July 18, 2005

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

Re: Rule 10a-1; Exemptive Relief under Short Sale Rule
File No.: TP-05-47

Dear Mr. Hammerman:

In your letter dated July 18, 2005, as supplemented by telephone conversations with the staff of the Division of Market Regulation ("Division"), you requested on behalf of the Securities Industry Association ("SIA") an exemption from Rule 10a-1 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), for any broker or dealer (collectively, a "broker-dealer") that facilitates customer buy or sell orders on a riskless principal basis. Specifically, the requested relief would allow broker-dealers to fill customer orders, without the restrictions of the short sale "tick" test, in the following situations: (i) a broker-dealer receives a sell order from a customer who is net "long" the securities being sold, and the broker-dealer then seeks to execute that order, either in whole or in part, by selling the security as riskless principal, even if the broker-dealer has an overall net "short" position in such security; or (ii) a broker-dealer receives a buy order from a customer, and the broker-dealer then seeks to execute that order, either in whole or in part, by purchasing the security as riskless principal, and then selling the security to the customer, even if the broker-dealer has an overall net "short" position in such security.

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. You state that in a riskless principal transaction, the broker-dealer submits a principal order to another market center in response to the receipt of a customer order. Upon receipt of an execution report from the other market center regarding its principal order, the broker-dealer then executes the related customer order residing on the broker-dealer's books on the same terms as its principal execution. More specifically, the National Association of Securities Dealers, Inc. ("NASD") rules define a riskless principal transaction as a "transaction in which a member, after having received an order to buy a security, purchases the security as principal at the same price to satisfy the order to buy or, after having received an order to sell, sells the security as principal at the same price to satisfy the order to sell."¹ You state that there are many reasons why a broker-dealer may send an order to another market center for execution, including to meet the broker-dealer's obligation to provide "best execution" to such customer order, or to facilitate price discovery and to access displayed or hidden liquidity.
    
2. You state that, absent relief, a broker-dealer may not consummate a sale transaction in a riskless principal capacity unless it has an overall net "long" position in the security being sold, or the broker-dealer effects such sale on a plus or zero-plus tick. In situations where a broker-dealer receives a customer "long" sale order, which is then forwarded to another market center by the broker-dealer for its proprietary account, such order would need to be marked "short" if the broker-dealer in fact has a proprietary net "short" position.
    
3. You note that the Commission proposed a specific exception from the proposed uniform "bid" test for broker-dealers engaged in riskless principal activity in the Regulation SHO Proposing Release.²
    
4. You state that a broker-dealer may receive orders from a customer who wishes to purchase securities, and the broker-dealer seeks to execute such order on a riskless principal basis by first purchasing the securities, and then selling to the customer at the same price. In the situation where the amount of securities that the broker-dealer purchases for the customer may not be sufficient to give the broker-dealer an overall net "long" position, the short sale tick test would constrain the ability of the broker-dealer to fill the customer buy order. In that such "short" sales would be effected only in response to a customer buy order, this should vitiate any concerns about such sales having a depressing impact on the security's price. Your letter notes that in this regard the Commission, in granting prior relief from the tick test, had similarly noted an absence of manipulative potential where a broker-dealer is selling short to facilitate a customer buy order.
    
5. You state that where a broker-dealer is facilitating a customer sale in a riskless principal transaction, because the ultimate seller is long the shares being sold, these transactions present none of the potential abuses that the short sale rule was designed to address. Moreover, you state that the application of the tick test to such riskless principal trades in fact oftentimes inhibits the broker-dealer's ability to provide timely (or any) execution to such customer long sale, in that if the broker-dealer has a net short position, it will be restricted from executing its own principal trade to complete the first leg of the riskless principal transaction. The broker-dealer would be similarly restricted from facilitating a customer who wants to purchase securities, in the event that the amount of securities that the broker-dealer purchases for the customer may not be sufficient to give the broker-dealer an overall net "long" position. As such, you represent that compliance with the tick test under these circumstances may adversely affect a broker-dealer's ability to provide best execution to a customer order.

In view of these representations, you have requested that the Commission grant any broker-dealer engaged in riskless principal transactions in the manner described herein an exemption from the tick provisions of Rule 10a-1.

Response:

Rule 200 of Regulation SHO³ defines the term "short sale," and Rule 10a-1 governs short sales generally. Paragraph (a) of Rule 10a-1 covers transactions in any security registered on a national securities exchange, if trades in such security are reported pursuant to an "effective transaction reporting plan" ("Reported Securities"). A short sale of a Reported Security may not be effected at a price either: (1) below the last reported price of a transaction reported in the consolidated transaction reporting system ("minus tick"); or (2) at the last reported price if that price is lower than the last reported different price ("zero-minus tick").

The Commission deferred consideration of the adoption of the proposed riskless principal exception to Rule 10a-1 pending the completion of the Regulation SHO Pilot program. However, Regulation NMS was adopted on June 9, 2005, requiring, among other things, trading centers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers.⁴ In adopting the Order Protection Rule, in particular, the Commission considered several factors, including whether the rule promoted best execution of customer market orders.⁵ You represent that a broker-dealer may send an order to another market center for execution in order to provide "best execution" to a customer's order, or to facilitate price discovery, and to access displayed or hidden liquidity. This would be consistent with the Order Protection Rule, as well as the proposed riskless principal exception.

Absent relief, a broker-dealer may not consummate a sale transaction from a proprietary account, including in a riskless principal capacity, unless it has an overall net "long" position in the security being sold, or if the last-reported price is a plus or zero-plus tick. Based on your representations, in particular, that: (i) where the broker-dealer is facilitating a customer sale in a riskless principal transaction, the ultimate seller has a net long position in the shares being sold; (ii) compliance with the tick test under these circumstances may adversely affect a broker-dealer's ability to provide best execution to a customer order; and (iii) the riskless principal transactions will be effected in the following manner: the broker-dealer, after having received an order to sell a security from a customer who has a net long position, will sell the security as principal at the same price to satisfy the order to sell, or, after having received an order to buy a security, will purchase the security as principal at the same price and then sell to the customer, the Division is of the view that broker-dealers facilitating customer buy and sell orders on a riskless principal basis is not inconsistent with the purposes of Rule 10a-1 of the Exchange Act, subject to the conditions specified below.

Accordingly, on the basis of your representations and the facts presented, and without necessarily concurring in your analysis, the Commission hereby grants an exemption from Rule 10a-1 to permit a broker-dealer to fill customer orders, without complying with the "tick" provisions of the rule, in the following situations: (i) a broker-dealer receives a sell order from a customer who is net "long" the securities being sold, and the broker-dealer then seeks to execute that order, either in whole or in part, by selling the security as riskless principal, even if the broker-dealer has an overall net "short" position in such security; or (ii) a broker-dealer receives a buy order from a customer, and the broker-dealer then seeks to execute that order, either in whole or in part, by purchasing the security as riskless principal, and then selling the security to the customer, even if the broker-dealer has an overall net "short" position in such security, subject to the following conditions:

1. The broker-dealer, after having received an order to sell a security from a customer who has a net "long" position, sells the security as principal at the same price to satisfy the order to sell, or, after having received an order to buy a security from a customer, purchases the security as principal at the same price and then sells to the customer;
2. The sell or buy order must be given the same per-share price at which the broker-dealer sold or bought shares, respectively, to satisfy the facilitated order, exclusive of any explicitly disclosed markup or markdown, commission equivalent, or other fee;
3. The broker-dealer must have written policies and procedures in place to assure that, at a minimum: the customer order was received prior to the offsetting transaction; the offsetting transaction is allocated to a riskless principal account or customer account within 60 seconds of execution; and the broker-dealer has supervisory systems in place to produce records that enable the broker-dealer to accurately and readily reconstruct, in a time-sequenced manner, all orders effected pursuant to this exemption; and
4. Sales effected in reliance on this relief shall be marked "short exempt" in accordance with Rule 200(g)(2) of Regulation SHO, and in no event will such sales be marked "long."

The foregoing exemption from Rule 10a-1(a) is based solely on your representations and the facts presented, and is strictly limited to the application of this rule to the proposed transactions as described above. Such transactions should be discontinued, pending presentation of the facts for our consideration, in the event that any material change occurs with respect to any of those facts and representations. The exemption granted herein 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.

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 broker-dealer effecting riskless principal transactions. The 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.

Endnotes

---

¹ NASD Rules 4632(d)(3)(B) (Nasdaq National Market System securities), 4642(d)(3)(B) (Nasdaq SmallCap securities), and 6420(d)(3)(B) (eligible securities).

² Securities Exchange Act Release No. 48709 (October 28, 2003), 68 FR 62972, 62991 (November 6, 2003) (Proposing Releas). In the Proposing Release, the Commission stated that for the purposes of the proposed exception, the position of a broker-dealer would be deemed to be the same as a customer's position, regardless of whether the broker-dealer has a proprietary net "long" or "short" position. Id. The Proposing Release provided the following example: if the customer seeking to sell 1,000 shares of XYZ and the customer was net short in XYZ, a market maker engaging in a riskless principal transaction on behalf of the customer would have to mark the sell order from his principal account short regardless of his own net position. 68 FR 62972, fn 170. In this context, the broker-dealer would effect the sale in a manner analogous to an agency execution. With respect to order marking, a short sale effected on a riskless principal basis would be marked according to the customer's, rather than the broker-dealer's, net position. In the example above, the order would be marked "short" even if the broker-dealer had a net "long" position in the security. In addition, in terms of order display, the broker-dealer's order, which would be marked short in accordance with the customer's position, should not be displayed if execution at the time of display would violate the Rule 10a-1 tick test.

³ 17 CFR 242.200.

⁴ 70 FR 37496 (June 29, 2005).

⁵ Id. at 37510.

Incoming Letter:

The Incoming Letter is in Acrobat format.

http://www.sec.gov/divisions/marketreg/mr-noaction/sia071805.htm