``Naked'' Short Selling Anti-Fraud Rule, 15376-15385 [E8-5697]

Download as PDF 15376 Federal Register / Vol. 73, No. 56 / Friday, March 21, 2008 / Proposed Rules SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 240 [Release No. 34–57511; File No. S7–08–08] RIN 3235–AK06 ‘‘Naked’’ Short Selling Anti-Fraud Rule Securities and Exchange Commission. ACTION: Proposed rule. AGENCY: SUMMARY: The Securities and Exchange Commission (‘‘Commission’’) is proposing an anti-fraud rule under the Securities Exchange Act of 1934 (‘‘Exchange Act’’) to address fails to deliver securities that have been associated with ‘‘naked’’ short selling. The proposed rule is intended to highlight the liability of persons that deceive specified persons about their intention or ability to deliver securities in time for settlement, including persons that deceive their broker-dealer about their locate source or ownership of shares and that fail to deliver securities by settlement date. DATES: Comments should be received on or before May 20, 2008. ADDRESSES: Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission’s Internet comment form (http://www.sec.gov/ rules/proposed.shtml); or • Send an e-mail to rulecomments@sec.gov. Please include File Number S7–08–08 on the subject line; or • Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments. jlentini on PROD1PC65 with PROPOSALS3 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 S7–08–08. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission’s Internet Web site (http://www.sec.gov/rules/ proposed.shtml). Comments are also available for public inspection and copying in the Commission’s Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 VerDate Aug<31>2005 18:48 Mar 20, 2008 Jkt 214001 a.m. and 3 p.m. 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, Joan M. Collopy, Special Counsel, Todd E. Freier and Christina M. Adams, Staff Attorneys, Office of Trading Practices and Processing, Division of Trading and Markets, 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 Rule 10b–21 under the Exchange Act. I. Introduction The Commission is proposing an antifraud rule, Rule 10b–21, aimed at short sellers, including broker-dealers acting for their own accounts, who deceive specified persons, such as a broker or dealer, about their intention or ability to deliver securities in time for settlement and that fail to deliver securities by settlement date. Among other things, proposed Rule 10b–21 would target short sellers who deceive their brokerdealers about their source of borrowable shares for purposes of complying with Regulation SHO’s ‘‘locate’’ requirement.1 The proposed rule would also apply to sellers who misrepresent to their broker-dealers that they own the shares being sold. A seller misrepresenting its short sale locate source or ownership of shares may intend to fail to deliver securities in time for settlement and, therefore, engage in abusive ‘‘naked’’ short selling. Although abusive ‘‘naked’’ short selling is not defined in the federal securities laws, it refers generally to selling short without having stock available for delivery and intentionally failing to deliver stock within the standard threeday settlement cycle.2 Although abusive ‘‘naked’’ short selling as part of a manipulative scheme is always illegal under the general antifraud provisions of the federal securities laws, including Rule 10b–5 under the Exchange Act,3 proposed Rule 10b–21 would highlight the specific liability of 1 See 17 CFR 242.203(b)(1). Exchange Act Release No. 56212 (Aug. 7, 2007), 72 FR 45544 (Aug. 14, 2007) (‘‘2007 Regulation SHO Amendments’’); Exchange Act Release No. 54154 (July 14, 2006), 71 FR 41710 (July 21, 2006) (‘‘2006 Regulation SHO Proposed Amendments’’). 3 17 CFR 240.10b–5. 2 See PO 00000 Frm 00002 Fmt 4701 Sfmt 4702 persons that deceive specified persons about their intention or ability to deliver securities in time for settlement, including persons that deceive their broker-dealer about their locate source or ownership of shares.4 We believe that a rule highlighting the illegality of these activities would focus the attention of market participants on such activities. The proposed rule would also highlight that the Commission believes such deceptive activities are detrimental to the markets and would provide a measure of predictability for market participants. All sellers of securities should promptly deliver, or arrange for delivery of, securities to the respective buyer and all buyers of securities have a right to expect prompt delivery of securities purchased. Thus, the proposal takes direct aim at an activity that may create fails to deliver. Those fails can have a negative effect on shareholders, potentially depriving them of the benefits of ownership, such as voting and lending. They also may create a misleading impression of the market for an issuer’s securities. Proposed Rule 10b–21 would also aid broker-dealers in complying with the locate requirement of Regulation SHO and, thereby, potentially reduce fails to deliver. In addition, the proposed rule could help reduce manipulative schemes involving ‘‘naked’’ short selling. II. Background A. Regulation SHO Short selling involves a sale of a security that the seller does not own and that is consummated by the delivery of a security borrowed by or on behalf of the seller.5 In a ‘‘naked’’ short sale, a seller does not borrow or arrange to borrow securities in time to make delivery to the buyer within the standard three-day settlement period.6 As a result, the seller fails to deliver securities to the buyer when delivery is due (known as a ‘‘fail’’ or ‘‘fail to deliver’’).7 Sellers sometimes 4 This conduct is also in violation of other provisions of the federal securities laws, including the anti-fraud provisions. 5 17 CFR 242.200(a). 6 See Exchange Act Release No. 50103 (July 28, 2004), 69 FR 48008 (Aug. 6, 2004) (‘‘2004 Regulation SHO Adopting Release’’) (stating that ‘‘naked’’ short selling generally refers to selling short without having borrowed the securities to make delivery). 7 Generally, investors 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 generally is received by its brokerage firm no later than three business days after the trade is executed. When the investor sells a security, the E:\FR\FM\21MRP3.SGM 21MRP3 Federal Register / Vol. 73, No. 56 / Friday, March 21, 2008 / Proposed Rules jlentini on PROD1PC65 with PROPOSALS3 intentionally fail to deliver securities as part of a scheme to manipulate the price of a security,8 or possibly to avoid borrowing costs associated with short sales. Although the majority of trades settle within the standard three-day settlement period,9 the Commission adopted Regulation SHO 10 in part to address problems associated with persistent fails to deliver securities and potentially abusive ‘‘naked’’ short selling.11 Rule 203 of Regulation SHO, in particular, contains a ‘‘locate’’ requirement that provides that, ‘‘[a] broker or dealer may not accept a short sale order in an equity security from another person, or effect a short sale in an equity security for its own account, seller generally delivers its securities, in certificated or electronic form, to its brokerage firm no later than three business days after the sale. The threeday 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. In addition, Rule 15c6–1 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; Exchange Act Release No. 33023 (Oct. 7, 1993), 58 FR 52891 (Oct. 13, 1993). However, failure to deliver securities on T+3 does not violate Rule 15c6–1. 8 In 2003, the Commission settled a case against certain parties relating to allegations of manipulative short selling in the stock of a corporation. The Commission alleged that the defendants profited from engaging in massive naked short selling that flooded the market with the 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) (Feb. 26, 2003). 9 According to the NSCC, 99% (by dollar value) of all trades settle within T+3. Thus, on an average day, approximately 1% (by dollar value) of all trades, including equity, debt, and municipal securities fail to settle on time. The vast majority of these fails are closed out within five days after T+3. In addition, fails to deliver may arise from either short sales or long sales of securities. There may be legitimate reasons for a fail to deliver. For example, human or mechanical errors or processing delays can result from transferring securities in custodial or other form rather than book-entry form, thus causing a fail to deliver on a long sale within the normal three-day settlement period. The Commission’s Office of Economic Analysis (‘‘OEA’’) estimates that, on an average day between May 1, 2007 and January 31, 2008, trades in ‘‘threshold securities,’’ as defined in Rule 203(b)(c)(6) of Regulation SHO, that fail to settle within T+3 account for approximately 0.6% of dollar value of trading in all securities. 10 17 CFR 242.200. Regulation SHO became effective on January 3, 2005. 11 See 2007 Regulation SHO Amendments, 72 FR at 45544 (stating that ‘‘[a]mong other things, Regulation SHO imposes a close-out requirement to address persistent failures to deliver stock on trade settlement date and to target potentially abusive ‘‘naked’’ short selling in certain equity securities’’). VerDate Aug<31>2005 18:48 Mar 20, 2008 Jkt 214001 unless the broker or dealer has: (1) Borrowed the security, or entered into a bona-fide arrangement to borrow the security; or (2) Reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due; and (3) Documented compliance with this paragraph (b)(1).’’ 12 In the 2004 Regulation SHO Adopting Release, the Commission explicitly permitted broker-dealers to rely on customer assurances that the customer has identified its own source of borrowable securities, provided it is reasonable for the broker-dealer to do so.13 We are concerned, however, that some short sellers may have been deliberately misrepresenting to broker-dealers that they have obtained a legitimate locate source.14 In addition, we are concerned that some short sellers may have made misrepresentations to their brokerdealers about their ownership of shares as an end run around Regulation SHO’s locate requirement.15 Some sellers have also misrepresented that their sales are long sales in order to circumvent Rule 105 of Regulation M,16 which prohibits certain short sellers from purchasing securities in a secondary or follow-on offering.17 Under Rule 200(g)(1) of Regulation SHO, ‘‘[a]n order to sell shall be marked ‘‘long’’ only if the seller is deemed to own the security being sold pursuant to paragraphs (a) through (f) of this section 18 and either: (i) The security to be delivered is in the physical possession or control of the broker or dealer; or (ii) it is reasonably 12 17 CFR 242.203(b). Market makers engaged in bona fide market making in the security at the time they effect the short sale are excepted from this requirement. 13 See 2004 Regulation SHO Adopting Release, 69 FR at 48014. 14 See, e.g., Sandell Asset Management Corp., Lars Eric Thomas Sandell, Patrick T. Burke and Richard F. Ecklord, Securities Act Release No. 8857 (Oct. 10, 2007) (settled order). 15 See id. 16 17 CFR 242.105. 17 See Goldman Sachs Execution and Clearing L.P., Exchange Act Release No. 55465 (Mar. 14, 2007) (settled order). 18 Rule 200(b) of Regulation SHO provides that a seller is deemed to own a security if, ‘‘(1) The person or his agent has title to it; or (2) The person has purchased, or has entered into an unconditional contract, binding on both parties thereto, to purchase it, but has not yet received it; or (3) The person owns a security convertible into or exchangeable for it and has tendered such security for conversion or exchange; or (4) The person has an option to purchase or acquire it and has exercised such option; or (5) The person has rights or warrants to subscribe to it and has exercised such rights or warrants; or (6) The person holds a security futures contract to purchase it and has received notice that the position will be physically settled and is irrevocably bound to receive the underlying security.’’ PO 00000 Frm 00003 Fmt 4701 Sfmt 4702 15377 expected that the security will be in the physical possession or control of the broker or dealer no later than the settlement of the transaction.’’ 19 Under Regulation SHO, the executing or order-entry broker-dealer is responsible for determining whether there are reasonable grounds to believe that a security can be borrowed so that it can be delivered on the date delivery is due on a short sale, and whether a seller owns the security being sold and can reasonably expect that the security will be in the physical possession or control of the broker-dealer no later than settlement date for a long sale. However, a broker-dealer relying on a customer that makes misrepresentations about its locate source or ownership of shares may not receive shares when delivery is due. For example, sellers may be making misrepresentations to their broker-dealers about their locate sources or ownership of shares for securities that are very difficult or expensive to borrow. Such sellers may know that they cannot deliver securities by settlement date due to, for example, a limited number of shares being available to borrow or purchase, or they may not intend to obtain shares for timely delivery because the cost of borrowing or purchasing may be high. This result undermines the Commission’s goal of addressing concerns related to ‘‘naked’’ short selling and extended fails to deliver. B. Concerns About ‘‘Naked’’ Short Selling We are concerned about persons that sell short securities and deceive specified persons about their intention or ability to deliver the securities in time for settlement, or deceive their broker-dealer about their locate source or ownership of shares, or otherwise engage in abusive ‘‘naked’’ short selling. Commission enforcement actions have contributed to our concerns about the extent of misrepresentations by short sellers about their locate sources and ownership of shares. For example, the Commission recently announced a settled enforcement action against hedge fund adviser Sandell Asset Management Corp. (‘‘SAM’’), its chief executive officer, and two employees in connection with allegedly (i) improperly marking some short sale orders ‘‘long’’ and (ii) misrepresenting to executing brokers that SAM personnel had located sufficient stock to borrow for short sale orders.20 19 17 CFR 242.200(g)(1). Sandell Asset Management Corp., Securities Act Release No. 8857; see also Goldman 20 See E:\FR\FM\21MRP3.SGM Continued 21MRP3 15378 Federal Register / Vol. 73, No. 56 / Friday, March 21, 2008 / Proposed Rules jlentini on PROD1PC65 with PROPOSALS3 As we have stated previously, we are concerned that fails to deliver may have a negative effect on the market and shareholders.21 For example, fails to deliver may deprive shareholders of the benefits of ownership, such as voting and lending.22 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 three-day settlement period) into an undated futures-type contract, to which the buyer might not have agreed, or that might have been priced differently.23 Moreover, sellers that fail to deliver securities on settlement date may be subject to fewer restrictions than sellers that are required to deliver the securities by settlement date, 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.24 For example, by not borrowing securities and, therefore, not making delivery within the standard three-day settlement period, the seller does not incur the costs of borrowing. In addition, issuers and investors have expressed concerns about fails to deliver in connection with ‘‘naked’’ short selling. For example, in response to proposed amendments to Regulation SHO in 2006 25 designed to further reduce the number of persistent fails to deliver in certain equity securities by eliminating Regulation SHO’s ‘‘grandfather’’ provision, and limiting the duration of the rule’s options market maker exception, the Commission received a number of comments that expressed concerns about ‘‘naked’’ short selling and extended delivery failures.26 Sachs Execution and Clearing L.P., Exchange Act Release No. 55465; U.S. v. Naftalin, 441 U.S. 768 (1979) (discussing a market manipulation scheme in which brokers suffered substantial losses when they had to purchase securities to replace securities they had borrowed to make delivery on short sale orders received from an individual investor who had falsely represented to the brokers that he owned the securities being sold). 21 See 2007 Regulation SHO Amendments, 72 FR at 45544; 2006 Regulation SHO Proposed Amendments, 71 FR at 41712; Exchange Act Release No. 56213 (Aug. 7, 2007), 72 FR 45558, 45558–45559 (Aug. 14, 2007) (‘‘2007 Regulation SHO Proposed Amendments’’). 22 See id. 23 See id. 24 See id. 25 See 2006 Regulation SHO Proposed Amendments. 26 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 (‘‘Royce’’); letter from Michael Read, dated April 29, 2007 (‘‘Read’’); letter from Robert DeVivo, VerDate Aug<31>2005 18:48 Mar 20, 2008 Jkt 214001 To the extent that 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,27 such fails to deliver may undermine the confidence of investors.28 These investors, in turn, may be reluctant to commit capital to an issuer they believe to be subject to such manipulative conduct.29 In addition, issuers may believe that they have suffered unwarranted reputational damage due to investors’ negative perceptions regarding fails to deliver in the issuer’s security.30 Any unwarranted dated April 26, 2007 (‘‘DeVivo’’); letter from Ahmed Akhtar, dated April 26, 2007 (‘‘Akhtar’’). 27 See supra, note 8 (discussing a case in which the Commission alleged that the defendants profited from engaging in massive naked short selling that flooded the market with the company’s stock, and depressed its price); see also S.E.C. v. Gardiner, 48 S.E.C. Docket 811, No. 91 Civ. 2091 (S.D.N.Y. March 27, 1991) (alleged manipulation by sales representative by directing or inducing customers to sell stock short in order to depress its price); U.S. v. Russo, 74 F.3d 1383, 1392 (2d Cir. 1996) (short sales were sufficiently connected to the manipulation scheme as to constitute a violation of Exchange Act Section 10(b) and Rule 10b–5). 28 In response to the 2006 Regulation SHO Proposed Amendments, the Commission received comment letters discussing the impact of fails to deliver on investor confidence. 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 (‘‘Blumenthal’’). 29 In response to the 2006 Regulation SHO Proposed Amendments, the Commission received comment letters 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. See, e.g., letter from Congressman Tom Feeney—Florida, U.S. House of Representatives, dated Sept. 25, 2006 (‘‘Feeney’’); see also 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.’’). 30 Due in part to such concerns, some 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. See Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR 62972, at 62975 (Nov. 6, 2003). Some 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. See id. Withdrawing securities from DTC or requiring custody-only transfers would undermine the goal of a national clearance and settlement system, designed to reduce the physical movement of certificates in the trading markets. See id. 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 PO 00000 Frm 00004 Fmt 4701 Sfmt 4702 reputational damage caused by fails to deliver might have an adverse impact on the security’s price.31 III. Discussion of Proposed Rule A. Proposed Anti-Fraud Rule To further address potentially abusive ‘‘naked’’ short selling and fails to deliver, we are proposing a narrowlytailored rule, Rule 10b–21, which would specify that it is unlawful for any person to submit an order to sell a security if such person deceives a broker-dealer, participant of a registered clearing agency, or purchaser 32 regarding its intention or ability to deliver the security on the date delivery is due, and such person fails to deliver the security on or before the date delivery is due.33 Scienter would be a necessary element for a violation of the proposed rule.34 The proposed rule would cover those situations where a seller deceives a broker-dealer, participant of a registered clearing agency, or a purchaser about its intention to deliver securities by settlement date, its locate source, or its share ownership, and the seller fails to deliver securities by settlement date. Proposed Rule 10b–21 would apply to the deception of persons participating in the transaction—broker-dealers, participants of registered clearing agencies, or purchasers. Further, because one of the principal goals of proposed Rule 10b–21 is to reduce fails procedure to process issuer withdrawal requests. See Securities Exchange Act Release No. 47978 (June 4, 2003), 68 FR 35037 (June 11, 2003). 31 See also 2006 Regulation SHO Proposed Amendments, 71 FR at 41712; 2007 Regulation SHO Amendments, 72 FR at 45544; 2007 Regulation SHO Proposed Amendments, 72 FR at 45558–45559 (providing additional discussion of the impact of fails to deliver on the market); see also Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR 62972, 62975 (Nov. 6, 2003) (‘‘2003 Regulation SHO Proposing Release’’) (discussing the impact of ‘‘naked’’ short selling on the market). 32 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. 33 Proposed Rule 10b–21. 34 Ernst & Ernst v. Hochfelder, et. al., 425 U.S. 185 (1976). Scienter has been defined as ‘‘a mental state embracing the intent to deceive, manipulate or defraud.’’ Id. at 193, n.12. While the Supreme Court has not decided the issue (see Aaron v. SEC, 446 U.S. 686 (1980); Ernst & Ernst, 425 at 193 n.12), federal appellate courts have concluded that scienter may be established by a showing of either knowing conduct or by ‘‘an ‘extreme departure from the standards of ordinary care * * * which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.’ ’’ Dolphin & Bradbury v. SEC, 512 F.3d 634 (D.C. Cir. Jan. 11, 2008) (quoting Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977)). E:\FR\FM\21MRP3.SGM 21MRP3 Federal Register / Vol. 73, No. 56 / Friday, March 21, 2008 / Proposed Rules jlentini on PROD1PC65 with PROPOSALS3 to deliver, violation of the proposed rule would occur only if a fail to deliver results from the relevant transaction. For purposes of the proposed rule, broker-dealers (including market makers) acting for their own accounts would be considered sellers. For example, a broker-dealer effecting short sales for its own account would be liable under the rule if it does not obtain a valid locate source and fails to deliver securities to the purchaser. Such brokerdealers defraud purchasers that may not receive delivery on time, in effect unilaterally forcing the purchaser into accepting an undated futures-type contract.35 As noted above, under Regulation SHO, the executing or order-entry broker-dealer is responsible for determining whether there are reasonable grounds to believe that a security can be borrowed so that it can be delivered on the date delivery is due on a short sale.36 In the 2004 Regulation SHO Adopting Release, the Commission explicitly permitted broker-dealers to rely on customer assurances that the customer has identified its own locate source, provided it is reasonable for the broker-dealer to do so.37 If a seller elects to provide its own locate source to a broker-dealer, the seller is representing that it has contacted that source and reasonably believes that the source can or intends to deliver the full amount of the securities to be sold short by settlement date. In addition, if a seller enters a short sale order into a brokerdealer’s direct market access or sponsored access system (‘‘DMA’’) with any information purporting to identify a locate source obtained by the seller, the seller would be making a representation to a broker-dealer for purposes of proposed Rule 10b–21.38 If a seller deceives a broker-dealer about the validity of its locate source, the seller would be liable under proposed Rule 10b–21 if the seller also fails to deliver securities by the date delivery is due. For example, a seller would be liable for a violation of proposed Rule 10b–21 if it represented that it had identified a source of borrowable securities, but the seller never contacted the purported source to 35 See 2007 Regulation SHO Amendments, 72 FR at 45544; 2006 Regulation SHO Proposed Amendments, 71 FR at 41712; 2007 Regulation SHO Proposed Amendments, 72 FR at 45558–45559. 36 See 17 CFR 242.203(b)(3)(1). 37 See 2004 Regulation SHO Adopting Release, 69 FR at 48014. 38 Broker-dealers may offer DMA to customers by providing them with electronic access to a market’s execution system using the broker-dealer’s market participant identifier. The broker-dealer, however, retains the ultimate responsibility for the trading activity of its customer. VerDate Aug<31>2005 18:48 Mar 20, 2008 Jkt 214001 determine whether shares were available and could be delivered in time for settlement and the seller fails to deliver securities by settlement date. A seller would also be liable if it contacted the source and learned that the source did not have sufficient shares for timely delivery, but the seller misrepresented that the source had sufficient shares that it could deliver in time for settlement and the seller fails to deliver securities by settlement date; or, if the seller contacted the source and the source had sufficient shares that it could deliver in time for settlement, but the seller never instructed the source to deliver the shares in time for settlement and the seller otherwise refused to deliver shares on settlement date such that the sale results in a fail to deliver. If, however, a seller is relying on a broker-dealer to comply with Regulation SHO’s locate obligation and to make delivery on a sale, the seller would not be representing at the time it submits an order to sell a security that it can or intends to deliver securities on the date delivery is due. For example, a seller might be relying on its broker-dealer to borrow or arrange to borrow the security to make delivery by settlement date. Alternatively, a seller might be relying on a broker-dealer’s ‘‘Easy to Borrow’’ list. If a seller in good faith relies on a broker-dealer’s ‘‘Easy to Borrow’’ list to satisfy the locate requirement, the seller would not be deceiving the brokerdealer at the time it submits an order to sell a security that it can or intends to deliver securities on the date delivery is due. In discussing the locate requirement of Regulation SHO, in the 2004 Regulation SHO Adopting Release, the Commission stated that ‘‘absent countervailing factors, ‘Easy to Borrow’ lists may provide ‘reasonable grounds’ for a broker-dealer to believe that the security sold short is available for borrowing without directly contacting the source of the borrowed securities.’’ 39 In addition, a market maker engaged in bona fide market making activity would not be making a representation at the time it submits an order to sell short that it can or intends to deliver securities on the date delivery is due, because such market makers are excepted from the locate requirement of Regulation SHO. Regulation SHO excepts from the locate requirement market makers engaged in bona-fide market making activities because market makers need to facilitate customer orders in a fast moving market without possible delays associated with 39 2004 Regulation SHO Adopting Release, 69 FR at 48014. PO 00000 Frm 00005 Fmt 4701 Sfmt 4702 15379 complying with the locate requirement.40 Thus, at the time of submitting an order to sell short, market makers that have an exception from the locate requirement of Regulation SHO may know that they may not be able to deliver securities on the date delivery is due. Under proposed Rule 10b–21, a seller would be liable if it deceives a brokerdealer, participant of a registered clearing agency, or purchaser about its ownership of shares or the deliverable condition of owned shares and fails to deliver securities by settlement date. For example, a seller would be liable for a violation of proposed Rule 10b–21 for causing a broker-dealer to mark an order to sell a security ‘‘long’’ if the seller knows or recklessly disregards that it is not ‘‘deemed to own’’ the security being sold, as defined in Rules 200(a) through (f) of Regulation SHO 41 or if the seller knows or recklessly disregards that the security being sold is not, or cannot reasonably be expected to be, in the broker-dealer’s physical possession or control by the date delivery is due, and the seller fails to deliver the security by settlement date. Broker-dealers acting for their own accounts would also be liable under the proposed rule for marking an order ‘‘long’’ if the brokerdealer knows or recklessly disregards that it is not ‘‘deemed to own’’ the security being sold or that the security being sold is not, or cannot reasonably be expected to be, in the broker-dealer’s physical possession or control by the date delivery is due, and the brokerdealer fails to deliver the security by settlement date.42 However, a seller would not be making a representation at the time it submits an order to sell a security that it can or intends to deliver securities on the date delivery is due if the seller submits an order to sell securities that are held in a margin account but the broker-dealer has loaned out the shares pursuant to the margin agreement. Under such circumstances, it would be reasonable for the seller to expect that the securities will be in the brokerdealer’s physical possession or control by settlement date. Although the proposed rule is primarily aimed at sellers that deceive specified persons about their intention or ability to deliver shares or about their locate sources and ownership of shares, as with any rule, broker-dealers could be liable for aiding and abetting a 40 See 2004 Regulation SHO Adopting Release, 69 FR at 48015, n. 67. 41 17 CFR 242.200(a)–(f). 42 Such broker-dealers would also be liable under Regulation SHO. E:\FR\FM\21MRP3.SGM 21MRP3 15380 Federal Register / Vol. 73, No. 56 / Friday, March 21, 2008 / Proposed Rules settlement that should be included in the proposed rule? As an alternative to listing who must be deceived, should the proposed rule provide that a person would be liable if it deceives ‘‘another person’’ about its intention or ability to deliver securities in time for settlement? Please explain. • The proposed rule includes a person failing to deliver securities when delivery is due as an element for a violation of the proposed rule. What are the costs and benefits, including to broker-dealers or customers, for including delivery as an element of the violation? Would the inclusion of a fail to deliver as an element of the proposed rule encourage broker-dealers, as a service to customers, to deliver securities on behalf of customers to prevent customers from failing to deliver securities by settlement date? Would broker-dealers feel any additional obligation to purchase or borrow securities on behalf of their customers to deliver on a customer’s sale? What would be the costs to brokerdealers if they were to take such actions, particularly if the sale involves an expensive or hard to borrow security? Would the inclusion of failing to deliver as an element for a violation of the Request for Comment proposed rule increase costs for The Commission seeks comment customers for inadvertent fails? Should generally on all aspects of proposed delivery be excluded as a required Rule 10b–21. In addition, we seek element for a violation? For example, comment on the following: should the rule language instead be: ‘‘It • Proposed Rule 10b–21 would apply shall constitute a ‘manipulative or to sales in all equity securities. Should deceptive device or contrivance’ as used we narrow the scope of the proposed in section 10(b) of this Act for any rule to apply only to sales of ‘‘threshold person to submit an order to sell a securities’’ as that term is defined in security if such person deceives a broker Rule 203(c)(6) of Regulation SHO 44 or to or dealer, participant of a registered certain types of securities? Why or why clearing agency, or a purchaser about its not? If so, to what types of securities intention or ability to deliver the should the proposed rule apply? If we security on the date delivery is due’’? narrow the proposed rule to apply only What would be the costs and benefits of to certain types of securities, should excluding delivery as an element for a exchange traded funds or other basket violation of the proposed rule? Would securities be excluded? Why or why excluding failing to deliver as an not? element for liability under the proposed • The proposed rule highlights the rule affect a self-regulatory specific liability of persons that deceive organization’s ability to surveil for broker-dealers, participants of a violations of the rule? registered clearing agency, or purchasers • In the 2004 Regulation SHO about their intention or ability to deliver Adopting Release, the Commission securities in time for settlement. Are stated that a broker-dealer could satisfy there other entities that could be the locate requirement of Regulation deceived about a seller’s intention or SHO by obtaining an assurance from a ability to deliver securities in time for customer that the customer can obtain securities from another identified source 43 The Commission would continue to monitor in time to settle the trade, provided the the effect of ‘‘naked’’ short selling practices to broker-dealer reasonably believes the determine whether additional rulemaking is customer’s assurance. Proposed Rule warranted. 44 Rule 203(c)(6) defines ‘‘threshold securities’’ as 10b–21 is aimed, in part, at sellers who ‘‘any equity security of an issuer that is registered make misrepresentations to their brokerpursuant to section 12 of the Exchange Act (15 dealers about their locate sources. U.S.C. 78l) or for which the issuer is required to file Should we instead no longer permit a reports pursuant to section 15(d) of the Exchange Act (15 U.S.C. 78o(d)).’’ 17 CFR 242.203(c)(6). broker-dealer to rely on such customer jlentini on PROD1PC65 with PROPOSALS3 customer’s fraud under the proposed rule. In addition, broker-dealers would remain subject to liability under Regulation SHO and the general antifraud provisions of the federal securities laws. Proposed Rule 10b–21 is narrowly tailored to apply when a seller, including a broker-dealer trading for its own account, deceives specified persons about its ability or intention to deliver securities in time for settlement, or about its locate source or ownership of shares and that fails to deliver securities by settlement date. While ‘‘naked’’ short selling as part of a manipulative scheme is already illegal under the general antifraud provisions of the federal securities laws, we believe that the proposed antifraud rule would highlight the specific liability of persons that deceive specified persons about their intention or ability to deliver securities in time for settlement, including persons that deceive their broker-dealer about their locate source or ownership of shares. Proposed Rule 10b–21 would also aid broker-dealers in complying with the locate requirement of Regulation SHO and, thereby, potentially reduce fails to deliver.43 VerDate Aug<31>2005 18:48 Mar 20, 2008 Jkt 214001 PO 00000 Frm 00006 Fmt 4701 Sfmt 4702 assurances in satisfying the locate requirement of Regulation SHO? What would be the costs and benefits of removing the ability of broker-dealers to rely on such customer assurances? What would be the impact on market participants (such as broker-dealers, stock lenders, investors)? Would smaller entities be affected more or less adversely than larger entities? • What procedures do broker-dealers currently have in place to assist in making the determination that there are reasonable grounds to believe that customers’ representations regarding a locate source are accurate? How do those procedures help to provide confidence regarding the accuracy of such representations? • What procedures do broker-dealers currently have in place to determine the accuracy of a seller’s representations that it owns the securities being sold and that the securities are reasonably expected to be in the broker-dealer’s physical possession or control by settlement? • Are there other types of transactions to which proposed Rule 10b–21 should not apply? • Are there any issues with respect to the application of the proposed rule in the context of the use of DMAs? If so, please explain. • Are there any issues with respect to the application of the proposed rule to trades submitted to, or effected on, electronic communications networks? • To what extent, if any, would the proposed rule encourage or result in fewer executing broker-dealers relying on customer assurances to satisfy the locate requirement of Regulation SHO? To what extent would such a result of the proposed rule impact prime brokerage relationships? Please explain. • Although the type of activity that would be illegal under the proposed rule is already prohibited by the general anti-fraud provisions of the federal securities laws, to what extent, if any, would the proposed rule impact liquidity and market quality in securities traded? Please explain. To what extent, if any, might the proposed rule result in short squeezes? What costs, if any, would the potential for short squeezes have on the efficiency of the market? • To what extent, if any, would the proposed rule induce short sellers to execute trades in overseas markets? IV. General Request for Comment The Commission seeks comment generally on all aspects of the proposed rule. Commenters are requested to provide empirical data to support their views and arguments related to E:\FR\FM\21MRP3.SGM 21MRP3 Federal Register / Vol. 73, No. 56 / Friday, March 21, 2008 / Proposed Rules proposed Rule 10b–21. In addition to the questions posed above, commenters are welcome to offer their views on any other matter raised by the proposed rule. With respect to any comments, we note that they are of the greatest assistance to our rulemaking initiative if accompanied by supporting data and analysis of the issues addressed in those comments and if accompanied by alternative suggestions to our proposals where appropriate. V. Paperwork Reduction Act Proposed Rule 10b–21 does not contain a ‘‘collection of information’’ requirement within the meaning of the Paperwork Reduction Act of 1995.45 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. VI. Consideration of Costs and Benefits of the Proposed Amendments The Commission is considering the costs and benefits of proposed Rule 10b–21. 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 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 rule. jlentini on PROD1PC65 with PROPOSALS3 A. Benefits Proposed Rule 10b–21 is intended to address abusive ‘‘naked’’ short selling and fails to deliver. The proposed rule is aimed at short sellers, including broker-dealers acting for their own accounts, who deceive broker-dealers, participants of a registered clearing agency, or purchasers about their intention or ability to deliver securities in time for settlement and that fail to deliver securities by settlement date. Among other things, proposed Rule 10b–21 would target short sellers who deceive their broker-dealers about their source of borrowable shares for purposes of complying with Regulation 45 44 U.S.C. 3501 et seq. VerDate Aug<31>2005 18:48 Mar 20, 2008 Jkt 214001 SHO’s ‘‘locate’’ requirement.46 The proposed rule would also apply to sellers who misrepresent to their brokerdealers that they own the shares being sold.47 A seller misrepresenting its short sale locate source or ownership of shares may intend to fail to deliver securities in time for settlement and, therefore, engage in abusive ‘‘naked’’ short selling. As noted above, although abusive ‘‘naked’’ short selling is not defined in the federal securities laws, it refers generally to selling short without having stock available for delivery and intentionally failing to deliver stock within the standard three-day settlement cycle.48 Such short selling may or may not be part of a scheme to manipulate the price of a security. Although ‘‘naked’’ short selling as part of a manipulative scheme is always illegal under the general anti-fraud provisions of the federal securities laws, including Rule 10b–5 under the Exchange Act,49 proposed Rule 10b–21 would highlight the specific liability of persons that deceive specified persons about their intention or ability to deliver securities in time for settlement, including persons that deceive their broker-dealer about their locate source or ownership of shares and that fail to deliver securities by settlement date. We believe that a rule specifying the illegality of these activities would focus the attention of market participants on such activities. The proposed rule would also highlight that the Commission believes such deceptive activities are detrimental to the markets and would provide a measure of predictability for market participants. All sellers of securities should promptly deliver, or arrange for delivery of, securities to the respective buyer and all buyers of securities have a right to expect prompt delivery of securities purchased. Thus, the proposal takes direct aim at an activity that may create fails to deliver. Those fails can have a negative effect on shareholders, potentially depriving them of the benefits of ownership, such as voting and lending. They also may create a misleading impression of the market for an issuer’s securities. As noted above, issuers and investors have expressed concerns about fails to deliver in connection with ‘‘naked’’ short selling. For example, in response to proposed amendments to Regulation SHO in 46 See 17 CFR 242.203(b)(1). Rule 10b–21. 48 See supra note 2. 49 17 CFR 240.10b–5. 47 Proposed PO 00000 Frm 00007 Fmt 4701 Sfmt 4702 15381 2006 50 designed to further reduce the number of persistent fails to deliver in certain equity securities by eliminating Regulation SHO’s ‘‘grandfather’’ provision, and limiting the duration of the rule’s options market maker exception, the Commission received a number of comments that expressed concerns about ‘‘naked’’ short selling and extended delivery failures.51 To the extent that 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,52 such fails to deliver may undermine the confidence of investors.53 These investors, in turn, may be reluctant to commit capital to an issuer they believe to be subject to such manipulative conduct.54 In addition, issuers may believe that they have suffered unwarranted reputational damage due to investors’ negative perceptions regarding fails to deliver in the issuer’s security.55 Any unwarranted reputational damage caused by fails to deliver might have an adverse impact on the security’s price.56 Thus, to the extent that fails to deliver might create a misleading impression of the market for an issuer’s securities, the proposed rule would benefit investors and issuers by taking direct aim at an activity that may create fails to deliver. In addition, to the extent that ‘‘naked’’ short selling and fails to deliver result in an unwarranted decline in investor confidence about a security, the proposed rule should improve investor confidence about the security. In addition, the proposed rule could lead to greater certainty in the settlement of securities which should strengthen investor confidence in that process. The proposed rule could result in broker-dealers having greater confidence that their customers have obtained a valid locate source and, therefore, that shares are available for delivery on settlement date. Thus, the proposed rule would aid broker-dealers in complying with the locate requirement of Regulation SHO and, thereby, potentially reduce fails to deliver. The proposed rule also may provide additional encouragement for broker50 See 2006 Regulation SHO Proposed Amendments. 51 See, e.g., letters from Overstock; TASER, Royce; Read; DeVivo; Akhtar. 52 See supra note 27. 53 See supra note 28. 54 See supra note 29. 55 See supra note 30 (discussing the fact that due to such concerns some 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 DTC or broker-dealers). 56 See supra note 31. E:\FR\FM\21MRP3.SGM 21MRP3 15382 Federal Register / Vol. 73, No. 56 / Friday, March 21, 2008 / Proposed Rules dealers to deliver shares by settlement date and, therefore, result in a reduction in fails to deliver. In addition, to the extent that sales of threshold securities do not result in fails to deliver, the proposed rule would reduce costs to broker-dealers because such brokerdealers would have to close out a lesser amount of fails to deliver under Regulation SHO’s close-out requirement.57 In addition, the proposed rule could help reduce manipulative schemes involving ‘‘naked’’ short selling. We solicit comment on any additional benefits that could be realized with the proposed rule, including both shortterm and long-term benefits. We solicit comment regarding benefits to market efficiency, pricing efficiency, market stability, market integrity and investor protection. jlentini on PROD1PC65 with PROPOSALS3 B. Costs As an aid in evaluating costs and reductions in costs associated with proposed Rule 10b–21, the Commission requests the public’s views and any supporting information. The proposed rule is intended to address abusive ‘‘naked’’ short selling by highlighting the liability of persons that deceive specified persons about their intention or ability to deliver securities in time for settlement, including persons that deceive their broker-dealer about their locate source or ownership of shares and that fail to deliver securities by settlement date. The Commission recognizes that the proposed rule might result in increased costs to broker-dealers to the extent that the proposed rule encourages or results in broker-dealers limiting the extent to which they rely on customer assurances in complying with the locate requirement of Regulation SHO. Because the failure to deliver securities by the date delivery is due is an element for a violation of the proposed rule, as a service to customers broker-dealers could feel an additional obligation to borrow or purchase securities to deliver on customer sales even though the broker-dealer did not enter into an arrangement with the customer to do so. The proposed rule could result in increased costs to customers who 57 Rule 203(b)(3)(iii) of Regulation SHO contains a close-out requirement that applies only to brokerdealers for securities in which a substantial amount of fails to deliver have occurred, also known as ‘‘threshold securities.’’ 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) system that has persisted for 13 consecutive settlement days by purchasing securities of like kind and quantity. VerDate Aug<31>2005 18:48 Mar 20, 2008 Jkt 214001 inadvertently fail to deliver securities because such customers, in an attempt to avoid liability under the proposed rule, might purchase or borrow securities to deliver on a sale at a time when, but for the proposed rule, the seller would have allowed the fail to deliver position to remain open. The Commission believes that the proposed rule would not compromise investor protection. We seek data, however, supporting any potential costs associated with the proposed rule. In addition, we request specific comment on any systems changes to computer hardware and software, or surveillance costs that might be necessary to implement the proposed rule. Specifically: • What would be the costs and benefits of the proposed rule? • Would the proposed rule create any costs associated with systems, surveillance, or recordkeeping modifications? Would these costs justify the benefits of better ensuring compliance with the federal securities laws? • How much would the proposed rule affect compliance costs for small, medium, and large broker-dealers (e.g., personnel or system changes)? We seek comment on the costs of compliance that may arise. VII. Consideration of Burden on Competition and Promotion of Efficiency, Competition, and Capital Formation Section 3(f) of the Exchange Act requires the Commission, whenever it engages in rulemaking and whenever it is required to consider or determine if an action is necessary or appropriate in the public interest, to consider whether the action would promote efficiency, competition, and capital formation.58 In addition, Section 23(a)(2) of the Exchange Act requires the Commission, when adopting rules under the Exchange Act, to consider the impact such rules would have on competition.59 Exchange Act Section 23(a)(2) prohibits the Commission from adopting any rule that would impose a burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. Proposed Rule 10b–21 is intended to address abusive ‘‘naked’’ short selling and fails to deliver. The proposed rule is aimed at short sellers, including broker-dealers acting for their own accounts, who deceive specified persons, such as a broker-dealer, about their intention or ability to deliver 58 15 59 15 PO 00000 U.S.C. 78c(f). U.S.C. 78w(a)(2). Frm 00008 Fmt 4701 Sfmt 4702 securities in time for settlement and fail to deliver securities by settlement date. Among other things, proposed Rule 10b–21 would target short sellers who deceive their broker-dealers about their source of borrowable shares for purposes of complying with Regulation SHO’s ‘‘locate’’ requirement.60 The proposed rule would also apply to sellers who misrepresent to their brokerdealers that they own the shares being sold.61 Although ‘‘naked’’ short selling as part of a manipulative scheme is always illegal under the general anti-fraud provisions of the federal securities laws, including Rule 10b–5 under the Exchange Act,62 proposed Rule 10b–21 would highlight the liability of persons that deceive specified persons about their intention or ability to deliver securities in time for settlement, including persons that deceive their broker-dealer about their locate source or ownership of shares and that fail to deliver securities by settlement date. We believe that a rule highlighting the illegality of these activities would focus the attention of market participants on such activities. The proposed rule would also provide a measure of predictability for market participants. We believe proposed Rule 10b–21 would have minimal impact on the promotion of price efficiency. We seek comment regarding whether proposed Rule 10b–21 may adversely impact liquidity, disrupt markets, or unnecessarily increase risks or costs to customers. In addition, we believe that the proposed rule would have minimal impact on the promotion of capital formation. The perception that abusive ‘‘naked’’ short selling is occurring in certain securities can undermine the confidence of investors. These investors, in turn, may be reluctant to commit capital to an issuer they believe to be subject to such manipulative conduct. We believe that any such effect on capital formation is limited by the relatively few securities from corporate issuers that persist on the Regulation SHO threshold list 63 and the fact that this persistence does not necessarily indicate abusive ‘‘naked’’ short selling 60 See 17 CFR 242.203(b)(1). Rule 10b–21. 62 17 CFR 240.10b–5. 63 On an average day over a nine month period from May 1, 2007 to January 31, 2008, approximately 50 securities had persisted on the threshold list for more than 17 days and had fails to deliver of 10,000 shares or more. However, the majority of these securities are exchange traded funds which suggests that only a small number of corporate issuers are potentially affected. 61 Proposed E:\FR\FM\21MRP3.SGM 21MRP3 Federal Register / Vol. 73, No. 56 / Friday, March 21, 2008 / Proposed Rules or a deleterious effect on the cost of capital for the issuer. In the 2006 Proposing Release, we sought comment on whether the proposed amendments to Regulation SHO would promote capital formation, including whether the proposed increased short sale restrictions would affect investors’ decisions to invest in certain equity securities. In response, commenters expressed concern about the potential impact of ‘‘naked’’ short selling on capital formation claiming that ‘‘naked’’ short selling causes a drop in an issuer’s stock price that may limit the issuer’s ability to access the capital markets.64 Thus, to the extent that ‘‘naked’’ short selling and fails to deliver result in an unwarranted decline in investor confidence about a security, the proposed rule should improve investor confidence about the security. We note, however, that persistent fails to deliver exist in only a small number of securities and may be a signal of overvaluation rather than undervaluation of a security’s price.65 In addition, we believe that the proposed rule could lead to greater certainty in the settlement of securities which should strengthen investor confidence in the settlement process. We also believe that proposed Rule 10b–21 would not impose any burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. By specifying that abusive ‘‘naked’’ short selling is a fraud, the Commission believes the proposed rule would promote competition by providing the industry with guidance regarding the liability of sellers that deceive specified persons about their intention or ability to deliver securities in time for settlement, including persons that deceive their broker-dealer about their locate sources or share ownership and that fail to deliver securities by settlement date. The Commission requests specific comment on whether the proposed rule would promote efficiency, competition, and capital formation. VIII. Consideration of Impact on the Economy jlentini on PROD1PC65 with PROPOSALS3 For purposes of the Small Business Regulatory Enforcement Fairness Act of 64 See, e.g., letter from Feeney. fails to deliver may be symptomatic of an inadequate supply of shares in the equity lending market. If short sellers are unable to short sell due to their inability to borrow shares, their opinions about the fundamental value of the security may not be fully reflected in a security’s price, which may lead to overvaluation. 65 Persistent VerDate Aug<31>2005 18:48 Mar 20, 2008 Jkt 214001 1996, or ‘‘SBREFA,’’ 66 we must advise the Office of Management and Budget as to whether the proposed regulation constitutes a ‘‘major’’ rule. Under SBREFA, a rule is considered ‘‘major’’ where, if adopted, it results or is likely to result in: • An annual effect on the economy of $100 million or more (either in the form of an increase or a decrease); • A major increase in costs or prices for consumers or individual industries; or • Significant adverse effect on competition, investment or innovation. If a rule is ‘‘major,’’ its effectiveness will generally be delayed for 60 days pending Congressional review. We request comment on the potential impact of the proposed rule on the economy on an annual basis. Commenters are requested to provide empirical data and other factual support for their view to the extent possible. IX. Initial Regulatory Flexibility Analysis The Commission has prepared an Initial Regulatory Flexibility Analysis (‘‘IRFA’’), in accordance with the provisions of the Regulatory Flexibility Act (‘‘RFA’’),67 regarding the proposed rule. A. Reasons for the Proposed Action Proposed Rule 10b–21 is intended to address fails to deliver associated with abusive ‘‘naked’’ short selling. While ‘‘naked’’ short selling as part of a manipulative scheme is already illegal under the general anti-fraud provisions of the federal securities laws, proposed Rule 10b–21 would specify that it is a fraud for any person to submit an order to sell a security if such person deceives a broker-dealer, participant of a registered clearing agency, or purchaser about its intention or ability to deliver securities on the date delivery is due and such person fails to deliver securities on or before the date delivery is due. Thus, the proposed rule would highlight the liability of persons that deceive specified persons about their intention or ability to deliver securities in time for settlement, including persons that deceive their broker-dealer about their locate source or ownership of shares. B. Objectives Proposed Rule 10b–21 is aimed at short sellers, including broker-dealers acting for their own accounts, who deceive specified persons, such as a 66 Pub. L. No. 104–121, Title II, 110 Stat. 857 (1996) (codified in various sections of 5 U.S.C., 15 U.S.C. and as a note to 5 U.S.C. 601). 67 5 U.S.C. 603. PO 00000 Frm 00009 Fmt 4701 Sfmt 4702 15383 broker or dealer, about their intention or ability to deliver securities in time for settlement and that fail to deliver securities by settlement date. We believe that a rule highlighting the illegality of these activities would focus the attention of market participants on such activities. The proposed rule would also underscore that the Commission believes such deceptive activities are detrimental to the markets and would provide a measure of predictability for market participants. All sellers of securities should promptly deliver, or arrange for delivery of, securities to the respective buyer and all buyers of securities have a right to expect prompt delivery of securities purchased. Thus, the proposal takes direct aim at an activity that may create fails to deliver. Those fails can have a negative effect on shareholders, potentially depriving them of the benefits of ownership, such as voting and lending. They also may create a misleading impression of the market for an issuer’s securities. Proposed Rule 10b–21 would also aid broker-dealers in complying with the locate requirement of Regulation SHO and, thereby, potentially reduce fails to deliver. In addition, the proposed rule could help reduce manipulative schemes involving ‘‘naked’’ short selling. C. Legal Basis Pursuant to the Exchange Act and, particularly, Sections 2, 3(b), 6, 9(h), 10, 11A, 15, 15A, 17, 17A, 19 and 23(a) thereof, 15 U.S.C. 78b, 78c(b), 78f, 78i(h), 78j, 78k–1, 78o, 78o–3, 78q, 78q– 1, 78s and 78w(a), the Commission is proposing a new anti-fraud rule, Rule 10b–21, to address fails to deliver associated with abusive ‘‘naked’’ short selling. D. Small Entities Subject to the Rule The entities covered by the proposed rule would include small brokerdealers, small businesses, and any investor who effects a short sale that qualifies as a small entity. Although it is impossible to quantify every type of small entity that may be able to effect a short sale in a security, Paragraph (c)(1) of Rule 0–10 under the Exchange Act 68 states that the term ‘‘small business’’ or ‘‘small organization,’’ when referring to a broker-dealer, means a broker or dealer that had total capital (net worth plus subordinated liabilities) of less than $500,000 on the date in the prior fiscal year as of which its audited financial statements were prepared pursuant to § 240.17a–5(d); and is not affiliated with any person (other than a 68 17 E:\FR\FM\21MRP3.SGM CFR 240.0–10(c)(1). 21MRP3 15384 Federal Register / Vol. 73, No. 56 / Friday, March 21, 2008 / Proposed Rules natural person) that is not a small business or small organization. As of 2006, the Commission estimates that there were approximately 894 brokerdealers that qualified as small entities as defined above.69 Any business, however, regardless of industry, could be subject to the proposed amendments if it effects a short or long sale. The Commission believes that, except for the brokerdealers discussed above, an estimate of the number of small entities that fall under the proposed rule is not feasible. jlentini on PROD1PC65 with PROPOSALS3 E. Reporting, Recordkeeping, and Other Compliance Requirements The proposed rule is intended to address abusive ‘‘naked’’ short selling by highlighting the liability of persons that deceive specified persons about their intention or ability to deliver securities in time for settlement, including persons that deceive their broker-dealer about their locate source or ownership of shares and that fail to deliver securities by settlement date. The Commission believes that the proposed rule could impose new or additional reporting, recordkeeping, or compliance costs on any affected party, including broker-dealers, that are small entities. To comply with Regulation SHO, small broker-dealers needed to modify their systems and surveillance mechanisms to comply with Regulation SHO’s locate, marking and delivery requirements. Thus, any systems and surveillance mechanisms necessary for broker-dealers to comply with the proposed rule should already be in place. We believe that any necessary additional systems and surveillance changes, in particular changes by sellers who are not broker-dealers, would be similar to the changes incurred by broker-dealers when Regulation SHO was implemented. We solicit comment on what new recordkeeping, reporting or compliance requirements may arise as a result of this proposed rule. F. Duplicative, Overlapping or Conflicting Federal Rules The Commission believes that there are no federal rules that duplicate or conflict with the proposed rule. ‘‘Naked’’ short selling as part of a manipulative scheme is always illegal under the general anti-fraud provisions of the federal securities laws, including Rule 10b–5 under the Exchange Act,70 69 These numbers are based on OEA’s review of 2006 FOCUS Report filings reflecting registered broker-dealers. This number does not include broker-dealers that are delinquent on FOCUS Report filings. 70 17 CFR 240.10b–5. VerDate Aug<31>2005 18:48 Mar 20, 2008 Jkt 214001 and, therefore, overlap to a certain extent with the proposed rule. Proposed Rule 10b–21 would highlight the specific liability of persons that deceive specified persons about their intention or ability to deliver securities in time for settlement, including persons that deceive their broker-dealer about their locate source or ownership of shares and that fail to deliver securities by settlement date. We believe that a rule highlighting the illegality of these activities would focus the attention of market participants on such activities. The proposed rule would also highlight that the Commission believes such deceptive activities are detrimental to the markets and would provide a measure of predictability for market participants. G. Significant Alternatives The RFA directs the Commission to consider significant alternatives that would accomplish the stated objective, while minimizing any significant adverse impact on small entities. Pursuant to Section 3(a) of the RFA,71 the Commission must consider the following types of alternatives: (a) The establishment of differing compliance or reporting requirements or timetables that take into account the resources available to small entities; (b) the clarification, consolidation, or simplification of compliance and reporting requirements under the rule for small entities; (c) the use of performance rather than design standards; and (d) an exemption from coverage of the rule, or any part thereof, for small entities. A primary goal of proposed Rule 10b– 21 is to address abusive ‘‘naked’’ short selling. While ‘‘naked’’ short selling as part of a manipulative scheme is always illegal under the general anti-fraud provisions of the federal securities laws, Rule 10b–21 would specify that it is a fraud for any person to submit an order to sell a security if such person deceives a broker-dealer, participant of a registered clearing agency, or purchaser about its intention or ability to deliver the security on the date delivery is due and such person fails to deliver the security on or before the date delivery is due. The proposed rule is aimed at short sellers, including broker-dealers acting for their own accounts, who deceive specified persons, such as a broker or dealer, about their intention or ability to deliver securities in time for settlement and who do not deliver securities by settlement date. Among other things, proposed Rule 10b–21 would target short sellers who deceive 71 5 PO 00000 U.S.C. 603(c). Frm 00010 Fmt 4701 their broker-dealers about their source of borrowable shares for purposes of complying with Regulation SHO’s ‘‘locate’’ requirement.72 The proposed rule would also apply to sellers who misrepresent to their broker-dealers that they own the shares being sold. We believe that imposing different compliance requirements, and possibly a different timetable for implementing compliance requirements, for small entities would undermine the Commission’s goal of addressing abusive ‘‘naked’’ short selling and fails to deliver. In addition, we have concluded similarly that it would not be consistent with the primary goal of the proposed rule to further clarify, consolidate, or simplify the proposed rule for small entities. Finally, the proposed rule would impose performance standards rather than design standards. H. Request for Comments The Commission encourages the submission of written comments with respect to any aspect of the IRFA. In particular, the Commission seeks comment on (i) the number of small entities that will be affected by the proposed rule; and (ii) the existence or nature of the potential impact of the proposed rule on small entities. Those comments should specify costs of compliance with the proposed rule, and suggest alternatives that would accomplish the objective of the proposed rule. X. Statutory Authority Pursuant to the Exchange Act and, particularly, Sections 2, 3(b), 6, 9(h), 10, 11A, 15, 15A, 17, 17A, 19 and 23(a) thereof, 15 U.S.C. 78b, 78c(b), 78f, 78i(h), 78j, 78k–1, 78o, 78o–3, 78q, 78q– 1, 78s and 78w(a), the Commission is proposing a new anti-fraud rule, Rule 10b–21, to address abusive ‘‘naked’’ short selling. List of Subjects in 17 CFR Part 240 Brokers, Fraud, Reporting and recordkeeping requirements, Securities. Text of the Proposed Rule Amendments For the reasons set out in the preamble, Title 17, Chapter II, of the Code of Federal Regulations is proposed to be amended as follows. PART 240—GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934 1. The authority citation for part 240 continues to read, in part, as follows: 72 See Sfmt 4702 E:\FR\FM\21MRP3.SGM 17 CFR 242.203(b)(1). 21MRP3 Federal Register / Vol. 73, No. 56 / Friday, March 21, 2008 / Proposed Rules Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z–2, 77z–3, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 78j, 78j–1, 78k, 78k–1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u–5, 78w, 78x, 78ll, 78mm, 80a– 20, 80a–23, 80a–29, 80a–37, 80b–3, 80b–4, 80b–11, and 7201 et seq.; and 18 U.S.C. 1350, unless otherwise noted. jlentini on PROD1PC65 with PROPOSALS3 2. Add § 240.10b–21 to read as follows: VerDate Aug<31>2005 18:48 Mar 20, 2008 Jkt 214001 15385 § 240.10b–21 Deception in connection with a seller’s ability or intent to deliver securities on the date delivery is due. It shall constitute a ‘‘manipulative or deceptive device or contrivance’’ as used in section 10(b) of this Act for any person to submit an order to sell a security if such person deceives a broker or dealer, a participant of a registered clearing agency, or a purchaser about its intention or ability to deliver the security on the date delivery is due, and such person fails to deliver the security on or before the date delivery is due. By the Commission. Dated: March 17, 2008. Florence E. Harmon, Deputy Secretary. [FR Doc. E8–5697 Filed 3–20–08; 8:45 am] PO 00000 Frm 00011 Fmt 4701 Sfmt 4702 BILLING CODE 8011–01–P E:\FR\FM\21MRP3.SGM 21MRP3

Agencies

[Federal Register Volume 73, Number 56 (Friday, March 21, 2008)]
[Proposed Rules]
[Pages 15376-15385]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-5697]



[[Page 15375]]

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Part IV





Securities and Exchange Commission





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17 CFR Part 240



Naked Short Selling Anti-Fraud Rule; Proposed Rule

Federal Register / Vol. 73, No. 56 / Friday, March 21, 2008 / 
Proposed Rules

[[Page 15376]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-57511; File No. S7-08-08]
RIN 3235-AK06


``Naked'' Short Selling Anti-Fraud Rule

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
proposing an anti-fraud rule under the Securities Exchange Act of 1934 
(``Exchange Act'') to address fails to deliver securities that have 
been associated with ``naked'' short selling. The proposed rule is 
intended to highlight the liability of persons that deceive specified 
persons about their intention or ability to deliver securities in time 
for settlement, including persons that deceive their broker-dealer 
about their locate source or ownership of shares and that fail to 
deliver securities by settlement date.

DATES: Comments should be received on or before May 20, 2008.

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

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number S7-08-08 on the subject line; or
     Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number S7-08-08. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments 
are also available for public inspection and copying in the 
Commission's Public Reference Room, 100 F Street, NE., Washington, DC 
20549, on official business days between the hours of 10 a.m. and 3 
p.m. 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, Joan M. Collopy, Special Counsel, Todd E. Freier and 
Christina M. Adams, Staff Attorneys, Office of Trading Practices and 
Processing, Division of Trading and Markets, 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 Rule 10b-21 under the Exchange Act.

I. Introduction

    The Commission is proposing an anti-fraud rule, Rule 10b-21, aimed 
at short sellers, including broker-dealers acting for their own 
accounts, who deceive specified persons, such as a broker or dealer, 
about their intention or ability to deliver securities in time for 
settlement and that fail to deliver securities by settlement date. 
Among other things, proposed Rule 10b-21 would target short sellers who 
deceive their broker-dealers about their source of borrowable shares 
for purposes of complying with Regulation SHO's ``locate'' 
requirement.\1\ The proposed rule would also apply to sellers who 
misrepresent to their broker-dealers that they own the shares being 
sold.
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    \1\ See 17 CFR 242.203(b)(1).
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    A seller misrepresenting its short sale locate source or ownership 
of shares may intend to fail to deliver securities in time for 
settlement and, therefore, engage in abusive ``naked'' short selling. 
Although abusive ``naked'' short selling is not defined in the federal 
securities laws, it refers generally to selling short without having 
stock available for delivery and intentionally failing to deliver stock 
within the standard three-day settlement cycle.\2\
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    \2\ See Exchange Act Release No. 56212 (Aug. 7, 2007), 72 FR 
45544 (Aug. 14, 2007) (``2007 Regulation SHO Amendments''); Exchange 
Act Release No. 54154 (July 14, 2006), 71 FR 41710 (July 21, 2006) 
(``2006 Regulation SHO Proposed Amendments'').
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    Although abusive ``naked'' short selling as part of a manipulative 
scheme is always illegal under the general anti-fraud provisions of the 
federal securities laws, including Rule 10b-5 under the Exchange 
Act,\3\ proposed Rule 10b-21 would highlight the specific liability of 
persons that deceive specified persons about their intention or ability 
to deliver securities in time for settlement, including persons that 
deceive their broker-dealer about their locate source or ownership of 
shares.\4\ We believe that a rule highlighting the illegality of these 
activities would focus the attention of market participants on such 
activities. The proposed rule would also highlight that the Commission 
believes such deceptive activities are detrimental to the markets and 
would provide a measure of predictability for market participants.
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    \3\ 17 CFR 240.10b-5.
    \4\ This conduct is also in violation of other provisions of the 
federal securities laws, including the anti-fraud provisions.
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    All sellers of securities should promptly deliver, or arrange for 
delivery of, securities to the respective buyer and all buyers of 
securities have a right to expect prompt delivery of securities 
purchased. Thus, the proposal takes direct aim at an activity that may 
create fails to deliver. Those fails can have a negative effect on 
shareholders, potentially depriving them of the benefits of ownership, 
such as voting and lending. They also may create a misleading 
impression of the market for an issuer's securities. Proposed Rule 10b-
21 would also aid broker-dealers in complying with the locate 
requirement of Regulation SHO and, thereby, potentially reduce fails to 
deliver. In addition, the proposed rule could help reduce manipulative 
schemes involving ``naked'' short selling.

II. Background

A. Regulation SHO

    Short selling involves a sale of a security that the seller does 
not own and that is consummated by the delivery of a security borrowed 
by or on behalf of the seller.\5\ In a ``naked'' short sale, a seller 
does not borrow or arrange to borrow securities in time to make 
delivery to the buyer within the standard three-day settlement 
period.\6\ As a result, the seller fails to deliver securities to the 
buyer when delivery is due (known as a ``fail'' or ``fail to 
deliver'').\7\ Sellers sometimes

[[Page 15377]]

intentionally fail to deliver securities as part of a scheme to 
manipulate the price of a security,\8\ or possibly to avoid borrowing 
costs associated with short sales.
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    \5\ 17 CFR 242.200(a).
    \6\ See Exchange Act Release No. 50103 (July 28, 2004), 69 FR 
48008 (Aug. 6, 2004) (``2004 Regulation SHO Adopting Release'') 
(stating that ``naked'' short selling generally refers to selling 
short without having borrowed the securities to make delivery).
    \7\ Generally, investors 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 
generally is received by its brokerage firm no later than three 
business days after the trade is executed. When the investor sells a 
security, the seller generally delivers 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. In addition, Rule 15c6-1 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; Exchange 
Act Release No. 33023 (Oct. 7, 1993), 58 FR 52891 (Oct. 13, 1993). 
However, failure to deliver securities on T+3 does not violate Rule 
15c6-1.
    \8\ In 2003, the Commission settled a case against certain 
parties relating to allegations of manipulative short selling in the 
stock of a corporation. The Commission alleged that the defendants 
profited from engaging in massive naked short selling that flooded 
the market with the 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) (Feb. 26, 2003).
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    Although the majority of trades settle within the standard three-
day settlement period,\9\ the Commission adopted Regulation SHO \10\ in 
part to address problems associated with persistent fails to deliver 
securities and potentially abusive ``naked'' short selling.\11\ Rule 
203 of Regulation SHO, in particular, contains a ``locate'' requirement 
that provides that, ``[a] broker or dealer may not accept a short sale 
order in an equity security from another person, or effect a short sale 
in an equity security for its own account, unless the broker or dealer 
has: (1) Borrowed the security, or entered into a bona-fide arrangement 
to borrow the security; or (2) Reasonable grounds to believe that the 
security can be borrowed so that it can be delivered on the date 
delivery is due; and (3) Documented compliance with this paragraph 
(b)(1).'' \12\ In the 2004 Regulation SHO Adopting Release, the 
Commission explicitly permitted broker-dealers to rely on customer 
assurances that the customer has identified its own source of 
borrowable securities, provided it is reasonable for the broker-dealer 
to do so.\13\ We are concerned, however, that some short sellers may 
have been deliberately misrepresenting to broker-dealers that they have 
obtained a legitimate locate source.\14\
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    \9\ According to the NSCC, 99% (by dollar value) of all trades 
settle within T+3. Thus, on an average day, approximately 1% (by 
dollar value) of all trades, including equity, debt, and municipal 
securities fail to settle on time. The vast majority of these fails 
are closed out within five days after T+3. In addition, fails to 
deliver may arise from either short sales or long sales of 
securities. There may be legitimate reasons for a fail to deliver. 
For example, human or mechanical errors or processing delays can 
result from transferring securities in custodial or other form 
rather than book-entry form, thus causing a fail to deliver on a 
long sale within the normal three-day settlement period. The 
Commission's Office of Economic Analysis (``OEA'') estimates that, 
on an average day between May 1, 2007 and January 31, 2008, trades 
in ``threshold securities,'' as defined in Rule 203(b)(c)(6) of 
Regulation SHO, that fail to settle within T+3 account for 
approximately 0.6% of dollar value of trading in all securities.
    \10\ 17 CFR 242.200. Regulation SHO became effective on January 
3, 2005.
    \11\ See 2007 Regulation SHO Amendments, 72 FR at 45544 (stating 
that ``[a]mong other things, Regulation SHO imposes a close-out 
requirement to address persistent failures to deliver stock on trade 
settlement date and to target potentially abusive ``naked'' short 
selling in certain equity securities'').
    \12\ 17 CFR 242.203(b). Market makers engaged in bona fide 
market making in the security at the time they effect the short sale 
are excepted from this requirement.
    \13\ See 2004 Regulation SHO Adopting Release, 69 FR at 48014.
    \14\ See, e.g., Sandell Asset Management Corp., Lars Eric Thomas 
Sandell, Patrick T. Burke and Richard F. Ecklord, Securities Act 
Release No. 8857 (Oct. 10, 2007) (settled order).
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    In addition, we are concerned that some short sellers may have made 
misrepresentations to their broker-dealers about their ownership of 
shares as an end run around Regulation SHO's locate requirement.\15\ 
Some sellers have also misrepresented that their sales are long sales 
in order to circumvent Rule 105 of Regulation M,\16\ which prohibits 
certain short sellers from purchasing securities in a secondary or 
follow-on offering.\17\ Under Rule 200(g)(1) of Regulation SHO, ``[a]n 
order to sell shall be marked ``long'' only if the seller is deemed to 
own the security being sold pursuant to paragraphs (a) through (f) of 
this section \18\ and either: (i) The security to be delivered is in 
the physical possession or control of the broker or dealer; or (ii) it 
is reasonably expected that the security will be in the physical 
possession or control of the broker or dealer no later than the 
settlement of the transaction.'' \19\
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    \15\ See id.
    \16\ 17 CFR 242.105.
    \17\ See Goldman Sachs Execution and Clearing L.P., Exchange Act 
Release No. 55465 (Mar. 14, 2007) (settled order).
    \18\ Rule 200(b) of Regulation SHO provides that a seller is 
deemed to own a security if, ``(1) The person or his agent has title 
to it; or (2) The person has purchased, or has entered into an 
unconditional contract, binding on both parties thereto, to purchase 
it, but has not yet received it; or (3) The person owns a security 
convertible into or exchangeable for it and has tendered such 
security for conversion or exchange; or (4) The person has an option 
to purchase or acquire it and has exercised such option; or (5) The 
person has rights or warrants to subscribe to it and has exercised 
such rights or warrants; or (6) The person holds a security futures 
contract to purchase it and has received notice that the position 
will be physically settled and is irrevocably bound to receive the 
underlying security.''
    \19\ 17 CFR 242.200(g)(1).
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    Under Regulation SHO, the executing or order-entry broker-dealer is 
responsible for determining whether there are reasonable grounds to 
believe that a security can be borrowed so that it can be delivered on 
the date delivery is due on a short sale, and whether a seller owns the 
security being sold and can reasonably expect that the security will be 
in the physical possession or control of the broker-dealer no later 
than settlement date for a long sale. However, a broker-dealer relying 
on a customer that makes misrepresentations about its locate source or 
ownership of shares may not receive shares when delivery is due. For 
example, sellers may be making misrepresentations to their broker-
dealers about their locate sources or ownership of shares for 
securities that are very difficult or expensive to borrow. Such sellers 
may know that they cannot deliver securities by settlement date due to, 
for example, a limited number of shares being available to borrow or 
purchase, or they may not intend to obtain shares for timely delivery 
because the cost of borrowing or purchasing may be high. This result 
undermines the Commission's goal of addressing concerns related to 
``naked'' short selling and extended fails to deliver.

B. Concerns About ``Naked'' Short Selling

    We are concerned about persons that sell short securities and 
deceive specified persons about their intention or ability to deliver 
the securities in time for settlement, or deceive their broker-dealer 
about their locate source or ownership of shares, or otherwise engage 
in abusive ``naked'' short selling. Commission enforcement actions have 
contributed to our concerns about the extent of misrepresentations by 
short sellers about their locate sources and ownership of shares. For 
example, the Commission recently announced a settled enforcement action 
against hedge fund adviser Sandell Asset Management Corp. (``SAM''), 
its chief executive officer, and two employees in connection with 
allegedly (i) improperly marking some short sale orders ``long'' and 
(ii) misrepresenting to executing brokers that SAM personnel had 
located sufficient stock to borrow for short sale orders.\20\
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    \20\ See Sandell Asset Management Corp., Securities Act Release 
No. 8857; see also Goldman Sachs Execution and Clearing L.P., 
Exchange Act Release No. 55465; U.S. v. Naftalin, 441 U.S. 768 
(1979) (discussing a market manipulation scheme in which brokers 
suffered substantial losses when they had to purchase securities to 
replace securities they had borrowed to make delivery on short sale 
orders received from an individual investor who had falsely 
represented to the brokers that he owned the securities being sold).

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[[Page 15378]]

    As we have stated previously, we are concerned that fails to 
deliver may have a negative effect on the market and shareholders.\21\ 
For example, fails to deliver may deprive shareholders of the benefits 
of ownership, such as voting and lending.\22\ 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 three-day settlement period) into an 
undated futures-type contract, to which the buyer might not have 
agreed, or that might have been priced differently.\23\ Moreover, 
sellers that fail to deliver securities on settlement date may be 
subject to fewer restrictions than sellers that are required to deliver 
the securities by settlement date, 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.\24\ For 
example, by not borrowing securities and, therefore, not making 
delivery within the standard three-day settlement period, the seller 
does not incur the costs of borrowing.
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    \21\ See 2007 Regulation SHO Amendments, 72 FR at 45544; 2006 
Regulation SHO Proposed Amendments, 71 FR at 41712; Exchange Act 
Release No. 56213 (Aug. 7, 2007), 72 FR 45558, 45558-45559 (Aug. 14, 
2007) (``2007 Regulation SHO Proposed Amendments'').
    \22\ See id.
    \23\ See id.
    \24\ See id.
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    In addition, issuers and investors have expressed concerns about 
fails to deliver in connection with ``naked'' short selling. For 
example, in response to proposed amendments to Regulation SHO in 2006 
\25\ designed to further reduce the number of persistent fails to 
deliver in certain equity securities by eliminating Regulation SHO's 
``grandfather'' provision, and limiting the duration of the rule's 
options market maker exception, the Commission received a number of 
comments that expressed concerns about ``naked'' short selling and 
extended delivery failures.\26\
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    \25\ See 2006 Regulation SHO Proposed Amendments.
    \26\ 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 (``Royce''); letter from Michael Read, dated April 
29, 2007 (``Read''); letter from Robert DeVivo, dated April 26, 2007 
(``DeVivo''); letter from Ahmed Akhtar, dated April 26, 2007 
(``Akhtar'').
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    To the extent that 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,\27\ such fails to deliver may 
undermine the confidence of investors.\28\ These investors, in turn, 
may be reluctant to commit capital to an issuer they believe to be 
subject to such manipulative conduct.\29\ In addition, issuers may 
believe that they have suffered unwarranted reputational damage due to 
investors' negative perceptions regarding fails to deliver in the 
issuer's security.\30\ Any unwarranted reputational damage caused by 
fails to deliver might have an adverse impact on the security's 
price.\31\
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    \27\ See supra, note 8 (discussing a case in which the 
Commission alleged that the defendants profited from engaging in 
massive naked short selling that flooded the market with the 
company's stock, and depressed its price); see also S.E.C. v. 
Gardiner, 48 S.E.C. Docket 811, No. 91 Civ. 2091 (S.D.N.Y. March 27, 
1991) (alleged manipulation by sales representative by directing or 
inducing customers to sell stock short in order to depress its 
price); U.S. v. Russo, 74 F.3d 1383, 1392 (2d Cir. 1996) (short 
sales were sufficiently connected to the manipulation scheme as to 
constitute a violation of Exchange Act Section 10(b) and Rule 10b-
5).
    \28\ In response to the 2006 Regulation SHO Proposed Amendments, 
the Commission received comment letters discussing the impact of 
fails to deliver on investor confidence. 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 (``Blumenthal'').
    \29\ In response to the 2006 Regulation SHO Proposed Amendments, 
the Commission received comment letters 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. See, e.g., letter from Congressman Tom Feeney--Florida, 
U.S. House of Representatives, dated Sept. 25, 2006 (``Feeney''); 
see also 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.'').
    \30\ Due in part to such concerns, some 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. See Exchange Act Release No. 48709 
(Oct. 28, 2003), 68 FR 62972, at 62975 (Nov. 6, 2003). Some 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. See id. Withdrawing securities from DTC 
or requiring custody-only transfers would undermine the goal of a 
national clearance and settlement system, designed to reduce the 
physical movement of certificates in the trading markets. See id. 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).
    \31\ See also 2006 Regulation SHO Proposed Amendments, 71 FR at 
41712; 2007 Regulation SHO Amendments, 72 FR at 45544; 2007 
Regulation SHO Proposed Amendments, 72 FR at 45558-45559 (providing 
additional discussion of the impact of fails to deliver on the 
market); see also Exchange Act Release No. 48709 (Oct. 28, 2003), 68 
FR 62972, 62975 (Nov. 6, 2003) (``2003 Regulation SHO Proposing 
Release'') (discussing the impact of ``naked'' short selling on the 
market).
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III. Discussion of Proposed Rule

A. Proposed Anti-Fraud Rule

    To further address potentially abusive ``naked'' short selling and 
fails to deliver, we are proposing a narrowly-tailored rule, Rule 10b-
21, which would specify that it is unlawful for any person to submit an 
order to sell a security if such person deceives a broker-dealer, 
participant of a registered clearing agency, or purchaser \32\ 
regarding its intention or ability to deliver the security on the date 
delivery is due, and such person fails to deliver the security on or 
before the date delivery is due.\33\ Scienter would be a necessary 
element for a violation of the proposed rule.\34\
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    \32\ 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.
    \33\ Proposed Rule 10b-21.
    \34\ Ernst & Ernst v. Hochfelder, et. al., 425 U.S. 185 (1976). 
Scienter has been defined as ``a mental state embracing the intent 
to deceive, manipulate or defraud.'' Id. at 193, n.12. While the 
Supreme Court has not decided the issue (see Aaron v. SEC, 446 U.S. 
686 (1980); Ernst & Ernst, 425 at 193 n.12), federal appellate 
courts have concluded that scienter may be established by a showing 
of either knowing conduct or by ``an `extreme departure from the 
standards of ordinary care * * * which presents a danger of 
misleading buyers or sellers that is either known to the defendant 
or is so obvious that the actor must have been aware of it.' '' 
Dolphin & Bradbury v. SEC, 512 F.3d 634 (D.C. Cir. Jan. 11, 2008) 
(quoting Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 
(7th Cir. 1977)).
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    The proposed rule would cover those situations where a seller 
deceives a broker-dealer, participant of a registered clearing agency, 
or a purchaser about its intention to deliver securities by settlement 
date, its locate source, or its share ownership, and the seller fails 
to deliver securities by settlement date. Proposed Rule 10b-21 would 
apply to the deception of persons participating in the transaction--
broker-dealers, participants of registered clearing agencies, or 
purchasers. Further, because one of the principal goals of proposed 
Rule 10b-21 is to reduce fails

[[Page 15379]]

to deliver, violation of the proposed rule would occur only if a fail 
to deliver results from the relevant transaction.
    For purposes of the proposed rule, broker-dealers (including market 
makers) acting for their own accounts would be considered sellers. For 
example, a broker-dealer effecting short sales for its own account 
would be liable under the rule if it does not obtain a valid locate 
source and fails to deliver securities to the purchaser. Such broker-
dealers defraud purchasers that may not receive delivery on time, in 
effect unilaterally forcing the purchaser into accepting an undated 
futures-type contract.\35\
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    \35\ See 2007 Regulation SHO Amendments, 72 FR at 45544; 2006 
Regulation SHO Proposed Amendments, 71 FR at 41712; 2007 Regulation 
SHO Proposed Amendments, 72 FR at 45558-45559.
---------------------------------------------------------------------------

    As noted above, under Regulation SHO, the executing or order-entry 
broker-dealer is responsible for determining whether there are 
reasonable grounds to believe that a security can be borrowed so that 
it can be delivered on the date delivery is due on a short sale.\36\ In 
the 2004 Regulation SHO Adopting Release, the Commission explicitly 
permitted broker-dealers to rely on customer assurances that the 
customer has identified its own locate source, provided it is 
reasonable for the broker-dealer to do so.\37\ If a seller elects to 
provide its own locate source to a broker-dealer, the seller is 
representing that it has contacted that source and reasonably believes 
that the source can or intends to deliver the full amount of the 
securities to be sold short by settlement date. In addition, if a 
seller enters a short sale order into a broker-dealer's direct market 
access or sponsored access system (``DMA'') with any information 
purporting to identify a locate source obtained by the seller, the 
seller would be making a representation to a broker-dealer for purposes 
of proposed Rule 10b-21.\38\
---------------------------------------------------------------------------

    \36\ See 17 CFR 242.203(b)(3)(1).
    \37\ See 2004 Regulation SHO Adopting Release, 69 FR at 48014.
    \38\ Broker-dealers may offer DMA to customers by providing them 
with electronic access to a market's execution system using the 
broker-dealer's market participant identifier. The broker-dealer, 
however, retains the ultimate responsibility for the trading 
activity of its customer.
---------------------------------------------------------------------------

    If a seller deceives a broker-dealer about the validity of its 
locate source, the seller would be liable under proposed Rule 10b-21 if 
the seller also fails to deliver securities by the date delivery is 
due. For example, a seller would be liable for a violation of proposed 
Rule 10b-21 if it represented that it had identified a source of 
borrowable securities, but the seller never contacted the purported 
source to determine whether shares were available and could be 
delivered in time for settlement and the seller fails to deliver 
securities by settlement date. A seller would also be liable if it 
contacted the source and learned that the source did not have 
sufficient shares for timely delivery, but the seller misrepresented 
that the source had sufficient shares that it could deliver in time for 
settlement and the seller fails to deliver securities by settlement 
date; or, if the seller contacted the source and the source had 
sufficient shares that it could deliver in time for settlement, but the 
seller never instructed the source to deliver the shares in time for 
settlement and the seller otherwise refused to deliver shares on 
settlement date such that the sale results in a fail to deliver.
    If, however, a seller is relying on a broker-dealer to comply with 
Regulation SHO's locate obligation and to make delivery on a sale, the 
seller would not be representing at the time it submits an order to 
sell a security that it can or intends to deliver securities on the 
date delivery is due. For example, a seller might be relying on its 
broker-dealer to borrow or arrange to borrow the security to make 
delivery by settlement date. Alternatively, a seller might be relying 
on a broker-dealer's ``Easy to Borrow'' list. If a seller in good faith 
relies on a broker-dealer's ``Easy to Borrow'' list to satisfy the 
locate requirement, the seller would not be deceiving the broker-dealer 
at the time it submits an order to sell a security that it can or 
intends to deliver securities on the date delivery is due. In 
discussing the locate requirement of Regulation SHO, in the 2004 
Regulation SHO Adopting Release, the Commission stated that ``absent 
countervailing factors, `Easy to Borrow' lists may provide `reasonable 
grounds' for a broker-dealer to believe that the security sold short is 
available for borrowing without directly contacting the source of the 
borrowed securities.'' \39\
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    \39\ 2004 Regulation SHO Adopting Release, 69 FR at 48014.
---------------------------------------------------------------------------

    In addition, a market maker engaged in bona fide market making 
activity would not be making a representation at the time it submits an 
order to sell short that it can or intends to deliver securities on the 
date delivery is due, because such market makers are excepted from the 
locate requirement of Regulation SHO. Regulation SHO excepts from the 
locate requirement market makers engaged in bona-fide market making 
activities because market makers need to facilitate customer orders in 
a fast moving market without possible delays associated with complying 
with the locate requirement.\40\ Thus, at the time of submitting an 
order to sell short, market makers that have an exception from the 
locate requirement of Regulation SHO may know that they may not be able 
to deliver securities on the date delivery is due.
---------------------------------------------------------------------------

    \40\ See 2004 Regulation SHO Adopting Release, 69 FR at 48015, 
n. 67.
---------------------------------------------------------------------------

    Under proposed Rule 10b-21, a seller would be liable if it deceives 
a broker-dealer, participant of a registered clearing agency, or 
purchaser about its ownership of shares or the deliverable condition of 
owned shares and fails to deliver securities by settlement date. For 
example, a seller would be liable for a violation of proposed Rule 10b-
21 for causing a broker-dealer to mark an order to sell a security 
``long'' if the seller knows or recklessly disregards that it is not 
``deemed to own'' the security being sold, as defined in Rules 200(a) 
through (f) of Regulation SHO \41\ or if the seller knows or recklessly 
disregards that the security being sold is not, or cannot reasonably be 
expected to be, in the broker-dealer's physical possession or control 
by the date delivery is due, and the seller fails to deliver the 
security by settlement date. Broker-dealers acting for their own 
accounts would also be liable under the proposed rule for marking an 
order ``long'' if the broker-dealer knows or recklessly disregards that 
it is not ``deemed to own'' the security being sold or that the 
security being sold is not, or cannot reasonably be expected to be, in 
the broker-dealer's physical possession or control by the date delivery 
is due, and the broker-dealer fails to deliver the security by 
settlement date.\42\
---------------------------------------------------------------------------

    \41\ 17 CFR 242.200(a)-(f).
    \42\ Such broker-dealers would also be liable under Regulation 
SHO.
---------------------------------------------------------------------------

    However, a seller would not be making a representation at the time 
it submits an order to sell a security that it can or intends to 
deliver securities on the date delivery is due if the seller submits an 
order to sell securities that are held in a margin account but the 
broker-dealer has loaned out the shares pursuant to the margin 
agreement. Under such circumstances, it would be reasonable for the 
seller to expect that the securities will be in the broker-dealer's 
physical possession or control by settlement date.
    Although the proposed rule is primarily aimed at sellers that 
deceive specified persons about their intention or ability to deliver 
shares or about their locate sources and ownership of shares, as with 
any rule, broker-dealers could be liable for aiding and abetting a

[[Page 15380]]

customer's fraud under the proposed rule. In addition, broker-dealers 
would remain subject to liability under Regulation SHO and the general 
anti-fraud provisions of the federal securities laws.
    Proposed Rule 10b-21 is narrowly tailored to apply when a seller, 
including a broker-dealer trading for its own account, deceives 
specified persons about its ability or intention to deliver securities 
in time for settlement, or about its locate source or ownership of 
shares and that fails to deliver securities by settlement date. While 
``naked'' short selling as part of a manipulative scheme is already 
illegal under the general anti-fraud provisions of the federal 
securities laws, we believe that the proposed anti-fraud rule would 
highlight the specific liability of persons that deceive specified 
persons about their intention or ability to deliver securities in time 
for settlement, including persons that deceive their broker-dealer 
about their locate source or ownership of shares. Proposed Rule 10b-21 
would also aid broker-dealers in complying with the locate requirement 
of Regulation SHO and, thereby, potentially reduce fails to 
deliver.\43\
---------------------------------------------------------------------------

    \43\ The Commission would continue to monitor the effect of 
``naked'' short selling practices to determine whether additional 
rulemaking is warranted.
---------------------------------------------------------------------------

Request for Comment
    The Commission seeks comment generally on all aspects of proposed 
Rule 10b-21. In addition, we seek comment on the following:
     Proposed Rule 10b-21 would apply to sales in all equity 
securities. Should we narrow the scope of the proposed rule to apply 
only to sales of ``threshold securities'' as that term is defined in 
Rule 203(c)(6) of Regulation SHO \44\ or to certain types of 
securities? Why or why not? If so, to what types of securities should 
the proposed rule apply? If we narrow the proposed rule to apply only 
to certain types of securities, should exchange traded funds or other 
basket securities be excluded? Why or why not?
---------------------------------------------------------------------------

    \44\ Rule 203(c)(6) defines ``threshold securities'' 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)).'' 17 CFR 242.203(c)(6).
---------------------------------------------------------------------------

     The proposed rule highlights the specific liability of 
persons that deceive broker-dealers, participants of a registered 
clearing agency, or purchasers about their intention or ability to 
deliver securities in time for settlement. Are there other entities 
that could be deceived about a seller's intention or ability to deliver 
securities in time for settlement that should be included in the 
proposed rule? As an alternative to listing who must be deceived, 
should the proposed rule provide that a person would be liable if it 
deceives ``another person'' about its intention or ability to deliver 
securities in time for settlement? Please explain.
     The proposed rule includes a person failing to deliver 
securities when delivery is due as an element for a violation of the 
proposed rule. What are the costs and benefits, including to broker-
dealers or customers, for including delivery as an element of the 
violation? Would the inclusion of a fail to deliver as an element of 
the proposed rule encourage broker-dealers, as a service to customers, 
to deliver securities on behalf of customers to prevent customers from 
failing to deliver securities by settlement date? Would broker-dealers 
feel any additional obligation to purchase or borrow securities on 
behalf of their customers to deliver on a customer's sale? What would 
be the costs to broker-dealers if they were to take such actions, 
particularly if the sale involves an expensive or hard to borrow 
security? Would the inclusion of failing to deliver as an element for a 
violation of the proposed rule increase costs for customers for 
inadvertent fails? Should delivery be excluded as a required element 
for a violation? For example, should the rule language instead be: ``It 
shall constitute a `manipulative or deceptive device or contrivance' as 
used in section 10(b) of this Act for any person to submit an order to 
sell a security if such person deceives a broker or dealer, participant 
of a registered clearing agency, or a purchaser about its intention or 
ability to deliver the security on the date delivery is due''? What 
would be the costs and benefits of excluding delivery as an element for 
a violation of the proposed rule? Would excluding failing to deliver as 
an element for liability under the proposed rule affect a self-
regulatory organization's ability to surveil for violations of the 
rule?
     In the 2004 Regulation SHO Adopting Release, the 
Commission stated that a broker-dealer could satisfy the locate 
requirement of Regulation SHO by obtaining an assurance from a customer 
that the customer can obtain securities from another identified source 
in time to settle the trade, provided the broker-dealer reasonably 
believes the customer's assurance. Proposed Rule 10b-21 is aimed, in 
part, at sellers who make misrepresentations to their broker-dealers 
about their locate sources. Should we instead no longer permit a 
broker-dealer to rely on such customer assurances in satisfying the 
locate requirement of Regulation SHO? What would be the costs and 
benefits of removing the ability of broker-dealers to rely on such 
customer assurances? What would be the impact on market participants 
(such as broker-dealers, stock lenders, investors)? Would smaller 
entities be affected more or less adversely than larger entities?
     What procedures do broker-dealers currently have in place 
to assist in making the determination that there are reasonable grounds 
to believe that customers' representations regarding a locate source 
are accurate? How do those procedures help to provide confidence 
regarding the accuracy of such representations?
     What procedures do broker-dealers currently have in place 
to determine the accuracy of a seller's representations that it owns 
the securities being sold and that the securities are reasonably 
expected to be in the broker-dealer's physical possession or control by 
settlement?
     Are there other types of transactions to which proposed 
Rule 10b-21 should not apply?
     Are there any issues with respect to the application of 
the proposed rule in the context of the use of DMAs? If so, please 
explain.
     Are there any issues with respect to the application of 
the proposed rule to trades submitted to, or effected on, electronic 
communications networks?
     To what extent, if any, would the proposed rule encourage 
or result in fewer executing broker-dealers relying on customer 
assurances to satisfy the locate requirement of Regulation SHO? To what 
extent would such a result of the proposed rule impact prime brokerage 
relationships? Please explain.
     Although the type of activity that would be illegal under 
the proposed rule is already prohibited by the general anti-fraud 
provisions of the federal securities laws, to what extent, if any, 
would the proposed rule impact liquidity and market quality in 
securities traded? Please explain. To what extent, if any, might the 
proposed rule result in short squeezes? What costs, if any, would the 
potential for short squeezes have on the efficiency of the market?
     To what extent, if any, would the proposed rule induce 
short sellers to execute trades in overseas markets?

IV. General Request for Comment

    The Commission seeks comment generally on all aspects of the 
proposed rule. Commenters are requested to provide empirical data to 
support their views and arguments related to

[[Page 15381]]

proposed Rule 10b-21. In addition to the questions posed above, 
commenters are welcome to offer their views on any other matter raised 
by the proposed rule. With respect to any comments, we note that they 
are of the greatest assistance to our rulemaking initiative if 
accompanied by supporting data and analysis of the issues addressed in 
those comments and if accompanied by alternative suggestions to our 
proposals where appropriate.

V. Paperwork Reduction Act

    Proposed Rule 10b-21 does not contain a ``collection of 
information'' requirement within the meaning of the Paperwork Reduction 
Act of 1995.\45\ 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.
---------------------------------------------------------------------------

    \45\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

VI. Consideration of Costs and Benefits of the Proposed Amendments

    The Commission is considering the costs and benefits of proposed 
Rule 10b-21. 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 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 rule.

A. Benefits

    Proposed Rule 10b-21 is intended to address abusive ``naked'' short 
selling and fails to deliver. The proposed rule is aimed at short 
sellers, including broker-dealers acting for their own accounts, who 
deceive broker-dealers, participants of a registered clearing agency, 
or purchasers about their intention or ability to deliver securities in 
time for settlement and that fail to deliver securities by settlement 
date. Among other things, proposed Rule 10b-21 would target short 
sellers who deceive their broker-dealers about their source of 
borrowable shares for purposes of complying with Regulation SHO's 
``locate'' requirement.\46\ The proposed rule would also apply to 
sellers who misrepresent to their broker-dealers that they own the 
shares being sold.\47\
---------------------------------------------------------------------------

    \46\ See 17 CFR 242.203(b)(1).
    \47\ Proposed Rule 10b-21.
---------------------------------------------------------------------------

    A seller misrepresenting its short sale locate source or ownership 
of shares may intend to fail to deliver securities in time for 
settlement and, therefore, engage in abusive ``naked'' short selling. 
As noted above, although abusive ``naked'' short selling is not defined 
in the federal securities laws, it refers generally to selling short 
without having stock available for delivery and intentionally failing 
to deliver stock within the standard three-day settlement cycle.\48\ 
Such short selling may or may not be part of a scheme to manipulate the 
price of a security. Although ``naked'' short selling as part of a 
manipulative scheme is always illegal under the general anti-fraud 
provisions of the federal securities laws, including Rule 10b-5 under 
the Exchange Act,\49\ proposed Rule 10b-21 would highlight the specific 
liability of persons that deceive specified persons about their 
intention or ability to deliver securities in time for settlement, 
including persons that deceive their broker-dealer about their locate 
source or ownership of shares and that fail to deliver securities by 
settlement date. We believe that a rule specifying the illegality of 
these activities would focus the attention of market participants on 
such activities. The proposed rule would also highlight that the 
Commission believes such deceptive activities are detrimental to the 
markets and would provide a measure of predictability for market 
participants.
---------------------------------------------------------------------------

    \48\ See supra note 2.
    \49\ 17 CFR 240.10b-5.
---------------------------------------------------------------------------

    All sellers of securities should promptly deliver, or arrange for 
delivery of, securities to the respective buyer and all buyers of 
securities have a right to expect prompt delivery of securities 
purchased. Thus, the proposal takes direct aim at an activity that may 
create fails to deliver. Those fails can have a negative effect on 
shareholders, potentially depriving them of the benefits of ownership, 
such as voting and lending. They also may create a misleading 
impression of the market for an issuer's securities. As noted above, 
issuers and investors have expressed concerns about fails to deliver in 
connection with ``naked'' short selling. For example, in response to 
proposed amendments to Regulation SHO in 2006 \50\ designed to further 
reduce the number of persistent fails to deliver in certain equity 
securities by eliminating Regulation SHO's ``grandfather'' provision, 
and limiting the duration of the rule's options market maker exception, 
the Commission received a number of comments that expressed concerns 
about ``naked'' short selling and extended delivery failures.\51\
---------------------------------------------------------------------------

    \50\ See 2006 Regulation SHO Proposed Amendments.
    \51\ See, e.g., letters from Overstock; TASER, Royce; Read; 
DeVivo; Akhtar.
---------------------------------------------------------------------------

    To the extent that 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,\52\ such fails to deliver may 
undermine the confidence of investors.\53\ These investors, in turn, 
may be reluctant to commit capital to an issuer they believe to be 
subject to such manipulative conduct.\54\ In addition, issuers may 
believe that they have suffered unwarranted reputational damage due to 
investors' negative perceptions regarding fails to deliver in the 
issuer's security.\55\ Any unwarranted reputational damage caused by 
fails to deliver might have an adverse impact on the security's 
price.\56\
---------------------------------------------------------------------------

    \52\ See supra note 27.
    \53\ See supra note 28.
    \54\ See supra note 29.
    \55\ See supra note 30 (discussing the fact that due to such 
concerns some 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 DTC or 
broker-dealers).
    \56\ See supra note 31.
---------------------------------------------------------------------------

    Thus, to the extent that fails to deliver might create a misleading 
impression of the market for an issuer's securities, the proposed rule 
would benefit investors and issuers by taking direct aim at an activity 
that may create fails to deliver. In addition, to the extent that 
``naked'' short selling and fails to deliver result in an unwarranted 
decline in investor confidence about a security, the proposed rule 
should improve investor confidence about the security. In addition, the 
proposed rule could lead to greater certainty in the settlement of 
securities which should strengthen investor confidence in that process.
    The proposed rule could result in broker-dealers having greater 
confidence that their customers have obtained a valid locate source 
and, therefore, that shares are available for delivery on settlement 
date. Thus, the proposed rule would aid broker-dealers in complying 
with the locate requirement of Regulation SHO and, thereby, potentially 
reduce fails to deliver. The proposed rule also may provide additional 
encouragement for broker-

[[Page 15382]]

dealers to deliver shares by settlement date and, therefore, result in 
a reduction in fails to deliver. In addition, to the extent that sales 
of threshold securities do not result in fails to deliver, the proposed 
rule would reduce costs to broker-dealers because such broker-dealers 
would have to close out a lesser amount of fails to deliver under 
Regulation SHO's close-out requirement.\57\
---------------------------------------------------------------------------

    \57\ Rule 203(b)(3)(iii) of Regulation SHO contains a close-out 
requirement that applies only to broker-dealers for securities in 
which a substantial amount of fails to deliver have occurred, also 
known as ``threshold securities.'' 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) system that has persisted for 13 consecutive 
settlement days by purchasing securities of like kind and quantity.
---------------------------------------------------------------------------

    In addition, the proposed rule could help reduce manipulative 
schemes involving ``naked'' short selling. We solicit comment on any 
additional benefits that could be realized with the proposed rule, 
including both short-term and long-term benefits. We solicit comment 
regarding benefits to market efficiency, pricing efficiency, market 
stability, market integrity and investor protection.

B. Costs

    As an aid in evaluating costs and reductions in costs associated 
with proposed Rule 10b-21, the Commission requests the public's views 
and any supporting information.
    The proposed rule is intended to address abusive ``naked'' short 
selling by highlighting the liability of persons that deceive specified 
persons about their intention or ability to deliver securities in time 
for settlement, including persons that deceive their broker-dealer 
about their locate source or ownership of shares and that fail to 
deliver securities by settlement date. The Commission recognizes that 
the proposed rule might result in increased costs to broker-dealers to 
the extent that the proposed rule encourages or results in broker-
dealers limiting the extent to which they rely on customer assurances 
in complying with the locate requirement of Regulation SHO. Because the 
failure to deliver securities by the date delivery is due is an element 
for a violation of the proposed rule, as a service to customers broker-
dealers could feel an additional obligation to borrow or purchase 
securities to deliver on customer sales even though the broker-dealer 
did not enter into an arrangement with the customer to do so. The 
proposed rule could result in increased costs to customers who 
inadvertently fail to deliver securities because such customers, in an 
attempt to avoid liability under the proposed rule, might purchase or 
borrow securities to deliver on a sale at a time when, but for the 
proposed rule, the seller would have allowed the fail to deliver 
position to remain open.
    The Commission believes that the proposed rule would not compromise 
investor protection. We seek data, however, supporting any potential 
costs associated with the proposed rule. In addition, we request 
specific comment on any systems changes to computer hardware and 
software, or surveillance costs that might be necessary to implement 
the proposed rule. Specifically:
     What would be the costs and benefits of the proposed rule?
     Would the proposed rule create any costs associated with 
systems, surveillance, or recordkeeping modifications? Would these 
costs justify the benefits of better ensuring compliance with the 
federal securities laws?
     How much would the proposed rule affect compliance costs 
for small, medium, and large broker-dealers (e.g., personnel or system 
changes)? We seek comment on the costs of compliance that may arise.

VII. Consideration of Burden on Competition and Promotion of 
Efficiency, Competition, and Capital Formation

    Section 3(f) of the Exchange Act requires the Commission, whenever 
it engages in rulemaking and whenever it is required to consider or 
determine if an action is necessary or appropriate in the public 
interest, to consider whether the action would promote efficiency, 
competition, and capital formation.\58\ In addition, Section 23(a)(2) 
of the Exchange Act requires the Commission, when adopting rules under 
the Exchange Act, to consider the impact such rules would have on 
competition.\59\ Exchange Act Section 23(a)(2) prohibits the Commission 
from adopting any rule that would impose a burden on competition not 
necessary or appropriate in furtherance of the purposes of the Exchange 
Act.
---------------------------------------------------------------------------

    \58\ 15 U.S.C. 78c(f).
    \59\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    Proposed Rule 10b-21 is intended to address abusive ``naked'' short 
selling and fails to deliver. The proposed rule is aimed at short 
sellers, including broker-dealers acting for their own accounts, who 
deceive specified persons, such as a broker-dealer, about their 
intention or ability to deliver securities in time for settlement and 
fail to deliver securities by settlement date. Among other things, 
proposed Rule 10b-21 would target short sellers who deceive their 
broker-dealers about their source of borrowable shares for purposes of 
complying with Regulation SHO's ``locate'' requirement.\60\ The 
proposed rule would also apply to sellers who misrepresent to their 
broker-dealers that they own the shares being sold.\61\
---------------------------------------------------------------------------

    \60\ See 17 CFR 242.203(b)(1).
    \61\ Proposed Rule 10b-21.
---------------------------------------------------------------------------

    Although ``naked'' short selling as part of a manipulative scheme 
is always illegal under the general anti-fraud provisions of the 
federal securities laws, including Rule 10b-5 under the Exchange 
Act,\62\ proposed Rule 10b-21 would highlight the liability of persons 
that deceive specified persons about their intention or ability to 
deliver securities in time for settlement, including persons that 
deceive their broker-dealer about their locate source or ownership of 
shares and that fail to deliver securities by settlement date. We 
believe that a rule highlighting the illegality of these activities 
would focus the attention of market participants on such activities. 
The proposed rule would also provide a measure of predictability for 
market participants. We believe proposed Rule 10b-21 would have minimal 
impact on the promotion of price efficiency. We seek comment regarding 
whether proposed Rule 10b-21 may adversely impact liquidity, disrupt 
markets, or unnecessarily increase risks or costs to customers.
---------------------------------------------------------------------------

    \62\ 17 CFR 240.10b-5.
---------------------------------------------------------------------------

    In addition, we believe that the proposed rule would have minimal 
impact on the promotion of capital formation. The perception that 
abusive ``naked'' short selling is occurring in certain securities can 
undermine the confidence of investors. These investors, in turn, may be 
reluctant to commit capital to an issuer they believe to be subject to 
such manipulative conduct. We believe that any such effect on capital 
formation is limited by the relatively few securities from corporate 
issuers that persist on the Regulation SHO threshold list \63\ and the 
fact that this persistence does not necessarily indicate abusive 
``naked'' short selling

[[Page 15383]]

or a deleterious effect on the cost of capital for the issuer.
---------------------------------------------------------------------------

    \63\ On an average day over a nine month period from May 1, 2007 
to January 31, 2008, approximately 50 securities had persisted on 
the threshold list for more than 17 days and had fails to deliver of 
10,000 shares or more. However, the majority of these securities are 
exchange traded funds which suggests that only a small number of 
corporate issuers are potentially affected.
---------------------------------------------------------------------------

    In the 2006 Proposing Release, we sought comment on whether the 
proposed amendments to Regulation SHO would promote capital formation, 
including whether the proposed increased short sale restrictions would 
affect investors' decisions to invest in certain equity securities. In 
response, commenters expressed concern about the potential impact of 
``naked'' short selling on capital formation claiming that ``naked'' 
short selling causes a drop in an issuer's stock price that may limit 
the issuer's ability to access the capital markets.\64\ Thus, to the 
extent that ``naked'' short selling and fails to deliver result in an 
unwarranted decline in investor confidence about a security, the 
proposed rule should improve investor confidence about the security. We 
note, however, that persistent fails to deliver exist in only a small 
number of securities and may be a signal of overvaluation rather than 
undervaluation of a security's price.\65\ In addition, we believe that 
the proposed rule could lead to greater certainty in the settlement of 
securities which should strengthen investor confidence in the 
settlement process.
---------------------------------------------------------------------------

    \64\ See, e.g., letter from Feeney.
    \65\ Persistent fails to deliver may be symptomatic of an 
inadequate supply of shares in the equity lending market. If short 
sellers are unable to short sell due to their inability to borrow 
shares, their opinions about the fundamental value of the security 
may not be fully reflected in a security's price, which may lead to 
overvaluation.
---------------------------------------------------------------------------

    We also believe that proposed Rule 10b-21 would not impose any 
burden on competition not necessary or appropriate in furtherance of 
the purposes of the Exchange Act. By specifying that abusive ``naked'' 
short selling is a fraud, the Commission believes the proposed rule 
would promote competition by providing the industry with guidance 
regarding the liability of sellers that deceive specified persons about 
their intention or ability to deliver securities in time for 
settlement, including persons that deceive their broker-dealer about 
their locate sources or share ownership and that fail to deliver 
securities by settlement date. The Commission requests specific comment 
on whether the proposed rule woul