Amendments to Regulation SHO, 45558-45590 [E7-15709]

Agencies

• SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 72, Number 156 (Tuesday, August 14, 2007)]
[Proposed Rules]
[Pages 45558-45590]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E7-15709]



Federal Register / Vol. 72, No. 156 / Tuesday, August 14, 2007 / 
Proposed Rules

[[Page 45558]]


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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 (https://
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 (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.

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 (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. 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 https://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

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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 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'').
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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 https://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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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 s