January 3, 2005

Ira Hammerman
Senior Vice President and General Counsel
Securities Industry Association
120 Broadway, 35th Floor
New York, NY 10271-0080

Dear Mr. Hammerman:

In your letter dated January 3, 2005, as supplemented by telephone conversations with the staff of the Division of Market Regulation ("Division"), you request on behalf of the Securities Industry Association ("SIA") confirmation that the Division will not recommend to the Commission enforcement action against a broker-dealer that marks "short," rather than "short exempt," a short sale effected in certain classes of securities, or during certain specified periods of time, that have been granted an exemption from the "tick" test of Rule 10a-1 under the Securities Exchange Act of 1934, as amended ("Exchange Act"), or the price test of any exchange or national securities association (collectively, a "price test"), as set forth in Appendix A of your letter. A copy of your letter is attached to this response. By including a copy of your correspondence, we avoid having to repeat or summarize the facts you presented. The defined terms in this letter have the same meaning as in your letter, unless otherwise noted.

In your letter you make the following representations, among others:

1. The Commission has previously granted various exemptions from short sale price test restrictions for certain classes of securities, including exchange traded funds ("ETFs") and other similar products. In granting such exemptions to ETFs, the Commission noted that its decision was generally based on the fact that the market value of ETF shares would rise or fall based on changes in the net asset value of the component stocks in the particular index, and supply and demand. The relief was conditioned on the ETF meeting certain enumerated conditions, either specific to certain products or included as part of a broader "class exemption."
    
2. The Commission has also previously granted exemptions from short sale price test restrictions for sales that occur during certain specified periods of time. For example, the Commission has granted relief from the price test to allow requesting exchanges and broker-dealers to execute short sales in after-hours crossing sessions at a price that is equal to a security's closing price on the primary exchange.
    
3. Absent relief, commencing on the Regulation SHO compliance date of January 3, 2005, broker-dealers would be required to mark "short exempt" all short sales effected in any class of products, or during certain specified periods of time, that have been granted an exemption from a price test. This would in turn would have broad impacts across many systems in the firms that process orders, including front-end systems to institute order marking changes for customers, trade processing systems, and customer and regulatory reporting systems. Implementing such systems changes would impose upon firms extreme time and financial burdens.
    
4. A "short exempt" marking requirement for such "transaction-based exemptions" may thus be necessary to inform the market center that an individual trade may properly be executed without regard to a price test where a seller is relying on an exception or exemption from the price test based on discrete facts and circumstances. These same concerns do not exist where an entire class of security, or a short sale effected during such designated periods of time, is subject to a wholesale exemption from a price test. To the contrary, requiring such short sales to be marked "short exempt" could actually serve to detriment investors by needlessly slowing down executions. For example, as noted in the recent New York Stock Exchange Information Memo on Regulation SHO, orders in the specialist book and good-till-executed orders, as well as certain other orders, automatically participate in NYSE Crossing Session I. However, absent the requested relief, if these orders were marked "short," they would need to be withdrawn and re-marked "short exempt," which could in turn cause these orders to lose priority, and risk only receiving a partial execution, or no execution at all.
    

Response:

Rule 200(g) of Regulation SHO provides that a broker-dealer must mark all sell orders of any equity security as "long," "short," or "short exempt." Rule 200(g)(2) requires that a short sale order must be marked "short exempt" if the seller is relying on an exception from the tick test of Rule 10a-1 of the Exchange Act or any short sale price test of any exchange or national securities association.

Based on your representations, in particular, that: (i) for each product and after-hours crossing session qualifying for the exemptions from the price test of Rule 10a-1 listed in Appendix A of your letter ("exempt short sales"), the various market centers that execute exempt short sales have instituted procedures to "mask" the short sale character of the transaction so that they are executed as short exempt; (ii) such market centers monitor on a regular basis to confirm that any such product or transaction continues to meet the conditions for the exemptive relief and re-institute the price test for any product or transaction that fails to satisfy such conditions; (iii) a broker-dealer executing exempt short sales will mark such sales as "short," and in no event will such sales be marked "long;" and (iv) the market centers will maintain an audit trail of all such trade executions, which is capable of being produced and subject to review upon request by the Commission and other appropriate regulatory authorities, the Division is of the view that broker-dealers marking exempt short sales as "short" rather than "short exempt" is not inconsistent with the purposes of Rule 200(g) of Regulation SHO.

Accordingly, on the basis of your representations and the facts presented, and without necessarily concurring in your analysis, the Division will not recommend to the Commission enforcement action under Rule 200(g) of Regulation SHO if a broker-dealer marks "short," rather than "short exempt," a short sale that is effected in the products or in the crossing sessions pursuant to exemptions from the price test of Rule 10a-1 that have been granted, as reflected in Appendix A to this letter, subject to the following conditions:

1. For each exempt short sale, the various market centers that execute such sales have instituted procedures to "mask" the short sale character of the transaction so that they are executed as short exempt;
    
2. Such market centers monitor on a regular basis to confirm that any such product or transaction continues to meet the conditions for the exemptive relief and re-institute the price test for any product or transaction that fails to satisfy such conditions;
    
3. A broker-dealer executing exempt short sales will mark such sales as "short," and in no event will such sales be marked "long;" and
    
4. The market centers will maintain an audit trail of all such trade executions, which is capable of being produced and subject to review upon request by the Commission and other appropriate regulatory authorities.
    

This position concerns enforcement action only and does not represent a legal conclusion with respect to the applicability of statutory or regulatory provisions of the federal securities laws. Moreover, this position is based on the facts you have presented and the representations you have made, and any different facts or conditions may require a different response. In addition, this position is subject to modification or revocation if at any time the Commission or the Division determines that such action is necessary or appropriate in furtherance of the purposes of the Exchange Act. Finally, the Division expresses no view with respect to any other questions that the proposed activities may raise, including the applicability of other federal or state laws to those activities.

In addition, your attention is directed to the anti-fraud and anti-manipulation provisions of the Exchange Act, particularly Sections 9(a) and 10(b), and Rule 10b-5 thereunder. Responsibility for compliance with these and any other applicable provisions of the federal securities laws must rest with the registered broker-dealer. This Division expresses no view with respect to any other questions that the proposed transactions may raise, including, but not limited to, the adequacy of the disclosure concerning, and the applicability of any federal or state laws to, the proposed transactions.

Very truly yours,

James A. Brigagliano
Assistant Director

Incoming Letter:

James A. Brigagliano
Assistant Director
Division of Market Regulation
U.S. Securities & Exchange Commission
450 Fifth Street, N.W.
Washington, D.C., 20549

Via Fax and Hand Delivery

Re: Request for No-Action Relief from Regulation SHO Marking Requirement

Dear Mr. Brigagliano:

The Securities Industry Association (the "SIA"),¹ hereby requests that the Staff of the Division of Market Regulation ("Division") confirm that it will not recommend enforcement action to the Securities and Exchange Commission ("Commission") against a broker-dealer that marks "short,"² rather than "short exempt," a short sale effected in any class of securities, or during certain specified periods of time, that have been granted an exemption³ from the "tick" test of Rule 10a-1 under the Securities Exchange Act of 1934, as amended ("Exchange Act"),⁴ or the price test of any national securities exchange or national securities association (collectively, a "price test").⁵ As the market centers will have made programming changes to remove the price test restrictions for all such classes of securities that have been granted an exemption, all orders marked "short" will be executed without regard to any price test. Any broker-dealer will still be required to mark sales in such securities "short," and in no circumstance should such sales be marked "long."⁶

I. Background

The Commission recently adopted Regulation SHO, which provides a new regulatory framework governing short sales of securities,⁷ and has a compliance date of January 3, 2005.⁸ As adopted, among other things, Rule 200(g) of Regulation SHO requires broker-dealers to mark all sell orders of any equity security as "long," "short," or "short exempt." A short sale order shall be marked "short exempt" if the seller is relying on an exception from a price test.

The Commission has previously granted (pursuant to authority delegated to the Division) various exemptions from short sale price test restrictions for certain classes of securities, including exchange traded funds ("ETFs") and other similar products.⁹ In granting such exemptions to ETFs, the Commission noted that its decision was generally based on the fact that the market value of ETF shares would rise or fall based on changes in the net asset value of the component stocks in the particular index, and supply and demand. The relief was conditioned on the ETF meeting certain enumerated conditions, either specific to certain products or included as part of a broader "class exemption."¹⁰

For each of these products that have been granted exemptions, the various market centers that execute short sales in such products (e.g., exchanges, Nasdaq, ECNs, executing brokers) have made programming changes to "mask" (i.e., remove) the price test restrictions.¹¹ These market centers also monitor on a regular basis to confirm that any such product continues to meet the conditions for the exemptive relief, and make programming changes to re-institute the price test for any product that fails to satisfy such conditions.¹² Based on the fact that the market centers have automatic programming procedures for these broad classes of securities, it is not necessary for market participants submitting orders in such securities to distinguish between "short" and "short exempt" orders, and the market centers generally allow orders marked "short" in these products to be executed without regard to a price test.

The Commission has also previously granted exemptions from short sale price test restrictions for sales that occur during certain specified periods of time. For example, the Commission has granted relief from the price test to allow requesting exchanges and broker-dealers to execute short sales in after-hours crossing sessions at a price that is equal to a security's closing price on the primary exchange.¹³ Absent relief, such short sales could violate Rule 10a-1, in that the matching price (the closing price) of a security could be on a minus or zero-minus tick with respect to the last sale in the consolidated transaction reporting system. In granting such relief, the Commission has noted that short sale transactions executed at the closing price generally do not represent the types of abusive practices that Rule 10a-1 is designed to prevent, largely due to the fact that short sales entered in the after-hours crossing sessions cannot influence the matching price.¹⁴ Similar to the exemptions that have been granted for certain products, the market centers that execute short sales during such specified periods of time have made generally the same programming changes to remove the price test restrictions, and it is thus not necessary for market participants to distinguish between "short" and "short exempt" orders.

II. Discussion

Absent relief, commencing on the Regulation SHO compliance date of January 3, 2005, broker-dealers would be required to mark "short exempt" all short sales effected in any class of products, or during certain specified periods of time, that have been granted an exemption from a price test. This would in turn have broad impacts across many systems in the firms that process orders, including front-end systems to institute order marking changes for customers, trade processing systems, and customer and regulatory reporting systems. Implementing such systems changes would impose upon firms extreme time and financial burdens.¹⁵

Moreover, it is highly questionable whether the benefits associated with such requirements would outweigh the associated costs. As noted above, the market centers that execute trades in such products, or effect short sales during such designated periods of time, have already instituted the necessary systems changes to remove the price test, where appropriate. In this regard, this is very different from the situation where a seller is relying on an exception or exemption from the price test based on discrete facts and circumstances.¹⁶ A "short exempt" marking requirement for such "transaction-based exemptions" may be necessary to inform the market center that an individual trade may properly be executed without regard to a price test. These same objectives do not exist where an entire class of security, or a short sale effected during such designated periods of time, is subject to a wholesale exemption from a price test.

To the contrary, requiring such short sales to be marked "short exempt" could actually act to the detriment of investors by needlessly slowing down executions. For example, as noted in the recent New York Stock Exchange Information Memo on Regulation SHO, orders in the specialist book and good-till-executed orders, as well as certain other orders, automatically participate in NYSE Crossing Session I.¹⁷ However, absent the requested relief, if these orders were marked "short," they would need to be withdrawn and re-marked "short exempt," which could in turn cause these orders to lose priority, and risk their receiving only a partial execution, or no execution at all.

III. Request for No-Action Relief

Based on the foregoing, we respectfully request that the Division confirm that it will not recommend enforcement action to the Commission against a broker-dealer that marks "short," rather than "short exempt," a short sale that is effected in any class of securities, or during certain periods of time, where the Commission has granted an exemption from a price test. The requested no-action relief shall be subject to the following conditions:

1. For each exempt short sale, the various market centers that execute such sales have instituted procedures to "mask" the short sale character of the transaction so that they are executed as short exempt;
    
2. Such market centers monitor on a regular basis to confirm that any such product or transaction continues to meet the conditions for the exemptive relief and re-institute the price test for any product or transaction that fails to satisfy such conditions;
    
3. A broker-dealer executing exempt short sales will mark such sales as "short,"¹⁸ and in no event will such sales be marked "long;"¹⁹ and
    
4. The market centers will maintain an audit trail of all such trade executions, which is capable of being produced and subject to review upon request by the Commission and other appropriate regulatory authorities.
    

If you have any questions or require further information, please do not hesitate to contact Amal Aly, Vice President and Associate General Counsel, at 212-608-1500 or Ann Vlcek, Vice President and Associate General Counsel, at 202-216-2000. Thank you for your attention to this request.

Attachment - Appendix A

Endnotes

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¹ The Securities Industry Association brings together the shared interests of nearly 600 securities firms to accomplish common goals. SIA's primary mission is to build and maintain public trust and confidence in the securities markets. At its core: Commitment to clarity, a commitment to openness and understanding as the guiding principles for all interactions between investors and the firms that serve them. SIA members (including investment banks, broker-dealers, and mutual fund companies) are active in all U.S. and foreign markets and in all phases of corporate and public finance. The U.S. securities industry employs 790,600 individuals, and its personnel manage the accounts of nearly 93 million investors directly and indirectly through corporate, thrift, and pension plans. In 2003, the industry generated $213 billion in domestic revenue and an estimated $283 billion in global revenues. (More information about SIA is available on its home page: http://www.sia.com.)

² Instead of marking sell orders "short," some broker-dealers currently mark such orders "SS," or use some other method to identify a short sale. The Division has confirmed in the recent Q&A on Regulation SHO that this practice is acceptable, provided the broker-dealers follow a clear and consistent methodology for marking orders, and maintain clear and accurate records to demonstrate compliance. See Division of Market Regulation: Responses to Frequently Asked Questions Concerning Regulation SHO at Question 2.2.

³ Thus, the requested relief would cover any situation where a product that has been granted a specific exemption from the price test, or meets the requirements for a class exemption. A list of all such exemptive letters that have been granted to date is attached hereto as Appendix A. For any product that is not eligible to rely on the class exemption, it would be necessary to obtain exemptive relief from the price test, as well as from the requirement to mark such sales "short exempt."

⁴ The "tick" test provides that, subject to certain exceptions, a short sale in an exchange-listed security may only be effected (i) at a price above the price at which the immediately preceding sale was effected (plus tick), or (ii) at the last sale price if it is higher than the last different price (zero-plus tick).

⁵ For example, the NASD "bid" test embodied in NASD Rule 3350 provides that, subject to certain exceptions, a short sale in a Nasdaq National Market System security may only be effected at a price above the current best (inside) bid when such best bid is lower than the immediately preceding bid for such security.

⁶ Although, pursuant to this no-action request, broker-dealers would not be required to mark such sales "short exempt," broker-dealers could still mark such sales "short exempt."

⁷ A "short sale" is generally defined in Rule 200(a) of Regulation SHO to mean any sale of a security which the seller does not own or any sale which is consummated by the delivery of borrowed securities.

⁸ Exchange Act Release No. 50103 (July 28, 2004), 69 FR 48008 (August 6, 2004) (the "Adopting Release").

⁹ ETFs are generally open-ended registered investment companies under the Investment Company Act of 1940 that have been granted exemptive relief from the Commission to allow secondary market trading in the ETF shares on exchanges, Nasdaq, and in the over-the-counter market. ETFs represent shares of ownership in either funds or unit investment trusts that hold portfolios of common stocks or bonds, which are designed to generally correspond to the price and yield performance of their underlying indexes, either broad stock market, stock industry sector, international stock, or U.S. bond. ETFs provide investors the opportunity to buy or sell an entire portfolio of stocks or bonds in a single security, in the same manner as buying or selling a share of stock.

¹⁰ See Letter re: ETFs (August 17, 2001). The conditions for the class exemption were as follows: (1) the ETF series must be issued by an open-end management investment company or a unit investment trust that is registered under the Investment Company Act of 1940; (2) the index or portfolio underlying the ETF series must consist of a "basket" of twenty (20) or more different component stocks, in which the most heavily weighted component stock cannot exceed 25% of the weight of the index or portfolio; (3) component stocks that in the aggregate account for at least 85% of the weight of the underlying index or portfolio must have a minimum public float value of at least $150 million and a minimum average daily trading volume ("ADTV") with a value of at least $1 million during each of the previous two (2) months of trading prior to formation of the ETF series; provided however, if such series has 200 or more component stocks, then component stocks that in the aggregate account for at least 75% of the weight of the underlying index or portfolio must meet the $150 million public float value and the $1 million ADTV value thresholds; (4) each component stock in the index or portfolio underlying the ETF series must be listed on a national securities exchange or the Nasdaq Stock Market, including the Nasdaq Small Cap Market; (5) the ETF series must be issued or redeemed in Creation Unit aggregations of 50,000 shares or more, and the value of each Creation Unit must be at least $1 million at the time of issuance; and (6) the ETF series must be passively managed and hold securities comprising an index or portfolio the components of which are publicly available, and the intra-day proxy value of the ETF series and the value of the "benchmark" index or portfolio must be publicly disseminated throughout the trading day.

¹¹ The market centers generally accomplish the masking process in a number of different ways. For example, the market centers may assign a special coding symbol in the master files to each exempt security, and such information from the master file may be loaded into the market centers' equity trading system each night when the trading system goes through its nightly processing. System software may use the product type field to determine whether the price test should be applied to any given security, and, for each exempt security, the system will be programmed to ignore the fact that an order is marked "short," and in turn will not administer the price test. The market centers' systems generally do not convert "short" orders into "short exempt" orders - rather there is no change to the order itself, and the information with respect to that order shown on the order ticket is maintained intact throughout the market centers' order flow system. In addition, the order as represented in the trading system will also generally reflect the order as "short" and not "short exempt." Finally, the market centers generally report the trade execution back to the entering firm in the same way (i.e., "short" or "short exempt") that the order was marked by the firm upon original entry. For example, an order in an ETF or other exempt product originally entered as "Sell Short" would indicate "Sold Short" on the execution report even though the price test was not applied. Finally, the market centers maintain an audit trail of all such trade executions, which is capable of being produced and subject to review upon request by the appropriate regulatory authority, to the extent necessary.

¹² For any such securities that cease to meet the requirements for an exemption from the price test, the market centers would generally assign a different coding symbol to such securities, and the price test would be applied to all orders marked "short" in such securities.

¹³ See Securities Exchange Act Release No. 48709 (October 28, 2003), 68 FR 62972, 62988-62989 (November 6, 2003)(Regulation SHO Proposing Release, which identified the following exemptive letters that have been provided to certain exchanges and broker-dealers: Letter re: Off-Hours Trading by the Amex (August 5, 1991); Letter re: Operation of Off-Hours Trading by the NYSE (June 13, 1991); Letter re: Burlington Capital Markets (July 1, 2003); Letter re: Bear, Stearns & Co., Inc. (January 19, 1996); Letter re: AZX, Inc. (November 15, 1995); Letter re: Instinet Corporation Crossing Network (July 1, 1992); Letter re. Portfolio System for Institutional Trading (December 31, 1991)).

¹⁴ Id. Such relief has generally been subject to the conditions that: (1) short sales of a security in the after-hours matching session shall not be effected at prices lower than the closing price of the security on its primary exchange; (2) persons relying on these exemptions shall not directly or indirectly effect any transactions designed to affect the closing price on the primary exchange for any security traded in the after-hours matching session; and (3) transactions effected in the after-hours matching session shall not be made for the purpose of creating actual, or apparent, active trading in or otherwise affecting the price of any security.

¹⁵ The Commission had noted that broker-dealers had expressed similar concerns in complying with the requirement to mark sales in all securities included in the Regulation SHO pilot program ("Pilot") "short exempt" in the recent Order delaying the commencement of the Pilot until May 2, 2005. Securities Exchange Act Release No. 50747 (November 29, 2004). In particular, it was noted that such a requirement would impose significant system changes on broker-dealers to ensure that such marking occurs and is maintained throughout the processing of the order. The Commission noted that a number of market centers have offered to assist broker-dealers seeking to execute short sales in Pilot securities, namely by allowing all such short sale orders to be executed without regard to a short sale price test, regardless of whether the order had been marked "short" or "short exempt." The Commission stated that it would consider requests for exemptive relief on behalf of these broker-dealers, to the extent the market centers have implemented the necessary systems changes to remove the price test.

¹⁶ For example, a seller may be entitled to rely on the exception provided in Rule 10a-1(e)(1) or NASD Rule 3350(c)(2) for situations where a seller owns the security sold and, while not being able to deliver the security by settlement date (and thus rendering the sale a short sale), the seller intends to deliver the security sold as soon as possible without undue inconvenience or expense. Such situations could include where a seller owns formerly restricted stock, and is unable to deliver the stock on settlement date due to processing delays to remove the restricted legend, but intends to deliver the stock soon thereafter. A seller relying on the exception in 10a-1(e)(1) or NASD Rule 3350(c)(2) in such situation would properly mark the sale "short exempt."

¹⁷ See NYSE Information Memo 04-64 (December 22, 2004).

¹⁸ Although, pursuant to this no-action request, broker-dealers would not be required to mark such sales "short exempt," broker-dealers could still mark such sales "short exempt."

¹⁹ A broker-dealer is required, pursuant to Rule 17a-3 under the Exchange Act, to make and keep current books and records relating to its business, which includes information relating to short sales.

http://www.sec.gov/divisions/marketreg/mr-noaction/sia010305.htm