\93\
---------------------------------------------------------------------------

    \92\ See 17 CFR 242.203(b)(1). Rule 203(b)(1) of Regulation SHO 
provides that ``[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 * * *.'' This provision is 
commonly referred to as the ``locate'' requirement.
    \93\ See 17 CFR 242.105 (prohibiting persons from covering a 
short sale with offering securities if the short sale occurred 
during the Rule 105 restricted period). See also, In the Matter of 
Goldman Sachs Execution & Clearing, L.P. f/k/a Spear, Leeds, & 
Kellogg, L.P., Securities Exchange Act Release No. 55465 (Mar. 14, 
2007), Admin. Proc. File No. 3-12590 (settling enforcement 
proceedings against a prime broker and clearing affiliate of The 
Goldman Sachs Group, Inc., Goldman Sachs Execution and Clearing 
L.P., for its violations arising from an illegal trading scheme 
carried out by customers through their accounts at the firm, which 
included the mismarking of sell orders as ``long.'').
---------------------------------------------------------------------------

    We believe that any costs that would arise from the proposed 
requirement that a broker-dealer must document the present location of 
securities being sold long when making the determination that a 
customer is deemed to own the securities being sold would be minimal 
because Rule 200(g)(1) currently requires that broker-dealers must 
ascertain whether the customer is ``deemed to own'' the securities 
being sold before marking a sell order ``long.'' \94\ Today's proposed 
amendment would require that the broker-dealer take the additional step 
of documenting the present location of the securities being sold. 
Broker-dealers could, however, need to put mechanisms in place to 
facilitate efficient documenting of the information required by the 
proposed amendment.
---------------------------------------------------------------------------

    \94\ See 17 CFR 242.200(g).
---------------------------------------------------------------------------

Request for Comment

    The Commission seeks comment generally on all aspects of the 
proposed amendment to Rule 200(g) of Regulation SHO. In addition, we 
seek comment on the following:
     Is the proposed documentation requirement appropriate? If 
not, why not?
     Commenters that responded to the request for comment 
regarding documentation of long sales in the 2006 Proposing Release 
stated that market participants already have in place procedures to 
ensure that orders to sell shares are properly marked. What are those 
procedures and how do they ensure that orders are properly marked? How 
do broker-dealers currently comply with the ``deemed to own'' 
requirement of Rule 200(g)(1) of Regulation SHO?
     One commenter that responded to the request for comment 
regarding documentation of long sales in the 2006 Proposing Release 
stated that the requirement would be inconsistent with the goal of 
fostering liquidity.\95\ To what extent, if any, would the proposed 
amendment impact liquidity in securities being sold long? Please 
explain.
---------------------------------------------------------------------------

    \95\ See letter from Millennium, supra note 75.
---------------------------------------------------------------------------

     The ``locate'' requirement of Rule 203(b)(1) of Regulation 
SHO contains an exception for market makers. Should market makers also 
have an exception for the proposed long sale documentation requirement? 
Please explain.
     Should we specify the proposed format of the 
documentation? Should the proposed documentation be on the order ticket 
or elsewhere? Please provide recommended alternatives and estimates of 
the costs of various alternatives.
     Under what circumstances, if any, should we allow the 
documentation to be generated post-trade?
     In addition to proposing documentation of the present 
location of the securities being sold, should we require additional 
documentation requirements to those proposed, such as requiring broker-
dealers to make a record reflecting the basis for believing that the 
securities are in good deliverable form, and the basis for believing 
that the securities will be in the broker-dealer's possession or 
control no later than settlement of the transaction?
     The Commission has previously stated that 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.\96\ 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.\97\ 
Should broker-dealers be required to take additional steps to determine 
whether or not the seller is deemed to own the securities being sold in 
conjunction with documenting the present location of the securities?
---------------------------------------------------------------------------

    \96\ See Adopting Release, 69 FR at 48019, n.111.
    \97\ See id.
---------------------------------------------------------------------------

     The proposed amendment would impose an obligation on 
broker-dealers to inquire into the present location of securities being 
sold and to document that location. To what extent would this proposed 
requirement impact the accuracy of marking by broker-dealers? To what 
extent would this proposed requirement impact the level of fails to

[[Page 45573]]

deliver in a security, such as fails to deliver due to mismarking? To 
what extent would this proposed requirement impact compliance with 
other short sale-related regulations, such as the locate requirement of 
Regulation SHO and Rule 105 of Regulation M?
     Should any trades be excepted from the proposed 
documentation requirement? For example, under former NASD Rule 3370(b) 
broker-dealers did not have to document long sales if the securities 
were on deposit in good deliverable form with certain depositories, if 
instructions had been forwarded to the depository to deliver the 
securities against payment (``DVP trades''). Should we consider 
including or specifically excluding an exception for DVP trades? Should 
any other trades be specifically included or excluded from the proposed 
documentation requirement?
     Former NASD Rule 3370(b) required broker-dealers making an 
affirmative determination that a customer was long to make a notation 
on the order ticket at the time an order was taken regarding the 
conversation with the customer as to the present location of the 
securities, whether they were in good deliverable form, and the 
customer's ability to deliver them to the member within three business 
days. The proposed amendment would require broker-dealers to document 
only the present location of the securities being sold long. To what 
extent would the requirements of the proposed amendment impose costs, 
such as personnel, systems, or surveillance costs on market 
participants that are any different from such costs imposed on market 
participants to comply with former NASD Rule 3370(b)?
     Most broker-dealers allow investors to submit orders 
electronically. Do these systems automatically verify the location of 
shares for long sales before routing the orders for execution? If so, 
how much would it cost for broker-dealers to adjust their systems to 
record the location of the securities being sold on the trade record? 
If not, what changes would the proposed documentation requirement 
require and how much would it cost for broker-dealers to adjust their 
systems to verify and document the location of the shares for long 
sales? To what extent do investors communicate order requests via other 
means, such as by telephone or in person? How do the costs of the 
proposed documentation requirement differ for these order requests 
versus electronic order submissions?
     Some investors have direct access to alternative trading 
systems. Are alternative trading systems already programmed to verify 
the location of the shares in orders marked as long sales? If not, to 
what extent, if any, should alternative trading systems be responsible 
for meeting this requirement? How much would it cost?
     Some broker-dealers sponsor direct access to exchanges for 
preferred clients. To what extent do these broker-dealers currently 
document the location of shares for long sales that their clients send 
directly to exchanges? What costs are associated with such 
documentation?
     Do algorithmic trading systems \98\ present any problems 
for compliance with the proposed amendment? Are there any other current 
market practices that present problems for compliance with 
documentation requirements?
---------------------------------------------------------------------------

    \98\ An algorithmic trading program detects trading 
opportunities for the strategies input by investors and responds to 
them by placing and managing orders on behalf of those investors.
---------------------------------------------------------------------------

V. General Request for Comment

    The Commission seeks comment generally on all aspects of the 
proposed amendments to Regulation SHO under the Exchange Act, including 
the proposed alternatives to the proposal to eliminate the options 
market maker exception. Commenters are requested to provide empirical 
data to support their views and arguments related to the proposals 
herein. In addition to the questions posed above, commenters are 
welcome to offer their views on any other matter raised by the proposed 
amendments to Regulation SHO. With respect to any comments, we note 
that they are of the greatest assistance to our rulemaking initiative 
if accompanied by supporting data and analysis of the issues addressed 
in those comments and if accompanied by alternative suggestions to our 
proposals where appropriate.

VI. Paperwork Reduction Act

    Certain provisions of the proposed amendments to Regulation SHO 
would impose new ``collection of information'' requirements within the 
meaning of the Paperwork Reduction Act of 1995 (``PRA'') \99\ which the 
Commission has submitted to the Office of Management and Budget 
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 
1320.11. An agency may not conduct or sponsor, and a person is not 
required to respond to, a collection of information unless it displays 
a currently valid OMB control number. OMB has not yet assigned a 
control number to the new collection of information.
---------------------------------------------------------------------------

    \99\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

A. Summary of Collections of Information

    The proposed amendment to eliminate the options market maker 
exception to the close-out requirement of Regulation SHO would not 
impose a new ``collection of information'' within the meaning of the 
PRA. The two proposed alternatives to elimination of the options market 
maker exception and the proposed amendment to Rule 200(g) of Regulation 
SHO would impose a new ``collection of information'' within the meaning 
of the PRA.
i. Proposed Alternatives to Elimination of the Options Market Maker 
Exception
    The proposed alternatives to elimination of the options market 
maker exception would both require that options market makers and 
participants of a registered clearing agency document that any fail to 
deliver positions that have not been closed out are excepted from the 
close-out requirement of Regulation SHO because the fails to deliver 
resulted from short sales effected by a registered options market maker 
to establish or maintain a hedge on options series in a portfolio that 
were created before the security became a threshold security. This 
would be a new collection of information because Regulation SHO does 
not currently require documentation to show eligibility for the options 
market maker exception.
ii. Proposed Amendment to Rule 200(g)(1)
    The proposed amendment to Rule 200(g)(1) of Regulation SHO would 
require that brokers and dealers marking orders as ``long'' sales 
document the present location of the securities.
    Under Rule 200(g)(1), a broker-dealer may mark an order to sell 
``long'' only if the seller is deemed to own the security being sold 
pursuant to paragraphs (a) through (f) of Rule 200,\100\ and either the 
security is in the physical possession or control of the broker or 
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 
the settlement of the transaction.\101\ Thus, in marking a sell order 
``long,'' a broker or dealer must determine whether the customer is 
``deemed to own'' the securities being sold.
---------------------------------------------------------------------------

    \100\ Rule 200(a) defines the term ``short sale,'' while Rules 
200(b) through 200(f) set forth circumstances in which a seller is 
deemed to own securities. See 17 CFR 242.200(a)-(f).
    \101\ 17 CFR 242.200(g)(1).
---------------------------------------------------------------------------

    This would be a new collection of information because Regulation 
SHO

[[Page 45574]]

does not currently require documentation by brokers and dealers when 
marking sell orders as ``long.''

B. Proposed Use of Information

i. Proposed Alternatives to Elimination of the Options Market Maker 
Exception
    The information that would be required by the proposed alternatives 
to elimination of the options market maker exception would assist the 
Commission in fulfilling its mandate under the Exchange Act to prevent 
fraudulent, manipulative, and deceptive acts and practices. The 
Commission and SROs would use the information collected to monitor 
whether or not the options market maker exception to the close-out 
requirement of Regulation SHO is being applied consistently with the 
rule. The information required by the proposed amendment would provide 
a record that would aid surveillance for compliance with this limited 
exception to Regulation SHO's close-out requirement.
ii. Proposed Amendment to Rule 200(g)(1)
    The information that would be required by the proposed amendment to 
Rule 200(g)(1) would assist the Commission in fulfilling its mandate 
under the Exchange Act to prevent fraudulent, manipulative, and 
deceptive acts and practices. Such a documentation requirement would 
aid in ensuring the correct marking of sell orders. To the extent that 
the seller is unable to provide the present location of the securities 
being sold, the broker-dealer would have reason to believe that the 
seller is not ``deemed to own'' the securities being sold and that the 
securities would not be in its physical possession or control no later 
than settlement of the transaction and, therefore, that the broker-
dealer would be required to mark the sale ``short'' rather than 
``long.'' \102\ We believe that this documentation requirement could 
also reduce the number of fails to deliver because, after making the 
inquiry into the present location of the securities being sold, a 
broker-dealer would know whether or not it needed to obtain securities 
for delivery.
---------------------------------------------------------------------------

    \102\ See id.
---------------------------------------------------------------------------

    In addition, we are concerned that broker-dealers marking orders 
``long'' may not be making a determination prior to marking the order 
that the seller is ``deemed to own'' the security being sold. Rule 
200(g)(1) currently requires that broker-dealers ascertain whether the 
customer is ``deemed to own'' the securities being sold before marking 
a sell order ``long.'' \103\ We believe that a documentation 
requirement would help ensure that the broker-dealer marking the sale 
``long'' has inquired into, and determined that, the seller is ``deemed 
to own'' the securities being sold because the broker-dealer would be 
required to document the present location of the securities being sold.
---------------------------------------------------------------------------

    \103\ See id.
---------------------------------------------------------------------------

    We also believe that the documentation requirement would enable the 
Commission and SROs to examine for compliance with the long sale 
marking provisions of Rule 200(g) more effectively because this 
documentation requirement would provide a record that the seller is 
``deemed to own'' the securities being sold in compliance with that 
rule. We also believe that the documentation requirement would aid the 
Commission and SROs in reviewing for mismarking designed to avoid 
compliance with other rules and regulations of the federal securities 
laws, such as the ``locate'' requirement of Regulation SHO,\104\ and 
Rule 105 of Regulation M.\105\
---------------------------------------------------------------------------

    \104\ See supra note 92.
    \105\ See supra note 93.
---------------------------------------------------------------------------

C. Respondents

i. Proposed Alternatives to Elimination of the Options Market Maker 
Exception
    The documentation requirement of the proposed alternatives to 
elimination of the options market maker exception would apply to all 
participants of a registered clearing agency and options market makers 
who have not closed out a fail to deliver position in a threshold 
security because it resulted from short sales effected by the 
registered options market maker to establish or maintain a hedge on 
options series in a portfolio that were created before the security 
became a threshold security.
ii. Proposed Amendment to Rule 200(g)(1)
    The proposed amendment to Rule 200(g)(1) of Regulation SHO would 
require that brokers and dealers marking orders as ``long'' sales 
document the present location of the securities. Thus, the amendment 
would apply to all brokers-dealers registered with the Commission as 
they could all execute long sales. The Commission's Office of Economic 
Analysis (``OEA'') estimates that at year-end 2006 there are 
approximately 5,808 active brokers-dealers registered with the 
Commission.\106\
---------------------------------------------------------------------------

    \106\ This number is based on OEA's review of 2006 FOCUS Report 
filings reflecting registered brokers-dealers. This number does not 
include broker-dealers that are delinquent with FOCUS Report 
filings.
---------------------------------------------------------------------------

D. Total Annual and Recordkeeping Burdens

i. Proposed Alternatives to Elimination of the Options Market Maker 
Exception
    The proposed alternatives to elimination of the options market 
maker exception would require that options market makers and 
participants of a registered clearing agency document that any fail to 
deliver positions that have not been closed out are excepted from the 
close-out requirement of Regulation SHO because the fails to deliver 
resulted from short sales effected by a registered options market maker 
to establish or maintain a hedge on options series in a portfolio that 
were created before the security became a threshold security.
    We estimate that it would take an options market maker no more than 
approximately 0.16 hours (10 minutes) to document that a fail to 
deliver position has not been closed out due to its eligibility for the 
options market maker exception.\107\ We understand that eligibility for 
the options market maker exception would likely be determined on a 
daily basis, rather than on a trade by trade basis. Based on data from 
the first quarter of 2006,\108\ for purposes of this PRA, we estimate 
that, on average, there would be approximately 75 securities each day 
that are (i) on a threshold securities list, and (ii) have open 
interest in exchange traded options. On average, we estimate there 
would be approximately 5 options market makers engaged in delta hedging 
these options.\109\ Thus, we estimate that on average, options market 
makers would have to document compliance with the proposed alternatives 
to the elimination of the options market maker exception 94,500 times 
per year (5 options market makers checking for compliance once per day 
on 75 securities, multiplied by 252 trading

[[Page 45575]]

days in a year). Thus, the total approximate estimated annual burden 
hour per year would be 15,120 burden hours (94,500 @ 0.16 hours/
documentation). A reasonable estimate for the paperwork compliance for 
the proposed alternatives for each options market maker would be 
approximately 3,024 burden hours (18,900 instances of documentation per 
respondent @ 0.16 hours/documentation).
---------------------------------------------------------------------------

    \107\ We do not believe that the documentation requirement is 
complex. We understand that options market makers receive daily 
trading reports from NSCC reflecting an options market maker's 
trading activity for that day. Options market makers should be able 
to use such information to document eligibility for the exception 
from the close-out requirement of Regulation SHO. Because options 
market makers receive these daily trading reports, we estimate that 
it would take an options market maker no more than approximately 10 
minutes to document that a fail to deliver position has not been 
closed out due to its eligibility for the options market maker 
exception.
    \108\ We used the first quarter of 2006 because this is the most 
recent period over which we have access to option open interest 
data.
    \109\ This estimate is based on there being 5 options exchanges 
that have a specialist or specialist-like structure and an 
estimation that each exchange would have 1 options market maker 
actively engaged in hedging threshold securities with listed 
options.
---------------------------------------------------------------------------

    We estimate that it would take a participant of a registered 
clearing agency no more than approximately 0.16 hours (10 minutes) to 
document that a fail to deliver position has not been closed out due to 
its eligibility for the options market maker exception.\110\ If a 
participant of a registered clearing agency had a fail to deliver 
position in a threshold security and after twelve consecutive 
settlement days the participant determined whether or not the fail to 
deliver position was excepted from Regulation SHO's close-out 
requirement due to hedging activity by a registered options market 
maker, we estimate that a participant of a registered clearing agency 
would have to make such determination with respect to approximately 
three threshold securities per day.\111\ We understand that there are 
currently approximately sixteen participants of a registered clearing 
agency that clear transactions for options market makers.\112\ Thus, we 
estimate that on average, a participant of a registered clearing agency 
would have to document compliance with the proposed alternatives to the 
elimination of the options market maker exception 12,096 times per year 
(16 participants checking for compliance once per day on three 
securities, multiplied by 252 trading days in a year). Thus, the total 
approximate estimated annual burden hour per year would be 
approximately 1,935 burden hours (12,096 @ 0.16 hours/documentation). A 
reasonable estimate for the paperwork compliance for the proposed 
alternatives for each participant would be approximately 120 burden 
hours (756 instances of documentation per respondent @ 0.16 hours/
documentation).
---------------------------------------------------------------------------

    \110\ We do not believe that the documentation requirement is 
complex. Such documentation requirement could involve a participant 
of a registered clearing agency contacting a registered options 
market maker for which it clears transactions to determine whether 
or not trading activity by the registered options market maker was 
responsible for the fail to deliver position and whether or not the 
fail to deliver position resulted from short sales effected by the 
registered options market maker to establish or maintain a hedge on 
options series in a portfolio that were created before the security 
became a threshold security. After making such determination, the 
proposed amendment would require that the participant document this 
information. We estimate that such procedures would take a 
participant of a registered clearing agency no more than 
approximately 10 minutes to complete.
    \111\ We estimated that a participant would make such a 
determination for approximately 3 threshold securities per day based 
on data from the first quarter of 2006. We used the first quarter of 
2006 because this is the most recent period over which we have 
access to option open interest data.
    \112\ This number is based on information received from the 
Options Clearing Corporation.
---------------------------------------------------------------------------

ii. Proposed Amendment to Rule 200(g)(1)
    The proposed amendment to Rule 200(g)(1) of Regulation SHO would 
require that brokers and dealers marking orders as ``long'' sales 
document the present location of the securities. We estimate that all 
of the approximately 5,808 registered broker-dealers may effect sell 
orders in securities covered by Regulation SHO and, therefore, would be 
required to comply with the proposed documentation requirement.
    For purposes of the PRA, OEA has estimated that a total of 
2,750,000,000 trades are executed annually.\113\ Of these 2,750,000,000 
trades, OEA estimates that approximately 75%, that is, 2,062,500,000, 
of these trades would be ``long'' sales.\114\ This would be an average 
of approximately 355,114 annual long sales by each respondent. In 
addition, because we believe that the documentation process is or will 
be automated, we estimate that it would take a registered broker-dealer 
approximately 0.000139 hours (0.5 seconds) to document the present 
location of the securities being sold.\115\
---------------------------------------------------------------------------

    \113\ In calendar year 2006, there were approximately 2.099 
billion trades in NYSE and Nasdaq-listed stocks. In addition, there 
were approximately 2.114 billion trades in over-the-counter bulletin 
board (``OTCBB'') traded stocks. OEA estimates that if we were to 
include Amex-listed and pink sheet stocks, the total annual trades 
would be approximately 2.75 billion trades.
    \114\ See Office of Economic Analysis U.S. Securities and 
Exchange Commission, Economic Analysis of the Short Sale Price 
Restrictions Under the Regulation SHO Pilot (Sept. 14, 2006), 
available at http://www.sec.gov/about/economic/shopilot091506/draft_reg_sho_pilot_report.pdf.
    \115\ In the 2003 Proposing Release, we stated that we thought 
it was reasonable that it would only take 0.5 seconds or 0.000139 
hours to mark an order ``long,'' ``short,'' or ``short exempt.'' See 
2003 Proposing Release, 68 FR at 63000. We believe it is reasonable 
that it would take a similar amount of time to document the present 
location of the securities being sold, if the documentation process 
were automated. In addition, we note that Regulation SHO requires 
broker-dealers executing short sales to document compliance with the 
``locate'' requirements of Rule 203(b)(1) of Regulation SHO, i.e., 
prior to accepting or effecting a short sale in an equity security, 
a broker-dealer must document that it 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. Thus, 
broker-dealers should already have in place systems similar to those 
necessary to document the present location of the securities being 
sold for purposes of long sales.
---------------------------------------------------------------------------

    Thus, the total approximate estimated annual burden hour per year 
would be 286,688 burden hours (2,062,500,000 trades @ 0.000139 hours/
trade). A reasonable estimate for the paperwork compliance for the 
proposed amendment for each broker-dealer would be approximately 49 
burden hours (355,114 trades per respondent @ 0.000139 hours/response).
    To the extent that broker-dealers need to automate the 
documentation process, we anticipate that such broker-dealers would 
spend varying amounts of time reprogramming systems, integrating 
systems, and potentially updating front-end software. Some broker-
dealers may spend very little time automating the documentation 
process, while changes at other broker-dealers might be more involved. 
On average, we estimate that reprogramming burdens at a broker-dealer 
would be approximately 16 hours (or two days) with one programmer.\116\ 
If broker-dealers hired new computer programmers at $67/hour, this 
would cost $1,072 per broker-dealer (16 hours @ $67 per hour) or an 
aggregate of $6,226,176 across all broker-dealers.\117\
---------------------------------------------------------------------------

    \116\ We believe that most of the relevant information is 
already stored in electronic form and, therefore, we do not believe 
that the automation process would be difficult or time-consuming to 
implement. Hence, we estimate that automation would on average take 
no longer than approximately 16 hours (2 days) to complete.
    \117\ The $67/hour figure for a computer programmer is based on 
the salary for a Senior Computer Operator from the SIA Report on 
Office Salaries in the Securities Industry 2006, modified to account 
for an 1800-hour work-year and multiplied by 2.93 to account for 
bonuses, firm size, employee benefits and overhead.
---------------------------------------------------------------------------

E. Collection of Information is Mandatory

i. Proposed Alternatives to Elimination of the Options Market Maker 
Exception
    The proposed collection of information for the proposed 
alternatives to elimination of the options market maker exception would 
be mandatory for a participant of a registered clearing agency and 
options market maker where a fail to deliver position has not been 
closed out because the fails to deliver resulted from short sales 
effected by a registered options market maker to establish or maintain 
a hedge on options series in a portfolio that were created before the 
security became a threshold security.
ii. Proposed Amendment to Rule 200(g)(1)
    The proposed collection of information would be mandatory for a

[[Page 45576]]

broker-dealer marking a sell order as ``long'' pursuant to Rule 
200(g)(1).

F. Confidentiality

i. Proposed Alternatives to Elimination of the Options Market Maker 
Exception
    The proposed collection of information for the proposed 
alternatives to elimination of the options market maker exception would 
be retained by participants of a registered clearing agency and options 
market makers and provided to the Commission and SRO examiners upon 
request, but not subject to public availability.
ii. Proposed Amendment to Rule 200(g)(1)
    The proposed collection of information under the proposed amendment 
to Rule 200(g)(1) would be retained by the broker-dealer and provided 
to the Commission and SRO examiners upon request, but would not be 
subject to public availability.

G. Record Retention Period

i. Proposed Alternatives to Elimination of the Options Market Maker 
Exception
    The proposed alternatives to elimination of the options market 
maker exception do not contain any new record retention requirements. 
All registered broker-dealers that would be subject to the proposed 
alternatives are currently required to retain records in accordance 
with Rule 17a-4 of the Exchange Act.\118\
---------------------------------------------------------------------------

    \118\ 17 CFR 240.17a-4.
---------------------------------------------------------------------------

    As discussed above, participants of a registered clearing agency 
include entities not registered as broker-dealers, such as banks, U.S. 
exchanges, and clearing agencies.\119\ Although we do not believe that 
participants of a registered clearing agency other than broker-dealers 
would trigger the obligations of the proposed alternatives, all banks 
subject to the proposed alternatives would be required to retain 
records in compliance with any existing or future record retention 
requirements established by the banking agencies. All U.S. exchanges 
and clearing agencies subject to the proposed alternatives would be 
required to retain records in compliance with Rule 17a-1 of the 
Exchange Act.\120\
---------------------------------------------------------------------------

    \119\ See supra note 22.
    \120\ 17 CFR 240.17a-1.
---------------------------------------------------------------------------

ii. Proposed Amendment to Rule 200(g)(1)
    The proposed amendment to Rule 200(g)(1) does not contain any new 
record retention requirements. All registered broker-dealers that would 
be subject to the proposed amendment are currently required to retain 
records in accordance with Rule 17a-4 of the Exchange Act.\121\
---------------------------------------------------------------------------

    \121\ Id. at 240.17a-4.
---------------------------------------------------------------------------

H. Request for Comment

    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits 
comments to: (i) Evaluate whether the proposed collection of 
information is necessary for the proper performance of the functions of 
the agency, including whether the information shall have practical 
utility; (ii) evaluate the accuracy of the Commission's estimate of the 
burden of the proposed collection of information; (iii) determine 
whether there are ways to enhance the quality, utility, and clarity of 
the information to be collected; and (iv) evaluate whether there are 
ways to minimize the burden of the collection of information on those 
who are to respond, including through the use of automated collection 
techniques or other forms of information technology.
    Persons submitting comments on the collection of information 
requirements should direct them to the Office of Management and Budget, 
Attention: Desk Officer for the Securities and Exchange Commission, 
Office of Information and Regulatory Affairs, Washington, DC 20503, and 
should also send a copy of their comments to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090, with reference to File No. S7-19-07. 
Requests for materials submitted to OMB by the Commission with regard 
to this collection of information should be in writing, with reference 
to File No. S7-19-07, and be submitted to the Securities and Exchange 
Commission, Records Management, Office of Filings and Information 
Services, 100 F Street, NE., Washington, DC 20549-1090. As OMB is 
required to make a decision concerning the collections of information 
between 30 and 60 days after publication, a comment to OMB is best 
assured of having its full effect if OMB receives it within 30 days of 
publication.

VII. Consideration of Costs and Benefits of Proposed Amendments to 
Regulation SHO

    The Commission is considering the costs and the benefits of the 
proposed amendments to Regulation SHO. The Commission is sensitive to 
these costs and benefits, and encourages commenters to discuss any 
additional costs or benefits beyond those discussed here, as well as 
any reductions in costs. In particular, the Commission requests comment 
on the potential costs for any modification to both computer systems 
and surveillance mechanisms and for information gathering, management, 
and recordkeeping systems or procedures, as well as any potential 
benefits resulting from the proposals for registrants, issuers, 
investors, brokers or dealers, other securities industry professionals, 
regulators, and other market participants. Commenters should provide 
analysis and data to support their views on the costs and benefits 
associated with the proposed amendments to Regulation SHO.

A. Elimination of the Options Market Maker Exception

1. Benefits
    The proposed amendment would eliminate the options market maker 
exception in Rule 203(b)(3)(iii) of Regulation SHO. In particular, as a 
transition measure, the proposal would require that any previously-
excepted fail to deliver position in a threshold security on the 
effective date of the amendment be closed out within 35 consecutive 
settlement days of the effective date of the amendment. If a security 
becomes a threshold security after the effective date of the amendment, 
any fails to deliver that result or resulted from short sales effected 
by a registered options market maker to establish or maintain a hedge 
on any options positions created before the security became a threshold 
security would be subject to Rule 203(b)(3)'s mandatory 13 consecutive 
settlement day close-out requirement, similar to any other fail to 
deliver position in a threshold security.
    On July 14, 2006, the Commission published proposed amendments to 
the options market maker exception contained in Regulation SHO to limit 
the duration of the exception.\122\ We proposed to narrow the options 
market maker exception at that time because we have observed a small 
number of threshold securities with substantial and persistent fail to 
deliver positions that are not being closed out under existing delivery 
and settlement guidelines and we believed that these persistent fail to 
deliver positions were attributable, in part, to the options market 
maker exception in Regulation SHO.\123\
---------------------------------------------------------------------------

    \122\ See 2006 Proposing Release, 71 FR 41710.
    \123\ See id. at 41712; Regulation SHO Re-Opening Release, 72 FR 
at 15079-15080.
---------------------------------------------------------------------------

    As a result of the comment process, however, we learned that 
commenters were concerned that the proposed

[[Page 45577]]

amendments to the options market maker exception could be costly and 
difficult to implement or possibly unworkable because options market 
makers typically use hedges to manage the risk of an entire inventory, 
not just a specific options position.
    We remain concerned that large and persistent fails to deliver are 
not being closed out due to the options market maker exception in 
Regulation SHO and that these fails to deliver may have a negative 
effect on the market in these securities. For example, large and 
persistent fails to deliver may deprive shareholders of the benefits of 
ownership, such as voting and lending. In addition, where a seller of 
securities fails to deliver securities on trade settlement date, in 
effect the seller unilaterally converts a securities contract (which 
should settle within the standard 3-day settlement period) into an 
undated futures-type contract, to which the buyer may not have agreed, 
or that would have been priced differently. Moreover, sellers that fail 
to deliver securities on settlement date may enjoy fewer restrictions 
than if they were required to deliver the securities within a 
reasonable period of time, and such sellers may attempt to use this 
additional freedom to engage in trading activities that deliberately 
depress the price of a security.
    In addition, many issuers and investors continue to express concern 
about extended fails to deliver in connection with ``naked'' short 
selling.\124\ To the extent that large and persistent fails to deliver 
may be indicative of manipulative ``naked'' short selling, which could 
be used as a tool to drive down a company's stock price, fails to 
deliver may undermine the confidence of investors.\125\ These 
investors, in turn, may be reluctant to commit capital to an issuer 
they believe to be subject to such manipulative conduct.\126\ In 
addition, issuers may believe that they have suffered unwarranted 
reputational damage due to investors' negative perceptions regarding 
large and persistent fails to deliver.\127\ Thus, large and persistent 
fails to deliver may result in an increase in artificial market 
influences on a security's price.\128\
---------------------------------------------------------------------------

    \124\ See, e.g., supra note 8 (citing to comment letters from 
issuers and investors discussing extended fails to deliver in 
connection with ``naked'' short selling).
    \125\ See, e.g., supra note 9 (citing to comment letters 
discussing the impact of fails to deliver on investor confidence).
    \126\ See, e.g., supra note 10 (citing to comment letters 
expressing concern regarding the impact of potential ``naked'' short 
selling on capital formation).
    \127\ See supra note 11.
    \128\ See also, 2006 Proposing Release, 71 FR at 41712 
(discussing the impact of large and persistent fails to deliver on 
the market). See also, 2003 Proposing Release, 68 FR at 62975 
(discussing the impact of ``naked'' short selling on the market).
---------------------------------------------------------------------------

    Also, as part of the comment process to the proposed amendments to 
the options market maker exception as set forth in the 2006 Proposing 
Release, some commenters' statements indicated to us that the current 
options market maker exception might not be sufficiently narrowly 
tailored to limit the extent to which options market makers can claim 
an exception to the close-out requirement of Regulation SHO. Thus, we 
determined to re-propose amendments to the options market maker 
exception that would eliminate the exception and, thereby, reduce the 
number of large and persistent fails to deliver in threshold 
securities.
    Consistent with the Commission's investor protection mandate, the 
proposed amendment would benefit investors by facilitating the receipt 
of shares so that more investors receive the benefits associated with 
share ownership, such as the use of the shares for voting and lending 
purposes. The proposal could enhance investor confidence as they make 
investment decisions by providing investors with greater assurance that 
securities would be delivered as expected. An increase in investor 
confidence in the market could facilitate investment.
    The proposed amendment should also benefit issuers. A high level of 
persistent fails to deliver in a security could be perceived by 
potential investors negatively and could affect their decision about 
making a capital commitment.\129\ Some issuers could believe that they 
have endured unwarranted reputational damage due to investors' negative 
perceptions regarding a security having a large fail to deliver 
position and becoming a threshold security.\130\ Thus, issuers could 
believe the elimination of the options market maker exception would 
restore their good name. Some issuers could also believe that large and 
persistent fails to deliver indicate that they have been the target of 
potentially manipulative conduct as a result of ``naked'' short 
selling.\131\ Thus, elimination of the options market maker could 
decrease the possibility of artificial market influences and, 
therefore, could contribute to price efficiency.
---------------------------------------------------------------------------

    \129\ See, e.g., supra note 10 (citing to comment letters 
expressing concern regarding the impact of potential ``naked'' short 
selling on capital formation).
    \130\ See, e.g., supra note 11.
    \131\ See, e.g., supra note 8 (citing to comment letters from 
issuers and investors discussing extended fails to deliver in 
connection with ``naked'' short selling).
---------------------------------------------------------------------------

    We solicit comment on any additional benefits that could be 
realized with the proposed amendment, including both short-term and 
long-term benefits. We solicit comment regarding other benefits to 
market efficiency, pricing efficiency, market stability, market 
integrity, and investor protection.
2. Costs
    To comply with Regulation SHO when it became effective in January 
2005, market participants needed to modify their recordkeeping systems 
and surveillance mechanisms. In addition, market participants should 
have retained and trained the necessary personnel to ensure compliance 
with the rule. Thus, the infrastructure necessary to comply with the 
proposed amendment should already be in place because the proposed 
amendment, if adopted, would require that all fails to deliver be 
closed out in accordance with the 13 consecutive settlement day 
mandatory close-out requirement of Regulation SHO. The only fails to 
deliver not subject to Regulation SHO's mandatory close-out requirement 
would be those fails to deliver that would be previously-excepted from 
the close-out requirement and, therefore, eligible for the one-time 35 
day phase-in period of the proposed amendment. Thus, any changes to 
personnel, computer hardware and software, recordkeeping or 
surveillance costs should be minimal.
    In the 2006 Proposing Release we requested comment regarding the 
costs of the proposed amendments to the options market maker exception 
and how those costs would affect liquidity in the options markets. 
Commenters who opposed the proposal to narrow the options market maker 
exception stated that the amendments would disrupt the markets because 
they would not provide sufficient flexibility to permit efficient 
hedging by options market makers, would unnecessarily increase risks 
and costs to hedge, and would adversely impact liquidity and result in 
higher costs to customers.\132\ These commenters stated that they 
believe the proposed amendments would likely discourage options market 
makers from making markets in illiquid securities since the risk 
associated in maintaining the hedges in these option positions would be 
too great.\133\ Moreover, these

[[Page 45578]]

commenters stated that the reluctance of options market makers to make 
markets in threshold securities would result in wider spreads in such 
securities to account for the increased costs of hedging, to the 
detriment of investors.\134\
---------------------------------------------------------------------------

    \132\ See, e.g., letter from CBOE, supra note 31.
    \133\ See id.
    \134\ See letter from Citigroup, supra note 31.
---------------------------------------------------------------------------

    Although we recognize commenters' concerns that a mandatory close-
out requirement for fails to deliver in threshold securities underlying 
options positions could potentially impact options market makers' 
willingness to provide liquidity in threshold securities, make it more 
costly for options market makers to accommodate customer buy orders, or 
result in wider bid-ask spreads or less depth, for the reasons 
discussed below, we believe that such an impact, if any, would be 
minimal.
    First, we believe that the potential effects, if any, of a 
mandatory close-out requirement would be minimal because the number of 
securities that would be impacted by a mandatory close-out requirement 
would be small. Regulation SHO's close-out requirement is narrowly 
tailored in that it targets only those securities where the level of 
fails to deliver is high (0.5% of total shares outstanding and 10,000 
shares or more) for a continuous period (five consecutive settlement 
days).\135\ Requiring close out only for securities with large and 
persistent fails to deliver limits the overall market impact. In 
addition, as noted by one commenter, a small number of securities that 
meet the definition of a ``threshold security'' have listed options, 
and those securities form a very small percentage of all securities 
that have options traded on them.\136\ Moreover, the current options 
market maker exception only excepts from Regulation SHO's mandatory 13 
consecutive settlement day close-out requirement those fail to deliver 
positions that result from short sales effected by registered options 
market makers to establish or maintain a hedge on options positions 
established before the underlying security became a threshold security. 
Thus, it does not apply to fails to deliver resulting from short sales 
effected to establish or maintain a hedge on options positions 
established after the underlying security became a threshold security. 
Because the current options market maker exception has a very limited 
application, the overall impact of its removal on liquidity, hedging 
costs, spreads, and depth should be relatively small.
---------------------------------------------------------------------------

    \135\ See supra note 7 (discussing the number of threshold 
securities as of March 31, 2007).
    \136\ See letter from Options Exchanges, supra note 49.
---------------------------------------------------------------------------

    Second, to the extent that a mandatory close-out requirement could 
potentially impact options market makers' willingness to provide 
liquidity in threshold securities, make it more costly for options 
market makers to accommodate customer buy orders, or result in wider 
bid-ask spreads or less depth, we believe that any such potential 
effects would likely be mitigated by the fact that even though fails to 
deliver that were previously-excepted from the close-out requirement of 
Regulation SHO would not be permitted to continue indefinitely, such 
fails to deliver would not have to be closed out immediately, or even 
within the standard 3-day settlement period. Instead, under Rule 
203(b)(3)'s 13 consecutive settlement day close-out requirement, fails 
to deliver in threshold securities would have an extended period of 
time within which to be closed out. An extended close-out requirement 
would provide options market makers with some flexibility in conducting 
their hedging activities in that it would allow them to not close out a 
fail to deliver position or pre-borrow to maintain a hedge in a 
threshold security for 13 consecutive settlement days.
    Third, as noted above, Regulation SHO's current options market 
maker exception is limited to only those fail to deliver positions that 
result from short sales effected by registered options market makers to 
establish or maintain a hedge on options positions established before 
the underlying security became a threshold security. Thus, it does not 
apply to fails to deliver resulting from short sales effected to 
establish or maintain a hedge on options positions established after 
the underlying security became a threshold security. In evaluating the 
application of the current mandatory close-out requirement of 
Regulation SHO for all non-excepted fail to deliver positions, we have 
not become aware of any evidence that the current close-out requirement 
for non-excepted fails to deliver in threshold securities has impacted 
options market makers' willingness to provide liquidity in threshold 
securities, made it more costly for options market makers to 
accommodate customer orders, or resulted in wider bid-ask spreads or 
less depth. Similarly, all fails to deliver in threshold securities 
resulting from long or short sales of securities in the equities 
markets must be closed out in accordance with Regulation SHO's 
mandatory 13 consecutive settlement day close-out requirement, and we 
are not aware that such a requirement has impacted the willingness of 
market makers to make markets in securities subject to the close-out 
requirement, or led to decreased liquidity, wider spreads, or less 
depth in these securities. Thus, we believe that the impact of 
requiring that fails to deliver in threshold securities resulting from 
short sales to hedge options positions created before the security 
became a threshold security be closed out would similarly be minimal, 
if any.
    Fourth, to the extent that a mandatory close-out requirement for 
all fails to deliver resulting from hedging activity in the options 
markets could potentially impact liquidity, hedging costs, depth, or 
spreads, or impact the willingness of options market makers to make a 
market in certain securities, we believe that such effects are 
justified by our belief, as discussed in more detail below, that fails 
to deliver resulting from hedging activities by options market makers 
should be treated similarly to fails to deliver resulting from sales in 
the equities markets so that market participants trading threshold 
securities in the options markets do not receive an advantage over 
those trading such securities in the equities markets.
    Fifth, to the extent that a mandatory close-out requirement for all 
fails to deliver resulting from hedging activity in the options markets 
could potentially impact liquidity, hedging costs, depth, or spreads, 
or impact the willingness of options market makers to make a market in 
certain securities, we believe that these potential effects are 
justified by the benefits of requiring that fails to deliver in all 
threshold securities be closed out within specific time-frames rather 
than being allowed to continue indefinitely. As discussed above, large 
and persistent fails to deliver can deprive shareholders of the 
benefits of ownership, such as voting and lending. They can also be 
indicative of potentially manipulative conduct, such as abusive 
``naked'' short selling. The deprivation of the benefits of ownership, 
as well as the perception that abusive ``naked'' short selling is 
occurring in certain securities, can undermine the confidence of 
investors. These investors, in turn, may be reluctant to commit capital 
to an issuer they believe to be subject to manipulative conduct.
    In the 2006 Proposing Release, we sought comment on whether the 
proposed amendments would promote capital formation, including whether 
the proposed increased short sale restrictions would affect investors' 
decisions to invest in certain equity securities. Commenters expressed 
concern about ``naked'' short selling

[[Page 45579]]

causing a drop in an issuer's stock price and that it may limit an 
issuer's ability to access the capital markets.\137\ We believe that, 
by requiring that all fails to deliver in threshold securities be 
closed out within specific time-frames rather than allowing them to 
continue indefinitely, there would be a decrease in the number of 
threshold securities with persistent and high levels of fails to 
deliver. If persistence on the threshold securities lists leads to an 
unwarranted decline in investor confidence about the security, the 
proposed amendments should improve investor confidence about the 
security. We also believe that the proposed amendments should lead to 
greater certainty in the settlement of securities which should 
strengthen investor confidence in the settlement process.
---------------------------------------------------------------------------

    \137\ See, e.g., letter from Feeney, supra note 10.
---------------------------------------------------------------------------

    Due to our concerns about the potentially negative market impact of 
large and persistent fails to deliver, and the fact that we continue to 
observe a small number of threshold securities with fail to deliver 
positions that are not being closed out under existing delivery and 
settlement requirements, we adopted amendments to eliminate Regulation 
SHO's grandfather provision that allowed fails to deliver resulting 
from long or short sales of equity securities to persist indefinitely 
if the fails to deliver occurred prior to the security becoming a 
threshold security.\138\ We believe that once a security becomes a 
threshold security, fails to deliver in that security must be closed 
out, regardless of whether or not the fails to deliver resulted from 
sales of the security in connection with the options or equities 
markets.
---------------------------------------------------------------------------

    \138\ See Securities Exchange Act Release No. 56212 (Aug. 7, 
2007); see also 2006 Proposing Release, 71 FR at 41711-41712.
---------------------------------------------------------------------------

    Moreover, we believe that fails to deliver resulting from hedging 
activities by options market makers should be treated similarly to 
fails to deliver resulting from sales in the equities markets so that 
market participants trading threshold securities in the options markets 
do not receive an advantage over those trading such securities in the 
equities markets. We are also concerned that the current options market 
maker exception might allow for a regulatory arbitrage not permitted in 
the equities markets. For example, an options market maker who sells 
short to hedge put options purchased by a market participant unable to 
locate shares for a short sale in accordance with Rule 203(b)(2) of 
Regulation SHO may not have to close out any fails to deliver that 
result from such short sales under the current options market maker 
exception. The ability of options market makers to sell short and never 
have to close out a resulting fail to deliver position, provided the 
short sale was effected to hedge options positions created before the 
security became a threshold security, runs counter to the goal of 
similar treatment for fails to deliver resulting from sales of 
securities in the options and equities markets, because no such ability 
is available in the equity markets.\139\
---------------------------------------------------------------------------

    \139\ See Securities Exchange Act Release No. 56212 (Aug. 7, 
2007).
---------------------------------------------------------------------------

    In addition, we believe the proposed 35 consecutive settlement day 
phase-in period should not result in market disruption, such as 
increased volatility or short squeezes, because it would provide time 
for participants of a registered clearing agency, or options market 
makers for which they clear transactions, to close out previously-
excepted fail to deliver positions in an orderly manner, particularly 
because participants and options market makers could begin closing out 
previously-excepted fail to deliver positions at any time before the 
proposed 35 day phase-in period. The 35 day phase-in period may result 
in some systems and surveillance-related costs, but these costs should 
be one-time rather than ongoing costs because the phase-in period would 
expire 35 settlement days after the effective date of the proposed 
amendment, if adopted.
    Also, the proposed pre-borrow requirement for fail to deliver 
positions that are not closed out within the applicable time-frames set 
forth in the proposed amendment would result in limited, if any, costs 
to participants of a registered clearing agency, and options market 
makers for which they clear transactions. The proposed pre-borrow 
requirement is similar to the pre-borrow requirement of Rule 
203(b)(3)(iii) of Regulation SHO, as originally adopted. Thus, 
participants of a registered clearing agency, and any options market 
maker for which it clears transactions, must already comply with such a 
requirement if a fail to deliver position has not been closed out in 
accordance with Regulation SHO's mandatory close-out requirement. 
Accordingly, these entities should already have in place the personnel, 
recordkeeping, systems, and surveillance mechanisms necessary to comply 
with the proposed pre-borrow requirement.
    We seek comment about any other costs and cost reductions 
associated with the proposed amendment or alternative suggestions. 
Specifically:
     What would be the costs of the proposed elimination of the 
options market maker exception? How would the proposed elimination of 
the options market maker exception affect the liquidity of securities 
with options traded on them? Would the proposed elimination of the 
options market maker exception mean that fewer market makers would be 
willing to make markets in securities with options traded on them, and 
could the proposed amendment increase transaction costs for securities 
with options traded on them? Would such an effect, if any, be more 
severe for liquid or illiquid securities? Would it lead to fewer listed 
options?
     How much would this proposed amendment to the options 
market maker exception affect the compliance costs for small, medium, 
and large participants of a registered clearing agency and for options 
market makers (e.g., personnel or system changes)? We seek comment on 
the costs of compliance that could arise as a result of the proposed 
amendment. For instance, to comply with the proposed amendment, would 
these entities be required to:
     Purchase new systems or implement changes to existing 
systems? Would changes to existing systems be significant? What would 
be the costs associated with acquiring new systems or making changes to 
existing systems? How much time would be required to fully implement 
any new or changed systems?
     Change existing records? What changes would need to be 
made? What would be the costs associated with any changes? How much 
time would be required to make any changes?
     Increase staffing and associated overhead costs? Would 
entities subject to the proposed amendment have to hire more staff? How 
many, and at what experience and salary level? Could existing staff be 
retrained? What would be the costs associated with hiring new staff or 
retraining existing staff? If retraining were required, what other 
costs could be incurred, e.g., would retrained staff be unable to 
perform existing duties in order to comply with the proposed amendment? 
Would other resources need to be re-dedicated to comply with the 
proposed amendment?
     Implement, enhance or modify surveillance systems and 
procedures? Please describe what would be needed, and what costs would 
be incurred.
     Establish and implement new supervisory or compliance 
procedures, or modify existing procedures? What would be the costs 
associated with such changes? Would new compliance or

[[Page 45580]]

supervisory personnel be needed? What would be the costs of obtaining 
such staff?
     Are there any costs that market participants could incur 
as a result of the proposed 35 consecutive settlement day phase-in 
period? Would the costs of a phase-in period be too significant to 
justify having one? Would a phase-in period create examination or 
surveillance difficulties? If so, how? What would be the costs and 
economic tradeoffs associated with longer or shorter phase-in periods?
     What would be the costs associated with including the pre-
borrow requirement for the proposed amendment to the options market 
maker exception?

B. Alternatives to Eliminating the Options Market Maker Exception

1. Benefits
    Due to the fact that large and persistent fails to deliver are not 
being closed out under existing delivery and settlement requirements 
and the fact that we are concerned that these fails to deliver may have 
a negative impact on the market for those securities, we believe that 
the options market maker exception to the mandatory close-out 
requirement of Rule 203(b)(3) of Regulation SHO should be eliminated.
    In part, in anticipation of commenters stating that a limited 
options market maker exception is necessary we are requesting comment 
regarding two specific limited alternatives to elimination of the 
options market maker exception. Each of the proposed alternatives would 
provide for a 35 consecutive settlement day phase-in period similar to 
the phase-in period discussed above in connection with the proposed 
elimination of the options market maker exception for securities that 
are threshold securities on the effective date of the amendment and 
that have previously-excepted fail to deliver positions. The phase-in 
period would reduce any potential market disruption, such as increased 
volatility or short squeezes, from having to close-out previously-
excepted fail to deliver positions because it would provide time for 
participants of a registered clearing agency to close out previously-
excepted fail to deliver positions in an orderly manner, particularly 
because participants could begin closing out these fail to deliver 
positions at any time before the proposed 35 day phase-in period.
    In addition, in response to comments about the proposed amendments 
to the options market maker exception in the 2006 Proposing Release 
that those proposed amendments would be costly and difficult to 
implement because portfolio hedging is the industry practice, the 
proposed alternatives would apply to fails to deliver resulting from 
short sales effected by a registered options market maker to establish 
or maintain a hedge on any options series, rather than an options 
position, created before an underlying security became a threshold 
security. Thus, the proposed alternatives would be more in line with 
industry practice and, therefore, less costly and difficult to 
implement than the commenters believed the proposed amendment in the 
2006 Proposing Release would be.
    The first alternative would require that a participant of a 
registered clearing agency that has a fail to deliver position in a 
threshold security that results or resulted from a short sale by a 
registered options market maker to establish or maintain a hedge on any 
options series within a portfolio that were created before the security 
became a threshold security close out the entire fail to deliver 
position, including any adjustments to that position, within 35 
consecutive settlement days of the security becoming a threshold 
security. After the 35 consecutive settlement days has expired, any 
additional fails to deliver would be subject to the 13 consecutive 
settlement day close-out requirement of Rule 203(b)(3) of Regulation 
SHO. In addition, the proposed first alternative would impose a pre-
borrow requirement similar to the pre-borrow requirement of Rule 
203(b)(3)(iv) of Regulation SHO.
    The second alternative would require that a participant of a 
registered clearing agency that has a fail to deliver position in a 
threshold security that results or resulted from a short sale by a 
registered options market maker to establish or maintain a hedge on any 
options series in a portfolio that were created before the security 
became a threshold security to close out the entire fail to deliver 
position, including any adjustments to that position, within the 
earlier of: (i) 35 Consecutive settlement days from the date on which 
the security became a threshold security, or (ii) 13 consecutive 
settlement days from the last date on which all options series within 
the portfolio that were created before the security became a threshold 
security expire or are liquidated. After the 35 or 13 consecutive 
settlement days has expired, any additional fails to deliver would be 
subject to the 13 consecutive settlement day close-out requirement of 
Rule 203(b)(3) of Regulation SHO. In addition, the proposed amendment 
would impose a pre-borrow requirement similar to the pre-borrow 
requirement of Rule 203(b)(3)(iv) of Regulation SHO.
    Similar to elimination of the options market maker exception, by 
proposing to require that all fails to deliver be closed out within 
specific time-frames, the proposed alternatives would reduce large and 
persistent fails to deliver. In addition, by proposing to require that 
shares be delivered to a buyer within a reasonable period of time, the 
proposed alternatives would result in shareholders receiving the 
benefits of ownership. Sellers would also be less able to unilaterally 
convert securities contracts into undated futures-type contracts to 
which the buyer would not have agreed, or that would have been priced 
differently. In addition, the delivery requirements of the proposed 
alternatives would enhance investor confidence as they make investment 
decisions by providing investors with greater assurance that securities 
would be delivered as expected.\140\ An increase in investor confidence 
in the market could facilitate investment. The proposed alternatives 
could benefit issuers because investors may be more willing to commit 
capital where fails levels are lower.\141\ In addition, some issuers 
could believe that a reduction in fails to deliver could reverse 
unwarranted reputational damage potentially caused by large and 
persistent fails to deliver and what they believe might be an 
indication of manipulative trading activities, such as ``naked'' short 
selling.\142\ Thus, the proposed requirement that all fails to deliver 
be closed out within specific time-frames, as would be required by the 
proposed alternatives, could decrease the possibility of artificial 
market influences and, therefore, could contribute to price efficiency.
---------------------------------------------------------------------------

    \140\ See, e.g., supra note 9 (citing to comment letters 
discussing the impact of fails to deliver on investor confidence).
    \141\ See, e.g., supra note 10 (citing to comment letters 
expressing concern regarding the impact of potential ``naked'' short 
selling on capital formation).
    \142\ See, e.g., supra note 11.
---------------------------------------------------------------------------

    The proposed alternatives would also require that participants of a 
registered clearing agency and options market makers document that any 
fails to deliver in threshold securities that have not been closed out 
in accordance with the 13 consecutive settlement days close-out 
requirement of Rule 203(b)(3) of Regulation SHO qualify for the options 
market maker exception. The proposed alternatives would require both 
options market makers and participants of a registered clearing agency 
that rely on the options market maker exception to not close out a fail

[[Page 45581]]

to deliver position in accordance with the mandatory close-out 
requirement of Rule 203(b)(3) of Regulation SHO to obtain, prepare, and 
keep documentation demonstrating that a fail to deliver position has 
not been closed out because it qualified for the exception. We 
anticipate such documentation could include, among other things, when 
the series being hedged was created, when the underlying security 
became a threshold security, and the age of the fail to deliver 
position that is not being closed out.
    A documentation requirement would enable the Commission and the 
SROs to monitor more easily whether or not the options market maker 
exception is being applied correctly. In addition, the information 
would provide a record that would aid surveillance for compliance with 
this limited exception to Regulation SHO's close-out requirement.
    We solicit comment on any additional benefits that could be 
realized with the proposed alternatives, including both short-term and 
long-term benefits. We solicit comment regarding other benefits to 
market efficiency, pricing efficiency, market stability, market 
integrity, and investor protection.
2. Costs
    To comply with Regulation SHO when it became effective in January 
2005, market participants needed to modify their recordkeeping, 
systems, and surveillance mechanisms. In addition, market participants 
should have retained and trained the necessary personnel to ensure 
compliance with the rule. Thus, for the most part the infrastructure 
necessary to comply with the proposed alternatives should already be in 
place because the proposed alternatives, if adopted, would require that 
all fails to deliver be closed out in accordance with specific time-
frames similar to the mandatory 13 consecutive settlement day close-out 
requirement of Regulation SHO. In addition, similar to the current 
options market maker exception in Regulation SHO, the proposed 
alternatives would only except from the mandatory close-out requirement 
of Rule 203(b)(3) those fails to deliver that resulted from short sales 
by a registered options market maker in connection with options created 
before the security became a threshold security.
    The proposed alternatives, however, would result in some increased 
recordkeeping, systems, and surveillance costs. The proposed 
alternatives would require that participants of a registered clearing 
agency, and options market makers for which they clear transactions, 
have the necessary recordkeeping, systems, and surveillance mechanisms 
in place to track whether a fail to deliver position resulted from a 
short sale effected by a registered options market maker to maintain or 
establish a hedge on option series created before the security became a 
threshold security. In addition, under the first proposed alternative, 
these entities would need to have systems and surveillance mechanisms 
in place to ensure that such fails to deliver are closed out within 35 
consecutive settlement days of the security becoming a threshold 
security. Under the second proposed alternative, these entities would 
need to have systems and surveillance mechanisms in place to determine 
whether the fails to deliver would be required to be closed out within 
the earlier of 13 consecutive settlement days of all options series 
within the portfolio expiring or being liquidated, or within 35 
consecutive settlement days of the security becoming a threshold 
security. Thus, participants of a registered clearing agency, and 
options market makers for which they clear, could incur costs in 
meeting these requirements.
    In addition, the proposed alternatives would allow for a one-time 
35 consecutive settlement day phase-in period for previously-excepted 
fail to deliver positions. Although any personnel, computer hardware 
and software, recordkeeping, or surveillance costs, associated with 
complying with this proposed phase-in period would not be an ongoing 
cost, entities subject to the requirement could incur some one-time 
costs in complying with this proposed requirement.
    Any costs associated with compliance with the proposed pre-borrow 
requirement for fail to deliver positions that are not closed out 
within the applicable time-frames set forth in the proposed 
alternatives should be limited, if any. The proposed pre-borrow 
requirements in the proposed alternatives are similar to the pre-borrow 
requirement of Rule 203(b)(3)(iii) of Regulation SHO, as originally 
adopted. Thus, participants of a registered clearing agency, and any 
broker-dealers for which it clears transactions, must already comply 
with such a requirement if a fail to deliver position has not been 
closed out in accordance with Regulation SHO's mandatory close-out 
requirement. Accordingly, these entities should already have in place 
the personnel, recordkeeping, systems, and surveillance mechanisms 
necessary to comply with the proposed pre-borrow requirement.
    As discussed above in connection with costs regarding the proposed 
elimination of the options market maker exception, although we 
recognize commenters' concerns that a mandatory close-out requirement 
for fails to deliver in threshold securities underlying options 
positions could potentially impact options market makers' willingness 
to provide liquidity in threshold securities, make it more costly for 
options market makers to accommodate customer orders, or result in 
wider bid-ask spreads or less depth,\143\ we believe the mandatory 
close-out requirements of each of the proposed alternatives would 
similarly minimally impact, if at all, liquidity, hedging costs, 
spreads, or depth in the securities subject to the close-out 
requirements of the proposed alternatives, or the willingness of 
options market makers to make markets in such securities.
---------------------------------------------------------------------------

    \143\ See, e.g., letters from CBOE, supra note 31; Citigroup, 
supra note 31.
---------------------------------------------------------------------------

    We believe that these potential effects of the close-out 
requirements of the proposed alternatives would be minimal, if any, 
because the number of securities that would be impacted by the close-
out requirements of the proposed alternatives would be small. The 
proposed alternatives would apply only to those threshold securities 
with listed options \144\ and would only impact fails to deliver in 
those securities that resulted from short sales by registered options 
market makers to hedge options series that were created before rather 
than after the security became a threshold security because all other 
fails to deliver in threshold securities are subject to Regulation 
SHO's current mandatory 13 consecutive settlement day close-out 
requirement.
---------------------------------------------------------------------------

    \144\ See letter from Options Exchanges, supra note 49 
(discussing the number of threshold securities with listed options).
---------------------------------------------------------------------------

    In addition, the proposed alternatives would provide options market 
makers with flexibility in conducting their hedging activities because 
they would each allow an extended period of time (i.e., 35 consecutive 
settlement days for purposes of Alternative 1 and 13 or 35 consecutive 
settlement days for purposes of Alternative 2) within which to close 
out all fails to deliver in threshold securities. As discussed above in 
connection with the proposed amendment to eliminate the options market 
maker exception, we believe that even a 13 consecutive settlement day 
close-out requirement would result in minimal impact on the willingness 
of

[[Page 45582]]

options market makers to make markets, liquidity, hedging costs, depth, 
and spreads because it would allow options market makers flexibility in 
conducting their hedging activities by permitting fails to deliver to 
remain open for an extended period of time (i.e., 13 consecutive 
settlement days) rather than, for example, requiring that such fails to 
deliver be closed out immediately, or even within the standard 3-day 
settlement period. During the period of time that the fail to deliver 
position can remain open, options market makers would be able to 
continue any hedging activity without having to close out the fail to 
deliver position or pre-borrow to maintain the hedge.
    In addition, we believe the proposed 35 consecutive settlement day 
phase-in period should not result in market disruption, such as 
increased volatility or short squeezes, because it would provide time 
for participants of a registered clearing agency to close out 
previously-excepted fail to deliver positions in an orderly manner, 
particularly because participants could begin closing out previously-
excepted fail to deliver positions at any time before the proposed 35 
day phase-in period.
    As discussed above in connection with the costs associated with 
elimination of the options market maker exception, to the extent that 
the mandatory close-out requirements of the proposed alternatives could 
potentially impact liquidity, hedging costs, depth, or spreads, or 
impact the willingness of options market makers to make markets in 
securities subject to the proposed alternatives, we believe such 
effects are justified by our belief that fails to deliver resulting 
from hedging activities by options market makers should be treated 
similarly to fails to deliver resulting from sales in the equities 
markets so that market participants trading threshold securities in the 
options markets do not receive an advantage over those trading such 
securities in the equities markets. In addition, we believe that such 
potential costs would be justified by the benefits, as discussed above, 
of requiring that all fails to deliver be closed out within specific 
time-frames rather than being allowed to continue indefinitely.
    Although the proposed alternatives would lessen the potential 
negative impact on the market of large and persistent fails to deliver 
similar to the proposed elimination of the options market maker 
exception because they would require that fails to deliver in threshold 
securities eventually be closed out, we believe that the proposed 
elimination of the options market maker exception would achieve this 
goal more effectively because under the proposed elimination of the 
options market maker exception, all fails to deliver in threshold 
securities would have to be closed out within Regulation SHO's 
mandatory 13 consecutive settlement day close-out requirement. The 
proposed alternatives, however, would each allow a longer period of 
time for fail to deliver positions to be closed out. Specifically, the 
first alternative would allow certain fails to deliver to be closed out 
within 35 consecutive settlement days of the security becoming a 
threshold security. Under the second alternative, although some fails 
to deliver would be required to be closed out in less than 35 
consecutive settlement days, other fails to deliver would not have be 
closed out until 35 consecutive settlement days from the security 
becoming a threshold security.
    The proposed alternatives would also impose recordkeeping costs not 
imposed by the proposed amendment to eliminate the options market maker 
exception. The documentation requirement of the proposed alternatives 
would require options market makers and participants of a registered 
clearing agency to obtain, prepare, and keep documentation 
demonstrating that a fail to deliver position has not been closed out 
because it was eligible for the exception. This documentation 
requirement could result in these entities incurring costs related to 
personnel, recordkeeping, systems and surveillance mechanisms. For 
example, as discussed in detail in Section VI.D.i. above, for purposes 
of the PRA, we estimate that it would take each options market maker or 
participant of a registered clearing agency no more than approximately 
10 minutes to document that a fail to deliver position has not been 
closed out due to its eligibility for the options market maker 
exception. In addition, we estimate that the total annual hour burden 
per year for each options market maker subject to the documentation 
requirement would be 3,024 burden hours. We estimate that the total 
annual hour burden per year for each participant of a registered 
clearing agency subject to the documentation requirement would be 120 
burden hours.
    We request specific comment on the systems changes to computer 
hardware and software, or surveillance costs that would be necessary to 
implement the proposed alternatives. Specifically:
     What would be the costs and benefits of the proposed 
alternatives to elimination of the options market maker exception? For 
instance, what would be the costs of the proposed alternatives if 
either of the alternatives were to reduce the willingness of options 
market makers to make markets in securities that could become threshold 
securities or in threshold securities?
     What would be the costs associated with including the pre-
borrow requirement for the proposed alternatives to the options market 
maker exception? What would be the costs of excluding a pre-borrow 
requirement for these proposals?
     What costs would be associated with the documentation 
requirement of the proposed alternatives?
     Based on the current requirements of Regulation SHO, what 
have been the costs and benefits of the current options market maker 
exception?
     What would be the specific costs associated with any 
technical or operational challenges that options market makers would 
face in complying with the proposed alternatives?
     Would the proposed alternatives create any costs, such as 
costs associated with systems, surveillance, or recordkeeping 
modifications that may be needed for participants to track fails to 
deliver subject to the proposed alternatives? If there were any costs 
associated with tracking fails to deliver would these costs justify the 
benefits of providing firms with additional time to close out fails to 
deliver resulting from short sales effected to establish or maintain a 
hedge on options series that were created before the security becomes a 
threshold security?
     How much would the proposed alternatives affect compliance 
costs for small, medium, and large participants of a clearing agency or 
options market maker for which they clear transactions (e.g., personnel 
or system changes)? We seek comment on the costs of compliance that may 
arise. For instance, to comply with the proposed alternatives, would 
these entities be required to:
     Purchase new systems or implement changes to existing 
systems? Would changes to existing systems be significant? What would 
be the costs associated with acquiring new systems or making changes to 
existing systems? How much time would be required to fully implement 
any new or changed systems?
     Change existing records? What changes would need to be 
made? What would be the costs associated with any changes? How much 
time would be required to make any changes?
     Increase staffing and associated overhead costs? Would 
entities subject to the proposed alternatives have to hire more staff? 
How many, and at what

[[Page 45583]]

experience and salary level? Could existing staff be retrained? What 
would be the costs associated with hiring new staff or retraining 
existing staff? If retraining were required, what other costs could be 
incurred, e.g., would retrained staff be unable to perform existing 
duties in order to comply with the proposed amendment? Would other 
resources need to be re-dedicated to comply with the proposed 
amendment?
     Implement, enhance or modify surveillance systems and 
procedures? Please describe what would be needed, and what costs would 
be incurred.
     Establish and implement new supervisory or compliance 
procedures, or modify existing procedures? What would be the costs 
associated with such changes? Would new compliance or supervisory 
personnel be needed? What would be the costs of obtaining such staff?
     Are there any costs that participants could incur as a 
result of the proposed 35 consecutive settlement day phase-in period? 
Would the costs of a phase-in period be too significant to justify 
having one? Would a phase-in period create examination or surveillance 
difficulties? If so, how? What would be the costs and economic 
tradeoffs associated with longer or shorter phase-in periods?

C. Proposed Amendment to Rule 200(g)(1) of Regulation SHO

1. Benefits
    We are proposing for comment a documentation requirement for 
broker-dealers marking orders to sell ``long'' pursuant to Regulation 
SHO that would require such broker-dealers to document the present 
location of the securities being sold. We believe that such a proposed 
documentation requirement would aid in ensuring the correct marking of 
sell orders. To the extent that the seller is unable to provide the 
present location of the securities being sold, the broker-dealer would 
have reason to believe that the seller is not ``deemed to own'' the 
securities being sold and that the securities would not be in its 
physical possession or control no later than settlement of the 
transaction and, therefore, that the broker-dealer would be required to 
mark the sale ``short'' rather than ``long.'' \145\ We believe that 
this proposed documentation requirement could also reduce the number of 
fails to deliver because, after making the inquiry into the present 
location of the securities being sold, a broker-dealer would know 
whether or not it needed to obtain securities for delivery.
---------------------------------------------------------------------------

    \145\ See 17 CFR 242.200(g).
---------------------------------------------------------------------------

    We are concerned that broker-dealers marking orders ``long'' may 
not be making a determination prior to marking the order that the 
seller is ``deemed to own'' the security being sold. Rule 200(g)(1) 
currently requires that broker-dealers ascertain whether the customer 
is ``deemed to own'' the securities being sold before marking a sell 
order ``long.'' \146\ Thus, we believe that the proposed documentation 
requirement would help ensure that the broker-dealer marking the sale 
``long'' has inquired into, and determined that, the seller is ``deemed 
to own'' the securities being sold because the broker-dealer would be 
required to document the present location of the securities being sold.
---------------------------------------------------------------------------

    \146\ See id.
---------------------------------------------------------------------------

    We also believe that the proposed documentation requirement would 
enable the Commission and SROs to more easily examine for compliance 
with the long sale marking provisions of Rule 200(g) more effectively 
because this proposed documentation requirement would provide a record 
that the seller is ``deemed to own'' the securities being sold in 
compliance with that rule. We also believe that the proposed 
documentation requirement would aid the Commission and SROs in 
reviewing for mismarking designed to avoid compliance with other rules 
and regulations of the federal securities laws, such as the ``locate'' 
requirement of Regulation SHO,\147\ and Rule 105 of Regulation M.\148\
---------------------------------------------------------------------------

    \147\ See supra, note 92.
    \148\ See supra, note 93.
---------------------------------------------------------------------------

2. Costs
    In response to our request for comment in the 2006 Proposing 
Release regarding a long sale documentation requirement, commenters 
stated that pre-trade documentation would unnecessarily impair 
efficiency as broker-dealers already have procedures to ensure orders 
are marked properly based on information provided by customers and 
their own books and records, and that documentation requirements would 
add substantial cost.\149\ One commenter also stated that compliance 
with such pre-trade documentation requirements would require a complete 
revamping of front end systems.\150\ Another commenter stated that the 
requirements would be inconsistent with the goal of fostering 
liquidity.\151\
---------------------------------------------------------------------------

    \149\ See letters from MFA, supra note 75; UBS, supra note 31; 
Knight, supra note 75.
    \150\ See letter from SIA, supra note 31.
    \151\ See letter from Millennium, supra note 75.
---------------------------------------------------------------------------

    Although commenters stated that pre-trade documentation for long 
sales would be inconsistent with the goal of fostering liquidity, would 
unnecessarily impair efficiency, and would add substantial cost, we 
believe that such costs, to the extent that there are any, would be 
justified by the benefits of a documentation requirement, as discussed 
above.
    In addition, we note that under former NASD Rule 3370(b), NASD 
member firms making an affirmative determination that a customer was 
long were required to make a notation on the order ticket at the time 
an order was taken which reflected the conversation with the customer 
as to the present location of the securities, whether they were in good 
deliverable form, and the customer's ability to deliver them to the 
member within three business days.\152\ Thus, many broker-dealers 
should already be familiar with a documentation requirement and one 
method that could be used to comply with such a requirement. Such 
familiarity should help reduce any costs associated with implementing 
the proposed documentation requirement. In addition, unlike with former 
NASD Rule 3370(b), the proposed amendment would not specify the format 
or methodology of the proposed documentation requirement. The absence 
of such specifications should help reduce costs to broker-dealers that 
would have to comply with this proposal because broker-dealers would be 
able to determine the most cost effective format and methodology for 
meeting the proposed documentation requirement.
---------------------------------------------------------------------------

    \152\ Brokers and dealers that were members of the NASD were 
obligated to comply with former NASD Rule 3370(b) prior to the 
adoption of Regulation SHO.
---------------------------------------------------------------------------

    We believe that any costs that would arise from the proposed 
requirement that a broker-dealer must document the present location of 
securities being sold long when making the determination that a 
customer is deemed to own the securities being sold would be minimal 
because Rule 200(g)(1) currently requires that broker-dealers must 
ascertain whether the customer is ``deemed to own'' the securities 
being sold before marking a sell order ``long.'' \153\ Today's proposed 
amendment would require that the broker-dealer take the additional step 
of documenting the present location of the securities being sold. 
Broker-dealers could, however, need to put mechanisms in place to 
facilitate efficient documenting of the

[[Page 45584]]

information required by the proposed amendment.
---------------------------------------------------------------------------

    \153\ See 17 CFR 242.200(g)(1).
---------------------------------------------------------------------------

    As discussed above in Section VI.D.ii., the paperwork burden is 
estimated at approximately 49 burden hours for each broker-dealer 
registered with the Commission, if the documentation process were 
automated. To the extent that broker-dealers need to automate the 
documentation process, we anticipate that such broker-dealers would 
spend varying amounts of time reprogramming systems, integrating 
systems, and potentially updating front-end software. Some broker-
dealers may spend very little time automating the documentation 
process, while changes at other broker-dealers might be more involved. 
On average, we estimate that reprogramming burdens at a broker-dealer 
would be approximately 16 hours (or two days) with one programmer. This 
would cost $1,072 per broker-dealer (16 hours @ $67 per hour) or an 
aggregate of $6,226,176 across all broker-dealers.\154\
---------------------------------------------------------------------------

    \154\ The $67/hour figure for a computer programmer is based on 
the salary for a Senior Computer Operator from the SIA Report on 
Office Salaries in the Securities Industry 2006, modified to account 
for an 1800-hour work-year and multiplied by 2.93 to account for 
bonuses, firm size, employee benefits and overhead.
---------------------------------------------------------------------------

    The Commission does not believe there are any additional costs to 
this proposal; however we seek any data supporting any additional costs 
not mentioned. In addition, we request specific comment on any systems 
changes to computer hardware and software, or surveillance costs that 
might be necessary to implement the proposed amendment. Specifically:
     What would be the costs and benefits of the proposed 
documentation requirement?
     Would the proposed amendment create any costs, such as 
costs associated with systems, surveillance, or recordkeeping 
modifications that may be needed for broker-dealers to document the 
present location of shares being sold? If there were any costs 
associated with the proposed documentation requirement would these 
costs justify the benefits of better ensuring compliance with federal 
securities laws?
     How much would the proposed amendment affect compliance 
costs for small, medium, and large broker-dealers (e.g., personnel or 
system changes)? We seek comment on the costs of compliance that may 
arise. For instance, to document the location of shares being sold, 
would these entities be required to:
     Purchase new systems or implement changes to existing 
systems? Would changes to existing systems be significant? What would 
be the costs associated with acquiring new systems or making changes to 
existing systems? How much time would be required to fully implement 
any new or changed systems?
     Change existing records? What changes would need to be 
made? What would be the costs associated with any changes? How much 
time would be required to make any changes?
     Increase staffing and associated overhead costs? Would 
entities subject to the proposed amendment have to hire more staff? How 
many, and at what experience and salary level? Could existing staff be 
retrained? What would be the costs associated with hiring new staff or 
retraining existing staff? If retraining were required, what other 
costs could be incurred, e.g., would retrained staff be unable to 
perform existing duties in order to comply with the proposed amendment? 
Would other resources need to be re-dedicated to comply with the 
proposed amendment?
     Implement, enhance or modify surveillance systems and 
procedures? Please describe what would be needed, and what costs would 
be incurred.
     Establish and implement new supervisory or compliance 
procedures, or modify existing procedures? What would be the costs 
associated with such changes? Would new compliance or supervisory 
personnel be needed? What would be the costs of obtaining such staff?

VIII. Consideration of Burden and Promotion of Efficiency, Competition, 
and Capital Formation

    Section 3(f) of the Exchange Act requires the Commission, whenever 
it engages in rulemaking and is required to consider or determine 
whether an action is necessary or appropriate in the public interest, 
to consider whether the action would promote efficiency, competition, 
and capital formation.\155\ In addition, Section 23(a)(2) of the 
Exchange Act requires the Commission, when making rules under the 
Exchange Act, to consider the impact such rules would have on 
competition.\156\ Exchange Act Section 23(a)(2) prohibits the 
Commission from adopting any rule that would impose a burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Exchange Act.
---------------------------------------------------------------------------

    \155\ 15 U.S.C. 78c(f).
    \156\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    We believe the proposed amendments, including the proposed 
alternatives, would have minimal impact on the promotion of price 
efficiency. In the 2006 Proposing Release we sought comment on whether 
the proposals would promote price efficiency, including whether the 
proposals might impact liquidity and the potential for manipulative 
short squeezes. One commenter stated that the Commission's concern over 
potential short squeezes is ``misplaced,'' as this is a risk short 
sellers assume when they sell short.\157\ Other commenters stated, 
however, that the proposed amendment to the options market maker 
exception would disrupt the markets because they would not provide 
sufficient flexibility to permit efficient hedging by options market 
makers, would unnecessarily increase risks and costs to hedge, and 
would adversely impact liquidity and result in higher costs to 
customers.\158\ These commenters stated that they believe the proposed 
amendments would likely discourage options market makers from making 
markets in illiquid securities since the risk associated in maintaining 
the hedges in these option positions would be too great.\159\ Moreover, 
these commenters stated that the reluctance of options market makers to 
make markets in threshold securities would result in wider spreads in 
such securities to account for the increased costs of hedging, to the 
detriment of investors.\160\
---------------------------------------------------------------------------

    \157\ See letter from H. Glenn Bagwell, Jr., dated Sept. 19, 
2006.
    \158\ See, e.g., letter from CBOE, supra note 31.
    \159\ See id.
    \160\ See letter from Citigroup, supra note 31.
---------------------------------------------------------------------------

    Although we recognize commenters' concerns that a mandatory close-
out requirement for fails to deliver in threshold securities underlying 
options positions could potentially impact options market makers' 
willingness to provide liquidity in threshold securities, make it more 
costly for options market makers to accommodate customer orders, or 
result in wider bid-ask spreads or less depth,\161\ we believe that the 
proposed elimination of the options market maker exceptions, and the 
mandatory close-out requirements of the proposed alternatives, would 
minimally impact, if at all, liquidity, hedging costs, spreads, or 
depth in the securities subject to these proposals, or the willingness 
of options market makers to make markets in such securities.
---------------------------------------------------------------------------

    \161\ See, e.g., letters from CBOE, supra note 31; Citigroup, 
supra note 31.
---------------------------------------------------------------------------

    We believe that these potential effects of the elimination of the 
options market maker exception, or the proposed close-out requirements 
of the proposed alternatives would be minimal, if any, because the 
number of securities that would be impacted by these proposals

[[Page 45585]]

would be relatively small. The proposal would apply only to those 
threshold securities with listed options\162\ and would only impact 
fails to deliver in those securities that resulted from short sales by 
registered options market makers to hedge options series (or options 
positions in the case of the proposed elimination of the current 
options market maker exception) that were created before, rather than 
after, the security became a threshold security because all other fails 
to deliver in threshold securities are currently subject to Regulation 
SHO's mandatory 13 consecutive settlement day close-out requirement.
---------------------------------------------------------------------------

    \162\ See letter from Options Exchanges, supra note 49 
(discussing the number of threshold securities with listed options).
---------------------------------------------------------------------------

    In addition, as discussed above in connection with the proposed 
amendment to eliminate the options market maker exception, we believe 
that even a 13 consecutive settlement day close-out requirement would 
result in minimal impact on the willingness of options market makers to 
make markets, liquidity, hedging costs, depth, and spreads of a 
mandatory close-out requirement because it would allow options market 
makers flexibility in conducting their hedging activities by permitting 
fails to deliver to remain open for an extended period of time (i.e., 
13 consecutive settlement days) rather than, for example, requiring 
that such fails to deliver be closed out immediately, or even within 
the standard 3-day settlement period. The close-out requirements of the 
proposed alternatives would provide options market makers with even 
greater flexibility in conducting their hedging activities because they 
would each allow even longer periods of time than the 13 consecutive 
settlement days allowed by current Rule 203(b)(3) of Regulation SHO 
(i.e., 35 consecutive settlement days for purposes of proposed 
Alternative 1, and 13 or 35 consecutive settlement days for purposes of 
proposed Alternative 2) within which to close out all fails to deliver 
in threshold securities.
    In addition, we believe the proposed 35 consecutive settlement day 
phase-in period for each of the proposals should not result in market 
disruption, such as increased volatility or short squeezes, because it 
would provide time for participants of a registered clearing agency to 
close out previously-excepted fail to deliver positions in an orderly 
manner, particularly because participants could begin closing out 
previously-excepted fail to deliver positions at any time before the 
proposed 35 day phase-in period.
    To the extent that a mandatory close-out requirement could 
potentially impact liquidity, hedging costs, depth, or spreads, or 
impact the willingness of options market makers to make markets in 
securities subject to such a requirement, we believe such effects are 
justified by our belief that fails to deliver resulting from hedging 
activities by options market makers should be treated similarly to 
fails to deliver resulting from sales in the equities markets so that 
market participants trading threshold securities in the options markets 
do not receive an advantage over those trading such securities in the 
equities markets. In addition, we believe that such potential costs 
would be justified by the benefits, as discussed below, of requiring 
that all fails to deliver be closed out within specific time-frames 
rather than being allowed to continue indefinitely.
    The proposed amendment to Rule 200(g) of Regulation SHO to require 
broker-dealers to document the present location of securities being 
sold in connection with an order marked ``long'' would promote price 
efficiency by reducing non-compliance with short sale-related 
regulations, such as Rule 105 of Regulation M, that we believe are 
beneficial to pricing efficiency.
    In addition, we believe that the proposed amendments, including the 
alternative proposals, would have minimal impact on the promotion of 
capital formation. Large and persistent fails to deliver can deprive 
shareholders of the benefits of ownership, such as voting and lending. 
They can also be indicative of potentially manipulative conduct, such 
as abusive ``naked'' short selling. The deprivation of the benefits of 
ownership, as well as the perception that abusive ``naked'' short 
selling is occurring in certain securities, can undermine the 
confidence of investors. These investors, in turn, may be reluctant to 
commit capital to an issuer they believe to be subject to such 
manipulative conduct. In the 2006 Proposing Release, we sought comment 
on whether the proposed amendments would promote capital formation, 
including whether the proposed increased short sale restrictions would 
affect investors' decisions to invest in certain equity securities. 
Commenters expressed concern about the potential impact of ``naked'' 
short selling on capital formation claiming that ``naked'' short 
selling causes a drop in an issuer's stock price that may limit the 
issuer's ability to access the capital markets.\163\ Another commenter 
submitted a theoretical economic study concluding that ``naked'' short 
selling is economically similar to other short selling.\164\
---------------------------------------------------------------------------

    \163\ See, e.g., letter from Feeney, supra note 10.
    \164\ See comment letter from J.B. Heaton, Bartlit Beck Herman 
Palenchar & Scott LLP, dated May 1, 2007.
---------------------------------------------------------------------------

    By requiring that all fails to deliver in threshold securities be 
closed out within specific time-frames rather than allowing them to 
continue indefinitely, we believe that there would be a decrease in the 
number of threshold securities with persistent and high levels of fails 
to deliver. If persistence on the threshold securities lists leads to 
an unwarranted decline in investor confidence about the security, the 
proposed amendments should improve investor confidence about the 
security. We also believe that the proposed amendments should lead to 
greater certainty in the settlement of securities which should 
strengthen investor confidence in the settlement process. The reduction 
in fails to deliver and the resulting reduction in the number of 
securities on the threshold securities lists could result in increased 
investor confidence.
    The proposed amendment to eliminate the options market maker 
exception and the proposed alternatives also would not impose any 
burden on competition not necessary or appropriate in furtherance of 
the purposes of the Exchange Act. By eliminating the options market 
maker exception, or, alternatively, adopting a limited options market 
maker exception, the Commission believes the proposals would promote 
competition by requiring similarly situated participants of a 
registered clearing agency, or options market makers for which they 
clear transactions, to close out fails to deliver in threshold 
securities within similar time-frames.
    The Commission requests comment on whether the proposed amendment 
to eliminate the options market maker exception, the proposed 
alternatives, and the proposed amendment to Rule 200(g) of Regulation 
SHO, would promote efficiency, competition, and capital formation.

IX. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \165\ we must advise the Office of 
Management and Budget as to whether the proposed regulation constitutes 
a ``major'' rule. Under

[[Page 45586]]

SBREFA, a rule is considered ``major'' where, if adopted, it results or 
is likely to result in:
---------------------------------------------------------------------------

    \165\ Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996) 
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note 
to 5 U.S.C. 601).
---------------------------------------------------------------------------

     An annual effect on the economy of $100 million or more 
(either in the form of an increase or a decrease);
     A major increase in costs or prices for consumers or 
individual industries; or
     Significant adverse effect on competition, investment or 
innovation.
    If a rule is ``major,'' its effectiveness will generally be delayed 
for 60 days pending Congressional review. We request comment on the 
potential impact of the proposed amendments on the economy on an annual 
basis. Commenters are requested to provide empirical data and other 
factual support for their view to the extent possible.

X. Initial Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis (``IRFA''), in accordance with the provisions of the 
Regulatory Flexibility Act (``RFA''),\166\ regarding the proposed 
amendments to Rules 200 and 203 of Regulation SHO under the Exchange 
Act.
---------------------------------------------------------------------------

    \166\ 5 U.S.C. 603.
---------------------------------------------------------------------------

A. Reasons for the Proposed Action

    On July 14, 2006, the Commission published proposed amendments to 
the options market maker exception contained in Regulation SHO to limit 
the duration of the exception.\167\ We proposed to narrow the options 
market maker exception at that time because we have observed a small 
number of threshold securities with substantial and persistent fail to 
deliver positions that are not being closed out under existing delivery 
and settlement requirements, and we believe that these persistent fail 
to deliver positions are attributable, in part, to the current options 
market maker exception in Regulation SHO.\168\
---------------------------------------------------------------------------

    \167\ 2006 Proposing Release, 71 FR 41710.
    \168\ See id. at 41712; Regulation SHO Re-Opening Release, 72 FR 
at 15079-15080.
---------------------------------------------------------------------------

    As a result of the comment process, however, we learned that the 
amendment, as proposed, could be very costly and difficult to implement 
or possibly unworkable because options market makers typically use 
hedges to manage the risk of an entire inventory, not just a specific 
options position. In addition, some commenters' statements indicated to 
us that options market makers may be interpreting the current options 
market maker exception more broadly than the Commission intended and 
possibly in violation of the exception. We also remain concerned that 
large and persistent fails to deliver may have a negative effect on the 
market in these securities. Although high fails levels exist only for a 
small percentage of securities, these fails to deliver could 
potentially impede the orderly functioning of the market for such 
securities, particularly less liquid securities. For example, a 
significant level of fails to deliver in a security may have adverse 
consequences for shareholders who may be relying on delivery of those 
shares for voting and lending purposes, or may otherwise affect an 
investor's decision to invest in that particular security. In addition, 
a seller that fails to deliver securities on settlement date 
effectively unilaterally converts a securities contract into an undated 
futures-type contract, to which the buyer might not have agreed, or 
that might have been priced differently.
    Thus, we determined to re-propose amendments to the options market 
maker exception that would eliminate the exception. In addition, we are 
requesting comment regarding two specific alternatives to our proposal 
to eliminate the options market maker exception that would require 
fails to deliver in threshold securities underlying options to be 
closed out within specific time-frames. By re-proposing amendments to 
the options market maker exception we seek additional information 
regarding the options markets that might assist us in determining 
whether or not to eliminate the options market maker exception.
    We are also proposing an amendment to the long sale marking 
provisions of Rule 200(g)(1) of Regulation SHO that would require that 
broker-dealers marking orders to sell ``long'' document the present 
location of the securities. We believe that such a proposed 
documentation requirement would aid in ensuring the correct marking of 
sell orders. To the extent that the seller is unable to provide the 
present location of the securities being sold, the broker-dealer would 
have reason to believe that the seller is not ``deemed to own'' the 
securities being sold and that the securities would not be in its 
physical possession or control no later than settlement of the 
transaction and, therefore, that the broker-dealer would be required to 
mark the sale ``short'' rather than ``long.'' \169\ We believe that 
this proposed documentation requirement could also reduce the number of 
fails to deliver because, after making the inquiry into the present 
location of the securities being sold, a broker-dealer would know 
whether or not it needed to obtain securities for delivery.
---------------------------------------------------------------------------

    \169\ See 17 CFR 242.200(g).
---------------------------------------------------------------------------

    We are concerned that broker-dealers marking orders ``long'' may 
not be making a determination prior to marking the order that the 
seller is ``deemed to own'' the security being sold. Rule 200(g)(1) 
currently requires that broker-dealers ascertain whether the customer 
is ``deemed to own'' the securities being sold before marking a sell 
order ``long.'' \170\ Thus, we believe that the proposed documentation 
requirement would help ensure that the broker-dealer marking the sale 
``long'' has inquired into, and determined that, the seller is ``deemed 
to own'' the securities being sold because the broker-dealer would be 
required to document the present location of the securities being sold.
---------------------------------------------------------------------------

    \170\ See id.
---------------------------------------------------------------------------

    We also believe that the proposed documentation requirement would 
enable the Commission and SROs to more easily examine for compliance 
with the long sale marking provisions of Rule 200(g) more effectively 
because this proposed documentation requirement would provide a record 
that the seller is ``deemed to own'' the securities being sold in 
compliance with that rule. We also believe that the proposed 
documentation requirement would aid the Commission and SROs in 
reviewing for mismarking designed to avoid compliance with other rules 
and regulations of the federal securities laws, such as the ``locate'' 
requirement of Regulation SHO,\171\ and Rule 105 of Regulation M.\172\
---------------------------------------------------------------------------

    \171\ See supra, note 92.
    \172\ See supra, note 93.
---------------------------------------------------------------------------

B. Objectives

    Our proposals regarding the options market maker exception are 
intended to further reduce the number of persistent fails to deliver in 
threshold securities. The proposed amendment to eliminate the options 
market maker exception, and the alternative proposals, are designed to 
help reduce persistent and large fail to deliver positions which may 
have a negative effect on the market in these securities and also could 
be used to facilitate manipulative trading strategies.
    Although high fails levels exist only for a small percentage of 
issuers,\173\ they could impede the orderly functioning of the market 
for such issuers, particularly issuers of less liquid securities. For 
example, a significant level of fails to deliver in a security may have 
adverse consequences for shareholders who may be relying on delivery of 
those shares for

[[Page 45587]]

voting and lending purposes, or may otherwise affect an investor's 
decision to invest in that particular security. In addition, a seller 
that fails to deliver securities on settlement date effectively 
unilaterally converts a securities contract into an undated futures-
type contract, to which the buyer might not have agreed, or that would 
have been priced differently.
---------------------------------------------------------------------------

    \173\ See supra note 7.
---------------------------------------------------------------------------

    To allow market participants sufficient time to comply with the new 
close-out requirements, the proposed amendment to eliminate the options 
market maker exception and the proposed alternatives would include a 
one-time 35 consecutive settlement day phase-in period following the 
effective date of the amendment. The phase-in period would provide 
participants flexibility in closing out previously-excepted fail to 
deliver positions.
    By proposing an amendment to Rule 200(g)(1) of Regulation SHO that 
would require broker-dealers to document the present location of 
securities a customer is deemed to own, we intend to aid surveillance 
for compliance with the marking requirements of Rule 200(g). In 
addition, such a requirement would help to ensure that broker-dealers 
only mark orders ``long'' after making a determination that a customer 
actually owns the securities being sold.

C. Legal Basis

    Pursuant to the Exchange Act and, particularly, Sections 2, 3(b), 
9(h), 10(a), 11A, 15, 17(a), 19, 23(a) thereof, 15 U.S.C. 78b, 78c, 
78i, 78j, 78k-l, 78o, 78q, 78s, 78w(a), the Commission is proposing 
amendments to Sec. Sec.  242.200 and 242.203 of Regulation SHO.

D. Small Entities Subject to the Rule

    The entities covered by these proposals would include small 
entities that are participants of a registered clearing agency, 
including small registered options market makers for which the 
participant clears trades or for which it is responsible for 
settlement. In addition, the entities covered by these proposals would 
include small entities that are market participants that effect sales 
subject to the requirements of Regulation SHO. Most small entities 
subject to the proposed amendments, including the proposed 
alternatives, would be registered broker-dealers. Although it is 
impossible to quantify every type of small entity covered by these 
proposals, Paragraph (c)(1) of Rule 0-10 \174\ states that the term 
``small business'' or ``small organization,'' when referring to a 
broker-dealer, means a broker or dealer that had total capital (net 
worth plus subordinated liabilities) of less than $500,000 on the date 
in the prior fiscal year as of which its audited financial statements 
were prepared pursuant to Sec.  240.17a-5(d); and is not affiliated 
with any person (other than a natural person) that is not a small 
business or small organization. As of 2006, the Commission estimates 
that there were approximately 894 registered broker-dealers that 
qualified as small entities as defined above.\175\
---------------------------------------------------------------------------

    \174\ 17 CFR 240.0-10(c)(1).
    \175\ These numbers are based on the Commission's Office of 
Economic Analysis's review of 2006 FOCUS Report filings reflecting 
registered broker dealers. This number does not include broker-
dealers that are delinquent on FOCUS Report filings.
---------------------------------------------------------------------------

    As noted above, the entities covered by these amendments will 
include small entities that are participants of a registered clearing 
agency. As of May 2007, approximately 90% of participants of the NSCC, 
the primary registered clearing agency responsible for clearing U.S. 
transactions, were registered as broker-dealers. Participants not 
registered as broker-dealers include such entities as banks, U.S.-
registered exchanges, and clearing agencies. Although these entities 
are participants of a registered clearing agency, generally these 
entities do not engage in the types of activities that would implicate 
the close-out requirements of Regulation SHO. Such activities of these 
entities include creating and redeeming Exchange Traded Funds, trading 
in municipal securities, and using NSCC's Envelope Settlement Service 
or Inter-city Envelope Settlement Service. These activities rarely lead 
to fails to deliver and, if fails to deliver do occur, they are small 
in number and are usually cleaned up within a day. Thus, such fails to 
deliver would not trigger the close-out provisions of Regulation SHO.
    The federal securities laws do not define what is a ``small 
business'' or ``small organization'' when referring to a bank. The 
Small Business Administration regulations define ``small entities'' to 
include banks and savings associations with total assets of $165 
million or less.\176\ As of May, 2007 no bank that was a participant of 
the NSCC was a small entity because none met this criteria.
---------------------------------------------------------------------------

    \176\ See 13 CFR 121.201.
---------------------------------------------------------------------------

    Paragraph (e) of Rule 0-10 under the Exchange Act \177\ states that 
the term ``small business'' or ``small organization,'' when referring 
to an exchange, means any exchange that: (1) Has been exempted from the 
reporting requirements of Rule 11Aa3-1 under the Exchange Act; and (2) 
is not affiliated with any person (other than a natural person) that is 
not a small business or small organization, as defined by Rule 0-10. No 
U.S. registered exchange is a small entity because none meets these 
criteria. There is one national securities association (NASD) that is 
subject to these amendments. NASD is not a small entity as defined by 
13 CFR 121.201.
---------------------------------------------------------------------------

    \177\ 17 CFR 240.0-10(e).
---------------------------------------------------------------------------

    Paragraph (d) of Rule 0-10 under the Exchange Act \178\ states that 
the term ``small business'' or ``small organization,'' when referring 
to a clearing agency, means a clearing agency that: (1) Compared, 
cleared and settled less than $500 million in securities transactions 
during the preceding fiscal year (or in the time that it has been in 
business, if shorter); (2) had less than $200 million in funds and 
securities in its custody or control at all times during the preceding 
fiscal year (or in the time that it has been in business, if shorter); 
and (3) is not affiliated with any person (other than a natural person) 
that is not a small business or small organization as defined by Rule 
0-10. No clearing agency that is subject to the requirements of 
Regulation SHO is a small entity because none meets these criteria.
---------------------------------------------------------------------------

    \178\ 17 CFR 240.0-10(d).
---------------------------------------------------------------------------

E. Reporting, Recordkeeping, and Other Compliance Requirements

    The proposed amendment to eliminate the options market maker 
exception, and the proposed alternatives, would impose some new or 
additional reporting, recordkeeping, or compliance costs on broker-
dealers that are small entities. In order to comply with Regulation SHO 
when it became effective in January, 2005, entities needed to modify 
their systems and surveillance mechanisms. Thus, the infrastructure 
necessary to comply with the proposed amendments regarding elimination 
of the options market maker exception should already be in place. Any 
additional changes to the infrastructure should be minimal. In 
addition, entities that would be subject to the mandatory 13 
consecutive settlement day close-out requirement of Rule 203(b)(3) of 
Regulation SHO should already have systems in place to close out non-
excepted fails to deliver as required by Regulation SHO. These 
entities, however, could be required to modify their systems and 
surveillance mechanisms to ensure compliance with the proposed 
alternatives to eliminating the options market maker exception.
    These entities could also be required to put in place mechanisms to 
facilitate communications between participants

[[Page 45588]]

of a registered clearing agency and options market makers to meet the 
documentation requirements of the proposed alternatives. We solicit 
comment on what new recordkeeping, reporting or compliance requirements 
could arise as a result of the proposed amendment to eliminate the 
options market maker exception and the proposed alternatives to 
elimination that would require fails to deliver in threshold securities 
underlying options to be closed out within specific time-frames.
    The proposed amendment to Rule 200(g)(1) that would require that 
broker-dealers document the present location of securities a customer 
is deemed to own prior to marking an order to sell ``long'' could 
impose some new or additional reporting, recordkeeping, or compliance 
costs on broker-dealers that are small entities. We believe, however, 
that such costs should be minimal. Rule 200(g)(1) currently requires 
that broker-dealers must determine whether the customer is ``deemed to 
own'' the securities being sold before marking a sell order ``long.'' 
Today's proposed amendment would require that the broker-dealer take 
the additional step of documenting the present location of the 
securities being sold. Broker-dealers may, however, need to put 
mechanisms in place to facilitate efficient documenting of the 
information that would be required by the proposed amendment.
    Moreover, we note that under former NASD Rule 3370(b), NASD member 
firms making an affirmative determination that a customer was long were 
required to make a notation on the order ticket at the time an order 
was taken which reflected the conversation with the customer as to the 
present location of the securities, whether they were in good 
deliverable form, and the customer's ability to deliver them to the 
member within three business days. Thus, many broker-dealers that are 
small entities should already be familiar with a documentation 
requirement and with one method that could be used to comply with such 
a requirement. We solicit comment, however, on what new recordkeeping, 
reporting or compliance requirements may arise as a result of the 
proposed amendment to Rule 200(g)(1) of Regulation SHO.

F. Duplicative, Overlapping or Conflicting Federal Rules

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

G. Significant Alternatives

    The RFA directs the Commission to consider significant alternatives 
that would accomplish the stated objective, while minimizing any 
significant adverse impact on small issuers and broker-dealers. 
Pursuant to Section 3(a) of the RFA,\179\ the Commission must consider 
the following types of alternatives: (a) The establishment of differing 
compliance or reporting requirements or timetables that take into 
account the resources available to small entities; (b) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rule for small entities; (c) the use 
of performance rather than design standards; and (d) an exemption from 
coverage of the rule, or any part thereof, for small entities.
---------------------------------------------------------------------------

    \179\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    A primary goal of the proposed amendment to eliminate the options 
market maker exception, and the proposed alternatives, is to reduce the 
number of persistent fails to deliver in threshold securities. As such, 
we believe that imposing different compliance requirements, and 
possibly a different timetable for implementing compliance 
requirements, for small entities would undermine the goal of reducing 
fails to deliver. In addition, we have concluded similarly that it 
would not be consistent with the primary goal of the proposals to 
further clarify, consolidate or simplify the proposals for small 
entities. Finally, the proposals would impose performance standards 
rather than design standards.

H. Request for Comments

    The Commission encourages the submission of written comments with 
respect to any aspect of the IRFA. In particular, the Commission seeks 
comment on: (i) The number of small entities that would be affected by 
the proposed amendments; and (ii) the existence or nature of the 
potential impact of the proposed amendments on small entities. Those 
comments should specify costs of compliance with the proposed 
amendments, and suggest alternatives that would accomplish the 
objective of the proposed amendments.

XI. Statutory Authority

    Pursuant to the Exchange Act and, particularly, Sections 2, 3(b), 
9(h), 10, 11A, 15, 17(a), 17A, and 23(a) thereof, 15 U.S.C. 78b, 
78c(b), 78i(h), 78j, 78k-1, 78o, 78q(a), 78q-1, 78w(a), the Commission 
is proposing amendments to Sec. Sec.  242.200 and 242.203.

Text of the Proposed Amendments to Regulation SHO

List of Subjects 17 CFR Part 242

    Brokers, Fraud, Reporting and recordkeeping requirements, 
Securities.

    For the reasons set out in the preamble, Title 17, Chapter II, part 
242, of the Code of Federal Regulations is proposed to be amended as 
follows.

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

    1. 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, 78n, 78o(b), 78o(c), 78o(g), 
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and 
80a-37.
* * * * *
    2. Section 242.200 is proposed to be amended by adding new 
paragraph (g)(2) to read as follows:


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

* * * * *
    (g) * * *
    (2) For purposes of paragraph (g)(1) of this section, in 
determining whether the seller is ``deemed to own'' the security being 
sold, the broker or dealer must document the present location of the 
security being sold.
    3. Section 242.203 is proposed to be amended by:
    a. Revising paragraph (b)(3)(iii);
    b. Redesignating paragraphs (b)(3)(vi) and (b)(3)(vii) as 
paragraphs (b)(3)(vii) and (b)(3)(viii);
    c. Adding new paragraph (b)(3)(vi);
    d. Removing the word ``and'' at the end of paragraph (b)(3)(vi); 
and
    e. Amending newly designated paragraph (b)(3)(vii) by adding the 
word ``and'' after the semi-colon at the end of the paragraph.
    The revisions and additions read as follows:


Sec.  242.203  Borrowing and delivery requirements.

* * * * *
    (b) * * *
    (3) * * *
    (iii) Provided, however, that a participant of a registered 
clearing agency that has a fail to deliver position at a registered 
clearing agency in a threshold security on the effective date of this 
amendment and which, prior to the effective date of this amendment, had 
been previously excepted from the close-out requirement in paragraph 
(b)(3) of this section (i.e., because the participant of a registered 
clearing

[[Page 45589]]

agency had a fail to deliver position in the threshold security that is 
attributed to short sales effected by a registered options market maker 
to establish or maintain a hedge on options positions that were created 
before the security became a threshold security), shall immediately 
close out that fail to deliver position, including any adjustments to 
the fail to deliver position, within 35 consecutive settlement days of 
the effective date of this amendment by purchasing securities of like 
kind and quantity;
* * * * *
    (vi) If a participant of a registered clearing agency entitled to 
rely on the 35 consecutive settlement day close-out requirement 
contained in paragraph (b)(3)(iii) of this section has a fail to 
deliver position at a registered clearing agency in the threshold 
security for 35 consecutive settlement days from the effective date of 
the amendment, 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)(ii) 
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;
    4. Alternative 1: Alternatively, Section 242.203 is proposed to be 
amended by:
    a. Revising paragraph (b)(3)(iii);
    b. Redesignating paragraphs (b)(3)(vi) and (b)(3)(vii) as 
paragraphs (b)(3)(vii) and (b)(3)(viii);
    c. Adding new paragraphs (b)(3)(vi) and (b)(3)(ix);
    d. Removing the word ``and'' at the end of paragraph (b)(3)(vi); 
and
    e. Amending newly designated paragraph (b)(3)(viii) by adding the 
word ``and'' after the semi-colon at the end of the paragraph.
    The revisions and additions read as follows:


Sec.  242.203  Borrowing and delivery requirements.

* * * * *
    (b) * * *
    (3) * * *
    (iii) The provisions of paragraph (b)(3) of this section 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 
any options series in a portfolio that were created before the security 
became a threshold security;
    (A) Provided, however, that if a participant of a registered 
clearing agency has a fail to deliver position at a registered clearing 
agency in a 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 series that were created before the 
security became a threshold security, the participant shall close out 
the fail to deliver position, including any adjustments to the fail to 
deliver position, within 35 consecutive settlement days from the date 
on which the security became a threshold security by purchasing 
securities of like kind and quantity;
    (B) Provided, however, that a participant of a registered clearing 
agency that has a fail to deliver position at a registered clearing 
agency in a threshold security on the effective date of this amendment 
which, prior to the effective date of this amendment, had been 
previously excepted from the close-out requirement in paragraph (b)(3) 
of this section (i.e., because the participant of a registered clearing 
agency had a fail to deliver position in the threshold security that is 
attributed to short sales effected 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), shall immediately close out that fail to deliver 
position, including any adjustments to the fail to deliver position, 
within 35 consecutive settlement days of the effective date of this 
amendment by purchasing securities of like kind and quantity;
* * * * *
    (vi) If a participant of a registered clearing agency entitled to 
rely on the 35 consecutive settlement day close-out requirement 
contained in paragraph (b)(3)(iii) of this section has a fail to 
deliver position at a registered clearing agency in the threshold 
security for 35 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)(ii) 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;
* * * * *
    (ix) To the extent that an amount of a fail to deliver position in 
a threshold security is attributed to short sales by a registered 
options market maker in accordance with paragraph (b)(3)(ii) of this 
section, a participant of a registered clearing agency and registered 
options market maker must document that the fail to deliver position 
resulted from short sales effected to establish or maintain a hedge on 
options series that were created before the security became a threshold 
security.
    5. Alternative 2: Alternatively, Section 242.203 is proposed to be 
amended by:
    a. Revising paragraph (b)(3)(iii);
    b. Redesignating paragraphs (b)(3)(vi) and (b)(3)(vii) as 
paragraphs (b)(3)(viii)and (b)(3)(ix);
    c. Adding new paragraphs (b)(3)(vi), (b)(3)(vii) and (b)(3)(x);
    d. Removing the word ``and'' at the end of paragraph (b)(3)(vi); 
and
    e. Amending newly designated paragraph (b)(3)(ix) by adding the 
word ``and'' after the semi-colon at the end of the paragraph.
    The revisions and additions read as follows:


Sec.  242.203  Borrowing and delivery requirements.

* * * * *
    (b) * * *
    (3) * * *
    (iii) The provisions of paragraph (b)(3) of this section 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 
any options series in a portfolio that were created before the security 
became a threshold security;
    (A) Provided, however, that if a participant of a registered 
clearing agency has a fail to deliver position at a registered clearing 
agency in a 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 series that were created before the 
security became a threshold security,

[[Page 45590]]

the participant shall close out the fail to deliver position, including 
any adjustments to the fail to deliver position, by purchasing 
securities of like kind and quantity within the earlier of: 35 
Consecutive settlement days from the date on which the security became 
a threshold security, or 13 consecutive settlement days from the last 
date on which all options series within the portfolio that were created 
before the underlying security became a threshold security expire or 
are liquidated;
    (B) Provided, however, that a participant of a registered clearing 
agency that has a fail to deliver position at a registered clearing 
agency in a threshold security on the effective date of this amendment 
which, prior to the effective date of this amendment, had been 
previously excepted from the close-out requirement in paragraph (b)(3) 
of this section (i.e., because the participant of a registered clearing 
agency had a 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), shall immediately close out that fail to deliver position, 
including any adjustments to the fail to deliver position, within 35 
consecutive settlement days of the effective date of this amendment by 
purchasing securities of like kind and quantity;
* * * * *
    (vi) If a participant of a registered clearing agency entitled to 
rely on the exception to the close-out requirement contained in 
paragraph (b)(3)(iii)(A) of this section has a fail to deliver position 
at a registered clearing agency in a threshold security for longer than 
the earlier of: 35 Consecutive settlement days from the date on which 
the security became a threshold security, or 13 consecutive settlement 
days from the last date on which all options series within the 
portfolio that were created before the security became a threshold 
security expire or are liquidated, 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)(ii) 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;
    (vii) If a participant of a registered clearing agency entitled to 
rely on the 35 consecutive settlement day close-out requirement 
contained in paragraph (b)(3)(iii)(B) of this section has a fail to 
deliver position at a registered clearing agency in the threshold 
security for 35 consecutive settlement days from the effective date of 
the amendment, 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)(ii) 
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;
* * * * *
    (x) To the extent that an amount of a fail to deliver position in a 
threshold security is attributed to short sales by a registered options 
market maker in accordance with paragraph (b)(3)(iii) of this section, 
a participant of a registered clearing agency and registered options 
market maker must document that the fail to deliver position resulted 
from short sales effected to establish or maintain a hedge on options 
series that were created before the security became a threshold 
security.
* * * * *

    By the Commission.

    Dated: August 7, 2007.
Nancy M. Morris,
Secretary.
 [FR Doc. E7-15709 Filed 8-13-07; 8:45 am]
BILLING CODE 8010-01-P