[Federal Register Volume 73, Number 202 (Friday, October 17, 2008)]
[Rules and Regulations]
[Pages 61666-61678]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-24714]


=======================================================================
-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-58774; File No. S7-08-08]
RIN 3235-AK06


``Naked'' Short Selling Antifraud Rule

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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

SUMMARY: The Securities and Exchange Commission (``Commission'') is 
adopting an antifraud rule under the Securities Exchange Act of 1934 
(``Exchange Act'') to address fails to deliver securities that have 
been associated with ``naked'' short selling. The rule will further 
evidence the liability of short sellers, including broker-dealers 
acting for their own

[[Page 61667]]

accounts, who deceive specified persons about their intention or 
ability to deliver securities in time for settlement (including persons 
that deceive their broker-dealer about their locate source or ownership 
of shares) and that fail to deliver securities by settlement date.

DATES: Effective Date: October 17, 2008.

FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Associate 
Director, Josephine J. Tao, Assistant Director, Victoria L. Crane, 
Branch Chief, Joan M. Collopy, Special Counsel, Christina M. Adams and 
Matthew Sparkes, Staff Attorneys, Office of Trading Practices and 
Processing, Division of Trading and Markets, at (202) 551-5720, at the 
Securities and Exchange Commission, 100 F Street, NE., Washington, DC 
20549-6628.

SUPPLEMENTARY INFORMATION: We are adding Rule 10b-21 [17 CFR 242.10b-
21] under the Exchange Act.

I. Introduction

    We are adopting an antifraud rule, Rule 10b-21, aimed at short 
sellers, including broker-dealers acting for their own accounts, who 
deceive specified persons, such as a broker or dealer, about their 
intention or ability to deliver securities in time for settlement and 
that fail to deliver securities by settlement date. Among other things, 
Rule 10b-21 will target short sellers who deceive their broker-dealers 
about their source of borrowable shares for purposes of complying with 
Regulation SHO's ``locate'' requirement.\1\ Rule 10b-21 will also apply 
to sellers who misrepresent to their broker-dealers that they own the 
shares being sold.
---------------------------------------------------------------------------

    \1\ See 17 CFR 242.203(b)(1).
---------------------------------------------------------------------------

    A seller misrepresenting its short sale locate source or ownership 
of shares may intend to fail to deliver securities in time for 
settlement and, therefore, engage in abusive ``naked'' short selling. 
Although abusive ``naked'' short selling is not defined in the federal 
securities laws, it refers generally to selling short without having 
stock available for delivery and intentionally failing to deliver stock 
within the standard three-day settlement cycle.\2\
---------------------------------------------------------------------------

    \2\ See Exchange Act Release No. 56212 (Aug. 7, 2007), 72 FR 
45544 (Aug. 14, 2007) (``2007 Regulation SHO Final Amendments''); 
Exchange Act Release No. 54154 (July 14, 2006), 71 FR 41710 (July 
21, 2006) (``2006 Regulation SHO Proposed Amendments'').
---------------------------------------------------------------------------

    Although abusive ``naked'' short selling as part of a manipulative 
scheme is always illegal under the general antifraud provisions of the 
federal securities laws, including Rule 10b-5 of the Exchange Act,\3\ 
Rule 10b-21 will further evidence the liability of persons that deceive 
others about their intention or ability to deliver securities in time 
for settlement, including persons that deceive their broker-dealer 
about their locate source or ownership of shares.\4\ We believe that a 
rule further evidencing the illegality of these activities will focus 
the attention of market participants on such activities. Rule 10b-21 
will also further evidence that the Commission believes such deceptive 
activities are detrimental to the markets and will provide a measure of 
predictability for market participants.
---------------------------------------------------------------------------

    \3\ 17 CFR 240.10b-5.
    \4\ This conduct is also in violation of other provisions of the 
federal securities laws, including the antifraud provisions.
---------------------------------------------------------------------------

    All sellers of securities should promptly deliver, or arrange for 
delivery of, securities to the respective buyer and all buyers of 
securities have the right to expect prompt delivery of securities 
purchased. Thus, Rule 10b-21 takes direct aim at an activity that may 
create fails to deliver. Those fails can have a negative effect on 
shareholders, potentially depriving them of the benefits of ownership, 
such as voting and lending. They also may create a misleading 
impression of the market for an issuer's securities. Rule 10b-21 will 
also aid broker-dealers in complying with the locate requirement of 
Regulation SHO and, thereby, potentially reduce fails to deliver. In 
addition, Rule 10b-21 could help reduce manipulative schemes involving 
``naked'' short selling.

II. Background

A. Regulation SHO

    Short selling involves a sale of a security that the seller does 
not own or that is consummated by the delivery of a security borrowed 
by or on behalf of the seller.\5\ In a ``naked'' short sale, a seller 
does not borrow or arrange to borrow securities in time to make 
delivery to the buyer within the standard three-day settlement 
period.\6\ As a result, the seller fails to deliver securities to the 
buyer when delivery is due (known as a ``fail'' or ``fail to 
deliver'').\7\ Sellers sometimes intentionally fail to deliver 
securities as part of a scheme to manipulate the price of a 
security,\8\ or possibly to avoid borrowing costs associated with short 
sales.
---------------------------------------------------------------------------

    \5\ 17 CFR 242.200(a).
    \6\ See Exchange Act Release No. 50103 (July 28, 2004), 69 FR 
48008 (Aug. 6, 2004) (``2004 Regulation SHO Adopting Release'') 
(stating that ``naked'' short selling generally refers to selling 
short without having borrowed the securities to make delivery).
    \7\ Generally, investors 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 
generally is received by its brokerage firm no later than three 
business days after the trade is executed. When the investor sells a 
security, the seller generally delivers 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. In addition, Rule 15c6-1 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; Exchange 
Act Release No. 33023 (Oct. 7, 1993), 58 FR 52891 (Oct. 13, 1993). 
However, failure to deliver securities on T+3 does not violate Rule 
15c6-1.
    \8\ In 2003, the Commission settled a case against certain 
parties relating to allegations of manipulative short selling in the 
stock of a corporation. The Commission alleged that the defendants 
profited from engaging in massive ``naked'' short selling that 
flooded the market with the 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) (Feb. 26, 2003); see also 
Securities Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR 
62972, 62975 (Nov. 6, 2003) (``2003 Regulation SHO Proposing 
Release'') (describing the alleged activity in the settled case 
involving stock of Sedona Corporation); 2004 Regulation SHO Adopting 
Release, 69 FR at 48016, n.76.
---------------------------------------------------------------------------

    Although the majority of trades settle within the standard three-
day settlement period,\9\ we adopted Regulation SHO \10\ in part to 
address problems associated with persistent fails to deliver securities 
and potentially abusive ``naked'' short selling.\11\ Rule

[[Page 61668]]

203 of Regulation SHO, in particular, contains a ``locate'' requirement 
that 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; and (iii) Documented compliance with this paragraph 
(b)(1).'' \12\ In the 2004 Regulation SHO Adopting Release, the 
Commission explicitly permitted broker-dealers to rely on customer 
assurances that the customer has identified its own source of 
borrowable securities, provided it is reasonable for the broker-dealer 
to do so.\13\ We are concerned, however, that some short sellers may 
have been deliberately misrepresenting to broker-dealers that they have 
obtained a legitimate locate source.\14\
---------------------------------------------------------------------------

    \9\ 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. In addition, fails to deliver may arise from either 
short or long sales of securities. There may be legitimate reasons 
for a fail to deliver. For example, human or mechanical errors or 
processing delays can result from transferring securities in 
custodial or other form rather than book-entry form, thereby causing 
a fail to deliver on a long sale within the normal three-day 
settlement period. In addition, broker-dealers that make markets 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. The Commission's Office of Economic Analysis (``OEA'') 
estimates that, on an average day between May 1, 2007 and July 31, 
2008 (i.e., the time period that includes all full months after the 
Commission started receiving price data from NSCC), trades in 
``threshold securities,'' as defined in Rule 203(b)(c)(6) of 
Regulation SHO, that fail to settle within T+3 account for 
approximately 0.3% of dollar value of trading in all equity 
securities.
    \10\ 17 CFR 242.200. Regulation SHO became effective on January 
3, 2005.
    \11\ See 2007 Regulation SHO Final Amendments, 72 FR at 45544 
(stating that ``[a]mong other things, Regulation SHO imposes a 
close-out requirement to address persistent failures to deliver 
stock on trade settlement date and to target potentially abusive 
``naked'' short selling in certain equity securities.'').
    \12\ 17 CFR 242.203(b). Market makers engaged in bona fide 
market making in the security at the time they effect the short sale 
are excepted from this requirement.
    \13\ See 2004 Regulation SHO Adopting Release, 69 FR at 48014.
    \14\ See, e.g., Sandell Asset Management Corp., Lars Eric Thomas 
Sandell, Patrick T. Burke and Richard F. Ecklord, Securities Act 
Release No. 8857 (Oct. 10, 2007) (settled order).
---------------------------------------------------------------------------

    In addition, we are concerned that some short sellers may have made 
misrepresentations to their broker-dealers about their ownership of 
shares as an end run around Regulation SHO's locate requirement.\15\ 
Some sellers have also misrepresented that their sales are long sales 
in order to circumvent Rule 105 of Regulation M,\16\ which prohibits 
certain short sellers from purchasing securities in a secondary or 
follow-on offering.\17\ Under Rule 200(g)(1) of Regulation SHO, ``[a]n 
order to sell shall be marked `long' only if the seller is deemed to 
own the security being sold pursuant to paragraphs (a) through (f) of 
this section \18\ and either: (i) The security to be delivered is in 
the physical possession or control of the broker or dealer; or (ii) it 
is reasonably expected that the security will be in the physical 
possession or control of the broker or dealer no later than the 
settlement of the transaction.'' \19\
---------------------------------------------------------------------------

    \15\ See id.
    \16\ 17 CFR 242.105.
    \17\ See Goldman Sachs Execution and Clearing L.P., Exchange Act 
Release No. 55465 (Mar. 14, 2007) (settled order); Weitz and Altman, 
Lit. Release No. 18121 (April 30, 2003) (settled civil action).
    \18\ Rule 200(b) of Regulation SHO provides that a seller is 
deemed to own a security if, ``(1) The person or his agent has title 
to it; or (2) The person has purchased, or has entered into an 
unconditional contract, binding on both parties thereto, to purchase 
it, but has not yet received it; or (3) The person owns a security 
convertible into or exchangeable for it and has tendered such 
security for conversion or exchange; or (4) The person has an option 
to purchase or acquire it and has exercised such option; or (5) The 
person has rights or warrants to subscribe to it and has exercised 
such rights or warrants; or (6) The person holds a security futures 
contract to purchase it and has received notice that the position 
will be physically settled and is irrevocably bound to receive the 
underlying security.''
    \19\ 17 CFR 242.200(g)(1).
---------------------------------------------------------------------------

    Under Regulation SHO, the executing or introducing broker-dealer is 
responsible for determining whether there are reasonable grounds to 
believe that a security can be borrowed so that it can be delivered on 
the date delivery is due on a short sale, and whether a seller owns the 
security being sold and can reasonably expect that the security will be 
in the physical possession or control of the broker-dealer no later 
than settlement date for a long sale. However, a broker-dealer relying 
on a customer that makes misrepresentations about its locate source or 
ownership of shares may not receive shares when delivery is due. For 
example, sellers may be making misrepresentations to their broker-
dealers about their locate sources or ownership of shares for 
securities that are very difficult or expensive to borrow. Such sellers 
may know that they cannot deliver securities by settlement date due to, 
for example, a limited number of shares being available to borrow or 
purchase, or they may not intend to obtain shares for timely delivery 
because the cost of borrowing or purchasing may be high. That result 
undermines the Commission's goal of addressing concerns related to 
``naked'' short selling and extended fails to deliver.

B. Concerns About ``Naked'' Short Selling

    We have been concerned about ``naked'' short selling and, in 
particular, abusive ``naked'' short selling, for some time. As 
discussed above, our concerns about potentially abusive ``naked'' short 
selling were an important reason for our adoption of Regulation SHO in 
2004. In addition, due to our concerns about the potentially negative 
market impact of large and persistent fails to deliver, and the fact 
that we continued to observe a small number of threshold securities 
\20\ with fail to deliver positions that were not being closed out 
under existing delivery and settlement requirements, in 2007 we 
eliminated the ``grandfather'' exception to Regulation SHO's close-out 
requirement \21\ and today we adopted amendments to eliminate the 
options market maker exception to the close-out requirement.\22\
---------------------------------------------------------------------------

    \20\ 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 disseminated to its members by a 
self-regulatory organization. 17 CFR 242.203(c)(6).
    \21\ See 2007 Regulation SHO Final Amendments, 72 FR 45544. The 
``grandfather'' exception had provided that fails to deliver 
established prior to a security becoming a threshold security did 
not have to be closed out in accordance with Regulation SHO's close-
out requirement. This amendment also contained a one-time phase-in 
period that provided that previously-grandfathered fails to deliver 
in a security that was a threshold security on the effective date of 
the amendment must be closed out within 35 consecutive settlement 
days from the effective date of the amendment. The phase-in period 
ended December 5, 2007.
    \22\ See Exchange Act Release No. 34-58775 (Oct. 14, 2008) 
(``2008 Regulation SHO Final Amendments''). The options market maker 
exception had excepted from the close-out requirement any fail to 
deliver position 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.
---------------------------------------------------------------------------

    In addition to the actions we have taken aimed at reducing fails to 
deliver and addressing potentially abusive ``naked'' short selling in 
threshold securities, recently we took emergency action targeting 
``naked'' short selling in some non-threshold securities. Specifically, 
on July 15, 2008, we published an emergency order under Section 12(k) 
of the Exchange Act (the ``July Emergency Order'') \23\ that 
temporarily imposed enhanced requirements on short sales in the 
publicly traded securities of certain substantial financial firms.\24\
---------------------------------------------------------------------------

    \23\ See Exchange Act Release No. 58166 (July 15, 2008).
    \24\ See id. The Emergency Order required that, in connection 
with transactions in the publicly traded securities of the 
substantial financial firms identified on Appendix A to the 
Emergency Order (``Appendix A Securities''), no person could effect 
a short sale in the Appendix A Securities using the means or 
instrumentalities of interstate commerce unless such person or its 
agent had borrowed or arranged to borrow the security or otherwise 
had the security available to borrow in its inventory prior to 
effecting such short sale and delivered the security on settlement 
date.
---------------------------------------------------------------------------

    We issued the July Emergency Order because we were concerned that 
false rumors spread by short sellers regarding financial institutions 
of significance in the U.S. could continue to threaten significant 
market disruption. As we

[[Page 61669]]

noted in the July Emergency Order, false rumors can lead to a loss of 
confidence in our markets. Such loss of confidence can lead to panic 
selling, which may be further exacerbated by ``naked'' short selling. 
As a result, the prices of securities may artificially and 
unnecessarily decline well below the price level that would have 
resulted from the normal price discovery process. If significant 
financial institutions are involved, this chain of events can threaten 
disruption of our markets.\25\
---------------------------------------------------------------------------

    \25\ We delayed the effective date of the Emergency Order to 
July 21, 2008 to create the opportunity to address, and to allow 
sufficient time for market participants to make, adjustments to 
their operations to implement the enhanced requirements. Moreover, 
in addressing anticipated operational accommodations necessary for 
implementation of the Emergency Order, we issued an amendment to the 
Emergency Order on July 18, 2008. See Exchange Act Release No. 58190 
(July 18, 2008) (excepting from the Emergency Order bona fide market 
makers, short sales in Appendix A Securities sold pursuant to Rule 
144 of the Securities Act of 1933, and certain short sales by 
underwriters, or members of a syndicate or group participating in 
distributions of Appendix A Securities).
---------------------------------------------------------------------------

    On July 29, 2008, we extended the July Emergency Order after 
carefully reevaluating the current state of the markets in consultation 
with officials of the Board of Governors of the Federal Reserve System, 
the Department of the Treasury, and the Federal Reserve Bank of New 
York. Due to our continued concerns about the ongoing threat of market 
disruption and effects on investor confidence, we determined that the 
standards of extension had been met.\26\ Pursuant to the extension, the 
July Emergency Order terminated at 11:59 p.m. EDT on August 12, 
2008.\27\
---------------------------------------------------------------------------

    \26\ See Exchange Act Release No. 58248 (July 29, 2008).
    \27\ In addition, on September 17, 2008, the Commission further 
addressed abusive ``naked'' short selling by issuing an Emergency 
Order that temporarily adopted amendments to Regulation SHO's close-
out requirement, amendments to eliminate Regulation SHO's options 
market maker exception to the close-out requirement, and Rule 10b-
21. See Exchange Act Release No. 58572 (Sept. 17, 2008). The 
Commission also issued emergency orders to require disclosure of 
short sales, Exchange Act Release 58591 (Sept. 18, 2008) and 58591A 
(Sept. 21, 2008), and temporarily halt short selling in financial 
stocks, Exchange Act Release 58592 (Sept. 18, 2008) and Exchange Act 
Release 58611 (Sept. 21, 2008).
---------------------------------------------------------------------------

    In addition to our adopting Rule 10b-21, as noted above, today we 
also adopted amendments to eliminate the options market maker exception 
to Regulation SHO's delivery requirement.\28\ We also adopted today an 
interim final temporary rule that enhances the delivery requirements 
for sales of all equity securities (``2008 Interim Rule'').\29\
---------------------------------------------------------------------------

    \28\ See supra note 22.
    \29\ See Exchange Act Release No. 58773 (Oct. 14, 2008).
---------------------------------------------------------------------------

    The amendments to the options market maker exception and the 2008 
Interim Rule that we adopted today both focus on the timely delivery of 
securities and are not aimed at pre-trade activity, such as compliance 
with Regulation SHO's locate requirement. Because we continue to be 
concerned about fails to deliver and potentially abusive ``naked'' 
short selling, in addition to our initiatives to strengthen Regulation 
SHO's delivery requirements, we are adopting Rule 10b-21 to also target 
sellers who deceive their broker-dealers or certain other persons about 
their source of borrowable shares and their share ownership.
    As we stated in the Proposing Release,\30\ we are concerned about 
persons that sell short securities and deceive specified persons about 
their intention or ability to deliver the securities in time for 
settlement, or deceive their broker-dealer about their locate source or 
ownership of shares. Commission enforcement actions have contributed to 
our concerns about the extent of misrepresentations by short sellers 
about their locate sources and ownership of shares, regardless of 
whether they result in fails to deliver. For example, the Commission 
recently announced a settled enforcement action against hedge fund 
adviser Sandell Asset Management Corp. (``SAM''), its chief executive 
officer, and two employees in connection with allegedly (i) improperly 
marking some short sale orders ``long'' and (ii) misrepresenting to 
executing brokers that SAM personnel had located sufficient stock to 
borrow for short sale orders.\31\
---------------------------------------------------------------------------

    \30\ Exchange Act Release No. 57511 (Mar. 17, 2008), 73 FR 
15376, 15377 (Mar. 21, 2008) (``Proposing Release'').
    \31\ See Sandell Asset Management Corp., Securities Act Release 
No. 8857; see also Goldman Sachs Execution and Clearing L.P., 
Exchange Act Release No. 55465; U.S. v. Naftalin, 441 U.S. 768 
(1979) (discussing a market manipulation scheme in which brokers 
suffered substantial losses when they had to purchase securities to 
replace securities they had borrowed to make delivery on short sale 
orders received from an individual investor who had falsely 
represented to the brokers that he owned the securities being sold).
---------------------------------------------------------------------------

    In addition, as we have stated on several prior occasions, we are 
concerned about the negative effect that fails to deliver may have on 
the markets and shareholders.\32\ For example, fails to deliver may 
deprive shareholders of the benefits of ownership, such as voting and 
lending.\33\ In addition, where a seller of securities fails to deliver 
securities on settlement date, in effect the seller unilaterally 
converts a securities contract (which is expected to settle within the 
standard three-day settlement period) into an undated futures-type 
contract, to which the buyer might not have agreed, or that might have 
been priced differently.\34\
---------------------------------------------------------------------------

    \32\ See supra note 22; 2007 Regulation SHO Final Amendments, 72 
FR at 45544; 2006 Regulation SHO Proposed Amendments, 71 FR at 
41712; 2007 Regulation SHO Proposed Amendments, 72 FR at 45558-
45559; Proposing Release, 73 FR at 15378.
    \33\ See id.
    \34\ See id.
---------------------------------------------------------------------------

    In addition, commenters (including issuers and investors) have 
repeatedly expressed concerns about fails to deliver in connection with 
manipulative ``naked'' short selling. For example, in response to 
proposed amendments to Regulation SHO in 2006 \35\ designed to further 
reduce the number of persistent fails to deliver in certain equity 
securities by eliminating Regulation SHO's ``grandfather'' exception, 
and amending the options market maker exception, we received a number 
of comments that expressed concerns about ``naked'' short selling and 
extended delivery failures.\36\ Commenters continued to express these 
concerns in response to proposed amendments to eliminate the options 
market maker exception to the close-out requirement of Regulation SHO 
in 2007 \37\ and in response to the Proposing Release.\38\
---------------------------------------------------------------------------

    \35\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
    \36\ 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 (``Royce''); letter from Michael Read, dated April 
29, 2007 (``Read''); letter from Robert DeVivo, dated April 26, 2007 
(``DeVivo''); letter from Ahmed Akhtar, dated April 26, 2007 
(``Akhtar'').
    \37\ See, e.g., letter from Jack M. Wedam, dated Oct. 16, 2007; 
letter from Michael J. Ryan, Executive Director and Senior Vice 
President, Center for Capital Markets Competitiveness, U.S. Chamber 
of Commerce, dated Sept. 13, 2007 (``U.S. Chamber of Commerce''); 
letter from Robert W. Raybould, CEO Enteleke Capital Corp., dated 
Sept. 12, 2007; letter from Mary Helburn, Executive Director, 
National Coalition Against Naked Shorting, dated Sept. 11, 2007 
(``NCANS 2007'').
    \38\ See, e.g., letter from Richard H. Baker, President and 
Chief Executive Officer, Managed Funds Association, dated May 21, 
2008 (``MFA'') (stating that ``[m]arket manipulation, such as 
intentional and abusive naked short selling, undermines the 
integrity of the U.S. capital markets and threatens investor 
confidence, market liquidity and market efficiency''); letter from 
Kurt N. Schacht and Linda Rittenhouse, Centre for Financial Market 
Integrity, dated June 17, 2008 (stating that they ``support efforts 
by the Commission to curtail naked short selling, for all the 
reasons noted in the [Proposing Release] relating to the detrimental 
effects on the marketplace. As noted [in the Proposing Release], 
this practice not only affects shareowners by depriving the[m] of 
the basic benefits of ownership, it also may detrimentally affect 
the issuer's reputation and subvert the appropriate workings of the 
market by avoiding certain restrictions applicable to those who 
deliver on time. All of these issues can ultimately undermine 
investor confidence.''); letter from Wallace E. Boston, President 
and Chief Executive Officer, American Public Education, Inc., dated 
May 20, 2008 (noting that ``[a]s the CEO of a recently public 
company, I am acutely aware of the impact that abusive short-selling 
can have on issuers and investors.'').

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

[[Page 61670]]

    To the extent that fails to deliver might be part of manipulative 
``naked'' short selling, which could be used as a tool to drive down a 
company's stock price,\39\ such fails to deliver may undermine the 
confidence of investors.\40\ These investors, in turn, may be reluctant 
to commit capital to an issuer they believe to be subject to such 
manipulative conduct.\41\ In addition, issuers may believe that they 
have suffered unwarranted reputational damage due to investors' 
negative perceptions regarding fails to deliver in the issuer's 
security.\42\ Unwarranted reputational damage caused by fails to 
deliver might have an adverse impact on the security's price.\43\
---------------------------------------------------------------------------

    \39\ See, e.g., 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) (Feb. 
26, 2003) (settled case in which we alleged that the defendants 
profited from engaging in massive ``naked'' short selling that 
flooded the market with the company's stock, and depressed its 
price); see also S.E.C. v. Gardiner, 48 S.E.C. Docket 811, No. 91 
Civ. 2091 (S.D.N.Y. 1991) (alleged manipulation by sales 
representative by directing or inducing customers to sell stock 
short in order to depress its price); U.S. v. Russo, 74 F.3d 1383, 
1392 (2d Cir. 1996) (short sales were sufficiently connected to the 
manipulation scheme as to constitute a violation of Exchange Act 
Section 10(b) and Rule 10b-5).
    \40\ In response to the 2007 Regulation SHO Proposed Amendments, 
we received comment letters discussing the impact of fails to 
deliver on investor confidence. See, e.g., letter from NCANS 2007. 
Commenters expressed similar concerns in response to the 2006 
Regulation SHO Proposed Amendments. See, e.g., letter from Mary 
Helburn, Executive Director, National Coalition Against Naked 
Shorting, dated Sept. 30, 2006 (``NCANS 2006''); letter from Richard 
Blumenthal, Attorney General, State of Connecticut, dated Sept. 19, 
2006.
    \41\ In response to the 2007 Regulation SHO Proposed Amendments, 
we received comment letters 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. See, e.g., letter from Robert K. Lifton, Chairman and CEO, 
Medis Technologies, Inc., dated Sept. 12, 2007; letter from NCANS 
2007. Commenters expressed similar concerns in response to the 2006 
Regulation SHO Proposed Amendments. See, e.g., letter from 
Congressman Tom Feeney--Florida, U.S. House of Representatives, 
dated Sept. 25, 2006; see also letter from Zix Corporation, dated 
Sept. 19, 2006 (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.'').
    \42\ Due in part to such concerns, some issuers have taken 
actions to attempt to make transfer of their securities ``custody 
only,'' thus preventing transfer of their stock to or from 
securities intermediaries such as the Depository Trust Company 
(``DTC'') or broker-dealers. See 2003 Regulation SHO Proposing 
Release, 68 FR at 62975. Some 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. See id. Withdrawing securities from DTC or requiring 
custody-only transfers would undermine the goal of a national 
clearance and settlement system designed to reduce the physical 
movement of certificates in the trading markets. See id. 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 Exchange Act 
Release No. 47978 (June 4, 2003), 68 FR 35037 (June 11, 2003).
    \43\ See also 2006 Regulation SHO Proposed Amendments, 71 FR at 
41712; 2007 Regulation SHO Amendments, 72 FR at 45544; 2007 
Regulation SHO Proposed Amendments, 72 FR at 45558-45559; Proposing 
Release, 73 FR at 15378 (providing additional discussion of the 
impact of fails to deliver on the market); see also 2003 Regulation 
SHO Proposing Release, 68 FR at 62975 (discussing the impact of 
``naked'' short selling on the market).
---------------------------------------------------------------------------

    Strengthening rules that address ``naked'' short selling will 
provide increased confidence in the markets. Since the issuance of the 
July Emergency Order, members of the public have repeatedly expressed 
their concerns about a loss of confidence in the markets. For example, 
one commenter stated that ``financial confidence is critically 
important'' for companies to do business.\44\ Another commenter stated 
that ``existing laws should be enforced, but further steps should be 
taken to prevent any further erosion of the investing publics [sic] 
confidence.'' \45\
---------------------------------------------------------------------------

    \44\ See Comment of Ron Heller (July 21, 2008) (``Heller'') 
(commenting on the Emergency Order).
    \45\ See Comment of Ronald L. Rourk (July 21, 2008) (``Rourk'') 
(commenting on the proposal to eliminate Regulation SHO's options 
market maker exception).
---------------------------------------------------------------------------

    We are concerned about the ability of short sellers to use 
``naked'' short selling as a tool to manipulate the prices of 
securities.\46\ Thus, in conjunction with our other short selling 
initiatives aimed at further reducing fails to deliver and addressing 
abusive ``naked'' short selling, we have adopted Rule 10b-21 
substantially as proposed.
---------------------------------------------------------------------------

    \46\ See, e.g., Commission press release, dated July 13, 2008, 
announcing that the Commission's Office of Compliance Inspections 
and Examinations, as well as FINRA and New York Stock Exchange 
Regulation, Inc., will immediately conduct examinations aimed at the 
prevention of the intentional spreading of false information 
intended to manipulate securities prices. See http://www.sec.gov/news/press/2008/2008-140.htm. In addition, in April of this year, 
the Commission charged Paul S. Berliner, a trader, with securities 
fraud and market manipulation for intentionally disseminating a 
false rumor concerning The Blackstone Group's acquisition of 
Alliance Data Systems Corp (``ADS''). The Commission alleged that 
this false rumor caused the price of ADS stock to plummet, and that 
Berliner profited by short selling ADS stock and covering those 
sales as the false rumor caused the price of ADS stock to fall. See 
http://www.sec.gov/litigation/litreleases/2008/lr20537.htm.
---------------------------------------------------------------------------

    Proposed Rule 10b-21 was narrowly tailored to specify that it is 
unlawful for any person to submit an order to sell a security if such 
person deceives a broker-dealer, participant of a registered clearing 
agency,\47\ or purchaser regarding its intention or ability to deliver 
the security on the date delivery is due, and such person fails to 
deliver the security on or before the date delivery is due.\48\ We 
received over 700 comment letters in response to the Proposing Release.
---------------------------------------------------------------------------

    \47\ 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.
    \48\ See Proposed Rule 10b-21.
---------------------------------------------------------------------------

    The comment letters were from numerous entities, including issuers, 
retail investors, broker-dealers, SROs, associations, members of 
Congress, and other elected officials.\49\ Many commenters supported 
our goals of further addressing potentially abusive ``naked'' short 
selling and fails to deliver, while not necessarily agreeing with the 
Commission's approach. For example, some commenters argued for more 
stringent short sale regulation.\50\ Others urged us to take stronger 
enforcement action against abusive ``naked'' short sellers under the 
current federal securities laws rather than, or in addition to, 
adopting Rule 10b-21.\51\

[[Page 61671]]

Some commenters asked that if we adopt Rule 10b-21 as proposed, we 
provide certain clarifications regarding the application of the 
rule.\52\ We highlight in the discussion below some of the main issues, 
concerns, and suggestions raised in the comment letters.
---------------------------------------------------------------------------

    \49\ The comment letters are available on the Commission's 
Internet Web Site at http://www.sec.gov/comments/s7-08-08/s70808.shtml.
    \50\ See, e.g., letter from Arik B. Fetscher, Esq., dated April 
2, 2008; letter from Fred Adams, Jr., Chairman and Chief Executive 
Officer, Cal-Maine Foods, Inc., dated May 19, 2008; letter from 
David T. Hirschman, President and Chief Executive Officer, Center 
for Capital Markets Competitiveness, United States Chamber of 
Commerce, dated May 20, 2008 (``Chamber of Commerce''); letter from 
Wallace E. Boston, Jr., President and Chief Executive Officer, 
American Public Education, Inc., dated May 20, 2008; letter from 
Kurt N. Schacht, Executive Director, and Linda L. Rittenhouse, 
Senior Policy Analyst, CFA Institute Centre for Financial Market 
Integrity, dated June 17, 2008; letter from Guillaume Cloutier, 
dated July 25, 2008; letter from Shunliang Wang, dated July 27, 
2008; letter from Scott Bridgford, dated July 29, 2008; letter from 
Keith Kottwitz, dated Aug. 1, 2008.
    \51\ See, e.g., letter from Tony J. Akin, Jr., Financial 
Advisor, dated March 31, 2008; letter from Gary D. Owens, CEO, OYO 
Geospace, dated April 22, 2008; letter from Daniel J. Popeo, 
Chairman & General Counsel, and Paul D. Kamenar, Senior Executive 
Counsel, Washington Legal Foundation, dated May 20, 2008; letter 
from David Hughes, dated July 17, 2008; letter from Dave Morgan, 
dated July 25, 2008; letter from Seth Bradley, dated July 30, 2008; 
letter from Michael Kianka, dated Aug. 1, 2008.
    \52\ See, e.g., letter from James J. Angel, Associate Professor 
of Finance, Georgetown University, dated May 17, 2008 (``Angel''); 
letter from Heather Traeger, Assistant Counsel, Investment Company 
Institute, dated May 20, 2008; letter from Dr. Robert J. Shapiro, 
Chairman, Sonecon, LLC, and former U.S. Under Secretary of Commerce, 
dated May 20, 2008 (``Shapiro''); letter from Ira D. Hammerman, 
Managing Director and General Counsel, Securities Industry and 
Financial Markets Association, dated May 22, 2008 (``SIFMA''); 
letter from Michael R. Trocchio, Bingham McCutchen LLP, dated July 
14, 2008 (``Bingham''); letter from MFA.
---------------------------------------------------------------------------

III. Discussion of Rule 10b-21

A. Rule 10b-21

    After careful consideration of the comments, we are adopting Rule 
10b-21 substantially as proposed. Rule 10b-21 specifies that it is 
unlawful for any person to submit an order to sell an equity security 
if such person deceives a broker-dealer, participant of a registered 
clearing agency,\53\ or purchaser regarding its intention or ability to 
deliver the security on the date delivery is due, and such person fails 
to deliver the security on or before the date delivery is due.\54\ 
Scienter is a necessary element for a violation of the rule.\55\ Some 
commenters questioned whether, similar to Regulation SHO, proposed Rule 
10b-21 would apply only to equity securities.\56\ In response to these 
comments, we clarify that as proposed and adopted, Rule 10b-21 applies 
only to equity securities.\57\
---------------------------------------------------------------------------

    \53\ See supra note 47 (defining the terms ``participant'' and 
``registered clearing agency'' for purposes of the rule).
    \54\ See Rule 10b-21.
    \55\ Ernst & Ernst v. Hochfelder, et al., 425 U.S. 185 (1976). 
Scienter has been defined as ``a mental state embracing the intent 
to deceive, manipulate or defraud.'' Id. at 193, n.12. While the 
Supreme Court has not decided the issue (see Aaron v. SEC, 446 U.S. 
686 (1980); Ernst & Ernst, 425 at 193 n.12), federal appellate 
courts have concluded that scienter may be established by a showing 
of either knowing conduct or by ``an `extreme departure from the 
standards of ordinary care * * * which presents a danger of 
misleading buyers or sellers that is either known to the defendant 
or is so obvious that the actor must have been aware of it.' '' 
Dolphin & Bradbury v. SEC, 512 F.3d 634 (D.C. Cir. Jan. 11, 2008) 
(quoting Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 
(7th Cir. 1977)). Some commenters stated they believe that Rule 10b-
21 should require a finding of ``intentional deception'' to best 
achieve our goals without deterring legitimate short selling. See, 
e.g., letter from MFA; another commenter, however, requested that we 
confirm that the concept of scienter, for purposes of Rule 10b-21, 
is identical to established precedent under Section 10(b) of the 
Exchange Act and Rule 10b-5 thereunder. See letter from SIFMA. We 
intend the scienter requirement of Rule 10b-21 to be the same as 
that required under Rule 10b-5.
    \56\ See, e.g., letter from MFA.
    \57\ See, e.g., Proposing Release, 73 FR at 15380; see also Rule 
10b-21.
---------------------------------------------------------------------------

    Rule 10b-21 will cover those situations where a seller deceives a 
broker-dealer, participant of a registered clearing agency, or a 
purchaser about its intention to deliver securities by settlement date, 
its locate source, or its share ownership, and the seller fails to 
deliver securities by settlement date.\58\ Rule 10b-21 will prohibit 
the deception of persons participating in the transaction--broker-
dealers, participants of registered clearing agencies, or purchasers. 
Further, because one of the principal goals of Rule 10b-21 is to reduce 
fails to deliver, violation of the rule will occur only if a fail to 
deliver results from the relevant transaction.
---------------------------------------------------------------------------

    \58\ As proposed, the rule referenced ``the date delivery is 
due.'' To provide specificity as to when delivery is due for 
purposes of the rule, we are modifying this language to ``settlement 
date'' and defining ``settlement date'' as ``the business day on 
which delivery of a security and payment of money is to be made 
through the facilities of a registered clearing agency in connection 
with the sale of a security.'' See Rule 10b-21(b).
---------------------------------------------------------------------------

    For purposes of Rule 10b-21, broker-dealers (including market 
makers) acting for their own accounts will be considered sellers. For 
example, a broker-dealer effecting short sales for its own account will 
be liable under the rule if it does not obtain a valid locate source 
and fails to deliver securities to the purchaser. Such broker-dealers 
defraud purchasers that may not receive delivery on time, in effect 
unilaterally forcing the purchaser into accepting an undated futures-
type contract.\59\
---------------------------------------------------------------------------

    \59\ See supra note 22; 2007 Regulation SHO Final Amendments, 72 
FR at 45544; 2006 Regulation SHO Proposed Amendments, 71 FR at 
41712; 2007 Regulation SHO Proposed Amendments, 72 FR at 45558-
45559.
---------------------------------------------------------------------------

    As noted above, under Regulation SHO, the executing or introducing 
broker-dealer is responsible for determining whether there are 
reasonable grounds to believe that a security can be borrowed so that 
it can be delivered on the date delivery is due on a short sale.\60\ In 
the 2004 Regulation SHO Adopting Release, the Commission explicitly 
permitted broker-dealers to rely on customer assurances that the 
customer has identified its own locate source, provided it is 
reasonable for the broker-dealer to do so.\61\ If a seller elects to 
provide its own locate source to a broker-dealer, the seller is 
representing that it has contacted that source and reasonably believes 
that the source can or intends to deliver the full amount of the 
securities to be sold short by settlement date. In addition, if a 
seller enters a short sale order into a broker-dealer's direct market 
access or sponsored access system (``DMA'') with any information 
purporting to identify a locate source obtained by the seller, the 
seller makes a representation to a broker-dealer for purposes of Rule 
10b-21.\62\
---------------------------------------------------------------------------

    \60\ See 17 CFR 242.203(b)(3)(1).
    \61\ See 2004 Regulation SHO Adopting Release, 69 FR at 48014.
    \62\ Broker-dealers offer DMA to some customers by providing 
them with electronic access to a market's execution system using the 
broker-dealer's market participant identifier. The broker-dealer, 
however, retains the ultimate responsibility for the trading 
activity of its customer.
---------------------------------------------------------------------------

    If a seller deceives a broker-dealer about the validity of its 
locate source, the seller will be liable under Rule 10b-21 if the 
seller also fails to deliver securities by the date delivery is due. 
For example, a seller will be liable for a violation of Rule 10b-21 if 
it represented that it had identified a source of borrowable 
securities, but the seller never contacted the purported source to 
determine whether shares were available and could be delivered in time 
for settlement and the seller fails to deliver securities by settlement 
date. A seller will also be liable if it contacted the source and 
learned that the source did not have sufficient shares for timely 
delivery, but the seller misrepresented that the source had sufficient 
shares that it could deliver in time for settlement and the seller 
fails to deliver securities by settlement date; or, if the seller 
contacted the source and the source had sufficient shares that it could 
deliver in time for settlement, but the seller never instructed the 
source to deliver the shares in time for settlement and the seller 
otherwise refused to deliver shares on settlement date such that the 
sale results in a fail to deliver.
    One commenter recommended that the rule focus on whether there is a 
fail to deliver in the Continuous Net Settlement (``CNS'') system, 
rather than on a seller's failure to deliver the securities sold.\63\ 
The majority of equity trades in the United States are cleared and 
settled through systems administered by clearing agencies registered 
with the Commission. The NSCC clears and settles the majority of equity 
securities trades conducted on the exchanges and in the over the 
counter market. NSCC clears and settles trades through the CNS system, 
which nets the securities delivery and payment obligations of all of 
its members. The majority of NSCC's members are broker-

[[Page 61672]]

dealers.\64\ 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. This commenter noted that a seller's clearing 
broker generally bears the responsibility to meet the firm's CNS 
delivery requirement and that it is difficult for a broker-dealer to 
determine which customer transactions or accounts give rise to a fail 
to deliver in the CNS system. We note, however, that Rule 10b-21 as 
proposed was not based on whether a fail to deliver occurred in CNS. 
Rather, the rule as proposed was concerned with whether an individual 
seller delivered securities that it sold. Along those lines, another 
commenter stated that the proposed rule should require a failure to 
deliver by the seller.\65\
---------------------------------------------------------------------------

    \63\ See letter from SIFMA.
    \64\ As of July 31, 2008 approximately 91% of members of the 
NSCC were registered as broker-dealers.
    \65\ See letter from Bingham.
---------------------------------------------------------------------------

    We have determined to adopt the rule as proposed. The rule targets 
the misconduct of sellers. As discussed above, sellers should promptly 
deliver the securities they have sold and purchasers have the right to 
the timely receipt of securities that they have purchased. Thus, Rule 
10b-21's focus is on whether or not there is a fail to deliver by the 
seller, rather than on whether or not there is a fail to deliver in the 
CNS system. Because fails to deliver in the CNS system are netted with 
pending deliveries, some sellers may be able to postpone delivery if 
another customer's purchase is received the same day. Thus, a person 
engaging in abusive ``naked'' short selling may be able to avoid 
detection for a period of time. This would undermine our goal of 
addressing abusive ``naked'' short selling.

B. Seller's Reliance on a Broker-Dealer or ``Easy to Borrow'' Lists

    Rule 10b-21 provides that it shall be unlawful for any person to 
submit an order to sell an equity security if such person deceives a 
broker-dealer, participant of a registered clearing agency, or 
purchaser regarding its intention or ability to deliver the security on 
the date delivery is due.\66\ Thus, as we discussed in the Proposing 
Release,\67\ if a seller is relying on a broker-dealer to comply with 
Regulation SHO's locate obligation and to make delivery on a sale, the 
seller would not be representing at the time it submits an order to 
sell a security that it can or intends to deliver securities on the 
date delivery is due. For example, a seller might be relying on its 
broker-dealer to borrow or arrange to borrow the security to make 
delivery by settlement date. Alternatively, a seller might be relying 
on a broker-dealer's ``Easy to Borrow'' list. If a seller in good faith 
relies on a broker-dealer's ``Easy to Borrow'' list to satisfy the 
locate requirement, the seller would not be deceiving the broker-dealer 
at the time it submits an order to sell a security that it can or 
intends to deliver securities on the date delivery is due. In 
discussing the locate requirement of Regulation SHO, in the 2004 
Regulation SHO Adopting Release, the Commission stated that ``absent 
countervailing factors, `Easy to Borrow' lists may provide `reasonable 
grounds' for a broker-dealer to believe that the security sold short is 
available for borrowing without directly contacting the source of the 
borrowed securities.'' \68\
---------------------------------------------------------------------------

    \66\ See Rule 10b-21.
    \67\ See Proposing Release, 73 FR at 15379.
    \68\ 2004 Regulation SHO Adopting Release, 69 FR at 48014.
---------------------------------------------------------------------------

C. Bona Fide Market Makers

    As we discussed in the Proposing Release,\69\ a market maker 
engaged in bona fide market making activity would not be making a 
representation at the time it submits an order to sell short that it 
can or intends to deliver securities on the date delivery is due, 
because such market makers are excepted from the locate requirement of 
Regulation SHO. Regulation SHO excepts from the locate requirement 
market makers engaged in bona-fide market making activities because 
market makers need to facilitate customer orders in a fast moving 
market without possible delays associated with complying with the 
locate requirement.\70\ Thus, at the time of submitting an order to 
sell short, market makers that have an exception from the locate 
requirement of Regulation SHO may know that they may not be able to 
deliver securities on the date delivery is due.
---------------------------------------------------------------------------

    \69\ See Proposing Release, 73 FR at 15379.
    \70\ See 2004 Regulation SHO Adopting Release, 69 FR at 48015, 
n. 67; see also 2008 Regulation SHO Final Amendments, supra note 22 
(providing interpretive guidance regarding bona fide market making 
activities for purposes of Regulation SHO).
---------------------------------------------------------------------------

D. ``Long'' Sales

    Under Rule 10b-21, a seller will be liable if it deceives a broker-
dealer, participant of a registered clearing agency, or purchaser about 
its ownership of shares or the deliverable condition of owned shares 
and fails to deliver securities by settlement date.\71\ As we discussed 
in the Proposing Release,\72\ a seller will be liable for a violation 
of Rule 10b-21 for causing a broker-dealer to mark an order to sell a 
security ``long'' if the seller knows or recklessly disregards that it 
is not ``deemed to own'' the security being sold, as defined in Rules 
200(a) through (f) of Regulation SHO \73\ or if the seller knows or 
recklessly disregards that the security being sold is not, or cannot 
reasonably be expected to be, in the broker-dealer's physical 
possession or control by the date delivery is due, and the seller fails 
to deliver the security by settlement date.
---------------------------------------------------------------------------

    \71\ See Rule 10b-21.
    \72\ See Proposing Release, 73 FR at 15379.
    \73\ 17 CFR 242.200(a)-(f).
---------------------------------------------------------------------------

    Broker-dealers acting for their own accounts will also be liable 
under Rule 10b-21 for marking an order ``long'' if the broker-dealer 
knows or recklessly disregards that it is not ``deemed to own'' the 
security being sold or that the security being sold is not, or cannot 
reasonably be expected to be, in the broker-dealer's physical 
possession or control by the date delivery is due, and the broker-
dealer fails to deliver the security by settlement date.\74\
---------------------------------------------------------------------------

    \74\ Such broker-dealers will also be liable under Regulation 
SHO Rule 203(a).
---------------------------------------------------------------------------

    However, a seller would not be making a representation at the time 
it submits an order to sell a security that it can or intends to 
deliver securities on the date delivery is due if the seller submits an 
order to sell securities that are held in a margin account but the 
broker-dealer has loaned out the shares pursuant to the margin 
agreement. Under such circumstances, it would be reasonable for the 
seller to expect that the securities will be in the broker-dealer's 
physical possession or control by settlement date.

E. Rule 10b-21 and Other Antifraud Provisions of the Federal Securities 
Laws

    One commenter stated that it believes proposed Rule 10b-21 is 
unnecessary ``because the Commission already has ample existing 
authority, under Section 10(b) of the Exchange Act and Rule 10b-5 
thereunder, to prosecute manipulative and/or fraudulent activity, 
including the type of activity that proposed Rule 10b-21 seeks to 
address.'' \75\ Other commenters urged us to use less formal means than 
rulemaking to address our concerns regarding misrepresentations in the 
order entry process.\76\ For

[[Page 61673]]

instance, these commenters suggested that the Commission or its staff 
could convey this message through FAQs, staff bulletins, and 
speeches.\77\ We have determined, however, that the negative effects of 
abusive ``naked'' short selling on market confidence warrant formal 
Commission action.
---------------------------------------------------------------------------

    \75\ See letter from SIFMA; see also letter from Bingham 
(stating that ``[t]he Firms agree that the illicit conduct the 
Commission seeks to address through [proposed Rule 10b-21] is 
already illegal''); letter from MFA.
    \76\ See, e.g., letter from Bingham; letter from MFA; but, c.f., 
letter from Chamber of Commerce (noting that although the activity 
covered by proposed Rule 10b-21 is already a violation of the 
antifraud provisions of the federal securities laws, ``[e]mphasizing 
that such deceit violates these laws may deter some of this activity 
in the future'').
    \77\ See, e.g., letter from Bingham.
---------------------------------------------------------------------------

    While ``naked'' short selling as part of a manipulative scheme is 
already illegal under the general antifraud provisions of the federal 
securities laws, we believe that a rule further evidencing the 
illegality of these activities will focus the attention of market 
participants on such activities. Rule 10b-21 will also further evidence 
that the Commission believes such deceptive activities are detrimental 
to the markets and will provide a measure of predictability for market 
participants.
    Some commenters sought clarification as to how this rule was 
different from Rule 10b-5.\78\ We note that the set of factors that 
will serve as the basis for a violation of Rule 10b-21 as adopted are 
not determinative of a person's obligations under the general antifraud 
provisions of the federal securities laws. Accordingly, and in order to 
clarify the continued applicability of the general antifraud provisions 
outside of the strict context of Rule 10b-21, we have added a 
preliminary note to the rule as adopted, which states: ``This rule is 
not intended to limit, or restrict, the applicability of the general 
antifraud provisions of the federal securities laws, such as section 
10(b) of the Act and rule 10b-5 thereunder.'' We added this preliminary 
note because we believe it is important to underscore that Rule 10b-21 
is not meant, in any way, to limit the general antifraud provisions of 
the federal securities laws. Additionally, this preliminary note 
provides much needed public clarity in answer to the confusion voiced 
by many commenters.
---------------------------------------------------------------------------

    \78\ See, e.g., letter from MFA; see also letter from SIFMA 
(seeking clarification as to whether the level of scienter in the 
proposed rule differs from that of Rule 10b-5).
---------------------------------------------------------------------------

    Similarly, we are modifying the proposed rule text slightly to add 
the word ``also,'' as follows: ``It shall also constitute a 
`manipulative or deceptive device or contrivance' as used in section 
10(b) of this Act for any person to submit an order to sell an equity 
security if such person deceives a broker or dealer, a participant of a 
registered clearing agency, or a purchaser about its intention or 
ability to deliver the security on or before the settlement date, and 
such person fails to deliver the security on or before the settlement 
date.''
    We believe the adding the word ``also'' in the rule text further 
clarifies that Rule 10b-21 does not affect the operation of Rule 10b-5 
or other antifraud rules, but is instead intended to supplement the 
existing antifraud rules.
    Commenters also raised questions whether there would be a private 
right of action for a violation of proposed Rule 10b-21.\79\ We note 
that the courts have held that a private right of action exists with 
respect to Rule 10b-5 provided the essential elements constituting a 
violation of the rule are met.\80\ Thus, a private plaintiff able to 
prove all those elements in a situation covered by Rule 10b-21 would be 
able to assert a claim under Section 10(b) of the Exchange Act and Rule 
10b-5 thereunder.
---------------------------------------------------------------------------

    \79\ See, e.g., letter from SIFMA. Another commenter stated that 
``[t]he Commission should make explicitly clear that the adoption of 
Proposed Rule 10b-21 does not create a private right of action for 
violations of the rule. * * *'' See letter from Bingham.
    \80\ See, e.g., Superintendent of Insurance v. Bankers Life & 
Cas. Co., 404 U.S. 6, 13, n. 9 (1971); Ernst & Ernst, 425 at 196 
(citing prior cases).
---------------------------------------------------------------------------

F. Aiding and Abetting Liability

    In the Proposing Release, we stated that ``[a]lthough the proposed 
rule is primarily aimed at sellers that deceive specified persons about 
their intention or ability to deliver shares or about their locate 
source and ownership of shares, as with any rule, broker-dealers could 
be liable for aiding and abetting a customer's fraud under the proposed 
rule.'' \81\ One commenter stated that broker-dealers should not be 
held responsible for policing their customer's compliance with their 
own legal requirements.\82\ Another commenter urged us to specifically 
state that reliance by a broker-dealer on a customer representation 
regarding long/short status or receipt of a locate does not rise to the 
level of scienter required for aiding and abetting liability.\83\ This 
commenter also asked us to make clear that broker-dealers who merely 
offer DMA or sponsored access to a customer who violates the new rule 
would not be liable for aiding and abetting such violation.\84\
---------------------------------------------------------------------------

    \81\ See Proposing Release, 72 FR at 15379.
    \82\ See letter from SIFMA.
    \83\ See letter from Bingham.
    \84\ See id.
---------------------------------------------------------------------------

    Rule 10b-21 as adopted does not impose any additional liability or 
requirements on any person, including broker-dealers, beyond those of 
any existing Exchange Act rule. As we stated in the Proposing Release, 
broker-dealers would remain subject to liability under Regulation SHO 
and the general antifraud provisions of the federal securities 
laws.\85\
---------------------------------------------------------------------------

    \85\ See Proposing Release, 72 FR at 15380.
---------------------------------------------------------------------------

G. Administrative Law Matters

    The Administrative Procedure Act also generally requires that an 
agency publish an adopted rule in the Federal Register 30 days before 
it becomes effective.\86\ This requirement, however, does not apply if 
the agency finds good cause for making the rule effective sooner.\87\ 
The Commission has determined that the rule should be effective in 
fewer than 30 days because it addresses illegal conduct that can cause 
market disruption. In addition, because the rule further evidences 
conduct that is manipulative and deceptive under existing general 
antifraud rules, market participants should not need time to adjust 
systems or procedures to comply with the rule. Therefore, the 
Commission finds good cause to make the rule effective on October 17, 
2008.
---------------------------------------------------------------------------

    \86\ See 5 U.S.C. Sec.  553(d).
    \87\ Id.
---------------------------------------------------------------------------

IV. Paperwork Reduction Act

    Rule 10b-21 does not contain a ``collection of information'' 
requirement within the meaning of the Paperwork Reduction Act of 
1995.\88\
---------------------------------------------------------------------------

    \88\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

V. Cost-Benefit Analysis

    We are sensitive to the costs and benefits of our rules and we have 
considered the costs and benefits of Rule 10b-21. In order to assist us 
in evaluating the costs and benefits, in the Proposing Release, we 
encouraged commenters to discuss any costs or benefits that the rule 
would impose. In particular, we requested comment on the potential 
costs for any modification to both computer systems and surveillance 
mechanisms and for information gathering, management, and recordkeeping 
systems or procedures, as well as any potential benefits resulting from 
the rule for issuers, investors, brokers or dealers, other securities 
industry professionals, regulators, and other market participants. 
Commenters were encouraged to provide analysis and data to support 
their views on the costs and benefits associated with the rule.

A. Benefits

    Rule 10b-21 is intended to address abusive ``naked'' short selling 
and fails

[[Page 61674]]

to deliver. The rule is aimed at short sellers, including broker-
dealers acting for their own accounts, who deceive broker-dealers, 
participants of a registered clearing agency, or purchasers about their 
intention or ability to deliver securities in time for settlement and 
that fail to deliver securities by settlement date. Among other things, 
Rule 10b-21 targets short sellers who deceive their broker-dealers 
about their source of borrowable shares for purposes of complying with 
Regulation SHO's ``locate'' requirement.\89\ The rule also applies to 
sellers who misrepresent to their broker-dealers that they own the 
shares being sold.\90\
---------------------------------------------------------------------------

    \89\ See 17 CFR 242.203(b)(1).
    \90\ See Rule 10b-21.
---------------------------------------------------------------------------

    A seller misrepresenting its short sale locate source or ownership 
of shares may intend to fail to deliver securities in time for 
settlement and, therefore, engage in abusive ``naked'' short selling. 
As noted above, although abusive ``naked'' short selling is not defined 
in the federal securities laws, it refers generally to selling short 
without having stock available for delivery and intentionally failing 
to deliver stock within the standard three-day settlement cycle.\91\ 
Such short selling may or may not be part of a scheme to manipulate the 
price of a security. Although ``naked'' short selling as part of a 
manipulative scheme is always illegal under the general antifraud 
provisions of the federal securities laws, including Rule 10b-5 under 
the Exchange Act,\92\ Rule 10b-21 will further evidence the specific 
liability of persons that deceive specified persons about their 
intention or ability to deliver securities in time for settlement, 
including persons that deceive their broker-dealer about their locate 
source or ownership of shares and that fail to deliver securities by 
settlement date. We believe that a rule specifying the illegality of 
these activities will focus the attention of market participants on 
such activities. The rule will also further evidence that the 
Commission believes such deceptive activities are detrimental to the 
markets and will provide a measure of predictability for market 
participants.
---------------------------------------------------------------------------

    \91\ See supra note 2.
    \92\ 17 CFR 240.10b-5.
---------------------------------------------------------------------------

    All sellers of securities should promptly deliver, or arrange for 
delivery of, securities to the respective buyer and all buyers of 
securities have a right to expect prompt delivery of securities 
purchased. Thus, the rule takes direct aim at an activity that may 
create fails to deliver. Those fails can have a negative effect on 
shareholders, potentially depriving them of the benefits of ownership, 
such as voting and lending. They also may create a misleading 
impression of the market for an issuer's securities. As noted above, 
issuers and investors have expressed concerns about fails to deliver in 
connection with ``naked'' short selling. For example, in response to 
the 2006 Regulation SHO Proposed Amendments, we received a number of 
comments that expressed concerns about ``naked'' short selling and 
extended delivery failures.\93\ Commenters continued to express these 
concerns in response to the 2007 Regulation SHO Proposed 
Amendments,\94\ and in response to the Proposing Release.\95\
---------------------------------------------------------------------------

    \93\ See supra note 36.
    \94\ See supra note 37.
    \95\ See supra note 38.
---------------------------------------------------------------------------

    To the extent that 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,\96\ such fails to deliver may 
undermine the confidence of investors.\97\ These investors, in turn, 
may be reluctant to commit capital to an issuer they believe to be 
subject to such manipulative conduct.\98\ In addition, issuers may 
believe that they have suffered unwarranted reputational damage due to 
investors' negative perceptions regarding fails to deliver in the 
issuer's security.\99\ Any unwarranted reputational damage caused by 
fails to deliver might have an adverse impact on the security's 
price.\100\
---------------------------------------------------------------------------

    \96\ See supra note 39.
    \97\ See supra note 40.
    \98\ See supra note 41.
    \99\ See supra note 42 (discussing the fact that due to such 
concerns some issuers have taken actions to attempt to make transfer 
of their securities ``custody only,'' thus preventing transfer of 
their stock to or from securities intermediaries such as the DTC or 
broker-dealers).
    \100\ See supra note 43.
---------------------------------------------------------------------------

    Thus, to the extent that fails to deliver might create a misleading 
impression of the market for an issuer's securities, the rule will 
benefit investors and issuers by taking direct aim at an activity that 
may create fails to deliver. In addition, to the extent that ``naked'' 
short selling and fails to deliver result in an unwarranted decline in 
investor confidence about a security, the rule will improve investor 
confidence about the security. In addition, the rule will lead to 
greater certainty in the settlement of securities which should 
strengthen investor confidence in that process.
    We believe the rule will result in broker-dealers having greater 
confidence that their customers have obtained a valid locate source 
and, therefore, that shares are available for delivery on settlement 
date. Thus, the rule will aid broker-dealers in complying with the 
locate requirement of Regulation SHO and, thereby, potentially reduce 
fails to deliver. In addition, to the extent that the rule results in 
fewer sales of threshold securities resulting in fails to deliver, the 
rule will reduce costs to broker-dealers because such broker-dealers 
will have to close-out a lesser amount of fails to deliver under 
Regulation SHO's close-out requirement.\101\ The rule should also help 
reduce manipulative schemes involving ``naked'' short selling.
---------------------------------------------------------------------------

    \101\ Rule 203(b)(3)(iii) of Regulation SHO contains a close-out 
requirement that applies only to broker-dealers for securities in 
which a substantial amount of fails to deliver have occurred, also 
known as ``threshold securities.'' Specifically, Rule 203(b)(3)'s 
close-out requirement requires a participant of a clearing agency 
registered with the Commission to take immediate action to close out 
a fail to deliver position in a threshold security in the CNS system 
that has persisted for 13 consecutive settlement days by purchasing 
securities of like kind and quantity; see also 2008 Interim Rule, 
supra note 29 (temporarily enhancing Regulation SHO's delivery 
requirements for sales of all equity securities).
---------------------------------------------------------------------------

    In the Proposing Release, we solicited comment on any additional 
benefits that could be realized with the proposed rule, including both 
short-term and long-term benefits. We also solicited comment regarding 
benefits to market efficiency, pricing efficiency, market stability, 
market integrity and investor protection. In response, one commenter 
stated that the ``rule will have a positive impact on liquidity and 
market quality in securities traded.'' \102\ Another commenter stated 
that ``the liquidity of the market and the market quality of securities 
traded can be threatened or damaged if investors perceive that naked 
short sales may artificially distort the price of securities, in ways 
and instances unknown to honest investors, * * * in this regard, the 
strict application of the rule * * * should enhance liquidity and the 
market quality of securities traded.'' \103\ This commenter also noted 
that, ``[b]y increasing the liability of naked short sellers, the 
proposed rule should reduce the incidence of naked short sales and 
thereby reduce the likelihood of short squeezes.'' \104\
---------------------------------------------------------------------------

    \102\ See letter from Susanne Trimbath, PhD., CEO and Chief 
Economist, STP Advisory Services, LLC, dated May 30, 2008 
(``Trimbath'') (noting also a tax benefit to investors from 
enforcing delivery on settlement date).
    \103\ See letter from Shapiro.
    \104\ See id.
---------------------------------------------------------------------------

B. Costs

    Rule 10b-21 is intended to address abusive ``naked'' short selling 
by further evidencing the liability of persons that deceive specified 
persons about their intention or ability to deliver securities

[[Page 61675]]

in time for settlement, including persons that deceive their broker-
dealer about their locate source or ownership of shares and that fail 
to deliver securities by settlement date. In the Proposing Release, we 
sought data supporting any potential costs associated with the rule, 
and specific comment on any systems changes to computer hardware and 
software, or surveillance costs that might be necessary to implement 
the rule. One commenter stated that ``the rule will have a positive 
impact on liquidity and market quality in securities traded * * * 
[w]ithout strict rules against settlement failures, a systemic crisis 
could occur where investors are reluctant to engage in trades in U.S. 
markets because settlement finality is in question. The markets and 
investors need the assurance of Rule 10b-21 that securities 
transactions will be settled.'' \105\ Another commenter stated that 
``the liquidity of the market and the market quality of securities 
traded can be threatened or damaged if investors perceive that naked 
short sales may artificially distort the price of securities, in ways 
and instances unknown to honest investors, * * * in this regard, the 
strict application of the rule * * * should enhance liquidity and the 
market quality of securities traded.'' \106\ This commenter also noted 
that, ``[b]y increasing the liability of naked short sellers, the 
proposed rule should reduce the incidence of naked short sales and 
thereby reduce the likelihood of short squeezes. The prospect of short 
squeezes is increased by the moral hazard that occurs when short 
sellers believe there is little or no cost to carrying out abusive 
naked short sales, and therefore rules that impose such costs reduce 
this prospect.'' \107\ The commenter also noted that any costs 
associated with purchasing or borrowing securities to deliver on a sale 
instead of allowing the fail to deliver position to remain open ``would 
not represent an additional cost, since a legitimate short sale 
involves borrowing the security for delivery at the cost of such 
borrowing. Therefore, it would reflect only the cost of complying with 
the rules and laws that apply to all investors.'' \108\ This commenter 
also noted that ``[s]trict liability for failing to deliver securities 
in short sales is needed to offset the implicit savings of violating 
the law and rules, and getting away with it.'' \109\
---------------------------------------------------------------------------

    \105\ See letter from Trimbath.
    \106\ See letter from Shapiro.
    \107\ See id.
    \108\ See id.
    \109\ See id.
---------------------------------------------------------------------------

    We recognize, however, that Rule 10b-21 may result in increased 
costs to broker-dealers to the extent that the rule encourages or 
results in broker-dealers limiting the extent to which they rely on 
customer assurances in complying with the locate requirement of 
Regulation SHO. In addition, the rule may result in increased costs to 
sellers who inadvertently fail to deliver securities because such 
sellers, in an attempt to avoid liability under the rule, might 
purchase or borrow securities to deliver on a sale at a time when, but 
for the rule, the seller would have allowed the fail to deliver 
position to remain open.
    One commenter stated that, ``unless Proposed Rule 10b-21 were 
modified to eliminate aiding and abetting liability and allow reliance 
upon customer assurances, the price discovery and liquidity provided 
through short sales may be constrained.'' \110\ Although broker-dealer 
concerns regarding aiding and abetting liability under Rule 10b-21 may 
potentially impact liquidity and efficiency in the markets, we believe 
that such an impact, if any, will be minimal. Rule 10b-21 as adopted 
does not impose any additional liability or requirements on any person, 
including broker-dealers, beyond those of any existing Exchange Act 
rule. Aiding and abetting liability is a question of fact, determined 
on a case-by-case basis. In addition, as we stated in the Proposing 
Release, broker-dealers would remain subject to liability under 
Regulation SHO and the general antifraud provisions of the federal 
securities laws.\111\
---------------------------------------------------------------------------

    \110\ See letter from Bingham.
    \111\ See Proposing Release, 72 FR at 15377.
---------------------------------------------------------------------------

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

    Section 3(f) of the Exchange Act requires the Commission, whenever 
it engages in rulemaking and whenever it is required to consider or 
determine if an action is necessary or appropriate in the public 
interest, to consider whether the action would promote efficiency, 
competition, and capital formation.\112\ In addition, Section 23(a)(2) 
of the Exchange Act requires the Commission, when adopting rules under 
the Exchange Act, to consider the impact such rules would have on 
competition.\113\ 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.
---------------------------------------------------------------------------

    \112\ 15 U.S.C. 78c(f).
    \113\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    Rule 10b-21 is intended to address abusive ``naked'' short selling 
and fails to deliver. The rule is aimed at short sellers, including 
broker-dealers acting for their own accounts, who deceive specified 
persons, such as a broker-dealer, about their intention or ability to 
deliver securities in time for settlement and fail to deliver 
securities by settlement date. Among other things, Rule 10b-21 targets 
short sellers who deceive their broker-dealers about their source of 
borrowable shares for purposes of complying with Regulation SHO's 
``locate'' requirement.\114\ The rule also applies to sellers who 
misrepresent to their broker-dealers that they own the shares being 
sold.\115\
---------------------------------------------------------------------------

    \114\ See 17 CFR 242.203(b)(1).
    \115\ See Rule 10b-21.
---------------------------------------------------------------------------

    Although ``naked'' short selling as part of a manipulative scheme 
is always illegal under the general antifraud provisions of the federal 
securities laws, including Rule 10b-5 under the Exchange Act,\116\ Rule 
10b-21 will further evidence the liability of persons that deceive 
specified persons about their intention or ability to deliver 
securities in time for settlement, including persons that deceive their 
broker-dealer about their locate source or ownership of shares and that 
fail to deliver securities by settlement date. We believe that a rule 
further evidencing the illegality of these activities will focus the 
attention of market participants on such activities. The rule will also 
provide a measure of predictability for market participants. We believe 
Rule 10b-21 will have minimal impact on the promotion of price 
efficiency.
---------------------------------------------------------------------------

    \116\ 17 CFR 240.10b-5.
---------------------------------------------------------------------------

    In the Proposing Release, we sought comment regarding whether Rule 
10b-21 will adversely impact liquidity, disrupt markets, or 
unnecessarily increase risks or costs to customers. In response, one 
commenter noted that, ``the liquidity of the market and the market 
quality of securities traded can be threatened or damaged if investors 
perceive that naked short sales may artificially distort the price of 
securities, in ways and instances unknown to honest investors, * * * in 
this regard, the strict application of the rule * * * should enhance 
liquidity and the market quality of securities traded.'' \117\ This 
commenter also noted that, ``[b]y increasing the liability of naked 
short sellers, the proposed rule should reduce the incidence of naked 
short sales and

[[Page 61676]]

thereby reduce the likelihood of short squeezes. * * *'' \118\
---------------------------------------------------------------------------

    \117\ See letter from Shapiro.
    \118\ See id.
---------------------------------------------------------------------------

    Another commenter stated that, ``unless Proposed Rule 10b-21 were 
modified to eliminate aiding and abetting liability and allow reliance 
upon customer assurances, the price discovery and liquidity provided 
through short sales may be constrained.'' \119\ Although broker-dealer 
concerns regarding aiding and abetting liability under Rule 10b-21 may 
potentially impact liquidity and efficiency in the markets, we believe 
that such an impact, if any, will be minimal. Rule 10b-21 as adopted 
does not impose any additional liability or requirements on any person, 
including broker-dealers, beyond those of any existing Exchange Act 
rule. Aiding and abetting liability is a question of fact, determined 
on a case-by-case basis. In addition, as we stated in the Proposing 
Release, broker-dealers would remain subject to liability under 
Regulation SHO and the general antifraud provisions of the federal 
securities laws.\120\
---------------------------------------------------------------------------

    \119\ See letter from Bingham.
    \120\ See Proposing Release, 72 FR at 15377.
---------------------------------------------------------------------------

    In addition, we believe that the rule will have minimal impact on 
the promotion of capital formation. 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. For example, in response to the Proposing 
Release, one commenter noted that, ``[c]onfidence in the securities 
markets is diminished when investors and others cannot rely on the 
receipt of securities in trades.'' \121\ Thus, we believe that 
strengthening our rules against ``naked'' short selling by targeting 
sellers who deceive their broker-dealers about their source of 
borrowable shares and their share ownership will provide increased 
confidence in the markets.
---------------------------------------------------------------------------

    \121\ See letter from Trimbath.
---------------------------------------------------------------------------

    In addition, we note that we have previously sought comment 
regarding the impact on capital formation of other proposed amendments 
aimed at reducing fails to deliver and addressing potentially abusive 
``naked'' short selling, including whether the proposed increased short 
sale restrictions would affect investors' decisions to invest in 
certain equity securities.\122\ In response, 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.\123\ Thus, to the extent that ``naked'' 
short selling and fails to deliver result in an unwarranted decline in 
investor confidence about a security, the rule is expected to improve 
investor confidence about the security. We note, however, that 
persistent fails to deliver exist in only a small number of securities 
and may be a signal of overvaluation rather than undervaluation of a 
security's price.\124\ In addition, we believe that the rule will lead 
to greater certainty in the settlement of securities, which is expected 
to strengthen investor confidence in the settlement process.
---------------------------------------------------------------------------

    \122\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41710; 
2007 Regulation SHO Proposed Amendments, 72 FR 45558.
    \123\ See, e.g., supra note 41 (citing to comment letters 
expressing concern regarding the impact of potential ``naked'' short 
selling on capital formation).
    \124\ Persistent fails to deliver may be symptomatic of an 
inadequate supply of shares in the equity lending market. If short 
sellers are unable to short sell due to their inability to borrow 
shares, their opinions about the fundamental value of the security 
may not be fully reflected in a security's price, which may lead to 
overvaluation.
---------------------------------------------------------------------------

    We also believe that Rule 10b-21 will not impose any burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Exchange Act. By specifying that abusive ``naked'' short selling 
is a fraud, the Commission believes the rule will promote competition 
by providing the industry with guidance regarding the liability of 
sellers that deceive specified persons about their intention or ability 
to deliver securities in time for settlement, including persons that 
deceive their broker-dealer about their locate sources or share 
ownership and that fail to deliver securities by settlement date.

VII. Final Regulatory Flexibility Analysis

    The Commission has prepared a Final Regulatory Flexibility Analysis 
(``FRFA''), in accordance with the provisions of the Regulatory 
Flexibility Act (``RFA''),\125\ regarding Rule 10b-21 under the 
Exchange Act. An Initial Regulatory Flexibility Analysis (``IRFA'') was 
prepared in accordance with the RFA and was included in the Proposing 
Release. We solicited comments on the IRFA.
---------------------------------------------------------------------------

    \125\ 5 U.S.C. 603.
---------------------------------------------------------------------------

A. Reasons for the Rule

    Rule 10b-21 is intended to address fails to deliver associated with 
abusive ``naked'' short selling. While ``naked'' short selling as part 
of a manipulative scheme is already illegal under the general antifraud 
provisions of the federal securities laws, Rule 10b-21 specifies that 
it is unlawful for any person to submit an order to sell an equity 
security if such person deceives a broker-dealer, participant of a 
registered clearing agency, or purchaser about its intention or ability 
to deliver securities on the date delivery is due, and such person 
fails to deliver the security on or before the date delivery is due. 
Thus, Rule 10b-21 will further evidence the liability of persons that 
deceive specified persons about their intention or ability to deliver 
securities in time for settlement, including persons that deceive their 
broker-dealer about their locate source or ownership of shares.

B. Objectives

    Rule 10b-21 is aimed at short sellers, including broker-dealers 
acting for their own accounts, that deceive specified persons, such as 
a broker or dealer, about their intention or ability to deliver 
securities in time for settlement and that fail to deliver securities 
by settlement date. We believe that a rule further evidencing the 
illegality of these activities will focus the attention of market 
participants on such activities. The rule will also underscore that the 
Commission believes such deceptive activities are detrimental to the 
markets and will provide a measure of predictability for market 
participants.
    All sellers of securities should promptly deliver, or arrange for 
delivery of, securities to the respective buyer and all buyers of 
securities have a right to expect prompt delivery of securities 
purchased. Thus, Rule 10b-21 takes direct aim at an activity that may 
create fails to deliver. Those fails can have a negative effect on 
shareholders, potentially depriving them of the benefits of ownership, 
such as voting and lending. They also may create a misleading 
impression of the market for an issuer's securities. Rule 10b-21 will 
also aid broker-dealers in complying with the locate requirement of 
Regulation SHO and, thereby, potentially reduce fails to deliver. In 
addition, the rule is expected to help reduce manipulative schemes 
involving ``naked'' short selling.

C. Significant Issues Raised By Public Comment

    The IRFA appeared in the Proposing Release. We requested comment on 
any aspect of the IRFA. In particular, we requested comment on: (i) The 
number of small entities that would be affected by the rule; and (ii) 
the existence or nature of the potential impact of the rule on small 
entities. We requested that the

[[Page 61677]]

comments specify costs of compliance with the rule, and suggest 
alternatives that would accomplish the objectives of the rule. We did 
not receive any comments that responded specifically to this request.

D. Small Entities Subject to the Rule

    The entities covered by Rule 10b-21 will include small broker-
dealers, small businesses, and any investor who effects a short sale 
that qualifies as a small entity. Although it is impossible to quantify 
every type of small entity that may be able to effect a short sale in a 
security, paragraph (c)(1) of Rule 0-10 under the Exchange Act \126\ 
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 2007, the Commission 
estimates that there were approximately 896 broker-dealers that 
qualified as small entities as defined above.\127\
---------------------------------------------------------------------------

    \126\ 17 CFR 240.0-10(c)(1).
    \127\ These numbers are based on OEA's review of 2007 FOCUS 
Report filings reflecting registered broker-dealers. This number 
does not include broker-dealers that are delinquent on FOCUS Report 
filings.
---------------------------------------------------------------------------

    Any business, however, regardless of industry, could be subject to 
the rule if it effects a short or long sale. The Commission believes 
that, except for the broker-dealers discussed above, an estimate of the 
number of small entities that fall under the rule is not feasible.

E. Reporting, Recordkeeping, and Other Compliance Requirements

    Rule 10b-21 is intended to address abusive ``naked'' short selling 
by further evidencing the liability of persons that deceive specified 
persons about their intention or ability to deliver securities in time 
for settlement, including persons that deceive their broker-dealer 
about their locate source or ownership of shares and that fail to 
deliver securities by settlement date. The Commission believes that the 
rule may impose new or additional compliance costs on any affected 
party, including broker-dealers, that are small entities. To comply 
with Regulation SHO, small broker-dealers needed to modify their 
systems and surveillance mechanisms to comply with Regulation SHO's 
locate, marking and delivery requirements. Thus, any systems and 
surveillance mechanisms necessary for broker-dealers to comply with the 
rule should already be in place. We believe that any necessary 
additional systems and surveillance changes, in particular changes by 
sellers who are not broker-dealers, will be similar to the changes 
incurred by broker-dealers when Regulation SHO was implemented.

F. Agency Action To Minimize Effect on Small Entities

    The RFA directs the Commission to consider significant alternatives 
that would accomplish the stated objective, while minimizing any 
significant adverse impact on small entities. Pursuant to Section 3(a) 
of the RFA,\128\ 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.
---------------------------------------------------------------------------

    \128\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    A primary goal of Rule 10b-21 is to address abusive ``naked'' short 
selling. While ``naked'' short selling as part of a manipulative scheme 
is always illegal under the general antifraud provisions of the federal 
securities laws, Rule 10b-21 specifies that it is a fraud for any 
person to submit an order to sell an equity security if such person 
deceives a broker-dealer, participant of a registered clearing agency, 
or purchaser about its intention or ability to deliver the security on 
the date delivery is due and such person fails to deliver the security 
on or before the date delivery is due. Rule 10b-21 is aimed at short 
sellers, including broker-dealers acting for their own accounts, who 
deceive specified persons, such as a broker or dealer, about their 
intention or ability to deliver securities in time for settlement and 
who do not deliver securities by settlement date. Among other things, 
Rule 10b-21 targets short sellers who deceive their broker-dealers 
about their source of borrowable shares for purposes of complying with 
Regulation SHO's ``locate'' requirement.\129\ The rule also applies to 
sellers who misrepresent to their broker-dealers that they own the 
shares being sold.
---------------------------------------------------------------------------

    \129\ See 17 CFR 242.203(b)(1).
---------------------------------------------------------------------------

    We believe that imposing different compliance requirements, and 
possibly a different timetable for implementing compliance 
requirements, for small entities would undermine the Commission's goal 
of addressing abusive ``naked'' short selling and fails to deliver. In 
addition, we have concluded similarly that it is not consistent with 
the primary goal of the rule to further clarify, consolidate, or 
simplify the rule for small entities. Finally, the rule imposes 
performance standards rather than design standards.

VIII. Statutory Authority

    Pursuant to the Exchange Act and, particularly, Sections 2, 3(b), 
6, 9(h), 10, 11A, 15, 15A, 17, 17A, 19 and 23(a) thereof, 15 U.S.C. 
78b, 78c(b), 78f, 78i(h), 78j, 78k-1, 78o, 78o-3, 78q, 78q-1, 78s and 
78w(a), the Commission is adopting a new antifraud rule, Rule 10b-21, 
to address abusive ``naked'' short selling.

List of Subjects in 17 CFR Part 240

    Brokers, Fraud, Reporting and recordkeeping requirements, 
Securities.

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

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

0
1. The authority citation for part 240 continues to read, in part, as 
follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 
78w, 78x, 78-ll, 78mm, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 
80b-11, and 7201 et seq.; and 18 U.S.C. 1350, unless otherwise 
noted.


0
2. Add Sec.  240.10b-21 to read as follows:


Sec.  240.10b-21   Deception in connection with a seller's ability or 
intent to deliver securities on the date delivery is due.

    Preliminary Note to Sec.  240.10b-21: This rule is not intended 
to limit, or restrict, the applicability of the general antifraud 
provisions of the federal securities laws, such as section 10(b) of 
the Act and rule 10b-5 thereunder.

    (a) It shall also constitute a ``manipulative or deceptive device 
or contrivance'' as used in section 10(b) of this Act for any person to 
submit an order to sell an equity security if such person deceives a 
broker or dealer, a participant of a registered clearing agency, or a 
purchaser about its intention or ability to deliver the security on or 
before the settlement date, and such person fails to deliver the

[[Page 61678]]

security on or before the settlement date.
    (b) For purposes of this rule, the term settlement date shall mean 
the business day on which delivery of a security and payment of money 
is to be made through the facilities of a registered clearing agency in 
connection with the sale of a security.

    By the Commission.

    Dated: October 14, 2008.
Florence E. Harmon,
Acting Secretary.
 [FR Doc. E8-24714 Filed 10-16-08; 8:45 am]
BILLING CODE 8011-01-P