Amendments to Regulation SHO, 41710-41722 [06-6386]

Agencies

• SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 71, Number 140 (Friday, July 21, 2006)]
[Proposed Rules]
[Pages 41710-41722]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-6386]



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Part VI





Securities and Exchange Commission





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17 CFR Part 242



Amendments to Regulation SHO; Proposed Rule

Federal Register / Vol. 71, No. 140 / Friday, July 21, 2006 / 
Proposed Rules

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 242

[Release No. 34-54154; File No. S7-12-06]
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 is 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 grandfather provision and narrowing the options market 
maker exception. The proposals also are intended to update the market 
decline limitation referenced in Regulation SHO.

DATES: Comments should be received on or before September 19, 2006.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (https://
www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number S7-12-06 on the subject line; or
     Use the Federal eRulemaking Portal (https://
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 20549-1090.

All submissions should refer to File Number S7-12-06. 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 (https://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 
20549-1090. 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, Acting Associate 
Director, Josephine J. Tao, Branch Chief, Joan M. Collopy, Special 
Counsel, Lillian S. Hagen, Special Counsel, Elizabeth A. Sandoe, 
Special Counsel, Victoria L. Crane, 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 20549-1090.

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, 
provides a new regulatory framework governing short sales.\1\ Among 
other things, Regulation SHO imposes a close-out requirement to address 
problems with failures to deliver stock on trade settlement date and to 
target abusive ``naked'' short selling (e.g., selling short without 
having stock available for delivery and intentionally failing to 
deliver stock within the standard three-day settlement period) in 
certain equity securities.\2\ While the majority of trades settle on 
time,\3\ 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 harm the market for that security. These 
fails to deliver may result from either short sales or long sales of 
stock.\4\
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    \1\ See Securities Exchange Act Release No. 50103 (July 28, 
2004), 69 FR 48008 (August 6, 2004) (``Adopting Release''), 
available at https://www.sec.gov/rules/final/34-50103.htm. For more 
information on Regulation SHO, see ``Frequently Asked Questions'' 
and ``Key Points about Regulation SHO'' (at https://www.sec.gov/
spotlight/shortsales.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 designed and 
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\ According to the National Securities Clearing Corporation 
(NSCC), on an average day, approximately 1% (by dollar value) of all 
trades, including equity, debt, and municipal securities, fail to 
settle. In other words, 99% (by dollar value) of all trades settle 
on time. The vast majority of these fails are closed out within five 
days after T+3.
    \4\ 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.
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    The close-out requirement, which is contained in Rule 203(b)(3) of 
Regulation SHO, applies only to broker-dealers for securities in which 
a substantial amount of fails to deliver have occurred (also known as 
``threshold securities'').\5\ As discussed more fully below, Rule 
203(b)(3) of Regulation SHO includes two exceptions to the mandatory 
close-out requirement. The first is the ``grandfather'' provision, 
which excepts fails to deliver established prior to a security becoming 
a threshold security; \6\ and the second is the ``options market

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maker exception,'' which excepts 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.\7\
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    \5\ 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)) for which there is an aggregate fail to 
deliver position for five consecutive settlement days at a 
registered clearing agency of 10,000 shares or more, and that is 
equal to at least 0.5% of the issue's total shares outstanding; and 
is included on a list disseminated to its members by a self-
regulatory organization (``SRO''). 17 CFR 242.203(c)(6). This is 
known as the ``threshold securities list.'' Each SRO is responsible 
for providing the threshold securities list for those securities for 
which the SRO is the primary market.
    \6\ The ``grandfathered'' status applies in two situations: (1) 
to fail positions occurring before January 3, 2005, Regulation SHO's 
effective date; and (2) to fail positions that were established on 
or after January 3, 2005 but prior to the security appearing on the 
threshold securities list. 17 CFR 242.203(b)(3)(i).
    \7\ 17 CFR 242.203(b)(3)(ii).
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    At the time of Regulation SHO's adoption in August 2004, the 
Commission stated that it would monitor the operation of Regulation 
SHO, particularly whether grandfathered fail 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.\8\ 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.\9\
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    \8\ See Adopting Release, 69 FR at 48018.
    \9\ See id. at 48019.
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    Based on examinations conducted by the Commission's staff and the 
SROs since Regulation SHO's adoption, we are proposing revisions to 
Regulation SHO. As discussed more fully below, our proposals would 
modify Rule 203(b)(3) by eliminating the grandfather provision and 
narrowing the options market maker exception. Regulation SHO has 
achieved substantial results. However, some persistent fails to deliver 
remain. The proposals are intended to reduce the number of persistent 
fails to deliver attributable primarily to the grandfather provision 
and, secondarily, to reliance on the options market maker exception. 
The proposals also would include a 35 settlement day phase-in period 
following the effective date of the amendment. The phase-in period is 
intended to provide additional time to begin closing out certain 
previously-excepted fail to deliver positions. Our proposals also would 
update the market decline limitation referenced in Rule 200(e)(3) of 
Regulation SHO. We also seek comment about other ways to modify 
Regulation SHO.

II. Background

A. Rule 203(b)(3)'s Close-Out Requirement

    One of Regulation SHO's primary goals is to reduce fails to 
deliver.\10\ Currently, Regulation SHO requires certain persistent fail 
to deliver positions to be closed out. Specifically, Rule 203(b)(3)'s 
close-out requirement requires a participant of a clearing agency 
registered with the Commission to take immediate action to close out a 
fail to deliver position in a threshold security in the Continuous Net 
Settlement (CNS) \11\ system that has persisted for 13 consecutive 
settlement days by purchasing securities of like kind and quantity.\12\ 
In addition, if the failure to deliver has persisted for 13 consecutive 
settlement days, Rule 203(b)(3)(iii) 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.\13\
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    \10\ Id. at 48009.
    \11\ The majority of equity trades in the United States are 
cleared and settled through systems administered by clearing 
agencies registered with the Commission. The NSCC clears and settles 
the majority of equity securities trades conducted on the exchanges 
and 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.
    \12\ 17 CFR 242.203(b)(3).
    \13\ 17 CFR 242.203(b)(3)(iii). It is possible under Regulation 
SHO that a close out by a broker-dealer may result in a failure to 
deliver position at another broker-dealer if the counterparty from 
which the broker-dealer purchases securities fails to deliver. 
However, Regulation SHO prohibits a broker-dealer from engaging in 
``sham close outs'' by entering into an arrangement with a 
counterparty to purchase securities for purposes of closing out a 
failure to deliver position and the broker-dealer knows or has 
reason to know that the counterparty will not deliver the 
securities, and which thus creates another failure to deliver 
position. 17 CFR 242.203(b)(3)(v); Adopting Release, 69 FR at 48018 
n. 96.
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B. Grandfathering Under Regulation SHO

    Rule 203(b)(3)'s close-out requirement does not apply to positions 
that were established prior to the security becoming a threshold 
security.\14\ This is known as grandfathering. Grandfathered positions 
include those that existed prior to the effective date of Regulation 
SHO and positions established prior to a security becoming a threshold 
security.\15\ Regulation SHO's grandfathering provision was adopted 
because the Commission was concerned about creating volatility through 
short squeezes \16\ if large pre-existing fail to deliver positions had 
to be closed out quickly after a security became a threshold security.
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    \14\ 17 CFR 242.203(b)(3)(i).
    \15\ See Adopting Release, 69 FR at 48018. However, any new 
fails in a security on the threshold list are subject to the 
mandatory close-out provisions of Rule 203(b)(3).
    \16\ The term short squeeze refers to the pressure on short 
sellers to cover their positions as a result of sharp price 
increases or difficulty in borrowing the security the sellers are 
short. The rush by short sellers to cover produces additional upward 
pressure on the price of the stock, which then can cause an even 
greater squeeze. Although some short squeezes may occur naturally in 
the market, a scheme to manipulate the price or availability of 
stock in order to cause a short squeeze is illegal.
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C. Regulation SHO's Options Market Maker Exception

    In addition, 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 an options position that was created 
before the security became a threshold security.\17\ The options market 
maker exception was created to address concerns regarding liquidity and 
the pricing of options. The exception does not require that such fails 
be closed out within any particular timeframe.
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    \17\ 17 CFR 242.203(b)(3)(ii).
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D. Regulation SHO Examinations

    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.\18\ 
However, despite this positive

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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 guidelines.
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    \18\ For example, in comparing a period prior to the 
effectiveness 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 May 31, 2006) 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 34.0%;
     The average daily number of securities with aggregate 
fails for at least 10,000 shares declined by 6.5%;
     The average daily number of fails to deliver positions 
declined by 15.3%;
     The average age of a fail position declined by 13.4%;
     The average daily number of threshold securities 
declined by 38.2%; and
     The average daily fails of threshold securities 
declined by 52.4%.
    Fails to deliver in the six securities that persisted on the 
threshold list from January 10, 2005 through May 31, 2006 declined 
by 68.6%.
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    Based on these examinations and our discussions with the SROs and 
market participants, we believe that these persistent fail positions 
may be attributable primarily to the grandfather provision and, 
secondarily, to reliance on the options market maker exception. 
Although high fails levels exist only for a small percentage of 
issuers,\19\ we are concerned that large and persistent fails to 
deliver may have a negative effect on the market in these securities. 
First, large and persistent fails to deliver can deprive shareholders 
of the benefits of ownership, such as voting and lending. Second, they 
can be indicative of manipulative naked short selling, which could be 
used as a tool to drive down a company's stock price. The perception of 
such manipulative conduct also may 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.
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    \19\ The average daily number of securities on the threshold 
list in May 2006 was approximately 298 securities, which comprised 
0.38% 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. NASD Rule 3210, which 
became effective on July 3, 2006, applies the Regulation SHO close-
out framework to non-reporting equity securities with aggregate 
fails to deliver equal to, or greater than, 10,000 shares and that 
have a last reported sale price during normal trading hours that 
would value the aggregate fail to deliver position at $50,000 or 
greater for five consecutive settlement days. See Securities 
Exchange Act Release No. 53596 (April 4, 2006), 71 FR 18392 (April 
11, 2006) (SR-NASD-2004-044). If the proposed amendments to 
Regulation SHO are adopted, we anticipate NASD Rule 3210 will be 
similarly amended.
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    Allowing these persistent fails to deliver to continue runs counter 
to one of Regulation SHO's primary goals of reducing fails to deliver 
in threshold securities. While some delays in closing out may be 
understandable and necessary, a seller should deliver shares to the 
buyer within a reasonable time period. Thus, we believe that all fails 
in threshold securities should be closed out after a certain period of 
time and not left open indefinitely. As such, we believe that 
eliminating the grandfathering provision and narrowing the options 
market maker exception is necessary to reduce the number of fails to 
deliver.
    Although we believe that no failure to deliver should last 
indefinitely, we note that requiring delivery without allowing 
flexibility for some failures may impede liquidity for some securities. 
For instance, if faced with a high probability of a mandatory close out 
or some other penalty for failing to deliver, market makers may find it 
more costly to accommodate customer buy orders, and may be less willing 
to provide liquidity for such securities. This may lead to wider bid-
ask spreads or less depth. Allowing flexibility for some failures to 
deliver also may deter the likelihood of manipulative short squeezes 
because manipulators would be less able to require counterparties to 
purchase at above-market value.
    Regulation SHO's close-out requirement is narrowly tailored in 
consideration of these concerns. For instance, Regulation SHO does not 
require close outs of non-threshold securities. The close-out provision 
only targets those securities where the level of fails is very high 
(0.5% of total shares outstanding and 10,000 shares or more) for a 
continuous period (five consecutive settlement days), and where a 
participant of a clearing agency has had a persistent fail in such 
threshold securities for 13 consecutive settlement days. Requiring 
close out only for securities with large, persistent fails limits the 
market impact. While some reduction in liquidity may occur as a result 
of requiring close out of these limited number of securities, we 
believe this should be balanced against the value derived from delivery 
of such securities within a reasonable period of time. We also seek 
specific comment on whether the proposed close-out periods are 
appropriate in light of these concerns.

III. Discussion of Proposed Amendments to Regulation SHO

A. Proposed Amendments to the Grandfather Provision

    To further reduce the number of persistent fails to deliver, we 
propose to eliminate the grandfather provision in Rule 203(b)(3)(i). In 
particular, the proposal would require that any previously-
grandfathered fail to deliver position in a security that is on the 
threshold list on the effective date of the amendment be closed out 
within 35 settlement days \20\ of the effective date of the 
amendment.\21\ If a security becomes a threshold security after the 
effective date of the amendment, any fails to deliver in that security 
that occurred prior to the security becoming a threshold security would 
become subject to Rule 203(b)(3)'s mandatory 13 settlement day close-
out requirement, similar to any other fail to deliver position in a 
threshold security.
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    \20\ If the security is a threshold security on the effective 
date of the amendment, participants of a registered clearing agency 
must close out that position within 35 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 is used in the 
current rule, and to allow participants additional time to close out 
their previously-grandfathered fail to deliver positions, given that 
some participants may have large previously-excepted fails with 
respect to a number of securities.
    Only previously-grandfathered fail to deliver positions in 
securities that are threshold securities on the effective date of 
the amendment would be subject to this 35 settlement day phase-in 
period. For instance, any previously-grandfathered fail position in 
a security that is a threshold security on the effective date of the 
amendment that is removed from the threshold list anytime after the 
effective date of the amendment but that reappears on the threshold 
list anytime thereafter would no longer qualify for the 35 day 
phase-in period and would be required to be closed out under the 
requirements of Rule 203(b)(3) as amended, i.e., if the fail 
persists for 13 consecutive settlement days.
    \21\ In addition, similar to the pre-borrow requirement in 
current Rule 203(b)(3)(iii), if the fail to deliver position has 
persisted for 35 settlement days, 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 
fail to deliver position by purchasing securities of like kind and 
quantity.
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    The amendment would help prevent fails to deliver in threshold 
securities from persisting for extended periods of time. At the same 
time, the amendment would provide participants flexibility and advance 
notice to close out the originally grandfathered fail to deliver 
positions.
Request for Comment
     The grandfather provision of Regulation SHO was adopted 
because the Commission was concerned about creating volatility from 
short squeezes where there were large pre-existing fail to deliver 
positions. The Commission intended to monitor whether grandfathered 
fail to deliver positions are being cleaned up to determine whether the 
grandfather provision should be amended to either eliminate the 
provision or limit the duration of grandfathered fail positions. Is the 
elimination of the grandfather provision from the close-out requirement 
in Rule 203(b)(3) appropriate? Should we consider instead providing a 
longer period of time to close out fails that occurred before January 
3, 2005 (the effective date of Regulation SHO),\22\ or

[[Page 41713]]

fails that occur before a security becomes a threshold security, or 
both? (e.g., 20 days)? Please explain in detail why a longer period 
should be allowed.
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    \22\ Between the effective date of Regulation SHO and March 31, 
2006, 99.2% of the fails that existed on Regulation SHO's January 3, 
2005 effective date have been closed out. This calculation is based 
on data, as reported by NSCC, that covers all stocks with aggregate 
fails to deliver of 10,000 shares or more.
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     Should we provide a longer (or shorter) phase-in period 
(e.g., 60 days instead of 35), or no phase-in period? What are the 
economic tradeoffs associated with a longer or shorter phase-in period? 
How much do these tradeoffs matter?
     Is a 35 settlement day phase-in period necessary as firms 
will have been on notice that they will have to close out previously-
grandfathered fails following the effective date of the amendment? 
Should we consider changing the phase-in period to 35 calendar days? If 
so, would this create systems problems or other costs? Would a phase-in 
period create examination or surveillance difficulties?
     Would the proposed amendments 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 day phase-in period from fails 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 
settlement day requirements, do these additional costs outweigh the 
benefits of providing firms with a 35 settlement day phase-in period?
     Please provide specific comment as to what length of 
implementation period is necessary to put firms on notice that 
positions would need to be closed out within the applicable timeframes, 
if adopted?
     Current Rule 203(b)(3) and the proposal to eliminate the 
grandfather provision are based on the premise that a high level of 
fails to deliver for a particular stock might harm the market for that 
security. In what ways do persistent grandfathered fails to deliver 
harm market quality for those securities, or otherwise have adverse 
consequences for investors?
     To what degree would the proposed amendments help reduce 
abusive practices by short sellers? Conversely, to what degree will 
eliminating the grandfather provision make it more difficult for short 
sellers to provide market discipline against abusive practices on the 
long side?
     To what extent will eliminating the grandfather provision 
affect the potential for manipulative activity? For instance, could it 
increase the potential for manipulative short squeezes?
     How much would the amendments affect the specific 
compliance costs for small, medium, and large clearing members (e.g., 
personnel or system changes)?
     What are the benefits of allowing fails of a certain 
duration, and what is the appropriate length of time for which a fail 
could have such a benefit?
     Should we consider changing the period of time in which 
any fail is allowed to persist before a firm is required to close out 
that fail (e.g., reduce the 13 consecutive settlement days to 10 
consecutive settlement days)?
     What are the economic costs of eliminating the grandfather 
provision? How will eliminating the grandfather provision affect the 
liquidity of equity securities? Are there any other costs associated 
with this proposal?
     Should grandfathering be eliminated only for those 
threshold securities where the highest levels of fails exist? If so, 
how should such positions be identified? What criteria should be used? 
What time period, if any, would be appropriate to grandfather threshold 
securities with lower levels of fails? Is there a de minimis amount of 
fails that should not be subject to a mandatory close out? If so, what 
is that amount?
     Should the Commission consider granting relief to allow 
market participants to close out fails in threshold securities that 
occurred because of an obvious or inadvertent trading error? If so, 
what factors should the Commission consider before granting the 
request? What documentation should market participants be required to 
create and maintain to demonstrate eligibility for relief? Should the 
cost of closing out the fail be a part of the economic cost of making a 
trading error? How would the proposed amendments affect price 
efficiency for fails resulting from trading errors?
     Some market participants have suggested that delivery 
failures in certain structured products, such as exchange traded funds 
(ETFs) do not raise the same concerns as fails in securities of 
individual issuers. We also understand that there may be particular 
difficulties in complying with the close-out requirements because of 
the structure of these products. Are there unique challenges associated 
with the clearance and settlement of ETFs? If so, what are these unique 
challenges? Should ETFs or other types of structured products be 
excepted from being considered threshold securities? If so, what 
reasons support excepting these securities?
     We understand that deliveries on sales of Rule 144 
restricted securities are sometimes delayed through no fault of the 
seller (e.g., to process removal of the restrictive legend). Should the 
current close-out requirement of 13 consecutive settlement days for 
Rule 144 restricted threshold securities be extended, e.g., to 35 
settlement days? Please identify specific delivery problems related to 
Rule 144 restricted securities. Should the current close-out 
requirement of 13 consecutive settlement days be similarly extended for 
any other type of securities and, if so, why?
     We solicit comment on any legitimate reason why a short or 
long seller may be unable to deliver securities within the current 13 
consecutive settlement day period of Rule 203(b)(3), or within any 
other alternative timeframes.
     The current definition of a ``threshold security'' is 
based, in part, on a security having a threshold level of fails that is 
``equal to at least one-half of one percent of an issuer's total shares 
outstanding.'' \23\ Is the current threshold level (one-half of one 
percent) too low or too high? If so, how should the current threshold 
level be changed?
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    \23\ See supra note 5.
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     When Regulation SHO was proposed, commenters noted 
difficulties tracking individual accounts in determining fails to 
deliver.\24\ However, we understand that some firms now track 
internally the accounts responsible for fails. Should we consider 
requiring customer account-level close out? Should firms be required to 
prohibit all short sales in that security by an account if that account 
becomes subject to close out in that security, rather than requiring 
that account to pre-borrow before effecting any further short sales in 
the particular threshold security?
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    \24\ See Adopting Release, 69 FR at 48017.
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     Should we impose a mandatory ``pre-borrow'' requirement 
(i.e., that would prohibit a participant of a registered clearing 
agency, or any broker-dealer for which it clears transactions, from 
accepting any short sale order or effecting further short sales in the 
particular threshold security without borrowing, or entering into a 
bona-fide arrangement to borrow, the security) for all firms whenever 
there are extended fails in a threshold security regardless of whether 
that particular firm has an extended fail position in that security? If 
so, how should we identify such securities? What criteria should be 
used to identify an extended fail? Should this alternative apply to all 
threshold securities? What are the costs and benefits of imposing

[[Page 41714]]

such a mandatory pre-borrow requirement? What percentage of these pre-
borrowed shares would eventually be required for delivery?
     Rule 203(b)(1)'s current locate requirement generally 
prohibits brokers from using the same shares located from the same 
source for multiple short sales. However, Rule 203(b)(1) does not 
similarly restrict the sources that provide the locates. We understand 
that some sources may be providing multiple locates using the same 
shares to multiple broker-dealers. Thus, should we amend Rule 203(b)(1) 
to provide for stricter locates? For example, should we require that 
brokers obtain locates only from sources that agree to, and that the 
broker reasonably believes will, decrement shares (so that the source 
may not provide a locate of the same shares to multiple parties)? Would 
doing so reduce the potential for fails to deliver? Should we consider 
other amendments to the locate requirement? Would requiring stricter 
locate requirements reduce liquidity? If so, would the reduction in 
liquidity affect some types of securities more than others (e.g., hard 
to borrow securities or securities issued by smaller companies)? Should 
stricter locate requirements be implemented only for securities that 
are hard to borrow (e.g., threshold securities)?
     Some people have asked for disclosure of aggregate fail to 
deliver positions to provide greater transparency. Should we require 
the amount or level of fails to deliver in threshold securities to be 
publicly disclosed? Would requiring information about the amount of 
fails to deliver help reduce the number of persistent fails to deliver? 
Should such disclosure be done on an aggregate or individual stock 
basis? If so, who should make this disclosure (e.g., should each broker 
be required to disclose the aggregate fails to deliver amount for each 
threshold security or, alternatively, should the SROs be required to 
post this information)? How should this information be disseminated? In 
what way would providing the investing public with access to aggregate 
fails data be useful? Would providing the investing public with access 
to this information on an individual stock basis increase the potential 
for manipulative short squeezes? If not, why not? How frequently should 
this information be disseminated? Should it be disseminated on a 
delayed basis to reduce the potential for manipulative short squeezes? 
If so, how much of a delay would be appropriate?
     Are there certain transactions or market practices that 
may cause fail to deliver positions to remain for extended periods of 
time that are not currently addressed by Rule 203 of Regulation SHO? If 
so, what are these transactions or practices? How should Rule 203 be 
amended to address these transactions or practices?
     Would borrowing, rather than purchasing, securities to 
close out a position be more effective in reducing fails to deliver, or 
could borrowing result in prolonging fails to deliver?
     Can the close-out provision of Rule 203(b) be easily 
evaded? If so, please explain.
     Does allowing some level of fails of limited duration 
enable market makers to create a market for less liquid securities? How 
long of a duration is reasonable? Does eliminating the grandfather 
provision mean fewer market makers will be willing to make markets in 
those securities, and could this increase costs and liquidity for those 
securities? Are there any other concerns or solutions associated with 
the effect of the amendment on market makers in highly illiquid stocks?
     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?

B. Proposed Amendments to the ``Options Market Maker Exception''

    We also propose to limit the duration of the options market maker 
exception in Rule 203(b)(3)(ii). Under the proposed amendment, for 
securities that are on the threshold list on the effective date of the 
amendment, any previously excepted fail to deliver position in the 
threshold security that resulted from short sales effected 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 settlement days of the effective 
date of the amendment.\25\ However, if the security appears on the 
threshold list after the effective date of the amendment, and if the 
options position has expired or been liquidated, all fail to deliver 
positions in the security that result or resulted from short sales 
effected to establish or maintain a hedge on an options position that 
existed before the security became a threshold security must 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 is later.\26\
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    \25\ In addition, similar to the pre-borrow requirement of 
current Rule 203(b)(3)(iii), if the fail to deliver has persisted 
for 35 settlement days, 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 fail to deliver 
position by purchasing securities of like kind and quantity.
    \26\ Also, similar to the pre-borrow requirement of current Rule 
203(b)(iii), if the options position has expired or been liquidated 
and the fail to deliver has persisted for 13 consecutive settlement 
days from the date on which the security becomes a threshold 
security or the option position expires or is liquidated, whichever 
is later, 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 fail to deliver position by 
purchasing securities of like kind and quantity.
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    Thus, under the proposed amendment, registered options market 
makers would still be able to continue to keep open fail positions in 
threshold securities that are being used to hedge

[[Page 41715]]

options positions, including adjusting such hedges, if the options 
positions that were created prior to the time that the underlying 
security became a threshold security have not expired or been 
liquidated. Once the security becomes a threshold security and the 
specific options position has expired or been liquidated, however, such 
fails would be subject to a 13 consecutive settlement day close-out 
requirement.
    We understand that, without the ability to hedge a pre-existing 
options position by selling short the underlying security, options 
market makers may be less willing to make markets in securities that 
are threshold securities.\27\ This in turn may reduce liquidity in such 
securities, to the detriment of investors in options. We also 
understand that additional time may be needed to close out a fail to 
deliver position resulting from a hedge on an options position that 
existed before the security became a threshold security. However, once 
the options position expires or is liquidated, we see no reason for 
maintaining the fail position. We believe that the 13 consecutive 
settlement day period provided for in this proposal would be a 
sufficient amount of time to allow a fail to remain that results from a 
short sale by an options market maker to hedge a pre-existing options 
position that has expired or been liquidated. Therefore, once the 
options position that was being hedged by a short sale in the 
underlying threshold security expires or is liquidated, reliance on the 
options market maker exception is no longer warranted and the fail to 
deliver position associated with that expired options position should 
be subsequently closed out.\28\ In addition, if the proposed amendments 
are adopted, we anticipate an implementation period that would put the 
firms on notice that positions need to be closed out within the 
applicable time frames.
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    \27\ See Adopting Release, 69 FR at 48018.
    \28\ Consistent with the current rule, options market makers 
would not be permitted to move their hedge on an original options 
position to another pre-existing options position to avoid 
application of the proposed close-out requirements. Once the options 
position expires or is liquidated, the proposed amendment would 
require closing out the fail that resulted from that original hedge. 
To clarify this, the proposed rule would amend Rule 203(b)(3)(ii) to 
refer to ``an options position'' rather than ``options positions.''
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    We believe the proposed amendments foster Regulation SHO's goal of 
reducing fails to deliver while still permitting options market makers 
to hedge existing options positions until the specific options position 
being hedged has expired or been liquidated. The 35 settlement day 
phase-in period also would provide options market makers advance notice 
to adjust to the new requirement. At the same time, the amendments 
would limit the amount of time in which a fail to deliver position can 
persist.
Request for Comment
     The options market maker exception was created to permit 
options market makers flexibility in maintaining and adjusting hedges 
for pre-existing options positions. Is narrowing the options market 
maker exception appropriate? If not, why not? Will narrowing the 
exception reduce the willingness of options market makers to make 
markets in threshold securities? Will narrowing this exception reduce 
liquidity in threshold securities? Should we consider providing a 
limited amount of additional time for options market makers to close 
out after the expiration or liquidation of the hedge (e.g., from 13 
days to 20 days)? What other measures or time frames would be effective 
in fostering Regulation SHO's goal of reducing fails while at the same 
time encouraging liquidity and market making by options market makers?
     Should we narrow the options market maker exception only 
for threshold securities with the highest level of fails? If so, how 
should such positions be identified? What criteria should be used? 
Should we provide a limited exception for threshold securities with a 
lower levels of fails? If so, how much time should we provide for 
options market maker fails in those securities (e.g., 20 days)?
     Should we eliminate the options market maker exception 
altogether? Would this impede liquidity, or otherwise reduce the 
willingness of options market makers to make markets in threshold 
securities? Please provide specific reasons and information to support 
an alternative recommendation.
     After the options position has expired or been liquidated, 
are there circumstances that might cause an options market maker to 
need to maintain an excepted fail to deliver position longer than 13 
consecutive settlement days? If so, what are those circumstances?
     Is there any legitimate reason an options market maker 
should be permitted to never have to close out a fail position that is 
excepted from the close-out requirement of this proposal? If so, what 
are the reasons?
     Are the terms ``expiration'' and ``liquidation'' of an 
options position sufficiently inclusive to prevent participants from 
evading the proposed close-out requirements? Are these terms 
understandable for compliance purposes? If not, what terms would be 
more appropriate? Please explain.
     Under the current rule a broker-dealer asserting the 
options market maker exception must demonstrate eligibility for the 
exception. Some market participants have noted that more specific 
documentation requirements may make it easier to establish a broker-
dealer's eligibility for the exception. Should a broker-dealer 
asserting the options market maker exception be required to make and 
keep more specific documentation regarding their eligibility for the 
exception? Such documentation may include tracking fail positions 
resulting from short sales to hedge specific pre-existing options 
positions and the options position. What other types of documentation 
would be helpful, and why?
     Should Rule 203(b)(3) of Regulation SHO be amended to 
permit options market makers to move excepted positions to hedge other, 
or new, pre-existing options positions? If so, please provide specific 
reasons and information to support your answer.
     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 amendments 
to the options market maker exception?
     What technical or operational challenges would options 
market makers face in complying with the proposed amendments?
     Would the proposed amendments 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 day phase-in period from fails 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 
settlement day requirements, do these additional costs outweigh the 
benefits of providing firms with a 35 settlement day phase-in period? 
Is a 35 settlement day phase-in period necessary given that firms will 
have been on notice that they will have to close out these fails to 
deliver positions following the effective date of the amendment?
     Should we consider changing the proposed phase-in period 
to 35 calendar days? 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 is necessary to put firms on notice that 
positions would need to be closed out

[[Page 41716]]

within the applicable timeframes, if adopted.

IV. Proposed Amendments to Rule 200(e) Exception for Unwinding Index 
Arbitrage Positions

    We also propose to update Rule 200(e) of Regulation SHO to 
reference the NYSE Composite Index (NYA), instead of the Dow Jones 
Industrial Average (DJIA), for purposes of the market decline 
limitation in subparagraph (e)(3) of Rule 200.

A. Background

    Regulation SHO provides a limited exception from the requirement 
that a person selling a security aggregate all of the person's 
positions in that security to determine whether the seller has a net 
long position. This provision, which is contained in Rule 200(e), 
allows broker-dealers to liquidate (or unwind) certain existing index 
arbitrage positions involving long baskets of stocks and short index 
futures or options without aggregating short stock positions in other 
proprietary accounts if and to the extent that those short stock 
positions are fully hedged.\29\ The exception, however, does not apply 
if the sale occurs during a period commencing at a time when the DJIA 
has declined below its closing value on the previous trading day by at 
least two percent and terminating upon the establishment of the closing 
value of the DJIA on the next succeeding trading day.\30\ If a market 
decline triggers the application of Rule 200(e)(3), a broker-dealer 
must aggregate all of its positions in that security to determine 
whether the seller has a net long position.\31\
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    \29\ To qualify for the exception under Rule 200(e), the 
liquidation of the index arbitrage position must relate to a 
securities index that is the subject of a financial futures contract 
(or options on such futures) traded on a contract market, or a 
standardized options contract, notwithstanding that such person may 
not have a net long position in that security. 17 CFR 242.200(e).
    \30\ Specifically, the exception under Rule 200(e) is limited to 
the following conditions: (1) The index arbitrage position involves 
a long basket of stock and one or more short index futures traded on 
a board of trade or one or more standardized options contracts; (2) 
such person's net short position is solely the result of one or more 
short positions created and maintained in the course of bona-fide 
arbitrage, risk arbitrage, or bona-fide hedge activities; and (3) 
the sale does not occur during a period commencing at the time that 
the DJIA has declined below its closing value on the previous day by 
at least two percent and terminating upon the establishment of the 
closing value of the DJIA on the next succeeding trading day. Id.
    \31\ 17 CFR 242.200(e)(3); Adopting Release, 69 FR at 48012.
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    The reference to the DJIA was based in part on NYSE Rule 80A (Index 
Arbitrage Trading Restrictions). As amended in 1999, NYSE Rule 80A 
provided for limitations on index arbitrage trading in any component 
stock of the S&P 500 Stock Price Index (``S&P 500'') whenever the 
change from the previous day's close in the DJIA was greater than or 
equal to two percent calculated pursuant to the rule.\32\ In addition, 
the two-percent market decline restriction was included in Rule 
200(e)(3) so that the market could avoid incremental temporary order 
imbalances during volatile trading days.\33\ The two-percent market 
decline restriction limits temporary order imbalances at the close of 
trading on a volatile trading day and at the opening of trading on the 
following day, since trading activity at these times may have a 
substantial effect on the market's short-term direction.\34\ The two-
percent safeguard also provides consistency within the equities 
markets.\35\
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    \32\ The restrictions were removed when the DJIA retreated to 
one percent or less, calculated pursuant to the rule, from the prior 
day's close.
    \33\ Adopting Release, 69 FR at 48011.
    \34\ Id.
    \35\ In 1999, the NYSE amended its rules on index arbitrage 
restrictions to include the two-percent trigger. The Commission's 
adoption of the same trigger provided a uniform protective measure. 
See Securities Exchange Act Release No. 41041 (February 11, 1999), 
64 FR 8424 (SR-NYSE-98-45) (February 19, 1999).
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    On August 24, 2005, the Commission approved an amendment to NYSE 
Rule 80A to use the NYA to calculate limitations on index arbitrage 
trading as provided in the rule instead of the DJIA.\36\ The effective 
date of the amendment was October 1, 2005. The Commission's approval 
order notes that, according to the NYSE, the NYA is a better reflection 
of market activity with respect to the S&P 500 and thus, a better 
indicator as to when the restrictions on index arbitrage trading 
provided by NYSE Rule 80A should be triggered.\37\ While Rule 200(e)(3) 
currently does not refer to the basis for determining the two-percent 
limitation, NYSE Rule 80A provides that the two percent is to be 
calculated at the beginning of each quarter and shall be two percent, 
rounded down to the nearest 10 points, of the average closing value of 
the NYA for the last month of the previous quarter.\38\
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    \36\ Securities Exchange Act Relese No. 52328 (Aug. 24, 2005), 
70 FR 51398 (Aug. 30, 2005).
    \37\ Id.
    \38\ Id. See also NYSE Rule 80A (Supplementary Material .10).
---------------------------------------------------------------------------

B. Proposed Amendments to Rule 200(e)

    In order to maintain uniformity with NYSE Rule 80A and to maintain 
a uniform protective measure, we propose to amend Rule 200(e)(3) of 
Regulation SHO to: (i) Reference the NYA instead of the DJIA; and (ii) 
add language to clarify how the two-percent limitation is to be 
calculated in accordance with NYSE Rule 80A for purposes of Rule 
200(e)(3).\39\
---------------------------------------------------------------------------

    \39\ Id. See also Proposed Rule 200(e)(3). In addition, because 
the NYA is already posted with this calculation, the amendment would 
make this reference point more easily accessible to market 
participants.
---------------------------------------------------------------------------

Request for Comment
     Are the proposed changes to the market decline limitation 
appropriate? Would another index be a more appropriate measure for the 
exception than the NYA?
     Is the proposed clarification language regarding the two-
percent calculation useful?
     Does this limitation affect the expected cost of entering 
into index arbitrage positions? Does the limitation reduce market 
efficiency by slowing down price discovery? Does the limitation affect 
only temporary order imbalances or does it also keep prices from fully 
adjusting to their fundamental value?
     What are the costs and benefits of the proposed amendments 
to Regulation SHO's exception for unwinding index arbitrage positions?

V. General Request for Comment

    The Commission seeks comment generally on all aspects of the 
proposed amendments to Regulation SHO under the Exchange Act. 
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 by 
alternatives to our proposals where appropriate.

VI. Paperwork Reduction Act

    The proposed amendments to Regulation SHO would not impose a new 
``collection of information'' within the meaning of the Paperwork 
Reduction Act of 1995.\40\ 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.
---------------------------------------------------------------------------

    \40\ 44 U.S.C. 3501 et seq.

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[[Page 41717]]

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. Proposed Amendments to Rule 203(b)(3)'s Delivery Requirements

1. Amendments to Rule 203(b)(3)(i)'s Grandfather Provision
    a. Benefits. The proposed amendments would eliminate the 
grandfather provision in Rule 203(b)(3)(i) of Regulation SHO. In 
particular, the proposal would require that any previously-
grandfathered fail to deliver position in a security that is on the 
threshold list on the effective date of the amendment be closed out 
within 35 settlement days. If a security becomes a threshold security 
after the effective date of the amendment, any fails to deliver that 
occurred prior to the security becoming a threshold security would 
become subject to Rule 203(b)(3)'s mandatory 13 settlement days close-
out requirement, similar to any other fail to deliver position in a 
threshold security. 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. We believe that these persistent fail positions are 
attributable primarily to the grandfather provision. We believe that 
the proposal to eliminate the grandfather provision would further 
reduce the number of persistent fails to deliver. We believe the 
proposed amendments to Rule 203(b)(3)(i) will protect and enhance the 
operation, integrity, and stability of the market.
    Consistent with the Commission's investor protection mandate, the 
proposed amendment will benefit investors. The proposed amendments 
would facilitate 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 may alleviate investor 
apprehension as they make investment decisions by providing them with 
greater assurance that securities will be delivered as expected. It 
should also foster the fair treatment of all investors.
    The proposed amendments should also benefit issuers. A high level 
of persistent fails in a security may be perceived by potential 
investors negatively and may affect their decision about making a 
capital commitment. Thus, the proposal may benefit issuers by removing 
a potential barrier to capital investment, thereby increasing 
liquidity. An increase in investor confidence in the market by 
providing greater assurance that trades will be delivered may also 
facilitate investment. In addition, some issuers may believe they have 
endured reputational damage if there are a high level of persistent 
fails in their securities as a high level of fails is often viewed 
negatively. Eliminatin