[Federal Register: August 14, 2007 (Volume 72, Number 156)]
[Proposed Rules]
[Page 45558-45590]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr14au07-30]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 242
[Release No. 34-56213; File No. S7-19-07]
RIN 3235-AJ57
Amendments to Regulation SHO
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is re-
proposing amendments to Regulation SHO under the Securities Exchange
Act of 1934 (``Exchange Act''). The proposed amendments are intended to
further reduce the number of persistent fails to deliver in certain
equity securities by eliminating the options market maker exception. In
addition, we are requesting comment regarding specific alternatives to
our proposal to eliminate the options market maker exception.
We are also proposing an amendment to the long sale marking
provisions of Regulation SHO that would require that brokers and
dealers marking a sale as ``long'' document the present location of the
securities being sold.
DATES: Comments should be received on or before September 13, 2007.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml.
); or Send an e-mail to rule-comments@sec.gov. Please include
File Number S7-19-07 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov
). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549.
All submissions should refer to File Number S7-19-07. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549. All comments received will be posted without change; we do not
edit personal identifying information from submissions. You should
submit only information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Associate
Director, Josephine J. Tao, Assistant Director, Victoria L. Crane,
Branch Chief, Elizabeth A. Sandoe, Branch Chief, Joan M. Collopy,
Special Counsel, and Lillian S. Hagen, Special Counsel, Office of
Trading Practices and Processing, Division of Market Regulation, at
(202) 551-5720, at the Securities and Exchange Commission, 100 F
Street, NE., Washington, DC 20549-6628.
SUPPLEMENTARY INFORMATION: The Commission is requesting public comment
on proposed amendments to Rules 200 and 203 of Regulation SHO [17 CFR
242.200 and 242.203] under the Exchange Act.
I. Introduction
Regulation SHO, which became fully effective on January 3, 2005,
sets forth the regulatory framework governing short sales.\1\ Among
other things, Regulation SHO imposes a close-out requirement to address
failures to deliver stock on trade settlement date\2\ and to target
potentially abusive ``naked'' short selling\3\ in certain equity
securities.\4\ While the majority of trades settle on time,\5\
Regulation SHO is intended to address those situations where the level
of fails to deliver for the particular stock is so substantial that it
might impact the market for that security.\6\ Although high fails
levels exist only for a small percentage of issuers,\7\ we are
concerned that large and persistent fails to deliver may have a
negative effect on the market in these securities. For example, large
and persistent fails to deliver may deprive shareholders of the
benefits of
[[Page 45559]]
ownership, such as voting and lending. In addition, where a seller of
securities fails to deliver securities on settlement date, in effect
the seller unilaterally converts a securities contract (which should
settle within the standard 3-day settlement period) into an undated
futures-type contract, to which the buyer might not have agreed, or
that might have been priced differently. Moreover, sellers that fail to
deliver securities on settlement date may enjoy fewer restrictions than
if they were required to deliver the securities within a reasonable
period of time, and such sellers may attempt to use this additional
freedom to engage in trading activities that are designed to improperly
depress the price of a security.
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\1\ 17 CFR 242.200. See also Securities Exchange Act Release No.
50103 (July 28, 2004), 69 FR 48008 (Aug. 6, 2004) (``Adopting
Release''), available at http://www.sec.gov/rules/final/34-50103.htm
.
A short sale is the sale of a security that the seller does not
own or any sale that is consummated by the delivery of a security
borrowed by, or for the account of, the seller. In order to deliver
the security to the purchaser, the short seller may borrow the
security, typically from a broker-dealer or an institutional
investor. The short seller later closes out the position by
purchasing equivalent securities on the open market, or by using an
equivalent security it already owns, and returning the security to
the lender. In general, short selling is used to profit from an
expected downward price movement, to provide liquidity in response
to unanticipated demand, or to hedge the risk of a long position in
the same security or in a related security.
\2\ Generally, investors must complete or settle their security
transactions within three business days. This settlement cycle is
known as T+3 (or ``trade date plus three days''). T+3 means that
when the investor purchases a security, the purchaser's payment must
be received by its brokerage firm no later than three business days
after the trade is executed. When the investor sells a security, the
seller must deliver its securities, in certificated or electronic
form, to its brokerage firm no later than three business days after
the sale. The three-day settlement period applies to most security
transactions, including stocks, bonds, municipal securities, mutual
funds traded through a brokerage firm, and limited partnerships that
trade on an exchange. Government securities and stock options settle
on the next business day following the trade. Because the Commission
recognized that there are many legitimate reasons why broker-dealers
may not deliver securities on settlement date, it adopted Rule 15c6-
1, which prohibits broker-dealers from effecting or entering into a
contract for the purchase or sale of a security that provides for
payment of funds and delivery of securities later than the third
business day after the date of the contract unless otherwise
expressly agreed to by the parties at the time of the transaction.
17 CFR 240.15c6-1. However, failure to deliver securities on T+3
does not violate the rule.
\3\ We have previously noted that abusive ``naked'' short
selling, while not defined in the federal securities laws generally
refers to selling short without having stock available for delivery
and intentionally failing to deliver stock within the standard three
day settlement cycle. See Securities Exchange Act Release No. 54154
(July 14, 2006), 71 FR 41710 (July 21, 2006) (``2006 Proposing
Release'').
\4\ In 2003, the Commission settled a case against certain
parties relating to allegations of manipulative short selling in the
stock of Sedona Corporation. The Commission alleged that the
defendants profited from engaging in massive naked short selling
that flooded the market with Sedona stock, and depressed its price.
See Rhino Advisors, Inc. and Thomas Badian, Lit. Rel. No. 18003
(Feb. 27, 2003); see also, SEC v. Rhino Advisors, Inc. and Thomas
Badian, Civ. Action No. 03 civ 1310 (RO) (S.D.N.Y). See also,
Securities Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR
62972, 62975 (Nov. 6, 2003) (``2003 Proposing Release'') (describing
the alleged activity in the case involving stock of Sedona
Corporation); Adopting Release, 69 FR at 48016, n.76.
\5\ According to the National Securities Clearing Corporation
(``NSCC''), 99% (by dollar value) of all trades settle on time.
Thus, on an average day, approximately 1% (by dollar value) of all
trades, including equity, debt, and municipal securities fail to
settle. The vast majority of these fails are closed out within five
days after T+3.
\6\ These fails to deliver may result from either short or long
sales of stock. There may be many reasons for a fail to deliver. For
example, human or mechanical errors or processing delays can result
from transferring securities in physical certificate rather than
book-entry form, thus causing a failure to deliver on a long sale
within the normal three-day settlement period. Also, broker-dealers
that make a market in a security (``market makers'') and who sell
short thinly-traded, illiquid stock in response to customer demand
may encounter difficulty in obtaining securities when the time for
delivery arrives.
\7\ The average daily number of securities on a threshold list
(as defined infra note 13) in March 2007 was approximately 311
securities, which comprised 0.39% of all equity securities,
including those that are not covered by Regulation SHO. Regulation
SHO's current close-out requirement applies to any equity security
of an issuer that is registered under Section 12 of the Exchange
Act, or that is required to file reports pursuant to Section 15(d)
of the Exchange Act.
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In addition, many issuers and investors continue to express
concerns about extended fails to deliver in connection with ``naked''
short selling.\8\ To the extent that large and persistent fails to
deliver might be indicative of manipulative ``naked'' short selling,
which could be used as a tool to drive down a company's stock price,
such fails to deliver may undermine the confidence of investors.\9\
These investors, in turn, may be reluctant to commit capital to an
issuer they believe to be subject to such manipulative conduct.\10\ In
addition, issuers may believe that they have suffered unwarranted
reputational damage due to investors' negative perceptions regarding
large and persistent fails to deliver in the issuer's security.\11\ Any
unwarranted reputational damage caused by large and persistent fails to
deliver might have an adverse impact on the security's price.\12\
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\8\ See, e.g., letter from Patrick M. Byrne, Chairman and Chief
Executive Officer, Overstock.com, Inc., dated Sept. 11, 2006
(``Overstock''); letter from Daniel Behrendt, Chief Financial
Officer, and Douglas Klint, General Counsel, TASER International,
dated Sept. 18, 2006 (``TASER''); letter from John Royce, dated
April 30, 2007; letter from Michael Read, dated April 29, 2007;
letter from Robert DeVivo, dated April 26, 2007; letter from Ahmed
Akhtar, dated April 26, 2007.
\9\ See, e.g., letter from Mary Helburn, Executive Director,
National Coalition Against Naked Shorting, dated Sept. 30, 2006
(``NCANS''); letter from Richard Blumenthal, Attorney General, State
of Connecticut, dated Sept. 19, 2006 (``State of Connecticut'')
(discussing the impact of fails to deliver on investor confidence).
\10\ See, e.g., letter from Congressman Tom Feeney--Florida,
U.S. House of Representatives, dated Sept. 25, 2006 (``Feeney'')
(expressing concern about the impact of potential ``naked'' short
selling on capital formation, claiming that ``naked'' short selling
causes a drop in an issuer's stock price and may limit the issuer's
ability to access the capital markets); letter from Zix Corporation,
dated Sept. 19, 2006 (``Zix'') (stating that ``[m]any investors
attribute the Company's frequent re-appearances on the Regulation
SHO list to manipulative short selling and frequently demand that
the Company ``do something'' about the perceived manipulative short
selling. This perception that manipulative short selling of the
Company's securities is continually occurring has undermined the
confidence of many of the Company's investors in the integrity of
the market for the Company's securities'').
\11\ Due, in part, to such concerns, issuers have taken actions
to attempt to make transfer of their securities ``custody only,''
thus preventing transfer of their stock to or from securities
intermediaries such as the Depository Trust Company (``DTC'') or
broker-dealers. A number of issuers have attempted to withdraw their
issued securities on deposit at DTC, which makes the securities
ineligible for book-entry transfer at a securities depository. We
note, however, that in 2003 the Commission approved a DTC rule
change clarifying that its rules provide that only its participants
may withdraw securities from their accounts at DTC, and establishing
a procedure to process issuer withdrawal requests. See Securities
Exchange Act Release No. 47978 (June 4, 2003), 68 FR 35037 (June 11,
2003).
\12\ See also 2006 Proposing Release, 71 FR at 41712 (discussing
the impact of large and persistent fails to deliver on the market).
See also 2003 Proposing Release, 68 FR at 62975 (discussing the
impact of ``naked'' short selling on the market).
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The close-out requirement, which is contained in Rule 203(b)(3) of
Regulation SHO, applies only to securities in which a substantial
amount of fails to deliver have occurred (also known as ``threshold
securities'').\13\ As adopted in August 2004, Rule 203(b)(3) of
Regulation SHO included two exceptions to the mandatory close-out
requirement. The first was the ``grandfather'' provision, which
excepted fails to deliver established prior to a security becoming a
threshold security.\14\ The second was the ``options market maker
exception,'' which excepted any fail to deliver in a threshold security
resulting from short sales effected by a registered options market
maker to establish or maintain a hedge on options positions that were
created before the underlying security became a threshold security.\15\
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\13\ A threshold security is defined in Rule 203(c)(6) as any
equity security of an issuer that is registered pursuant to section
12 of the Exchange Act (15 U.S.C. 78l) or for which the issuer is
required to file reports pursuant to section 15(d) of the Exchange
Act (15 U.S.C. 78o(d)): (i) for which there is an aggregate fail to
deliver position for five consecutive settlement days at a
registered clearing agency of 10,000 shares or more, and that is
equal to at least 0.5% of the issue's total shares outstanding; and
(ii) that is included on a list (``threshold securities list'')
disseminated to its members by a self-regulatory organization
(``SRO''). See 17 CFR 242.203(c)(6). Each SRO is responsible for
providing the threshold securities list for those securities for
which the SRO is the primary market.
\14\ See Adopting Release, 69 FR at 48031. The ``grandfathered''
status applied in two situations: (i) to fail to deliver positions
occurring before January 3, 2005, Regulation SHO's effective date;
and (ii) to fail to deliver positions that were established on or
after January 3, 2005 but prior to the security appearing on a
threshold securities list.
\15\ See Adopting Release, 69 FR at 48031.
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At the time of Regulation SHO's adoption, the Commission stated
that it would monitor the operation of Regulation SHO to determine
whether grandfathered fail to deliver positions were being cleared up
under the existing delivery and settlement guidelines or whether any
further regulatory action with respect to the close out provisions of
Regulation SHO was warranted.\16\ In addition, with respect to the
options market maker exception, the Commission noted that it would take
into consideration any indications that this provision was operating
significantly differently from the Commission's original
expectations.\17\
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\16\ See id. at 48018.
\17\ See id. at 48019.
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Based, in part, on the results of examinations conducted by the
Commission's staff and the SROs since Regulation SHO's adoption, as
well as the persistence of certain securities on threshold securities
lists, on July 14, 2006, the Commission published proposed amendments
to Regulation SHO,\18\ which were intended to reduce the number of
persistent fails to deliver in certain equity securities by eliminating
the grandfather provision and narrowing the options market maker
exception contained in that rule. In addition, in March 2007, the
Commission re-opened the comment period to the 2006 Proposing Release
for thirty days to provide the public with an opportunity to comment on
a summary of the National Association of Securities Dealers, Inc.'s
(``NASD's'') analysis that the NASD had submitted to the public file on
March 12, 2007. In addition, the notice regarding the re-opening of the
comment period directed the public's attention to summaries of data
collected by the Commission's Office of Compliance Inspections and
Examinations and the New York Stock Exchange LLC (``NYSE'').\19\
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\18\ See 2006 Proposing Release, 71 FR 41719.
\19\ In formulating its proposal to eliminate the grandfather
provision and narrow the options market maker exception of
Regulation SHO, the Commission relied in part on data collected by
the NASD. In response to commenters' concerns regarding the public
availability of data relied on by the Commission, we re-opened the
comment period to the 2006 Proposing Release for thirty days to
provide the public with an opportunity to comment on a summary of
the NASD's analysis that the NASD had submitted to the public file
on March 12, 2007. See Securities Exchange Act Release No. 55520
(March 26, 2007), 72 FR 15079 (March 30, 2007) (``Regulation SHO Re-
Opening Release'').
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On June 13, 2007, in a companion rule to this proposal, after
careful consideration of public comments, we approved the adoption of
the amendment, as proposed, to eliminate the grandfather provision of
Regulation
[[Page 45560]]
SHO.\20\ With respect to the options market maker exception, however,
in response to comments to the 2006 Proposing Release, we are re-
proposing amendments to the current options market maker exception that
would eliminate the exception.
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\20\ See Securities Exchange Act Release No. 56212 (Aug. 7,
2007).
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We are concerned that persistent fails to deliver will continue in
certain equity securities unless the options market maker exception is
eliminated entirely. Thus, as discussed more fully below, our proposal
would modify Rule 203(b)(3) by eliminating the exception. In addition,
we are requesting comment regarding alternatives to eliminating the
options market maker exception that would require fails to deliver in
threshold securities underlying options to be closed out within
specific time-frames.
We are also proposing an amendment to the long sale marking
provisions of Rule 200(g)(1) of Regulation SHO that would require that
brokers and dealers marking a sale as ``long'' document the present
location of the securities.
II. Background
A. Rule 203(b)(3)'s Close-out Requirement
One of Regulation SHO's primary goals is to reduce fails to deliver
in those securities with a substantial amount of fails to deliver by
imposing additional delivery requirements on participants of a
registered clearing agency with fails to deliver in these
securities.\21\ As discussed above, we believe that additional delivery
requirements help protect and enhance the operation, integrity and
stability of the markets, as well as reduce short selling abuses.
Thus, Rule 203(b)(3)'s close-out requirement requires a participant
of a clearing agency registered with the Commission \22\ to take
immediate action to close out a fail to deliver position in a threshold
security in the Continuous Net Settlement (``CNS'') \23\ system that
has persisted for 13 consecutive settlement days by purchasing
securities of like kind and quantity.\24\ In addition, if the failure
to deliver has persisted for 13 consecutive settlement days, Rule
203(b)(3)(iv) prohibits the participant, and any broker-dealer for
which it clears transactions, including market makers, from accepting
any short sale orders or effecting further short sales in the
particular threshold security without borrowing, or entering into a
bona-fide arrangement to borrow, the security until the participant
closes out the fail to deliver position by purchasing securities of
like kind and quantity.\25\
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\21\ See Adopting Release, 69 FR at 48009.
\22\ For purposes of Regulation SHO, the term ``participant''
has the same meaning as in section 3(a)(24) of the Exchange Act. See
15 U.S.C. 78c(a)(24). The term ``registered clearing agency'' means
a clearing agency, as defined in section 3(a)(23) of the Exchange
Act, that is registered as such pursuant to section 17A of the
Exchange Act. See 15 U.S.C. 78c(a)(23)(A), 78q-1 and 15 U.S.C. 78q-
1(b), respectively. See also, Adopting Release, 69 FR at 48031. As
of May 2007, approximately 90% of participants of the NSCC, the
primary registered clearing agency responsible for clearing U.S.
transactions, were registered as broker-dealers. Those participants
not registered as broker-dealers include such entities as banks,
U.S.-registered exchanges, and clearing agencies. Although these
entities are participants of a registered clearing agency, generally
these entities do not engage in the types of activities that would
implicate the close-out requirements of Regulation SHO. Such
activities of these entities include creating and redeeming Exchange
Traded Funds, trading in municipal securities, and using NSCC's
Envelope Settlement Service or Inter-city Envelope Settlement
Service. These activities rarely lead to fails to deliver and, if
fails to deliver do occur, they are small in number and are usually
closed out within a day. Thus, such fails to deliver would not
trigger the close-out provisions of Regulation SHO.
\23\ The majority of equity trades in the United States are
cleared and settled through systems administered by clearing
agencies registered with the Commission. The National Securities
Clearing Corporation (``NSCC'') clears and settles the majority of
equity securities trades conducted on the exchanges and over the
counter. NSCC clears and settles trades through the CNS system,
which nets the securities delivery and payment obligations of all of
its members. NSCC notifies its members of their securities delivery
and payment obligations daily. In addition, NSCC guarantees the
completion of all transactions and interposes itself as the
contraparty to both sides of the transaction. While NSCC's rules do
not authorize it to require member firms to close out or otherwise
resolve fails to deliver, NSCC reports to the SROs those securities
with fails to deliver of 10,000 shares or more. The SROs use NSCC
fails data to determine which securities are threshold securities
for purposes of Regulation SHO.
\24\ 17 CFR 242.203(b)(3).
\25\ Id. at (b)(3)(iv). It is possible under Regulation SHO that
a close out by a participant of a registered clearing agency may
result in a fail to deliver position at another participant if the
counterparty from which the participant purchases securities fails
to deliver. However, Regulation SHO prohibits a participant of a
registered clearing agency, or a broker-dealer for which it clears
transactions, from engaging in ``sham close outs'' by entering into
an arrangement with a counterparty to purchase securities for
purposes of closing out a fail to deliver position and the purchaser
knows or has reason to know that the counterparty will not deliver
the securities, and which thus creates another fail to deliver
position. See id. at (b)(3)(vii); Adopting Release, 69 FR at 48018
n.96. In addition, we note that borrowing securities, or otherwise
entering into an arrangement with another person to create the
appearance of a purchase would not satisfy the close-out requirement
of Regulation SHO. For example, the purchase of paired positions of
stock and options that are designed to create the appearance of a
bona fide purchase of securities but that are nothing more than a
temporary stock lending arrangement would not satisfy Regulation
SHO's close-out requirement.
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B. Regulation SHO's Options Market Maker Exception
1. Current Options Market Maker Exception
Regulation SHO's options market maker exception excepts from the
close-out requirement of Rule 203(b)(3) any fail to deliver position in
a threshold security that is attributed to short sales by a registered
options market maker, if and to the extent that the short sales are
effected by the registered options market maker to establish or
maintain a hedge on options positions that were created before the
security became a threshold security.\26\ The options market maker
exception was created to address concerns regarding liquidity and the
pricing of options.\27\ The exception does not require that such fails
to deliver be closed out.
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\26\ 17 CFR 242.203(b)(3)(iii).
\27\ In response to the proposal to adopt Regulation SHO and the
Commission's determination at that time not to provide an exception
for market makers, including options market makers, from the
delivery requirements of proposed Regulation SHO, the Commission
received letters that stated that the effect of not including such
an exception would be to cease altogether options trading in
securities that are difficult to borrow, as it was argued that no
options market makers would make markets without the ability to
hedge by selling short the underlying security. In addition, one
commenter stated that the heightened delivery requirements of
proposed Regulation SHO for threshold securities could drain
liquidity in other securities where there is no current indication
of significant settlement failures. The commenter believed that,
while a blanket exception would be preferable, at a minimum the
implementation of any such provision should not apply to market
maker positions acquired prior to the effective date of the rule,
and likewise should not apply to any short position acquired prior
to the time that the subject security meets the designated
threshold. See Adopting Release, 69 FR at 48019 (discussing the
comment letters received in response to the delivery requirements of
proposed Regulation SHO). In part, in response to these comments, we
adopted a limited options market maker exception to the close-out
requirement of Regulation SHO. As discussed in more detail in this
release and, in particular, in Section II.B.3. below, we no longer
believe that the current options market maker exception is
necessary.
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Since Regulation SHO's effective date in January, 2005, the Staff
and the SROs have been examining firms for compliance with Regulation
SHO, including the close-out provisions. We have received preliminary
data that indicates that Regulation SHO appears to be significantly
reducing fails to deliver without disruption to the market.\28\
However, despite this positive
[[Page 45561]]
impact, we continue to observe a small number of threshold securities
with substantial and persistent fail to deliver positions that are not
being closed out under existing delivery and settlement requirements.
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\28\ For example, in comparing a period prior to the effective
date of the current rule (April 1, 2004 to December 31, 2004) to a
period following the effective date of the current rule (January 1,
2005 to March 31, 2007) for all stocks with aggregate fails to
deliver of 10,000 shares or more as reported by NSCC:
The average daily aggregate fails to deliver declined
by 29.5%;
The average daily number of securities with aggregate
fails to deliver of at least 10,000 shares declined by 5.8%;
The average daily number of fails to deliver declined
by 15.1%;
The average age of a fail to deliver position declined
by 25.5%;
The average daily number of threshold securities
declined by 39.0%; and
The average daily fails to deliver of threshold
securities declined by 52.9%.
See also supra note 7.
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Based on the examinations and our discussions with the SROs and
market participants, we believe that these persistent fail to deliver
positions may be attributable, in part, to reliance on the options
market maker exception.\29\ Accordingly, on July 14, 2006, the
Commission published the 2006 Proposing Release that included proposed
amendments to limit the duration of the options market maker
exception.\30\
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\29\ As noted in the 2006 Proposing Release and the Regulation
SHO Re-Opening Release, we believe that the persistent fails to
deliver may be attributable primarily to the grandfather provision
and, secondarily, to reliance on the options market maker exception.
See 2006 Proposing Release, 71 FR at 41712; Regulation SHO Re-
Opening Release, 72 FR at 15079 (providing a summary of data
received from certain SROs regarding reasons for the extended fails
to deliver).
\30\ See 2006 Proposing Release, 71 FR at 41722.
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The Commission, in the 2006 Proposing Release, proposed that for
securities that are threshold securities on the effective date of the
amendment, any previously excepted fail to deliver position in the
threshold security that resulted from short sales effected by a
registered options market maker to establish or maintain a hedge on an
options position that existed before the security became a threshold
security, but that has expired or been liquidated on or before the
effective date of the amendment, would be required to be closed out
within 35 consecutive settlement days of the effective date of the
amendment. In addition, if the fail to deliver position persisted for
35 consecutive settlement days, the proposal would have prohibited a
participant of a registered clearing agency, and any broker-dealer for
which it clears transactions, including market makers, from accepting
any short sale orders or effecting further short sales in the
particular threshold security without borrowing, or entering into a
bona-fide arrangement to borrow, the security until the participant
closed out the entire fail to deliver position by purchasing securities
of like kind and quantity.
If the security became a threshold security after the effective
date of the amendment, all fail to deliver positions in the security
that result or resulted from short sales effected by a registered
options market maker to establish or maintain a hedge on an options
position that existed before the security became a threshold security
would have to be closed out within 13 consecutive settlement days of
the security becoming a threshold security or of the expiration or
liquidation of the options position, whichever was later. In addition,
if the fail to deliver position persisted for 13 consecutive settlement
days from the date on which the security became a threshold security or
the options position had expired or was liquidated, whichever was
later, the proposal would have prohibited a participant of a registered
clearing agency, and any broker-dealer for which it clears
transactions, including market makers, from accepting any short sale
orders or effecting further short sales in the particular threshold
security without borrowing, or entering into a bona-fide arrangement to
borrow, the security until the participant closed out the entire fail
to deliver position by purchasing securities of like kind and quantity.
Thus, under the 2006 Proposing Release, registered options market
makers would still have been able to continue to keep open fail to
deliver positions in threshold securities that resulted from short
sales to hedge an options position created prior to the time the
underlying security became a threshold security, provided the options
position had not expired or been liquidated. Once the underlying
security became a threshold security and the specific options position
being hedged had expired or been liquidated, however, such fails to
deliver would have been subject to a 13 consecutive settlement day
close-out requirement.
2. Comments to the 2006 Proposing Release
We received a number of comment letters on the proposed narrowing
of the options market maker exception from a variety of entities
including options market makers, SROs, associations, issuers, an
academic, and individual retail investors.\31\
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\31\ See, e.g., letter from Overstock, supra note 8; letter from
NCANS, supra note 9; letter from Joseph P. Borg, Esq., President,
North American Securities Administrators Association, Inc., dated
Oct. 4, 2006 (``NASAA''); letter from TASER, supra note 8; letter
from James J. Angel, PhD, CFA, dated July 18, 2006 (``Angel'');
letter from Margaret Wiermanski, Chief Operations Officer and
Matthew Abraham, Compliance Officer, CTC LLC, dated Sept. 28, 2006
(``CTC LLC''); letter from Timothy D. Lobach, Keystone Trading
Partners, dated Sept. 19, 2006 (``Keystone''); letter from Steve
Keltz, General Counsel, Citigroup Derivatives Markets, Inc., dated
Sept. 29, 2006 (``Citigroup''); letter from Robert Bellick, Managing
Director, Chris Gust, Managing Director, and Megan Flaherty,
Director of Compliance and Chief Legal Counsel, Wolverine Trading
LLC, dated Sept. 25, 2006 (``Wolverine''); letter from Edward J.
Joyce, President and Chief Operating Officer, Chicago Board Options
Exchange, dated October 11, 2006 (``CBOE''); letter from The
American Stock Exchange, Boston Options Exchange, Chicago Board
Options Exchange, International Securities Exchange, NYSE/Arca, The
Options Clearing Corporation, Philadelphia Stock Exchange, dated
Sept. 22, 2006 (``Options Exchanges''); letter from Ira D.
Hammerman, Senior Vice President and General Counsel, Securities
Industry Association, dated Sept. 19, 2006 (``SIA''); letter from
Keith F. Higgins, Chair, Committee on Federal Regulation of
Securities, American Bar Association Section of Business Law, dated
Sept. 27, 2006 (``ABA''); letter from Gerard S. Citera, Executive
Director, U.S. Equities, UBS Securities LLC, dated Sept. 22, 2006
(``UBS'').
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Several commenters supported the proposal to narrow the options
market maker exception. For example, one commenter stated that 13
consecutive settlement days was more than a sufficient amount of time
in which to close out a fail to deliver position relating to an options
position.\32\ Another commenter stated that it believes the current
``exemption can be exploited to manipulate prices downward by
manipulators buying large numbers of put options in already heavily-
shorted securities.'' \33\ Some of these commenters recommended that
the Commission eliminate the options market maker exception
altogether,\34\ or, reduce the close-out requirement to five
consecutive settlement days.\35\ In addition, commenters that supported
the proposal to narrow the options market maker exception also urged
the Commission to enhance the documentation requirements for
establishing eligibility for the exception.\36\
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\32\ See letter from Overstock, supra note 8.
\33\ See letter from NCANS, supra note 9.
\34\ See, e.g., id.
\35\ See letter from NASAA, supra note 31.
\36\ See, e.g., id.; TASER, supra note 8.
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Commenters who opposed the proposal to narrow the options market
maker exception stated that the proposed amendments would disrupt the
markets because they would not provide sufficient flexibility to permit
efficient hedging by options market makers, would unnecessarily
increase risks and costs to hedge, and would adversely impact liquidity
and result in higher costs to customers.\37\ These commenters stated
that they believe the proposed amendments would likely
[[Page 45562]]
discourage options market makers from making markets in illiquid
securities since the risk associated in maintaining the hedges in these
option positions would be too great.\38\ Moreover, these commenters
claimed that the reluctance of options market makers to make markets in
threshold securities would result in wider spreads in such securities
to account for the increased costs of hedging, to the detriment of
investors.\39\
---------------------------------------------------------------------------
\37\ See, e.g., letter from CBOE, supra note 31.
\38\ See id.
\39\ See letter from Citigroup, supra note 31.
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Many of the commenters who opposed the proposal to narrow the
options market maker exception argued that the requirement that fail to
deliver positions be closed out upon liquidation or expiration of a
specifically hedged options position was impracticable, given that the
industry practice is to use hedges to manage risk of an entire
inventory, not just a specific options position.\40\ These commenters
noted that options market makers typically facilitate an investor's
rolling of an existing options position to either a different strike
price within the same expiration month or to a future month as
expiration approaches, and retain the short position to hedge the new
options position.\41\ These commenters argued that the amendment would
require the options market maker to buy in the short position and/or
pre-borrow to maintain a hedge, even though the overall position may
have changed very little from a risk perspective, which, they argued,
could potentially be a costly and time consuming measure.\42\
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\40\ For example, CBOE stated that options market makers hedge
on a class basis and, therefore, as options positions are rolled to
forward months, the options market maker may need to maintain the
hedge. Thus, the stock position would need to be maintained not
because it hedges a particular series, but because it maintains a
delta of an overall position. See letter from CBOE, supra note 31.
See, also, letters from CTC LLC, supra note 31; Citigroup, supra
note 31; Wolverine, supra note 31.
\41\ See, e.g., letters from Citigroup, supra note 31;
Wolverine, supra note 31; Options Exchanges, supra note 31.
\42\ See, e.g., letters from Wolverine, supra note 31;
Citigroup, supra note 31.
---------------------------------------------------------------------------
Commenters who opposed the proposed amendments to the options
market maker exception favored maintaining the current exception, which
they believe is already narrowly tailored.\43\ For example, one
commenter stated that it believes the current exception preserves the
integrity of legitimate hedging practices and prevents manipulative
short squeezes.\44\ Another commenter stated that the current exception
enables it to better service market participants by allowing it to
continuously quote and disseminate bids and offers even where it may be
difficult to borrow certain stock.\45\ Another commenter stated that it
is unaware of any statistics establishing that fails to deliver
attributable to legitimate options market making activity are
correlated to abusive short selling practices, and cautioned that ``the
possible detrimental effects on options markets in threshold securities
should first be quantified to guard against an unanticipated,
significant peril to another facet of the capital markets.'' \46\
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\43\ See id.
\44\ See letter from Keystone, supra note 31.
\45\ See letter from Citigroup, supra note 31.
\46\ See letter from CTC LLC, supra note 31. Statistical
evidence of options market maker failing practices can be found in
Failure is an Option: Impediments to Short Selling and Options
Prices by Evans, Geczy, Musto, and Reed, forthcoming in the Review
of Financial Studies. See http://finance.wharton.upenn.edu/~musto/papers/egmr.pdf
.
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3. Response to Comments to the 2006 Proposing Release
We proposed to narrow the options market maker exception in
Regulation SHO because we are concerned about large and persistent
fails to deliver in threshold securities attributable, in part, to the
options market maker exception, and our concerns that such fails to
deliver might have a negative effect on the market in these
securities.\47\
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\47\ See 2006 Proposing Release, 71 FR at 41711-41712; see also,
Regulation SHO Re-Opening Release, 72 FR 15079-15080. See also,
discussion above in Section I. Introduction.
---------------------------------------------------------------------------
Regulation SHO's options market maker exception does not require
fails to deliver to be closed out if they resulted from short sales
effected by registered options market makers to establish or maintain a
hedge on options positions established before the underlying security
became a threshold security. For the reasons discussed below, although
we recognize commenters' concerns that a mandatory close-out
requirement for fails to deliver in threshold securities underlying
options positions could potentially impact options market makers'
willingness to provide liquidity in threshold securities, make it more
costly for options market makers to accommodate customer buy orders, or
result in wider bid-ask spreads or less depth, we believe that such an
impact, if any, would be minimal.
First, we believe that the potential effects, if any, of a
mandatory close-out requirement would be minimal because the number of
securities that would be impacted by a mandatory close-out requirement
would be relatively small. Regulation SHO's close-out requirement is
narrowly tailored in that it targets only those securities where the
level of fails to deliver is high (0.5% of total shares outstanding and
10,000 shares or more) for a continuous period (five consecutive
settlement days).\48\ Requiring close-out only for securities with
large and persistent fails to deliver limits the overall market impact.
In addition, as noted by one commenter, a small number of securities
that meet the definition of a ``threshold security'' have listed
options, and those securities form a very small percentage of all
securities that have options traded on them.\49\ Moreover, the current
options market maker exception only excepts from Regulation SHO's
mandatory 13 consecutive settlement day close-out requirement those
fail to deliver positions that result from short sales effected by
registered options market makers to establish or maintain a hedge on
options positions established before the underlying security became a
threshold security. Thus, it does not apply to fails to deliver
resulting from short sales effected to establish or maintain a hedge on
options positions established after the underlying security became a
threshold security. Because the current options market maker exception
has a very limited application, the overall impact of its removal on
liquidity, hedging costs, spreads, and depth, should be relatively
small.
---------------------------------------------------------------------------
\48\ See supra note 7 (discussing the number of threshold
securities as of March 31, 2007).
\49\ See letter from Options Exchanges, supra note 31 (noting
that as of the date of the 2006 Proposing Release, approximately 84
of the approximately 300 threshold securities had options traded on
them). This commenter also noted that ``options on a number of these
threshold securities are very actively traded as are the securities
themselves. Among the actively traded threshold securities with
active options trading are iShares Russell 2000 ETF, Avanir
Pharmaceuticals, Krispy Kreme Donuts, Martha Stewart Living
Omnimedia, Mittal Steel, Navarre Corp., and Novastar Financial.''
See id.
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Second, to the extent that a mandatory close-out requirement could
potentially impact options market makers' willingness to provide
liquidity in threshold securities, make it more costly for options
market makers to accommodate customer buy orders, or result in wider
bid-ask spreads or less depth, we believe that any such potential
effects would likely be mitigated by the fact that even though fails to
deliver that were previously-excepted from the close-out requirement of
Regulation SHO would not be permitted to continue indefinitely, such
fails to deliver would not have to be closed out immediately, or even
within the standard 3-day settlement period. Instead, under a mandatory
close-out requirement, such as that imposed
[[Page 45563]]
currently by the 13 consecutive settlement day requirement of Rule
203(b)(3) of Regulation SHO, fails to deliver in threshold securities
would have an extended period of time within which to be closed out. An
extended close-out requirement would provide options market makers with
some flexibility in conducting their hedging activities in that it
would allow them to not buy-in a fail to deliver position or pre-borrow
to maintain a hedge for the time that the fail to deliver position can
remain open.
Third, as noted above, Regulation SHO's current options market
maker exception is limited to only those fail to deliver positions that
result from short sales effected by registered options market makers to
establish or maintain a hedge on options positions established before
the underlying security became a threshold security. Thus, it does not
apply to fails to deliver resulting from short sales effected to
establish or maintain a hedge on options positions established after
the underlying security became a threshold security. In examining the
application of the current mandatory close-out requirement of
Regulation SHO for all non-excepted fail to deliver positions, we have
not become aware of any evidence that the current close-out requirement
for non-excepted fails to deliver in threshold securities has impacted
options market makers' willingness to provide liquidity in threshold
securities, made it more costly for options market makers to
accommodate customer orders, or resulted in wider bid-ask spreads or
less depth.
Similarly, all fails to deliver in threshold securities resulting
from long or short sales of securities in the equities markets must be
closed out in accordance with Regulation SHO's mandatory 13 consecutive
settlement day close-out requirement, and we are not aware that such a
requirement has impacted the willingness of market makers to make
markets in securities subject to the close-out requirement, or led to
decreased liquidity, wider spreads, or less depth in these securities.
Thus, we believe that the impact of requiring that fails to deliver in
threshold securities resulting from short sales to hedge options
positions created before the security became a threshold security be
closed out would similarly be minimal, if any.
Fourth, to the extent that a mandatory close-out requirement for
all fails to deliver resulting from hedging activity in the options
markets could potentially impact liquidity, hedging costs, depth, or
spreads, or impact the willingness of options market makers to make
markets in certain securities, we believe that such effects are
justified by our belief, as discussed in more detail below, that fails
to deliver resulting from hedging activities by options market makers
should be treated similarly to fails to deliver resulting from sales in
the equities markets so that market participants trading threshold
securities in the options markets do not receive an advantage over
those trading such securities in the equities markets.
Fifth, to the extent that a mandatory close-out requirement for all
fails to deliver resulting from hedging activity in the options markets
could potentially impact liquidity, hedging costs, depth, or spreads,
or impact the willingness of options market makers to make a market in
certain securities, we believe that these potential effects are
justified by the benefits of requiring that fails to deliver in all
threshold securities be closed out within specific time-frames rather
than being allowed to continue indefinitely. As discussed above, large
and persistent fails to deliver can deprive shareholders of the
benefits of ownership, such as voting and lending. They can also be
indicative of potentially manipulative conduct, such as abusive
``naked'' short selling. The deprivation of the benefits of ownership,
as well as the perception that abusive ``naked'' short selling is
occurring in certain securities, can undermine the confidence of
investors. These investors, in turn, may be reluctant to commit capital
to an issuer they believe to be subject to manipulative conduct.
In the 2006 Proposing Release, we sought comment on whether the
proposed amendments would promote capital formation, including whether
the proposed increased short sale restrictions would affect investors'
decisions to invest in certain equity securities. Commenters expressed
concern about ``naked'' short selling causing a drop in an issuer's
stock price and that it may limit an issuer's ability to access the
capital markets.\50\ We believe that, by requiring that all fails to
deliver in threshold securities be closed out within specific time-
frames rather than allowing them to continue indefinitely, there would
be a decrease in the number of threshold securities with persistent and
high levels of fails to deliver. If persistence on the threshold
securities lists leads to an unwarranted decline in investor confidence
about the security, the proposed amendments should improve investor
confidence about the security. We also believe that the proposed
amendments should lead to greater certainty in the settlement of
securities which should strengthen investor confidence in the
settlement process. The reduction in fails to deliver and the resulting
reduction in the number of securities on the threshold securities lists
could result in increased investor confidence, and the promotion of
price efficiency and capital formation.
---------------------------------------------------------------------------
\50\ See, e.g., letter from Feeney, supra note 10.
---------------------------------------------------------------------------
Due to our concerns about the potentially negative market impact of
large and persistent fails to deliver, and the fact that we continue to
observe a small number of threshold securities with fail to deliver
positions that are not being closed out under existing delivery and
settlement requirements, we adopted amendments to eliminate Regulation
SHO's grandfather provision that allowed fails to deliver resulting
from long or short sales of equity securities to persist indefinitely
if the fails to deliver occurred prior to the security becoming a
threshold security.\51\ We believe that once a security becomes a
threshold security, fails to deliver in that security must be closed
out, regardless of whether or not the fails to deliver resulted from
sales of the security in connection with the options or equities
markets.
---------------------------------------------------------------------------
\51\ See Securities Exchange Act Release No. 56212 (Aug. 7,
2007); see also, 2006 Proposing Release, 71 FR at 41711-41712.
---------------------------------------------------------------------------
Moreover, we believe that fails to deliver resulting from hedging
activities by options market makers should be treated similarly to
fails to deliver resulting from sales in the equities markets so that
market participants trading threshold securities in the options markets
do not receive an advantage over those trading such securities in the
equities markets. We are also concerned that the current options market
maker exception might allow for a regulatory arbitrage not permitted in
the equities markets. For example, an options market maker who sells
short to hedge put options purchased by a market participant unable to
locate shares for a short sale in accordance with Rule 203(b)(2) of
Regulation SHO may not have to close out any fails to deliver that
result from such short sales under the current options market maker
exception. The ability of options market makers to sell short and never
have to close out a resulting fail to deliver position, provided the
short sale was effected to hedge options positions created before the
security became a threshold security, runs counter to the goal of
similar treatment for fails to deliver resulting from sales of
securities in the options and equities markets, because
[[Page 45564]]
no such ability is available in the equity markets.\52\
---------------------------------------------------------------------------
\52\ See Securities Exchange Act Release No. 56212 (Aug. 7,
2007).
---------------------------------------------------------------------------
Although commenters who opposed the proposed amendments to the
options market maker exception favored maintaining Regulation SHO's
current options market maker exception, it has become apparent to us
during the comment process that the language of the current exception
is being interpreted more broadly than the Commission intended, such
that the exception seems to be operating significantly differently from
our original expectations.\53\ Thus, we are concerned that options
market makers are claiming the exception even where options positions
are created after the underlying security becomes a threshold security.
For example, options market makers' practice of ``rolling'' positions
from one expiration month to the next potentially allows these options
market makers to not close out fail to deliver positions as required by
the close-out requirements of Regulation SHO. According to commenters,
when the options that allow an options market maker to be exempt from
the close-out requirement expire or are closed out, investors on the
opposite side may roll their long put or short call positions to a new
expiration month.\54\ It appears that options market makers are not
treating the rolling of options positions to a new expiration month as
creating new options positions for purposes of the current options
market maker exception even though the current options position
typically is closed out and the same position is opened in the next
expiration month.\55\
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\53\ The Commission noted in the Adopting Release that it would
monitor the operation of Regulation SHO and, in so doing, would take
into consideration any indications that the options market maker
exception was operating significantly differently from the
Commission's original expectations. See Adopting Release, 69 FR at
48018-48019.
\54\ See, e.g., letters from ABA, supra note 31; Wolverine,
supra note 31.
\55\ See, e.g., letter from Wolverine, supra note 31.
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Thus, options market makers providing liquidity to customers who
are ``rolling'' positions from one expiration month to the next appear
to use the original short sale to maintain the hedge on these new
options positions, rather than closing out that original short sale and
any fails to deliver that resulted from the short sale and establishing
a new hedge. Regulation SHO's current options market maker exception
provides that a fail to deliver position does not have to be closed out
if it results from a short sale effected to establish or maintain a
hedge on options positions created before the underlying security
became a threshold security. Options market makers also may not be
closing out fails to deliver that result from short sales effected to
maintain or establish a hedge on options positions created after the
underlying security became a threshold security. Such conduct would not
be in compliance with the current options market maker exception and
would allow options market makers to avoid improperly Regulation SHO's
close-out requirement.\56\
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\56\ In addition, we are concerned that options market makers
may not have systems in place to determine whether or not fails to
deliver resulted from short sales effected to establish or maintain
a hedge on options positions created before or after the underlying
security became a threshold security, and, therefore, may not be
complying with the requirements of the current exception.
---------------------------------------------------------------------------
In addition, as a practical matter, we note that the cost of
maintaining a fail to deliver position may change over time and, in
particular, when a security becomes a threshold security. Thus, if
options market makers, in accommodating their customers' rolling of
options positions from one expiration month to the next, use the
original short sale to maintain the hedge on these new options
positions rather than closing out that short sale and any fails to
deliver that resulted from the short sale and establishing a new hedge,
any additional cost of maintaining a fail to deliver in the underlying
security would not be properly transferred to the options positions.
Despite our concerns noted above regarding the application of
Regulation SHO's current options market maker exception, we credit
commenters' statements that the amendments proposed in 2006 to narrow
the current options market maker exception would be costly and
difficult to implement, or even possibly unworkable, because they do
not reflect how options market makers hedge their options positions.
According to commenters, options market makers usually hedge their
options positions on a portfolio basis.\57\ Thus, an options market
maker typically does not assign a particular short or long position to
a particular options position as would be required if the Commission
were to adopt the 2006 amendments, as proposed. Only one commenter
asked that the Commission be sensitive to the time necessary to make
systems changes to track the requirements of the proposed
amendments.\58\ Most commenters simply stated that the amendments
proposed in 2006 would be difficult and costly to implement or possibly
unworkable.
---------------------------------------------------------------------------
\57\ See, e.g., letters from CBOE, supra note 31; Options
Exchanges, supra note 31; Wolverine, supra note 31; UBS, supra note
31; Angel, supra note 31.
\58\ See letter from UBS, supra note 31.
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Based on commenters' concerns that they would be unable to comply
with the amendments to the options market maker exception as proposed
in the 2006 Proposing Release, and statements indicating that options
market makers might be violating the current exception, we have
determined to re-propose amendments to the options market maker
exception.
III. Proposed Amendments to the Options Market Maker Exception
A. Elimination of the Options Market Maker Exception
We propose to eliminate the options market maker exception in Rule
203(b)(3) of Regulation SHO. In particular, the proposed amendment
would require that any previously excepted fail to deliver position in
a threshold security on the effective date of the amendment, including
any adjustments to that fail to deliver position, be closed out within
35 consecutive settlement days \59\ of the effective date of the
amendment. This 35 consecutive settlement day requirement would be a
one-time phase-in period. Thus, after 35 consecutive settlement days
from the effective date of the amendment this phase-in period would
expire and any additional fails to deliver in the threshold security
would be subject to the current mandatory 13 consecutive settlement day
close-out requirement of Rule 203(b)(3) of Regulation SHO.\60\
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\59\ If the security is a threshold security on the effective
date of the amendment, participants of a registered clearing agency
would have to close out that position within 35 consecutive
settlement days, regardless of whether the security becomes a non-
threshold security after the effective date of the amendment.
We chose 35 settlement days because 35 days was used in
Regulation SHO as adopted in August 2004, and in Regulation SHO, as
amended. See Adopting Release, 69 FR at 48031; Securities Exchange
Act Release No. 56212 (Aug. 7, 2007). In addition, we believe that
35 settlement days would allow participants time to close out their
previously-excepted fail to deliver positions given that some
participants may have large previously-excepted fails with respect
to a number of securities.
\60\ For example, assume that on the effective date of the
amendment XYZ security is a threshold security and a participant of
a registered clearing agency has fails to deliver in XYZ security
that resulted from short sales by a registered options market maker
to hedge options positions that were created before XYZ security
became a threshold security. The participant must close out the
fails to deliver in XYZ security within 35 consecutive settlement
days of the effective date of the amendment, including any
additional fails to deliver during that 35-day period that result
from short sales by the registered options market maker to hedge
options positions that were created before XYZ security became a
threshold security. After the 35-day period has expired, if XYZ
security remains a threshold security, any additional fails to
deliver in XYZ security must be closed out in accordance with
Regulation SHO's 13 consecutive settlement day close-out
requirement, regardless of whether or not the fails to deliver
resulted from short sales by a registered options market maker to
hedge options positions that were created before XYZ security became
a threshold security.
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[[Page 45565]]
In addition, similar to the pre-borrow requirement of Rule
203(b)(3)(iv) of Regulation SHO, if the fail to deliver position
persists for 35 consecutive settlement days from the effective date of
the amendment, the proposed amendment would prohibit a participant, and
any broker-dealer for which it clears transactions, including market
makers, from accepting any short sale orders or effecting further short
sales in the particular threshold security without borrowing, or
entering into a bona-fide arrangement to borrow, the security until the
participant closes out the entire fail to deliver position by
purchasing securities of like kind and quantity. Any fails to deliver
that were not previously-excepted from the close-out requirement of
Rule 203(b)(3) of Regulation SHO as of the effective date of the
amendment and, therefore, not subject to the one-time 35 consecutive
settlement day phase-in period, would be subject to the pre-borrow
requirement of Rule 203(b)(3)(iv) of Regulation SHO.
If a security becomes a threshold security after the effective date
of the amendment, any fails to deliver that result or resulted from
short sales effected by a registered options market maker to establish
or maintain a hedge on options positions that were created before the
security became a threshold security would be subject to Rule
203(b)(3)'s mandatory 13 consecutive settlement day close-out
requirement, similar to any other fail to deliver position in a
threshold security.
For the reasons discussed above and in the 2006 Proposing Release,
we believe that no fail to deliver position should be left open
indefinitely. Although we included in Rule 203 of Regulation SHO
exceptions to the close-out requirement of the rule, we also stated
that we would pay close attention to the operation and efficacy of the
provisions adopted in Rule 203, and would consider whether any further
action was warranted.\61\ As discussed above, we continue to see a
small number of threshold securities with large and persistent fails to
deliver that are not being closed out under existing delivery and
settlement requirements. We are concerned that these fails to deliver
may have a potentially negative impact on the market for these
securities by impeding the orderly functioning of the markets for these
securities, depriving investors of ownership rights, undermining
investor and issuer confidence in the markets, and being indicative of
potentially manipulative trading activities. In addition, a seller that
fails to deliver securities on trade settlement date effectively
unilaterally converts a securities contract (that should settle within
the standard 3-day settlement period) into an undated futures-type
contract, to which the buyer might not have agreed, or that might have
been priced differently.
---------------------------------------------------------------------------
\61\ See Adopting Release, 69 FR at 48019.
---------------------------------------------------------------------------
Thus, by proposing to eliminate the current options market maker
exception of Regulation SHO so that all fails to deliver in threshold
securities that result from short sales effected to maintain or
establish a hedge on options positions would have to be closed out
within Regulation SHO's current mandatory 13 consecutive settlement day
close-out requirement similar to all other fails to deliver in
threshold securities, we hope to reduce the number of threshold
securities with large and persistent fails to deliver and, thereby,
limit any potential negative impact of such fails to deliver on the
market for these securities.
In addition, the overly-broad interpretation of the current options
market maker exception, as discussed above, could be contributing to
some securities with listed options having large and persistent fails
to deliver and remaining on the threshold securities list. Thus, we
further believe it would be appropriate to eliminate the current
exception.
By proposing to eliminate the current options market maker
exception, fails to deliver from hedging activities by options market
makers would be treated similarly to fails to deliver resulting from
sales in the equities markets so that market participants trading
threshold securities in the options market would not receive an
advantage over those trading such securities in the equities markets.
In addition, we believe the proposed amendment would be warranted
because it strikes the appropriate balance between reducing large and
persistent fails to deliver in threshold securities while still
allowing participants some flexibility in conducting their hedging
activities. Under the proposed amendment, other than those previously-
excepted fails to deliver that would be subject to the one-time 35-day
phase-in period, all fails to deliver in threshold securities would be
subject to the current mandatory 13 consecutive settlement day close-
out requirement of Rule 203(b)(3) of Regulation SHO. Thus, the proposed
amendment would provide flexibility because it would allow an extended
period of time (i.e., 13 consecutive settlement days) within which to
close out all fails to deliver in threshold securities, rather than,
for example, requiring that such fails to deliver be closed out
immediately, or even within the standard 3-day settlement period.
During the period of time that the fail to deliver position could
remain open, options market makers would be able to continue any
hedging activity without having to close out the fail to deliver
position or pre-borrow to maintain the hedge.
In addition, we note that the one-time 35 consecutive settlement
day phase-in period would help reduce any potential for market
disruption, such as increased volatility or short squeezes, from having
to close-out previously-excepted fail to deliver positions particularly
as participants would be able to begin to close out such positions at
anytime before the 35-day phase-in period.
Request for Comment
The Commission seeks comment generally on all aspects of this
proposed amendment to Regulation SHO. In addition, we seek comment on
the following:
The proposed amendment to eliminate the options market
maker exception would require that fails to deliver that result from
short sales effected to maintain or establish a hedge on options
positions be closed out within Regulation SHO's current mandatory 13
consecutive settlement day close-out requirement similar to other fails
to deliver in any threshold security. We believe that fails to deliver
in threshold securities should not last indefinitely. Thus, we proposed
and adopted amendments to eliminate the grandfather provision in
Regulation SHO so that fails to deliver resulting from long or short
sales in the equities markets must be closed out within 13 consecutive
settlement days. Should fails to deliver that result from short sales
effected to maintain or establish a hedge on options positions be
treated differently from fails to deliver that result from short or
long sales of threshold securities in the equities markets? If so, why?
Should market makers in the options markets be permitted to maintain a
fail to deliver position in a threshold security for an extended period
of time or indefinitely when market makers in the equities markets are
not able to do so? If so, why? If not, why not?
[[Page 45566]]
The options market maker exception was created to provide
options market makers with flexibility in establishing and maintaining
hedges on options positions created before the underlying security
became a threshold security. Would elimination of the options market
maker exception be appropriate? If so, why? If not, why not? Would
elimination of the options market maker exception result in fewer
options on threshold securities and what effect would this have on
market efficiency and capital formation? Would eliminating the
exception reduce the willingness of options market makers to make
markets in securities that might become threshold securities or that
are threshold securities? Would eliminating the exception result in
increased costs to investors? Would options investors bear any
additional costs that are not borne by the equivalent equity investors?
Would eliminating this exception reduce liquidity in securities that
might become threshold securities or that are threshold securities? How
significant would such an impact be, if any, given that fails to
deliver would be subject to Regulation SHO's current 13 consecutive
settlement days close-out requirement similar to all other fails to
deliver in threshold securities and that we are not aware that
compliance with the current mandatory close-out requirement of
Regulation SHO for non-excepted fails to deliver has resulted in market
disruption? What other measures or time-frames would be effective in
fostering Regulation SHO's goal of reducing fails to deliver while at
the same time allowing market making by options market makers?
Based on current experience with Regulation SHO, what have
been the costs and benefits of the current options market maker
exception?
What are the costs and benefits of the proposed amendment
to eliminate the options market maker exception?
What technical or operational challenges would options
market makers face in complying with the proposed amendment?
Would the proposed amendment create additional costs, such
as costs associated with systems, surveillance, or recordkeeping
modifications that may be needed for participants to track fails to
deliver subject to the 35 consecutive settlement day phase-in period
from fails to deliver that are not eligible for the phase-in period? If
there are additional costs associated with tracking fails to deliver
subject to the 35 versus 13 consecutive settlement day requirements,
would these additional costs justify the benefits of providing firms
with a 35 consecutive settlement day phase-in period? Would a 35
consecutive settlement day phase-in period be necessary given that
firms would have been on notice that they would have to close out these
fail to deliver positions following the effective date of the
amendment?
Should we consider changing the proposed phase-in period
to 35 calendar days? If not, why not? If so, would this create systems
problems or other costs? Would a phase-in period create examination or
surveillance difficulties?
Please provide specific comment as to what length of
implementation period would be necessary such that participants would
be able to meet the requirements that fail to deliver positions in
threshold securities be closed out within the applicable time-frames,
if adopted.
B. Alternatives To Eliminating the Options Market Maker Exception
As discussed above, due to the fact that large and persistent fails
to deliver are not being closed out under existing delivery and
settlement requirements and because we are concerned that these fails
to deliver may have a negative impact on the market for those
securities, we believe that the options market maker exception to the
mandatory close-out requirement of Rule 203(b)(3) of Regulation SHO
should be eliminated. In addition, we believe that the options market
maker exception should be eliminated because we believe that fails to
deliver resulting from hedging activities by options market makers
should be treated similarly to fails to deliver resulting from sales in
the equities markets so that market participants trading threshold
securities in the options markets do not receive an advantage over
those trading such securities in the equities market.
We anticipate, however, that in response to our request for comment
on the proposed amendments to eliminate the options market maker
exception, we will receive comment that an options market maker
exception, similar to the current exception in Regulation SHO, is
necessary. It has become apparent to us, however, that the current
exception is being interpreted in such a way that the exception seems
to be operating significantly differently from our original
expectations, and that options market makers might be using the current
exception to improperly avoid closing out certain fails to deliver in
threshold securities. In addition, commenters stated that the proposed
amendments to the options market maker exception set forth in the 2006
Proposing Release would be impractical given the industry practice of
using hedges to manage the risk of an entire inventory, not just a
specific options position.\62\ Thus, in conjunction with our proposal
to eliminate the options market maker exception, we have determined to
solicit comment regarding two narrowly-tailored alternatives to the
current options market maker exception and to our proposed elimination
of that exception.
---------------------------------------------------------------------------
\62\ See, e.g., letters from CBOE, supra note 31; CTC LLC, supra
note 31; Citigroup, supra note 31; Wolverine, supra note 31.
---------------------------------------------------------------------------
Because we are concerned that any exception to Regulation SHO's
close-out requirement for fails to deliver resulting from short sales
effected to establish or maintain a hedge on options positions might
result in continued large and persistent fails to deliver in securities
with options traded on them, the proposed alternatives would provide
very limited exceptions to the close-out requirement of Regulation SHO
so that all fails to deliver in threshold securities underlying options
would eventually have to be closed out. Similar to elimination of the
options market maker exception, by proposing to require that all fails
to deliver be closed out within specific time-frames, the proposed
alternatives should reduce large and persistent fails to deliver. The
proposed alternatives, however, would provide participants of a
registered clearing agency, or options market makers for which they
clear transactions, longer periods of time than Regulation SHO's
current mandatory 13 consecutive settlement day close-out requirement,
within which to close out such fails to deliver.
Also, similar to the proposed amendment to eliminate the options
market maker exception, by proposing to require that fails to deliver
be closed out within specific time-frames, the proposed alternatives
would be more likely to result in shareholders receiving the benefits
of ownership than under the current options market maker exception.
Sellers would also be less able to unilaterally convert securities
contracts into undated futures-type contracts to which the buyer may
not have agreed, or that would have been priced differently. In
addition, the delivery requirements of the proposed alternatives could
enhance investor confidence as they make investment decisions by
providing investors with greater assurance that securities would be
delivered as expected. An increase in investor confidence in the market
could facilitate investment.
The proposed alternatives could benefit issuers because investors
may be
[[Page 45567]]
more willing to commit capital where fails levels are lower. In
addition, some issuers could believe that a reduction in fails to
deliver could reverse unwarranted reputational damage potentially
caused by large and persistent fails to deliver and what they believe
might be an indication of manipulative trading activities, such as
``naked'' short selling.\63\ Thus, the proposed requirement that all
fails to deliver be closed out within specific time-frames, as proposed
to be required by the alternatives, could decrease the possibility of
artificial market influences and, therefore, could contribute to price
efficiency.
---------------------------------------------------------------------------
\63\ See, e.g., supra note 8 (citing to comment letters from
issuers and investors discussing extended fails to deliver in
connection with ``naked'' short selling).
---------------------------------------------------------------------------
Although the proposed alternatives could lessen the potential
negative impact of large and persistent fails to deliver similar to the
proposed elimination of the options market maker exception because the
proposed alternatives would require that fails to deliver in threshold
securities eventually be closed out, we believe that complete
elimination of the options market maker exception would achieve this
goal more effectively. Under the proposed elimination of the options
market maker exception, all fails to deliver in threshold securities
would have to be closed out within Regulation SHO's mandatory 13
consecutive settlement day close-out requirement. The proposed
alternatives, however, would each allow a longer period of time for
fail to deliver positions to be closed out. Specifically, the first
alternative would allow certain fails to deliver to be closed out
within 35 consecutive settlement days of the security becoming a
threshold security. Under the second alternative, although some fails
to deliver would be required to be closed out in less than 35
consecutive settlement days, other fails to deliver would not have be
closed out until 35 consecutive settlement days from the security
becoming a threshold security.
Similar to our discussions above in connection with our response to
comments regarding the proposed amendment in the 2006 Proposing Release
to limit the duration of the current options market maker exception and
regarding the proposed amendment to eliminate the options market maker
exception, we believe the mandatory close-out requirements of each of
the proposed alternatives would similarly minimally impact, if at all,
liquidity, hedging costs, spreads, or depth in the securities subject
to the close-out requirements of the proposed alternatives, or the
willingness of options market makers to make markets in such
securities.
We believe that these potential effects of the close-out
requirements of the proposed alternatives would be minimal, if any,
because the number of securities that would be impacted by the close-
requirements would be relatively small. The proposed alternatives would
apply only to those threshold securities with listed options \64\ and
would only impact fails to deliver in those securities that resulted
from short sales by registered options market makers to hedge options
series that were created before, rather than after, the security became
a threshold security because all other fails to deliver in threshold
securities are subject to Regulation SHO's current mandatory 13
consecutive settlement day close-out requirement.
---------------------------------------------------------------------------
\64\ See letter from Options Exchanges, supra note 49
(discussing the number of threshold securities with listed options).
---------------------------------------------------------------------------
In addition, the proposed alternatives would provide options market
makers with flexibility in conducting their hedging activities because
they would each allow an extended period of time (i.e., 35 consecutive
settlement days for purposes of proposed Alternative 1 and 13 or 35
consecutive settlement days for purposes of proposed Alternative 2)
within which to close out all fails to deliver in threshold securities.
As discussed above in connection with the proposed amendment to
eliminate the options market maker exception, we believe that even a 13
consecutive settlement day close-out requirement would result in
minimal impact on the willingness of options market makers to make
markets, liquidity, hedging costs, depth, and spreads because it would
allow options market makers flexibility in conducting their hedging
activities by permitting fails to deliver to remain open for an
extended period of time (i.e., 13 consecutive settlement days) rather
than, for example, requiring that such fails to deliver be closed out
immediately, or even within the standard 3-day settlement period.
During the period of time that the fail to deliver position can remain
open, options market makers would be able to continue any hedging
activity without having to close out the fail to deliver position or
pre-borrow to maintain the hedge.
The extended close-out requirements of the proposed alternatives
would expire, however, after 35 consecutive settlement days of the
security becoming a threshold security. In each of the proposed
alternatives, after the excepted period expires, any additional fails
to deliver that result from short sales in the threshold security,
whether or not effected to establish or maintain a hedge on options
series in the portfolio that were created before the security became a
threshold security, would have to be closed within Rule 203(b)(3)'s
mandatory 13 consecutive settlement day close-out requirement.
The proposed alternatives are narrowly tailored in response to our
concerns that options market makers are interpreting the current
exception more broadly than the Commission intended and in response to
comments that options market makers manage their risk based on an
assessment of the entire portfolio rather than of a specific options
position. Based on comments that portfolio hedging is the industry
practice, the proposed alternatives refer to the hedging of options
series in a portfolio rather than an options position. In addition, the
proposed alternatives would permit options market makers to adjust
their hedges on options series created before the underlying security
became a threshold security provided any resulting fails to deliver are
closed out within the applicable time-frames.
The proposed alternatives would also require that participants of a
registered clearing agency and options market makers document that any
fails to deliver in threshold securities that have not been closed out
in accordance with the 13 consecutive settlement days close-out
requirement of Rule 203(b)(3) of Regulation SHO are eligible for the
options market maker exception.\65\ The current exception does not set
forth a specific documentation requirement, although some options
market makers may in fact keep records that relate to their compliance
with the exception. In the absence of such a requirement, we are
concerned that many options market makers are not preparing or
retaining records with regard to their eligibility for the exception.
Without such a documentation requirement, it may be difficult for the
Commission and SROs to monitor whether the options market maker
exception is being applied consistently with the rule.
---------------------------------------------------------------------------
\65\ Commenters to the 2006 Proposing Release urged the
Commission to add specific documentation requirements for
establishing eligibility for the options market maker exception.
See, e.g., letters from NASAA, supra note 31; TASER, supra note 8.
---------------------------------------------------------------------------
Thus, to the extent we retain an options market maker exception, we
believe it would be necessary to add a provision to Regulation SHO that
would
[[Page 45568]]
require both options market makers and participants of a registered
clearing agency that rely on the options market maker exception to not
close out a fail to deliver position in accordance with the mandatory
close-out requirement of Rule 203(b)(3) of Regulation SHO to obtain,
prepare, and keep documentation demonstrating that a fail to deliver
position has not been closed out because it qualified for the
exception. Such documentation could indicate, among other things, when
the series being hedged was created, when the underlying security
became a threshold security, and the age of the fail to deliver
position that is not being closed out.
A documentation requirement would enable the Commission and the
SROs to monitor more effectively whether or not the options market
maker exception is being applied correctly. In addition, the
information would provide a record that would aid surveillance for
compliance with this limited exception to Regulation SHO's close-out
requirement.
The Alternatives
We are requesting comment regarding specific alternatives, as
described below, to eliminating the options market maker exception.
Each of the proposed alternatives would provide for a 35 consecutive
settlement day phase-in period similar to the phase-in period discussed
above for securities that are threshold securities on the effective
date of the amendment and that have previously excepted fail to deliver
positions.\66\ In addition, as explained in more detail below, these
alternatives would apply only to fails to deliver resulting from short
sales effected by a registered options market maker to establish or
maintain a hedge on any options series created before an underlying
security became a threshold security. These alternatives would also
require such fails to deliver to be closed out within specific time-
frames so that the fails to deliver would not last indefinitely.
---------------------------------------------------------------------------
\66\ This 35 consecutive settlement day phase-in period would
operate in the same manner as that outlined above in the discussion
of the elimination of the options market maker exception.
---------------------------------------------------------------------------
i. Alternative 1
We request comment regarding an options market maker exception that
would require a participant of a registered clearing agency that has a
fail to deliver position in a threshold security that results or
resulted from a short sale by a registered options market maker to
establish or maintain a hedge on any options series within a portfolio
that were created before the security became a threshold security to
close out the entire fail to deliver position, including any
adjustments to that position, within 35 consecutive settlement days of
the security becoming a threshold security. After the 35 consecutive
settlement days has expired, any additional fails to deliver would be
subject to the mandatory 13 consecutive settlement day close-out
requirement of Rule 203(b)(3) of Regulation SHO.
We propose 35 consecutive settlement days for purposes of proposed
Alternative 1 because 35 days was used in Regulation SHO as adopted in
August 2004, and in Regulation SHO, as amended and, therefore, is a
period of time with which market participants subject to Regulation SHO
are familiar.\67\ In addition, because we believe that all fails to
deliver should be closed out within specific time-frames we did not
want to propose an alternative that would allow fails to deliver to
continue indefinitely, or for a period of time that would undermine the
goal of requiring that all fails to deliver be closed out within a
reasonable time period. We believe that 35 consecutive settlement days
would allow participants time to close out their excepted fail to
deliver positions without extending the close-out requirement beyond
what we believe would be a reasonable period of time within which fails
to deliver should be closed out.
---------------------------------------------------------------------------
\67\ See Adopting Release, 69 FR at 48031; Securities Exchange
Act Release No. 56212 (Aug. 7, 2007).
---------------------------------------------------------------------------
In addition, similar to the pre-borrow requirement of Rule
203(b)(3)(iv) of Regulation SHO, if the fail to deliver position
persists for 35 consecutive settlement days, the proposed alternative
would prohibit a participant, and any broker-dealer for which it clears
transactions, including market makers, from accepting any short sale
orders or effecting further short sales in the particular threshold
security without borrowing, or entering into a bona-fide arrangement to
borrow, the security until the participant closes out the entire fail
to deliver position by purchasing securities of like kind and quantity.
Example: The following is an example of how proposed Alternative
1 would work if it were effective in February. XYZ security becomes
a threshold security in March. On the date on which XYZ security
becomes a threshold security, a participant of a registered clearing
agency has fails to deliver in XYZ security that resulted from short
sales by a registered options market maker to hedge options series
in XYZ portfolio that were created before XYZ security became a
threshold security. The participant must close out the entire fail
to deliver position in XYZ security, including any additional fails
that result from short sales to hedge options series in XYZ
portfolio that were created before XYZ security became a threshold
security, within 35 consecutive settlement days of the date on which
XYZ security became a threshold security in March. After the 35
consecutive settlement days, any additional fails to deliver in XYZ
security, whether or not they result or resulted from short sales by
a registered options market maker to hedge options series in XYZ
portfolio that were created before XYZ security became a threshold
security, must be closed out in accordance with Regulation SHO's
mandatory 13 consecutive settlement day close-out requirement.
ii. Alternative 2
As another alternative to eliminating the options market maker
exception, we request comment regarding a proposed options market maker
exception that would require a participant of a registered clearing
agency that has a fail to deliver position in a threshold security that
results or resulted from a short sale by a registered options market
maker to establish or maintain a hedge on any options series in a
portfolio that were created before the security became a threshold
security to close out the entire fail to deliver position, including
any adjustments to that position, within the earlier of: (i) 35
Consecutive settlement days from the date on which the security became
a threshold security, or (ii) 13 consecutive settlement days from the
last date on which all options series within the portfolio that were
created before the security became a threshold security expire or are
liquidated. After the 35 or 13 consecutive settlement days has expired,
any additional fails to deliver would be subject to the mandatory 13
consecutive settlement day close-out requirement of Rule 203(b)(3) of
Regulation SHO.
We propose to require in Alternative 2 that fails to deliver be
closed out within 13 consecutive settlement days if all options series
within the portfolio that were created before the security became a
threshold security expire or are liquidated because, at that point,
there would be nothing in the portfolio for the original short sale and
resulting fail to deliver position to hedge. We chose a proposed close-
out requirement of 13 consecutive settlement days for such situations
because it is a time-frame currently used in the mandatory close-out
requirement of Rule 203(b)(3) of Regulation SHO \68\ and, therefore, is
a time-frame with which market
[[Page 45569]]
participants subject to the close-out requirement of Regulation SHO are
currently familiar and with which such entities appear able to comply.
---------------------------------------------------------------------------
\68\ See 17 CFR 242.203(b)(3).
---------------------------------------------------------------------------
In addition, as discussed above for proposed Alternative 1, we
chose 35 consecutive settlement days for purposes of proposed
Alternative 2 because this is also a time-frame already used in
Regulation SHO as adopted in August 2004, and in Regulation SHO, as
amended and, therefore, is a time-frame with which market participants
subject to Regulation SHO are already familiar.\69\ In addition,
because we believe that all fails to deliver should be closed out
within specific time-frames we did not want to propose an alternative
that would allow fails to deliver to continue indefinitely, or for a
period of time that would undermine the goal of requiring that all
fails to deliver be closed out within a reasonable time period. We
believe that a close-out requirement that provides that fails to
deliver must be closed out within the time-frames specified by proposed
Alternative 2 would allow participants time to close out their excepted
fail to deliver positions without extending the close-out requirement
beyond what we believe would be a reasonable period of time within
which fails to deliver should be closed out.
---------------------------------------------------------------------------
\69\ See Adopting Release, 69 FR at 48031; Securities Exchange
Act Release No. 56212 (Aug. 7, 2007).
---------------------------------------------------------------------------
In addition, similar to the pre-borrow requirement of Rule
203(b)(3)(iv) of Regulation SHO, if the excepted fail to deliver
position has persisted for longer than the earlier of: (i) 35
Consecutive settlement days from the date on which the security became
a threshold security, or (ii) 13 consecutive settlement days from the
last date on which all options series within the portfolio that were
created before the security became a threshold security expire or are
liquidated, the proposal would prohibit a participant, and any broker-
dealer for which it clears transactions, including market makers, from
accepting any short sale orders or effecting further short sales in the
particular threshold security without borrowing, or entering into a
bona-fide arrangement to borrow, the security until the participant
closes out the entire excepted fail to deliver position by purchasing
securities of like kind and quantity.
Example 1. The following is an example of how proposed
Alternative 2 would work if it were effective in February. XYZ
security becomes a threshold security in March. On the date on which
XYZ security becomes a threshold security, a participant of a
registered clearing agency has fails to deliver in XYZ security that
resulted from short sales by a registered options market maker to
hedge its XYZ portfolio that were created before XYZ security became
a threshold security. On the date on which XYZ security becomes a
threshold security, XYZ portfolio consists of XYZ April 50 Calls and
XYZ July 50 Calls. The last date on which the options within XYZ
portfolio expire is July, which is later than 35 consecutive
settlement days from the date on which XYZ security became a
threshold security. In addition, none of the options series within
XYZ portfolio have been exercised. Thus, the participant must close
out the entire fail to deliver position in XYZ security, including
any additional fails that result from short sales to hedge options
series in XYZ portfolio that were created before XYZ security became
a threshold security, within 35 consecutive settlement days of the
date on which XYZ security became a threshold security in March.
After the 35 consecutive settlement days, any additional fails to
deliver in XYZ security, whether or not they result or resulted from
short sales by a registered options market maker to hedge options
series in XYZ portfolio that were created before XYZ security became
a threshold security, must be closed out in accordance with
Regulation SHO's mandatory 13 consecutive settlement day close-out
requirement.
Example 2. The following is another example of how proposed
Alternative 2 would work if it were effective in February. XYZ
security becomes a threshold security in March. On the date on which
XYZ security becomes a threshold security, a participant of a
registered clearing agency has fails to deliver in XYZ security that
resulted from short sales by a registered options market maker to
hedge options series in its XYZ portfolio that were created before
XYZ security became a threshold security. On the date on which XYZ
security becomes a threshold security, XYZ portfolio consists of XYZ
April 50 Calls and XYZ July 50 Calls. Options market maker firm
exercises both call options in March, shortly after XYZ security
became a threshold security. Because options market maker firm
liquidated the entire XYZ portfolio prior to the expiration of 35
consecutive settlement days from the date on which XYZ security
became a threshold security, or the last expiration date for the
options comprising the XYZ portfolio, the participant must close out
the entire fail to deliver position in XYZ security, including any
additional fails to deliver that result from short sales by a
registered options market maker to hedge options series in XYZ
portfolio that were created before XYZ security became a threshold
security, within 13 consecutive settlement days of the date on which
the options series within XYZ portfolio were exercised.
Request for Comment
The Commission seeks comment generally on all aspects of the
proposed alternatives to elimination of the options market maker
exception. In addition, we seek comment on the following:
As set forth in proposed Alternative 1, should
participants of a registered clearing agency, or options market makers
that have been allocated the close-out requirement under Regulation
SHO, have a limited exception to the close-out requirement that would
allow 35 consecutive settlement days from the security becoming a
threshold security for the fail to deliver position to be closed out?
If so, why? If not, why not? Alternatively, as set forth in proposed
Alternative 2, should the limited exception allow the earlier of: (i)
35 Consecutive settlement days from the date on which the security
becomes a threshold security, or (ii) 13 consecutive settlement days
from the last date on which all options series within the portfolio
that were created before the security became a threshold security
expire or are liquidated, for the fail to deliver position to be closed
out? If so, why?
In our discussion above regarding the impact of the
proposed amendment to eliminate Regulation SHO's current options market
maker exception on liquidity, spreads, depth, and hedging costs, we
stated that we believe that such an impact would be minimal, if any.
For similar reasons, we believe that the impact of the mandatory close-
out requirements in the proposed alternatives on liquidity, spreads,
depth, and hedging costs would be minimal, if any. To what extent would
an options market maker exception as set forth in the proposed
alternatives, rather than eliminating the exception, impact liquidity
in securities that might become threshold securities or in threshold
securities? To what extent would an options market maker exception as
set forth in the proposed alternatives, rather than eliminating the
exception, impact the willingness of options market makers to make
markets in securities that might become threshold securities or in
threshold securities? What other measures or time-frames would be
effective in fostering Regulation SHO's goal of reducing fails to
deliver while at the same time not discouraging market making by
options market makers?
In the proposed alternatives to eliminating the options
market maker exception, fails to deliver would only be excepted from
the close out requirement of Regulation SHO if the fail to deliver
position results or resulted from a short sale effected to establish or
maintain a hedge on options series created before the security became a
threshold security. Is the reference to ``options series'' appropriate?
Please explain.
[[Page 45570]]
Are the terms ``expiration'' and ``liquidation'' of an
options series sufficiently inclusive to prevent participants from
evading the close-out requirements in the proposed alternatives? Are
these terms understandable for compliance purposes? If not, what terms
would be more appropriate? What difficulties, if any, could arise from
having to determine the last date on which all options series within a
portfolio that were created before the security became a threshold
securities have expired or been liquidated?
We provide examples of how the proposed alternatives would
be applied. We request comment regarding these examples, and
suggestions regarding additional examples that would be helpful in
understanding how the proposed alternatives would work that could be
incorporated by the Commission into any future releases, if the
Commission were to adopt either of the proposed alternatives.
What types of costs would be incurred in complying with
the proposed alternatives? For example, what types of costs, if any,
could be incurred for tracking the 35 or 13 consecutive settlement day
close-out requirements? What types of costs, if any, could be incurred
in determining whether or not options series were created before the
security became a threshold security? What types of costs could be
incurred in determining whether or not a fail to deliver position
resulted from a short sale to establish or maintain a hedge on options
series created before the security became a threshold security? How
would these costs differ from costs incurred to comply with the current
options market maker exception in Regulation SHO? Would the costs
relating to the alternative proposals justify the benefits of allowing
for a limited exception to the close-out requirement for options market
makers?
What would be the costs and benefits of the proposed
alternatives to eliminating the options market maker exception?
Under the proposed alternatives, after the specific time-
frames have expired, fails to deliver would be required to be closed
out in compliance with the 13 consecutive settlement day close-out
requirement of Rule 203(b)(3) of Regulation SHO regardless of whether
or not the fails to deliver result or resulted from short sales
effected by a registered options market maker to establish or maintain
a hedge on options series created before the security became a
threshold security. Under the proposed alternatives, might an options
market maker need to maintain such fail to deliver positions beyond the
13 consecutive settlement days allowed by the close-out requirement of
Rule 203(b)(3) of Regulation SHO? What might be the impact, if any, of
requiring such fails to deliver to be closed out?
What technical or operational challenges would options
market makers face in complying with the proposed alternatives?
Should we consider changing the proposed alternatives to
35 calendar days from the date on which the security becomes a
threshold security? If so, would this create systems problems or other
costs?
The proposed alternatives would require that options
market makers document eligibility for the exception. What should
options market makers and participants of a registered clearing agency
be required to include in the documentation? Should we specify in
detail what would be required to be retained? For example, should we
require that such documentation include, at a minimum, documentation
evidencing when the series being hedged was created, when the
underlying security became a threshold security, and the age of the
fail to deliver position that is not being closed out?
The proposed alternatives would require that participants
of a registered clearing agency maintain documentation to demonstrate
that a fail to deliver position has not been closed out due to the
options market maker exception. Would this documentation requirement
raise compliance concerns or any other concerns for participants? If
so, please explain.
The proposed alternatives would allow for a 35 consecutive
settlement day phase-in period for previously excepted fails to deliver
to be closed out. Is 35 consecutive settlement days from the effective
date of the amendment a long enough period of time, or too long, for
fails to deliver that were previously excepted from the close-out
requirement of Regulation SHO to be closed out? If so, what would be an
appropriate period of time?
Would the proposed phase-in period create additional
costs, such as costs associated with systems, surveillance, or
recordkeeping modifications that could be needed for participants to
track fails to deliver subject to the 35 consecutive settlement day
phase-in period from fails to deliver that are not eligible for the
phase-in period? If there were additional costs associated with
tracking fails to deliver subject to the phase-in period, would these
additional costs justify the benefits of providing firms with a 35
consecutive settlement day phase-in period? Is a 35 consecutive
settlement day phase-in period necessary given that firms would have
been on notice that they would have to close out these fail to deliver
positions following the effective date of the amendment? Please provide
estimates of these costs.
Please provide specific comment as to what length of
implementation period would be necessary such that participants would
be able to meet the requirements that fail to deliver positions in
threshold securities be closed out within the applicable time-frames,
if adopted.
IV. Proposed Amendment to Rule 200(g)(1) of Regulation SHO
We are proposing an amendment to the long sale marking provisions
of Rule 200(g)(1) of Regulation SHO that would require that brokers-
dealers marking orders as ``long'' sales document the present location
of the securities.
Prior to the adoption of Regulation SHO in August 2004, broker-
dealers that were members of the NASD were obligated to comply with
former NASD Rule 3370(b). Former NASD Rule 3370(b) required a broker-
dealer making an affirmative determination that a customer was long to
notate on the order ticket at the time an order was taken, the
conversation with the customer as to the present location of the
securities, whether they were in good deliverable form, and the
customer's ability to deliver them to the member within three business
days.\70\
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\70\ NASD repealed NASD Rule 3370(b), the ``affirmative
determination'' for long sales, following the adoption of Regulation
SHO. The repeal of NASD Rule 3370(b) was effective on January 3,
2005, the effective date of Regulation SHO. See NASD Notice to
Members 04-93. See also, Securities Exchange Act Release No. 50822
(Dec. 8, 2004), 69 FR 74554 (Dec. 14, 2004).
---------------------------------------------------------------------------
Regulation SHO does not contain a similar provision to former NASD
Rule 3370(b) regarding documentation of long sales.\71\ Rule 200(g)(1)
of
[[Page 45571]]
Regulation SHO, however, provides that a broker-dealer may mark an
order to sell ``long'' only if the seller is deemed to own the security
being sold pursuant to paragraphs (a) through (f) of Rule 200,\72\ and
either the security is in the physical possession or control of the
broker or dealer or it is reasonably expected that the security will be
in the physical possession or control of the broker or dealer no later
than the settlement of the transaction.\73\ Thus, in marking a sell
order ``long,'' a broker-dealer must determine whether the customer is
``deemed to own'' the securities being sold.
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\71\ Because Regulation SHO does not include a similar provision
to former NASD Rule 3370(b) regarding documentation of long sales,
on July 20, 2005, the NASD filed with the Commission, pursuant to
Section 19(b)(3)(A) of the Exchange Act, a rule filing to amend NASD
Rule 3370 to clarify that members must make an affirmative
determination and document compliance when effecting long sale
orders. In the filing, the NASD stated that it proposed to amend
NASD Rule 3370 ``to re-adopt expressly the affirmative determination
requirements as they now relate to member obligations with respect
to long sales under Regulation SHO.'' The NASD designated the rule
change as ``non-controversial.'' In response to the proposed rule
change, the Commission received three comment letters, the substance
of which called into question the ``non-controversial'' designation
of the proposal. The Commission found that it was appropriate in the
public interest, for the protection of investors, and otherwise in
furtherance of the purposes of the Exchange Act, to abrogate the
proposed rule change. See Securities Exchange Act Release No. 52426
(Sept. 14, 2005); Securities Exchange Act Release No. 52131 (July
27, 2005), 70 FR 44707 (Aug. 3, 2005). The NASD took no further
action with respect to the proposed rule change.
\72\ Rule 200(a) defines the term ``short sale,'' while Rules
200(b) through 200(f) set forth circumstances in which a seller is
deemed to own securities. See 17 CFR 242.200(a)-(f).
\73\ 17 CFR 242.200(g)(1).
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In the 2006 Proposing Release we requested comment regarding
whether we should consider amending Regulation SHO to include
documentation requirements for long sales similar to those required by
former NASD Rule 3370(b).\74\ We received approximately 8 comment
letters in response to the request for comment.\75\
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\74\ See 2006 Proposing Release, 71 FR at 41714. Specifically we
stated: ``Current Rule 203(a) provides that on a long sale, a
broker-dealer cannot fail or loan shares unless, in advance of the
sale, it has demonstrated that it has ascertained that the customer
owned the shares, and had been reasonably informed that the seller
would deliver the security prior to settlement of the transaction.
Former NASD Rule 3370 required that a broker making an affirmative
determination that a customer was long must make a notation on the
order ticket at the time an order was taken which reflected the
conversation with the customer as to the present location of the
securities, whether they were in good deliverable form, and the
customer's ability to deliver them to the member within three
business days. Should we consider amending Regulation SHO to include
these additional documentation requirements? If so, should any
modifications be made to these additional requirements? In the prior
SRO rules, brokers did not have to document long sales if the
securities were on deposit in good deliverable form with certain
depositories, if instructions had been forwarded to the depository
to deliver the securities against payment (``DVP trades''). Under
Regulation SHO, a broker may not lend or arrange to lend, or fail,
on any security marked long unless, among other things, the broker
knows or has been reasonably informed by the seller that the seller
owns the security and that the seller would deliver the security
prior to settlement and failed to do so. Is it generally reasonable
for a broker to believe that a DVP trade will settle on time? Should
we consider including or specifically excluding an exception for DVP
trades or other trades on any rule requiring documentation of long
sales?''
\75\ See, e.g., letters from NASAA, supra note 31; UBS, supra
note 31; SIA, supra note 31. See also, letter from Leonard J.
Amoruso, Compliance and Regulatory Affairs, Knight Capital Group,
Inc., dated Sept. 20, 2006 (``Knight''); letter from John G. Gaine,
President, Managed Funds Association, dated Sept. 19, 2006
(``MFA''); letter from Martin Schwartz, Chief Compliance Officer,
Millennium Partners, LP, Oct. 10, 2006 (``Millennium''); letter from
Susan Trimbath, Ph.D., CEO and Chief Economist, STP Advisory
Services, LLC, Aug. 29, 2006 (``Trimbath''); letter from Wayne
Klein, Director, Division of Securities, State of Utah Department of
Commerce, Sept. 13, 2006 (``Utah Department of Commerce'').
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Commenters that supported documentation requirements for long sales
argued that the ``volume of outstanding fails is too large to permit
the execution of trades where there is doubt about delivery.'' \76\
Commenters opposing documentation requirements for long sales stated
that pre-trade documentation would unnecessarily impair efficiency, as
broker-dealers already have procedures to ensure orders are marked
properly based on information provided by customers and their own books
and records, and the documentation requirements would add substantial
cost.\77\ One commenter stated that compliance with such pre-trade
documentation requirements would require a complete revamping of front
end systems.\78\ Another commenter stated that the requirements would
be inconsistent with the goal of fostering liquidity.\79\
---------------------------------------------------------------------------
\76\ See, e.g., Letters from NASAA, supra note 31; Utah
Department of Commerce, supra note 75.
\77\ See letters from MFA, supra note 75; UBS, supra note 31;
Knight, supra note 75.
\78\ See letter from SIA, supra note 31.
\79\ See letter from Millennium, supra note 75.
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Commenters also argued that the Commission has not presented
evidence that long sales are contributing to a troublesome level of
fails \80\ or abusive or manipulative activity,\81\ and that lack of
documentation is related to those fails.\82\ One commenter stated that
there is no valid purpose to put this additional burden on the
industry.\83\ Another commenter argued that requiring this additional
documentation should be considered only where the benefits clearly
outweigh the burdens.\84\ Commenters also suggested that if the
Commission did adopt additional long sale documentation requirements,
it should except prime broker and DVP trades, ``done with'' trades, and
orders submitted electronically,\85\ or where settlement instructions
are on file with the executing broker.\86\
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\80\ See letter from MFA, supra note 75. See also, letter from
Millennium, supra note 75.
\81\ See letter from SIA, supra note 31 .
\82\ See letter from MFA, supra note 75.
\83\ See letter from UBS, supra note 31.
\84\ See letter from MFA, supra note 75.
\85\ See letters from SIA, supra note 31; Knight, supra note 75.
The SIA commented that ``a broker-dealer should be provided an
exception from such long sale annotation requirements if the broker-
dealer has information regarding the client's custodial
relationship. Providing such an exception would be consistent with
the Commission's long-standing policy of allowing broker-dealers to
enter into bona-fide agreements with their customers regarding
marking of orders.'' See letter from SIA, supra note 31.
\86\ See letter from Knight, supra note 75.
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Although some commenters stated that pre-trade documentation for
long sales would be inconsistent with the goal of fostering liquidity,
would unnecessarily impair efficiency, and would add substantial
cost,\87\ we believe that such costs, to the extent that there are any,
would be justified by the benefits of a documentation requirement, as
described below. In addition, we note that under former NASD Rule
3370(b), NASD member firms making an affirmative determination that a
customer was long were required to make a notation on the order ticket
at the time an order was taken which reflected the conversation with
the customer as to the present location of the securities, whether they
were in good deliverable form, and the customer's ability to deliver
them to the member within three business days.\88\ Thus, many broker-
dealers should already be familiar with a documentation requirement and
one method that could be used to comply with such a requirement. Such
familiarity should help reduce any costs associated with implementing
the proposed documentation requirement. In addition, unlike with former
NASD Rule 3370(b), the proposed amendment would not specify the format
or methodology of the proposed documentation requirement. The absence
of such specifications should help reduce costs to broker-dealers that
would have to comply with this proposal because broker-dealers would be
able to determine the most cost effective format and methodology for
meeting the proposed documentation requirement.
---------------------------------------------------------------------------
\87\ See, e.g., letters from MFA, supra note 75; UBS, supra note
31; Knight, supra note 75; SIA, supra note 31; Millenium, supra note
75.
\88\ Brokers and dealers that were members of the NASD were
obligated to comply with former NASD Rule 3370(b) prior to the
adoption of Regulation SHO.
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We are proposing for further comment a documentation requirement
for broker-dealers marking orders to sell ``long'' pursuant to
Regulation SHO that would require such broker-dealers to document the
present location of the securities being sold. First, we believe that
such a proposed documentation requirement would aid in ensuring the
correct marking of sell orders. To the extent that the seller is unable
to provide the present location of the securities being sold, the
broker-dealer
[[Page 45572]]
would have reason to believe that the seller is not ``deemed to own''
the securities being sold and that the securities would not be in its
physical possession or control no later than settlement of the
transaction and, therefore, that the broker-dealer would be required to
mark the sale ``short'' rather than ``long.'' \89\ We believe that this
proposed documentation requirement could also reduce the number of
fails to deliver because, after making the inquiry into the present
location of the securities being sold, a broker-dealer would know
whether or not it needed to obtain securities for delivery.
---------------------------------------------------------------------------
\89\ See 17 CFR 242.200(g).
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Second, we are concerned that broker-dealers marking orders
``long'' may not be making a determination prior to marking the order
that the seller is ``deemed to own'' the security being sold.\90\ Rule
200(g)(1) currently requires that broker-dealers ascertain whether the
customer is ``deemed to own'' the securities being sold before marking
a sell order ``long.'' \91\ We believe that a proposed documentation
requirement would help ensure that the broker-dealer marking the sale
``long'' has inquired into, and determined that, the seller is ``deemed
to own'' the securities being sold because the broker-dealer would be
required to document the present location of the securities being sold.
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\90\ See id. at 242.200(g)(1).
\91\ In the Adopting Release, we stated that ``* * * Rule 203(a)
provides that on a long sale, a broker-dealer cannot fail or loan
shares unless, in advance of the sale, it ascertained that the
customer owned the shares, and had been reasonably informed that the
seller would deliver the security prior to settlement of the
transaction. This requirement is consistent with changes being made
to the order marking requirements, which require that for an order
to be marked long, the seller must own the security.'' See Adopting
Release, 69 FR at 48021.
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Third, we believe that the proposed documentation requirement would
enable the Commission and SROs to examine for compliance with the long
sale marking provisions of Rule 200(g) more effectively because this
proposed documentation requirement would provide a record that the
seller is ``deemed to own'' the securities being sold in compliance
with that rule. We also believe that the proposed documentation
requirement would aid the Commission and SROs in reviewing for
mismarking designed to avoid compliance with other rules and
regulations of the federal securities laws, such as the ``locate''
requirement of Regulation SHO,\92\ and Rule 105 of Regulation M.\93\
---------------------------------------------------------------------------
\92\ See 17 CFR 242.203(b)(1). Rule 203(b)(1) of Regulation SHO
provides that ``[a] broker or dealer may not accept a short sale
order in an equity security from another person, or effect a short
sale in an equity security for its own account, unless the broker or
dealer has: (i) Borrowed the security, or entered into a bona fide
arrangement to borrow the security; or (ii) Reasonable grounds to
believe that the security can be borrowed so that it can be
delivered on the date delivery is due * * *.'' This provision is
commonly referred to as the ``locate'' requirement.
\93\ See 17 CFR 242.105 (prohibiting persons from covering a
short sale with offering securities if the short sale occurred
during the Rule 105 restricted period). See also, In the Matter of
Goldman Sachs Execution & Clearing, L.P. f/k/a Spear, Leeds, &
Kellogg, L.P., Securities Exchange Act Release No. 55465 (Mar. 14,
2007), Admin. Proc. File No. 3-12590 (settling enforcement
proceedings against a prime broker and clearing affiliate of The
Goldman Sachs Group, Inc., Goldman Sachs Execution and Clearing
L.P., for its violations arising from an illegal trading scheme
carried out by customers through their accounts at the firm, which
included the mismarking of sell orders as ``long.'').
---------------------------------------------------------------------------
We believe that any costs that would arise from the proposed
requirement that a broker-dealer must document the present location of
securities being sold long when making the determination that a
customer is deemed to own the securities being sold would be minimal
because Rule 200(g)(1) currently requires that broker-dealers must
ascertain whether the customer is ``deemed to own'' the securities
being sold before marking a sell order ``long.'' \94\ Today's proposed
amendment would require that the broker-dealer take the additional step
of documenting the present location of the securities being sold.
Broker-dealers could, however, need to put mechanisms in place to
facilitate efficient documenting of the information required by the
proposed amendment.
---------------------------------------------------------------------------
\94\ See 17 CFR 242.200(g).
---------------------------------------------------------------------------
Request for Comment
The Commission seeks comment generally on all aspects of the
proposed amendment to Rule 200(g) of Regulation SHO. In addition, we
seek comment on the following:
Is the proposed documentation requirement appropriate? If
not, why not?
Commenters that responded to the request for comment
regarding documentation of long sales in the 2006 Proposing Release
stated that market participants already have in place procedures to
ensure that orders to sell shares are properly marked. What are those
procedures and how do they ensure that orders are properly marked? How
do broker-dealers currently comply with the ``deemed to own''
requirement of Rule 200(g)(1) of Regulation SHO?
One commenter that responded to the request for comment
regarding documentation of long sales in the 2006 Proposing Release
stated that the requirement would be inconsistent with the goal of
fostering liquidity.\95\ To what extent, if any, would the proposed
amendment impact liquidity in securities being sold long? Please
explain.
---------------------------------------------------------------------------
\95\ See letter from Millennium, supra note 75.
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The ``locate'' requirement of Rule 203(b)(1) of Regulation
SHO contains an exception for market makers. Should market makers also
have an exception for the proposed long sale documentation requirement?
Please explain.
Should we specify the proposed format of the
documentation? Should the proposed documentation be on the order ticket
or elsewhere? Please provide recommended alternatives and estimates of
the costs of various alternatives.
Under what circumstances, if any, should we allow the
documentation to be generated post-trade?
In addition to proposing documentation of the present
location of the securities being sold, should we require additional
documentation requirements to those proposed, such as requiring broker-
dealers to make a record reflecting the basis for believing that the
securities are in good deliverable form, and the basis for believing
that the securities will be in the broker-dealer's possession or
control no later than settlement of the transaction?
The Commission has previously stated that it may be
unreasonable for a broker-dealer to treat a sale as long where orders
marked ``long'' from the same customer repeatedly require borrowed
shares for delivery or result in fails to deliver.\96\ A broker-dealer
also may not treat a sale as long if the broker-dealer knows or has
reason to know that the customer borrowed the shares being sold.\97\
Should broker-dealers be required to take additional steps to determine
whether or not the seller is deemed to own the securities being sold in
conjunction with documenting the present location of the securities?
---------------------------------------------------------------------------
\96\ See Adopting Release, 69 FR at 48019, n.111.
\97\ See id.
---------------------------------------------------------------------------
The proposed amendment would impose an obligation on
broker-dealers to inquire into the present location of securities being
sold and to document that location. To what extent would this proposed
requirement impact the accuracy of marking by broker-dealers? To what
extent would this proposed requirement impact the level of fails to
[[Page 45573]]
deliver in a security, such as fails to deliver due to mismarking? To
what extent would this proposed requirement impact compliance with
other short sale-related regulations, such as the locate requirement of
Regulation SHO and Rule 105 of Regulation M?
Should any trades be excepted from the proposed
documentation requirement? For example, under former NASD Rule 3370(b)
broker-dealers did not have to document long sales if the securities
were on deposit in good deliverable form with certain depositories, if
instructions had been forwarded to the depository to deliver the
securities against payment (``DVP trades''). Should we consider
including or specifically excluding an exception for DVP trades? Should
any other trades be specifically included or excluded from the proposed
documentation requirement?
Former NASD Rule 3370(b) required broker-dealers making an
affirmative determination that a customer was long to make a notation
on the order ticket at the time an order was taken regarding the
conversation with the customer as to the present location of the
securities, whether they were in good deliverable form, and the
customer's ability to deliver them to the member within three business
days. The proposed amendment would require broker-dealers to document
only the present location of the securities being sold long. To what
extent would the requirements of the proposed amendment impose costs,
such as personnel, systems, or surveillance costs on market
participants that are any different from such costs imposed on market
participants to comply with former NASD Rule 3370(b)?
Most broker-dealers allow investors to submit orders
electronically. Do these systems automatically verify the location of
shares for long sales before routing the orders for execution? If so,
how much would it cost for broker-dealers to adjust their systems to
record the location of the securities being sold on the trade record?
If not, what changes would the proposed documentation requirement
require and how much would it cost for broker-dealers to adjust their
systems to verify and document the location of the shares for long
sales? To what extent do investors communicate order requests via other
means, such as by telephone or in person? How do the costs of the
proposed documentation requirement differ for these order requests
versus electronic order submissions?
Some investors have direct access to alternative trading
systems. Are alternative trading systems already programmed to verify
the location of the shares in orders marked as long sales? If not, to
what extent, if any, should alternative trading systems be responsible
for meeting this requirement? How much would it cost?
Some broker-dealers sponsor direct access to exchanges for
preferred clients. To what extent do these broker-dealers currently
document the location of shares for long sales that their clients send
directly to exchanges? What costs are associated with such
documentation?
Do algorithmic trading systems \98\ present any problems
for compliance with the proposed amendment? Are there any other current
market practices that present problems for compliance with
documentation requirements?
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\98\ An algorithmic trading program detects trading
opportunities for the strategies input by investors and responds to
them by placing and managing orders on behalf of those investors.
---------------------------------------------------------------------------
V. General Request for Comment
The Commission seeks comment generally on all aspects of the
proposed amendments to Regulation SHO under the Exchange Act, including
the proposed alternatives to the proposal to eliminate the options
market maker exception. Commenters are requested to provide empirical
data to support their views and arguments related to the proposals
herein. In addition to the questions posed above, commenters are
welcome to offer their views on any other matter raised by the proposed
amendments to Regulation SHO. With respect to any comments, we note
that they are of the greatest assistance to our rulemaking initiative
if accompanied by supporting data and analysis of the issues addressed
in those comments and if accompanied by alternative suggestions to our
proposals where appropriate.
VI. Paperwork Reduction Act
Certain provisions of the proposed amendments to Regulation SHO
would impose new ``collection of information'' requirements within the
meaning of the Paperwork Reduction Act of 1995 (``PRA'') \99\ which the
Commission has submitted to the Office of Management and Budget
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR
1320.11. An agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless it displays
a currently valid OMB control number. OMB has not yet assigned a
control number to the new collection of information.
---------------------------------------------------------------------------
\99\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------
A. Summary of Collections of Information
The proposed amendment to eliminate the options market maker
exception to the close-out requirement of Regulation SHO would not
impose a new ``collection of information'' within the meaning of the
PRA. The two proposed alternatives to elimination of the options market
maker exception and the proposed amendment to Rule 200(g) of Regulation
SHO would impose a new ``collection of information'' within the meaning
of the PRA.
i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
The proposed alternatives to elimination of the options market
maker exception would both require that options market makers and
participants of a registered clearing agency document that any fail to
deliver positions that have not been closed out are excepted from the
close-out requirement of Regulation SHO because the fails to deliver
resulted from short sales effected by a registered options market maker
to establish or maintain a hedge on options series in a portfolio that
were created before the security became a threshold security. This
would be a new collection of information because Regulation SHO does
not currently require documentation to show eligibility for the options
market maker exception.
ii. Proposed Amendment to Rule 200(g)(1)
The proposed amendment to Rule 200(g)(1) of Regulation SHO would
require that brokers and dealers marking orders as ``long'' sales
document the present location of the securities.
Under Rule 200(g)(1), a broker-dealer may mark an order to sell
``long'' only if the seller is deemed to own the security being sold
pursuant to paragraphs (a) through (f) of Rule 200,\100\ and either the
security is in the physical possession or control of the broker or
dealer or it is reasonably expected that the security will be in the
physical possession or control of the broker or dealer no later than
the settlement of the transaction.\101\ Thus, in marking a sell order
``long,'' a broker or dealer must determine whether the customer is
``deemed to own'' the securities being sold.
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\100\ Rule 200(a) defines the term ``short sale,'' while Rules
200(b) through 200(f) set forth circumstances in which a seller is
deemed to own securities. See 17 CFR 242.200(a)-(f).
\101\ 17 CFR 242.200(g)(1).
---------------------------------------------------------------------------
This would be a new collection of information because Regulation
SHO
[[Page 45574]]
does not currently require documentation by brokers and dealers when
marking sell orders as ``long.''
B. Proposed Use of Information
i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
The information that would be required by the proposed alternatives
to elimination of the options market maker exception would assist the
Commission in fulfilling its mandate under the Exchange Act to prevent
fraudulent, manipulative, and deceptive acts and practices. The
Commission and SROs would use the information collected to monitor
whether or not the options market maker exception to the close-out
requirement of Regulation SHO is being applied consistently with the
rule. The information required by the proposed amendment would provide
a record that would aid surveillance for compliance with this limited
exception to Regulation SHO's close-out requirement.
ii. Proposed Amendment to Rule 200(g)(1)
The information that would be required by the proposed amendment to
Rule 200(g)(1) would assist the Commission in fulfilling its mandate
under the Exchange Act to prevent fraudulent, manipulative, and
deceptive acts and practices. Such a documentation requirement would
aid in ensuring the correct marking of sell orders. To the extent that
the seller is unable to provide the present location of the securities
being sold, the broker-dealer would have reason to believe that the
seller is not ``deemed to own'' the securities being sold and that the
securities would not be in its physical possession or control no later
than settlement of the transaction and, therefore, that the broker-
dealer would be required to mark the sale ``short'' rather than
``long.'' \102\ We believe that this documentation requirement could
also reduce the number of fails to deliver because, after making the
inquiry into the present location of the securities being sold, a
broker-dealer would know whether or not it needed to obtain securities
for delivery.
---------------------------------------------------------------------------
\102\ See id.
---------------------------------------------------------------------------
In addition, we are concerned that broker-dealers marking orders
``long'' may not be making a determination prior to marking the order
that the seller is ``deemed to own'' the security being sold. Rule
200(g)(1) currently requires that broker-dealers ascertain whether the
customer is ``deemed to own'' the securities being sold before marking
a sell order ``long.'' \103\ We believe that a documentation
requirement would help ensure that the broker-dealer marking the sale
``long'' has inquired into, and determined that, the seller is ``deemed
to own'' the securities being sold because the broker-dealer would be
required to document the present location of the securities being sold.
---------------------------------------------------------------------------
\103\ See id.
---------------------------------------------------------------------------
We also believe that the documentation requirement would enable the
Commission and SROs to examine for compliance with the long sale
marking provisions of Rule 200(g) more effectively because this
documentation requirement would provide a record that the seller is
``deemed to own'' the securities being sold in compliance with that
rule. We also believe that the documentation requirement would aid the
Commission and SROs in reviewing for mismarking designed to avoid
compliance with other rules and regulations of the federal securities
laws, such as the ``locate'' requirement of Regulation SHO,\104\ and
Rule 105 of Regulation M.\105\
---------------------------------------------------------------------------
\104\ See supra note 92.
\105\ See supra note 93.
---------------------------------------------------------------------------
C. Respondents
i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
The documentation requirement of the proposed alternatives to
elimination of the options market maker exception would apply to all
participants of a registered clearing agency and options market makers
who have not closed out a fail to deliver position in a threshold
security because it resulted from short sales effected by the
registered options market maker to establish or maintain a hedge on
options series in a portfolio that were created before the security
became a threshold security.
ii. Proposed Amendment to Rule 200(g)(1)
The proposed amendment to Rule 200(g)(1) of Regulation SHO would
require that brokers and dealers marking orders as ``long'' sales
document the present location of the securities. Thus, the amendment
would apply to all brokers-dealers registered with the Commission as
they could all execute long sales. The Commission's Office of Economic
Analysis (``OEA'') estimates that at year-end 2006 there are
approximately 5,808 active brokers-dealers registered with the
Commission.\106\
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\106\ This number is based on OEA's review of 2006 FOCUS Report
filings reflecting registered brokers-dealers. This number does not
include broker-dealers that are delinquent with FOCUS Report
filings.
---------------------------------------------------------------------------
D. Total Annual and Recordkeeping Burdens
i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
The proposed alternatives to elimination of the options market
maker exception would require that options market makers and
participants of a registered clearing agency document that any fail to
deliver positions that have not been closed out are excepted from the
close-out requirement of Regulation SHO because the fails to deliver
resulted from short sales effected by a registered options market maker
to establish or maintain a hedge on options series in a portfolio that
were created before the security became a threshold security.
We estimate that it would take an options market maker no more than
approximately 0.16 hours (10 minutes) to document that a fail to
deliver position has not been closed out due to its eligibility for the
options market maker exception.\107\ We understand that eligibility for
the options market maker exception would likely be determined on a
daily basis, rather than on a trade by trade basis. Based on data from
the first quarter of 2006,\108\ for purposes of this PRA, we estimate
that, on average, there would be approximately 75 securities each day
that are (i) on a threshold securities list, and (ii) have open
interest in exchange traded options. On average, we estimate there
would be approximately 5 options market makers engaged in delta hedging
these options.\109\ Thus, we estimate that on average, options market
makers would have to document compliance with the proposed alternatives
to the elimination of the options market maker exception 94,500 times
per year (5 options market makers checking for compliance once per day
on 75 securities, multiplied by 252 trading
[[Page 45575]]
days in a year). Thus, the total approximate estimated annual burden
documentation). A reasonable estimate for the paperwork compliance for
the proposed alternatives for each options market maker would be
approximately 3,024 burden hours (18,900 instances of documentation per
---------------------------------------------------------------------------
\107\ We do not believe that the documentation requirement is
complex. We understand that options market makers receive daily
trading reports from NSCC reflecting an options market maker's
trading activity for that day. Options market makers should be able
to use such information to document eligibility for the exception
from the close-out requirement of Regulation SHO. Because options
market makers receive these daily trading reports, we estimate that
it would take an options market maker no more than approximately 10
minutes to document that a fail to deliver position has not been
closed out due to its eligibility for the options market maker
exception.
\108\ We used the first quarter of 2006 because this is the most
recent period over which we have access to option open interest
data.
\109\ This estimate is based on there being 5 options exchanges
that have a specialist or specialist-like structure and an
estimation that each exchange would have 1 options market maker
actively engaged in hedging threshold securities with listed
options.
---------------------------------------------------------------------------
We estimate that it would take a participant of a registered
clearing agency no more than approximately 0.16 hours (10 minutes) to
document that a fail to deliver position has not been closed out due to
its eligibility for the options market maker exception.\110\ If a
participant of a registered clearing agency had a fail to deliver
position in a threshold security and after twelve consecutive
settlement days the participant determined whether or not the fail to
deliver position was excepted from Regulation SHO's close-out
requirement due to hedging activity by a registered options market
maker, we estimate that a participant of a registered clearing agency
would have to make such determination with respect to approximately
three threshold securities per day.\111\ We understand that there are
currently approximately sixteen participants of a registered clearing
agency that clear transactions for options market makers.\112\ Thus, we
estimate that on average, a participant of a registered clearing agency
would have to document compliance with the proposed alternatives to the
elimination of the options market maker exception 12,096 times per year
(16 participants checking for compliance once per day on three
securities, multiplied by 252 trading days in a year). Thus, the total
approximate estimated annual burden hour per year would be
reasonable estimate for the paperwork compliance for the proposed
alternatives for each participant would be approximately 120 burden
documentation).
---------------------------------------------------------------------------
\110\ We do not believe that the documentation requirement is
complex. Such documentation requirement could involve a participant
of a registered clearing agency contacting a registered options
market maker for which it clears transactions to determine whether
or not trading activity by the registered options market maker was
responsible for the fail to deliver position and whether or not the
fail to deliver position resulted from short sales effected by the
registered options market maker to establish or maintain a hedge on
options series in a portfolio that were created before the security
became a threshold security. After making such determination, the
proposed amendment would require that the participant document this
information. We estimate that such procedures would take a
participant of a registered clearing agency no more than
approximately 10 minutes to complete.
\111\ We estimated that a participant would make such a
determination for approximately 3 threshold securities per day based
on data from the first quarter of 2006. We used the first quarter of
2006 because this is the most recent period over which we have
access to option open interest data.
\112\ This number is based on information received from the
Options Clearing Corporation.
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ii. Proposed Amendment to Rule 200(g)(1)
The proposed amendment to Rule 200(g)(1) of Regulation SHO would
require that brokers and dealers marking orders as ``long'' sales
document the present location of the securities. We estimate that all
of the approximately 5,808 registered broker-dealers may effect sell
orders in securities covered by Regulation SHO and, therefore, would be
required to comply with the proposed documentation requirement.
For purposes of the PRA, OEA has estimated that a total of
2,750,000,000 trades are executed annually.\113\ Of these 2,750,000,000
trades, OEA estimates that approximately 75%, that is, 2,062,500,000,
of these trades would be ``long'' sales.\114\ This would be an average
of approximately 355,114 annual long sales by each respondent. In
addition, because we believe that the documentation process is or will
be automated, we estimate that it would take a registered broker-dealer
approximately 0.000139 hours (0.5 seconds) to document the present
location of the securities being sold.\115\
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\113\ In calendar year 2006, there were approximately 2.099
billion trades in NYSE and Nasdaq-listed stocks. In addition, there
were approximately 2.114 billion trades in over-the-counter bulletin
board (``OTCBB'') traded stocks. OEA estimates that if we were to
include Amex-listed and pink sheet stocks, the total annual trades
would be approximately 2.75 billion trades.
\114\ See Office of Economic Analysis U.S. Securities and
Exchange Commission, Economic Analysis of the Short Sale Price
Restrictions Under the Regulation SHO Pilot (Sept. 14, 2006),
available at http://www.sec.gov/about/economic/shopilot091506/draft_reg_sho_pilot_report.pdf
.
\115\ In the 2003 Proposing Release, we stated that we thought
it was reasonable that it would only take 0.5 seconds or 0.000139
hours to mark an order ``long,'' ``short,'' or ``short exempt.'' See
2003 Proposing Release, 68 FR at 63000. We believe it is reasonable
that it would take a similar amount of time to document the present
location of the securities being sold, if the documentation process
were automated. In addition, we note that Regulation SHO requires
broker-dealers executing short sales to document compliance with the
``locate'' requirements of Rule 203(b)(1) of Regulation SHO, i.e.,
prior to accepting or effecting a short sale in an equity security,
a broker-dealer must document that it has (i) borrowed the security,
or entered into a bona-fide arrangement to borrow the security, or
(ii) reasonable grounds to believe that the security can be borrowed
so that it can be delivered on the date delivery is due. Thus,
broker-dealers should already have in place systems similar to those
necessary to document the present location of the securities being
sold for purposes of long sales.
---------------------------------------------------------------------------
Thus, the total approximate estimated annual burden hour per year
trade). A reasonable estimate for the paperwork compliance for the
proposed amendment for each broker-dealer would be approximately 49
To the extent that broker-dealers need to automate the
documentation process, we anticipate that such broker-dealers would
spend varying amounts of time reprogramming systems, integrating
systems, and potentially updating front-end software. Some broker-
dealers may spend very little time automating the documentation
process, while changes at other broker-dealers might be more involved.
On average, we estimate that reprogramming burdens at a broker-dealer
would be approximately 16 hours (or two days) with one programmer.\116\
If broker-dealers hired new computer programmers at $67/hour, this
aggregate of $6,226,176 across all broker-dealers.\117\
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\116\ We believe that most of the relevant information is
already stored in electronic form and, therefore, we do not believe
that the automation process would be difficult or time-consuming to
implement. Hence, we estimate that automation would on average take
no longer than approximately 16 hours (2 days) to complete.
\117\ The $67/hour figure for a computer programmer is based on
the salary for a Senior Computer Operator from the SIA Report on
Office Salaries in the Securities Industry 2006, modified to account
for an 1800-hour work-year and multiplied by 2.93 to account for
bonuses, firm size, employee benefits and overhead.
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E. Collection of Information is Mandatory
i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
The proposed collection of information for the proposed
alternatives to elimination of the options market maker exception would
be mandatory for a participant of a registered clearing agency and
options market maker where a fail to deliver position has not been
closed out because the fails to deliver resulted from short sales
effected by a registered options market maker to establish or maintain
a hedge on options series in a portfolio that were created before the
security became a threshold security.
ii. Proposed Amendment to Rule 200(g)(1)
The proposed collection of information would be mandatory for a
[[Page 45576]]
broker-dealer marking a sell order as ``long'' pursuant to Rule
200(g)(1).
F. Confidentiality
i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
The proposed collection of information for the proposed
alternatives to elimination of the options market maker exception would
be retained by participants of a registered clearing agency and options
market makers and provided to the Commission and SRO examiners upon
request, but not subject to public availability.
ii. Proposed Amendment to Rule 200(g)(1)
The proposed collection of information under the proposed amendment
to Rule 200(g)(1) would be retained by the broker-dealer and provided
to the Commission and SRO examiners upon request, but would not be
subject to public availability.
G. Record Retention Period
i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
The proposed alternatives to elimination of the options market
maker exception do not contain any new record retention requirements.
All registered broker-dealers that would be subject to the proposed
alternatives are currently required to retain records in accordance
with Rule 17a-4 of the Exchange Act.\118\
---------------------------------------------------------------------------
\118\ 17 CFR 240.17a-4.
---------------------------------------------------------------------------
As discussed above, participants of a registered clearing agency
include entities not registered as broker-dealers, such as banks, U.S.
exchanges, and clearing agencies.\119\ Although we do not believe that
participants of a registered clearing agency other than broker-dealers
would trigger the obligations of the proposed alternatives, all banks
subject to the proposed alternatives would be required to retain
records in compliance with any existing or future record retention
requirements established by the banking agencies. All U.S. exchanges
and clearing agencies subject to the proposed alternatives would be
required to retain records in compliance with Rule 17a-1 of the
Exchange Act.\120\
---------------------------------------------------------------------------
\119\ See supra note 22.
\120\ 17 CFR 240.17a-1.
---------------------------------------------------------------------------
ii. Proposed Amendment to Rule 200(g)(1)
The proposed amendment to Rule 200(g)(1) does not contain any new
record retention requirements. All registered broker-dealers that would
be subject to the proposed amendment are currently required to retain
records in accordance with Rule 17a-4 of the Exchange Act.\121\
---------------------------------------------------------------------------
\121\ Id. at 240.17a-4.
---------------------------------------------------------------------------
H. Request for Comment
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to: (i) Evaluate whether the proposed collection of
information is necessary for the proper performance of the functions of
the agency, including whether the information shall have practical
utility; (ii) evaluate the accuracy of the Commission's estimate of the
burden of the proposed collection of information; (iii) determine
whether there are ways to enhance the quality, utility, and clarity of
the information to be collected; and (iv) evaluate whether there are
ways to minimize the burden of the collection of information on those
who are to respond, including through the use of automated collection
techniques or other forms of information technology.
Persons submitting comments on the collection of information
requirements should direct them to the Office of Management and Budget,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Washington, DC 20503, and
should also send a copy of their comments to Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090, with reference to File No. S7-19-07.
Requests for materials submitted to OMB by the Commission with regard
to this collection of information should be in writing, with reference
to File No. S7-19-07, and be submitted to the Securities and Exchange
Commission, Records Management, Office of Filings and Information
Services, 100 F Street, NE., Washington, DC 20549-1090. As OMB is
required to make a decision concerning the collections of information
between 30 and 60 days after publication, a comment to OMB is best
assured of having its full effect if OMB receives it within 30 days of
publication.
VII. Consideration of Costs and Benefits of Proposed Amendments to
Regulation SHO
The Commission is considering the costs and the benefits of the
proposed amendments to Regulation SHO. The Commission is sensitive to
these costs and benefits, and encourages commenters to discuss any
additional costs or benefits beyond those discussed here, as well as
any reductions in costs. In particular, the Commission requests comment
on the potential costs for any modification to both computer systems
and surveillance mechanisms and for information gathering, management,
and recordkeeping systems or procedures, as well as any potential
benefits resulting from the proposals for registrants, issuers,
investors, brokers or dealers, other securities industry professionals,
regulators, and other market participants. Commenters should provide
analysis and data to support their views on the costs and benefits
associated with the proposed amendments to Regulation SHO.
A. Elimination of the Options Market Maker Exception
1. Benefits
The proposed amendment would eliminate the options market maker
exception in Rule 203(b)(3)(iii) of Regulation SHO. In particular, as a
transition measure, the proposal would require that any previously-
excepted fail to deliver position in a threshold security on the
effective date of the amendment be closed out within 35 consecutive
settlement days of the effective date of the amendment. If a security
becomes a threshold security after the effective date of the amendment,
any fails to deliver that result or resulted from short sales effected
by a registered options market maker to establish or maintain a hedge
on any options positions created before the security became a threshold
security would be subject to Rule 203(b)(3)'s mandatory 13 consecutive
settlement day close-out requirement, similar to any other fail to
deliver position in a threshold security.
On July 14, 2006, the Commission published proposed amendments to
the options market maker exception contained in Regulation SHO to limit
the duration of the exception.\122\ We proposed to narrow the options
market maker exception at that time because we have observed a small
number of threshold securities with substantial and persistent fail to
deliver positions that are not being closed out under existing delivery
and settlement guidelines and we believed that these persistent fail to
deliver positions were attributable, in part, to the options market
maker exception in Regulation SHO.\123\
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\122\ See 2006 Proposing Release, 71 FR 41710.
\123\ See id. at 41712; Regulation SHO Re-Opening Release, 72 FR
at 15079-15080.
---------------------------------------------------------------------------
As a result of the comment process, however, we learned that
commenters were concerned that the proposed
[[Page 45577]]
amendments to the options market maker exception could be costly and
difficult to implement or possibly unworkable because options market
makers typically use hedges to manage the risk of an entire inventory,
not just a specific options position.
We remain concerned that large and persistent fails to deliver are
not being closed out due to the options market maker exception in
Regulation SHO and that these fails to deliver may have a negative
effect on the market in these securities. For example, large and
persistent fails to deliver may deprive shareholders of the benefits of
ownership, such as voting and lending. In addition, where a seller of
securities fails to deliver securities on trade settlement date, in
effect the seller unilaterally converts a securities contract (which
should settle within the standard 3-day settlement period) into an
undated futures-type contract, to which the buyer may not have agreed,
or that would have been priced differently. Moreover, sellers that fail
to deliver securities on settlement date may enjoy fewer restrictions
than if they were required to deliver the securities within a
reasonable period of time, and such sellers may attempt to use this
additional freedom to engage in trading activities that deliberately
depress the price of a security.
In addition, many issuers and investors continue to express concern
about extended fails to deliver in connection with ``naked'' short
selling.\124\ To the extent that large and persistent fails to deliver
may be indicative of manipulative ``naked'' short selling, which could
be used as a tool to drive down a company's stock price, fails to
deliver may undermine the confidence of investors.\125\ These
investors, in turn, may be reluctant to commit capital to an issuer
they believe to be subject to such manipulative conduct.\126\ In
addition, issuers may believe that they have suffered unwarranted
reputational damage due to investors' negative perceptions regarding
large and persistent fails to deliver.\127\ Thus, large and persistent
fails to deliver may result in an increase in artificial market
influences on a security's price.\128\
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\124\ See, e.g., supra note 8 (citing to comment letters from
issuers and investors discussing extended fails to deliver in
connection with ``naked'' short selling).
\125\ See, e.g., supra note 9 (citing to comment letters
discussing the impact of fails to deliver on investor confidence).
\126\ See, e.g., supra note 10 (citing to comment letters
expressing concern regarding the impact of potential ``naked'' short
selling on capital formation).
\127\ See supra note 11.
\128\ See also, 2006 Proposing Release, 71 FR at 41712
(discussing the impact of large and persistent fails to deliver on
the market). See also, 2003 Proposing Release, 68 FR at 62975
(discussing the impact of ``naked'' short selling on the market).
---------------------------------------------------------------------------
Also, as part of the comment process to the proposed amendments to
the options market maker exception as set forth in the 2006 Proposing
Release, some commenters' statements indicated to us that the current
options market maker exception might not be sufficiently narrowly
tailored to limit the extent to which options market makers can claim
an exception to the close-out requirement of Regulation SHO. Thus, we
determined to re-propose amendments to the options market maker
exception that would eliminate the exception and, thereby, reduce the
number of large and persistent fails to deliver in threshold
securities.
Consistent with the Commission's investor protection mandate, the
proposed amendment would benefit investors by facilitating the receipt
of shares so that more investors receive the benefits associated with
share ownership, such as the use of the shares for voting and lending
purposes. The proposal could enhance investor confidence as they make
investment decisions by providing investors with greater assurance that
securities would be delivered as expected. An increase in investor
confidence in the market could facilitate investment.
The proposed amendment should also benefit issuers. A high level of
persistent fails to deliver in a security could be perceived by
potential investors negatively and could affect their decision about
making a capital commitment.\129\ Some issuers could believe that they
have endured unwarranted reputational damage due to investors' negative
perceptions regarding a security having a large fail to deliver
position and becoming a threshold security.\130\ Thus, issuers could
believe the elimination of the options market maker exception would
restore their good name. Some issuers could also believe that large and
persistent fails to deliver indicate that they have been the target of
potentially manipulative conduct as a result of ``naked'' short
selling.\131\ Thus, elimination of the options market maker could
decrease the possibility of artificial market influences and,
therefore, could contribute to price efficiency.
---------------------------------------------------------------------------
\129\ See, e.g., supra note 10 (citing to comment letters
expressing concern regarding the impact of potential ``naked'' short
selling on capital formation).
\130\ See, e.g., supra note 11.
\131\ See, e.g., supra note 8 (citing to comment letters from
issuers and investors discussing extended fails to deliver in
connection with ``naked'' short selling).
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We solicit comment on any additional benefits that could be
realized with the proposed amendment, including both short-term and
long-term benefits. We solicit comment regarding other benefits to
market efficiency, pricing efficiency, market stability, market
integrity, and investor protection.
2. Costs
To comply with Regulation SHO when it became effective in January
2005, market participants needed to modify their recordkeeping systems
and surveillance mechanisms. In addition, market participants should
have retained and trained the necessary personnel to ensure compliance
with the rule. Thus, the infrastructure necessary to comply with the
proposed amendment should already be in place because the proposed
amendment, if adopted, would require that all fails to deliver be
closed out in accordance with the 13 consecutive settlement day
mandatory close-out requirement of Regulation SHO. The only fails to
deliver not subject to Regulation SHO's mandatory close-out requirement
would be those fails to deliver that would be previously-excepted from
the close-out requirement and, therefore, eligible for the one-time 35
day phase-in period of the proposed amendment. Thus, any changes to
personnel, computer hardware and software, recordkeeping or
surveillance costs should be minimal.
In the 2006 Proposing Release we requested comment regarding the
costs of the proposed amendments to the options market maker exception
and how those costs would affect liquidity in the options markets.
Commenters who opposed the proposal to narrow the options market maker
exception stated that the amendments would disrupt the markets because
they would not provide sufficient flexibility to permit efficient
hedging by options market makers, would unnecessarily increase risks
and costs to hedge, and would adversely impact liquidity and result in
higher costs to customers.\132\ These commenters stated that they
believe the proposed amendments would likely discourage options market
makers from making markets in illiquid securities since the risk
associated in maintaining the hedges in these option positions would be
too great.\133\ Moreover, these
[[Page 45578]]
commenters stated that the reluctance of options market makers to make
markets in threshold securities would result in wider spreads in such
securities to account for the increased costs of hedging, to the
detriment of investors.\134\
---------------------------------------------------------------------------
\132\ See, e.g., letter from CBOE, supra note 31.
\133\ See id.
\134\ See letter from Citigroup, supra note 31.
---------------------------------------------------------------------------
Although we recognize commenters' concerns that a mandatory close-
out requirement for fails to deliver in threshold securities underlying
options positions could potentially impact options market makers'
willingness to provide liquidity in threshold securities, make it more
costly for options market makers to accommodate customer buy orders, or
result in wider bid-ask spreads or less depth, for the reasons
discussed below, we believe that such an impact, if any, would be
minimal.
First, we believe that the potential effects, if any, of a
mandatory close-out requirement would be minimal because the number of
securities that would be impacted by a mandatory close-out requirement
would be small. Regulation SHO's close-out requirement is narrowly
tailored in that it targets only those securities where the level of
fails to deliver is high (0.5% of total shares outstanding and 10,000
shares or more) for a continuous period (five consecutive settlement
days).\135\ Requiring close out only for securities with large and
persistent fails to deliver limits the overall market impact. In
addition, as noted by one commenter, a small number of securities that
meet the definition of a ``threshold security'' have listed options,
and those securities form a very small percentage of all securities
that have options traded on them.\136\ Moreover, the current options
market maker exception only excepts from Regulation SHO's mandatory 13
consecutive settlement day close-out requirement those fail to deliver
positions that result from short sales effected by registered options
market makers to establish or maintain a hedge on options positions
established before the underlying security became a threshold security.
Thus, it does not apply to fails to deliver resulting from short sales
effected to establish or maintain a hedge on options positions
established after the underlying security became a threshold security.
Because the current options market maker exception has a very limited
application, the overall impact of its removal on liquidity, hedging
costs, spreads, and depth should be relatively small.
---------------------------------------------------------------------------
\135\ See supra note 7 (discussing the number of threshold
securities as of March 31, 2007).
\136\ See letter from Options Exchanges, supra note 49.
---------------------------------------------------------------------------
Second, to the extent that a mandatory close-out requirement could
potentially impact options market makers' willingness to provide
liquidity in threshold securities, make it more costly for options
market makers to accommodate customer buy orders, or result in wider
bid-ask spreads or less depth, we believe that any such potential
effects would likely be mitigated by the fact that even though fails to
deliver that were previously-excepted from the close-out requirement of
Regulation SHO would not be permitted to continue indefinitely, such
fails to deliver would not have to be closed out immediately, or even
within the standard 3-day settlement period. Instead, under Rule
203(b)(3)'s 13 consecutive settlement day close-out requirement, fails
to deliver in threshold securities would have an extended period of
time within which to be closed out. An extended close-out requirement
would provide options market makers with some flexibility in conducting
their hedging activities in that it would allow them to not close out a
fail to deliver position or pre-borrow to maintain a hedge in a
threshold security for 13 consecutive settlement days.
Third, as noted above, Regulation SHO's current options market
maker exception is limited to only those fail to deliver positions that
result from short sales effected by registered options market makers to
establish or maintain a hedge on options positions established before
the underlying security became a threshold security. Thus, it does not
apply to fails to deliver resulting from short sales effected to
establish or maintain a hedge on options positions established after
the underlying security became a threshold security. In evaluating the
application of the current mandatory close-out requirement of
Regulation SHO for all non-excepted fail to deliver positions, we have
not become aware of any evidence that the current close-out requirement
for non-excepted fails to deliver in threshold securities has impacted
options market makers' willingness to provide liquidity in threshold
securities, made it more costly for options market makers to
accommodate customer orders, or resulted in wider bid-ask spreads or
less depth. Similarly, all fails to deliver in threshold securities
resulting from long or short sales of securities in the equities
markets must be closed out in accordance with Regulation SHO's
mandatory 13 consecutive settlement day close-out requirement, and we
are not aware that such a requirement has impacted the willingness of
market makers to make markets in securities subject to the close-out
requirement, or led to decreased liquidity, wider spreads, or less
depth in these securities. Thus, we believe that the impact of
requiring that fails to deliver in threshold securities resulting from
short sales to hedge options positions created before the security
became a threshold security be closed out would similarly be minimal,
if any.
Fourth, to the extent that a mandatory close-out requirement for
all fails to deliver resulting from hedging activity in the options
markets could potentially impact liquidity, hedging costs, depth, or
spreads, or impact the willingness of options market makers to make a
market in certain securities, we believe that such effects are
justified by our belief, as discussed in more detail below, that fails
to deliver resulting from hedging activities by options market makers
should be treated similarly to fails to deliver resulting from sales in
the equities markets so that market participants trading threshold
securities in the options markets do not receive an advantage over
those trading such securities in the equities markets.
Fifth, to the extent that a mandatory close-out requirement for all
fails to deliver resulting from hedging activity in the options markets
could potentially impact liquidity, hedging costs, depth, or spreads,
or impact the willingness of options market makers to make a market in
certain securities, we believe that these potential effects are
justified by the benefits of requiring that fails to deliver in all
threshold securities be closed out within specific time-frames rather
than being allowed to continue indefinitely. As discussed above, large
and persistent fails to deliver can deprive shareholders of the
benefits of ownership, such as voting and lending. They can also be
indicative of potentially manipulative conduct, such as abusive
``naked'' short selling. The deprivation of the benefits of ownership,
as well as the perception that abusive ``naked'' short selling is
occurring in certain securities, can undermine the confidence of
investors. These investors, in turn, may be reluctant to commit capital
to an issuer they believe to be subject to manipulative conduct.
In the 2006 Proposing Release, we sought comment on whether the
proposed amendments would promote capital formation, including whether
the proposed increased short sale restrictions would affect investors'
decisions to invest in certain equity securities. Commenters expressed
concern about ``naked'' short selling
[[Page 45579]]
causing a drop in an issuer's stock price and that it may limit an
issuer's ability to access the capital markets.\137\ We believe that,
by requiring that all fails to deliver in threshold securities be
closed out within specific time-frames rather than allowing them to
continue indefinitely, there would be a decrease in the number of
threshold securities with persistent and high levels of fails to
deliver. If persistence on the threshold securities lists leads to an
unwarranted decline in investor confidence about the security, the
proposed amendments should improve investor confidence about the
security. We also believe that the proposed amendments should lead to
greater certainty in the settlement of securities which should
strengthen investor confidence in the settlement process.
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\137\ See, e.g., letter from Feeney, supra note 10.
---------------------------------------------------------------------------
Due to our concerns about the potentially negative market impact of
large and persistent fails to deliver, and the fact that we continue to
observe a small number of threshold securities with fail to deliver
positions that are not being closed out under existing delivery and
settlement requirements, we adopted amendments to eliminate Regulation
SHO's grandfather provision that allowed fails to deliver resulting
from long or short sales of equity securities to persist indefinitely
if the fails to deliver occurred prior to the security becoming a
threshold security.\138\ We believe that once a security becomes a
threshold security, fails to deliver in that security must be closed
out, regardless of whether or not the fails to deliver resulted from
sales of the security in connection with the options or equities
markets.
---------------------------------------------------------------------------
\138\ See Securities Exchange Act Release No. 56212 (Aug. 7,
2007); see also 2006 Proposing Release, 71 FR at 41711-41712.
---------------------------------------------------------------------------
Moreover, we believe that fails to deliver resulting from hedging
activities by options market makers should be treated similarly to
fails to deliver resulting from sales in the equities markets so that
market participants trading threshold securities in the options markets
do not receive an advantage over those trading such securities in the
equities markets. We are also concerned that the current options market
maker exception might allow for a regulatory arbitrage not permitted in
the equities markets. For example, an options market maker who sells
short to hedge put options purchased by a market participant unable to
locate shares for a short sale in accordance with Rule 203(b)(2) of
Regulation SHO may not have to close out any fails to deliver that
result from such short sales under the current options market maker
exception. The ability of options market makers to sell short and never
have to close out a resulting fail to deliver position, provided the
short sale was effected to hedge options positions created before the
security became a threshold security, runs counter to the goal of
similar treatment for fails to deliver resulting from sales of
securities in the options and equities markets, because no such ability
is available in the equity markets.\139\
---------------------------------------------------------------------------
\139\ See Securities Exchange Act Release No. 56212 (Aug. 7,
2007).
---------------------------------------------------------------------------
In addition, we believe the proposed 35 consecutive settlement day
phase-in period should not result in market disruption, such as
increased volatility or short squeezes, because it would provide time
for participants of a registered clearing agency, or options market
makers for which they clear transactions, to close out previously-
excepted fail to deliver positions in an orderly manner, particularly
because participants and options market makers could begin closing out
previously-excepted fail to deliver positions at any time before the
proposed 35 day phase-in period. The 35 day phase-in period may result
in some systems and surveillance-related costs, but these costs should
be one-time rather than ongoing costs because the phase-in period would
expire 35 settlement days after the effective date of the proposed
amendment, if adopted.
Also, the proposed pre-borrow requirement for fail to deliver
positions that are not closed out within the applicable time-frames set
forth in the proposed amendment would result in limited, if any, costs
to participants of a registered clearing agency, and options market
makers for which they clear transactions. The proposed pre-borrow
requirement is similar to the pre-borrow requirement of Rule
203(b)(3)(iii) of Regulation SHO, as originally adopted. Thus,
participants of a registered clearing agency, and any options market
maker for which it clears transactions, must already comply with such a
requirement if a fail to deliver position has not been closed out in
accordance with Regulation SHO's mandatory close-out requirement.
Accordingly, these entities should already have in place the personnel,
recordkeeping, systems, and surveillance mechanisms necessary to comply
with the proposed pre-borrow requirement.
We seek comment about any other costs and cost reductions
associated with the proposed amendment or alternative suggestions.
Specifically:
What would be the costs of the proposed elimination of the
options market maker exception? How would the proposed elimination of
the options market maker exception affect the liquidity of securities
with options traded on them? Would the proposed elimination of the
options market maker exception mean that fewer market makers would be
willing to make markets in securities with options traded on them, and
could the proposed amendment increase transaction costs for securities
with options traded on them? Would such an effect, if any, be more
severe for liquid or illiquid securities? Would it lead to fewer listed
options?
How much would this proposed amendment to the options
market maker exception affect the compliance costs for small, medium,
and large participants of a registered clearing agency and for options
market makers (e.g., personnel or system changes)? We seek comment on
the costs of compliance that could arise as a result of the proposed
amendment. For instance, to comply with the proposed amendment, would
these entities be required to:
Purchase new systems or implement changes to existing
systems? Would changes to existing systems be significant? What would
be the costs associated with acquiring new systems or making changes to
existing systems? How much time would be required to fully implement
any new or changed systems?
Change existing records? What changes would need to be
made? What would be the costs associated with any changes? How much
time would be required to make any changes?
Increase staffing and associated overhead costs? Would
entities subject to the proposed amendment have to hire more staff? How
many, and at what experience and salary level? Could existing staff be
retrained? What would be the costs associated with hiring new staff or
retraining existing staff? If retraining were required, what other
costs could be incurred, e.g., would retrained staff be unable to
perform existing duties in order to comply with the proposed amendment?
Would other resources need to be re-dedicated to comply with the
proposed amendment?
Implement, enhance or modify surveillance systems and
procedures? Please describe what would be needed, and what costs would
be incurred.
Establish and implement new supervisory or compliance
procedures, or modify existing procedures? What would be the costs
associated with such changes? Would new compliance or
[[Page 45580]]
supervisory personnel be needed? What would be the costs of obtaining
such staff?
Are there any costs that market participants could incur
as a result of the proposed 35 consecutive settlement day phase-in
period? Would the costs of a phase-in period be too significant to
justify having one? Would a phase-in period create examination or
surveillance difficulties? If so, how? What would be the costs and
economic tradeoffs associated with longer or shorter phase-in periods?
What would be the costs associated with including the pre-
borrow requirement for the proposed amendment to the options market
maker exception?
B. Alternatives to Eliminating the Options Market Maker Exception
1. Benefits
Due to the fact that large and persistent fails to deliver are not
being closed out under existing delivery and settlement requirements
and the fact that we are concerned that these fails to deliver may have
a negative impact on the market for those securities, we believe that
the options market maker exception to the mandatory close-out
requirement of Rule 203(b)(3) of Regulation SHO should be eliminated.
In part, in anticipation of commenters stating that a limited
options market maker exception is necessary we are requesting comment
regarding two specific limited alternatives to elimination of the
options market maker exception. Each of the proposed alternatives would
provide for a 35 consecutive settlement day phase-in period similar to
the phase-in period discussed above in connection with the proposed
elimination of the options market maker exception for securities that
are threshold securities on the effective date of the amendment and
that have previously-excepted fail to deliver positions. The phase-in
period would reduce any potential market disruption, such as increased
volatility or short squeezes, from having to close-out previously-
excepted fail to deliver positions because it would provide time for
participants of a registered clearing agency to close out previously-
excepted fail to deliver positions in an orderly manner, particularly
because participants could begin closing out these fail to deliver
positions at any time before the proposed 35 day phase-in period.
In addition, in response to comments about the proposed amendments
to the options market maker exception in the 2006 Proposing Release
that those proposed amendments would be costly and difficult to
implement because portfolio hedging is the industry practice, the
proposed alternatives would apply to fails to deliver resulting from
short sales effected by a registered options market maker to establish
or maintain a hedge on any options series, rather than an options
position, created before an underlying security became a threshold
security. Thus, the proposed alternatives would be more in line with
industry practice and, therefore, less costly and difficult to
implement than the commenters believed the proposed amendment in the
2006 Proposing Release would be.
The first alternative would require that a participant of a
registered clearing agency that has a fail to deliver position in a
threshold security that results or resulted from a short sale by a
registered options market maker to establish or maintain a hedge on any
options series within a portfolio that were created before the security
became a threshold security close out the entire fail to deliver
position, including any adjustments to that position, within 35
consecutive settlement days of the security becoming a threshold
security. After the 35 consecutive settlement days has expired, any
additional fails to deliver would be subject to the 13 consecutive
settlement day close-out requirement of Rule 203(b)(3) of Regulation
SHO. In addition, the proposed first alternative would impose a pre-
borrow requirement similar to the pre-borrow requirement of Rule
203(b)(3)(iv) of Regulation SHO.
The second alternative would require that a participant of a
registered clearing agency that has a fail to deliver position in a
threshold security that results or resulted from a short sale by a
registered options market maker to establish or maintain a hedge on any
options series in a portfolio that were created before the security
became a threshold security to close out the entire fail to deliver
position, including any adjustments to that position, within the
earlier of: (i) 35 Consecutive settlement days from the date on which
the security became a threshold security, or (ii) 13 consecutive
settlement days from the last date on which all options series within
the portfolio that were created before the security became a threshold
security expire or are liquidated. After the 35 or 13 consecutive
settlement days has expired, any additional fails to deliver would be
subject to the 13 consecutive settlement day close-out requirement of
Rule 203(b)(3) of Regulation SHO. In addition, the proposed amendment
would impose a pre-borrow requirement similar to the pre-borrow
requirement of Rule 203(b)(3)(iv) of Regulation SHO.
Similar to elimination of the options market maker exception, by
proposing to require that all fails to deliver be closed out within
specific time-frames, the proposed alternatives would reduce large and
persistent fails to deliver. In addition, by proposing to require that
shares be delivered to a buyer within a reasonable period of time, the
proposed alternatives would result in shareholders receiving the
benefits of ownership. Sellers would also be less able to unilaterally
convert securities contracts into undated futures-type contracts to
which the buyer would not have agreed, or that would have been priced
differently. In addition, the delivery requirements of the proposed
alternatives would enhance investor confidence as they make investment
decisions by providing investors with greater assurance that securities
would be delivered as expected.\140\ An increase in investor confidence
in the market could facilitate investment. The proposed alternatives
could benefit issuers because investors may be more willing to commit
capital where fails levels are lower.\141\ In addition, some issuers
could believe that a reduction in fails to deliver could reverse
unwarranted reputational damage potentially caused by large and
persistent fails to deliver and what they believe might be an
indication of manipulative trading activities, such as ``naked'' short
selling.\142\ Thus, the proposed requirement that all fails to deliver
be closed out within specific time-frames, as would be required by the
proposed alternatives, could decrease the possibility of artificial
market influences and, therefore, could contribute to price efficiency.
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\140\ See, e.g., supra note 9 (citing to comment letters
discussing the impact of fails to deliver on investor confidence).
\141\ See, e.g., supra note 10 (citing to comment letters
expressing concern regarding the impact of potential ``naked'' short
selling on capital formation).
\142\ See, e.g., supra note 11.
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The proposed alternatives would also require that participants of a
registered clearing agency and options market makers document that any
fails to deliver in threshold securities that have not been closed out
in accordance with the 13 consecutive settlement days close-out
requirement of Rule 203(b)(3) of Regulation SHO qualify for the options
market maker exception. The proposed alternatives would require both
options market makers and participants of a registered clearing agency
that rely on the options market maker exception to not close out a fail
[[Page 45581]]
to deliver position in accordance with the mandatory close-out
requirement of Rule 203(b)(3) of Regulation SHO to obtain, prepare, and
keep documentation demonstrating that a fail to deliver position has
not been closed out because it qualified for the exception. We
anticipate such documentation could include, among other things, when
the series being hedged was created, when the underlying security
became a threshold security, and the age of the fail to deliver
position that is not being closed out.
A documentation requirement would enable the Commission and the
SROs to monitor more easily whether or not the options market maker
exception is being applied correctly. In addition, the information
would provide a record that would aid surveillance for compliance with
this limited exception to Regulation SHO's close-out requirement.
We solicit comment on any additional benefits that could be
realized with the proposed alternatives, including both short-term and
long-term benefits. We solicit comment regarding other benefits to
market efficiency, pricing efficiency, market stability, market
integrity, and investor protection.
2. Costs
To comply with Regulation SHO when it became effective in January
2005, market participants needed to modify their recordkeeping,
systems, and surveillance mechanisms. In addition, market participants
should have retained and trained the necessary personnel to ensure
compliance with the rule. Thus, for the most part the infrastructure
necessary to comply with the proposed alternatives should already be in
place because the proposed alternatives, if adopted, would require that
all fails to deliver be closed out in accordance with specific time-
frames similar to the mandatory 13 consecutive settlement day close-out
requirement of Regulation SHO. In addition, similar to the current
options market maker exception in Regulation SHO, the proposed
alternatives would only except from the mandatory close-out requirement
of Rule 203(b)(3) those fails to deliver that resulted from short sales
by a registered options market maker in connection with options created
before the security became a threshold security.
The proposed alternatives, however, would result in some increased
recordkeeping, systems, and surveillance costs. The proposed
alternatives would require that participants of a registered clearing
agency, and options market makers for which they clear transactions,
have the necessary recordkeeping, systems, and surveillance mechanisms
in place to track whether a fail to deliver position resulted from a
short sale effected by a registered options market maker to maintain or
establish a hedge on option series created before the security became a
threshold security. In addition, under the first proposed alternative,
these entities would need to have systems and surveillance mechanisms
in place to ensure that such fails to deliver are closed out within 35
consecutive settlement days of the security becoming a threshold
security. Under the second proposed alternative, these entities would
need to have systems and surveillance mechanisms in place to determine
whether the fails to deliver would be required to be closed out within
the earlier of 13 consecutive settlement days of all options series
within the portfolio expiring or being liquidated, or within 35
consecutive settlement days of the security becoming a threshold
security. Thus, participants of a registered clearing agency, and
options market makers for which they clear, could incur costs in
meeting these requirements.
In addition, the proposed alternatives would allow for a one-time
35 consecutive settlement day phase-in period for previously-excepted
fail to deliver positions. Although any personnel, computer hardware
and software, recordkeeping, or surveillance costs, associated with
complying with this proposed phase-in period would not be an ongoing
cost, entities subject to the requirement could incur some one-time
costs in complying with this proposed requirement.
Any costs associated with compliance with the proposed pre-borrow
requirement for fail to deliver positions that are not closed out
within the applicable time-frames set forth in the proposed
alternatives should be limited, if any. The proposed pre-borrow
requirements in the proposed alternatives are similar to the pre-borrow
requirement of Rule 203(b)(3)(iii) of Regulation SHO, as originally
adopted. Thus, participants of a registered clearing agency, and any
broker-dealers for which it clears transactions, must already comply
with such a requirement if a fail to deliver position has not been
closed out in accordance with Regulation SHO's mandatory close-out
requirement. Accordingly, these entities should already have in place
the personnel, recordkeeping, systems, and surveillance mechanisms
necessary to comply with the proposed pre-borrow requirement.
As discussed above in connection with costs regarding the proposed
elimination of the options market maker exception, although we
recognize commenters' concerns that a mandatory close-out requirement
for fails to deliver in threshold securities underlying options
positions could potentially impact options market makers' willingness
to provide liquidity in threshold securities, make it more costly for
options market makers to accommodate customer orders, or result in
wider bid-ask spreads or less depth,\143\ we believe the mandatory
close-out requirements of each of the proposed alternatives would
similarly minimally impact, if at all, liquidity, hedging costs,
spreads, or depth in the securities subject to the close-out
requirements of the proposed alternatives, or the willingness of
options market makers to make markets in such securities.
---------------------------------------------------------------------------
\143\ See, e.g., letters from CBOE, supra note 31; Citigroup,
supra note 31.
---------------------------------------------------------------------------
We believe that these potential effects of the close-out
requirements of the proposed alternatives would be minimal, if any,
because the number of securities that would be impacted by the close-
out requirements of the proposed alternatives would be small. The
proposed alternatives would apply only to those threshold securities
with listed options \144\ and would only impact fails to deliver in
those securities that resulted from short sales by registered options
market makers to hedge options series that were created before rather
than after the security became a threshold security because all other
fails to deliver in threshold securities are subject to Regulation
SHO's current mandatory 13 consecutive settlement day close-out
requirement.
---------------------------------------------------------------------------
\144\ See letter from Options Exchanges, supra note 49
(discussing the number of threshold securities with listed options).
---------------------------------------------------------------------------
In addition, the proposed alternatives would provide options market
makers with flexibility in conducting their hedging activities because
they would each allow an extended period of time (i.e., 35 consecutive
settlement days for purposes of Alternative 1 and 13 or 35 consecutive
settlement days for purposes of Alternative 2) within which to close
out all fails to deliver in threshold securities. As discussed above in
connection with the proposed amendment to eliminate the options market
maker exception, we believe that even a 13 consecutive settlement day
close-out requirement would result in minimal impact on the willingness
of
[[Page 45582]]
options market makers to make markets, liquidity, hedging costs, depth,
and spreads because it would allow options market makers flexibility in
conducting their hedging activities by permitting fails to deliver to
remain open for an extended period of time (i.e., 13 consecutive
settlement days) rather than, for example, requiring that such fails to
deliver be closed out immediately, or even within the standard 3-day
settlement period. During the period of time that the fail to deliver
position can remain open, options market makers would be able to
continue any hedging activity without having to close out the fail to
deliver position or pre-borrow to maintain the hedge.
In addition, we believe the proposed 35 consecutive settlement day
phase-in period should not result in market disruption, such as
increased volatility or short squeezes, because it would provide time
for participants of a registered clearing agency to close out
previously-excepted fail to deliver positions in an orderly manner,
particularly because participants could begin closing out previously-
excepted fail to deliver positions at any time before the proposed 35
day phase-in period.
As discussed above in connection with the costs associated with
elimination of the options market maker exception, to the extent that
the mandatory close-out requirements of the proposed alternatives could
potentially impact liquidity, hedging costs, depth, or spreads, or
impact the willingness of options market makers to make markets in
securities subject to the proposed alternatives, we believe such
effects are justified by our belief that fails to deliver resulting
from hedging activities by options market makers should be treated
similarly to fails to deliver resulting from sales in the equities
markets so that market participants trading threshold securities in the
options markets do not receive an advantage over those trading such
securities in the equities markets. In addition, we believe that such
potential costs would be justified by the benefits, as discussed above,
of requiring that all fails to deliver be closed out within specific
time-frames rather than being allowed to continue indefinitely.
Although the proposed alternatives would lessen the potential
negative impact on the market of large and persistent fails to deliver
similar to the proposed elimination of the options market maker
exception because they would require that fails to deliver in threshold
securities eventually be closed out, we believe that the proposed
elimination of the options market maker exception would achieve this
goal more effectively because under the proposed elimination of the
options market maker exception, all fails to deliver in threshold
securities would have to be closed out within Regulation SHO's
mandatory 13 consecutive settlement day close-out requirement. The
proposed alternatives, however, would each allow a longer period of
time for fail to deliver positions to be closed out. Specifically, the
first alternative would allow certain fails to deliver to be closed out
within 35 consecutive settlement days of the security becoming a
threshold security. Under the second alternative, although some fails
to deliver would be required to be closed out in less than 35
consecutive settlement days, other fails to deliver would not have be
closed out until 35 consecutive settlement days from the security
becoming a threshold security.
The proposed alternatives would also impose recordkeeping costs not
imposed by the proposed amendment to eliminate the options market maker
exception. The documentation requirement of the proposed alternatives
would require options market makers and participants of a registered
clearing agency to obtain, prepare, and keep documentation
demonstrating that a fail to deliver position has not been closed out
because it was eligible for the exception. This documentation
requirement could result in these entities incurring costs related to
personnel, recordkeeping, systems and surveillance mechanisms. For
example, as discussed in detail in Section VI.D.i. above, for purposes
of the PRA, we estimate that it would take each options market maker or
participant of a registered clearing agency no more than approximately
10 minutes to document that a fail to deliver position has not been
closed out due to its eligibility for the options market maker
exception. In addition, we estimate that the total annual hour burden
per year for each options market maker subject to the documentation
requirement would be 3,024 burden hours. We estimate that the total
annual hour burden per year for each participant of a registered
clearing agency subject to the documentation requirement would be 120
burden hours.
We request specific comment on the systems changes to computer
hardware and software, or surveillance costs that would be necessary to
implement the proposed alternatives. Specifically:
What would be the costs and benefits of the proposed
alternatives to elimination of the options market maker exception? For
instance, what would be the costs of the proposed alternatives if
either of the alternatives were to reduce the willingness of options
market makers to make markets in securities that could become threshold
securities or in threshold securities?
What would be the costs associated with including the pre-
borrow requirement for the proposed alternatives to the options market
maker exception? What would be the costs of excluding a pre-borrow
requirement for these proposals?
What costs would be associated with the documentation
requirement of the proposed alternatives?
Based on the current requirements of Regulation SHO, what
have been the costs and benefits of the current options market maker
exception?
What would be the specific costs associated with any
technical or operational challenges that options market makers would
face in complying with the proposed alternatives?
Would the proposed alternatives create any costs, such as
costs associated with systems, surveillance, or recordkeeping
modifications that may be needed for participants to track fails to
deliver subject to the proposed alternatives? If there were any costs
associated with tracking fails to deliver would these costs justify the
benefits of providing firms with additional time to close out fails to
deliver resulting from short sales effected to establish or maintain a
hedge on options series that were created before the security becomes a
threshold security?
How much would the proposed alternatives affect compliance
costs for small, medium, and large participants of a clearing agency or
options market maker for which they clear transactions (e.g., personnel
or system changes)? We seek comment on the costs of compliance that may
arise. For instance, to comply with the proposed alternatives, would
these entities be required to:
Purchase new systems or implement changes to existing
systems? Would changes to existing systems be significant? What would
be the costs associated with acquiring new systems or making changes to
existing systems? How much time would be required to fully implement
any new or changed systems?
Change existing records? What changes would need to be
made? What would be the costs associated with any changes? How much
time would be required to make any changes?
Increase staffing and associated overhead costs? Would
entities subject to the proposed alternatives have to hire more staff?
How many, and at what
[[Page 45583]]
experience and salary level? Could existing staff be retrained? What
would be the costs associated with hiring new staff or retraining
existing staff? If retraining were required, what other costs could be
incurred, e.g., would retrained staff be unable to perform existing
duties in order to comply with the proposed amendment? Would other
resources need to be re-dedicated to comply with the proposed
amendment?
Implement, enhance or modify surveillance systems and
procedures? Please describe what would be needed, and what costs would
be incurred.
Establish and implement new supervisory or compliance
procedures, or modify existing procedures? What would be the costs
associated with such changes? Would new compliance or supervisory
personnel be needed? What would be the costs of obtaining such staff?
Are there any costs that participants could incur as a
result of the proposed 35 consecutive settlement day phase-in period?
Would the costs of a phase-in period be too significant to justify
having one? Would a phase-in period create examination or surveillance
difficulties? If so, how? What would be the costs and economic
tradeoffs associated with longer or shorter phase-in periods?
C. Proposed Amendment to Rule 200(g)(1) of Regulation SHO
1. Benefits
We are proposing for comment a documentation requirement for
broker-dealers marking orders to sell ``long'' pursuant to Regulation
SHO that would require such broker-dealers to document the present
location of the securities being sold. We believe that such a proposed
documentation requirement would aid in ensuring the correct marking of
sell orders. To the extent that the seller is unable to provide the
present location of the securities being sold, the broker-dealer would
have reason to believe that the seller is not ``deemed to own'' the
securities being sold and that the securities would not be in its
physical possession or control no later than settlement of the
transaction and, therefore, that the broker-dealer would be required to
mark the sale ``short'' rather than ``long.'' \145\ We believe that
this proposed documentation requirement could also reduce the number of
fails to deliver because, after making the inquiry into the present
location of the securities being sold, a broker-dealer would know
whether or not it needed to obtain securities for delivery.
---------------------------------------------------------------------------
\145\ See 17 CFR 242.200(g).
---------------------------------------------------------------------------
We are concerned that broker-dealers marking orders ``long'' may
not be making a determination prior to marking the order that the
seller is ``deemed to own'' the security being sold. Rule 200(g)(1)
currently requires that broker-dealers ascertain whether the customer
is ``deemed to own'' the securities being sold before marking a sell
order ``long.'' \146\ Thus, we believe that the proposed documentation
requirement would help ensure that the broker-dealer marking the sale
``long'' has inquired into, and determined that, the seller is ``deemed
to own'' the securities being sold because the broker-dealer would be
required to document the present location of the securities being sold.
---------------------------------------------------------------------------
\146\ See id.
---------------------------------------------------------------------------
We also believe that the proposed documentation requirement would
enable the Commission and SROs to more easily examine for compliance
with the long sale marking provisions of Rule 200(g) more effectively
because this proposed documentation requirement would provide a record
that the seller is ``deemed to own'' the securities being sold in
compliance with that rule. We also believe that the proposed
documentation requirement would aid the Commission and SROs in
reviewing for mismarking designed to avoid compliance with other rules
and regulations of the federal securities laws, such as the ``locate''
requirement of Regulation SHO,\147\ and Rule 105 of Regulation M.\148\
---------------------------------------------------------------------------
\147\ See supra, note 92.
\148\ See supra, note 93.
---------------------------------------------------------------------------
2. Costs
In response to our request for comment in the 2006 Proposing
Release regarding a long sale documentation requirement, commenters
stated that pre-trade documentation would unnecessarily impair
efficiency as broker-dealers already have procedures to ensure orders
are marked properly based on information provided by customers and
their own books and records, and that documentation requirements would
add substantial cost.\149\ One commenter also stated that compliance
with such pre-trade documentation requirements would require a complete
revamping of front end systems.\150\ Another commenter stated that the
requirements would be inconsistent with the goal of fostering
liquidity.\151\
---------------------------------------------------------------------------
\149\ See letters from MFA, supra note 75; UBS, supra note 31;
Knight, supra note 75.
\150\ See letter from SIA, supra note 31.
\151\ See letter from Millennium, supra note 75.
---------------------------------------------------------------------------
Although commenters stated that pre-trade documentation for long
sales would be inconsistent with the goal of fostering liquidity, would
unnecessarily impair efficiency, and would add substantial cost, we
believe that such costs, to the extent that there are any, would be
justified by the benefits of a documentation requirement, as discussed
above.
In addition, we note that under former NASD Rule 3370(b), NASD
member firms making an affirmative determination that a customer was
long were required to make a notation on the order ticket at the time
an order was taken which reflected the conversation with the customer
as to the present location of the securities, whether they were in good
deliverable form, and the customer's ability to deliver them to the
member within three business days.\152\ Thus, many broker-dealers
should already be familiar with a documentation requirement and one
method that could be used to comply with such a requirement. Such
familiarity should help reduce any costs associated with implementing
the proposed documentation requirement. In addition, unlike with former
NASD Rule 3370(b), the proposed amendment would not specify the format
or methodology of the proposed documentation requirement. The absence
of such specifications should help reduce costs to broker-dealers that
would have to comply with this proposal because broker-dealers would be
able to determine the most cost effective format and methodology for
meeting the proposed documentation requirement.
---------------------------------------------------------------------------
\152\ Brokers and dealers that were members of the NASD were
obligated to comply with former NASD Rule 3370(b) prior to the
adoption of Regulation SHO.
---------------------------------------------------------------------------
We believe that any costs that would arise from the proposed
requirement that a broker-dealer must document the present location of
securities being sold long when making the determination that a
customer is deemed to own the securities being sold would be minimal
because Rule 200(g)(1) currently requires that broker-dealers must
ascertain whether the customer is ``deemed to own'' the securities
being sold before marking a sell order ``long.'' \153\ Today's proposed
amendment would require that the broker-dealer take the additional step
of documenting the present location of the securities being sold.
Broker-dealers could, however, need to put mechanisms in place to
facilitate efficient documenting of the
[[Page 45584]]
information required by the proposed amendment.
---------------------------------------------------------------------------
\153\ See 17 CFR 242.200(g)(1).
---------------------------------------------------------------------------
As discussed above in Section VI.D.ii., the paperwork burden is
estimated at approximately 49 burden hours for each broker-dealer
registered with the Commission, if the documentation process were
automated. To the extent that broker-dealers need to automate the
documentation process, we anticipate that such broker-dealers would
spend varying amounts of time reprogramming systems, integrating
systems, and potentially updating front-end software. Some broker-
dealers may spend very little time automating the documentation
process, while changes at other broker-dealers might be more involved.
On average, we estimate that reprogramming burdens at a broker-dealer
would be approximately 16 hours (or two days) with one programmer. This
aggregate of $6,226,176 across all broker-dealers.\154\
---------------------------------------------------------------------------
\154\ The $67/hour figure for a computer programmer is based on
the salary for a Senior Computer Operator from the SIA Report on
Office Salaries in the Securities Industry 2006, modified to account
for an 1800-hour work-year and multiplied by 2.93 to account for
bonuses, firm size, employee benefits and overhead.
---------------------------------------------------------------------------
The Commission does not believe there are any additional costs to
this proposal; however we seek any data supporting any additional costs
not mentioned. In addition, we request specific comment on any systems
changes to computer hardware and software, or surveillance costs that
might be necessary to implement the proposed amendment. Specifically:
What would be the costs and benefits of the proposed
documentation requirement?
Would the proposed amendment create any costs, such as
costs associated with systems, surveillance, or recordkeeping
modifications that may be needed for broker-dealers to document the
present location of shares being sold? If there were any costs
associated with the proposed documentation requirement would these
costs justify the benefits of better ensuring compliance with federal
securities laws?
How much would the proposed amendment affect compliance
costs for small, medium, and large broker-dealers (e.g., personnel or
system changes)? We seek comment on the costs of compliance that may
arise. For instance, to document the location of shares being sold,
would these entities be required to:
Purchase new systems or implement changes to existing
systems? Would changes to existing systems be significant? What would
be the costs associated with acquiring new systems or making changes to
existing systems? How much time would be required to fully implement
any new or changed systems?
Change existing records? What changes would need to be
made? What would be the costs associated with any changes? How much
time would be required to make any changes?
Increase staffing and associated overhead costs? Would
entities subject to the proposed amendment have to hire more staff? How
many, and at what experience and salary level? Could existing staff be
retrained? What would be the costs associated with hiring new staff or
retraining existing staff? If retraining were required, what other
costs could be incurred, e.g., would retrained staff be unable to
perform existing duties in order to comply with the proposed amendment?
Would other resources need to be re-dedicated to comply with the
proposed amendment?
Implement, enhance or modify surveillance systems and
procedures? Please describe what would be needed, and what costs would
be incurred.
Establish and implement new supervisory or compliance
procedures, or modify existing procedures? What would be the costs
associated with such changes? Would new compliance or supervisory
personnel be needed? What would be the costs of obtaining such staff?
VIII. Consideration of Burden and Promotion of Efficiency, Competition,
and Capital Formation
Section 3(f) of the Exchange Act requires the Commission, whenever
it engages in rulemaking and is required to consider or determine
whether an action is necessary or appropriate in the public interest,
to consider whether the action would promote efficiency, competition,
and capital formation.\155\ In addition, Section 23(a)(2) of the
Exchange Act requires the Commission, when making rules under the
Exchange Act, to consider the impact such rules would have on
competition.\156\ Exchange Act Section 23(a)(2) prohibits the
Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.
---------------------------------------------------------------------------
\155\ 15 U.S.C. 78c(f).
\156\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
We believe the proposed amendments, including the proposed
alternatives, would have minimal impact on the promotion of price
efficiency. In the 2006 Proposing Release we sought comment on whether
the proposals would promote price efficiency, including whether the
proposals might impact liquidity and the potential for manipulative
short squeezes. One commenter stated that the Commission's concern over
potential short squeezes is ``misplaced,'' as this is a risk short
sellers assume when they sell short.\157\ Other commenters stated,
however, that the proposed amendment to the options market maker
exception would disrupt the markets because they would not provide
sufficient flexibility to permit efficient hedging by options market
makers, would unnecessarily increase risks and costs to hedge, and
would adversely impact liquidity and result in higher costs to
customers.\158\ These commenters stated that they believe the proposed
amendments would likely discourage options market makers from making
markets in illiquid securities since the risk associated in maintaining
the hedges in these option positions would be too great.\159\ Moreover,
these commenters stated that the reluctance of options market makers to
make markets in threshold securities would result in wider spreads in
such securities to account for the increased costs of hedging, to the
detriment of investors.\160\
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\157\ See letter from H. Glenn Bagwell, Jr., dated Sept. 19,
2006.
\158\ See, e.g., letter from CBOE, supra note 31.
\159\ See id.
\160\ See letter from Citigroup, supra note 31.
---------------------------------------------------------------------------
Although we recognize commenters' concerns that a mandatory close-
out requirement for fails to deliver in threshold securities underlying
options positions could potentially impact options market makers'
willingness to provide liquidity in threshold securities, make it more
costly for options market makers to accommodate customer orders, or
result in wider bid-ask spreads or less depth,\161\ we believe that the
proposed elimination of the options market maker exceptions, and the
mandatory close-out requirements of the proposed alternatives, would
minimally impact, if at all, liquidity, hedging costs, spreads, or
depth in the securities subject to these proposals, or the willingness
of options market makers to make markets in such securities.
---------------------------------------------------------------------------
\161\ See, e.g., letters from CBOE, supra note 31; Citigroup,
supra note 31.
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We believe that these potential effects of the elimination of the
options market maker exception, or the proposed close-out requirements
of the proposed alternatives would be minimal, if any, because the
number of securities that would be impacted by these proposals
[[Page 45585]]
would be relatively small. The proposal would apply only to those
threshold securities with listed options\162\ and would only impact
fails to deliver in those securities that resulted from short sales by
registered options market makers to hedge options series (or options
positions in the case of the proposed elimination of the current
options market maker exception) that were created before, rather than
after, the security became a threshold security because all other fails
to deliver in threshold securities are currently subject to Regulation
SHO's mandatory 13 consecutive settlement day close-out requirement.
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\162\ See letter from Options Exchanges, supra note 49
(discussing the number of threshold securities with listed options).
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In addition, as discussed above in connection with the proposed
amendment to eliminate the options market maker exception, we believe
that even a 13 consecutive settlement day close-out requirement would
result in minimal impact on the willingness of options market makers to
make markets, liquidity, hedging costs, depth, and spreads of a
mandatory close-out requirement because it would allow options market
makers flexibility in conducting their hedging activities by permitting
fails to deliver to remain open for an extended period of time (i.e.,
13 consecutive settlement days) rather than, for example, requiring
that such fails to deliver be closed out immediately, or even within
the standard 3-day settlement period. The close-out requirements of the
proposed alternatives would provide options market makers with even
greater flexibility in conducting their hedging activities because they
would each allow even longer periods of time than the 13 consecutive
settlement days allowed by current Rule 203(b)(3) of Regulation SHO
(i.e., 35 consecutive settlement days for purposes of proposed
Alternative 1, and 13 or 35 consecutive settlement days for purposes of
proposed Alternative 2) within which to close out all fails to deliver
in threshold securities.
In addition, we believe the proposed 35 consecutive settlement day
phase-in period for each of the proposals should not result in market
disruption, such as increased volatility or short squeezes, because it
would provide time for participants of a registered clearing agency to
close out previously-excepted fail to deliver positions in an orderly
manner, particularly because participants could begin closing out
previously-excepted fail to deliver positions at any time before the
proposed 35 day phase-in period.
To the extent that a mandatory close-out requirement could
potentially impact liquidity, hedging costs, depth, or spreads, or
impact the willingness of options market makers to make markets in
securities subject to such a requirement, we believe such effects are
justified by our belief that fails to deliver resulting from hedging
activities by options market makers should be treated similarly to
fails to deliver resulting from sales in the equities markets so that
market participants trading threshold securities in the options markets
do not receive an advantage over those trading such securities in the
equities markets. In addition, we believe that such potential costs
would be justified by the benefits, as discussed below, of requiring
that all fails to deliver be closed out within specific time-frames
rather than being allowed to continue indefinitely.
The proposed amendment to Rule 200(g) of Regulation SHO to require
broker-dealers to document the present location of securities being
sold in connection with an order marked ``long'' would promote price
efficiency by reducing non-compliance with short sale-related
regulations, such as Rule 105 of Regulation M, that we believe are
beneficial to pricing efficiency.
In addition, we believe that the proposed amendments, including the
alternative proposals, would have minimal impact on the promotion of
capital formation. Large and persistent fails to deliver can deprive
shareholders of the benefits of ownership, such as voting and lending.
They can also be indicative of potentially manipulative conduct, such
as abusive ``naked'' short selling. The deprivation of the benefits of
ownership, as well as the perception that abusive ``naked'' short
selling is occurring in certain securities, can undermine the
confidence of investors. These investors, in turn, may be reluctant to
commit capital to an issuer they believe to be subject to such
manipulative conduct. In the 2006 Proposing Release, we sought comment
on whether the proposed amendments would promote capital formation,
including whether the proposed increased short sale restrictions would
affect investors' decisions to invest in certain equity securities.
Commenters expressed concern about the potential impact of ``naked''
short selling on capital formation claiming that ``naked'' short
selling causes a drop in an issuer's stock price that may limit the
issuer's ability to access the capital markets.\163\ Another commenter
submitted a theoretical economic study concluding that ``naked'' short
selling is economically similar to other short selling.\164\
---------------------------------------------------------------------------
\163\ See, e.g., letter from Feeney, supra note 10.
\164\ See comment letter from J.B. Heaton, Bartlit Beck Herman
Palenchar & Scott LLP, dated May 1, 2007.
---------------------------------------------------------------------------
By requiring that all fails to deliver in threshold securities be
closed out within specific time-frames rather than allowing them to
continue indefinitely, we believe that there would be a decrease in the
number of threshold securities with persistent and high levels of fails
to deliver. If persistence on the threshold securities lists leads to
an unwarranted decline in investor confidence about the security, the
proposed amendments should improve investor confidence about the
security. We also believe that the proposed amendments should lead to
greater certainty in the settlement of securities which should
strengthen investor confidence in the settlement process. The reduction
in fails to deliver and the resulting reduction in the number of
securities on the threshold securities lists could result in increased
investor confidence.
The proposed amendment to eliminate the options market maker
exception and the proposed alternatives also would not impose any
burden on competition not necessary or appropriate in furtherance of
the purposes of the Exchange Act. By eliminating the options market
maker exception, or, alternatively, adopting a limited options market
maker exception, the Commission believes the proposals would promote
competition by requiring similarly situated participants of a
registered clearing agency, or options market makers for which they
clear transactions, to close out fails to deliver in threshold
securities within similar time-frames.
The Commission requests comment on whether the proposed amendment
to eliminate the options market maker exception, the proposed
alternatives, and the proposed amendment to Rule 200(g) of Regulation
SHO, would promote efficiency, competition, and capital formation.
IX. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \165\ we must advise the Office of
Management and Budget as to whether the proposed regulation constitutes
a ``major'' rule. Under
[[Page 45586]]
SBREFA, a rule is considered ``major'' where, if adopted, it results or
is likely to result in:
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\165\ Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
---------------------------------------------------------------------------
An annual effect on the economy of $100 million or more
(either in the form of an increase or a decrease);
A major increase in costs or prices for consumers or
individual industries; or
Significant adverse effect on competition, investment or
innovation.
If a rule is ``major,'' its effectiveness will generally be delayed
for 60 days pending Congressional review. We request comment on the
potential impact of the proposed amendments on the economy on an annual
basis. Commenters are requested to provide empirical data and other
factual support for their view to the extent possible.
X. Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (``IRFA''), in accordance with the provisions of the
Regulatory Flexibility Act (``RFA''),\166\ regarding the proposed
amendments to Rules 200 and 203 of Regulation SHO under the Exchange
Act.
---------------------------------------------------------------------------
\166\ 5 U.S.C. 603.
---------------------------------------------------------------------------
A. Reasons for the Proposed Action
On July 14, 2006, the Commission published proposed amendments to
the options market maker exception contained in Regulation SHO to limit
the duration of the exception.\167\ We proposed to narrow the options
market maker exception at that time because we have observed a small
number of threshold securities with substantial and persistent fail to
deliver positions that are not being closed out under existing delivery
and settlement requirements, and we believe that these persistent fail
to deliver positions are attributable, in part, to the current options
market maker exception in Regulation SHO.\168\
---------------------------------------------------------------------------
\167\ 2006 Proposing Release, 71 FR 41710.
\168\ See id. at 41712; Regulation SHO Re-Opening Release, 72 FR
at 15079-15080.
---------------------------------------------------------------------------
As a result of the comment process, however, we learned that the
amendment, as proposed, could be very costly and difficult to implement
or possibly unworkable because options market makers typically use
hedges to manage the risk of an entire inventory, not just a specific
options position. In addition, some commenters' statements indicated to
us that options market makers may be interpreting the current options
market maker exception more broadly than the Commission intended and
possibly in violation of the exception. We also remain concerned that
large and persistent fails to deliver may have a negative effect on the
market in these securities. Although high fails levels exist only for a
small percentage of securities, these fails to deliver could
potentially impede the orderly functioning of the market for such
securities, particularly less liquid securities. For example, a
significant level of fails to deliver in a security may have adverse
consequences for shareholders who may be relying on delivery of those
shares for voting and lending purposes, or may otherwise affect an
investor's decision to invest in that particular security. In addition,
a seller that fails to deliver securities on settlement date
effectively unilaterally converts a securities contract into an undated
futures-type contract, to which the buyer might not have agreed, or
that might have been priced differently.
Thus, we determined to re-propose amendments to the options market
maker exception that would eliminate the exception. In addition, we are
requesting comment regarding two specific alternatives to our proposal
to eliminate the options market maker exception that would require
fails to deliver in threshold securities underlying options to be
closed out within specific time-frames. By re-proposing amendments to
the options market maker exception we seek additional information
regarding the options markets that might assist us in determining
whether or not to eliminate the options market maker exception.
We are also proposing an amendment to the long sale marking
provisions of Rule 200(g)(1) of Regulation SHO that would require that
broker-dealers marking orders to sell ``long'' document the present
location of the securities. We believe that such a proposed
documentation requirement would aid in ensuring the correct marking of
sell orders. To the extent that the seller is unable to provide the
present location of the securities being sold, the broker-dealer would
have reason to believe that the seller is not ``deemed to own'' the
securities being sold and that the securities would not be in its
physical possession or control no later than settlement of the
transaction and, therefore, that the broker-dealer would be required to
mark the sale ``short'' rather than ``long.'' \169\ We believe that
this proposed documentation requirement could also reduce the number of
fails to deliver because, after making the inquiry into the present
location of the securities being sold, a broker-dealer would know
whether or not it needed to obtain securities for delivery.
---------------------------------------------------------------------------
\169\ See 17 CFR 242.200(g).
---------------------------------------------------------------------------
We are concerned that broker-dealers marking orders ``long'' may
not be making a determination prior to marking the order that the
seller is ``deemed to own'' the security being sold. Rule 200(g)(1)
currently requires that broker-dealers ascertain whether the customer
is ``deemed to own'' the securities being sold before marking a sell
order ``long.'' \170\ Thus, we believe that the proposed documentation
requirement would help ensure that the broker-dealer marking the sale
``long'' has inquired into, and determined that, the seller is ``deemed
to own'' the securities being sold because the broker-dealer would be
required to document the present location of the securities being sold.
---------------------------------------------------------------------------
\170\ See id.
---------------------------------------------------------------------------
We also believe that the proposed documentation requirement would
enable the Commission and SROs to more easily examine for compliance
with the long sale marking provisions of Rule 200(g) more effectively
because this proposed documentation requirement would provide a record
that the seller is ``deemed to own'' the securities being sold in
compliance with that rule. We also believe that the proposed
documentation requirement would aid the Commission and SROs in
reviewing for mismarking designed to avoid compliance with other rules
and regulations of the federal securities laws, such as the ``locate''
requirement of Regulation SHO,\171\ and Rule 105 of Regulation M.\172\
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\171\ See supra, note 92.
\172\ See supra, note 93.
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B. Objectives
Our proposals regarding the options market maker exception are
intended to further reduce the number of persistent fails to deliver in
threshold securities. The proposed amendment to eliminate the options
market maker exception, and the alternative proposals, are designed to
help reduce persistent and large fail to deliver positions which may
have a negative effect on the market in these securities and also could
be used to facilitate manipulative trading strategies.
Although high fails levels exist only for a small percentage of
issuers,\173\ they could impede the orderly functioning of the market
for such issuers, particularly issuers of less liquid securities. For
example, a significant level of fails to deliver in a security may have
adverse consequences for shareholders who may be relying on delivery of
those shares for
[[Page 45587]]
voting and lending purposes, or may otherwise affect an investor's
decision to invest in that particular security. In addition, a seller
that fails to deliver securities on settlement date effectively
unilaterally converts a securities contract into an undated futures-
type contract, to which the buyer might not have agreed, or that would
have been priced differently.
---------------------------------------------------------------------------
\173\ See supra note 7.
---------------------------------------------------------------------------
To allow market participants sufficient time to comply with the new
close-out requirements, the proposed amendment to eliminate the options
market maker exception and the proposed alternatives would include a
one-time 35 consecutive settlement day phase-in period following the
effective date of the amendment. The phase-in period would provide
participants flexibility in closing out previously-excepted fail to
deliver positions.
By proposing an amendment to Rule 200(g)(1) of Regulation SHO that
would require broker-dealers to document the present location of
securities a customer is deemed to own, we intend to aid surveillance
for compliance with the marking requirements of Rule 200(g). In
addition, such a requirement would help to ensure that broker-dealers
only mark orders ``long'' after making a determination that a customer
actually owns the securities being sold.
C. Legal Basis
Pursuant to the Exchange Act and, particularly, Sections 2, 3(b),
9(h), 10(a), 11A, 15, 17(a), 19, 23(a) thereof, 15 U.S.C. 78b, 78c,
78i, 78j, 78k-l, 78o, 78q, 78s, 78w(a), the Commission is proposing
amendments to Sec. Sec. 242.200 and 242.203 of Regulation SHO.
D. Small Entities Subject to the Rule
The entities covered by these proposals would include small
entities that are participants of a registered clearing agency,
including small registered options market makers for which the
participant clears trades or for which it is responsible for
settlement. In addition, the entities covered by these proposals would
include small entities that are market participants that effect sales
subject to the requirements of Regulation SHO. Most small entities
subject to the proposed amendments, including the proposed
alternatives, would be registered broker-dealers. Although it is
impossible to quantify every type of small entity covered by these
proposals, Paragraph (c)(1) of Rule 0-10 \174\ states that the term
``small business'' or ``small organization,'' when referring to a
broker-dealer, means a broker or dealer that had total capital (net
worth plus subordinated liabilities) of less than $500,000 on the date
in the prior fiscal year as of which its audited financial statements
were prepared pursuant to Sec. 240.17a-5(d); and is not affiliated
with any person (other than a natural person) that is not a small
business or small organization. As of 2006, the Commission estimates
that there were approximately 894 registered broker-dealers that
qualified as small entities as defined above.\175\
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\174\ 17 CFR 240.0-10(c)(1).
\175\ These numbers are based on the Commission's Office of
Economic Analysis's review of 2006 FOCUS Report filings reflecting
registered broker dealers. This number does not include broker-
dealers that are delinquent on FOCUS Report filings.
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As noted above, the entities covered by these amendments will
include small entities that are participants of a registered clearing
agency. As of May 2007, approximately 90% of participants of the NSCC,
the primary registered clearing agency responsible for clearing U.S.
transactions, were registered as broker-dealers. Participants not
registered as broker-dealers include such entities as banks, U.S.-
registered exchanges, and clearing agencies. Although these entities
are participants of a registered clearing agency, generally these
entities do not engage in the types of activities that would implicate
the close-out requirements of Regulation SHO. Such activities of these
entities include creating and redeeming Exchange Traded Funds, trading
in municipal securities, and using NSCC's Envelope Settlement Service
or Inter-city Envelope Settlement Service. These activities rarely lead
to fails to deliver and, if fails to deliver do occur, they are small
in number and are usually cleaned up within a day. Thus, such fails to
deliver would not trigger the close-out provisions of Regulation SHO.
The federal securities laws do not define what is a ``small
business'' or ``small organization'' when referring to a bank. The
Small Business Administration regulations define ``small entities'' to
include banks and savings associations with total assets of $165
million or less.\176\ As of May, 2007 no bank that was a participant of
the NSCC was a small entity because none met this criteria.
---------------------------------------------------------------------------
\176\ See 13 CFR 121.201.
---------------------------------------------------------------------------
Paragraph (e) of Rule 0-10 under the Exchange Act \177\ states that
the term ``small business'' or ``small organization,'' when referring
to an exchange, means any exchange that: (1) Has been exempted from the
reporting requirements of Rule 11Aa3-1 under the Exchange Act; and (2)
is not affiliated with any person (other than a natural person) that is
not a small business or small organization, as defined by Rule 0-10. No
U.S. registered exchange is a small entity because none meets these
criteria. There is one national securities association (NASD) that is
subject to these amendments. NASD is not a small entity as defined by
13 CFR 121.201.
---------------------------------------------------------------------------
\177\ 17 CFR 240.0-10(e).
---------------------------------------------------------------------------
Paragraph (d) of Rule 0-10 under the Exchange Act \178\ states that
the term ``small business'' or ``small organization,'' when referring
to a clearing agency, means a clearing agency that: (1) Compared,
cleared and settled less than $500 million in securities transactions
during the preceding fiscal year (or in the time that it has been in
business, if shorter); (2) had less than $200 million in funds and
securities in its custody or control at all times during the preceding
fiscal year (or in the time that it has been in business, if shorter);
and (3) is not affiliated with any person (other than a natural person)
that is not a small business or small organization as defined by Rule
0-10. No clearing agency that is subject to the requirements of
Regulation SHO is a small entity because none meets these criteria.
---------------------------------------------------------------------------
\178\ 17 CFR 240.0-10(d).
---------------------------------------------------------------------------
E. Reporting, Recordkeeping, and Other Compliance Requirements
The proposed amendment to eliminate the options market maker
exception, and the proposed alternatives, would impose some new or
additional reporting, recordkeeping, or compliance costs on broker-
dealers that are small entities. In order to comply with Regulation SHO
when it became effective in January, 2005, entities needed to modify
their systems and surveillance mechanisms. Thus, the infrastructure
necessary to comply with the proposed amendments regarding elimination
of the options market maker exception should already be in place. Any
additional changes to the infrastructure should be minimal. In
addition, entities that would be subject to the mandatory 13
consecutive settlement day close-out requirement of Rule 203(b)(3) of
Regulation SHO should already have systems in place to close out non-
excepted fails to deliver as required by Regulation SHO. These
entities, however, could be required to modify their systems and
surveillance mechanisms to ensure compliance with the proposed
alternatives to eliminating the options market maker exception.
These entities could also be required to put in place mechanisms to
facilitate communications between participants
[[Page 45588]]
of a registered clearing agency and options market makers to meet the
documentation requirements of the proposed alternatives. We solicit
comment on what new recordkeeping, reporting or compliance requirements
could arise as a result of the proposed amendment to eliminate the
options market maker exception and the proposed alternatives to
elimination that would require fails to deliver in threshold securities
underlying options to be closed out within specific time-frames.
The proposed amendment to Rule 200(g)(1) that would require that
broker-dealers document the present location of securities a customer
is deemed to own prior to marking an order to sell ``long'' could
impose some new or additional reporting, recordkeeping, or compliance
costs on broker-dealers that are small entities. We believe, however,
that such costs should be minimal. Rule 200(g)(1) currently requires
that broker-dealers must determine whether the customer is ``deemed to
own'' the securities being sold before marking a sell order ``long.''
Today's proposed amendment would require that the broker-dealer take
the additional step of documenting the present location of the
securities being sold. Broker-dealers may, however, need to put
mechanisms in place to facilitate efficient documenting of the
information that would be required by the proposed amendment.
Moreover, we note that under former NASD Rule 3370(b), NASD member
firms making an affirmative determination that a customer was long were
required to make a notation on the order ticket at the time an order
was taken which reflected the conversation with the customer as to the
present location of the securities, whether they were in good
deliverable form, and the customer's ability to deliver them to the
member within three business days. Thus, many broker-dealers that are
small entities should already be familiar with a documentation
requirement and with one method that could be used to comply with such
a requirement. We solicit comment, however, on what new recordkeeping,
reporting or compliance requirements may arise as a result of the
proposed amendment to Rule 200(g)(1) of Regulation SHO.
F. Duplicative, Overlapping or Conflicting Federal Rules
The Commission believes that there are no federal rules that
duplicate, overlap, or conflict with the proposed amendments.
G. Significant Alternatives
The RFA directs the Commission to consider significant alternatives
that would accomplish the stated objective, while minimizing any
significant adverse impact on small issuers and broker-dealers.
Pursuant to Section 3(a) of the RFA,\179\ the Commission must consider
the following types of alternatives: (a) The establishment of differing
compliance or reporting requirements or timetables that take into
account the resources available to small entities; (b) the
clarification, consolidation, or simplification of compliance and
reporting requirements under the rule for small entities; (c) the use
of performance rather than design standards; and (d) an exemption from
coverage of the rule, or any part thereof, for small entities.
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\179\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------
A primary goal of the proposed amendment to eliminate the options
market maker exception, and the proposed alternatives, is to reduce the
number of persistent fails to deliver in threshold securities. As such,
we believe that imposing different compliance requirements, and
possibly a different timetable for implementing compliance
requirements, for small entities would undermine the goal of reducing
fails to deliver. In addition, we have concluded similarly that it
would not be consistent with the primary goal of the proposals to
further clarify, consolidate or simplify the proposals for small
entities. Finally, the proposals would impose performance standards
rather than design standards.
H. Request for Comments
The Commission encourages the submission of written comments with
respect to any aspect of the IRFA. In particular, the Commission seeks
comment on: (i) The number of small entities that would be affected by
the proposed amendments; and (ii) the existence or nature of the
potential impact of the proposed amendments on small entities. Those
comments should specify costs of compliance with the proposed
amendments, and suggest alternatives that would accomplish the
objective of the proposed amendments.
XI. Statutory Authority
Pursuant to the Exchange Act and, particularly, Sections 2, 3(b),
9(h), 10, 11A, 15, 17(a), 17A, and 23(a) thereof, 15 U.S.C. 78b,
78c(b), 78i(h), 78j, 78k-1, 78o, 78q(a), 78q-1, 78w(a), the Commission
is proposing amendments to Sec. Sec. 242.200 and 242.203.
Text of the Proposed Amendments to Regulation SHO
List of Subjects 17 CFR Part 242
Brokers, Fraud, Reporting and recordkeeping requirements,
Securities.
For the reasons set out in the preamble, Title 17, Chapter II, part
242, of the Code of Federal Regulations is proposed to be amended as
follows.
PART 242--REGULATIONS M, SHO, ATS, AC, AND NMS, AND CUSTOMER MARGIN
REQUIREMENTS FOR SECURITY FUTURES
1. The authority citation for part 242 continues to read as
follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g),
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and
80a-37.
* * * * *
2. Section 242.200 is proposed to be amended by adding new
paragraph (g)(2) to read as follows:
Sec. 242.200 Definition of ``short sale'' and marking requirements.
* * * * *
(g) * * *
(2) For purposes of paragraph (g)(1) of this section, in
determining whether the seller is ``deemed to own'' the security being
sold, the broker or dealer must document the present location of the
security being sold.
3. Section 242.203 is proposed to be amended by:
a. Revising paragraph (b)(3)(iii);
b. Redesignating paragraphs (b)(3)(vi) and (b)(3)(vii) as
paragraphs (b)(3)(vii) and (b)(3)(viii);
c. Adding new paragraph (b)(3)(vi);
d. Removing the word ``and'' at the end of paragraph (b)(3)(vi);
and
e. Amending newly designated paragraph (b)(3)(vii) by adding the
word ``and'' after the semi-colon at the end of the paragraph.
The revisions and additions read as follows:
Sec. 242.203 Borrowing and delivery requirements.
* * * * *
(b) * * *
(3) * * *
(iii) Provided, however, that a participant of a registered
clearing agency that has a fail to deliver position at a registered
clearing agency in a threshold security on the effective date of this
amendment and which, prior to the effective date of this amendment, had
been previously excepted from the close-out requirement in paragraph
(b)(3) of this section (i.e., because the participant of a registered
clearing
[[Page 45589]]
agency had a fail to deliver position in the threshold security that is
attributed to short sales effected by a registered options market maker
to establish or maintain a hedge on options positions that were created
before the security became a threshold security), shall immediately
close out that fail to deliver position, including any adjustments to
the fail to deliver position, within 35 consecutive settlement days of
the effective date of this amendment by purchasing securities of like
kind and quantity;
* * * * *
(vi) If a participant of a registered clearing agency entitled to
rely on the 35 consecutive settlement day close-out requirement
contained in paragraph (b)(3)(iii) of this section has a fail to
deliver position at a registered clearing agency in the threshold
security for 35 consecutive settlement days from the effective date of
the amendment, the participant and any broker or dealer for which it
clears transactions, including any market maker, that would otherwise
be entitled to rely on the exception provided in paragraph (b)(2)(ii)
of this section, may not accept a short sale order in the threshold
security from another person, or effect a short sale in the threshold
security for its own account, without borrowing the security or
entering into a bona-fide arrangement to borrow the security, until the
participant closes out the fail to deliver position by purchasing
securities of like kind and quantity;
4. Alternative 1: Alternatively, Section 242.203 is proposed to be
amended by:
a. Revising paragraph (b)(3)(iii);
b. Redesignating paragraphs (b)(3)(vi) and (b)(3)(vii) as
paragraphs (b)(3)(vii) and (b)(3)(viii);
c. Adding new paragraphs (b)(3)(vi) and (b)(3)(ix);
d. Removing the word ``and'' at the end of paragraph (b)(3)(vi);
and
e. Amending newly designated paragraph (b)(3)(viii) by adding the
word ``and'' after the semi-colon at the end of the paragraph.
The revisions and additions read as follows:
Sec. 242.203 Borrowing and delivery requirements.
* * * * *
(b) * * *
(3) * * *
(iii) The provisions of paragraph (b)(3) of this section shall not
apply to the amount of the fail to deliver position in the threshold
security that is attributed to short sales by a registered options
market maker, if and to the extent that the short sales are effected by
the registered options market maker to establish or maintain a hedge on
any options series in a portfolio that were created before the security
became a threshold security;
(A) Provided, however, that if a participant of a registered
clearing agency has a fail to deliver position at a registered clearing
agency in a threshold security that is attributed to short sales by a
registered options market maker, if and to the extent that the short
sales are effected by the registered options market maker to establish
or maintain a hedge on options series that were created before the
security became a threshold security, the participant shall close out
the fail to deliver position, including any adjustments to the fail to
deliver position, within 35 consecutive settlement days from the date
on which the security became a threshold security by purchasing
securities of like kind and quantity;
(B) Provided, however, that a participant of a registered clearing
agency that has a fail to deliver position at a registered clearing
agency in a threshold security on the effective date of this amendment
which, prior to the effective date of this amendment, had been
previously excepted from the close-out requirement in paragraph (b)(3)
of this section (i.e., because the participant of a registered clearing
agency had a fail to deliver position in the threshold security that is
attributed to short sales effected by a registered options market
maker, if and to the extent that the short sales are effected by the
registered options market maker to establish or maintain a hedge on
options positions that were created before the security became a
threshold security), shall immediately close out that fail to deliver
position, including any adjustments to the fail to deliver position,
within 35 consecutive settlement days of the effective date of this
amendment by purchasing securities of like kind and quantity;
* * * * *
(vi) If a participant of a registered clearing agency entitled to
rely on the 35 consecutive settlement day close-out requirement
contained in paragraph (b)(3)(iii) of this section has a fail to
deliver position at a registered clearing agency in the threshold
security for 35 consecutive settlement days, the participant and any
broker or dealer for which it clears transactions, including any market
maker, that would otherwise be entitled to rely on the exception
provided in paragraph (b)(2)(ii) of this section, may not accept a
short sale order in the threshold security from another person, or
effect a short sale in the threshold security for its own account,
without borrowing the security or entering into a bona-fide arrangement
to borrow the security, until the participant closes out the fail to
deliver position by purchasing securities of like kind and quantity;
* * * * *
(ix) To the extent that an amount of a fail to deliver position in
a threshold security is attributed to short sales by a registered
options market maker in accordance with paragraph (b)(3)(ii) of this
section, a participant of a registered clearing agency and registered
options market maker must document that the fail to deliver position
resulted from short sales effected to establish or maintain a hedge on
options series that were created before the security became a threshold
security.
5. Alternative 2: Alternatively, Section 242.203 is proposed to be
amended by:
a. Revising paragraph (b)(3)(iii);
b. Redesignating paragraphs (b)(3)(vi) and (b)(3)(vii) as
paragraphs (b)(3)(viii)and (b)(3)(ix);
c. Adding new paragraphs (b)(3)(vi), (b)(3)(vii) and (b)(3)(x);
d. Removing the word ``and'' at the end of paragraph (b)(3)(vi);
and
e. Amending newly designated paragraph (b)(3)(ix) by adding the
word ``and'' after the semi-colon at the end of the paragraph.
The revisions and additions read as follows:
Sec. 242.203 Borrowing and delivery requirements.
* * * * *
(b) * * *
(3) * * *
(iii) The provisions of paragraph (b)(3) of this section shall not
apply to the amount of the fail to deliver position in the threshold
security that is attributed to short sales by a registered options
market maker, if and to the extent that the short sales are effected by
the registered options market maker to establish or maintain a hedge on
any options series in a portfolio that were created before the security
became a threshold security;
(A) Provided, however, that if a participant of a registered
clearing agency has a fail to deliver position at a registered clearing
agency in a threshold security that is attributed to short sales by a
registered options market maker, if and to the extent that the short
sales are effected by the registered options market maker to establish
or maintain a hedge on options series that were created before the
security became a threshold security,
[[Page 45590]]
the participant shall close out the fail to deliver position, including
any adjustments to the fail to deliver position, by purchasing
securities of like kind and quantity within the earlier of: 35
Consecutive settlement days from the date on which the security became
a threshold security, or 13 consecutive settlement days from the last
date on which all options series within the portfolio that were created
before the underlying security became a threshold security expire or
are liquidated;
(B) Provided, however, that a participant of a registered clearing
agency that has a fail to deliver position at a registered clearing
agency in a threshold security on the effective date of this amendment
which, prior to the effective date of this amendment, had been
previously excepted from the close-out requirement in paragraph (b)(3)
of this section (i.e., because the participant of a registered clearing
agency had a fail to deliver position in the threshold security that is
attributed to short sales by a registered options market maker, if and
to the extent that the short sales are effected by the registered
options market maker to establish or maintain a hedge on options
positions that were created before the security became a threshold
security), shall immediately close out that fail to deliver position,
including any adjustments to the fail to deliver position, within 35
consecutive settlement days of the effective date of this amendment by
purchasing securities of like kind and quantity;
* * * * *
(vi) If a participant of a registered clearing agency entitled to
rely on the exception to the close-out requirement contained in
paragraph (b)(3)(iii)(A) of this section has a fail to deliver position
at a registered clearing agency in a threshold security for longer than
the earlier of: 35 Consecutive settlement days from the date on which
the security became a threshold security, or 13 consecutive settlement
days from the last date on which all options series within the
portfolio that were created before the security became a threshold
security expire or are liquidated, the participant and any broker or
dealer for which it clears transactions, including any market maker
that would otherwise be entitled to rely on the exception provided in
paragraph (b)(2)(ii) of this section, may not accept a short sale order
in the threshold security from another person, or effect a short sale
in the threshold security for its own account, without borrowing the
security or entering into a bona-fide arrangement to borrow the
security, until the participant closes out the fail to deliver position
by purchasing securities of like kind and quantity;
(vii) If a participant of a registered clearing agency entitled to
rely on the 35 consecutive settlement day close-out requirement
contained in paragraph (b)(3)(iii)(B) of this section has a fail to
deliver position at a registered clearing agency in the threshold
security for 35 consecutive settlement days from the effective date of
the amendment, the participant and any broker or dealer for which it
clears transactions, including any market maker, that would otherwise
be entitled to rely on the exception provided in paragraph (b)(2)(ii)
of this section, may not accept a short sale order in the threshold
security from another person, or effect a short sale in the threshold
security for its own account, without borrowing the security or
entering into a bona-fide arrangement to borrow the security, until the
participant closes out the fail to deliver position by purchasing
securities of like kind and quantity;
* * * * *
(x) To the extent that an amount of a fail to deliver position in a
threshold security is attributed to short sales by a registered options
market maker in accordance with paragraph (b)(3)(iii) of this section,
a participant of a registered clearing agency and registered options
market maker must document that the fail to deliver position resulted
from short sales effected to establish or maintain a hedge on options
series that were created before the security became a threshold
security.
* * * * *
By the Commission.
Dated: August 7, 2007.
Nancy M. Morris,
Secretary.
[FR Doc. E7-15709 Filed 8-13-07; 8:45 am]
BILLING CODE 8010-01-P