[Federal Register Volume 74, Number 146 (Friday, July 31, 2009)]
[Rules and Regulations]
[Pages 38266-38293]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E9-18185]



[[Page 38265]]

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Part II





Securities and Exchange Commission





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17 CFR Parts 200 and 242



Amendments to Regulation SHO; Final Rule

  Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules 
and Regulations  

[[Page 38266]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 200 and 242

[Release No. 34-60388; File No. S7-30-08]
RIN 3235-AK22


Amendments to Regulation SHO

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
finalizing amendments to Regulation SHO under the Securities Exchange 
Act of 1934 (``Exchange Act'') by making permanent amendments contained 
in Interim Final Temporary Rule 204T (``temporary Rule 204T'') of 
Regulation SHO, with some modifications to address commenters' 
concerns. These amendments are intended to help further our goal of 
reducing fails to deliver by maintaining the reductions in fails to 
deliver achieved by the adoption of temporary Rule 204T, as well as 
other actions taken by the Commission. In addition, these amendments 
are intended to help further our goal of addressing abusive ``naked'' 
short selling in all equity securities. These goals will be furthered 
by requiring that, subject to certain limited exceptions, if a 
participant of a registered clearing agency has a fail to deliver 
position at a registered clearing agency it must immediately purchase 
or borrow securities to close out the fail to deliver position by no 
later than the beginning of regular trading hours on the settlement day 
following the day the participant incurred the fail to deliver 
position. Failure to comply with the close-out requirement of this 
final rule is a violation of the rule. In addition, a participant that 
does not comply with this close-out requirement, and any broker-dealer 
from which it receives trades for clearance and settlement, will not be 
able to short sell the security either for itself or for the account of 
another, unless it has previously arranged to borrow or borrowed the 
security, until the fail to deliver position is closed out.

DATES: Effective Date: July 31, 2009.

FOR FURTHER INFORMATION CONTACT: Jo Anne Swindler, Acting Associate 
Director; Josephine Tao, Assistant Director; Victoria Crane, Branch 
Chief; David Bloom and Christina M. Adams, Special Counsels; Matthew 
Sparkes or Katrina Wilson, Staff Attorneys, Office of Trading Practices 
and Processing, Division of Trading and Markets, at (202) 551-5720, at 
the Commission, 100 F Street, NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION: We are adding Rule 204 of Regulation SHO [17 
CFR 242.204] under the Exchange Act and removing Rule 204T of 
Regulation SHO [17 CFR 242.204T] under the Exchange Act.

I. Introduction

    In October 2008, we adopted temporary Rule 204T of Regulation SHO 
as an interim final temporary rule, with an expiration date of July 31, 
2009.\1\ As discussed in more detail below, temporary Rule 204T 
strengthens the close-out requirements of Regulation SHO for failures 
to deliver securities (known as ``fails'' or ``fails to deliver'') \2\ 
resulting from sales of any equity security. Our adoption of temporary 
Rule 204T followed a series of other steps aimed at reducing fails to 
deliver and addressing potentially abusive ``naked'' short selling.\3\
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    \1\ See Exchange Act Release No. 58733 (Oct. 14, 2008), 73 FR 
61706 (Oct. 17, 2008) (``Rule 204T Adopting Release'').
    \2\ Fails to deliver occur when a seller fails to deliver 
securities to the buyer when delivery is due. See infra note 16 and 
accompanying text.
    \3\ See infra Section II (discussing other Commission actions 
aimed at reducing fails to deliver and addressing potentially 
abusive ``naked'' short selling).
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    In addition, at the time that we adopted temporary Rule 204T, we 
noted our concerns about the sudden and unexplained declines in the 
prices of equity securities generally and the deterioration in investor 
confidence in our financial markets.\4\ Such price declines can give 
rise to questions about the underlying financial condition of an 
entity, which in turn can create a crisis of confidence even without a 
fundamental underlying basis.\5\ This crisis of confidence can impair 
the liquidity and ultimate viability of an entity, with potentially 
broad market consequences.\6\ Thus, we also adopted temporary Rule 204T 
to further our goal of preventing substantial disruption in the 
securities markets by providing a powerful disincentive to those who 
might otherwise engage in potentially abusive ``naked'' short 
selling.\7\
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    \4\ See Rule 204T Adopting Release, 73 FR 61707.
    \5\ See id.
    \6\ See id.
    \7\ See id.
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    Preliminary results from the Commission's Office of Economic 
Analysis (``OEA'') indicate that our various actions to further reduce 
fails to deliver and, thereby, address potentially abusive ``naked'' 
short selling are having their intended effect. For example, these 
preliminary results indicate a significant downward trend in the number 
of fails to deliver in all equity securities since, among other 
actions, the adoption of temporary Rule 204T.\8\ These results provide, 
among other things, that in comparing a pre- to post-temporary Rule 
204T adoption period,\9\ the average daily number of fails to deliver 
for all equity securities has declined from 1.1 billion to 478 million 
for a total decline of 56.6 percent. In addition, the average daily 
number of threshold securities declined from 480 securities to 108 
securities in comparing the pre- to post-temporary Rule 204T adoption 
period, a decline of 77.5%.\10\
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    \8\ See Memorandum from OEA Re: Impact of Recent SHO Rule 
Changes on Fails to Deliver, November 26, 2008 at http://www.sec.gov/comments/s7-30-08/s73008-37.pdf; see also Memorandum 
from OEA Re: Impact of Recent SHO Rule Changes on Fails to Deliver, 
March 20, 2009 at http://www.sec.gov/comments/s7-30-08/s73008-107.pdf; Memorandum from OEA Re: Impact of Recent SHO Rule Changes 
on Fails to Deliver, April 16, 2009 (``OEA April 2009 Memorandum'') 
at http://www.sec.gov/comments/s7-30-08/s73008-121.pdf.
    \9\ The OEA April 2009 Memorandum defined the pre-Rule period as 
the period from January 1, 2008 to September 22, 2008, and the post-
Rule period as September 23, 2008 to March 31, 2009. The post-Rule 
period was also post elimination of the options market maker 
exception to Regulation SHO's close-out requirement in Rule 
203(b)(3) of Regulation SHO. See OEA April 2009 Memorandum; see also 
infra notes 38-41 and accompanying text.
    \10\ See OEA April 2009 Memorandum.
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    Due to the positive impact that temporary Rule 204T,\11\ as well as 
other recent Commission actions, are having on reducing fails to 
deliver and after considering the comments received to temporary Rule 
204T, we are adopting the provisions of that rule in a permanent rule, 
Rule 204 of Regulation SHO, with some limited modifications to refine 
provisions and address commenters' concerns.\12\ In general, as 
discussed in more detail below, we are maintaining the structure of 
temporary Rule 204T, while making some

[[Page 38267]]

adjustments to promote its workability.\13\
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    \11\ We note in this regard that at a public Roundtable to 
Examine Short Sale Price Test and Circuit Breaker Restrictions held 
on May 5, 2009 (the ``Short Sale Price Test Roundtable''), a number 
of participants of the Roundtable commented on the success of 
temporary Rule 204T at reducing fails to deliver and urged the 
Commission to adopt temporary Rule 204T as a permanent rule. See, 
e.g., http://www.sec.gov/spotlight/shortsales/roundtable050509/shortsalesroundtable050509-transcript.txt.
    \12\ We received approximately 120 comment letters in response 
to the Rule 204T Adopting Release. The comment letters are available 
on the Commission's Internet Web site at http://www.sec.gov/comments/s7-30-08/s73008.shtml. Further, as noted above, a number of 
participants at the Commission's Short Sale Price Test Roundtable 
expressed views about temporary Rule 204T. See e.g., http://www.sec.gov/spotlight/shortsales/roundtable050509/shortsalesroundtable050509-transcript.txt. See also comments to the 
Short Sale Price Test Roundtable at http://www.sec.gov/comments/4-581/4-581.shtml.
    \13\ See infra Section III (discussing Rule 204 of Regulation 
SHO and commenters' concerns).
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    We believe that Rule 204 of Regulation SHO will continue to help 
further our goal of reducing fails to deliver by maintaining the 
reductions in fails to deliver achieved by the adoption of temporary 
Rule 204T, as well as other actions taken by the Commission. In 
addition, these amendments are intended to help further our goal of 
addressing potentially abusive ``naked'' short selling. These goals 
will be furthered by, among other things, requiring that securities are 
purchased or borrowed to close out any fail to deliver position 
resulting from a short sale of an equity security by no later than the 
beginning of regular trading hours on the settlement day following the 
date on which the fail to deliver position occurred. Similar to 
temporary Rule 204T of Regulation SHO, Rule 204 will continue to 
provide a disincentive to those who might otherwise engage in 
potentially abusive ``naked'' short selling.

II. Background

    Short selling involves a sale of a security that the seller does 
not own or a sale which is consummated by the delivery of a security 
borrowed by, or for the account of, the seller.\14\ Short sales 
normally are settled by the delivery of a security borrowed by or on 
behalf of the seller. In a ``naked'' short sale, however, the short 
seller does not borrow securities in time to make delivery to the buyer 
within the standard three-day settlement period.\15\ As a result, the 
seller fails to deliver securities to the buyer when delivery is 
due.\16\ Sellers sometimes intentionally fail to deliver securities as 
part of a scheme to manipulate the price of a security,\17\ or possibly 
to avoid borrowing costs associated with short sales, especially when 
the costs of borrowing stock are high.
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    \14\ 17 CFR 242.200(a).
    \15\ See Exchange Act Release No. 50103 (July 28, 2004), 69 FR 
48008, 48009 n. 10 (Aug. 6, 2004) (``2004 Regulation SHO Adopting 
Release'').
    \16\ Generally, investors complete or settle their security 
transactions within three settlement days. This settlement cycle is 
known as T+3 (or ``trade date plus three days''). T+3 means that 
when a trade occurs, the participants to the trade deliver and pay 
for the security at a clearing agency three settlement days after 
the trade is executed so the brokerage firm can exchange those funds 
for the securities on that third settlement day. 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 
settlement day following the trade (or T+1). 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; see also Exchange Act Release No. 
56212 (Aug. 7, 2007), 72 FR 45544, n. 2 (Aug. 14, 2007) (``2007 
Regulation SHO Final Amendments'').
    \17\ 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); SEC v. Rhino Advisors, Inc. and Thomas Badian, Civ. 
Action No. 03 civ 1310 (RO) (S.D.N.Y); see also 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 case involving stock of Sedona Corporation); 2004 Regulation 
SHO Adopting Release, 69 FR 48016, n.76; Exchange Act Release No. 
58774 (Oct. 14, 2008), 73 FR 61666 (Oct. 17, 2008) (``Anti-Fraud 
Rule Adopting Release'').
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    We have been concerned about reducing fails to deliver and 
addressing ``naked'' short selling, in particular, potentially abusive 
``naked'' short selling, for some time. As we have stated on several 
prior occasions, we believe that 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.\18\ 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.\19\
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    \18\ See, e.g., Rule 204T Adopting Release, 73 FR 61709; 
Exchange Act Release No. 57511 (Mar. 17, 2008), 73 FR 15376, 15377 
(Mar. 31, 2008) (``Anti-Fraud Rule Proposing Release'').
    \19\ See, e.g., Rule 204T Adopting Release, 73 FR 61709; 2007 
Regulation SHO Final Amendments, 72 FR 45544; Exchange Act Release 
No. 54154 (July 14, 2006), 71 FR 41710, 41712 (July 21, 2006) 
(``2006 Regulation SHO Proposed Amendments''); Exchange Act Release 
No. 56213 (Aug. 7, 2007), 72 FR 45558, 45558-45559 (Aug. 14, 2007) 
(``2007 Regulation SHO Proposed Amendments''); Anti-Fraud Rule 
Proposing Release, 73 FR 15378.
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    For example, large and persistent fails to deliver may deprive 
shareholders of the benefits of ownership, such as voting and 
lending.\20\ 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.\21\ Moreover, sellers that fail to deliver 
securities on settlement date may attempt to use this additional 
freedom to engage in trading activities to improperly depress the price 
of a security. By not borrowing securities and, therefore, not making 
delivery within the standard three-day settlement period, the seller 
has additional freedom because it does not incur the costs of 
borrowing.
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    \20\ See id.
    \21\ See id.
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    In addition, 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,\22\ which were designed to 
further reduce the number of persistent fails to deliver in certain 
equity securities by eliminating Regulation SHO's ``grandfather'' 
exception and limit the duration of the rule's options market maker 
exception, we received a number of comments that expressed concerns 
about ``naked'' short selling and extended delivery failures.\23\ 
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 \24\ and in response to 
the Rule 204T Adopting Release.\25\
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    \22\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
    \23\ 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; letter from John Royce, dated April 30, 2007; 
letter from Michael Read, dated April 29, 2007; letter from Robert 
DeVivo, dated April 26, 2007; letter from Ahmed Akhtar, dated April 
26, 2007.
    \24\ 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 (``Raybould''); letter from Mary Helburn, Executive 
Director, National Coalition Against Naked Shorting, dated Sept. 12, 
2007 (``NCANS'').
    \25\ See e.g., letter from Roel Campos, dated Mar. 25, 2009 
(``Campos''); letter from the Risk Management Association, dated 
Dec. 23, 2008; letter from Professor James Angel, Ph.D, CFA, dated 
Dec. 17, 2008 (``Angel''); letter from Patrick Byrne, Ph.D., dated 
Dec. 16, 2008; letter from the American Bankers Association, dated 
Dec. 16, 2008 (``ABA''); letter from Fairfax Financial Holdings, 
Ltd., dated Oct. 16, 2008.
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    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,\26\ such fails to deliver may

[[Page 38268]]

undermine the confidence of investors.\27\ These investors, in turn, 
may be reluctant to commit capital to an issuer they believe to be 
subject to such manipulative conduct.\28\ 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.\29\ Unwarranted reputational damage caused by fails 
to deliver might have an adverse impact on the security's price.\30\
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    \26\ See supra note 17 (discussing a 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. Mar. 27, 1991) (alleged manipulation 
by sales representative by directing or inducing customers to sell 
stock short in order to depress its price); U.S. v. Russo, 74 F.3d 
1383, 1392 (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).
    \27\ In response to the Rule 204T Adopting Release, we received 
comment letters discussing the impact of fails to deliver on 
investor confidence. See e.g., letter from David Patch, dated Mar. 
19, 2009; letter from Charles J. Greiner, dated Mar. 11, 2009. In 
response to the 2007 Regulation SHO Proposed Amendments, commenters 
discussed the impact of fails to deliver on investor confidence. 
See, e.g., letter from NCANS. 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 (``Blumenthal'').
    \28\ In response to the Rule 204T Adopting Release, 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 Campos (noting that ``[i]n its most benign form, 
naked short selling is a hidden tax on equity markets, our largest 
wealth creation mechanism. At its worst, it is a violent force of 
wealth destruction that affects all market participants.''); letter 
from Patrick Byrne Ph.D., Chairman and Chief Executive Officer, 
Overstock.com Inc., dated Dec. 16, 2008 (stating that ``more needs 
to be done to correct the problem of naked short selling and to 
prevent more companies from being taken down by those that use it as 
a tool for manipulation.''); see also letter from ABA. Commenters 
expressed similar concerns in response to the 2007 Regulation SHO 
Proposed Amendments. See, e.g., letter from Robert K. Lifton, 
Chairman and CEO, Medis Technologies, Inc., dated Sept. 12, 2007 
(``Medis''); letter from NCANS. Commenters also 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 (``Feeney''); see also 
letter from Zix Corporation, dated Sept. 19, 2006 (``Zix'') (stating 
that ``[m]any investors attribute the Company's frequent re-
appearances on the Regulation SHO list to manipulative short selling 
and frequently demand that the Company ``do something'' about the 
perceived manipulative short selling. This perception that 
manipulative short selling of the Company's securities is 
continually occurring has undermined the confidence of many of the 
Company's investors in the integrity of the market for the Company's 
securities.'').
    \29\ Due in part to such concerns, some issuers have taken 
actions to attempt to make transfer of their securities ``custody 
only,'' (i.e., certificating the securities and prohibiting 
ownership by a securities intermediary) thus preventing transfer of 
their stock to or from securities intermediaries such as the 
Depository Trust Company (``DTC'') or broker-dealers. See Exchange 
Act Release No. 48709 (Oct. 28, 2003), 68 FR 62972, at 62975 (Nov. 
6, 2003). Some issuers have attempted to withdraw their issued 
securities on deposit at DTC in order to make 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. See Exchange Act Release No. 47978 (June 
4, 2003), 68 FR 35037 (June 11, 2003).
    \30\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41712; 
2007 Regulation SHO Final Amendments, 72 FR 45545; 2007 Regulation 
SHO Proposed Amendments, 72 FR 45558-45559; Anti-Fraud Rule 
Proposing Release, 73 FR 15378; Rule 204T Adopting Release, 73 FR 
61709-61710 (providing discussion of the impact of fails to deliver 
on the market); see also 2003 Regulation SHO Proposing Release, 68 
FR 62975 (Nov. 6, 2003) (discussing the impact of ``naked'' short 
selling on the market).
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    Although the majority of trades settle within T+3,\31\ we adopted 
Regulation SHO \32\ on July 28, 2004, in part to address problems 
associated with persistent fails to deliver securities and potentially 
abusive ``naked'' short selling. For example, Regulation SHO requires 
broker-dealers to ``locate'' securities that the broker-dealer 
reasonably believes can be delivered within the standard three-day 
settlement period.\33\
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    \31\ According to the National Securities Clearing Corporation 
(``NSCC''), 99% (by dollar value) of all trades settle within T+3. 
Thus, on an average day, only approximately 1% (by dollar value) of 
all trades, including equity, debt, and municipal securities fail to 
settle on time.
    \32\ 17 CFR 242.200. Regulation SHO became effective on January 
3, 2005.
    \33\ 17 CFR 242.203(b)(1). Rule 203(b)(1) of Regulation SHO 
requires 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).'' This is known as the 
``locate'' requirement. Market makers engaged in bona fide market 
making in the security at the time they effect the short sale are 
excepted from this requirement. In connection with this ``locate'' 
requirement, as well as other provisions of Regulation SHO that 
require a reasonableness determination (i.e., Rules 200(g)(1) and 
203(a)(2)(ii)), we remind any broker-dealer subject to such 
provisions that they have an affirmative obligation to obtain and 
consider information from their own records and/or from the records 
of another source helpful to making the reasonableness 
determinations required by such rules. Such information may include, 
but is not limited to, information regarding a customer's prior 
assurances regarding a locate source, its share ownership, or 
delivery of shares by settlement date. See 17 CFR 242.203(b)(1), 
242.200(g)(1), 203(a)(2)(ii). See also 2004 Regulation SHO Adopting 
Release, 69 FR 48014, n. 58, 48019 at n. 111.
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    Another requirement of Regulation SHO aimed at potentially abusive 
``naked'' short selling and reducing fails to deliver in certain equity 
securities is the rule's ``close-out'' requirement. Since Regulation 
SHO was adopted it has required participants \34\ of a registered 
clearing agency,\35\ which includes broker-dealers, to purchase shares 
to close out fails to deliver in securities with large and persistent 
fails to deliver, i.e., ``threshold securities.'' \36\ Until the 
position is closed out, the participant responsible for the fail to 
deliver position and any broker-dealer from which it receives trades 
for clearance and settlement may not effect further short sales in that 
threshold security without first borrowing or arranging to borrow the 
security.\37\
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    \34\ For purposes of Regulation SHO, the term ``participant'' 
has the same meaning as in section 3(a)(24) of the Exchange Act. See 
15 U.S.C. 78c(a)(24).
    \35\ The term ``registered clearing agency'' means a clearing 
agency, as defined in Section 3(a)(23)(A) 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) and 78q-1, respectively; see also 2004 
Regulation SHO Adopting Release, 69 FR 48031. 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 Continuous Net Settlement 
(``CNS'') system, which nets the securities delivery and payment 
obligations of all of its members. NSCC notifies its members of 
their securities delivery and payment obligations daily. In 
addition, NSCC guarantees the completion of all transactions and 
interposes itself as the contraparty to both sides of the 
transaction. We intend to closely monitor fails to deliver resulting 
from trades that are not cleared and settled through the CNS system.
    \36\ Rule 203(c)(6) of Regulation SHO defines a ``threshold 
security'' 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)) 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 is included on a list disseminated to its members 
by a self-regulatory organization (``SRO''). See 17 CFR 
242.203(c)(6).
    \37\ See 17 CFR 242.203(b)(3)(iv).
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    As adopted, Regulation SHO included two major exceptions to the 
close-out requirement: The ``grandfather'' provision and the ``options 
market maker'' exception. The ``grandfather'' provision 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 thirteen consecutive settlement day close-out 
requirement.

[[Page 38269]]

    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 threshold securities with fail to deliver positions that 
were not being closed out under existing delivery and settlement 
requirements, effective on October 15, 2007, we adopted an amendment to 
Regulation SHO that eliminated the ``grandfather'' provision.\38\
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    \38\ See 2007 Regulation SHO Final Amendments, 72 FR 45544. 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 on 
December 5, 2007.
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    The options market maker exception excepted 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. On September 17, 2008, we adopted and made 
immediately effective, as an emergency rule, an amendment to Rule 
203(b)(3) of Regulation SHO to eliminate the options market maker 
exception to the rule's close-out requirement.\39\ Following the 
issuance of the September Emergency Order, we adopted amendments making 
permanent the elimination of the options market maker exception.\40\ As 
we discussed in the 2008 Regulation SHO Final Amendments, we believed 
it was appropriate to eliminate the options market maker exception in 
part because substantial levels of fails to deliver continued to 
persist in threshold securities and it appeared that a significant 
number of these fails to deliver were as a result of the options market 
maker exception.\41\
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    \39\ See Exchange Act Release No. 58572 (Sept. 17, 2008), 73 FR 
54875 (Sept. 23, 2008) (``September Emergency Order'').
    \40\ See Exchange Act Release No. 58775 (Oct. 14, 2008), 73 FR 
61690 (Oct. 17, 2008) (``2008 Regulation SHO Final Amendments''); 
see also 2007 Regulation SHO Proposed Amendments, 72 FR 45558; 2006 
Regulation SHO Proposed Amendments, 71 FR 41710; Exchange Act 
Release No. 58107 (July 7, 2008), 73 FR 40201 (July 14, 2008) 
(``2008 Regulation SHO Re-Opening Release'').
    \41\ See 2008 Regulation SHO Final Amendments, 73 FR 61690; see 
also 2008 Regulation SHO Re-Opening Release, 73 FR 40201.
---------------------------------------------------------------------------

    In adopting temporary Rule 204T of Regulation SHO pursuant to the 
September Emergency Order and subsequently pursuant to the Rule 204T 
Adopting Release, we strengthened further the close-out requirements of 
Regulation SHO by applying close-out requirements to fails to deliver 
resulting from sales of all equity securities and reducing the time-
frame within which fails to deliver must be closed out.\42\
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    \42\ In addition to these amendments to Regulation SHO, recently 
we have taken other actions aimed at reducing fails to deliver and 
addressing potentially abusive ``naked'' short selling. For example, 
in July 2008, we published an emergency order under section 12(k) of 
the Exchange Act (the ``July Emergency Order'') that temporarily 
restricted ``naked'' short selling in the publicly traded securities 
of nineteen financial institutions. See Exchange Act Release No. 
58166 (July 15, 2008), 73 FR 55169 (July 21, 2008) (imposing 
borrowing and delivery requirements on short sales of the equity 
securities of nineteen financial companies); see also Exchange Act 
Release No. 58248 (July 29, 2008), 73 FR 45257 (Aug. 4, 2008) 
(extending the July Emergency Order such that it expired on August 
12, 2008). In September 2008, we published an emergency order that 
temporarily banned short selling in the publicly traded securities 
of approximately 1,000 financial institutions (the ``Short Sale 
Ban''). See Exchange Act Release No. 58592 (Sept. 18, 2008), 73 FR 
55169 (Sept. 24, 2008); see also Exchange Act Release No. 58611 
(Sept. 21, 2008), 73 FR 55556 (Sept. 25, 2008) (amending the Short 
Sale Ban). The Short Sale Ban expired on October 8, 2008. In 
addition, in the September Emergency Order, we adopted and made 
immediately effective a ``naked'' short selling anti-fraud rule, 
Rule 10b-21, aimed at sellers, including broker-dealers acting for 
their own accounts, who deceive certain specified persons about 
their intention or ability to deliver securities in time for 
settlement and that fail to deliver securities by settlement date. 
See September Emergency Order. Following the issuance of the 
September Emergency Order, we adopted final amendments making Rule 
10b-21 permanent. See Anti-Fraud Rule Adopting Release, 73 FR 61666; 
see also Anti-Fraud Rule Proposing Release, 73 FR 15376. In 
addition, on April 8, 2009, we proposed amendments to Regulation SHO 
that, if adopted, would add a short sale price test restriction or 
short sale circuit breaker rule to Regulation SHO. See Exchange Act 
Release No. 59748 (Apr. 10, 2009), 74 FR 18042 (Apr. 20, 2009) (the 
``Short Sale Price Test Proposing Release'').
---------------------------------------------------------------------------

    As noted above, since the adoption of temporary Rule 204T and the 
elimination of Regulation SHO's options market maker exception, we have 
seen a significant reduction in the number of fails to deliver in all 
equity securities. To continue advancing our goal of reducing fails to 
deliver by maintaining the reductions in fails to deliver achieved by 
the adoption of temporary Rule 204T, as well as other actions taken by 
the Commission, and addressing potentially abusive ``naked'' short 
selling, we are adopting the substance of temporary Rule 204T in a 
permanent rule, Rule 204. We continue to believe that strengthening the 
close-out requirements of Regulation SHO will further help to protect 
and enhance the operation, integrity, and stability of the markets, as 
well as help reduce potential short selling abuses.

III. Discussion of Rule 204 of Regulation SHO

    As discussed in more detail below, we are maintaining the structure 
of temporary Rule 204T with limited modifications to address 
commenters' concerns. In discussing the provisions of Rule 204, we 
highlight below some of the main issues, concerns, and suggestions 
raised by commenters.\43\
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    \43\ See supra note 12.
---------------------------------------------------------------------------

A. Rule 204's Close-Out Requirement

1. Close-Out Period
    In Rule 204(a), we are adopting the close-out requirements of 
temporary Rule 204T(a) without modification. Temporary Rule 204T(a) 
provides that a participant of a registered clearing agency must 
deliver securities to a registered clearing agency for clearance and 
settlement on a long or short sale in any equity security by settlement 
date, or if a participant of a registered clearing agency has a fail to 
deliver position at a registered clearing agency in any equity security 
for a long or short sale transaction in that equity security, the 
participant shall, by no later than the beginning of regular trading 
hours \44\ on the settlement day \45\ following the settlement date 
(i.e., T+4), immediately close out the fail to deliver position by 
borrowing or purchasing securities of like kind and quantity.\46\
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    \44\ ``Regular trading hours'' has the same meaning as in Rule 
600(b)(64) of Regulation NMS. Rule 600(b)(64) provides that 
``Regular trading hours means the time between 9:30 a.m. and 4:00 
p.m. Eastern Time, or such other time as is set forth in the 
procedures established pursuant to Sec.  242.605(a)(2).''
    \45\ The term ``settlement day'' is defined in Rule 203(c)(5) of 
Regulation SHO as: ``* * * any business day on which deliveries of 
securities and payments of money may be made through the facilities 
of a registered clearing agency.'' 17 CFR 242.203(c)(5).
    \46\ See temporary Rule 204T(a).
---------------------------------------------------------------------------

    Under certain circumstances, temporary Rule 204T provides 
additional time during which fails to deliver may be closed out. 
Specifically, temporary Rule 204T(a)(1) and (a)(3) provide that, 
subject to certain conditions, fails to deliver resulting from long 
sales or certain bona fide market making activity must be closed out by 
no later than the beginning of regular trading hours on the third 
settlement day after settlement date (i.e., T+6).\47\
---------------------------------------------------------------------------

    \47\ In addition, temporary Rule 204T(a)(2) provides that fails 
to deliver resulting from sales of securities pursuant to Rule 144 
of the Securities Act of 1933 (``Rule 144 Securities'') must be 
closed out by no later than the beginning of regular trading hours 
on the thirty-sixth consecutive settlement day following settlement 
date (i.e., T+39).
---------------------------------------------------------------------------

    In response to our requests for comment, a number of commenters 
expressed concerns regarding the time periods within which fails to 
deliver must be closed out under temporary Rule 204T. Commenters 
expressed concern that temporary Rule 204T's

[[Page 38270]]

requirement to close-out fails to deliver by no later than the 
beginning of regular trading hours can create buying pressure at the 
open, that may temporarily distort the price of the security.\48\ To 
minimize the market impact of the close-out requirement, commenters 
suggested allowing participants to close out fails to deliver by the 
end of regular trading hours, or the close of business on the New York 
Stock Exchange (``NYSE''), rather than by no later than the beginning 
of regular trading hours.\49\ In requesting additional time during the 
day to close out fails to deliver, one commenter noted that such a 
change ``would significantly alleviate the market pressures associated 
with execution of potentially large purchases at the opening of 
trading--a time when markets are particularly susceptible to price 
fluctuations.'' \50\ This commenter also stated that, as a practical 
matter, ``transactions effected at market open to close-out open fail 
positions are no different from those effected later on in the trading 
session because both are part of the same clearance and settlement 
cycle. Thus, providing this relief would not add any delay of 
consequence to the close-out process.'' \51\
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    \48\ See, e.g., letter from Stuart Kaswell, Executive Vice 
President and General Counsel, Managed Funds Association, dated Dec. 
15, 2008 (``MFA''); letter from Edward J. Joyce, President and Chief 
Operating Officer, Chicago Board Options Exchange, dated Dec. 23, 
2008 (``CBOE''); letter from Amal Aly, Managing Director and 
Associate General Counsel, SIFMA, dated Dec. 16, 2008 (``SIFMA''); 
letter from Eric Swanson, General Counsel, BATS Exchange, Inc., 
dated Dec. 29, 2008 (``BATS''); letter from Michael P. McAuley, 
Chair, RMA Committee on Securities Lending, dated Dec. 23, 2008 
(``RMA''); letter from Stefan Gavell, Executive Vice President and 
Head of Regulatory Industry Affairs, State Street Corporation, dated 
Dec. 16, 2008 (``State Street'').
    \49\ See, e.g., letters from SIFMA; MFA; State Street; BATS; 
letter from A. Peter Allman-Ward, Executive Vice President and CFO, 
Wedbush Morgan Securities, Inc., dated Dec. 15, 2008 (``Wedbush'').
    \50\ Letter from SIFMA.
    \51\ See id.
---------------------------------------------------------------------------

    Other commenters requested additional days within which to close 
out fails to deliver in connection with short sales. For example, some 
commenters requested that the Commission extend the close-out period 
for fails to deliver resulting from short sales to three settlement 
days after the fail occurs, consistent with the close-out period for 
fails to deliver resulting from long sales and market making 
activity.\52\ Other commenters requested that the Commission extend the 
close-out requirement for fails to deliver resulting from all sales to 
five settlement days after the fail to deliver position occurs.\53\ 
These commenters stated that the additional time to close out fails to 
deliver would allow the majority of trades to clear and settle on their 
own within a few days following the regular settlement date (i.e, 
T+3).\54\
---------------------------------------------------------------------------

    \52\ See e.g., letter from Peter Kovac, Chief Operating Officer 
and Financial and Operations Principal, EWT, LLC, dated Nov. 25, 
2008 (``EWT''); letter from James S. Chanos, Chairman, Coalition of 
Private Investment Companies, dated Dec. 16, 2008 (``Coalition of 
Private Investment Companies''); letters from SIFMA; MFA; State 
Street.
    \53\ See, e.g., letter CBOE; letter from Boston Options 
Exchange, Chicago Board Options Exchange, International Securities 
Exchange, NASDAQ Options Market, NASDAQ OMX PHLX, NYSE Alternext US, 
NYSE Arca, and The Options Clearing Corporation, dated Dec. 19, 2008 
(``Options Exchanges'').
    \54\ See, e.g., letters from SIFMA; MFA; State Street; CBOE; 
Options Exchanges; Coalition of Private Investment Companies.
---------------------------------------------------------------------------

    Some commenters expressed concerns about the effect of the close-
out requirements of temporary Rule 204T on securities lending.\55\ For 
example, one commenter stated that the compressed time-frame for 
closing out fails to deliver under temporary Rule 204T ``has generated 
over-buying and borrowing of securities that would otherwise settle in 
the normal course, thus impairing liquidity by tying up shares that 
would otherwise be available to natural buyers and sellers.'' \56\ This 
commenter also noted that in practice fails to deliver resulting from 
sales of securities on loan, which are considered ``long'' sales, are 
often closed out in accordance with the time-frames for fails to 
deliver resulting from short sales rather than long sales because 
temporary Rule 204T does not provide sufficient time to determine 
whether or not a fail to deliver position resulted from a long or short 
sale.\57\ According to this commenter, such purchasing activity acts as 
a disincentive to lending and causes institutions to question their 
participation in lending programs.\58\
---------------------------------------------------------------------------

    \55\ As stated in the Rule 204T Adopting Release, if a person 
that has loaned a security to another person sells the security and 
a bona fide recall of the security is initiated within two business 
days after trade date, the person that has loaned the security will 
be ``deemed to own'' the security for purposes of Rule 200(g)(1) of 
Regulation SHO, and such sale will not be treated as a short sale 
for purposes of temporary Rule 204T. In addition, a broker-dealer 
may mark such orders as ``long'' sales provided such marking is also 
in compliance with Rule 200(c) of Regulation SHO. See Rule 204T 
Adopting Release, 73 FR 61713, n. 70.
    \56\ Letter from SIFMA.
    \57\ See letter from SIFMA; see also letter from RMA; letter 
from Heather Traeger, Assistant Counsel, Investment Company 
Institute, dated Dec. 16, 2008 (``ICI'').
    \58\ See letter from SIFMA; see also letter from RMA 
(recommending the extension of the close-out period for fails to 
deliver for all sales to settlement date plus three days (i.e., T+6) 
``to ensure that beneficial owners selling on-loan positions are not 
compromised by close-outs of long sales on T+4'').
---------------------------------------------------------------------------

    Other commenters stated that where the holder of a long position 
sells securities that have been financed through a securities loan, the 
close-out requirements of temporary Rule 204T may not provide 
sufficient time for the securities to be recalled and delivered in time 
for settlement of the sale transaction.\59\ These commenters stated, 
among other things, that temporary Rule 204T's requirement that 
securities be delivered by no later than the beginning of regular 
trading hours does not allow for the completion of the securities 
lending cycle, which may not occur until the close of the DTC 
settlement window on the third settlement day after settlement date 
(i.e., T+6).\60\
---------------------------------------------------------------------------

    \59\ See letters from EWT; BATS; RMA; ICI; Wedbush.
    \60\ See letters from EWT; BATS; RMA; ICI. EWT stated that a 
recall typically occurs to assure that the securities are returned 
on the settlement date for the sale transaction. If the securities 
are not returned by that date, the lender may initiate a buy-in 
process designed to obtain the securities as promptly as possible. 
This buy-in is intended to result in delivery of the securities 
after three business days, such that the lender will not complete 
the buy-in process until the close of the DTC settlement window on 
the third business day following initiation of the buy-in process. 
Accordingly, this commenter recommended, among other things, that we 
should: (1) either (a) create an exception for fails to deliver 
where the securities are loaned but have been recalled or (b) 
confirm that the issuance of a bona fide loan recall notice is a 
valid form of close-out for a fail to deliver; or (2) extend the 
close-out period from settlement date plus three days (i.e., T+6), 
to settlement date plus six days (i.e., T+9) for fails to deliver 
resulting from long sales. See also letter from RMA (stating that 
due to operational complexity and the number of market participants 
involved in the sale of an ``on-loan position,'' it is commonplace 
for a sale to be settled during the day on T+6).
---------------------------------------------------------------------------

    As noted above, the close-out requirements of temporary Rule 204T 
are advancing our goal of further reducing fails to deliver, as 
evidenced in part by preliminary results from OEA regarding its impact 
on the number of fails to deliver.\61\ Thus, we are adopting as a 
permanent rule the structure of the close-out requirements of temporary 
Rule 204T. Specifically, Rule 204(a) provides that a participant of a 
registered clearing agency must deliver securities to a registered 
clearing agency for clearance and settlement on a long or short sale in 
any equity security by settlement date, or if a participant of a 
registered clearing agency has a fail to deliver position at a 
registered clearing agency in any equity security for a long or short 
sale transaction in that equity security, the participant shall, by no 
later than the beginning of regular trading hours \62\ on the 
settlement day \63\

[[Page 38271]]

following the settlement date, immediately close out the fail to 
deliver position by borrowing or purchasing securities of like kind and 
quantity.\64\
---------------------------------------------------------------------------

    \61\ See supra note 8, and accompanying text.
    \62\ See supra note 44 (discussing the definition of the term 
``regular trading hours'' for purposes of Regulation SHO).
    \63\ See supra note 45 (discussing the definition of the term 
``settlement day'' for purposes of Regulation SHO).
    \64\ See Rule 204(a).
---------------------------------------------------------------------------

    In addition, as discussed in more detail below, we are adopting in 
Rule 204(a)(1) and (a)(3) the close-out requirements of temporary Rule 
204T(a)(1) and (a)(3) for fails to deliver resulting from long sales 
and certain bona fide market making activity so that such fails to 
deliver must be closed out by no later than the beginning of regular 
trading hours on the close-out date (i.e., T+6) for such fails to 
deliver.\65\
---------------------------------------------------------------------------

    \65\ In addition, as discussed in Section III.E. below, we are 
adopting the close-out requirements of Rule 204(a)(2) for fails to 
deliver resulting from sales of Rule 144 Securities so that such 
fails to deliver must be closed out by no later than the beginning 
of regular trading hours on the applicable close-out date.
---------------------------------------------------------------------------

    Although we recognize commenters' concerns regarding the potential 
market impact of the close-out requirements of temporary Rule 204T, 
particularly at the market open, we believe that these potential 
effects are justified by the benefits of retaining the strict close-out 
requirements of temporary Rule 204T. As discussed above, since the 
adoption of temporary Rule 204T, and other actions taken by the 
Commission aimed at reducing fails to deliver, there has been a 
significant reduction in fails to deliver. To maintain these declines, 
we believe it is necessary at this time to continue to require that 
participants close out fails to deliver by no later than the beginning 
of regular trading hours on the applicable close-out date. We believe 
that the strict close-out requirements of the temporary rule have 
helped reduce fails to deliver by providing a disincentive to those 
who, but for the rule, may have failed to deliver securities by 
settlement date. In addition, we note that participants have been 
operating pursuant to the close-out requirements of the temporary rule, 
as adopted, and appear to have adjusted to its requirements.\66\
---------------------------------------------------------------------------

    \66\ In discussing the requirement to purchase securities by no 
later than the beginning of regular trading hours on the applicable 
close-out date, some commenters discussed the ability to use, among 
other mechanisms, volume weighted average price (``VWAP'') orders 
entered at the beginning of the day to more effectively manage their 
buy-in risk. See, e.g., letters from Duncan L. Niederaurer, CEO, 
NYSE Euronext and Richard G. Ketchum, NYSE Regulation, Inc., dated 
Dec. 16, 2008 (``NYSE''); ICI. We note that if a participant has a 
fail to deliver position at a registered clearing agency that it 
must close out in accordance with Rule 204 of Regulation SHO, the 
participant may satisfy the close-out requirement to purchase 
securities of like kind and quantity with a VWAP order provided: (i) 
the order to purchase the equity security on a VWAP basis is 
irrevocable and received by no later than the beginning of regular 
trading hours on the applicable close-out date; and (ii) the final 
execution price of any such transaction is not determined until 
after the close of regular trading hours when the VWAP value is 
calculated and the execution is on an agency basis.
---------------------------------------------------------------------------

    We believe that continuing to require that fails to deliver be 
closed out on the day immediately following the day on which the fail 
to deliver occurs is consistent with our goal of reducing fails to 
deliver by maintaining the reductions in fails to deliver achieved by 
the adoption of temporary Rule 204T, as well as other actions taken by 
the Commission, and addressing ``naked'' short selling and, in 
particular, potentially abusive ``naked'' short selling. Although 
extending the time-frames within which fails to deliver must be closed 
out may allow for ordinary course settlement, as several commenters 
contend, we believe that the close-out requirements of Rule 204 are 
necessary to continue to help encourage delivery by settlement date and 
achieve our goal of not allowing fails to deliver to persist.\67\
---------------------------------------------------------------------------

    \67\ See supra note 16 (discussing the standard three-day 
settlement cycle).
---------------------------------------------------------------------------

    As we discussed in the Rule 204T Adopting Release, we believe that 
delivery on sales should be made by settlement date.\68\ In the Rule 
204T Adopting Release, we noted that the vast majority of fails to 
deliver are closed out within five days after T+3.\69\ In addition, in 
that release we referenced a recent analysis by OEA that found that 
more than half of all fails to deliver and more than 70% of all fail to 
deliver positions are closed out within two settlement days after 
T+3.\70\ We also noted in that release, however, that although this 
information shows that delivery is being made, it demonstrates that 
often delivery is not being made until several days following the 
standard three-day settlement cycle.
---------------------------------------------------------------------------

    \68\ See Rule 204T Adopting Release, 73 FR 61712-61713.
    \69\ See id.
    \70\ See id. at n. 68. We note that OEA's analysis examined the 
period from January to July 2008 and used the age of the fail to 
deliver position as reported by the NSCC. The NSCC data included 
only securities with at least 10,000 shares in fails to deliver. 
These numbers also included securities that were not subject to the 
close-out requirement in Rule 203(b)(3) of Regulation SHO, which 
applies only to ``threshold securities'' as defined in Rule 
203(c)(6) of Regulation SHO.
---------------------------------------------------------------------------

    In addition, as discussed above, fails to deliver may be part of a 
scheme to manipulate the price of a security. We are also concerned 
about the negative effect that fails to deliver and potentially abusive 
``naked'' short selling may have on the market and the broader economy, 
including on investor confidence.\71\ The close-out requirements of 
Rule 204 help address these concerns by prohibiting the persistence of 
fails to deliver.
---------------------------------------------------------------------------

    \71\ See, e.g., Anti-Fraud Rule Adopting Release, 73 FR 61666.
---------------------------------------------------------------------------

    We understand, however, that fails to deliver may occur from long 
sales within the first two settlement days after settlement date for 
legitimate reasons.\72\ 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.\73\
---------------------------------------------------------------------------

    \72\ See Rule 204T Adopting Release, 73 FR 61713.
    \73\ See id.
---------------------------------------------------------------------------

    Thus, in Rule 204(a)(1), we are adopting, with certain limited 
modifications, the provisions of temporary Rule 204T(a)(1) relating to 
closing out fails to deliver resulting from long sales. Specifically, 
Rule 204(a)(1) provides that if a participant of a registered clearing 
agency has a fail to deliver position at a registered clearing agency 
in any equity security and the participant can demonstrate on its books 
and records that such fail to deliver position resulted from a long 
sale, the participant shall by no later than the beginning of regular 
trading hours on the third consecutive settlement day following the 
settlement date immediately close out the fail to deliver position by 
purchasing or borrowing securities of like kind and quantity.\74\
---------------------------------------------------------------------------

    \74\ See Rule 204(a)(1).
---------------------------------------------------------------------------

    In response to a request for comment, some commenters requested 
that we provide additional flexibility to the close-out requirements of 
temporary Rule 204T(a)(1) by allowing participants to borrow as well as 
purchase securities to close out such fails to deliver.\75\ In 
temporary Rule 204T(a)(1), we required a participant to purchase 
securities to close out fails to deliver resulting from long sales to 
be consistent with the close-out requirements of Rule 203(b)(3) of 
Regulation SHO which require that a participant that has a fail to 
deliver position in a threshold security for thirteen consecutive 
settlement days immediately thereafter close out the fail to deliver 
position by purchasing securities of like kind and quantity.\76\
---------------------------------------------------------------------------

    \75\ See e.g., letters from SIFMA; EWT; MFA; State Street; BATS; 
Wedbush; Angel.
    \76\ See 17 CFR 242.203(b)(3). Some commenters requested 
clarification regarding a broker-dealer's obligations under FINRA 
Rule 11810 (the ``FINRA Buy-In Rule'') and the close-out 
requirements of temporary Rule 204T. See, e.g., letter from Joseph 
Zangri, Chief Compliance Officer, Bloomberg Tradebook, LLC (Dec. 16, 
2008) (``Bloomberg''). We note that because the requirements of Rule 
204 apply to broker-dealers involved in the sell-side of a 
transaction, whereas the FINRA Buy-In Rule sets forth procedures 
applicable to a purchaser that chooses to buy-in a seller, we 
believe that these rules apply separate and distinct obligations on 
market participants and, therefore, are not in conflict.

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

[[Page 38272]]

    Commenters stated that borrowing securities serves the same purpose 
as purchasing securities to close out fails to deliver.\77\ In 
addition, commenters noted that allowing a borrow to close out such 
fails would be consistent with the close-out requirements for short 
sales. After considering the comments received, we provide in Rule 
204(a)(1) the ability for a participant to close out a fail to deliver 
position resulting from a long sale by purchasing or borrowing 
securities.\78\ We believe that such an amendment is consistent with 
our goal of reducing fails to deliver by maintaining the reductions in 
fails to deliver achieved by the adoption of temporary Rule 204T, as 
well as other actions taken by the Commission, because it will provide 
additional flexibility to participants in closing out fail to deliver 
positions.\79\ Permitting a borrow as well as a purchase will also make 
the close-out requirements of Rule 204(a)(1) consistent with the close-
out requirements of Rule 204(a).
---------------------------------------------------------------------------

    \77\ See e.g., letter from MFA.
    \78\ See Rule 204(a)(1). Although Rule 204(a)(1) permits 
borrowing to close out a fail to deliver position resulting from a 
long sale, broker-dealers must also comply with Rule 203(a) of 
Regulation SHO. Rule 203(a)(1) provides that, unless an exception 
applies, ``[i]f a broker or dealer knows or has reasonable grounds 
to believe that the sale of an equity security was or will be 
effected pursuant to an order marked ``long,'' such broker or dealer 
shall not lend or arrange for the loan of any security for delivery 
to the purchaser's broker after the sale, or fail to deliver a 
security on the date delivery is due.'' 17 CFR 242.203(a).
    \79\ See letter from CBOE (stating that the close-out procedures 
under temporary Rule 204T for fails to deliver attributable to bona 
fide market making activity should be amended to permit borrows or 
purchases throughout the close-out period).
---------------------------------------------------------------------------

    As we stated with respect to Rule 204T's close-out requirements, 
under Rule 204's close-out requirements for fails to deliver resulting 
from long or short sales, a participant must take affirmative action to 
close out a fail to deliver position by purchasing or borrowing 
securities.\80\ Thus, a participant may not offset the amount of its 
fail to deliver position with shares that the participant receives or 
will receive during the applicable close-out date (i.e., during T+4 or 
T+6, as applicable).\81\ In addition, as we stated in the Rule 204T 
Adopting Release, to meet its close-out obligation a participant also 
must be able to demonstrate on its books and records that on the 
applicable close-out date, it purchased or borrowed shares in the full 
quantity of its fail to deliver position and, therefore, that the 
participant has a net flat or net long position on its books and 
records on the applicable close-out date (i.e., during T+4 or T+6, as 
applicable).\82\
---------------------------------------------------------------------------

    \80\ See Rule 204T Adopting Release, 73 FR 61710.
    \81\ In determining its close-out obligation, a participant may 
rely on its net delivery obligation as reflected in its notification 
from NSCC regarding its securities delivery and payment obligations, 
provided such notification is received prior to the beginning of 
regular trading hours on the applicable close-out date. See Rule 
204T Adopting Release, 73 FR 61711, at n. 46 (and accompanying 
text).
    \82\ See Rule 204T Adopting Release, 73 FR 61711. Both temporary 
Rule 204T and Rule 204 require that a participant purchase or borrow 
shares, as applicable, to close out a fail to deliver position. 
Accordingly, the purchase or borrow on the applicable close-out date 
must be for the full quantity of the fail to deliver position that 
is subject to the close-out requirement. In addition, where a 
participant subject to the close-out requirement purchases or 
borrows securities on the applicable close-out date and on that same 
date engages in sale transactions that can be used to re-establish 
or otherwise extend the participant's fail position, and for which 
the participant is unable to demonstrate a legitimate economic 
purpose, the participant will not be deemed to have satisfied the 
close-out requirement.
---------------------------------------------------------------------------

    Consistent with temporary Rule 204T, Rule 204 defines a 
``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.'' 
\83\ As we noted in the Rule 204T Adopting Release, this definition is 
consistent with Rule 15c6-1 under the Exchange Act that 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.\84\
---------------------------------------------------------------------------

    \83\ See Rule 204(g)(1); see also Rule 204T(f)(1).
    \84\ See 17 CFR 240.15c6-1; see also Rule 204T Adopting Release, 
73 FR 61711.
---------------------------------------------------------------------------

    Because most transactions settle by T+3 and because delivery on all 
sales should be made by settlement date, participants should consider 
having in place policies and procedures to help ensure that delivery is 
being made by settlement date. As we stated in the Rule 204T Adopting 
Release, we intend to examine participants' policies and procedures to 
determine whether, among other things, such policies and procedures 
require broker-dealers to monitor for delivery by settlement date.\85\
---------------------------------------------------------------------------

    \85\ See Rule 204T Adopting Release, 73 FR 61711. Of course, 
broker-dealers must comply with any applicable SRO policies and 
procedures requirements. For example, NASD Rule 3010 contains, among 
other things, written procedures requirements for member firms.
---------------------------------------------------------------------------

    Consistent with the existing close-out requirements of Rule 
203(b)(3) of Regulation SHO and temporary Rule 204T, the close-out 
requirements of Rule 204 are based on a participant's fail to deliver 
position at a registered clearing agency. As noted above, the NSCC 
clears and settles the majority of equity securities trades conducted 
on the exchanges and in the over-the-counter markets. NSCC clears and 
settles trades through the CNS system, which nets the securities 
delivery and payment obligations of all of its members. NSCC notifies 
its members of their securities delivery and payment obligations daily. 
Because Rule 204 is based on a participant's fail to deliver position 
at a registered clearing agency, it is consistent with current 
settlement practices and procedures and with the Regulation SHO 
framework regarding delivery of securities.\86\
---------------------------------------------------------------------------

    \86\ See temporary Rule 204T; see also 17 CFR 242.203(b)(3).
---------------------------------------------------------------------------

2. Application to All Equity Securities
    Consistent with temporary Rule 204T, the close-out requirements of 
Rule 204 apply to fails to deliver in all equity securities. As 
discussed in the Rule 204T Adopting Release, this requirement differs 
from the close-out requirement of Rule 203(b)(3) of Regulation SHO that 
applies the close-out requirements of that rule only to those 
securities with a large and persistent level of fails to deliver, i.e., 
threshold securities.\87\
---------------------------------------------------------------------------

    \87\ See Rule 204T Adopting Release, 73 FR 61711; see also 17 
CFR 242.203(b)(3).
---------------------------------------------------------------------------

    A purpose of Rule 204 is to help limit the use of ``naked'' short 
selling as part of a manipulative scheme. To achieve this purpose, we 
are applying the rule to all equity securities, regardless of the level 
or persistence of any fails to deliver in such securities. In addition, 
as discussed above, we believe that all sellers of equity 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. We believe this should be the 
case for sales in all equity securities and are adopting this rule to 
further that goal.
    We note that in the Rule 204T Adopting Release, we requested 
comment regarding whether temporary Rule 204T should be expanded to 
apply to debt as well as equity securities. In response, commenters 
opposed the extension of temporary Rule 204T to debt securities.\88\ 
One such commenter stated that the Commission has expressly carved out 
debt securities from all short sale regulations, including Regulation 
SHO, citing in support the non-manipulative potential associated

[[Page 38273]]

with fixed income securities.\89\ This commenter stated that it 
believes that certain structured products should also be excluded from 
the application of temporary Rule 204T.\90\ This commenter 
acknowledged, however, that the ``equity'' status of some structured 
products may not be clear and its view that it may not be feasible for 
the Commission to make broad-based determinations on whether categories 
of securities constitute debt or equity.\91\
---------------------------------------------------------------------------

    \88\ See, e.g., letters from SIFMA; MFA; State Street.
    \89\ See letter from SIFMA (referring to, among other things, 
Securities Exchange Act Release No. 56206 (Aug. 6, 2007), 72 FR 
45094 (Aug. 10, 2007)).
    \90\ See id.
    \91\ See id.
---------------------------------------------------------------------------

    After considering the comments and because all other provisions of 
Regulation SHO apply only to equity securities, at this time, we are 
not extending Rule 204 to securities other than equity securities. We 
note, however, for those securities for which market participants 
believe the ``equity'' status is unclear, we will consider on a case-
by-case basis whether the provisions of Rule 204, and Regulation SHO 
more generally, apply.
    Regulation SHO, as adopted in 2004, was a first step in reducing 
persistent fails to deliver and addressing abusive ``naked'' short 
selling. In Regulation SHO, we took a targeted approach, imposing 
additional delivery requirements on securities with a substantial and 
persistent amount of fails to deliver. As we stated in the 2004 
Regulation SHO Adopting Release, we took this targeted approach at that 
time in an effort to address the problem but at the same time not to 
burden the vast majority of securities where there are not similar 
concerns regarding settlement.\92\ In addition, Regulation SHO's close-
out requirement was adopted to address potential abuses that may occur 
with large, extended fails to deliver.\93\ We also noted in the 2004 
Regulation SHO Adopting Release, however, that we would pay close 
attention to the operation and efficacy of the provisions we were 
adopting at that time and would consider whether any further action was 
warranted.\94\
---------------------------------------------------------------------------

    \92\ See 2004 Regulation SHO Adopting Release, 69 FR 48016.
    \93\ See id. at 48017.
    \94\ See id. at 48018.
---------------------------------------------------------------------------

    Because of continued concerns about the potentially negative market 
impact of fails to deliver, and the fact that through our monitoring of 
the efficacy of Regulation SHO's close-out requirement we continued to 
observe threshold securities with fail to deliver positions that were 
not being closed out, we eliminated the ``grandfather'' and options 
market maker exceptions to Regulation SHO's close-out requirements.\95\
---------------------------------------------------------------------------

    \95\ See supra Section II (discussing the elimination of 
Regulation SHO's ``grandfather'' and options market maker 
exceptions).
---------------------------------------------------------------------------

    However, as we stated in the Rule 204T Adopting Release, we were 
concerned that the close-out requirements of Regulation SHO, as 
adopted, had not gone far enough in reducing fails to deliver and 
addressing potentially abusive ``naked'' short selling.\96\ In light of 
the recent instability and lack of investor confidence in the financial 
markets,\97\ we believe that the requirements of temporary Rule 204T 
should be made permanent to maintain the reduced fails to deliver and 
to address potentially abusive ``naked'' short selling.
---------------------------------------------------------------------------

    \96\ See Rule 204T Adopting Release, 73 FR 61711-61712.
    \97\ See, e.g., letter from Leland Chan, General Counsel, 
California Bankers Association, dated Aug. 21, 2008; letter from 
Eric C. Jensen, Esq., Cooley Godward Kronish L.L.P., dated Aug. 21, 
2008; letter from Steven B. Boehm and Cynthia M. Krus, Sutherland 
Asbill Brennan LLP, dated July 31, 2008; letter from James J. Angel, 
Professor of Finance, Georgetown University, McDonough School of 
Business, dated Aug. 20, 2008; letter from Tuan Nguyen, dated Aug. 
8, 2008; see also Short Sale Price Test Proposing Release, 74 FR 
18042 (proposing short sale price test restrictions and short sale 
circuit breaker rules due to recent changes in market conditions and 
a deterioration in investor confidence).
---------------------------------------------------------------------------

    We note that one commenter to the Rule 204T Adopting Release 
suggested eliminating temporary Rule 204T of Regulation SHO, such that 
only the close-out requirements of Rule 203(b)(3) would apply.\98\ If 
we were to take such an approach, Regulation SHO's close-out 
requirements would apply only to threshold securities and fails to 
deliver in such securities would not have to be closed out until such 
fails to deliver had persisted for thirteen consecutive settlement 
days. As discussed above, we are applying the close-out requirements of 
Rule 204 to all equity securities to further our goal of reducing fails 
to deliver by maintaining the reductions in fails to deliver achieved 
by the adoption of temporary Rule 204T, as well as other actions taken 
by the Commission, in both threshold and non-threshold securities and, 
thereby, also help continue to address abusive ``naked'' short selling 
in such securities. In the Rule 204T Adopting Release, we noted that 
prior to its adoption, fails to deliver in non-threshold securities 
averaged approximately 624 million shares or $4.6 billion in value per 
day from January to July 2008.\99\ Since adoption of the temporary 
rule, and in connection with other Commission actions to address fails 
to deliver, this number has declined significantly such that from 
December 2008 to March 2009, OEA estimates that fails to deliver in 
non-threshold securities averaged approximately 307 million shares or 
$1.1 billion in value per day. We are applying Rule 204's close-out 
requirements to all equity securities to help maintain the benefits 
already achieved.
---------------------------------------------------------------------------

    \98\ See letter from CBOE.
    \99\ See Rule 204T Adopting Release, 73 FR 61712, n. 60. We also 
noted these fails accounted for approximately 54.5% (56.6%) of all 
fail to deliver shares (by dollar value).
---------------------------------------------------------------------------

3. Allocation of a Fail To Deliver Position
    Temporary Rule 204T(d) provides that a participant may reasonably 
allocate its responsibility to close out a fail to deliver position to 
another broker-dealer from which the participant receives trades for 
clearance and settlement.\100\ Consistent with temporary Rule 204T(d), 
Rule 204(d) provides for allocation of a fail to deliver position by a 
participant to a broker-dealer. Specifically, Rule 204(d) provides that 
if a participant of a registered clearing agency reasonably allocates a 
portion of a fail to deliver position to another registered broker or 
dealer for which it clears trades or from which it receives trades for 
settlement, based on such broker's or dealer's short position, the 
provisions of Rule 204(a) and (b) relating to such fail to deliver 
position shall apply to such registered broker or dealer that was 
allocated the fail to deliver position, and not to the 
participant.\101\
---------------------------------------------------------------------------

    \100\ See temporary Rule 204T(d); see also 17 CFR 
242.203(b)(3)(vi). Rule 203(b)(3)(vi) of Regulation SHO provides 
that ``[i]f a participant of a registered clearing agency reasonably 
allocates a portion of a fail to deliver position to another 
registered broker or dealer for which it clears trades or for which 
it is responsible for settlement, based on such broker or dealer's 
short position, then the provisions of this paragraph (b)(3) 
relating to such fail to deliver position shall apply to the portion 
of such registered broker or dealer that was allocated the fail to 
deliver position, and not to the participant.''
    \101\ See Rule 204(d).
---------------------------------------------------------------------------

    Thus, participants that are able to identify the accounts of 
broker-dealers for which they clear or from which they receive trades 
for settlement may allocate the responsibility to close out the fail to 
deliver position to the particular broker-dealer account(s) whose 
trading activities have caused the fail to deliver position provided 
the allocation is reasonable (e.g., the allocation must be timely). 
Absent such identification, however, the participant would remain 
subject to the close-out requirement.\102\
---------------------------------------------------------------------------

    \102\ One commenter requested that we clarify whether an 
allocated broker-dealer may reasonably re-allocate to the broker-
dealer from which it received the trade all or a portion of the fail 
to deliver position that it was allocated. This commenter stated 
that such re-allocation may continue until the fail position is 
allocated to the ultimate initiating broker-dealer. See letter from 
Bloomberg. We note that Rule 204(d) applies only to the allocation 
by a participant to a registered broker or dealer for which it 
clears trades or from which it receives trades for settlement. Thus, 
if a participant allocates all or a portion of a fail to deliver 
position to a broker-dealer, the close-out requirements of Rule 204 
will apply to that allocated broker-dealer. This is consistent with 
the allocation provisions of temporary Rule 204T and Rule 203(b)(3) 
of Regulation SHO. Rule 204 does not, by its terms, apply to the 
allocation of costs by a broker-dealer in connection with meeting 
its close-out requirements.

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

[[Page 38274]]

    If a participant allocates a fail to deliver position to a broker-
dealer in accordance with Rule 204(d), such that the close-out 
requirements of Rule 204(a) apply to that broker-dealer, the broker-
dealer to which the position was allocated must be able to demonstrate 
that on the applicable close-out date, it purchased or borrowed shares 
in the full quantity of the fail to deliver position allocated to it, 
and that it has a net flat or net long position on its books and 
records for that security on the applicable close-out date.\103\
---------------------------------------------------------------------------

    \103\ See Rule 204(d); see also supra note 82.
---------------------------------------------------------------------------

    In addition, as discussed above and consistent with temporary Rule 
204T, the close-out requirements of Rule 204 require that the allocated 
broker-dealer take affirmative action to close out the fail to deliver 
position by purchasing or borrowing securities. Thus, a broker-dealer 
allocated a fail to deliver position may not offset the amount of its 
fail to deliver position with shares that the broker-dealer receives or 
will receive during the applicable close-out date (i.e., during T+4 or 
T+6, as applicable).\104\
---------------------------------------------------------------------------

    \104\ See supra note 81 and supporting text.
---------------------------------------------------------------------------

    Temporary Rule 204T(d) imposes a notification requirement on a 
broker-dealer that has been allocated responsibility for complying with 
the rule's requirements. Specifically, temporary Rule 204T(d) provides 
that a broker-dealer that has been allocated a portion of a fail to 
deliver position that does not comply with the provisions of temporary 
Rule 204T(a) must immediately notify the participant that it has become 
subject to the borrowing requirements of temporary Rule 204T(b).\105\ 
In the Rule 204T Adopting Release, we stated that we adopted this 
notification requirement so that participants would know when a broker-
dealer for which they clear and settle trades has become subject to the 
temporary rule's borrowing requirements.\106\ We did not receive any 
comments specific to this notification requirement. We believe that the 
reasons for adopting this notification requirement in temporary Rule 
204T(d) apply to Rule 204(d) as well. Thus, we have determined to 
maintain the requirement under Rule 204(d) that a broker-dealer that 
has been allocated a portion of a fail to deliver position that does 
not comply with the provisions of Rule 204(a) must immediately notify 
the participant that it has become subject to the borrowing 
requirements of Rule 204(b).\107\
---------------------------------------------------------------------------

    \105\ See temporary Rule 204T(d).
    \106\ See Rule 204T Adopting Release, 73 FR 61711.
    \107\ See Rule 204(d).
---------------------------------------------------------------------------

 B. Rule 204(b)--Borrowing Requirement

 1. Borrowing Requirement
    We are adopting in Rule 204(b) the requirements of temporary Rule 
204T(b) without modification. If a participant does not purchase or 
borrow shares, as applicable, to close out a fail to deliver position 
in accordance with Rule 204, the participant violates the close-out 
requirement of the rule. Rule 204(b), like temporary Rule 204T(b), also 
imposes on the participant and on all broker-dealers from which that 
participant receives trades for clearance and settlement (including 
introducing and executing brokers), a requirement to borrow or arrange 
to borrow securities prior to accepting or effecting further short 
sales in that security. Specifically, Rule 204(b) provides that the 
participant and any broker-dealer from which it receives trades for 
clearance and settlement, including any market maker that is otherwise 
entitled to rely on the exception provided in Rule 203(b)(2)(iii) of 
Regulation SHO,\108\ may not accept a short sale order in an equity 
security from another person, or effect a short sale order in such 
equity security for its own account, to the extent that the broker-
dealer submits its short sales to that participant for clearance and 
settlement, without first borrowing the security, or entering into a 
bona-fide arrangement to borrow the security, until the participant 
closes out the fail to deliver position by purchasing securities of 
like kind and quantity and that purchase has cleared and settled at a 
registered clearing agency.\109\
---------------------------------------------------------------------------

    \108\ See 17 CFR 242.203(b)(2)(iii) (providing an exception from 
Regulation SHO's ``locate'' requirement for short sales effected by 
a market maker in connection with bona fide market making activities 
in the securities for which the exception is claimed).
    \109\ See Rule 204(b). The borrow requirements of Rule 204(b) 
are also consistent with the requirements of Rule 203(b)(3)(iv) of 
Regulation SHO for a participant that has not closed out a fail to 
deliver position in a threshold security that has persisted for 
thirteen consecutive settlement days. See 17 CFR 242.203(b)(3)(iv). 
Rule 203(b)(3)(iv) of Regulation SHO provides that ``[i]f a 
participant of a registered clearing agency has a fail to deliver 
position at a registered clearing agency in a threshold security for 
thirteen consecutive settlement days, the participant and any broker 
or dealer for which it clears transactions, including any market 
maker that would otherwise be entitled to rely on the exception 
provided in paragraph (b)(2)(iii) of this section, many not accept a 
short sale order in the threshold security from another person, or 
effect a short sale in the threshold security for its own account, 
without borrowing the security or entering into a bona fide 
arrangement to borrow the security, until the participant closes out 
the fail to deliver position by purchasing securities of like kind 
and quantity''.
---------------------------------------------------------------------------

    We believe it is appropriate to include in the rule borrow 
requirements for broker-dealers, including participants, that sell 
short a security for which a fail to deliver position has not been 
closed out in accordance with the requirements of the rule. We believe 
that the borrow requirements of Rule 204(b) will further our goal of 
limiting fails to deliver, thereby addressing abusive ``naked'' short 
selling by promoting the prompt and accurate clearance and settlement 
of securities transactions. By requiring that participants and broker-
dealers from which they receive trades for clearance and settlement 
borrow or arrange to borrow securities prior to accepting or effecting 
short sales in the security that has a fail to deliver position that 
has not been closed out, the rule will help to ensure that shares will 
be available for delivery on the short sale by settlement date and, 
thereby, help to avoid additional fails to deliver occurring in the 
security.
    One commenter asked for clarification regarding whether a 
participant ceases to be subject to the borrow requirements of 
temporary Rule 204T(b) if that participant no longer has a fail to 
deliver position at a registered clearing agency due the participant 
borrowing the securities or the participant receiving securities from 
the seller (e.g., in connection with long sales).\110\ Temporary Rule 
204T(b) imposes short sale borrowing requirements until the participant 
closes out the fail to deliver position by purchasing securities of 
like kind and quantity and that purchase has cleared and settled at a 
registered clearing agency. Thus, under temporary Rule 204T regardless 
of whether a participant borrows or receives delivery of securities, 
the requirements of temporary Rule 204T(b) continue to apply until the 
participant purchases securities to close out the fail to deliver 
position and that purchase has cleared and settled at a registered 
clearing agency.
---------------------------------------------------------------------------

    \110\ See letter from SIFMA.
---------------------------------------------------------------------------

    We have incorporated these same requirements into Rule 204(b) 
without modification. Rule 204(b) requires the purchase and clearance 
and settlement

[[Page 38275]]

of shares purchased to help ensure that the fail to deliver position is 
closed out before the participant, and broker-dealers from which they 
receive trades for clearance and settlement, can accept or effect 
additional short sales without first borrowing or arranging to borrow 
such securities. Moreover, the provisions of Rule 204(b) are intended 
to act as an additional incentive to broker-dealers to deliver 
securities by settlement date, and to close out fail to deliver 
positions in accordance with the requirements of Rule 204. We believe 
that these goals would not be furthered absent the purchase requirement 
of Rule 204(b).
    As discussed above in Section III.A.3, Rule 204(d) provides that a 
participant may reasonably allocate (e.g., the allocation must be 
timely) its responsibility to close out a fail to deliver position to 
another broker-dealer for which the participant clears or from which 
the participant receives trades for settlement. Thus, to the extent 
that the participant can identify the broker-dealer(s) that contributed 
to the fail to deliver position, and the participant has reasonably 
allocated the close-out obligation to the broker-dealer(s), the 
requirement to borrow or arrange to borrow prior to effecting further 
short sales in that security will apply to only those particular 
broker-dealer(s).
    Rule 204(b), however, includes an exception from the borrowing 
requirements for any broker-dealer that can demonstrate that it was not 
responsible for any part of the fail to deliver position of the 
participant. We have incorporated into Rule 204(b) the language of 
temporary Rule 204T(b)(1), without modification. Thus, Rule 204(b) 
provides that a broker-dealer shall not be subject to the requirements 
of paragraph (b) of Rule 204 if the broker-dealer timely certifies to 
the participant that it has not incurred a fail to deliver position on 
settlement date for a long or short sale in an equity security for 
which the participant has a fail to deliver position at a registered 
clearing agency or that the broker-dealer is in compliance with the 
requirements of Rule 204(e).\111\ We have included this exception 
because we do not believe that a broker-dealer should be subject to the 
borrowing requirements of the temporary rule if the broker-dealer can 
demonstrate that it did not incur a fail to deliver position in the 
security on settlement date, or if it has taken steps, in accordance 
with Rule 204(e), to close out the fail to deliver position.
---------------------------------------------------------------------------

    \111\ See Rule 204(b). Rule 204(e) is discussed in detail below 
in Section III.C.
---------------------------------------------------------------------------

2. Notification Requirement
    In connection with the borrowing requirements of Rule 204(b), we 
are incorporating into Rule 204(c) the notification requirement 
contained in temporary Rule 204T(c), without modification. In 
accordance with Rule 204(c), participants must notify all broker-
dealers from which they receive trades for clearance and settlement 
that a fail to deliver position has not been closed out in accordance 
with Rule 204. Specifically, Rule 204(c) provides that the participant 
must notify any broker-dealer from which it receives trades for 
clearance and settlement, including any market maker that is otherwise 
entitled to rely on the exception provided in Rule 203(b)(2)(iii) of 
Regulation SHO,\112\ (a) that the participant has a fail to deliver 
position in an equity security at a registered clearing agency that has 
not been closed out in accordance with the requirements of Rule 204, 
and (b) when the purchase that the participant has made to close out 
the fail to deliver position has cleared and settled at a registered 
clearing agency.\113\
---------------------------------------------------------------------------

    \112\ See supra note 108.
    \113\ See Rule 204(c).
---------------------------------------------------------------------------

    We are including this notification requirement in Rule 204(c) so 
that all broker-dealers that submit trades for clearance and settlement 
to a participant that has a fail to deliver position in a security that 
has not been closed out in accordance with Rule 204 will be on notice 
that short sales in that security to be cleared or settled through that 
participant will be subject to the borrow requirements of Rule 204(b) 
until the fail to deliver position has been closed out, or unless the 
broker-dealer can demonstrate, as specified in Rule 204(b), that it is 
not responsible for the fail to deliver position.

C. Credit for Early Close-Outs

    To encourage early close outs of fail to deliver positions, 
temporary Rule 204T(e) provides that a broker-dealer can satisfy the 
temporary rule's close-out requirement by purchasing securities in 
accordance with the conditions of that provision (i.e., broker-dealers 
will receive ``pre-fail credit'' for the purchase).\114\ Encouraging 
early close outs of fail to deliver positions advances our goal of 
reducing fails to deliver. Thus, we have incorporated the conditions of 
temporary Rule 204T(e) into Rule 204 with some limited modifications to 
address commenters' concerns and to provide clarification regarding the 
applicability of the conditions.
---------------------------------------------------------------------------

    \114\ See temporary Rule 204T(e).
---------------------------------------------------------------------------

    Specifically, Rule 204(e) provides that even if a participant of a 
registered clearing agency has not closed out a fail to deliver 
position at a registered clearing agency in accordance with Rule 
204(a), or has not allocated a fail to deliver position to a broker-
dealer in accordance with Rule 204(d), a broker-dealer shall not be 
subject to the requirements of Rule 204(a) or (b) if the broker-dealer 
purchases or borrows \115\ the securities, and complies with the 
conditions set forth in Rule 204(e)(1) though (4), as described in more 
detail below.
---------------------------------------------------------------------------

    \115\ As discussed in more detail below, in contrast to 
temporary Rule 204T(e), Rule 204(e) permits a broker-dealer to 
borrow as well as purchase securities to close-out a fail to deliver 
position prior to the applicable close-out date.
---------------------------------------------------------------------------

    One commenter requested that we allow a broker-dealer to borrow as 
well as purchase shares to obtain credit for closing out a position 
prior to the applicable close-out date.\116\ Temporary Rule 204T(e) 
provides that a broker-dealer must purchase securities to obtain credit 
for closing out a position prior to the applicable close-out date 
because under Rule 203(b)(3) of Regulation SHO, we understand that 
broker-dealers purchased shares to obtain credit for closing out fails 
to deliver in threshold securities prior to the thirteenth consecutive 
settlement day of having a fail to deliver position in such security. 
We believe, however, that allowing a broker-dealer to borrow as well as 
purchase securities to obtain credit for early close-outs is consistent 
with our goal of maintaining the benefits already achieved under 
temporary Rule 204T, as well as other actions by the Commission, such 
as the recent reduction in fails to deliver, by providing broker-
dealers with additional flexibility in closing out fails to deliver. We 
also note that allowing a borrow is consistent with the close-out 
requirements of Rule 204(a) which permit a participant to close out 
fails to deliver on the applicable close-out date by either borrowing 
or purchasing securities.\117\
---------------------------------------------------------------------------

    \116\ See letter from SIFMA.
    \117\ See Rule 204(a); see also supra Section III.A.1. 
(discussing the close-out requirements of Rule 204(a)).
---------------------------------------------------------------------------

    Consistent with temporary Rule 204T(e)(1), to obtain pre-fail 
credit under Rule 204(e), the purchase or borrow must be ``bona fide.'' 
Thus, where a broker-dealer enters into an arrangement with another 
person to purchase or borrow securities, and the broker-dealer knows or 
has reason to know that the other person will not deliver securities in 
settlement of the

[[Page 38276]]

transaction, the purchase or borrow will not be ``bona fide.'' \118\
---------------------------------------------------------------------------

    \118\ See infra Section III.F. (discussing bona fide purchases 
and borrows for purposes of the close-out requirements of Rule 204); 
see also 17 CFR 203(b)(3)(vii).
---------------------------------------------------------------------------

    Also consistent with temporary Rule 204T(e)(2), Rule 204(e)(2) 
provides that to obtain pre-fail credit, i.e., credit for purchases or 
borrows to close out fails to deliver resulting from short sales, the 
purchase or borrow must be executed after trade date but by no later 
than the end of regular trading hours on settlement date (i.e., T+3) 
for the transaction. Thus, the purchase or borrow must be executed on 
T+1, 2, or 3.
    Temporary Rule 204T(e)(3) provides that the purchase must be of a 
quantity of securities sufficient to cover the entire amount of the 
broker-dealer's open short position. One commenter stated that it 
believes that the broker-dealer should only have to close out its open 
fail to deliver position, and not its open short position.\119\ This 
commenter noted that a broker-dealer's open short position could far 
exceed its open fail to deliver position and, therefore, a requirement 
to purchase securities to close out the broker-dealer's entire open 
short position would not encourage early close outs of fail to deliver 
positions.\120\
---------------------------------------------------------------------------

    \119\ See letter from SIFMA.
    \120\ See id.
---------------------------------------------------------------------------

    The purpose of Rule 204(e) is to encourage broker-dealers to close 
out fail to deliver positions prior to the close-out date. Requiring a 
broker-dealer to close out its open fail to deliver position prior to 
the applicable close-out date is more effective at achieving that goal 
than requiring a broker-dealer to close out its open short position 
prior to the applicable close-date because a broker-dealer's open short 
position could far exceed its open fail to deliver position and, 
therefore, requiring close out of the potentially smaller fail to 
deliver position only is more likely to encourage broker-dealers to 
close out such positions early. Thus, in contrast to temporary Rule 
204T(e)(3), Rule 204(e)(3) provides that a broker-dealer must purchase 
or borrow a quantity of securities sufficient to cover the entire 
amount of that broker-dealer's fail to deliver position at a registered 
clearing agency in that security, rather than the entire amount of the 
broker-dealer's open short position.\121\
---------------------------------------------------------------------------

    \121\ See Rule 204(e)(3).
---------------------------------------------------------------------------

    In addition, to help ensure that broker-dealers purchase sufficient 
shares to close out their fail to deliver positions, Rule 204(e)(4) 
incorporates the condition of temporary Rule 204T(e)(4) that the 
broker-dealer that is purchasing or borrowing securities must be net 
flat or net long in that security on its books and records on the day 
of the purchase or borrow.\122\ Consistent with temporary Rule 
204T(e)(4), Rule 204(e)(4) requires that the broker-dealer demonstrate 
that it has complied with this requirement.\123\ This requirement will 
enable the Commission and SROs to monitor more effectively whether or 
not a broker-dealer has complied with the requirements of Rule 204(e).
---------------------------------------------------------------------------

    \122\ See Rule 204(e)(4).
    \123\ See id.
---------------------------------------------------------------------------

D. Market Makers

    To allow broker-dealers that are market makers to facilitate 
customer orders in a fast moving market, temporary Rule 204T includes a 
limited exception from the temporary rule's close-out requirement for 
fails to deliver attributable to bona fide market making activities by 
registered market makers, options market makers, or other market makers 
obligated to quote in the over-the-counter market. Temporary Rule 204T 
requires that such fails to deliver are closed out by no later than the 
beginning of regular trading hours on the third settlement day 
following the settlement date for the transaction (i.e., T+6).\124\
---------------------------------------------------------------------------

    \124\ See temporary Rule 204T(a)(3).
---------------------------------------------------------------------------

    Similar to commenters' discussions regarding extending the close-
out period to the end of the day for fails to deliver subject to the 
requirements of temporary Rule 204T(a) and (a)(1), commenters requested 
that we extend the market maker close-out period under temporary Rule 
204T(a)(3) to the end of regular trading hours on the close-out date to 
help reduce buy-in risk.\125\
---------------------------------------------------------------------------

    \125\ See, e.g., letters from NYSE; CBOE; The Specialist 
Association (discussing increased volatility at the opening of 
trading due to the requirement under temporary Rule 204T that fails 
to deliver be closed out by no later than the beginning of regular 
trading hours). One commenter recommended that we also extend the 
close-out period to five settlement days after settlement date 
(i.e., T+8) for fails to deliver resulting from bona fide market 
making activity. See letter from CBOE. For the reasons set forth in 
section III.A.1 above, discussing generally the close-out periods 
under Rule 204, we have determined not to extend the close-out 
period to provide additional days to close out such fails to 
deliver.
---------------------------------------------------------------------------

    We recognize commenters' concerns regarding the market impact of 
temporary Rule 204T's close-out requirements, particularly at the 
market open. As discussed above, however, we believe, at this time, 
that it is appropriate to adopt temporary Rule 204T's requirement that 
fails to deliver, including fails to deliver resulting from market 
making activity, are closed out by no later than the beginning of 
regular trading hours on the applicable close-out date to help further 
our goal of reducing fails to deliver by maintaining the reductions in 
fails to deliver achieved by the adoption of temporary Rule 204T, as 
well as other actions taken by the Commission, and to maintain the 
benefits achieved pursuant to temporary Rule 204T. Thus, Rule 204(a)(3) 
provides that if a participant of a registered clearing agency has a 
fail to deliver position at a registered clearing agency in any equity 
security that is attributable to bona fide market making activities by 
a registered market maker, options market maker, or other market maker 
obligated to quote in the over-the-counter market, the participant 
shall by no later than the beginning of regular trading hours on the 
third consecutive settlement day following the settlement date, 
immediately close out the fail to deliver position.\126\
---------------------------------------------------------------------------

    \126\ See Rule 204(a)(3).
---------------------------------------------------------------------------

    In contrast to temporary Rule 204T(a)(3), however, Rule 204(a)(3) 
permits a participant to borrow securities to close-out a fail to 
deliver position. In temporary Rule 204T, we required a participant to 
purchase securities to close out fails to deliver attributable to bona 
fide market making activity to be consistent with the close-out 
requirements of Rule 203(b)(3) of Regulation SHO which require that a 
participant that has a fail to deliver position in a threshold security 
for thirteen consecutive settlement days immediately thereafter close 
out the fail to deliver position by purchasing securities of like kind 
and quantity.\127\
---------------------------------------------------------------------------

    \127\ See 17 CFR 242.203(b)(3).
---------------------------------------------------------------------------

    Rule 204(a)(3) permits a borrow as well as a purchase to close out 
a fail to deliver position because we believe that such an amendment is 
consistent with our goal of maintaining the recent reduction in fails 
to deliver because it will provide additional flexibility to 
participants in closing out fail to deliver positions.\128\ Permitting 
a borrow as well as a purchase will also make the close-out 
requirements of Rule 204(a)(3) consistent with the close-out 
requirements of Rule 204(a) and (a)(1).
---------------------------------------------------------------------------

    \128\ See letter from CBOE (stating that the close-out 
procedures under temporary Rule 204T for fails to deliver 
attributable to bona fide market making activity should be amended 
to permit borrows or purchases throughout the close-out period).
---------------------------------------------------------------------------

    As noted above and consistent with temporary Rule 204T, the close-
out requirements of Rule 204 require that a broker-dealer take 
affirmative action to close out the fail to deliver position by 
purchasing or borrowing securities. Thus, under Rule 204(a)(3), a 
market maker may not offset the amount of a fail to deliver position 
with shares that

[[Page 38277]]

it receives or will receive during the close-out date.\129\
---------------------------------------------------------------------------

    \129\ See supra note 81 and supporting text.
---------------------------------------------------------------------------

    Temporary Rule 204T(b)(2) included an exception from the borrowing 
requirements of temporary Rule 204T(b) for market makers that can 
demonstrate that they do not have an open short position in the equity 
security at the time of any additional short sales.\130\ We do not 
believe that a similar exception is necessary under Rule 204(b) 
because, as with other broker-dealers, a market maker is excepted from 
the borrowing requirements of Rule 204(b) if it timely certifies to the 
participant that it has not incurred a fail to deliver position on 
settlement date for a long or short sale in an equity security for 
which the participant has a fail to deliver position at a registered 
clearing agency or that it is in compliance with the requirements of 
Rule 204(e). Because Rule 204(b) includes an exception applicable to 
all broker-dealers, including market makers, we do not think it is 
necessary to maintain a separate exception applicable only to market 
makers.
---------------------------------------------------------------------------

    \130\ See temporary Rule 204T(b)(2).
---------------------------------------------------------------------------

E. Sales of Certain Deemed To Own Securities

    Temporary Rule 204T(a)(2) includes an exception from the temporary 
rule's close-out requirements for sales of Rule 144 Securities.\131\ 
Specifically, temporary Rule 204T(a)(2) provides that if a participant 
of a registered clearing agency has a fail to deliver position at a 
registered clearing agency in an equity security sold pursuant to Rule 
144 for thirty-five consecutive settlement days after the settlement 
date for a sale in that equity security, the participant shall, by no 
later than the beginning of regular trading hours on the thirty-sixth 
consecutive settlement day following the settlement date for the 
transaction, immediately close out the fail to deliver position by 
purchasing securities of like kind and quantity.\132\
---------------------------------------------------------------------------

    \131\ See 17 CFR 230.144.
    \132\ See temporary Rule 204T(a)(2).
---------------------------------------------------------------------------

    Regulation SHO provides an exception from the ``locate'' 
requirement of Rule 203(b)(1) for situations where a broker-dealer 
effects a short sale on behalf of a customer that is deemed to own the 
security pursuant to Rule 200 of Regulation SHO, although, through no 
fault of the customer or broker-dealer, it is not reasonably expected 
that the security will be in the physical possession or control of the 
broker-dealer by settlement date and, therefore, is a ``short'' sale 
under the marking requirements of Rule 200(g). Rule 203(b)(2)(ii) of 
Regulation SHO provides that in such circumstances, delivery must be 
made on the sale as soon as all restrictions on delivery have been 
removed, and in any event no later than 35 days after trade date, at 
which time the broker-dealer that sold on behalf of the person must 
either borrow securities or close out the open position by purchasing 
securities of like kind and quantity.\133\ In addition, in 2007 we 
adopted amendments to the close-out requirement of Regulation SHO to 
allow fails to deliver resulting from sales of threshold securities 
pursuant to Rule 144 to be closed out within 35 rather than 13 
consecutive settlement days.\134\
---------------------------------------------------------------------------

    \133\ See 17 CFR 242.203(b)(2)(ii). In the 2004 Regulation SHO 
Adopting Release, the Commission stated that it believed that 35 
calendar days is a reasonable outer limit to allow for restrictions 
on a security to be removed if ownership is certain. In addition, 
the Commission noted that Section 220.8(b)(2) of Regulation T of the 
Federal Reserve Board allows 35 calendar days to pay for securities 
delivered against payment if the delivery delay is due to the 
mechanics of the transactions. See 2004 Regulation SHO Adopting 
Release, 69 FR 48015, n.72.
    \134\ See 2007 Regulation SHO Final Amendments, 72 FR 45550-
45551.
---------------------------------------------------------------------------

    We included in temporary Rule 204T an exception for Rule 144 
Securities because these securities are formerly restricted securities 
that a seller is ``deemed to own,'' as defined by Rule 200(a) of 
Regulation SHO.\135\ The securities, however, may not be capable of 
being delivered on the settlement date due to processing delays related 
to removal of the restricted legend and, therefore, sales of these 
securities frequently result in fails to deliver. In addition, this 
exception is consistent with our statements in connection with our 
recent amendments to Rule 203(b)(3) of Regulation SHO which extended 
the close-out requirements of that rule for fails to deliver in 
threshold securities sold pursuant to Rule 144.\136\ We limited the 
exception in temporary Rule 204T to Rule 144 Securities, rather than 
extending the exception to all formerly restricted securities that a 
seller is ``deemed to own,'' to remain consistent with Rule 203(b)(3) 
of Regulation SHO.
---------------------------------------------------------------------------

    \135\ See 17 CFR 242.200(a).
    \136\ See 2007 Regulation SHO Final Amendments, 72 FR 45550-
45551.
---------------------------------------------------------------------------

    In response to a request for comment, one commenter that discussed 
the requirements of temporary Rule 204T(a)(2) relating to fails to 
deliver resulting from sales of Rule 144 Securities urged the 
Commission to retain the exception, and to extend it to cover sales of 
other securities that a person owns, but is unable to deliver on 
settlement date.\137\ In particular, the commenter stated that the 
exception should apply to the same universe of securities to which the 
exception in Rule 203(b)(2)(ii) of Regulation SHO applies.\138\ In 
addition, the commenter stated that for those securities subject to the 
close-out requirements of temporary Rule 204T(a)(2) and the delivery 
requirements of Rule 203(b)(2)(ii) there is confusion as to which time-
frame for closing out fails to deliver resulting from sales of these 
securities should apply.\139\ We note, however, that rather than 
changing the close-out requirement of temporary Rule 204T(a)(2), this 
commenter recommended extending the delivery time-frame of Rule 
203(b)(2)(ii) of Regulation SHO to 35 settlement days, rather than 
calendar days, from trade date.\140\
---------------------------------------------------------------------------

    \137\ See letter from SIFMA.
    \138\ See id.; see also supra note 133, and accompanying text.
    \139\ See letter from SIFMA.
    \140\ See id.
---------------------------------------------------------------------------

    After considering the comments and to provide consistency between 
the delivery requirements of Rule 203(b)(2)(ii) of Regulation SHO and 
the close-out requirements of Rule 204, we are adopting in Rule 
204(a)(2) the requirements of temporary Rule 204T(a)(2) with some 
modifications. Specifically, we are expanding the universe of 
securities to which Rule 204(a)(2) will apply. It will apply to fails 
to deliver resulting from the sale of an equity security that a person 
is ``deemed to own'' pursuant to Rule 200 of Regulation SHO and that 
such person intends to deliver as soon as all restrictions on delivery 
have been removed.\141\ In addition, we are revising the close-out 
period within which a participant must close out fails to deliver 
resulting from sales of such securities to be consistent with the 
delivery period contained in Rule

[[Page 38278]]

203(b)(2)(ii) of Regulation SHO. Accordingly, Rule 204(a)(2) provides 
that if a participant of a registered clearing agency has a fail to 
deliver position at a registered clearing agency in any equity security 
resulting from the sale of a security that a person is deemed to own 
pursuant to Rule 200 of Regulation SHO and that such person intends to 
deliver as soon as all restrictions on delivery have been removed, the 
participant shall, by no later than the beginning of regular trading 
hours on the thirty-fifth consecutive calendar day following the trade 
date for the transaction, immediately close out the fail to deliver 
position by purchasing securities of like kind and quantity.\142\
---------------------------------------------------------------------------

    \141\ Such circumstances could include the situation where a 
convertible security, option, or warrant has been tendered for 
conversion or exchange, but the underlying security is not 
reasonably expected to be received by settlement date. See 2004 
Regulation SHO Adopting Release, 69 FR 48015; see also 17 CFR 
242.200(b) (defining when a person shall be ``deemed to own'' a 
security). Another situation could include the sale of a Rule 144 
Security. See Rule 204T Adopting Release, 73 FR 61715. In addition, 
we understand that sellers that own restricted equity securities 
that wish to sell pursuant to an effective resale registration 
statement under Rule 415 under the Securities Act experience similar 
types of potential settlement delays as sales of Rule 144 
Securities. Thus, fails to deliver in such securities may be closed 
out in accordance with Rule 204(a)(2) if the fails to deliver 
resulted from sales of securities that were outstanding at the time 
they were sold and the sale occurred after a registration has become 
effective. In addition, we understand that sales pursuant to broker-
assisted cashless exercises of compensatory options to purchase a 
company's stock, may result in potential settlement delays and, 
therefore, fails to deliver. Such fails to deliver may be closed out 
in accordance with Rule 204(a)(2).
    \142\ See Rule 204(a)(2).
---------------------------------------------------------------------------

    In addition to being consistent with the delivery time-frame under 
Rule 203(b)(2)(ii) of Regulation SHO, we believe that a close-out 
requirement of 35 consecutive calendar days from trade date for fails 
to deliver resulting from sales of such owned securities will permit 
the orderly settlement of such sales without the risk of causing market 
disruption due to unnecessary purchasing activity (particularly if the 
purchases are for sizable quantities of stock). Because the security 
being sold will be received as soon as all processing delays have been 
removed, this additional time will allow participants to close out 
fails to deliver resulting from the sale of the security with the 
security sold, rather than having to close out such fail to deliver 
position by purchasing securities in the market. In addition, we note 
that although a commenter requested that we maintain the close-out 
requirement of temporary Rule 204T(a)(2) but amend the delivery time-
frame of Rule 203(b)(2)(ii) of Regulation SHO to 35 settlement rather 
than calendar days, we have determined not to make such an amendment 
because we believe that 35 calendar days from trade date should be a 
sufficient period of time within which delivery can be made on sales of 
such securities. We also note that 35 calendar days from trade date is 
the delivery time-frame with which broker-dealers have had to comply 
since the effective date of Regulation SHO in January 2005, if relying 
on the exception in Rule 203(b)(2)(ii) to the rule's locate 
requirement. We are not aware that broker-dealers have been unable to 
comply with this delivery requirement.
    Although this amendment will provide an extended period of time 
within which fails to deliver resulting from sales of certain ``deemed 
to own'' securities must be closed out, we believe that such additional 
time is warranted and does not undermine our goal of reducing fails to 
deliver because these are sales of owned securities that cannot be 
delivered by settlement date due solely to processing delays outside 
the seller's or broker-dealer's control. Moreover, delivery will be 
made on such sales as soon as all restrictions on delivery have been 
removed. In addition, Rule 204(b)'s borrowing requirements will help 
ensure that, if a fail to deliver position is not closed out in 
accordance with Rule 204(a)(2), additional fails to deliver cannot 
occur until securities have been purchased to close out the fail to 
deliver position and such purchase has cleared and settled. If a 
participant does not close out a fail to deliver position at a 
registered clearing agency in accordance with Rule 204(a)(2), the rule 
prohibits the participant, and any broker-dealer from which it receives 
trades for clearance and settlement, including market makers, from 
accepting any short sale orders or effecting further short sales in the 
particular security without borrowing, or entering into a bona-fide 
arrangement to borrow, the security until the participant closes out 
the entire fail to deliver position by purchasing securities of like 
kind and quantity and that purchase has cleared and settled at a 
registered clearing agency.\143\ In addition, we intend to closely 
monitor whether fails to deliver are being closed out in accordance 
with the requirements of Rule 204(a)(2).
---------------------------------------------------------------------------

    \143\ See Rule 204(b).
---------------------------------------------------------------------------

F. Sham Close-Outs

    In the Rule 204T Adopting Release, we stated that it is possible 
under Regulation SHO that a close out by a participant of a registered 
clearing agency may result in a fail to deliver position at another 
participant if the counterparty from which the participant purchases 
securities fails to deliver. We also noted, however, that Regulation 
SHO prohibits a participant of a registered clearing agency, or a 
broker-dealer for which it clears transactions, from engaging in ``sham 
close outs'' by entering into an arrangement with a counterparty to 
purchase securities for purposes of closing out a fail to deliver 
position and the purchaser knows or has reason to know that the 
counterparty will not deliver the securities, and which thus creates 
another fail to deliver position.\144\ Because these same concepts 
apply to the close-out requirements of Rule 204, we have determined to 
include rule text in subparagraph (f) of Rule 204 to provide that a 
participant of a registered clearing agency shall not be deemed to have 
fulfilled the requirements of Rule 204 where the participant enters 
into an arrangement with another person to purchase or borrow 
securities as required by Rule 204, and the participant knows or has 
reason to know that the other person will not deliver securities in 
settlement of the purchase or borrow.\145\
---------------------------------------------------------------------------

    \144\ See Rule 204T Adopting Release, 73 FR 61714, n.78; see 
also 17 CFR 242.203(b)(3)(vii); 2004 Regulation SHO Adopting 
Release, 69 FR 48018, n.96.
    \145\ See Rule 204(f).
---------------------------------------------------------------------------

G. De Minimis Fail To Deliver Positions

    Some commenters requested that the Commission consider including an 
exception from temporary Rule 204T's close-out requirements where a 
participant's fail to deliver position at a registered clearing agency 
is below a certain amount.\146\ One commenter suggested that such an 
exception be voluntary so that firms could decide whether or not to 
take advantage of the exception based on their particular business 
model and capabilities.\147\ Another commenter noted that de minimis 
fails to deliver are particularly likely to occur in connection with 
odd lot trading.\148\ This commenter stated that it believes that 
permitting a de minimis fail to deliver, particularly in less-than-
round lots, would not undermine the intent of temporary Rule 204T.\149\ 
Other commenters, in discussing odd lot orders and fails to deliver, 
recommended a de minimis exception for fails to deliver of less than 
1,000 shares.\150\ One other commenter recommended a de minimis 
exception that would except a fail to deliver position from the close-
out requirements if the net value of the fail in the particular 
security across all firm accounts is under one million dollars.\151\
---------------------------------------------------------------------------

    \146\ See, e.g., letters from SIFMA; NYSE; Wedbush; Lek 
Securities Corporation; CBOE; BATS; EWT; The Specialist Association.
    \147\ See letter from SIFMA.
    \148\ See, e.g., letter from NYSE (stating that by operation of 
NYSE and NYSE Alternext rules, odd lot executions take place 
automatically, with the designated market maker (``DMM'') acting as 
the contra-side to all odd lot trades. As a result, DMMs may sell 
short in a de minimis amount automatically and without prior 
knowledge. This commenter further stated that if the odd lot trade 
occurs in hard-to-borrow or illiquid securities, the DMM may not be 
able to avoid failing to deliver).
    \149\ See letter from NYSE.
    \150\ See letters from The Specialist Association; Wedbush.
    \151\ See letter from EWT; see also letter from Lek Securities 
Corporation.
---------------------------------------------------------------------------

    A primary goal of Rule 204 is to continue the recent reduction in 
fails to deliver. We believe that an exception

[[Page 38279]]

from Rule 204's close-out requirements that would permit certain fails 
to deliver to persist indefinitely could undermine this goal. 
Accordingly, we have determined at this time not to include a de 
minimis or odd-lot related exception that would permit such fails to 
deliver to not have to be closed out. We will continue to monitor, 
however, whether a de minimis or odd-lot related exception is 
appropriate.

IV. Administrative Procedure Act

    Section 553(d) of the Administrative Procedure Act (``APA'') 
provides that a substantive rule generally may not be made effective 
less than 30 days after notice is published in the Federal 
Register.\152\ Section 553(d), however, also provides an exception to 
the 30-day requirement where an agency finds good cause for providing a 
shorter effective date.\153\
---------------------------------------------------------------------------

    \152\ 5 U.S.C. 553(d).
    \153\ See id. at 553(d)(1), (d)(3).
---------------------------------------------------------------------------

    Temporary Rule 204T will expire on July 31, 2009. Rule 204 makes 
permanent the provisions of temporary Rule 204T with limited 
modifications to address commenters' concerns and to help ensure the 
workability of the rule on a permanent basis. Rule 204 is intended to 
help maintain the benefits achieved in part by temporary Rule 204T, 
such as maintaining the recent reduction in fails to deliver, and 
address potentially abusive ``naked'' short selling by strengthening 
the close-out requirements of Regulation SHO. A gap between the 
expiration of temporary Rule 204T and the effective date of Rule 204 
would be contrary to these purposes and goals. Rule 204 in significant 
part, moreover, continues the restrictions on short selling that are 
currently in place, and with which participants are already familiar. 
In addition, the modifications that are made in Rule 204 from Rule 204T 
relieve participants of some of the regulatory burdens imposed by 
temporary Rule 204T by, for example, allowing participants to close out 
fail to deliver positions from long sales and market making activities 
by borrowing securities. Thus, the Commission finds that there is good 
cause for making Rule 204 effective on July 31, 2009.

V. Amendments to Rule 30-3

    The Commission is adopting an amendment to Rule 30-3 of its Rules 
of Organization and Program Management governing delegations of 
authority to the Director of the Division of Trading and Markets (the 
``Director'').\154\ The amendment delegates to the Director the 
authority to grant by order an exemption from the provisions of 
Regulation SHO of the Exchange Act, under Section 36 of the Exchange 
Act. Such an exemption may be granted either unconditionally, or on 
specified conditions.
---------------------------------------------------------------------------

    \154\ See 17 CFR 200.30-3.
---------------------------------------------------------------------------

    Section 36 of the Exchange Act provides that ``the Commission, by 
rule, regulation, or order, may conditionally or unconditionally exempt 
any person, security, or transaction, or any class or classes of 
persons, securities, or transactions, from any provision or provisions 
of this chapter or of any rule or regulation thereunder, to the extent 
that such exemption is necessary or appropriate in the public interest, 
and is consistent with the protection of investors.'' \155\
---------------------------------------------------------------------------

    \155\ See 15 U.S.C. 78mm(a).
---------------------------------------------------------------------------

    This delegation of authority to the Director is intended to 
conserve Commission resources and provide market participants needed 
flexibility by allowing the staff, pursuant to Section 36(a) of the 
Exchange Act, to review and act by order on applications for exemptions 
from Regulation SHO. Pursuant to the amendment, the Director may 
consider and act upon appropriate requests for relief from the 
provisions of Regulation SHO, and will consider the particular facts 
and circumstances relevant to each such request, the potential 
ramifications of granting any exemptive relief, and any appropriate 
conditions to be imposed as part of such an exemption.
    The Commission anticipates that the delegation of authority will 
facilitate efficient review. Nevertheless, the staff may submit matters 
to the Commission for consideration as it deems appropriate, and the 
Commission ``may, in its sole discretion, decline to entertain any 
application for an order of exemption under this section.'' \156\
---------------------------------------------------------------------------

    \156\ See 15 U.S.C. 78mm(a)(2).
---------------------------------------------------------------------------

    The Commission finds, in accordance with the Administrative 
Procedure Act, 5 U.S.C. 553(b)(3)(A), that this amendment to Rule 30-3 
relates solely to agency organization, procedure and practice and thus, 
notice and the opportunity for public comment before its effective date 
are unnecessary. In addition, because the amendment to Rule 30-3 
relates solely to the internal processes of the Commission with regard 
to the grant of exemptions from the provisions of Regulation SHO, the 
Commission finds, pursuant to Section 553(d)(3) of the Administrative 
Procedure Act, 5 U.S.C. 553(d)(3), that there is good cause for making 
the amendment effective upon publication in the Federal Register. For 
similar reasons, the amendment does not require an analysis under the 
Regulatory Flexibility Act or analysis of major status under the Small 
Business Regulatory Enforcement Fairness Act.\157\
---------------------------------------------------------------------------

    \157\ See 5 U.S.C. 601(2) (for purposes of Regulatory 
Flexibility Act analysis, the term ``rule'' means any rule for which 
the agency publishes a general notice of proposed rulemaking) and 5 
U.S.C. 804(3)(C) (for purposes of congressional review of agency 
rulemaking, the term ``rule'' does not include any rule of agency 
organization, procedure, or practice that does not substantially 
affect the rights or obligations of non-agency parties).
---------------------------------------------------------------------------

VI. Paperwork Reduction Act

    Like temporary Rule 204T, several provisions under Rule 204 will 
impose a ``collection of information'' within the meaning of the 
Paperwork Reduction Act of 1995 (``Paperwork Reduction Act'').\158\ 
These collections of information are mandatory. With the single 
exception of the elimination in Rule 204 of the exception in temporary 
Rule 204T(b)(2) for market makers from the borrowing requirement in 
Rule 204(b),\159\ all collections of information from temporary Rule 
204T have been incorporated into Rule 204 without modification. The 
collection of information requirements of temporary Rule 204T have not 
been substantively or materially modified in Rule 204; therefore, the 
time and cost estimates for compliance with these provisions are the 
same for Rule 204 as our prior time and cost estimates for temporary 
Rule 204T, which we incorporate by reference.\160\
---------------------------------------------------------------------------

    \158\ 44 U.S.C. 3501 et seq.
    \159\ In contrast to temporary Rule 204T(b), Rule 204(b) does 
not include an exception from the borrowing requirement of the Rule 
specific to market makers. We eliminated this exception because, as 
with other broker-dealers, a market maker is excepted from the 
borrowing requirements of Rule 204(b) if it timely certifies to the 
participant that it has not incurred a fail to deliver position on 
settlement date for a long or short sale in an equity security for 
which the participant has a fail to deliver position at the 
registered clearing agency or that it is in compliance with the 
requirements of Rule 204(e). Market makers, like all other broker-
dealers, will continue to be subject to the certification 
requirements under Rule 204(b). See supra Section III.B. (discussing 
Rule 204(b)).
    \160\ See Rule 204T Adopting Release, 73 FR 61717-61722.
---------------------------------------------------------------------------

    We published a notice of our estimated time requirements for 
participants to comply with these collection of information provisions 
and requested comment on the collection of information requirements in 
connection with temporary Rule 204T. We submitted the collection of 
information to OMB for review and approval in accordance with 44 U.S.C. 
3507(j) and 5 CFR 1320.13.
    One commenter indicated that compliance with temporary Rule 204T 
resulted in an increase in man-hours to monitor multiple levels of data 
across various system platforms and business

[[Page 38280]]

units within a firm,\161\ and other commenters expressed general 
concerns with the administrative and operational burdens on clearing 
firms, customers, and their regulators.\162\ The Commission, however, 
did not receive any comments as to the burdens associated with the 
collection of information requirements in temporary Rule 204T.
---------------------------------------------------------------------------

    \161\ See letter from SIFMA. The commenter noted that one firm 
indicated its operations personnel initially spent an extra 60 man-
hours per day to comply with the rule, but acknowledged that time 
amount had tapered down through automation. The comment is addressed 
more directly in the cost-benefit analysis in Section VII below.
    \162\ See e.g., letters from CBOE; State Street.
---------------------------------------------------------------------------

    The information collected under Rule 204 will continue to be 
retained and/or provided to other entities pursuant to the specific 
rule provisions and will be available to the Commission and SRO 
examiners upon request. The information collected will continue to aid 
the Commission and SROs in monitoring compliance with these 
requirements. In addition, the information collected will aid those 
subject to Rule 204 in complying with its requirements.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a 
currently valid OMB control number. The title for the collection of 
information is changed from ``Temporary Rule 204T'' to ``Rule 204'' to 
indicate that the collection is no longer with regard to a temporary 
rule and the OMB control number for the collection of information is 
3235-0647.

VII. Cost-Benefit Analysis

A. Summary

    The Commission is sensitive to the costs and benefits of its rules 
and we have considered such with respect to the adoption of Rule 204 of 
Regulation SHO. We are incorporating by reference the cost-benefit 
discussion in the Rule 204T Adopting Release, except to the extent that 
we have made modifications or because we are addressing comments.
    In order to assist our evaluation, we solicited comment via 
questions as to the costs and benefits of temporary Rule 204T, which is 
substantially similar to Rule 204. We address these comments as applied 
to permanent Rule 204 in detail below. In addition, we discuss in more 
detail below that we believe the benefits of adopting Rule 204 justify 
its costs. We also believe that the benefits of adopting Rule 204 
justify forgoing benefits that might accrue if the Commission were to 
allow temporary Rule 204T to expire without a substantially similar 
replacement.\163\
---------------------------------------------------------------------------

    \163\ Temporary Rule 204T will expire on July 31, 2009.
---------------------------------------------------------------------------

    As discussed above, preliminary results from OEA indicate that our 
actions to further reduce fails to deliver and, thereby, help address 
potentially abusive ``naked'' short selling are having their intended 
effect. For example, these preliminary results indicate a significant 
downward trend in the number of fails to deliver in all equity 
securities since, in addition to other measures, the adoption of 
temporary Rule 204T.\164\
---------------------------------------------------------------------------

    \164\ See Memorandum from OEA Re: Impact of Recent SHO Rule 
Changes on Fails to Deliver, November 26, 2008 at http://www.sec.gov/comments/s7-30-08/s73008-37.pdf; see also Memorandum 
from OEA Re: Impact of Recent SHO Rule Changes on Fails to Deliver, 
March 20, 2009 at http://www.sec.gov/comments/s7-30-08/s73008-107.pdf; Memorandum from OEA Re: Impact of Recent SHO Rule Changes 
on Fails to Deliver, April 16, 2009 at http://www.sec.gov/comments/s7-30-08/s73008-121.pdf.
---------------------------------------------------------------------------

    Due to the positive impact that temporary Rule 204T, among other 
actions, is having on reducing fails to deliver and after considering 
the comments received, we believe adopting the provisions of that rule 
in a permanent rule, Rule 204 of Regulation SHO, with limited 
modifications to promote the rule's workability and address commenters' 
concerns, will further the goals outlined above and below. We believe 
these modifications will aid compliance with Rule 204.
    We believe that Rule 204 will help maintain the recent reduction in 
fails to deliver and address potentially abusive ``naked'' short 
selling in all equity securities by requiring that, subject to certain 
limited exceptions, if a participant of a registered clearing agency 
has a fail to deliver position at a registered clearing agency it must 
immediately purchase or borrow securities to close out the fail to 
deliver position by no later than the beginning of regular trading 
hours on the settlement day following the day the participant incurs 
the fail to deliver position. We recognize that, like temporary Rule 
204T, Rule 204 may impose increased purchasing and borrowing costs 
beyond those that would occur if the rule was not in place and that 
these costs may increase the costs of legitimate short selling. We 
believe, however, that continuing the requirements of temporary Rule 
204T by adopting them in Rule 204 is necessary to maintain the 
reduction in fails to deliver and to continue to address potentially 
abusive ``naked'' short selling. We believe that continuing these 
benefits achieved under temporary Rule 204T justifies the potential 
costs associated with making the requirements of that rule permanent.
    Further, we believe that the benefits of making the requirements of 
temporary Rule 204T permanent in Rule 204 will justify forgoing any 
potential benefits that might accrue if the Commission were to allow 
temporary Rule 204T to expire. If the Commission were to allow 
temporary Rule 204T to expire without replacement, there might be 
potential benefits. For example, some commenters noted that they 
believe that there has been price disruption and market volatility 
resulting from temporary Rule 204T's requirement that participants 
close out fails to deliver by no later than the beginning of regular 
trading hours on the applicable close-out date.\165\ Some commenters 
stated that temporary Rule 204T's close-out requirements cause over-
buying and over-borrowing at the market open by parties seeking to meet 
the close-out requirements and has unnecessarily interfered in 
transactions that would settle in the normal course.\166\
---------------------------------------------------------------------------

    \165\ See e.g., letters from BATS; LEK; MFA; SIFMA; State 
Street.
    \166\ See, e.g., letter from SIFMA.
---------------------------------------------------------------------------

    If we were to allow temporary Rule 204T to expire without adopting 
a substantially similar rule, the marketplace would revert back to the 
close-out requirements of Rule 203(b)(3) of Regulation SHO that apply 
only to those securities with a large and persistent level of fails to 
deliver, i.e., threshold securities, and only to those fail to deliver 
positions that have persisted for thirteen consecutive settlement 
days.\167\ Thus, it is plausible that a return to this pre-temporary 
Rule 204T close-out requirement might alleviate concerns expressed by 
commenters regarding potential over-buying, over-borrowing, volatility, 
and price disruption at the market open, be easier to comply with and, 
therefore, potentially reduce transaction costs to market participants. 
Further, according to some commenters, temporary Rule 204T may provide 
disincentives to lenders of securities and, thus, may cause lower 
liquidity levels in the market place.\168\
---------------------------------------------------------------------------

    \167\ See 17 CFR 242.203(b)(3).
    \168\ See letters from BATS; ICI; SIFMA.
---------------------------------------------------------------------------

    In addition, if we were to allow temporary Rule 204T to expire 
without taking substantially similar action, participants might 
experience fewer costs in terms of monitoring systems platforms and 
notification obligations associated with complying with temporary Rule 
204T \169\ and with Rule

[[Page 38281]]

204. For instance, the demonstration and notification requirements of 
temporary Rule 204T and Rule 204 and related compliance costs in terms 
of personnel, recordkeeping, systems, and surveillance mechanisms would 
not apply. However, as noted in the temporary Rule 204T Adopting 
Release, we believe any potential additional costs incurred in 
implementing the collection of information requirements under temporary 
Rule 204T would be minimal. We believe the same with respect to the 
costs associated with Rule 204. In addition, we note that most of the 
infrastructure necessary to comply with Rule 204 should already be in 
place in order to meet the close-out requirements of Rule 203(b)(3) of 
Regulation SHO and, more recently, of temporary Rule 204T.
---------------------------------------------------------------------------

    \169\ See letters from CBOE; SIFMA; State Street (noting some of 
the potential costs associated with complying with temporary Rule 
204T's close-out requirements).
---------------------------------------------------------------------------

    For the reasons articulated above and below, in more detail, we 
believe that a reversion to the pre-temporary Rule 204T close-out 
regime would result in a number of costs to the securities markets in 
the forms of an increase in the level of fails to deliver and a lack of 
incentive for sellers to promptly deliver securities by settlement 
date. Such results would undermine our goals of reducing fails to 
deliver and addressing potentially abusive ``naked'' short selling.
    As previously noted, and stated in the temporary Rule 204T Adopting 
Release, we are concerned that the close-out requirements of Regulation 
SHO do not adequately address our goals of reducing fails to deliver 
and addressing potentially abusive ``naked'' short selling.\170\ In 
part due to such concerns, we have taken measures to help further 
reduce fails to deliver in all equity securities. As discussed above, 
OEA's findings regarding the impact of temporary Rule 204T, and other 
Commission actions, indicate a significant reduction in the number of 
fails to deliver.\171\ Thus, we believe it is necessary to adopt 
temporary Rule 204T's close-out requirements in a permanent rule, Rule 
204, such that fails in all equity securities must be closed out within 
specific timeframes and, thereby, help maintain the recent reduction in 
fails to deliver and the benefits already achieved.
---------------------------------------------------------------------------

    \170\ See, e.g., Rule 204T Adopting Release, 73 FR 61711-61712.
    \171\ See supra note 164.
---------------------------------------------------------------------------

B. Benefits

    By continuing to require that participants of a registered clearing 
agency immediately close-out a fail to deliver position on the 
applicable close-out date, Rule 204 will further our goals of reducing 
fails to deliver by maintaining the reductions in fails to deliver 
achieved by the adoption of temporary Rule 204T, as well as other 
actions taken by the Commission, and addressing potentially abusive 
``naked'' short selling. This, in turn, will help to ensure that 
investors remain confident that trading can be conducted without the 
influence of illegal manipulation.\172\ The rule also furthers the 
goals of helping to maintain fair and orderly markets against the 
threat of sudden and excessive fluctuations of securities prices and 
substantial disruption in the functioning of the securities markets. 
The rule also promotes the prompt and accurate clearance and settlement 
of transactions in equity securities.
---------------------------------------------------------------------------

    \172\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41712; 
2007 Regulation SHO Final Amendments, 72 FR 45545; 2007 Regulation 
SHO Proposed Amendments, 72 FR 45558-45559; Anti-Fraud Rule 
Proposing Release, 73 FR 15378; Rule 204T Adopting Release, 73 FR 
61709-61710 (providing discussion of the impact of fails to deliver 
on the market); see also 2003 Regulation SHO Proposing Release, 68 
FR 62975 (Nov. 6, 2003) (discussing the impact of ``naked'' short 
selling on the market).
---------------------------------------------------------------------------

    In addition, by helping to further our goal of reducing fails to 
deliver by maintaining the reductions in fails to deliver achieved by 
the adoption of temporary Rule 204T, as well as other actions taken by 
the Commission, Rule 204, like temporary Rule 204T, will help continue 
to address concerns that fails may create a misleading impression of 
the market for securities. Large and persistent fails to deliver may 
have a negative effect on shareholders, potentially depriving them of 
the benefits of ownership, such as voting and lending.\173\ Thus, by 
facilitating the prompt receipt of shares, Rule 204 will help enable 
investors to receive the benefits associated with share ownership.
---------------------------------------------------------------------------

    \173\ See supra Section II. (discussing the potential negative 
impact of large and persistent fail to delivers).
---------------------------------------------------------------------------

    Persistent fails to deliver in a security may also be perceived by 
potential investors negatively and may affect their investment 
decisions.\174\ Thus, providing greater assurance that securities will 
be delivered might help alleviate investor apprehension about investing 
in certain securities and increase investor confidence in the 
settlement process.\175\
---------------------------------------------------------------------------

    \174\ See id.
    \175\ See id.
---------------------------------------------------------------------------

 1. Close-Out Requirements
    By maintaining the close-out requirements of temporary Rule 204T we 
believe Rule 204 will continue to help restore, maintain, and enhance 
investor confidence in the securities markets. It will also help 
continue to limit the use of manipulative schemes involving ``naked'' 
short selling in all equity securities.\176\ Without the requirements 
of Rule 204, sellers that fail to deliver securities on settlement date 
may attempt to engage in trading activities that deliberately depress 
the price of a security. Rule 204's close-out requirements will 
continue the limitations on a potential means of manipulation, thereby 
decreasing the possibility of artificial market influences and 
contributing to price efficiency. Rule 204's close-out requirements are 
also expected to prevent large, widespread build-ups of fails over 
time.
---------------------------------------------------------------------------

    \176\ See 204T Adopting Release, 73 FR 61709-61710.
---------------------------------------------------------------------------

    As in temporary Rule 204T(a), Rule 204(a) provides that a 
participant of a registered clearing agency must deliver securities to 
a registered clearing agency for clearance and settlement on a long or 
short sale in any equity security by settlement date or, if a 
participant of a registered clearing agency has a fail to deliver 
position at a registered clearing agency in any equity security for a 
long or short sale transaction in that equity security, the participant 
shall, by no later than the beginning of regular trading hours on the 
settlement day following the settlement date, immediately close out the 
fail to deliver position by borrowing or purchasing securities of like 
kind and quantity.\177\ Similarly, consistent with temporary Rule 
204T(a)(1) and (a)(3), the close-out requirements of Rule 204(a)(1) and 
(a)(3) for fails to deliver resulting from long sales and certain bona 
fide market making activity must be closed out by the beginning of 
regular trading hours on the close-out date for such fails to deliver 
(i.e., T+6).\178\
---------------------------------------------------------------------------

    \177\ See Rule 204(a).
    \178\ See Rules 204(a)(1) and 204(a)(3).
---------------------------------------------------------------------------

    As discussed in Section III above, some commenters requested that 
we extend the close-out period for fails to deliver resulting from 
short sales, long sales, and bona fide market making activity from the 
beginning to the end of regular trading hours on the applicable close-
out date. Commenters expressed concern that temporary Rule 204T's 
requirement to close out fails to deliver by no later than the 
beginning of regular trading hours can create buying pressure at the 
open, that may temporarily distort the price of the security.\179\
---------------------------------------------------------------------------

    \179\ See, e.g., letters from MFA; CBOE; SIFMA; BATS; RMA; State 
Street.
---------------------------------------------------------------------------

    Other commenters requested additional days within which to close

[[Page 38282]]

out fails to deliver in connection with short sales. For example, some 
commenters requested that the Commission extend the close-out period 
for fails to deliver resulting from short sales to three settlement 
days after the fail occurs, consistent with the close-out period for 
fails to deliver resulting from long sales and market making 
activity.\180\ Other commenters requested that the Commission extend 
the close-out requirement for fails to deliver resulting from all sales 
to five settlement days after the fail to deliver position occurs.\181\ 
These commenters stated that the additional time to close out fails to 
deliver would allow the majority of trades to clear and settle on their 
own within a few days following the regular settlement date (i.e., 
T+3).\182\
---------------------------------------------------------------------------

    \180\ See, e.g., letters from EWT; Coalition of Private 
Investment Companies; SIFMA; MFA; State Street.
    \181\ See, e.g., letters from CBOE; Options Exchanges.
    \182\ See, e.g., letters from SIFMA; MFA; State Street; CBOE; 
Options Exchanges; Coalition of Private Investment Companies.
---------------------------------------------------------------------------

    Some commenters expressed concerns about the effect of the close-
out requirements of temporary Rule 204T on securities lending.\183\ One 
commenter also noted that in practice fails to deliver resulting from 
sales of securities on loan, which are considered ``long'' sales, are 
often closed out in accordance with the time-frames for fails to 
deliver resulting from short sales rather than long sales because 
temporary Rule 204T does not provide sufficient time to determine 
whether or not a fail to deliver position resulted from a long or short 
sale.\184\ According to this commenter, because some broker-dealers are 
purchasing securities by no later than the beginning of regular trading 
hours on the settlement date after the fail to deliver occurs, in 
accordance with the close-out requirements for short sales, such 
purchasing activity acts as a disincentive to lending and causes 
institutions to question their participation in lending programs.\185\
---------------------------------------------------------------------------

    \183\ See, e.g., letter from SIFMA.
    \184\ See letter from SIFMA; see also letters from RMA; ICI.
    \185\ See letter from SIFMA; see also letter from RMA 
(recommending the extension of the close-out period for fails to 
deliver for all sales to settlement date plus three days (i.e., T+6) 
``to ensure that beneficial owners selling on-loan positions are not 
compromised by close-outs of long sales on T+4'').
---------------------------------------------------------------------------

    Other commenters stated that where the holder of a long position 
sells securities that have been financed through a securities loan, the 
close-out requirements of temporary Rule 204T may not provide 
sufficient time for the securities to be recalled and delivered in time 
for settlement of the sale transaction.\186\ These commenters stated, 
among other things, that temporary Rule 204T's requirement that 
securities be delivered by no later than the beginning of regular 
trading hours does not allow for the completion of the securities 
lending cycle, which may not occur until the close of the DTC 
settlement window on the third settlement day after settlement date 
(i.e., T+6).\187\
---------------------------------------------------------------------------

    \186\ See letters from EWT; BATS; RMA; ICI; Wedbush.
    \187\ See letters from EWT; BATS; RMA; ICI; RMA.
---------------------------------------------------------------------------

    Although we recognize commenters' concerns regarding the potential 
market impact of the close-out requirements of temporary Rule 204T, 
particularly at the market open, we believe that these potential 
concerns are justified by the benefits of retaining in Rule 204 the 
strict close-out requirements of temporary Rule 204T. As discussed 
above, since the adoption of temporary Rule 204T, and other actions 
taken by the Commission aimed at reducing fails to deliver, there has 
been a significant reduction in fails to deliver. To maintain this 
reduction, we believe it is appropriate at this time to continue to 
require that participants close out fails to deliver by no later than 
the beginning of regular trading hours on the applicable close-out 
date. Thus, we are adopting as a permanent rule the requirement that 
fails to deliver resulting from short sales, long sales, and certain 
bona fide market making activity must be closed out by no later than 
the beginning of regular trading hours on the applicable close-out 
date.
    In addition, we believe that continuing to require that fails to 
deliver be closed out on the day immediately following the day on which 
the fail to deliver occurs is consistent with our goals of reducing 
fails to deliver by maintaining the reductions in fails to deliver 
achieved by the adoption of temporary Rule 204T, as well as other 
actions taken by the Commission, and addressing ``naked'' short selling 
and, in particular, potentially abusive ``naked'' short selling. 
Although extending the time-frames within which fails to deliver must 
be closed out may allow for ordinary course settlement, as several 
commenters contend, we believe that the close-out requirements of Rule 
204 are necessary to help encourage delivery by settlement date and 
achieve our goal of not allowing fails to deliver to persist.\188\
---------------------------------------------------------------------------

    \188\ See supra note 16 (discussing the standard three-day 
settlement cycle).
---------------------------------------------------------------------------

    As we discussed in the Rule 204T Adopting Release, we believe that 
delivery on sales should be made by settlement date.\189\ In the Rule 
204T Adopting Release, we noted that the vast majority of fails to 
deliver are closed out within five days after T+3.\190\ In addition, in 
that release we referenced a recent analysis by OEA that found that 
more than half of all fails to deliver and more than 70% of all fail to 
deliver positions are closed out within two settlement days after 
T+3.\191\ We also noted in that release, however, that although this 
information shows that delivery is being made, it demonstrates that 
often delivery is not being made until several days following the 
standard three-day settlement cycle.
---------------------------------------------------------------------------

    \189\ See Rule 204T Adopting Release, 73 FR 61712-61713.
    \190\ See id.
    \191\ See id. at n. 68. We note that OEA's analysis examined the 
period from January to July 2008 and used the age of the fail to 
deliver position as reported by the NSCC. The NSCC data included 
only securities with at least 10,000 shares in fails to deliver. 
These numbers also included securities that were not subject to the 
close-out requirement in Rule 203(b)(3) of Regulation SHO, which 
applies only to ``threshold securities'' as defined in Rule 
203(c)(6) of Regulation SHO.
---------------------------------------------------------------------------

    In addition, as discussed above, fails to deliver may be associated 
with a scheme to manipulate the price of a security. We are also 
concerned about the negative effect that fails to deliver and 
potentially abusive ``naked'' short selling may have on individual 
securities and the broader market, including on investor 
confidence.\192\ The close-out requirements of Rule 204 help address 
these concerns by encouraging timely settlement and not allowing fails 
to deliver to persist.
---------------------------------------------------------------------------

    \192\ See, e.g., Anti-Fraud Rule Adopting Release, 73 FR 61666.
---------------------------------------------------------------------------

    We understand, however, that fails to deliver may occur from long 
sales within the first two settlement days after settlement date for 
legitimate reasons. 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.
    Thus, in Rule 204(a)(1), we are adopting, with certain limited 
modifications, the provisions of temporary Rule 204T(a)(1) relating to 
closing out fails to deliver resulting from long sales. Specifically, 
Rule 204(a)(1) provides that if a participant of a registered clearing 
agency has a fail to deliver position at a registered clearing agency 
in any equity security and the participant can demonstrate on its books 
and records that such fail to deliver position resulted from a long 
sale, the participant shall by no later than the beginning of regular 
trading hours on the third consecutive settlement day

[[Page 38283]]

following the settlement date immediately close out the fail to deliver 
position by purchasing or borrowing securities of like kind and 
quantity.\193\
---------------------------------------------------------------------------

    \193\ See Rule 204(a)(1).
---------------------------------------------------------------------------

    In addition, consistent with temporary Rule 204T(a)(3), Rule 
204(a)(3) extends the close-out requirement for fails to deliver 
attributable to certain bona fide market making activities by requiring 
a participant to close out the fail to deliver position attributable to 
such activities by no later than the beginning of regular trading hours 
on the third settlement day after the settlement date. We believe this 
exception to Rule 204(a)'s close-out requirement benefits clearing 
agency participants because the two additional days to close-out these 
fail to deliver positions may reduce close-out costs for such 
participants.
    Although we have determined at this time not to provide additional 
time within which fails to deliver must be closed out on the applicable 
close-out date, we are providing additional flexibility to the close-
out requirements for fails to deliver resulting from long sales and 
certain bona fide market making activity by, in contrast to temporary 
Rule 204T(a)(1) and (a)(3), providing in Rule 204(a)(1) and (a)(3) the 
ability to borrow as well as purchase securities to close out a fail to 
deliver position. As some commenters noted, we believe that the ability 
to borrow a security to close-out a fail to deliver position may have 
less market impact than a purchase, while serving the objective of 
closing-out a fail position.\194\ In addition, we believe that the 
additional flexibility afforded by the ability to close out a fail to 
deliver position either through a purchase or a borrow, will allow 
participants to access additional liquidity sources, thereby 
potentially reducing close-out costs and helping to ensure that fails 
to deliver are closed out on the applicable close-out date.\195\
---------------------------------------------------------------------------

    \194\ See e.g., letters from SIFMA; EWT; MFA; State Street; 
BATS; Wedbush.
    \195\ Although Rule 204(a)(1) permits borrowing to close out a 
fail to deliver position resulting from a long sale, broker-dealers 
must also comply with Rule 203(a) of Regulation SHO. Rule 203(a)(1) 
provides that, unless an exception applies, ``[i]f a broker or 
dealer knows or has reasonable grounds to believe that the sale of 
an equity security was or will be effected pursuant to an order 
marked `long,' such broker or dealer shall not lend or arrange for 
the loan of any security for delivery to the purchaser's broker 
after the sale, or fail to deliver a security on the date delivery 
is due.'' 17 CFR 242.203(a).
---------------------------------------------------------------------------

    Temporary Rule 204T(d) provides that a participant may reasonably 
allocate its responsibility to close out a fail to deliver position to 
another broker-dealer from which the participant receives trades for 
clearance and settlement.\196\ Consistent with temporary Rule 204T(d), 
Rule 204(d) provides for allocation of a fail to deliver position by a 
participant to a broker-dealer. Specifically, Rule 204(d) provides that 
if a participant of a registered clearing agency reasonably allocates a 
portion of a fail to deliver position to another registered broker-
dealer for which it clears trades or from which it receives trades for 
settlement, based on such broker-dealer's short position, the 
provisions of Rule 204(a) and (b) relating to such fail to deliver 
position shall apply to such registered broker-dealer that was 
allocated the fail to deliver position, and not to the 
participant.\197\ This allocation provision benefits participants 
because if a participant can identify the accounts of broker-dealers 
for which they clear or from which they receive trades for settlement, 
the participant can allocate the responsibility to close out the fail 
to deliver position to the particular broker-dealer account(s) whose 
trading activities caused the fail to deliver position, provided the 
allocation is reasonable. In this way, the allocated broker-dealer 
rather than the participant will incur any costs associated with Rule 
204's close-out requirement.
---------------------------------------------------------------------------

    \196\ See temporary Rule 204T(d); see also 17 CFR 
242.203(b)(3)(vi). Rule 203(b)(3)(vi) of Regulation SHO provides 
that ``[i]f a participant of a registered clearing agency reasonably 
allocates a portion of a fail to deliver position to another 
registered broker or dealer for which it clears trades or for which 
it is responsible for settlement, based on such broker or dealer's 
short position, then the provisions of this paragraph (b)(3) 
relating to such fail to deliver position shall apply to the portion 
of such registered broker or dealer that was allocated the fail to 
deliver position, and not to the participant.''
    \197\ See Rule 204(d).
---------------------------------------------------------------------------

    In addition, consistent with temporary Rule 204T(d), Rule 204(d) 
imposes a notification requirement on a broker-dealer that has been 
allocated responsibility for complying with the rule's requirements. 
Thus, under the rule's allocation provision, if the broker-dealer does 
not comply with the provisions of Rule 204(a), it must immediately 
notify the participant that it has become subject to the borrowing 
requirements of Rule 204(b). This notification requirement is intended 
to let participants know when a broker-dealer from which the 
participant receives trades for clearance and settlement has become 
subject to the rule's borrowing requirements. The notification 
requirement furthers the Commission's goals of limiting fails to 
deliver and addressing abusive ``naked'' short selling by promoting the 
prompt and accurate clearance and settlement of transactions involving 
equity securities. The notification requirement will also help ensure 
that participants that receive trades for clearance and settlement from 
broker-dealers will be on notice that the broker-dealer is subject to 
the borrow requirements of Rule 204(b) until the fail to deliver 
position has been closed out.
    Under Rule 204(e), even if a participant of a registered clearing 
agency has not closed out a fail to deliver position at a registered 
clearing agency in accordance with Rule 204(a), or has not allocated a 
fail to deliver position to a broker-dealer in accordance with Rule 
204(d), a broker-dealer shall not be subject to the requirements of 
Rule 204(a) or (b) if it purchases or borrows securities, and complies 
with the conditions set forth in Rule 204(e)(1) through (4), as 
described in detail in Section III.C. above. We note that, unlike 
temporary Rule 204T(e), Rule 204(e) permits a broker-dealer to use a 
borrow, as well as a purchase, to close out a position prior to the 
applicable close-out date. Rule 204(e), similar to temporary Rule 
204T(e), encourages early close-outs of fail to deliver positions, by 
providing that a broker-dealer can satisfy the rule's close-out 
requirements by purchasing securities prior to the applicable close-out 
date provided the broker-dealer complies with certain conditions. In 
addition, as noted above, Rule 204(e) provides more flexibility than 
temporary Rule 204T(e) by allowing a broker-dealer to close out a fail 
to deliver position prior to the applicable close-out date by 
borrowing, as well as purchasing securities. We believe this ability to 
borrow, as well as purchase, securities further encourages early close-
outs of fail to deliver positions which serves the benefit of promoting 
our goal of maintaining the reductions in fails to deliver achieved by 
the adoption of temporary Rule 204T, as well as other actions taken by 
the Commission, by facilitating the ability to close-out fails faster.
    Further, Rule 204(e) is modified from temporary Rule 204T(e)(3)'s 
provision that the purchase must be of a quantity of securities 
sufficient to cover the entire amount of the broker-dealer's open short 
position. The purpose of Rule 204(e) is to encourage broker-dealers to 
close out fail to deliver positions prior to the applicable close-out 
date (i.e., T+4 or T+6) by reducing the costs of the early close-out. 
Requiring a broker-dealer to close out its open fail to deliver 
position prior to the applicable close-out date is more closely 
tailored towards achieving that goal than requiring a broker-dealer to 
close out its open short position prior to the

[[Page 38284]]

applicable close-out date. Thus, in response to commenters' concerns, 
in Rule 204(e)(3) we have modified the requirement of temporary Rule 
204T(e)(3) to provide that a broker-dealer must purchase or borrow a 
quantity of securities sufficient to cover the entire amount of that 
broker-dealer's fail to deliver position at a registered clearing 
agency in that security on the day of the purchase. Consequently, we 
believe our incorporation of the conditions of temporary Rule 204T(e), 
with the noted modifications, facilitates early close-outs of fail to 
deliver positions.\198\
---------------------------------------------------------------------------

    \198\ See supra Section III.C. (explaining the conditions of 
Rule 204(e), as well as commenters' concerns that by requiring 
broker-dealers to close-out their entire open short position 
temporary Rule 204T(e) does not encourage early close-outs).
---------------------------------------------------------------------------

2. Borrowing Requirements
    Under temporary Rule 204T(b), if a participant does not purchase or 
borrow shares, as applicable, to close out a fail to deliver position 
in accordance with temporary Rule 204T, the participant violates the 
close-out requirements of that rule. We are adopting in Rule 204(b) the 
borrowing requirements of temporary Rule 204T(b), without modification. 
Accordingly, Rule 204(b) imposes on the participant and on all broker-
dealers from which that participant receives trades for clearance and 
settlement (including introducing and executing brokers) a requirement 
to borrow or arrange to borrow securities prior to accepting or 
effecting further short sales in that security. We believe that this 
borrow requirement is beneficial in that it furthers our goals of 
reducing fails to deliver by helping to maintain the reductions in 
fails to deliver achieved by the adoption of temporary Rule 204T, as 
well as other actions taken by the Commission, and addressing 
potentially abusive ``naked'' short selling, by promoting the prompt 
and accurate clearance and settlement of securities transactions.
    Specifically, Rule 204(b) provides that the participant and any 
broker-dealer from which it receives trades for clearance and 
settlement, including any market maker that is otherwise entitled to 
rely on the exception provided in Rule 203(b)(2)(iii) of Regulation 
SHO,\199\ may not accept a short sale order in an equity security from 
another person, or effect a short sale order in such equity security 
for its own account, to the extent that the broker-dealer submits its 
short sales to that participant for clearance and settlement, without 
first borrowing the security, or entering into a bona-fide arrangement 
to borrow the security, until the participant closes out the fail to 
deliver position by purchasing securities of like kind and quantity and 
that purchase has cleared and settled at a registered clearing 
agency.\200\
---------------------------------------------------------------------------

    \199\ See 17 CFR 242.203(b)(2)(iii) (providing an exception from 
Regulation SHO's ``locate'' requirement for short sales effected by 
a market maker in connection with bona fide market making activities 
in the securities for which the exception is claimed).
    \200\ See Rule 204(b). The borrow requirements of Rule 204(b) 
are also consistent with the requirements of Rule 203(b)(3)(iv) of 
Regulation SHO for a participant that has not closed out a fail to 
deliver position in a threshold security that has persisted for 
thirteen consecutive settlement days. See 17 CFR 242.203(b)(3)(iv). 
Rule 203(b)(3)(iv) of Regulation SHO provides that ``[i]f a 
participant of a registered clearing agency has a fail to deliver 
position at a registered clearing agency in a threshold security for 
thirteen consecutive settlement days, the participant and any broker 
or dealer for which it clears transactions, including any market 
maker that would otherwise be entitled to rely on the exception 
provided in paragraph (b)(2)(iii) of this section, many not accept a 
short sale order in the threshold security from another person, or 
effect a short sale in the threshold security for its own account, 
without borrowing the security or entering into a bona fide 
arrangement to borrow the security, until the participant closes out 
the fail to deliver position by purchasing securities of like kind 
and quantity.''
---------------------------------------------------------------------------

    Rule 204, like temporary Rule 204T, is aimed at reducing fails to 
deliver and addressing potentially abusive ``naked'' short selling. To 
that end, we believe it is appropriate to include in the rule borrowing 
requirements for broker-dealers, including participants, that sell 
short a security for which a fail to deliver position has not been 
closed out in accordance with the requirements of the rule. We believe 
that the borrowing requirements of Rule 204(b) will help further our 
goals of reducing fails to deliver by helping to maintain the 
reductions in fails to deliver achieved by the adoption of temporary 
Rule 204T, as well as other actions taken by the Commission, and 
addressing potentially abusive ``naked'' short selling by promoting the 
prompt and accurate clearance and settlement of securities 
transactions. In addition, we believe the rule's requirement that 
participants and broker-dealers from which they receive trades for 
clearance and settlement borrow or arrange to borrow securities prior 
to accepting or effecting short sales in the security that has a fail 
to deliver position that has not been closed out will help continue to 
ensure that shares will be available for delivery on any additional 
short sales by settlement date and, thereby, help to avoid additional 
fails to deliver occurring in the security.
    We note that one commenter asked for clarification regarding 
whether a participant ceases to be subject to the borrow requirements 
of temporary Rule 204T(b) if a participant no longer has a fail to 
deliver position at a registered clearing agency due to the participant 
borrowing the securities or the participant receiving securities from 
the seller (e.g., in connection with long sales).\201\ Temporary Rule 
204T(b) imposes short sale borrowing requirements until the participant 
closes out the fail to deliver position by purchasing securities of 
like kind and quantity and that purchase has cleared and settled at a 
registered clearing agency. Thus, under temporary Rule 204T, regardless 
of whether a participant borrows or receives delivery of securities, 
the requirements of temporary Rule 204T(b) continue to apply until the 
participant purchases securities to close out the fail to deliver 
position and that purchase has cleared and settled at a registered 
clearing agency.
---------------------------------------------------------------------------

    \201\ See letter from SIFMA.
---------------------------------------------------------------------------

    We have incorporated these same requirements into Rule 204(b) 
without modification. The provisions of Rule 204(b) are intended to act 
as an additional incentive to broker-dealers to deliver securities by 
settlement date, and to close out fail to deliver positions in 
accordance with the requirements of Rule 204. We believe that the 
purchase requirement of Rule 204(b) is beneficial in that it will 
continue to further these goals.
    In connection with the borrowing requirements of Rule 204(b), we 
are incorporating into Rule 204(c) the notification requirement 
contained in temporary Rule 204T(c), without modification. In 
accordance with Rule 204(c), participants must notify all broker-
dealers from which they receive trades for clearance and settlement 
that a fail to deliver position has not been closed out in accordance 
with Rule 204. Specifically, Rule 204(c) provides that the participant 
must notify any broker-dealer from which it receives trades for 
clearance and settlement, including any market maker that is otherwise 
entitled to rely on the exception provided in Rule 203(b)(2)(iii) of 
Regulation SHO,\202\ (a) that the participant has a fail to deliver 
position in an equity security at a registered clearing agency that has 
not been closed out in accordance with the requirements of Rule 204, 
and (b) when the purchase that the participant has made to close out 
the fail to deliver position has cleared and settled at a registered 
clearing agency.\203\
---------------------------------------------------------------------------

    \202\ See supra note 199.
    \203\ See Rule 204(c).
---------------------------------------------------------------------------

    We are including this notification requirement in Rule 204(c) so 
that all broker-dealers that submit trades for clearance and settlement 
to a participant

[[Page 38285]]

that has a fail to deliver position in a security that has not been 
closed out in accordance with Rule 204 will be on notice that short 
sales in that security to be cleared or settled through that 
participant will be subject to the borrow requirements of Rule 204(b) 
until the fail to deliver position has been closed out. We believe this 
notification requirement will help serve the goal of addressing 
potentially abusive ``naked'' short selling in equity securities.
    As noted above, Rule 204(d) provides that a participant may 
reasonably allocate (e.g., the allocation must be timely) its 
responsibility to close out a fail to deliver position to another 
broker-dealer for which the participant clears or from which the 
participant receives trades for settlement. Thus, to the extent that 
the participant can identify the broker-dealer(s) that have contributed 
to the fail to deliver position, and the participant has reasonably 
allocated the close-out obligation to the broker-dealer(s), the 
requirement to borrow or arrange to borrow prior to effecting further 
short sales in that security will continue to apply to only those 
particular broker-dealer(s).\204\
---------------------------------------------------------------------------

    \204\ See Rule 204(d).
---------------------------------------------------------------------------

    Rule 204(b) includes an exception from the borrowing requirements 
for any broker-dealer that can demonstrate that it was not responsible 
for any part of the fail to deliver position of the participant. We 
have incorporated into Rule 204(b) the language of temporary Rule 
204T(b)(1), without modification. Thus, Rule 204(b) provides that a 
broker-dealer shall not be subject to the requirements of paragraph (b) 
of Rule 204 if the broker-dealer timely certifies to the participant 
that it has not incurred a fail to deliver position on settlement date 
for a long or short sale in an equity security for which the 
participant has a fail to deliver position at a registered clearing 
agency or that the broker-dealer is in compliance with the requirements 
of Rule 204(e).\205\ We have included this exception because we 
continue to believe that a broker-dealer should not be subject to the 
borrowing requirements of the rule if the broker-dealer can demonstrate 
that it did not incur a fail to deliver position in the security on 
settlement date, or if it has taken steps, in accordance with Rule 
204(e), to close out the fail to deliver position.
---------------------------------------------------------------------------

    \205\ See Rule 204(b).
---------------------------------------------------------------------------

    Temporary Rule 204T(b)(2) included an exception from the borrowing 
requirements of temporary Rule 204T(b) for market makers that can 
demonstrate that they do not have an open short position in the equity 
security at the time of any additional short sales.\206\ We do not 
believe that a similar exception is necessary under Rule 204(b) 
because, as with other broker-dealers, a market maker is excepted from 
the borrowing requirements of Rule 204(b) if it timely certifies to the 
participant that it has not incurred a fail to deliver position on 
settlement date for a long or short sale in an equity security for 
which the participant has a fail to deliver position at a registered 
clearing agency or that it is in compliance with the requirements of 
Rule 204(e). Because Rule 204(b) includes an exception applicable to 
all broker-dealers, including market makers, we do not think it is 
necessary to maintain a separate exception applicable only to market 
makers.
---------------------------------------------------------------------------

    \206\ See temporary Rule 204T(b)(2).
---------------------------------------------------------------------------

3. Sales of Certain Deemed To Own Securities
    After considering the comments and to provide consistency between 
the delivery requirements of Rule 203(b)(2)(ii) of Regulation SHO and 
the close-out requirements of Rule 204, we are adopting in Rule 
204(a)(2) the requirements of temporary Rule 204T(a)(2) with some 
limited modifications.\207\ Specifically, we are expanding the universe 
of securities to which Rule 204(a)(2) will apply. Rule 204(a)(2) will 
apply to fails to deliver resulting from the sale of an equity security 
that a person is ``deemed to own'' pursuant to Rule 200 of Regulation 
SHO and that such person intends to deliver as soon as all restrictions 
on delivery have been removed.\208\ In addition, we are revising the 
close-out period within which a participant must close out fails to 
deliver resulting from sales of such securities to be consistent with 
the delivery period contained in Rule 203(b)(2)(ii) of Regulation SHO.
---------------------------------------------------------------------------

    \207\ See e.g., letter from SIFMA.
    \208\ See Rule 204(a)(2).
---------------------------------------------------------------------------

    Thus, Rule 204(a)(2) provides that if a participant of a registered 
clearing agency has a fail to deliver position at a registered clearing 
agency in any equity security resulting from the sale of a security 
that a person is deemed to own pursuant to Rule 200 of Regulation SHO 
and that such person intends to deliver as soon as all restrictions on 
delivery have been removed, the participant shall, by no later than the 
beginning of regular trading hours on the thirty-fifth consecutive 
calendar day following the trade date for the transaction, immediately 
close out the fail to deliver position by purchasing securities of like 
kind and quantity.\209\ We believe that amending the close-out 
requirement to 35 consecutive calendar days from trade date for fails 
to deliver resulting from sales of such owned securities will better 
permit the orderly settlement of such sales without the risk of causing 
market disruption due to unnecessary purchasing activity (particularly 
if the purchases are for sizable quantities of stock). In addition, the 
amendment to the close-out period relieves an inconsistency between 
Rule 203(b)(2)(ii) of Regulation SHO and temporary Rule 204T(a)(2), as 
noted by one commenter.\210\
---------------------------------------------------------------------------

    \209\ See id.
    \210\ See letter from SIFMA.
---------------------------------------------------------------------------

    Although this amendment will provide an extended period of time 
within which fails to deliver resulting from sales of certain ``deemed 
to own'' securities must be closed out, we believe that such additional 
time is warranted and does not undermine our goal of reducing fails to 
deliver because these are sales of owned securities that cannot be 
delivered by settlement date due solely to processing delays outside 
the seller's or broker-dealer's control. Moreover, delivery will be 
made on such sales as soon as all restrictions on delivery have been 
removed. In addition, if a fail to deliver position is not closed out 
in accordance with Rule 204(a)(2), the borrowing requirements of Rule 
204(b) will apply. Rule 204(b)'s borrowing requirements will help 
ensure that additional fails to deliver cannot occur until securities 
have been purchased to close out the fail to deliver position and such 
purchase has cleared and settled.
    Thus, if a participant does not close out a fail to deliver 
position at a registered clearing agency in accordance with Rule 
204(a)(2), the rule prohibits the participant, and any broker-dealer 
from which it receives trades for clearance and settlement, including 
market makers, from accepting any short sale orders or effecting 
further short sales in the particular security without borrowing, or 
entering into a bona-fide arrangement to borrow, the security until the 
participant closes out the entire fail to deliver position by 
purchasing securities of like kind and quantity and that purchase has 
cleared and settled at a registered clearing agency.\211\
---------------------------------------------------------------------------

    \211\ See Rule 204(b).
---------------------------------------------------------------------------

C. Costs

    We recognize that temporary Rule 204T may have resulted in 
increased short selling costs for participants that may have impacted 
legitimate short

[[Page 38286]]

selling activities.\212\ To the extent that the requirements of 
temporary Rule 204T have resulted in increased short selling costs, we 
do not believe that such costs will increase, and may in fact decrease, 
under Rule 204 because, as discussed below, among other things, we have 
provided additional flexibility to closing out fails to deliver under 
Rule 204 as compared to Rule 204T.
---------------------------------------------------------------------------

    \212\ See, e.g., letter from CBOE (noting its belief that 
legitimate short selling activity has been damaged by temporary Rule 
204T).
---------------------------------------------------------------------------

    Some commenters stated that temporary Rule 204T has imposed burdens 
on market participants in several areas, including on firm operations 
personnel.\213\ Some industry participants have stated that lending 
rates increased significantly following the adoption of temporary Rule 
204T and other recent Commission actions.\214\ We note, however, that 
the evidence that attempts to specify the cause of any such increase in 
lending rates is confounded by the unusual circumstances of the 
continued credit crisis. In addition, we note that a recent academic 
study that examined borrowing costs after the September Emergency Order 
\215\ found no significant increase in average lending rates.\216\
---------------------------------------------------------------------------

    \213\ See letters from CBOE (stating that temporary Rule 204T 
has created undue burdens in trading and risk management, clearing, 
lending and buy-in operations and front-end trading, back-office and 
regulatory systems); SIFMA; State Street (noting the ``additional 
transactional, operational and market costs which the industry had 
to incur'').
    \214\ See supra notes 39-42 and accompanying text (discussing 
recent Commission actions in addition to the adoption of temporary 
Rule 204T).
    \215\ See September Emergency Order, 73 FR 54875.
    \216\ See Adam C. Kolasinski, Adam V. Reed, and Jacob R. 
Thornock, Prohibitions versus Constraints: The 2008 Short Sales 
Regulations, March 2009 working paper.
---------------------------------------------------------------------------

    As discussed in more detail below, some commenters also stated that 
the inflexibility of temporary Rule 204T's requirement that 
participants purchase securities to close-out a fail to deliver 
position by no later than the beginning of regular trading hours on the 
applicable close-out date has led to increased market pressures and 
market volatility due to the need to execute potentially large 
purchases at the market open.\217\
---------------------------------------------------------------------------

    \217\ See e.g., letters from SIFMA; MFA; Wedbush; Lek 
Securities; State Street.
---------------------------------------------------------------------------

    To the extent that the requirements of Rule 204 result in increased 
costs to short selling in equity securities, it may lessen some of the 
benefits of legitimate short selling and, thereby, result in a 
reduction in short selling generally. Such a reduction may lead to a 
decrease in market efficiency and price discovery, less protection 
against upward stock price manipulations, a less efficient allocation 
of capital, an increase in trading costs, and a decrease in liquidity. 
We also recognize that requiring that participants close out fails to 
deliver in equity securities in accordance with the rule may 
potentially impact the willingness of participants to provide 
liquidity. As one commenter stated, certain aspects of the close-out 
process ``may have an unintended impact on the securities lending 
market and therefore the efficient functioning of the markets.'' \218\ 
As a result, securities lending could become more risky and costly and, 
in turn, impact market liquidity and price discovery benefits of short 
selling.\219\
---------------------------------------------------------------------------

    \218\ Letter from ICI; see also letter from CBOE.
    \219\ See letters from ICI; BATS.
---------------------------------------------------------------------------

    Although we recognize that Rule 204 may result in the continuation 
of some costs, as well as new costs, to certain participants, as 
discussed in detail below, we believe such costs will be limited and 
are justified by the fact that the rule will continue our efforts to 
achieve our goals of reducing fails to deliver by maintaining the 
reductions in fails to deliver achieved by the adoption of temporary 
Rule 204T, as well as other actions taken by the Commission, and 
addressing potentially abusive ``naked'' short selling and, thereby 
help restore, maintain, and enhance investor confidence in the markets.
1. Close-Out Requirements
    Consistent with temporary Rule 204T(a), Rule 204(a) provides that a 
participant of a registered clearing agency must deliver securities to 
a registered clearing agency for clearance and settlement on a long or 
short sale in any equity security by settlement date, or if a 
participant of a registered clearing agency has a fail to deliver 
position at a registered clearing agency in any equity security for a 
long or short sale transaction in that equity security, the participant 
shall, by no later than the beginning of regular trading hours on the 
settlement date, immediately close out the fail to deliver position by 
borrowing or purchasing securities of like kind and quantity.\220\ 
Similarly, consistent with temporary Rule 204T(a)(1) and (a)(3), the 
close-out requirements of Rule 204(a)(1) and (a)(3) for fails to 
deliver resulting from long sales and certain bona fide market making 
activity must be closed out by the beginning of regular trading hours 
on the close-out date for such fails to deliver (i.e., T+6).\221\
---------------------------------------------------------------------------

    \220\ See Rule 204(a).
    \221\ See Rules 204(a)(1) and 204(a)(3).
---------------------------------------------------------------------------

    As discussed in detail above in Section VII.B. in connection with 
the benefits of Rule 204, some commenters requested that we extend the 
close-out period for fails to deliver resulting from short sales, long 
sales, and bona fide market making activity from the beginning to the 
end of regular trading hours on the applicable close-out date due to 
concerns that temporary Rule 204T's requirement to close out fails to 
deliver by no later than the beginning of regular trading hours can 
create buying pressure at the open, that may temporarily distort the 
price of the security.\222\ Other commenters requested additional days 
within which to close out fails to deliver in connection with short 
sales.\223\ Commenters stated that the additional time to close out 
fails to deliver would allow the majority of trades to clear and settle 
on their own within a few days following the regular settlement date 
(i.e., T+3).\224\
---------------------------------------------------------------------------

    \222\ See, e.g., letters from MFA; CBOE; SIFMA; BATS; RMA; State 
Street.
    \223\ See e.g., letters from EWT; Coalition of Private 
Investment Companies; SIFMA; MFA; State Street; CBOE; Options 
Exchanges.
    \224\ See, e.g., letters from SIFMA; MFA; State Street; CBOE; 
Options Exchanges; Coalition of Private Investment Companies.
---------------------------------------------------------------------------

    Some commenters expressed concerns about the effect of the close-
out requirements of temporary Rule 204T on securities lending.\225\ One 
commenter also noted that in practice fails to deliver resulting from 
sales of securities on loan, which are considered ``long'' sales, are 
often closed out in accordance with the time-frames for fails to 
deliver resulting from short sales rather than long sales because 
temporary Rule 204T does not provide sufficient time to determine 
whether or not a fail to deliver position resulted from a long or short 
sale, which acts as a disincentive to lending and causes institutions 
to question their participation in lending programs.\226\ Other 
commenters expressed concerns regarding the impact of temporary Rule 
204T's close-out requirements on the lending recall process.\227\
---------------------------------------------------------------------------

    \225\ See, e.g., letter from SIFMA.
    \226\ See letter from SIFMA; see also letters from RMA; ICI.
    \227\ See letters from EWT; BATS; RMA; ICI; Wedbush; RMA.
---------------------------------------------------------------------------

    As discussed above, although we recognize commenters' concerns 
regarding the potential market impact of the close-out requirements of 
temporary Rule 204T, such close-out requirements are furthering our 
goal of reducing fails to deliver, as evidenced in part by preliminary 
results from OEA regarding its impact on the number of fails to

[[Page 38287]]

deliver.\228\ To maintain this reduction, we believe it is appropriate 
at this time to adopt as a permanent rule the requirement that fails to 
deliver resulting from short sales, long sales, and certain bona fide 
market making activity must be closed out by no later than the 
beginning of regular trading hours on the applicable close-out date.
---------------------------------------------------------------------------

    \228\ See supra note 164.
---------------------------------------------------------------------------

    In addition, as discussed above, we believe that continuing to 
require that fails to deliver be closed out on the day immediately 
following the day on which the fail to deliver occurs is consistent 
with our goal of reducing fails to deliver and addressing ``naked'' 
short selling and, in particular, potentially abusive ``naked'' short 
selling. Although extending the time-frames within which fails to 
deliver must be closed out may allow for ordinary course settlement, as 
several commenters contend, we believe that the close-out requirements 
of Rule 204 are necessary to help encourage delivery by settlement date 
and achieve our goal of not allowing fails to deliver to persist.
    We recognize that Rule 204T's close-out requirement resulted in 
costs for participants of a registered clearing agency in terms of 
systems and surveillance modifications and recordkeeping, as well as 
changes to processes and procedures. Because we have made limited 
modifications in Rule 204 to some of the requirements of temporary Rule 
204T, compliance with Rule 204's requirements may result in new costs 
for participants in terms of systems and surveillance modifications and 
recordkeeping, as well as changes to processes and procedures.
    We believe, however, that most of the infrastructure and personnel 
necessary to comply with Rule 204 is already in place to meet the 
requirements of Rule 203(b)(3) of Regulation SHO \229\ and temporary 
Rule 204T. As temporary Rule 204T has been in effect since September 
2008, and Rule 204 incorporates the substance of temporary Rule 204T 
with limited modifications, market participants should already have 
established systems and processes that should mitigate many of the 
costs to comply with Rule 204. Thus, we believe any additional costs 
incurred with respect to complying with Rule 204's close-out 
requirements, over those incurred with respect to complying with 
temporary Rule 204T, will be minimal.
---------------------------------------------------------------------------

    \229\ See 17 CFR 242.203(b)(3).
---------------------------------------------------------------------------

    In addition, we note that the close-out requirements of Rule 204 
are consistent with current settlement practices and procedures and 
with the close-out requirements of temporary Rule 204T and Rule 
203(b)(3) of Regulation SHO. For example, because most transactions 
settle by T+3, participants should already have had in place policies 
and procedures to help ensure that delivery is being made by settlement 
date prior to the implementation of the requirements of temporary Rule 
204T.\230\ Nevertheless, under Rule 204, as under temporary Rule 204T, 
we recognize that participants will continue to incur costs for each 
close-out and these costs could accumulate to significant amounts over 
time and across participants. For example, one commenter noted that 
``the close-out process is manual in nature and involves intensive 
monitoring of multiple levels of data across various system platforms 
and business units within the firm.'' \231\ We believe, however, that 
the experience participants have gained to date in complying with 
temporary Rule 204T is expected to reduce the costs to participants in 
complying with Rule 204 from those incurred in connection with 
complying with Rule 204T.
---------------------------------------------------------------------------

    \230\ See supra note 16.
    \231\ Letter from SIFMA.
---------------------------------------------------------------------------

    Moreover, similar to the existing close-out requirements of Rule 
203(b)(3) of Regulation SHO and consistent with temporary Rule 204T, 
the requirements of Rule 204 are based on a participant's fail to 
deliver position at a registered clearing agency. As noted above, the 
NSCC clears and settles the majority of equity securities trades 
conducted on the exchanges and in the over-the-counter markets.\232\ 
The NSCC clears and settles trades through the CNS system, which nets 
the securities delivery and payment obligations of all of its 
members.\233\ The NSCC notifies its members of their securities 
delivery and payment obligations daily.\234\ Because Rule 204 is based 
on a participant's fail to deliver position at a registered clearing 
agency, it is consistent with current settlement practices and 
procedures and with the Regulation SHO framework regarding delivery of 
securities.\235\ As such, we anticipate that most participants will 
already have systems, processes and procedures in place in order to 
comply with Rule 204's close-out requirements and, therefore, that any 
additional implementation costs associated with the rule will be 
minimal.
---------------------------------------------------------------------------

    \232\ See supra note 35.
    \233\ See id.
    \234\ See id.
    \235\ See 17 CFR 242.203(b)(3).
---------------------------------------------------------------------------

    In addition, to comply with Regulation SHO's close-out requirement 
when it became effective in January 2005, participants needed to modify 
their recordkeeping systems and surveillance mechanisms.\236\ 
Participants also should have retained and trained the necessary 
personnel to ensure compliance with the Regulation SHO's close-out 
requirements. As we noted in the Rule 204T Adopting Release, the 
infrastructure necessary to comply with the requirements of that rule 
should already be in place.\237\ Because Rule 204 incorporates the 
substance of temporary Rule 204T with limited modifications, we 
similarly believe that most of the infrastructure necessary to comply 
with Rule 204's close-out requirements will already be in place. Thus, 
we believe minimal modifications will be necessary to comply with Rule 
204. Accordingly, we believe that any changes to personnel, computer 
hardware and software, recordkeeping or surveillance costs will be 
minimal.\238\
---------------------------------------------------------------------------

    \236\ See, e.g., letter from SIFMA (indicating that their 
existing system for tracking and eliminating fails to deliver is 
based on the Regulation SHO framework).
    \237\ See Rule 204T Adopting Release, 73 FR 61725.
    \238\ See also supra Section VII.B.I. (discussing benefits of 
the close-out requirements despite commenters' costs concerns).
---------------------------------------------------------------------------

    We recognize that the requirements of Rule 204(a)(1) with respect 
to closing out fails to deliver resulting from long sales, may impose 
additional costs on participants. However, we believe that these costs 
are consistent with those currently borne by these entities in 
complying with temporary Rule 204T(a)(1). Under Rule 204(a)(1), a 
participant of a registered clearing agency that has a fail to deliver 
position at a registered clearing agency in an equity security and can 
demonstrate on its books and records that the fail to deliver position 
resulted from a long sale will have until no later than the beginning 
of regular trading hours on the third consecutive settlement day 
following the settlement date to immediately close out the fail to 
deliver position by purchasing or borrowing securities of like kind and 
quantity.\239\ Thus, to qualify for this additional time to close out a 
fail to deliver position, the rule requires the participant to 
demonstrate on its books and records that the fail to deliver position 
resulted from a long sale. This demonstration requirement may result in 
participants continuing to incur costs related to personnel, 
recordkeeping, systems, and surveillance mechanisms. However, because 
most of these systems have been in place since September 2008 in order 
for broker-dealers to comply with the requirements of temporary Rule

[[Page 38288]]

204T, we do not believe that the demonstration requirements of Rule 
204(a)(1) will result in significant additional cost.
---------------------------------------------------------------------------

    \239\ See Rule 204(a)(1).
---------------------------------------------------------------------------

    In addition, we recognize that the allocation notification 
requirement of Rule 204(d) may continue to impose costs on broker-
dealers that have been allocated responsibility for the close-out 
requirement under the rule. As discussed above, consistent with 
temporary Rule 204T(d), Rule 204(d) requires a broker-dealer that has 
been allocated a portion of a fail to deliver position that has not 
complied with the close-out requirements under the rule to notify the 
participant that it has become subject to the borrowing requirements of 
Rule 204(b). This notification requirement may result in broker-dealers 
incurring costs related to personnel, recordkeeping, systems, and 
surveillance mechanisms. Again, as most of these mechanisms have been 
in place since the implementation of temporary Rule 204T, we believe 
any further implementation costs will be minimal, and the costs 
incurred with each notification will be similar to those incurred under 
temporary Rule 204T.
    We also recognize that like temporary Rule 204T, the requirements 
of Rule 204(e) may continue to impose costs on broker-dealers. Rule 
204(e) allows a broker-dealer to obtain credit if it purchases 
securities in accordance with the conditions specified in that 
provision of the rule. Rule 204(e) requires, among other things, that a 
broker-dealer demonstrate that it has a net long position or net flat 
position on its books and records on the settlement day for which the 
broker-dealer is claiming credit. This demonstration requirement may 
continue to result in participants incurring costs related to 
personnel, recordkeeping, systems, and surveillance mechanisms. 
However, we believe the costs associated with Rule 204(e) will be 
minimal because the mechanisms necessary to comply with this 
requirement should already be in place.
2. Borrowing Requirements
    Consistent with temporary Rule 204T, we believe that Rule 204's 
borrowing requirements for fail to deliver positions that are not 
closed out in accordance with the rule will result in limited, if any, 
implementation costs--in terms of personnel, recordkeeping, systems and 
surveillance mechanisms--to participants of a registered clearing 
agency, and broker-dealers from which they receive trades for clearance 
and settlement. These entities have already had to comply with the 
borrowing requirements of Rule 203(b)(3)(iv) of Regulation SHO,\240\ 
since January 2005, and temporary Rule 204T since September 2008, as 
applicable, if a fail to deliver position has not been closed out in 
accordance with those rules' mandatory close-out requirements. 
Accordingly, participants and broker-dealers are already required to 
have in place the personnel, recordkeeping, systems, and surveillance 
mechanisms necessary to comply with Rule 204(b)'s borrowing 
requirements. Nevertheless, we recognize that these borrowing 
requirements will impose costs on participants, broker-dealers, and 
investors, and these costs can accumulate to significant amounts if the 
borrowing requirement is triggered often. One commenter stated a 
concern that, ``[R]equiring a borrow or arrangement to borrow 
securities prior to accepting or effectuating further short sales in a 
security that failed to deliver and has not been closed out, are overly 
restrictive.'' \241\ Because Rule 204 does not modify this requirement, 
we expect these costs to be similar to those under temporary Rule 204T.
---------------------------------------------------------------------------

    \240\ 17 CFR 242.203(b)(3)(iv).
    \241\ Letter from MFA.
---------------------------------------------------------------------------

    Consistent with temporary Rule 204T, however, Rule 204 is aimed at 
addressing potentially abusive ``naked'' short selling. To that end, we 
believe it is appropriate to continue to include in the rule borrowing 
requirements for participants and broker-dealers that sell short a 
security for which a fail to deliver position has not been closed out 
in accordance with the requirements of the rule. We believe that the 
borrowing requirements of Rule 204(b), like those already required by 
temporary Rule 204T(b), will help further our goals of reducing fails 
to deliver by helping to maintain the reductions in fails to deliver 
achieved by the adoption of temporary Rule 204T, as well as other 
actions taken by the Commission, and addressing potentially abusive 
``naked'' short selling by promoting the prompt and accurate clearance 
and settlement of securities transactions. By continuing to require 
that participants and broker-dealers from which they receive trades for 
clearance and settlement borrow or arrange to borrow securities prior 
to accepting or effecting additional short sales in the security that 
has a fail to deliver position that has not been closed out, the rule 
will continue to help ensure that shares will be available for delivery 
on the short sale by settlement date and, thereby, will continue to 
help avoid additional fails to deliver occurring in the security.
    Moreover, we believe any other costs incurred in connection with 
the borrowing requirements of Rule 204(b) will be limited because, 
consistent with temporary Rule 204T(b)(1), if a participant becomes 
subject to the borrowing requirements of Rule 204(b), a broker-dealer 
that clears through the participant will not also be subject to the 
borrowing requirements of Rule 204(b) if that broker-dealer can 
demonstrate that it was not responsible for any part of the fail to 
deliver position of the participant or that it has complied with the 
requirement of Rule 204(e).\242\
---------------------------------------------------------------------------

    \242\ See Rule 204(b).
---------------------------------------------------------------------------

    The certification requirement of Rule 204(b) may impose some costs 
on a broker-dealer having to demonstrate that it was not responsible 
for any part of the fail to deliver position of the participant. As 
discussed above, Rule 204(b) requires a broker-dealer to timely certify 
to the participant that it has not incurred a fail to deliver position 
on settlement date in an equity security for which the participant has 
a fail to deliver position at a registered clearing agency or the 
broker-dealer is in compliance with the requirements set forth in Rule 
204(e).\243\ However, as we noted in the PRA section for temporary Rule 
204T, the certification requirement's impact on broker-dealers' costs 
related to personnel, recordkeeping, systems, and surveillance 
mechanisms is expected to be limited.\244\ We expect that Rule 204's 
impact on broker-dealers' costs similarly will be limited because the 
requirements of Rule 204(b) are consistent with the requirements of 
temporary Rule 204T(b)(1).
---------------------------------------------------------------------------

    \243\ See id.
    \244\ See Rule 204T Adopting Release, 73 FR 61726-61727.
---------------------------------------------------------------------------

    Consistent with existing requirements under temporary Rule 204T(c), 
the notification requirement of Rule 204(c) may continue to impose 
costs on participants of a registered clearing agency. Rule 204(c) 
requires a participant to notify any broker-dealer from which it 
receives trades for clearance and settlement, including any market 
maker that would otherwise be entitled to rely on the exception 
provided in Rule 203(b)(2)(iii) of Regulation SHO,\245\ (1) that the 
participant has a fail to deliver position in an equity security at a 
registered clearing agency that has not been closed out in accordance 
with the requirements of Rule 204(a), and (2) when the purchase that 
the participant has made to close out the fail to deliver position has 
cleared and settled at a registered

[[Page 38289]]

clearing agency.\246\ This notification requirement may result in 
participants incurring costs related to personnel, recordkeeping, 
systems, and surveillance mechanisms. We believe, however, that any 
additional costs under Rule 204 will be minimal because participants 
should already have in place mechanisms necessary to comply with this 
requirement pursuant to temporary Rule 204T.
---------------------------------------------------------------------------

    \245\ See supra note 199.
    \246\ See Rule 204(c).
---------------------------------------------------------------------------

 3. Sales of Certain Deemed To Own Securities
    We do not believe that the modification in Rule 204(a)(2) to apply 
the close-out requirement to fails to deliver resulting from the sale 
of any equity security that a person is ``deemed to own'' pursuant to 
Rule 200 of Regulation SHO, and that such person intends to deliver as 
soon as all restrictions on delivery have been removed, rather than 
just fails to deliver resulting from sales of Rule 144 Securities as in 
temporary Rule 204T(a)(2), will impose any significant additional cost 
on participants.\247\ In fact, this modification is responsive to 
issues raised by commenters and should decrease costs from those of 
temporary Rule 204T by providing additional time to close out fails to 
deliver in additional ``deemed to own'' securities.\248\
---------------------------------------------------------------------------

    \247\ See Rule 204(a)(2).
    \248\ See, e.g., letter from SIFMA.
---------------------------------------------------------------------------

    Participants may incur some costs to implement changes to their 
current systems to comply with the limited modifications in Rule 
204(a)(2) as compared with temporary Rule 204T(a)(2). Specifically, 
participants will have to ensure that their systems apply the close-out 
requirements to all ``deemed to own'' securities, rather than just 
equity securities sold pursuant to Rule 144 of the Securities Act, as 
well as monitor for compliance with the 35 calendar day close-out 
period. However, we believe the costs for such adjustments will be 
minimal.

VIII. 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 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.\249\ 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.\250\ 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.
---------------------------------------------------------------------------

    \249\ 15 U.S.C. 78c(f).
    \250\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    We believe Rule 204 will not materially affect the promotion of the 
efficiency of the capital markets. Rule 204 makes some modifications 
relative to temporary Rule 204T and we believe that Rule 204 will help 
limit disruptions due to potentially abusive ``naked'' short selling, 
but several commenters argue that temporary Rule 204T created 
disruptions at the open and empirical evidence suggests that fails to 
deliver, on average, are unrelated to stock prices.\251\
---------------------------------------------------------------------------

    \251\ See, e.g., Fotak, Raman, and Yadav, 2009, Naked Short 
Selling: The Emperor's New Clothes?, working paper, University of 
Oklahoma.
---------------------------------------------------------------------------

    As discussed in the Rule 204T Adopting Release, we believe that 
Rule 204 will help further our goals of reducing fails to deliver by 
maintaining the reductions in fails to deliver achieved by the adoption 
of temporary Rule 204T, as well as other actions taken by the 
Commission, and addressing potentially abusive ``naked'' short selling 
without unduly burdening legitimate short selling activity. Rule 204 is 
intended to maintain the significant reductions in the number of fails 
to deliver in all equity securities since, among other actions, the 
adoption of temporary Rule 204T \252\ by requiring that participants of 
a registered clearing agency that have a fail to deliver position, 
immediately close out the fail to deliver position by borrowing or 
purchasing securities of like kind and quantity by no later than the 
beginning of regular trading hours on the applicable close-out date. A 
participant that does not comply with Rule 204's close-out 
requirements, and any broker-dealer from which it receives trades for 
clearance and settlement, will not be able to short sell the security 
either for itself or for the account of another, unless it has borrowed 
the security, or entered into a bona fide arrangement to borrow the 
security, until the fail to deliver position is closed out.
---------------------------------------------------------------------------

    \252\ See supra note 164.
---------------------------------------------------------------------------

    The rule is designed to help ensure that buyers of equity 
securities receive delivery of their shares, thereby helping to 
discourage persistent fails to deliver, which may have a negative 
effect on the securities markets and investors and also may be used to 
facilitate manipulative trading strategies. By requiring that 
participants of a registered clearing agency borrow or purchase 
securities to close out a fail to deliver position by no later than the 
beginning of regular trading hours on the applicable close-out date, 
Rule 204 will promote the prompt clearance and settlement of securities 
transactions. By doing so, the rule will help further our goals of 
reducing fails to deliver by maintaining the reductions in fails to 
deliver achieved by the adoption of temporary Rule 204T, as well as 
other actions taken by the Commission, and addressing potentially 
abusive ``naked'' short selling and, thereby, will help ensure that 
investors remain confident that trading can be conducted without the 
illegal influence of manipulation. A loss of confidence in the market 
for these securities can lead to panic selling, which may be further 
exacerbated by potentially abusive ``naked'' short selling.
    We sought comment regarding whether the rule may adversely impact 
liquidity, disrupt markets, or unnecessarily increase risks or costs to 
participants of a registered clearing agency. We are incorporating by 
reference the discussion in the Rule 204T Adopting Release regarding 
the burden on competition and promotion of efficiency, competition, and 
capital formation,\253\ except to the extent that we have made 
modifications or because we are addressing comments.
---------------------------------------------------------------------------

    \253\ See Rule 204T Adopting Release, 73 FR 61728-61729.
---------------------------------------------------------------------------

    Several commenters suggested that temporary Rule 204T has had a 
negative impact, particularly at the market open.\254\ Although we 
recognize commenters' concerns regarding the potential market impact of 
the close-out requirements of temporary Rule 204T, we believe that 
these potential concerns are justified by the benefits of retaining the 
strict close-out requirements of temporary Rule 204T. In addition, we 
note that the close-out provisions of Rule 204 provide additional 
flexibility in 204(a)(1) and (a)(3) by allowing a participant to close 
out a fail to deliver position resulting from a long sale or certain 
bona fide market making activity by borrowing as well as purchasing 
securities. In addition, as discussed above, in contrast to temporary 
Rule 204T, participants may satisfy the close-out requirement to 
purchase securities of like kind and quantity with a VWAP order.\255\ 
This increased flexibility in

[[Page 38290]]

Rule 204, as compared with temporary Rule 204T, is expected to reduce 
the possibility of the increased volatility and market disruptions 
potentially caused by temporary Rule 204T by potentially providing 
additional sources of liquidity from which to obtain shares to close 
out fail to deliver positions.
---------------------------------------------------------------------------

    \254\ See supra Section III (discussing commenters' concerns 
regarding the market impact of temporary Rule 204T).
    \255\ See supra note 66.
---------------------------------------------------------------------------

    We believe that the rule will promote capital formation. Issuers 
and investors have repeatedly expressed concerns about fails to deliver 
in connection with potentially manipulative ``naked'' short 
selling.\256\ The perception that potentially abusive ``naked'' short 
selling is occurring in securities could 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.\257\ 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. 
As previously noted, preliminary results from OEA indicate that the 
Commission's various recent actions with respect to further reducing 
fails to deliver, including the adoption of temporary Rule 204T, have 
contributed to a significant reduction in the number of fails to 
deliver.\258\ In addition, the rule may lead to a greater certainty in 
the settlement of these securities which is expected to strengthen 
investor confidence in the settlement process. Therefore, we believe 
maintaining the substance of temporary Rule 204T in permanent Rule 204 
will help achieve the Commission's goals of preventing substantial 
disruption in the securities markets, reducing fails to deliver by 
maintaining the reductions in fails to deliver achieved by the adoption 
of temporary Rule 204T, as well as other actions taken by the 
Commission, and helping to prevent potentially abusive ``naked'' short-
selling.
---------------------------------------------------------------------------

    \256\ See, e.g., 2008 Regulation SHO Final Amendments, 73 FR 
61690.
    \257\ See supra note 28 (discussing comments in response to the 
Rule 204T Adopting Release 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). In connection with prior proposed amendments to Regulation 
SHO aimed at reducing fails to deliver and addressing potentially 
abusive ``naked'' short selling, such as the 2007 Regulation SHO 
Proposed Amendments, we sought comment on whether such proposed 
amendments would promote capital formation, including whether the 
proposed increased short sale restrictions would affect investors' 
decisions to invest in certain equity securities. 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. See, e.g., letters 
from Medis; NCANS.
    \258\ See supra note 164.
---------------------------------------------------------------------------

    We also believe that the rule will not impose any burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Exchange Act. By requiring that participants of a registered 
clearing agency borrow or purchase securities to close out a fail to 
deliver position by no later than the beginning of regular trading 
hours on the applicable close-out date, we believe the rule will 
promote competition by requiring similarly situated participants of a 
registered clearing agency, including broker-dealers from which they 
receive trades for clearance and settlement, to close out fail to 
deliver positions in any equity securities within similar time-frames. 
Moreover, the requirements of the rule will help to further reduce any 
possibility that potentially abusive ``naked'' short selling may 
contribute to the disruption of markets in equity securities and, 
therefore, will help ensure that all investors remain confident that 
trading in these securities can be conducted without the influence of 
illegal manipulation. We also believe that the rule will promote 
competition by protecting and enhancing the operation, integrity, and 
stability of the markets. At the same time, the rule will help to 
maintain fair and orderly markets without unduly restricting legitimate 
short selling.

IX. Final Regulatory Flexibility Analysis

    The Final Regulatory Flexibility Analysis (``FRFA'') has been 
prepared in accordance with 5 U.S.C. 604. This FRFA relates to the 
adoption of Rule 204 to Regulation SHO.\259\
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    \259\ Although the requirements of the Regulatory Flexibility 
Act are not applicable to rules adopted under the Administrative 
Procedure Act's ``good cause'' exception, see 5 U.S.C. 601(2) 
(defining ``rule'' and notice requirements under the Administrative 
Procedures Act), we nevertheless prepared an FRFA.
---------------------------------------------------------------------------

A. Need for and Objectives of the Rule

    Sections I through VI of this release describe the reasons for and 
objectives of Rule 204. As previously stated in the temporary Rule 204T 
Adopting Release,\260\ we are concerned that the close-out requirements 
of Regulation SHO have not gone far enough in reducing fails to deliver 
and addressing potentially abusive ``naked'' short selling. Thus, we 
are incorporating the requirements of temporary Rule 204T with limited 
modification into Rule 204 to help maintain the recent reductions in 
fails to deliver resulting from the implementation of temporary Rule 
204T and other Commission actions. We believe the adoption of Rule 204 
is appropriate to continue our goals of reducing fails to deliver by 
maintaining the reductions in fails to deliver achieved by the adoption 
of temporary Rule 204T, as well as other actions taken by the 
Commission, addressing potentially abusive ``naked'' short selling, and 
providing an incentive for sellers to promptly deliver securities by 
settlement date.
---------------------------------------------------------------------------

    \260\ See Rule 204T Adopting Release, 73 FR 61712.
---------------------------------------------------------------------------

B. Small Entities Affected by the Rule

    The entities covered by the rule will include small entities that 
are participants of a registered clearing agency and small broker-
dealers from which participants receive trades for clearance and 
settlement. In addition, the entities covered by the rule will include 
small entities that are market participants that effect sales subject 
to the requirements of Regulation SHO. Although it is impossible to 
quantify every type of small entity covered by the rule, Paragraph 
(c)(1) of Rule 0-10 under the Exchange Act \261\ 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. We estimate that as of 2008 there were 
approximately 915 broker-dealers that qualified as small entities as 
defined above.\262\
---------------------------------------------------------------------------

    \261\ 17 CFR 240.0-10(c)(1).
    \262\ These numbers are based on OEA's review of 2008 FOCUS 
Report filings reflecting registered broker-dealers. This number 
does not include broker-dealers that are delinquent on FOCUS Report 
filings.
---------------------------------------------------------------------------

    As noted above, the entities covered by the rule will include small 
entities that are participants of a registered clearing agency. As of 
May 30, 2009, approximately 89% of participants of the NSCC, the 
primary registered clearing agency responsible for clearing U.S. 
transactions, were registered as broker-dealers. Participants not 
registered as broker-dealers include such entities as banks, U.S.-
registered exchanges, and clearing agencies. Although these entities 
are participants of a registered clearing agency, generally these 
entities do not engage in the types of activities that would implicate 
the close-out requirements of Regulation SHO.

[[Page 38291]]

    The Federal securities laws do not define what is a ``small 
business'' or ``small organization'' when referring to a bank. The 
Small Business Administration regulations define ``small entities'' to 
include banks and savings associations with total assets of $175 
million or less.\263\ As of May 30, 2009, no bank that was a 
participant of the NSCC was a ``small entity'' because none met that 
criteria.
---------------------------------------------------------------------------

    \263\ See 13 CFR 121.201.
---------------------------------------------------------------------------

    Paragraph (e) of Rule 0-10 under the Exchange Act \264\\\ states 
that the term ``small business'' or ``small organization,'' when 
referring to an exchange, means any exchange that: (1) Has been 
exempted from the reporting requirements of Rule 601 under the Exchange 
Act; and (2) is not affiliated with any person (other than a natural 
person) that is not a small business or small organization, as defined 
by Rule 0-10. No U.S. registered exchange is a small entity because 
none meets these criteria.
---------------------------------------------------------------------------

    \264\ 17 CFR 240.0-10(e).
---------------------------------------------------------------------------

    Paragraph (d) of Rule 0-10 under the Exchange Act \265\ states that 
the term ``small business'' or ``small organization,'' when referring 
to a clearing agency, means a clearing agency that: (1) Compared, 
cleared and settled less than $500 million in securities transactions 
during the preceding fiscal year (or in the time that it has been in 
business, if shorter); (2) had less than $200 million in funds and 
securities in its custody or control at all times during the preceding 
fiscal year (or in the time that it has been in business, if shorter); 
and (3) is not affiliated with any person (other than a natural person) 
that is not a small business or small organization as defined by Rule 
0-10. No clearing agency that is subject to the requirements of 
Regulation SHO is a small entity because none meets these criteria.
---------------------------------------------------------------------------

    \265\ 17 CFR 240.0-10(d).
---------------------------------------------------------------------------

C. Projected Reporting, Recordkeeping and Other Compliance Requirements

    The rule may impose some new or additional reporting, 
recordkeeping, or compliance costs on small entities that are 
participants of a clearing agency registered with the Commission and 
small broker-dealers from which the participant receives trades for 
clearance and settlement. We do not believe, at this time, that any 
specialized professional skills will be necessary to comply with the 
rule.

D. Agency Action To Minimize Effect on Small Entities

    As required by the Regulatory Flexibility Act, we have considered 
alternatives that would accomplish our stated objectives, while 
minimizing any significant adverse impact on small entities. Rule 204 
is not expected to adversely affect small entities because it imposes 
minimal reporting, record keeping, or compliance requirements, many of 
which were previously required of small entities pursuant to the 
implementation of Regulation SHO and, more recently, temporary Rule 
204T. Moreover, it is not appropriate to develop separate requirements 
for small entities because we believe that to accomplish the 
Commission's stated goals, all broker-dealers, regardless of size, 
should be subject to the same enhanced delivery requirements imposed by 
the rule.

E. Duplicative, Overlapping, or Conflicting Federal Rules

    The Commission believes that there are no rules that duplicate, 
overlap, or conflict with Rule 204. The Commission has designed the 
rule so that it is consistent with the close-out requirements of Rule 
203(b)(3) of Regulation SHO. In addition, with limited modifications to 
address commenters' concerns, Rule 204 incorporates the substance and 
maintains most of the components of temporary Rule 204T of Regulation 
SHO and will become effective on July 31, 2009, the expiration date for 
temporary Rule 204T.

F. Significant Alternatives

    The Regulatory Flexibility Act directs us to consider significant 
alternatives that would accomplish our stated objective, while 
minimizing any significant adverse impact on small entities.\266\ In 
connection with the rule, we considered the following alternatives: (1) 
Establishing different compliance or reporting standards or timetable 
that take into account the resources available to small entities; (2) 
clarifying, consolidating, or simplifying compliance requirements under 
the rule for small entities; (3) using performance rather than design 
standards; and (4) exempting small entities from coverage of the rule, 
or any part of the rule.
---------------------------------------------------------------------------

    \266\ See 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    The rule furthers the Commission's stated goal of helping to 
eliminate the possibility that potentially abusive ``naked'' short 
selling may contribute to disruption in the securities markets and, 
therefore, to help ensure that investors remain confident that trading 
in equity securities can be conducted without the illegal influence of 
manipulation. The rule also furthers the goals of helping to maintain 
fair and orderly markets against the threat of sudden and excessive 
fluctuations of securities prices generally.
    The rule should not adversely affect small entities because the 
rule will impose only minimal compliance requirements, many of which 
were previously required of small entities pursuant to the 
implementation of Regulation SHO and, more recently, temporary Rule 
204T. Moreover, it is not appropriate to develop different compliance 
requirements for small entities with respect to the rule because we 
believe all entities, including small entities, should be subject to 
the requirements of the rule. We believe that imposing different 
compliance requirements, and possibly a different timetable for 
implementing compliance requirements, for small entities would 
undermine the Commission's goals of reducing fails to deliver by 
maintaining the reductions in fails to deliver achieved by the adoption 
of temporary Rule 204T, as well as other actions taken by the 
Commission, and addressing potentially abusive ``naked'' short selling. 
We have concluded similarly that it is not consistent with the goal of 
the rule to further clarify, consolidate or simplify the rule for small 
entities. The Commission also believes that it is inconsistent with the 
purposes of the Exchange Act to exempt small entities from having to 
comply with the rule.

X. Statutory Authority

    Pursuant to the Exchange Act and, particularly, Sections 2, 9(h), 
10, 11A, 15, 17, 17A, and 23(a) thereof, 15 U.S.C. 78b, 78i(h), 78j, 
78k-1, 78o, 78q, 78q-1, and 78w(a), the Commission is amending 
Regulation SHO to adopt Rule 204.

XI. Text of Amendments

List of Subjects

17 CFR Part 200

    Administrative practice and procedure, Authority delegations 
(Government agencies).

17 CFR Part 242

    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:

[[Page 38292]]

PART 200--ORGANIZATION; CONDUCT AND ETHICS; AND INFORMATION AND 
REQUESTS

0
1. The authority citation for Part 200, Subpart A, continues to read in 
part as follows:

    Authority:  15 U.S.C. 77o, 77s, 77sss, 78d, 78d-1, 78d-2, 78w, 
78ll(d), 78mm, 80a-37, 80b-11, and 7202, unless otherwise noted.
* * * * *

0
2. Section 200.30-3 is amended by adding paragraph (a)(11) to read as 
follows:


Sec.  200.30-3  Delegation of authority to Director of Division of 
Trading and Markets.

* * * * *
    (a) * * *
    (11) Upon written application or upon its own motion, either 
unconditionally or on specified terms and conditions, to grant or deny 
by order an exemption from the requirements of Regulation SHO (Sec.  
242.200 of this chapter) under the Act pursuant to Section 36 of the 
Act (15 U.S.C. 78mm).
* * * * *

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

0
3. The authority citation for part 242 continues to read as follows:

    Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2), 
78i(a), 78j, 78k-1(c), 781, 78m, 78n, 78o(b), 78o(c), 78o(g), 
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and 
80a-37.


0
4. Section 242.204 is added to read as follows:


Sec.  242.204  Close-out requirement.

    (a) A participant of a registered clearing agency must deliver 
securities to a registered clearing agency for clearance and settlement 
on a long or short sale in any equity security by settlement date, or 
if a participant of a registered clearing agency has a fail to deliver 
position at a registered clearing agency in any equity security for a 
long or short sale transaction in that equity security, the participant 
shall, by no later than the beginning of regular trading hours on the 
settlement day following the settlement date, immediately close out its 
fail to deliver position by borrowing or purchasing securities of like 
kind and quantity; Provided, however:
    (1) If a participant of a registered clearing agency has a fail to 
deliver position at a registered clearing agency in any equity security 
and the participant can demonstrate on its books and records that such 
fail to deliver position resulted from a long sale, the participant 
shall by no later than the beginning of regular trading hours on the 
third consecutive settlement day following the settlement date, 
immediately close out the fail to deliver position by purchasing or 
borrowing securities of like kind and quantity;
    (2) If a participant of a registered clearing agency has a fail to 
deliver position at a registered clearing agency in any equity security 
resulting from a sale of a security that a person is deemed to own 
pursuant to Sec.  242.200 and that such person intends to deliver as 
soon as all restrictions on delivery have been removed, the participant 
shall, by no later than the begining of regular trading hours on the 
thirty-fifth consecutive calendar day following the trade date for the 
transaction, immediately close out the fail to deliver position by 
purchasing securities of like kind and quantity; or
    (3) If a participant of a registered clearing agency has a fail to 
deliver position at a registered clearing agency in any equity security 
that is attributable to bona fide market making activities by a 
registered market maker, options market maker, or other market maker 
obligated to quote in the over-the-counter market, the participant 
shall by no later than the beginning of regular trading hours on the 
third consecutive settlement day following the settlement date, 
immediately close out the fail to deliver position by purchasing or 
borrowing securities of like kind and quantity.
    (b) If a participant of a registered clearing agency has a fail to 
deliver position in any equity security at a registered clearing agency 
and does not close out such fail to deliver position in accordance with 
the requirements of paragraph (a) of this section, the participant and 
any broker or dealer from which it receives trades for clearance and 
settlement, including any market maker that would otherwise be entitled 
to rely on the exception provided in Sec.  242.203(b)(2)(iii), may not 
accept a short sale order in the equity security from another person, 
or effect a short sale in the equity security for its own account, to 
the extent that the broker or dealer submits its short sales to that 
participant for clearance and settlement, without first borrowing the 
security, or entering into a bona fide arrangement to borrow the 
security, until the participant closes out the fail to deliver position 
by purchasing securities of like kind and quantity and that purchase 
has cleared and settled at a registered clearing agency; Provided, 
however: A broker or dealer shall not be subject to the requirements of 
this paragraph if the broker or dealer timely certifies to the 
participant of a registered clearing agency that it has not incurred a 
fail to deliver position on settlement date for a long or short sale in 
an equity security for which the participant has a fail to deliver 
position at a registered clearing agency or that the broker or dealer 
is in compliance with paragraph (e) of this section.
    (c) The participant must notify any broker or dealer from which it 
receives trades for clearance and settlement, including any market 
maker that would otherwise be entitled to rely on the exception 
provided in Sec.  242.203(b)(2)(iii):
    (1) That the participant has a fail to deliver position in an 
equity security at a registered clearing agency that has not been 
closed out in accordance with the requirements of paragraph (a) of this 
section; and
    (2) When the purchase that the participant has made to close out 
the fail to deliver position has cleared and settled at a registered 
clearing agency.
    (d) If a participant of a registered clearing agency reasonably 
allocates a portion of a fail to deliver position to another registered 
broker or dealer for which it clears trades or from which it receives 
trades for settlement, based on such broker's or dealer's short 
position, the provisions of paragraphs (a) and (b) of this section 
relating to such fail to deliver position shall apply to such 
registered broker or dealer that was allocated the fail to deliver 
position, and not to the participant. A broker or dealer that has been 
allocated a portion of a fail to deliver position that does not comply 
with the provisions of paragraph (a) of this section must immediately 
notify the participant that it has become subject to the requirements 
of paragraph (b) of this section.
    (e) Even if a participant of a registered clearing agency has not 
closed out a fail to deliver position at a registered clearing agency 
in accordance with paragraph (a) of this section, or has not allocated 
a fail to deliver position to a broker or dealer in accordance with 
paragraph (d) of this section, a broker or dealer shall not be subject 
to the requirements of paragraph (a) or (b) of this section if the 
broker or dealer purchases or borrows the securities, and if:
    (1) The purchase or borrow is bona fide;
    (2) The purchase or borrow is executed after trade date but by no 
later than the end of regular trading hours on settlement date for the 
transaction;
    (3) The purchase or borrow is of a quantity of securities 
sufficient to cover the entire amount of that broker's or

[[Page 38293]]

dealer's fail to deliver position at a registered clearing agency in 
that security; and
    (4) The broker or dealer can demonstrate that it has a net flat or 
net long position on its books and records on the day of the purchase 
or borrow.
    (f) A participant of a registered clearing agency shall not be 
deemed to have fulfilled the requirements of this section where the 
participant enters into an arrangement with another person to purchase 
or borrow securities as required by this section, and the participant 
knows or has reason to know that the other person will not deliver 
securities in settlement of the purchase or borrow.
    (g) Definitions. (1) For purposes of this section, 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.
    (2) For purposes of this section, the term regular trading hours 
has the same meaning as in Rule 600(b)(64) of Regulation NMS (17 CFR 
242.600(b)(64)).

    Dated: July 27, 2009.

    By the Commission.
Elizabeth M. Murphy,
 Secretary.
[FR Doc. E9-18185 Filed 7-30-09; 8:45 am]
BILLING CODE 8010-01-P