``Naked'' Short Selling Antifraud Rule, 61666-61678 [E8-24714]

Download as PDF 61666 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations in cooperation with entities the Administration has considered appropriate, for example, industry trade associations, industry members, and energy efficiency organizations. The Administration is making available the information and materials developed under the program to small business concerns, including smaller design, engineering, and construction firms, and other Federal programs for energy efficiency, such as the Energy Star for Small Business Program. The Administration will develop a strategy to educate, encourage, and assist small business concerns in adopting energy efficient building fixtures and equipment. Consideration of Comments This is a direct final rule, and SBA will review all comments. SBA believes that this rule is routine and noncontroversial, and SBA anticipates no significant adverse comments to this rulemaking. If SBA receives any significant adverse comments, it will publish a timely withdrawal of this direct final rule. Paperwork Reduction Act, 44 U.S.C. Ch. 35 SBA has determined that this proposed rule does not impose additional reporting or recordkeeping requirements under the Paperwork Reduction Act, 44 U.S.C. Chapter 35. Regulatory Flexibility Act, 5 U.S.C. 601– 612 The Regulatory Flexibility Act (RFA) 5 U.S.C. 601, requires administrative agencies to consider the effect of their actions on small entities, small nonprofit enterprises, and small local governments. Pursuant to the RFA, when an agency issues a rulemaking, the agency must prepare a regulatory flexibility analysis which describes the impact of the rule on small entities. However, section 605 of the RFA allows an agency to certify a rule, in lieu of preparing an analysis, if the rulemaking is not expected to have a significant economic impact on a substantial number of small entities. Within the meaning of RFA, SBA certifies that this rule will not have a significant economic impact on a substantial number of small entities. The Office of Management and Budget (OMB) has determined that this rule does not constitute a significant regulatory action under Executive Order 12866. List of Subjects in 13 CFR Part 101 Administrative practice and procedure, Authority delegations (Government agencies), Intergovernmental relations, Investigations, Organization and functions (Government agencies), Reporting and recordkeeping requirements. ■ For the reasons stated in the preamble, the Small Business Administration amends 13 CFR part 101 as follows: Executive Order 12988 PART 101–ADMINISTRATION This action meets applicable standards set forth in sections 3(a) and 3(b)(2) of Executive Order 12988, Civil Justice Reform, to minimize litigation, eliminate ambiguity, and reduce burden. The action does not have retroactive or preemptive effect. ■ Compliance With Executive Orders 12866, 12988, and 13132, the Paperwork Reduction Act (44 U.S.C. Ch. 35), and the Regulatory Flexibility Act (5 U.S.C. 601–612) Executive Order 12866 Executive Order 13132 jlentini on PROD1PC65 with RULES program, which is located at http:// www.sba.gov/energy, building on the Energy Star for Small Business Program, to assist small business concerns in becoming more energy efficient, understanding the cost savings from improved energy efficiency, and identifying financing options for energy efficiency upgrades. (b) The Program has been developed and coordinated in consultation with the Secretary of the Department of Energy and the Administrator of the Environmental Protection Agency, and in cooperation with entities the Administrator has considered appropriate, for example, such as industry trade associations, industry members, and energy efficiency organizations. SBA’s Office of Policy and Strategic Planning will be responsible for overseeing the program but will coordinate with the Department of Energy and EPA. (c) The Administration is distributing and making available online, the information and materials developed under the program to small business concerns, including smaller design, engineering, and construction firms, and other Federal programs for energy efficiency, such as the Energy Star for Small Business Program. (d) The Administration will develop a strategy to educate, encourage, and assist small business concerns in adopting energy efficient building fixtures and equipment. For purposes of E.O. 13132, the SBA has determined that the rule will not have substantial, direct effects on the States, on the relationship between the national government and the States, or on the distribution of power and responsibilities among the various levels of government. Therefore, for the purpose of Executive Order 13132, Federalism, SBA determines that this proposed rule has no federalism implications warranting preparation of a federalism assessment. VerDate Aug<31>2005 17:16 Oct 16, 2008 Jkt 217001 1. The authority citation for part 101 is revised to read as follows: Authority: 5 U.S.C. 552 and App. 3, secs. 2, 4(a), 6(a), and 9(a)(1)(T); 15 U.S.C. 633, 634, 687; 31 U.S.C. 6506; 44 U.S.C. 3512; 42 U.S.C. 6307(d); 15 U.S.C. 657h; E.O. 12372 (July 14, 1982), 47 FR 30959, 3 CFR, 1982 Comp., p. 197, as amended by E.O. 12416 (April 8, 1983), 48 FR 15887, 3 CFR, 1983 Comp., p. 186. 2. Amend part 101 by adding Subpart E to read as follows: ■ Subpart E—Small Business Energy Efficiency Sec. 101.500 Small Business Energy Efficiency Program. § 101.500 Small Business Energy Efficiency Program. (a) The Administration has developed and coordinated a Government-wide PO 00000 Frm 00010 Fmt 4700 Sfmt 4700 Sandy K. Baruah, Acting Administrator. [FR Doc. E8–24599 Filed 10–16–08; 8:45 am] BILLING CODE 8025–01–P SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 240 [Release No. 34–58774; File No. S7–08–08] RIN 3235–AK06 ‘‘Naked’’ Short Selling Antifraud Rule Securities and Exchange Commission. ACTION: Final rule. AGENCY: SUMMARY: The Securities and Exchange Commission (‘‘Commission’’) is adopting an antifraud 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 rule will further evidence the liability of short sellers, including broker-dealers acting for their own E:\FR\FM\17OCR1.SGM 17OCR1 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations accounts, who 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: Effective Date: October 17, 2008. FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Associate Director, Josephine J. Tao, Assistant Director, Victoria L. Crane, Branch Chief, Joan M. Collopy, Special Counsel, Christina M. Adams and Matthew Sparkes, 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: We are adding Rule 10b–21 [17 CFR 242.10b– 21] under the Exchange Act. I. Introduction We are adopting 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, Rule 10b–21 will 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 Rule 10b–21 will 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 of the Exchange Act,3 Rule 10b–21 will further evidence the liability of persons 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 Final 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. jlentini on PROD1PC65 with RULES 2 See VerDate Aug<31>2005 17:16 Oct 16, 2008 Jkt 217001 that deceive others 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 further evidencing the illegality of these activities will focus the attention of market participants on such activities. Rule 10b–21 will also further evidence that the Commission believes such deceptive activities are detrimental to the markets and will 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 the right to expect prompt delivery of securities purchased. Thus, Rule 10b–21 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. Rule 10b–21 will also aid broker-dealers in complying with the locate requirement of Regulation SHO and, thereby, potentially reduce fails to deliver. In addition, Rule 10b–21 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 or 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 antifraud 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 seller generally delivers its securities, in certificated or electronic form, to its brokerage firm no later PO 00000 Frm 00011 Fmt 4700 Sfmt 4700 61667 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 we adopted Regulation SHO 10 in part to address problems associated with persistent fails to deliver securities and potentially abusive ‘‘naked’’ short selling.11 Rule 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); see also Securities Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR 62972, 62975 (Nov. 6, 2003) (‘‘2003 Regulation SHO Proposing Release’’) (describing the alleged activity in the settled case involving stock of Sedona Corporation); 2004 Regulation SHO Adopting Release, 69 FR at 48016, n.76. 9 According to the National Securities Clearing Corporation (‘‘NSCC’’), 99% (by dollar value) of all trades settle on time. Thus, on an average day, approximately 1% (by dollar value) of all trades, including equity, debt, and municipal securities fail to settle. The vast majority of these fails are closed out within five days after T+3. In addition, fails to deliver may arise from either short 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, thereby causing a fail to deliver on a long sale within the normal threeday settlement period. In addition, broker-dealers that make markets in a security (‘‘market makers’’) and who sell short thinly-traded, illiquid stock in response to customer demand may encounter difficulty in obtaining securities when the time for delivery arrives. The Commission’s Office of Economic Analysis (‘‘OEA’’) estimates that, on an average day between May 1, 2007 and July 31, 2008 (i.e., the time period that includes all full months after the Commission started receiving price data from NSCC), 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 0.3% of dollar value of trading in all equity securities. 10 17 CFR 242.200. Regulation SHO became effective on January 3, 2005. 11 See 2007 Regulation SHO Final Amendments, 72 FR at 45544 (stating that ‘‘[a]mong other things, E:\FR\FM\17OCR1.SGM Continued 17OCR1 61668 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations jlentini on PROD1PC65 with RULES 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: (i) Borrowed the security, or entered into a bona-fide arrangement to borrow the security; or (ii) Reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due; and (iii) 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 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). 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); Weitz and Altman, Lit. Release No. 18121 (April 30, 2003) (settled civil action). 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 VerDate Aug<31>2005 17:16 Oct 16, 2008 Jkt 217001 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 Under Regulation SHO, the executing or introducing 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. That 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 have been concerned about ‘‘naked’’ short selling and, in particular, abusive ‘‘naked’’ short selling, for some time. As discussed above, our concerns about potentially abusive ‘‘naked’’ short selling were an important reason for our adoption of Regulation SHO in 2004. In addition, due to our concerns about the potentially negative market impact of large and persistent fails to deliver, and the fact that we continued to observe a small number of threshold securities 20 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). 20 A ‘‘threshold security’’ is defined in Rule 203(c)(6) as any equity security of an issuer that is registered pursuant to section 12 of the Exchange Act (15 U.S.C. 78l) or for which the issuer is PO 00000 Frm 00012 Fmt 4700 Sfmt 4700 with fail to deliver positions that were not being closed out under existing delivery and settlement requirements, in 2007 we eliminated the ‘‘grandfather’’ exception to Regulation SHO’s close-out requirement 21 and today we adopted amendments to eliminate the options market maker exception to the close-out requirement.22 In addition to the actions we have taken aimed at reducing fails to deliver and addressing potentially abusive ‘‘naked’’ short selling in threshold securities, recently we took emergency action targeting ‘‘naked’’ short selling in some non-threshold securities. Specifically, on July 15, 2008, we published an emergency order under Section 12(k) of the Exchange Act (the ‘‘July Emergency Order’’) 23 that temporarily imposed enhanced requirements on short sales in the publicly traded securities of certain substantial financial firms.24 We issued the July Emergency Order because we were concerned that false rumors spread by short sellers regarding financial institutions of significance in the U.S. could continue to threaten significant market disruption. As we required to file reports pursuant to section 15(d) of the Exchange Act (15 U.S.C. 78o(d)): (i) For which there is an aggregate fail to deliver position for five consecutive settlement days at a registered clearing agency of 10,000 shares or more, and that is equal to at least 0.5% of the issue’s total shares outstanding; and (ii) that is included on a list disseminated to its members by a self-regulatory organization. 17 CFR 242.203(c)(6). 21 See 2007 Regulation SHO Final Amendments, 72 FR 45544. The ‘‘grandfather’’ exception had provided that fails to deliver established prior to a security becoming a threshold security did not have to be closed out in accordance with Regulation SHO’s close-out requirement. This amendment also contained a one-time phase-in period that provided that previously-grandfathered fails to deliver in a security that was a threshold security on the effective date of the amendment must be closed out within 35 consecutive settlement days from the effective date of the amendment. The phase-in period ended December 5, 2007. 22 See Exchange Act Release No. 34–58775 (Oct. 14, 2008) (‘‘2008 Regulation SHO Final Amendments’’). The options market maker exception had excepted from the close-out requirement any fail to deliver position in a threshold security resulting from short sales effected by a registered options market maker to establish or maintain a hedge on options positions that were created before the underlying security became a threshold security. 23 See Exchange Act Release No. 58166 (July 15, 2008). 24 See id. The Emergency Order required that, in connection with transactions in the publicly traded securities of the substantial financial firms identified on Appendix A to the Emergency Order (‘‘Appendix A Securities’’), no person could effect a short sale in the Appendix A Securities using the means or instrumentalities of interstate commerce unless such person or its agent had borrowed or arranged to borrow the security or otherwise had the security available to borrow in its inventory prior to effecting such short sale and delivered the security on settlement date. E:\FR\FM\17OCR1.SGM 17OCR1 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations jlentini on PROD1PC65 with RULES noted in the July Emergency Order, false rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by ‘‘naked’’ short selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process. If significant financial institutions are involved, this chain of events can threaten disruption of our markets.25 On July 29, 2008, we extended the July Emergency Order after carefully reevaluating the current state of the markets in consultation with officials of the Board of Governors of the Federal Reserve System, the Department of the Treasury, and the Federal Reserve Bank of New York. Due to our continued concerns about the ongoing threat of market disruption and effects on investor confidence, we determined that the standards of extension had been met.26 Pursuant to the extension, the July Emergency Order terminated at 11:59 p.m. EDT on August 12, 2008.27 In addition to our adopting Rule 10b– 21, as noted above, today we also adopted amendments to eliminate the options market maker exception to Regulation SHO’s delivery requirement.28 We also adopted today an interim final temporary rule that enhances the delivery requirements for 25 We delayed the effective date of the Emergency Order to July 21, 2008 to create the opportunity to address, and to allow sufficient time for market participants to make, adjustments to their operations to implement the enhanced requirements. Moreover, in addressing anticipated operational accommodations necessary for implementation of the Emergency Order, we issued an amendment to the Emergency Order on July 18, 2008. See Exchange Act Release No. 58190 (July 18, 2008) (excepting from the Emergency Order bona fide market makers, short sales in Appendix A Securities sold pursuant to Rule 144 of the Securities Act of 1933, and certain short sales by underwriters, or members of a syndicate or group participating in distributions of Appendix A Securities). 26 See Exchange Act Release No. 58248 (July 29, 2008). 27 In addition, on September 17, 2008, the Commission further addressed abusive ‘‘naked’’ short selling by issuing an Emergency Order that temporarily adopted amendments to Regulation SHO’s close-out requirement, amendments to eliminate Regulation SHO’s options market maker exception to the close-out requirement, and Rule 10b–21. See Exchange Act Release No. 58572 (Sept. 17, 2008). The Commission also issued emergency orders to require disclosure of short sales, Exchange Act Release 58591 (Sept. 18, 2008) and 58591A (Sept. 21, 2008), and temporarily halt short selling in financial stocks, Exchange Act Release 58592 (Sept. 18, 2008) and Exchange Act Release 58611 (Sept. 21, 2008). 28 See supra note 22. VerDate Aug<31>2005 17:16 Oct 16, 2008 Jkt 217001 sales of all equity securities (‘‘2008 Interim Rule’’).29 The amendments to the options market maker exception and the 2008 Interim Rule that we adopted today both focus on the timely delivery of securities and are not aimed at pre-trade activity, such as compliance with Regulation SHO’s locate requirement. Because we continue to be concerned about fails to deliver and potentially abusive ‘‘naked’’ short selling, in addition to our initiatives to strengthen Regulation SHO’s delivery requirements, we are adopting Rule 10b–21 to also target sellers who deceive their broker-dealers or certain other persons about their source of borrowable shares and their share ownership. As we stated in the Proposing Release,30 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. Commission enforcement actions have contributed to our concerns about the extent of misrepresentations by short sellers about their locate sources and ownership of shares, regardless of whether they result in fails to deliver. 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.31 In addition, as we have stated on several prior occasions, we are concerned about the negative effect that fails to deliver may have on the markets and shareholders.32 For example, fails to deliver may deprive shareholders of 29 See Exchange Act Release No. 58773 (Oct. 14, 2008). 30 Exchange Act Release No. 57511 (Mar. 17, 2008), 73 FR 15376, 15377 (Mar. 21, 2008) (‘‘Proposing Release’’). 31 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). 32 See supra note 22; 2007 Regulation SHO Final Amendments, 72 FR at 45544; 2006 Regulation SHO Proposed Amendments, 71 FR at 41712; 2007 Regulation SHO Proposed Amendments, 72 FR at 45558–45559; Proposing Release, 73 FR at 15378. PO 00000 Frm 00013 Fmt 4700 Sfmt 4700 61669 the benefits of ownership, such as voting and lending.33 In addition, where a seller of securities fails to deliver securities on settlement date, in effect the seller unilaterally converts a securities contract (which is expected to 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.34 In addition, commenters (including issuers and investors) have repeatedly expressed concerns about fails to deliver in connection with manipulative ‘‘naked’’ short selling. For example, in response to proposed amendments to Regulation SHO in 2006 35 designed to further reduce the number of persistent fails to deliver in certain equity securities by eliminating Regulation SHO’s ‘‘grandfather’’ exception, and amending the options market maker exception, we received a number of comments that expressed concerns about ‘‘naked’’ short selling and extended delivery failures.36 Commenters continued to express these concerns in response to proposed amendments to eliminate the options market maker exception to the close-out requirement of Regulation SHO in 2007 37 and in response to the Proposing Release.38 33 See id. id. 35 See 2006 Regulation SHO Proposed Amendments, 71 FR 41710. 36 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’’). 37 See, e.g., letter from Jack M. Wedam, dated Oct. 16, 2007; letter from Michael J. Ryan, Executive Director and Senior Vice President, Center for Capital Markets Competitiveness, U.S. Chamber of Commerce, dated Sept. 13, 2007 (‘‘U.S. Chamber of Commerce’’); letter from Robert W. Raybould, CEO Enteleke Capital Corp., dated Sept. 12, 2007; letter from Mary Helburn, Executive Director, National Coalition Against Naked Shorting, dated Sept. 11, 2007 (‘‘NCANS 2007’’). 38 See, e.g., letter from Richard H. Baker, President and Chief Executive Officer, Managed Funds Association, dated May 21, 2008 (‘‘MFA’’) (stating that ‘‘[m]arket manipulation, such as intentional and abusive naked short selling, undermines the integrity of the U.S. capital markets and threatens investor confidence, market liquidity and market efficiency’’); letter from Kurt N. Schacht and Linda Rittenhouse, Centre for Financial Market Integrity, dated June 17, 2008 (stating that they ‘‘support efforts by the Commission to curtail naked short selling, for all the reasons noted in the [Proposing Release] relating to the detrimental effects on the marketplace. As noted [in the Proposing Release], this practice not only affects 34 See E:\FR\FM\17OCR1.SGM Continued 17OCR1 61670 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations jlentini on PROD1PC65 with RULES To the extent that fails to deliver might be part of manipulative ‘‘naked’’ short selling, which could be used as a tool to drive down a company’s stock price,39 such fails to deliver may undermine the confidence of investors.40 These investors, in turn, may be reluctant to commit capital to an issuer they believe to be subject to such manipulative conduct.41 In addition, issuers may believe that they have suffered unwarranted reputational damage due to investors’ negative perceptions regarding fails to deliver in shareowners by depriving the[m] of the basic benefits of ownership, it also may detrimentally affect the issuer’s reputation and subvert the appropriate workings of the market by avoiding certain restrictions applicable to those who deliver on time. All of these issues can ultimately undermine investor confidence.’’); letter from Wallace E. Boston, President and Chief Executive Officer, American Public Education, Inc., dated May 20, 2008 (noting that ‘‘[a]s the CEO of a recently public company, I am acutely aware of the impact that abusive short-selling can have on issuers and investors.’’). 39 See, e.g., 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) (settled case in which we 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. 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). 40 In response to the 2007 Regulation SHO Proposed Amendments, we received comment letters discussing the impact of fails to deliver on investor confidence. See, e.g., letter from NCANS 2007. Commenters expressed similar concerns in response to the 2006 Regulation SHO Proposed Amendments. See, e.g., letter from Mary Helburn, Executive Director, National Coalition Against Naked Shorting, dated Sept. 30, 2006 (‘‘NCANS 2006’’); letter from Richard Blumenthal, Attorney General, State of Connecticut, dated Sept. 19, 2006. 41 In response to the 2007 Regulation SHO Proposed Amendments, we 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 Robert K. Lifton, Chairman and CEO, Medis Technologies, Inc., dated Sept. 12, 2007; letter from NCANS 2007. Commenters expressed similar concerns in response to the 2006 Regulation SHO Proposed Amendments. See, e.g., letter from Congressman Tom Feeney—Florida, U.S. House of Representatives, dated Sept. 25, 2006; see also letter from Zix Corporation, dated Sept. 19, 2006 (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.’’). VerDate Aug<31>2005 17:16 Oct 16, 2008 Jkt 217001 the issuer’s security.42 Unwarranted reputational damage caused by fails to deliver might have an adverse impact on the security’s price.43 Strengthening rules that address ‘‘naked’’ short selling will provide increased confidence in the markets. Since the issuance of the July Emergency Order, members of the public have repeatedly expressed their concerns about a loss of confidence in the markets. For example, one commenter stated that ‘‘financial confidence is critically important’’ for companies to do business.44 Another commenter stated that ‘‘existing laws should be enforced, but further steps should be taken to prevent any further erosion of the investing publics [sic] confidence.’’ 45 We are concerned about the ability of short sellers to use ‘‘naked’’ short selling as a tool to manipulate the prices of securities.46 Thus, in conjunction with 42 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 2003 Regulation SHO Proposing Release, 68 FR at 62975. 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 Exchange Act Release No. 47978 (June 4, 2003), 68 FR 35037 (June 11, 2003). 43 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; Proposing Release, 73 FR at 15378 (providing additional discussion of the impact of fails to deliver on the market); see also 2003 Regulation SHO Proposing Release, 68 FR at 62975 (discussing the impact of ‘‘naked’’ short selling on the market). 44 See Comment of Ron Heller (July 21, 2008) (‘‘Heller’’) (commenting on the Emergency Order). 45 See Comment of Ronald L. Rourk (July 21, 2008) (‘‘Rourk’’) (commenting on the proposal to eliminate Regulation SHO’s options market maker exception). 46 See, e.g., Commission press release, dated July 13, 2008, announcing that the Commission’s Office of Compliance Inspections and Examinations, as well as FINRA and New York Stock Exchange Regulation, Inc., will immediately conduct examinations aimed at the prevention of the intentional spreading of false information intended to manipulate securities prices. See http:// www.sec.gov/news/press/2008/2008-140.htm. In addition, in April of this year, the Commission charged Paul S. Berliner, a trader, with securities fraud and market manipulation for intentionally disseminating a false rumor concerning The Blackstone Group’s acquisition of Alliance Data Systems Corp (‘‘ADS’’). The Commission alleged that this false rumor caused the price of ADS stock to plummet, and that Berliner profited by short PO 00000 Frm 00014 Fmt 4700 Sfmt 4700 our other short selling initiatives aimed at further reducing fails to deliver and addressing abusive ‘‘naked’’ short selling, we have adopted Rule 10b–21 substantially as proposed. Proposed Rule 10b–21 was narrowly tailored to 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,47 or purchaser 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.48 We received over 700 comment letters in response to the Proposing Release. The comment letters were from numerous entities, including issuers, retail investors, broker-dealers, SROs, associations, members of Congress, and other elected officials.49 Many commenters supported our goals of further addressing potentially abusive ‘‘naked’’ short selling and fails to deliver, while not necessarily agreeing with the Commission’s approach. For example, some commenters argued for more stringent short sale regulation.50 Others urged us to take stronger enforcement action against abusive ‘‘naked’’ short sellers under the current federal securities laws rather than, or in addition to, adopting Rule 10b–21.51 selling ADS stock and covering those sales as the false rumor caused the price of ADS stock to fall. See http://www.sec.gov/litigation/litreleases/2008/ lr20537.htm. 47 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. 48 See Proposed Rule 10b–21. 49 The comment letters are available on the Commission’s Internet Web Site at http:// www.sec.gov/comments/s7-08-08/s70808.shtml. 50 See, e.g., letter from Arik B. Fetscher, Esq., dated April 2, 2008; letter from Fred Adams, Jr., Chairman and Chief Executive Officer, Cal-Maine Foods, Inc., dated May 19, 2008; letter from David T. Hirschman, President and Chief Executive Officer, Center for Capital Markets Competitiveness, United States Chamber of Commerce, dated May 20, 2008 (‘‘Chamber of Commerce’’); letter from Wallace E. Boston, Jr., President and Chief Executive Officer, American Public Education, Inc., dated May 20, 2008; letter from Kurt N. Schacht, Executive Director, and Linda L. Rittenhouse, Senior Policy Analyst, CFA Institute Centre for Financial Market Integrity, dated June 17, 2008; letter from Guillaume Cloutier, dated July 25, 2008; letter from Shunliang Wang, dated July 27, 2008; letter from Scott Bridgford, dated July 29, 2008; letter from Keith Kottwitz, dated Aug. 1, 2008. 51 See, e.g., letter from Tony J. Akin, Jr., Financial Advisor, dated March 31, 2008; letter from Gary D. Owens, CEO, OYO Geospace, dated April 22, 2008; letter from Daniel J. Popeo, Chairman & General Counsel, and Paul D. Kamenar, Senior Executive Counsel, Washington Legal Foundation, dated May E:\FR\FM\17OCR1.SGM 17OCR1 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations Some commenters asked that if we adopt Rule 10b–21 as proposed, we provide certain clarifications regarding the application of the rule.52 We highlight in the discussion below some of the main issues, concerns, and suggestions raised in the comment letters. III. Discussion of Rule 10b–21 jlentini on PROD1PC65 with RULES A. Rule 10b–21 After careful consideration of the comments, we are adopting Rule 10b–21 substantially as proposed. Rule 10b–21 specifies that it is unlawful for any person to submit an order to sell an equity security if such person deceives a broker-dealer, participant of a registered clearing agency,53 or purchaser 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.54 Scienter is a necessary element for a violation of the rule.55 Some commenters questioned whether, similar to Regulation SHO, proposed Rule 10b–21 would apply only to equity 20, 2008; letter from David Hughes, dated July 17, 2008; letter from Dave Morgan, dated July 25, 2008; letter from Seth Bradley, dated July 30, 2008; letter from Michael Kianka, dated Aug. 1, 2008. 52 See, e.g., letter from James J. Angel, Associate Professor of Finance, Georgetown University, dated May 17, 2008 (‘‘Angel’’); letter from Heather Traeger, Assistant Counsel, Investment Company Institute, dated May 20, 2008; letter from Dr. Robert J. Shapiro, Chairman, Sonecon, LLC, and former U.S. Under Secretary of Commerce, dated May 20, 2008 (‘‘Shapiro’’); letter from Ira D. Hammerman, Managing Director and General Counsel, Securities Industry and Financial Markets Association, dated May 22, 2008 (‘‘SIFMA’’); letter from Michael R. Trocchio, Bingham McCutchen LLP, dated July 14, 2008 (‘‘Bingham’’); letter from MFA. 53 See supra note 47 (defining the terms ‘‘participant’’ and ‘‘registered clearing agency’’ for purposes of the rule). 54 See Rule 10b–21. 55 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)). Some commenters stated they believe that Rule 10b–21 should require a finding of ‘‘intentional deception’’ to best achieve our goals without deterring legitimate short selling. See, e.g., letter from MFA; another commenter, however, requested that we confirm that the concept of scienter, for purposes of Rule 10b–21, is identical to established precedent under Section 10(b) of the Exchange Act and Rule 10b–5 thereunder. See letter from SIFMA. We intend the scienter requirement of Rule 10b–21 to be the same as that required under Rule 10b–5. VerDate Aug<31>2005 17:16 Oct 16, 2008 Jkt 217001 securities.56 In response to these comments, we clarify that as proposed and adopted, Rule 10b–21 applies only to equity securities.57 Rule 10b–21 will 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.58 Rule 10b–21 will prohibit 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 Rule 10b–21 is to reduce fails to deliver, violation of the rule will occur only if a fail to deliver results from the relevant transaction. For purposes of Rule 10b–21, brokerdealers (including market makers) acting for their own accounts will be considered sellers. For example, a broker-dealer effecting short sales for its own account will 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.59 As noted above, under Regulation SHO, the executing or introducing 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.60 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.61 If a seller elects to provide its own locate source to a broker-dealer, the seller is representing 56 See, e.g., letter from MFA. e.g., Proposing Release, 73 FR at 15380; see also Rule 10b–21. 58 As proposed, the rule referenced ‘‘the date delivery is due.’’ To provide specificity as to when delivery is due for purposes of the rule, we are modifying this language to ‘‘settlement date’’ and defining ‘‘settlement date’’ as ‘‘the business day on which delivery of a security and payment of money is to be made through the facilities of a registered clearing agency in connection with the sale of a security.’’ See Rule 10b–21(b). 59 See supra note 22; 2007 Regulation SHO Final Amendments, 72 FR at 45544; 2006 Regulation SHO Proposed Amendments, 71 FR at 41712; 2007 Regulation SHO Proposed Amendments, 72 FR at 45558–45559. 60 See 17 CFR 242.203(b)(3)(1). 61 See 2004 Regulation SHO Adopting Release, 69 FR at 48014. 57 See, PO 00000 Frm 00015 Fmt 4700 Sfmt 4700 61671 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 makes a representation to a broker-dealer for purposes of Rule 10b– 21.62 If a seller deceives a broker-dealer about the validity of its locate source, the seller will be liable under Rule 10b– 21 if the seller also fails to deliver securities by the date delivery is due. For example, a seller will be liable for a violation of 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 will 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. One commenter recommended that the rule focus on whether there is a fail to deliver in the Continuous Net Settlement (‘‘CNS’’) system, rather than on a seller’s failure to deliver the securities sold.63 The majority of equity trades in the United States are cleared and settled through systems administered by clearing agencies registered with the Commission. The NSCC clears and settles the majority of equity securities trades conducted on the exchanges and in the over the counter market. NSCC clears and settles trades through the CNS system, which nets the securities delivery and payment obligations of all of its members. The majority of NSCC’s members are broker62 Broker-dealers offer DMA to some 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. 63 See letter from SIFMA. E:\FR\FM\17OCR1.SGM 17OCR1 61672 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations dealers.64 NSCC notifies its members of their securities delivery and payment obligations daily. In addition, NSCC guarantees the completion of all transactions and interposes itself as the contraparty to both sides of the transaction. This commenter noted that a seller’s clearing broker generally bears the responsibility to meet the firm’s CNS delivery requirement and that it is difficult for a broker-dealer to determine which customer transactions or accounts give rise to a fail to deliver in the CNS system. We note, however, that Rule 10b–21 as proposed was not based on whether a fail to deliver occurred in CNS. Rather, the rule as proposed was concerned with whether an individual seller delivered securities that it sold. Along those lines, another commenter stated that the proposed rule should require a failure to deliver by the seller.65 We have determined to adopt the rule as proposed. The rule targets the misconduct of sellers. As discussed above, sellers should promptly deliver the securities they have sold and purchasers have the right to the timely receipt of securities that they have purchased. Thus, Rule 10b-21’s focus is on whether or not there is a fail to deliver by the seller, rather than on whether or not there is a fail to deliver in the CNS system. Because fails to deliver in the CNS system are netted with pending deliveries, some sellers may be able to postpone delivery if another customer’s purchase is received the same day. Thus, a person engaging in abusive ‘‘naked’’ short selling may be able to avoid detection for a period of time. This would undermine our goal of addressing abusive ‘‘naked’’ short selling. jlentini on PROD1PC65 with RULES B. Seller’s Reliance on a Broker-Dealer or ‘‘Easy to Borrow’’ Lists Rule 10b–21 provides that it shall be unlawful for any person to submit an order to sell an equity security if such person deceives a broker-dealer, participant of a registered clearing agency, or purchaser regarding its intention or ability to deliver the security on the date delivery is due.66 Thus, as we discussed in the Proposing Release,67 if 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 64 As of July 31, 2008 approximately 91% of members of the NSCC were registered as brokerdealers. 65 See letter from Bingham. 66 See Rule 10b–21. 67 See Proposing Release, 73 FR at 15379. VerDate Aug<31>2005 17:16 Oct 16, 2008 Jkt 217001 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.’’ 68 C. Bona Fide Market Makers As we discussed in the Proposing Release,69 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.70 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. D. ‘‘Long’’ Sales Under Rule 10b–21, a seller will 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.71 68 2004 Regulation SHO Adopting Release, 69 FR at 48014. 69 See Proposing Release, 73 FR at 15379. 70 See 2004 Regulation SHO Adopting Release, 69 FR at 48015, n. 67; see also 2008 Regulation SHO Final Amendments, supra note 22 (providing interpretive guidance regarding bona fide market making activities for purposes of Regulation SHO). 71 See Rule 10b–21. PO 00000 Frm 00016 Fmt 4700 Sfmt 4700 As we discussed in the Proposing Release,72 a seller will be liable for a violation of 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 73 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 will also be liable under Rule 10b–21 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.74 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. E. Rule 10b–21 and Other Antifraud Provisions of the Federal Securities Laws One commenter stated that it believes proposed Rule 10b–21 is unnecessary ‘‘because the Commission already has ample existing authority, under Section 10(b) of the Exchange Act and Rule 10b– 5 thereunder, to prosecute manipulative and/or fraudulent activity, including the type of activity that proposed Rule 10b– 21 seeks to address.’’ 75 Other commenters urged us to use less formal means than rulemaking to address our concerns regarding misrepresentations in the order entry process.76 For 72 See Proposing Release, 73 FR at 15379. CFR 242.200(a)–(f). 74 Such broker-dealers will also be liable under Regulation SHO Rule 203(a). 75 See letter from SIFMA; see also letter from Bingham (stating that ‘‘[t]he Firms agree that the illicit conduct the Commission seeks to address through [proposed Rule 10b–21] is already illegal’’); letter from MFA. 76 See, e.g., letter from Bingham; letter from MFA; but, c.f., letter from Chamber of Commerce (noting 73 17 E:\FR\FM\17OCR1.SGM 17OCR1 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations jlentini on PROD1PC65 with RULES instance, these commenters suggested that the Commission or its staff could convey this message through FAQs, staff bulletins, and speeches.77 We have determined, however, that the negative effects of abusive ‘‘naked’’ short selling on market confidence warrant formal Commission action. 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 a rule further evidencing the illegality of these activities will focus the attention of market participants on such activities. Rule 10b–21 will also further evidence that the Commission believes such deceptive activities are detrimental to the markets and will provide a measure of predictability for market participants. Some commenters sought clarification as to how this rule was different from Rule 10b–5.78 We note that the set of factors that will serve as the basis for a violation of Rule 10b–21 as adopted are not determinative of a person’s obligations under the general antifraud provisions of the federal securities laws. Accordingly, and in order to clarify the continued applicability of the general antifraud provisions outside of the strict context of Rule 10b–21, we have added a preliminary note to the rule as adopted, which states: ‘‘This rule is not intended to limit, or restrict, the applicability of the general antifraud provisions of the federal securities laws, such as section 10(b) of the Act and rule 10b–5 thereunder.’’ We added this preliminary note because we believe it is important to underscore that Rule 10b–21 is not meant, in any way, to limit the general antifraud provisions of the federal securities laws. Additionally, this preliminary note provides much needed public clarity in answer to the confusion voiced by many commenters. Similarly, we are modifying the proposed rule text slightly to add the word ‘‘also,’’ as follows: ‘‘It shall also 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 an equity 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 that although the activity covered by proposed Rule 10b–21 is already a violation of the antifraud provisions of the federal securities laws, ‘‘[e]mphasizing that such deceit violates these laws may deter some of this activity in the future’’). 77 See, e.g., letter from Bingham. 78 See, e.g., letter from MFA; see also letter from SIFMA (seeking clarification as to whether the level of scienter in the proposed rule differs from that of Rule 10b–5). VerDate Aug<31>2005 17:16 Oct 16, 2008 Jkt 217001 security on or before the settlement date, and such person fails to deliver the security on or before the settlement date.’’ We believe the adding the word ‘‘also’’ in the rule text further clarifies that Rule 10b–21 does not affect the operation of Rule 10b–5 or other antifraud rules, but is instead intended to supplement the existing antifraud rules. Commenters also raised questions whether there would be a private right of action for a violation of proposed Rule 10b–21.79 We note that the courts have held that a private right of action exists with respect to Rule 10b–5 provided the essential elements constituting a violation of the rule are met.80 Thus, a private plaintiff able to prove all those elements in a situation covered by Rule 10b–21 would be able to assert a claim under Section 10(b) of the Exchange Act and Rule 10b–5 thereunder. F. Aiding and Abetting Liability In the Proposing Release, we stated that ‘‘[a]lthough the proposed rule is primarily aimed at sellers that deceive specified persons about their intention or ability to deliver shares or about their locate source and ownership of shares, as with any rule, broker-dealers could be liable for aiding and abetting a customer’s fraud under the proposed rule.’’ 81 One commenter stated that broker-dealers should not be held responsible for policing their customer’s compliance with their own legal requirements.82 Another commenter urged us to specifically state that reliance by a broker-dealer on a customer representation regarding long/ short status or receipt of a locate does not rise to the level of scienter required for aiding and abetting liability.83 This commenter also asked us to make clear that broker-dealers who merely offer DMA or sponsored access to a customer who violates the new rule would not be liable for aiding and abetting such violation.84 Rule 10b–21 as adopted does not impose any additional liability or requirements on any person, including broker-dealers, beyond those of any 79 See, e.g., letter from SIFMA. Another commenter stated that ‘‘[t]he Commission should make explicitly clear that the adoption of Proposed Rule 10b–21 does not create a private right of action for violations of the rule. * * *’’ See letter from Bingham. 80 See, e.g., Superintendent of Insurance v. Bankers Life & Cas. Co., 404 U.S. 6, 13, n. 9 (1971); Ernst & Ernst, 425 at 196 (citing prior cases). 81 See Proposing Release, 72 FR at 15379. 82 See letter from SIFMA. 83 See letter from Bingham. 84 See id. PO 00000 Frm 00017 Fmt 4700 Sfmt 4700 61673 existing Exchange Act rule. As we stated in the Proposing Release, broker-dealers would remain subject to liability under Regulation SHO and the general antifraud provisions of the federal securities laws.85 G. Administrative Law Matters The Administrative Procedure Act also generally requires that an agency publish an adopted rule in the Federal Register 30 days before it becomes effective.86 This requirement, however, does not apply if the agency finds good cause for making the rule effective sooner.87 The Commission has determined that the rule should be effective in fewer than 30 days because it addresses illegal conduct that can cause market disruption. In addition, because the rule further evidences conduct that is manipulative and deceptive under existing general antifraud rules, market participants should not need time to adjust systems or procedures to comply with the rule. Therefore, the Commission finds good cause to make the rule effective on October 17, 2008. IV. Paperwork Reduction Act Rule 10b–21 does not contain a ‘‘collection of information’’ requirement within the meaning of the Paperwork Reduction Act of 1995.88 V. Cost-Benefit Analysis We are sensitive to the costs and benefits of our rules and we have considered the costs and benefits of Rule 10b–21. In order to assist us in evaluating the costs and benefits, in the Proposing Release, we encouraged commenters to discuss any costs or benefits that the rule would impose. In particular, we requested 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 rule for issuers, investors, brokers or dealers, other securities industry professionals, regulators, and other market participants. Commenters were encouraged to provide analysis and data to support their views on the costs and benefits associated with the rule. A. Benefits Rule 10b–21 is intended to address abusive ‘‘naked’’ short selling and fails 85 See 86 See Proposing Release, 72 FR at 15380. 5 U.S.C. § 553(d). 87 Id. 88 44 E:\FR\FM\17OCR1.SGM U.S.C. 3501 et seq. 17OCR1 jlentini on PROD1PC65 with RULES 61674 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations to deliver. The 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, Rule 10b–21 targets short sellers who deceive their broker-dealers about their source of borrowable shares for purposes of complying with Regulation SHO’s ‘‘locate’’ requirement.89 The rule also applies to sellers who misrepresent to their broker-dealers that they own the shares being sold.90 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.91 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 antifraud provisions of the federal securities laws, including Rule 10b–5 under the Exchange Act,92 Rule 10b–21 will further evidence 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 will focus the attention of market participants on such activities. The rule will also further evidence that the Commission believes such deceptive activities are detrimental to the markets and will 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 rule takes direct aim at an activity that may create fails to deliver. Those fails can have a negative effect on shareholders, 89 See 17 CFR 242.203(b)(1). Rule 10b–21. 91 See supra note 2. 92 17 CFR 240.10b–5. 90 See VerDate Aug<31>2005 17:16 Oct 16, 2008 Jkt 217001 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 the 2006 Regulation SHO Proposed Amendments, we received a number of comments that expressed concerns about ‘‘naked’’ short selling and extended delivery failures.93 Commenters continued to express these concerns in response to the 2007 Regulation SHO Proposed Amendments,94 and in response to the Proposing Release.95 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,96 such fails to deliver may undermine the confidence of investors.97 These investors, in turn, may be reluctant to commit capital to an issuer they believe to be subject to such manipulative conduct.98 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.99 Any unwarranted reputational damage caused by fails to deliver might have an adverse impact on the security’s price.100 Thus, to the extent that fails to deliver might create a misleading impression of the market for an issuer’s securities, the rule will 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 rule will improve investor confidence about the security. In addition, the rule will lead to greater certainty in the settlement of securities which should strengthen investor confidence in that process. We believe the rule will 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 93 See supra note 36. supra note 37. 95 See supra note 38. 96 See supra note 39. 97 See supra note 40. 98 See supra note 41. 99 See supra note 42 (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). 100 See supra note 43. 94 See PO 00000 Frm 00018 Fmt 4700 Sfmt 4700 settlement date. Thus, the rule will aid broker-dealers in complying with the locate requirement of Regulation SHO and, thereby, potentially reduce fails to deliver. In addition, to the extent that the rule results in fewer sales of threshold securities resulting in fails to deliver, the rule will reduce costs to broker-dealers because such brokerdealers will have to close-out a lesser amount of fails to deliver under Regulation SHO’s close-out requirement.101 The rule should also help reduce manipulative schemes involving ‘‘naked’’ short selling. In the Proposing Release, we solicited comment on any additional benefits that could be realized with the proposed rule, including both short-term and long-term benefits. We also solicited comment regarding benefits to market efficiency, pricing efficiency, market stability, market integrity and investor protection. In response, one commenter stated that the ‘‘rule will have a positive impact on liquidity and market quality in securities traded.’’ 102 Another commenter stated that ‘‘the liquidity of the market and the market quality of securities traded can be threatened or damaged if investors perceive that naked short sales may artificially distort the price of securities, in ways and instances unknown to honest investors, * * * in this regard, the strict application of the rule * * * should enhance liquidity and the market quality of securities traded.’’ 103 This commenter also noted that, ‘‘[b]y increasing the liability of naked short sellers, the proposed rule should reduce the incidence of naked short sales and thereby reduce the likelihood of short squeezes.’’ 104 B. Costs Rule 10b–21 is intended to address abusive ‘‘naked’’ short selling by further evidencing the liability of persons that deceive specified persons about their intention or ability to deliver securities 101 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 CNS system that has persisted for 13 consecutive settlement days by purchasing securities of like kind and quantity; see also 2008 Interim Rule, supra note 29 (temporarily enhancing Regulation SHO’s delivery requirements for sales of all equity securities). 102 See letter from Susanne Trimbath, PhD., CEO and Chief Economist, STP Advisory Services, LLC, dated May 30, 2008 (‘‘Trimbath’’) (noting also a tax benefit to investors from enforcing delivery on settlement date). 103 See letter from Shapiro. 104 See id. E:\FR\FM\17OCR1.SGM 17OCR1 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations jlentini on PROD1PC65 with RULES 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. In the Proposing Release, we sought data supporting any potential costs associated with the rule, and specific comment on any systems changes to computer hardware and software, or surveillance costs that might be necessary to implement the rule. One commenter stated that ‘‘the rule will have a positive impact on liquidity and market quality in securities traded * * * [w]ithout strict rules against settlement failures, a systemic crisis could occur where investors are reluctant to engage in trades in U.S. markets because settlement finality is in question. The markets and investors need the assurance of Rule 10b–21 that securities transactions will be settled.’’ 105 Another commenter stated that ‘‘the liquidity of the market and the market quality of securities traded can be threatened or damaged if investors perceive that naked short sales may artificially distort the price of securities, in ways and instances unknown to honest investors, * * * in this regard, the strict application of the rule * * * should enhance liquidity and the market quality of securities traded.’’ 106 This commenter also noted that, ‘‘[b]y increasing the liability of naked short sellers, the proposed rule should reduce the incidence of naked short sales and thereby reduce the likelihood of short squeezes. The prospect of short squeezes is increased by the moral hazard that occurs when short sellers believe there is little or no cost to carrying out abusive naked short sales, and therefore rules that impose such costs reduce this prospect.’’ 107 The commenter also noted that any costs associated with purchasing or borrowing securities to deliver on a sale instead of allowing the fail to deliver position to remain open ‘‘would not represent an additional cost, since a legitimate short sale involves borrowing the security for delivery at the cost of such borrowing. Therefore, it would reflect only the cost of complying with the rules and laws that apply to all investors.’’ 108 This commenter also noted that ‘‘[s]trict liability for failing to deliver securities in short sales is needed to offset the implicit savings of violating the law and rules, and getting away with it.’’ 109 letter from Trimbath. letter from Shapiro. 107 See id. 108 See id. 109 See id. We recognize, however, that Rule 10b–21 may result in increased costs to broker-dealers to the extent that the 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. In addition, the rule may result in increased costs to sellers who inadvertently fail to deliver securities because such sellers, in an attempt to avoid liability under the rule, might purchase or borrow securities to deliver on a sale at a time when, but for the rule, the seller would have allowed the fail to deliver position to remain open. One commenter stated that, ‘‘unless Proposed Rule 10b–21 were modified to eliminate aiding and abetting liability and allow reliance upon customer assurances, the price discovery and liquidity provided through short sales may be constrained.’’ 110 Although broker-dealer concerns regarding aiding and abetting liability under Rule 10b–21 may potentially impact liquidity and efficiency in the markets, we believe that such an impact, if any, will be minimal. Rule 10b–21 as adopted does not impose any additional liability or requirements on any person, including broker-dealers, beyond those of any existing Exchange Act rule. Aiding and abetting liability is a question of fact, determined on a case-by-case basis. In addition, as we stated in the Proposing Release, broker-dealers would remain subject to liability under Regulation SHO and the general antifraud provisions of the federal securities laws.111 VI. 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.112 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.113 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. Rule 10b–21 is intended to address abusive ‘‘naked’’ short selling and fails to deliver. The rule is aimed at short sellers, including broker-dealers acting for their own accounts, who deceive specified persons, such as a brokerdealer, about their intention or ability to deliver securities in time for settlement and fail to deliver securities by settlement date. Among other things, Rule 10b–21 targets short sellers who deceive their broker-dealers about their source of borrowable shares for purposes of complying with Regulation SHO’s ‘‘locate’’ requirement.114 The rule also applies to sellers who misrepresent to their broker-dealers that they own the shares being sold.115 Although ‘‘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,116 Rule 10b–21 will further evidence 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 further evidencing the illegality of these activities will focus the attention of market participants on such activities. The rule will also provide a measure of predictability for market participants. We believe Rule 10b–21 will have minimal impact on the promotion of price efficiency. In the Proposing Release, we sought comment regarding whether Rule 10b– 21 will adversely impact liquidity, disrupt markets, or unnecessarily increase risks or costs to customers. In response, one commenter noted that, ‘‘the liquidity of the market and the market quality of securities traded can be threatened or damaged if investors perceive that naked short sales may artificially distort the price of securities, in ways and instances unknown to honest investors, * * * in this regard, the strict application of the rule * * * should enhance liquidity and the market quality of securities traded.’’ 117 This commenter also noted that, ‘‘[b]y increasing the liability of naked short sellers, the proposed rule should reduce the incidence of naked short sales and 105 See 106 See VerDate Aug<31>2005 17:16 Oct 16, 2008 letter from Bingham. Proposing Release, 72 FR at 15377. 112 15 U.S.C. 78c(f). 113 15 U.S.C. 78w(a)(2). 110 See 114 See 111 See Jkt 217001 115 See PO 00000 Frm 00019 Fmt 4700 Sfmt 4700 61675 17 CFR 242.203(b)(1). Rule 10b–21. 116 17 CFR 240.10b–5. 117 See letter from Shapiro. E:\FR\FM\17OCR1.SGM 17OCR1 61676 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations thereby reduce the likelihood of short squeezes. * * *’’ 118 Another commenter stated that, ‘‘unless Proposed Rule 10b–21 were modified to eliminate aiding and abetting liability and allow reliance upon customer assurances, the price discovery and liquidity provided through short sales may be constrained.’’ 119 Although brokerdealer concerns regarding aiding and abetting liability under Rule 10b–21 may potentially impact liquidity and efficiency in the markets, we believe that such an impact, if any, will be minimal. Rule 10b–21 as adopted does not impose any additional liability or requirements on any person, including broker-dealers, beyond those of any existing Exchange Act rule. Aiding and abetting liability is a question of fact, determined on a case-by-case basis. In addition, as we stated in the Proposing Release, broker-dealers would remain subject to liability under Regulation SHO and the general antifraud provisions of the federal securities laws.120 In addition, we believe that the rule will 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. For example, in response to the Proposing Release, one commenter noted that, ‘‘[c]onfidence in the securities markets is diminished when investors and others cannot rely on the receipt of securities in trades.’’ 121 Thus, we believe that strengthening our rules against ‘‘naked’’ short selling by targeting sellers who deceive their broker-dealers about their source of borrowable shares and their share ownership will provide increased confidence in the markets. In addition, we note that we have previously sought comment regarding the impact on capital formation of other proposed amendments aimed at reducing fails to deliver and addressing potentially abusive ‘‘naked’’ short selling, including whether the proposed increased short sale restrictions would affect investors’ decisions to invest in certain equity securities.122 In response, commenters expressed concern about the potential impact of ‘‘naked’’ short jlentini on PROD1PC65 with RULES 118 See id. letter from Bingham. Proposing Release, 72 FR at 15377. 121 See letter from Trimbath. 122 See 2006 Regulation SHO Proposed Amendments, 71 FR 41710; 2007 Regulation SHO Proposed Amendments, 72 FR 45558. 119 See 120 See VerDate Aug<31>2005 17:16 Oct 16, 2008 Jkt 217001 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.123 Thus, to the extent that ‘‘naked’’ short selling and fails to deliver result in an unwarranted decline in investor confidence about a security, the rule is expected to 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.124 In addition, we believe that the rule will lead to greater certainty in the settlement of securities, which is expected to strengthen investor confidence in the settlement process. We also believe that Rule 10b–21 will 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 rule will 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. general antifraud provisions of the federal securities laws, Rule 10b–21 specifies that it is unlawful for any person to submit an order to sell an equity 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 the security on or before the date delivery is due. Thus, Rule 10b–21 will further evidence 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. A. Reasons for the Rule 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 B. Objectives Rule 10b–21 is aimed at short sellers, including broker-dealers acting for their own accounts, that 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. We believe that a rule further evidencing the illegality of these activities will focus the attention of market participants on such activities. The rule will also underscore that the Commission believes such deceptive activities are detrimental to the markets and will 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, Rule 10b–21 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. Rule 10b–21 will also aid broker-dealers in complying with the locate requirement of Regulation SHO and, thereby, potentially reduce fails to deliver. In addition, the rule is expected to help reduce manipulative schemes involving ‘‘naked’’ short selling. 123 See, e.g., supra note 41 (citing to comment letters expressing concern regarding the impact of potential ‘‘naked’’ short selling on capital formation). 124 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. 125 5 U.S.C. 603. C. Significant Issues Raised By Public Comment The IRFA appeared in the Proposing Release. We requested comment on any aspect of the IRFA. In particular, we requested comment on: (i) The number of small entities that would be affected by the rule; and (ii) the existence or nature of the potential impact of the rule on small entities. We requested that the VII. Final Regulatory Flexibility Analysis The Commission has prepared a Final Regulatory Flexibility Analysis (‘‘FRFA’’), in accordance with the provisions of the Regulatory Flexibility Act (‘‘RFA’’),125 regarding Rule 10b–21 under the Exchange Act. An Initial Regulatory Flexibility Analysis (‘‘IRFA’’) was prepared in accordance with the RFA and was included in the Proposing Release. We solicited comments on the IRFA. PO 00000 Frm 00020 Fmt 4700 Sfmt 4700 E:\FR\FM\17OCR1.SGM 17OCR1 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations comments specify costs of compliance with the rule, and suggest alternatives that would accomplish the objectives of the rule. We did not receive any comments that responded specifically to this request. D. Small Entities Subject to the Rule The entities covered by Rule 10b–21 will include small broker-dealers, 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 126 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 natural person) that is not a small business or small organization. As of 2007, the Commission estimates that there were approximately 896 broker-dealers that qualified as small entities as defined above.127 Any business, however, regardless of industry, could be subject to the rule if it effects a short or long sale. The Commission believes that, except for the broker-dealers discussed above, an estimate of the number of small entities that fall under the rule is not feasible. jlentini on PROD1PC65 with RULES E. Reporting, Recordkeeping, and Other Compliance Requirements Rule 10b–21 is intended to address abusive ‘‘naked’’ short selling by further evidencing 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 rule may impose new or additional 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 126 17 CFR 240.0–10(c)(1). numbers are based on OEA’s review of 2007 FOCUS Report filings reflecting registered broker-dealers. This number does not include broker-dealers that are delinquent on FOCUS Report filings. 127 These VerDate Aug<31>2005 18:20 Oct 16, 2008 Jkt 217001 mechanisms necessary for brokerdealers to comply with the rule should already be in place. We believe that any necessary additional systems and surveillance changes, in particular changes by sellers who are not brokerdealers, will be similar to the changes incurred by broker-dealers when Regulation SHO was implemented. F. Agency Action To Minimize Effect on Small Entities 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,128 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 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 antifraud provisions of the federal securities laws, Rule 10b– 21 specifies that it is a fraud for any person to submit an order to sell an equity 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. Rule 10b–21 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, Rule 10b–21 targets short sellers who deceive their broker-dealers about their source of borrowable shares for purposes of complying with Regulation SHO’s ‘‘locate’’ requirement.129 The rule also applies 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 128 5 U.S.C. 603(c). 17 CFR 242.203(b)(1). 129 See PO 00000 Frm 00021 Fmt 4700 Sfmt 4700 61677 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 is not consistent with the primary goal of the rule to further clarify, consolidate, or simplify the rule for small entities. Finally, the rule imposes performance standards rather than design standards. VIII. 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 adopting a new antifraud 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. ■ For the reasons set out in the preamble, Title 17, Chapter II, of the Code of Federal Regulations is 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: ■ 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, 78–ll, 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. 2. Add § 240.10b–21 to read as follows: ■ § 240.10b–21 Deception in connection with a seller’s ability or intent to deliver securities on the date delivery is due. Preliminary Note to § 240.10b–21: This rule is not intended to limit, or restrict, the applicability of the general antifraud provisions of the federal securities laws, such as section 10(b) of the Act and rule 10b–5 thereunder. (a) It shall also 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 an equity 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 or before the settlement date, and such person fails to deliver the E:\FR\FM\17OCR1.SGM 17OCR1 61678 Federal Register / Vol. 73, No. 202 / Friday, October 17, 2008 / Rules and Regulations security on or before the settlement date. (b) For purposes of this rule, the term settlement date shall mean the business day on which delivery of a security and payment of money is to be made through the facilities of a registered clearing agency in connection with the sale of a security. By the Commission. Dated: October 14, 2008. Florence E. Harmon, Acting Secretary. [FR Doc. E8–24714 Filed 10–16–08; 8:45 am] BILLING CODE 8011–01–P SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 240 and 249 [Release No. 34–58785; File No. S7–31–08; October 15, 2008] RIN 3235–AK23 Disclosure of Short Sales and Short Positions by Institutional Investment Managers Securities and Exchange Commission. ACTION: Interim final temporary rule; Request for comments. AGENCY: SUMMARY: The Commission is adopting an interim final temporary rule requiring certain institutional investment managers to file information on Form SH concerning their short sales and positions of section 13(f) securities, other than options. The new rule extends the reporting requirements established by our Emergency Orders dated September 18, 2008, September 21, 2008 and October 2, 2008, with some modifications. The extension will be effective until August 1, 2009. Consistent with the Orders, the rule requires an institutional investment manager that exercises investment discretion with respect to accounts holding section 13(f) securities having an aggregate fair market value of at least $100 million to file Form SH with the Commission following a calendar week in which it effected a short sale in a section 13(f) security, with some exceptions. Effective Date: §§ 240.10a–3T, 249.326T and temporary Form SH are effective from October 18, 2008 until August 1, 2009. Compliance Dates: An institutional investment manager that is required to file a Form SH report on October 24, 2008 or October 31, 2008, must comply with Rule 10a–3T, except that it: jlentini on PROD1PC65 with RULES DATES: VerDate Aug<31>2005 17:16 Oct 16, 2008 Jkt 217001 • May exclude disclosure of short positions reflecting short sales before September 22, 2008 from the Form SH report filed on either or both of those dates. An institutional investment manager choosing to exclude these short sales effected before September 22 is not required to report short positions otherwise reportable if the short position in the section 13(f) security constitutes less than one-quarter of one percent of that class of the issuer’s securities issued and outstanding as reported on the issuer’s most recent annual or quarterly report, and any current report subsequent thereto, filed with the Commission pursuant to the Securities Exchange Act of 1934, unless the manager knows or has reason to believe that the information contained therein is inaccurate, and the fair market value of the short position in the section 13(f) security is less than $1,000,000; and • Does not have to file Form SH in XML format in accordance with the special filing instructions posted on the Commission’s Web site. Instead, the institutional investment manager may file Form SH on EDGAR in the same manner as the form was filed pursuant to the Emergency Orders dated September 18, 2008, September 21, 2008 and October 2, 2008. Comment Date: Comments on the interim final temporary rule should be received on or before December 16, 2008. Comments may be submitted by any of the following methods: ADDRESSES: Electronic Comments • Use the Commission’s Internet comment form (http://www.sec.gov/ rules/final.shtml); or • Send an e-mail to rulecomments@sec.gov. Please include File Number S7–31–08 on the subject line; or • Use the Federal Rulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments. Paper Comments • Send paper comments in triplicate to Florence E. Harmon, Acting Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549–1090. All submissions should refer to File Number S7–31–08. 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 PO 00000 Frm 00022 Fmt 4700 Sfmt 4700 (http://www.sec.gov/rules/final.shtml). Comments are also available for public inspection and copying in the Commission’s Public Reference Room, 100 F Street, NE., Washington, DC 20549. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make publicly available. FOR FURTHER INFORMATION CONTACT: Steven Hearne, at (202) 551–3430, in the Division of Corporation Finance, Marlon Paz, at (202) 551–5756, in the Division of Trading and Markets, or Stephan N. Packs, at (202) 551–6865, in the Division of Investment Management, U.S. Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549–3010. SUPPLEMENTARY INFORMATION: The Commission is adopting temporary Rule 10a–3T and Temporary Form SH (Form SH) under the Securities Exchange Act of 1934 1 as an interim temporary final rule. We are soliciting comments on all aspects of the interim temporary final rule and Form SH. We will carefully consider the comments that we receive and intend to address them in a subsequent release. I. Background Recently, we have become concerned that there is a substantial threat of sudden and excessive fluctuations of securities prices and disruption in the functioning of the securities markets that could threaten fair and orderly markets. These concerns are evidenced by our recent publication of Emergency Orders under section 12(k) of the Exchange Act in July 2 and September of this year.3 In these Orders, we noted our concerns about the possible unnecessary or artificial price movements that may be based on unfounded rumors and may be exacerbated by short selling. Short selling involves a sale of a security that the seller does not own or a sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller.4 Short sales normally are settled by the 1 15 U.S.C. 78 et seq. No. 34–58166 (July 15, 2008) [73 FR 42379] (imposing borrowing and delivery requirements on short sales of the equity securities of certain financial institutions). 3 Release Nos. 34–58592 (Sept. 18, 2008) [73 FR 55169] (temporarily prohibiting short selling in the publicly traded securities of certain financial institutions), 34–58591 (Sept. 18, 2008) [73 FR 55175] (requiring institutional investment managers to report short sales activities) and 34–58572 (Sept. 17, 2008) [73 FR 54875] (imposing enhanced delivery requirements on sales of all equity securities). 4 17 CFR 242.200(a). 2 Release E:\FR\FM\17OCR1.SGM 17OCR1

Agencies

[Federal Register Volume 73, Number 202 (Friday, October 17, 2008)]
[Rules and Regulations]
[Pages 61666-61678]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-24714]


=======================================================================
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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-58774; File No. S7-08-08]
RIN 3235-AK06


``Naked'' Short Selling Antifraud Rule

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
adopting an antifraud 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 rule will further 
evidence the liability of short sellers, including broker-dealers 
acting for their own

[[Page 61667]]

accounts, who 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: Effective Date: October 17, 2008.

FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Associate 
Director, Josephine J. Tao, Assistant Director, Victoria L. Crane, 
Branch Chief, Joan M. Collopy, Special Counsel, Christina M. Adams and 
Matthew Sparkes, 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: We are adding Rule 10b-21 [17 CFR 242.10b-
21] under the Exchange Act.

I. Introduction

    We are adopting 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, 
Rule 10b-21 will 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\ Rule 10b-21 will also apply 
to sellers who misrepresent to their broker-dealers that they own the 
shares being sold.
---------------------------------------------------------------------------

    \1\ See 17 CFR 242.203(b)(1).
---------------------------------------------------------------------------

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

    \2\ See Exchange Act Release No. 56212 (Aug. 7, 2007), 72 FR 
45544 (Aug. 14, 2007) (``2007 Regulation SHO Final Amendments''); 
Exchange Act Release No. 54154 (July 14, 2006), 71 FR 41710 (July 
21, 2006) (``2006 Regulation SHO Proposed Amendments'').
---------------------------------------------------------------------------

    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 of the Exchange Act,\3\ 
Rule 10b-21 will further evidence the liability of persons that deceive 
others 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 further evidencing the illegality of these activities will focus 
the attention of market participants on such activities. Rule 10b-21 
will also further evidence that the Commission believes such deceptive 
activities are detrimental to the markets and will provide a measure of 
predictability for market participants.
---------------------------------------------------------------------------

    \3\ 17 CFR 240.10b-5.
    \4\ This conduct is also in violation of other provisions of the 
federal securities laws, including the antifraud provisions.
---------------------------------------------------------------------------

    All sellers of securities should promptly deliver, or arrange for 
delivery of, securities to the respective buyer and all buyers of 
securities have the right to expect prompt delivery of securities 
purchased. Thus, Rule 10b-21 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. Rule 10b-21 will 
also aid broker-dealers in complying with the locate requirement of 
Regulation SHO and, thereby, potentially reduce fails to deliver. In 
addition, Rule 10b-21 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 or 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 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.
---------------------------------------------------------------------------

    \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); see also 
Securities Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR 
62972, 62975 (Nov. 6, 2003) (``2003 Regulation SHO Proposing 
Release'') (describing the alleged activity in the settled case 
involving stock of Sedona Corporation); 2004 Regulation SHO Adopting 
Release, 69 FR at 48016, n.76.
---------------------------------------------------------------------------

    Although the majority of trades settle within the standard three-
day settlement period,\9\ we adopted Regulation SHO \10\ in part to 
address problems associated with persistent fails to deliver securities 
and potentially abusive ``naked'' short selling.\11\ Rule

[[Page 61668]]

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: (i) Borrowed the security, or entered into a bona-fide arrangement 
to borrow the security; or (ii) Reasonable grounds to believe that the 
security can be borrowed so that it can be delivered on the date 
delivery is due; and (iii) 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\
---------------------------------------------------------------------------

    \9\ According to the National Securities Clearing Corporation 
(``NSCC''), 99% (by dollar value) of all trades settle on time. 
Thus, on an average day, approximately 1% (by dollar value) of all 
trades, including equity, debt, and municipal securities fail to 
settle. The vast majority of these fails are closed out within five 
days after T+3. In addition, fails to deliver may arise from either 
short 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, thereby causing 
a fail to deliver on a long sale within the normal three-day 
settlement period. In addition, broker-dealers that make markets in 
a security (``market makers'') and who sell short thinly-traded, 
illiquid stock in response to customer demand may encounter 
difficulty in obtaining securities when the time for delivery 
arrives. The Commission's Office of Economic Analysis (``OEA'') 
estimates that, on an average day between May 1, 2007 and July 31, 
2008 (i.e., the time period that includes all full months after the 
Commission started receiving price data from NSCC), 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 0.3% of dollar value of trading in all equity 
securities.
    \10\ 17 CFR 242.200. Regulation SHO became effective on January 
3, 2005.
    \11\ See 2007 Regulation SHO Final 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).
---------------------------------------------------------------------------

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

    \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); Weitz and Altman, 
Lit. Release No. 18121 (April 30, 2003) (settled civil action).
    \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).
---------------------------------------------------------------------------

    Under Regulation SHO, the executing or introducing 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. That 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 have been concerned about ``naked'' short selling and, in 
particular, abusive ``naked'' short selling, for some time. As 
discussed above, our concerns about potentially abusive ``naked'' short 
selling were an important reason for our adoption of Regulation SHO in 
2004. In addition, due to our concerns about the potentially negative 
market impact of large and persistent fails to deliver, and the fact 
that we continued to observe a small number of threshold securities 
\20\ with fail to deliver positions that were not being closed out 
under existing delivery and settlement requirements, in 2007 we 
eliminated the ``grandfather'' exception to Regulation SHO's close-out 
requirement \21\ and today we adopted amendments to eliminate the 
options market maker exception to the close-out requirement.\22\
---------------------------------------------------------------------------

    \20\ A ``threshold security'' is defined in Rule 203(c)(6) as 
any equity security of an issuer that is registered pursuant to 
section 12 of the Exchange Act (15 U.S.C. 78l) or for which the 
issuer is required to file reports pursuant to section 15(d) of the 
Exchange Act (15 U.S.C. 78o(d)): (i) For which there is an aggregate 
fail to deliver position for five consecutive settlement days at a 
registered clearing agency of 10,000 shares or more, and that is 
equal to at least 0.5% of the issue's total shares outstanding; and 
(ii) that is included on a list disseminated to its members by a 
self-regulatory organization. 17 CFR 242.203(c)(6).
    \21\ See 2007 Regulation SHO Final Amendments, 72 FR 45544. The 
``grandfather'' exception had provided that fails to deliver 
established prior to a security becoming a threshold security did 
not have to be closed out in accordance with Regulation SHO's close-
out requirement. This amendment also contained a one-time phase-in 
period that provided that previously-grandfathered fails to deliver 
in a security that was a threshold security on the effective date of 
the amendment must be closed out within 35 consecutive settlement 
days from the effective date of the amendment. The phase-in period 
ended December 5, 2007.
    \22\ See Exchange Act Release No. 34-58775 (Oct. 14, 2008) 
(``2008 Regulation SHO Final Amendments''). The options market maker 
exception had excepted from the close-out requirement any fail to 
deliver position in a threshold security resulting from short sales 
effected by a registered options market maker to establish or 
maintain a hedge on options positions that were created before the 
underlying security became a threshold security.
---------------------------------------------------------------------------

    In addition to the actions we have taken aimed at reducing fails to 
deliver and addressing potentially abusive ``naked'' short selling in 
threshold securities, recently we took emergency action targeting 
``naked'' short selling in some non-threshold securities. Specifically, 
on July 15, 2008, we published an emergency order under Section 12(k) 
of the Exchange Act (the ``July Emergency Order'') \23\ that 
temporarily imposed enhanced requirements on short sales in the 
publicly traded securities of certain substantial financial firms.\24\
---------------------------------------------------------------------------

    \23\ See Exchange Act Release No. 58166 (July 15, 2008).
    \24\ See id. The Emergency Order required that, in connection 
with transactions in the publicly traded securities of the 
substantial financial firms identified on Appendix A to the 
Emergency Order (``Appendix A Securities''), no person could effect 
a short sale in the Appendix A Securities using the means or 
instrumentalities of interstate commerce unless such person or its 
agent had borrowed or arranged to borrow the security or otherwise 
had the security available to borrow in its inventory prior to 
effecting such short sale and delivered the security on settlement 
date.
---------------------------------------------------------------------------

    We issued the July Emergency Order because we were concerned that 
false rumors spread by short sellers regarding financial institutions 
of significance in the U.S. could continue to threaten significant 
market disruption. As we

[[Page 61669]]

noted in the July Emergency Order, false rumors can lead to a loss of 
confidence in our markets. Such loss of confidence can lead to panic 
selling, which may be further exacerbated by ``naked'' short selling. 
As a result, the prices of securities may artificially and 
unnecessarily decline well below the price level that would have 
resulted from the normal price discovery process. If significant 
financial institutions are involved, this chain of events can threaten 
disruption of our markets.\25\
---------------------------------------------------------------------------

    \25\ We delayed the effective date of the Emergency Order to 
July 21, 2008 to create the opportunity to address, and to allow 
sufficient time for market participants to make, adjustments to 
their operations to implement the enhanced requirements. Moreover, 
in addressing anticipated operational accommodations necessary for 
implementation of the Emergency Order, we issued an amendment to the 
Emergency Order on July 18, 2008. See Exchange Act Release No. 58190 
(July 18, 2008) (excepting from the Emergency Order bona fide market 
makers, short sales in Appendix A Securities sold pursuant to Rule 
144 of the Securities Act of 1933, and certain short sales by 
underwriters, or members of a syndicate or group participating in 
distributions of Appendix A Securities).
---------------------------------------------------------------------------

    On July 29, 2008, we extended the July Emergency Order after 
carefully reevaluating the current state of the markets in consultation 
with officials of the Board of Governors of the Federal Reserve System, 
the Department of the Treasury, and the Federal Reserve Bank of New 
York. Due to our continued concerns about the ongoing threat of market 
disruption and effects on investor confidence, we determined that the 
standards of extension had been met.\26\ Pursuant to the extension, the 
July Emergency Order terminated at 11:59 p.m. EDT on August 12, 
2008.\27\
---------------------------------------------------------------------------

    \26\ See Exchange Act Release No. 58248 (July 29, 2008).
    \27\ In addition, on September 17, 2008, the Commission further 
addressed abusive ``naked'' short selling by issuing an Emergency 
Order that temporarily adopted amendments to Regulation SHO's close-
out requirement, amendments to eliminate Regulation SHO's options 
market maker exception to the close-out requirement, and Rule 10b-
21. See Exchange Act Release No. 58572 (Sept. 17, 2008). The 
Commission also issued emergency orders to require disclosure of 
short sales, Exchange Act Release 58591 (Sept. 18, 2008) and 58591A 
(Sept. 21, 2008), and temporarily halt short selling in financial 
stocks, Exchange Act Release 58592 (Sept. 18, 2008) and Exchange Act 
Release 58611 (Sept. 21, 2008).
---------------------------------------------------------------------------

    In addition to our adopting Rule 10b-21, as noted above, today we 
also adopted amendments to eliminate the options market maker exception 
to Regulation SHO's delivery requirement.\28\ We also adopted today an 
interim final temporary rule that enhances the delivery requirements 
for sales of all equity securities (``2008 Interim Rule'').\29\
---------------------------------------------------------------------------

    \28\ See supra note 22.
    \29\ See Exchange Act Release No. 58773 (Oct. 14, 2008).
---------------------------------------------------------------------------

    The amendments to the options market maker exception and the 2008 
Interim Rule that we adopted today both focus on the timely delivery of 
securities and are not aimed at pre-trade activity, such as compliance 
with Regulation SHO's locate requirement. Because we continue to be 
concerned about fails to deliver and potentially abusive ``naked'' 
short selling, in addition to our initiatives to strengthen Regulation 
SHO's delivery requirements, we are adopting Rule 10b-21 to also target 
sellers who deceive their broker-dealers or certain other persons about 
their source of borrowable shares and their share ownership.
    As we stated in the Proposing Release,\30\ 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. Commission enforcement actions have contributed to 
our concerns about the extent of misrepresentations by short sellers 
about their locate sources and ownership of shares, regardless of 
whether they result in fails to deliver. 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.\31\
---------------------------------------------------------------------------

    \30\ Exchange Act Release No. 57511 (Mar. 17, 2008), 73 FR 
15376, 15377 (Mar. 21, 2008) (``Proposing Release'').
    \31\ 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).
---------------------------------------------------------------------------

    In addition, as we have stated on several prior occasions, we are 
concerned about the negative effect that fails to deliver may have on 
the markets and shareholders.\32\ For example, fails to deliver may 
deprive shareholders of the benefits of ownership, such as voting and 
lending.\33\ In addition, where a seller of securities fails to deliver 
securities on settlement date, in effect the seller unilaterally 
converts a securities contract (which is expected to 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.\34\
---------------------------------------------------------------------------

    \32\ See supra note 22; 2007 Regulation SHO Final Amendments, 72 
FR at 45544; 2006 Regulation SHO Proposed Amendments, 71 FR at 
41712; 2007 Regulation SHO Proposed Amendments, 72 FR at 45558-
45559; Proposing Release, 73 FR at 15378.
    \33\ See id.
    \34\ See id.
---------------------------------------------------------------------------

    In addition, commenters (including issuers and investors) have 
repeatedly expressed concerns about fails to deliver in connection with 
manipulative ``naked'' short selling. For example, in response to 
proposed amendments to Regulation SHO in 2006 \35\ designed to further 
reduce the number of persistent fails to deliver in certain equity 
securities by eliminating Regulation SHO's ``grandfather'' exception, 
and amending the options market maker exception, we received a number 
of comments that expressed concerns about ``naked'' short selling and 
extended delivery failures.\36\ Commenters continued to express these 
concerns in response to proposed amendments to eliminate the options 
market maker exception to the close-out requirement of Regulation SHO 
in 2007 \37\ and in response to the Proposing Release.\38\
---------------------------------------------------------------------------

    \35\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
    \36\ 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'').
    \37\ See, e.g., letter from Jack M. Wedam, dated Oct. 16, 2007; 
letter from Michael J. Ryan, Executive Director and Senior Vice 
President, Center for Capital Markets Competitiveness, U.S. Chamber 
of Commerce, dated Sept. 13, 2007 (``U.S. Chamber of Commerce''); 
letter from Robert W. Raybould, CEO Enteleke Capital Corp., dated 
Sept. 12, 2007; letter from Mary Helburn, Executive Director, 
National Coalition Against Naked Shorting, dated Sept. 11, 2007 
(``NCANS 2007'').
    \38\ See, e.g., letter from Richard H. Baker, President and 
Chief Executive Officer, Managed Funds Association, dated May 21, 
2008 (``MFA'') (stating that ``[m]arket manipulation, such as 
intentional and abusive naked short selling, undermines the 
integrity of the U.S. capital markets and threatens investor 
confidence, market liquidity and market efficiency''); letter from 
Kurt N. Schacht and Linda Rittenhouse, Centre for Financial Market 
Integrity, dated June 17, 2008 (stating that they ``support efforts 
by the Commission to curtail naked short selling, for all the 
reasons noted in the [Proposing Release] relating to the detrimental 
effects on the marketplace. As noted [in the Proposing Release], 
this practice not only affects shareowners by depriving the[m] of 
the basic benefits of ownership, it also may detrimentally affect 
the issuer's reputation and subvert the appropriate workings of the 
market by avoiding certain restrictions applicable to those who 
deliver on time. All of these issues can ultimately undermine 
investor confidence.''); letter from Wallace E. Boston, President 
and Chief Executive Officer, American Public Education, Inc., dated 
May 20, 2008 (noting that ``[a]s the CEO of a recently public 
company, I am acutely aware of the impact that abusive short-selling 
can have on issuers and investors.'').

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[[Page 61670]]

    To the extent that fails to deliver might be part of manipulative 
``naked'' short selling, which could be used as a tool to drive down a 
company's stock price,\39\ such fails to deliver may undermine the 
confidence of investors.\40\ These investors, in turn, may be reluctant 
to commit capital to an issuer they believe to be subject to such 
manipulative conduct.\41\ 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.\42\ Unwarranted reputational damage caused by fails to 
deliver might have an adverse impact on the security's price.\43\
---------------------------------------------------------------------------

    \39\ See, e.g., 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) (settled case in which we 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. 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).
    \40\ In response to the 2007 Regulation SHO Proposed Amendments, 
we received comment letters discussing the impact of fails to 
deliver on investor confidence. See, e.g., letter from NCANS 2007. 
Commenters expressed similar concerns in response to the 2006 
Regulation SHO Proposed Amendments. See, e.g., letter from Mary 
Helburn, Executive Director, National Coalition Against Naked 
Shorting, dated Sept. 30, 2006 (``NCANS 2006''); letter from Richard 
Blumenthal, Attorney General, State of Connecticut, dated Sept. 19, 
2006.
    \41\ In response to the 2007 Regulation SHO Proposed Amendments, 
we 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 Robert K. Lifton, Chairman and CEO, 
Medis Technologies, Inc., dated Sept. 12, 2007; letter from NCANS 
2007. Commenters expressed similar concerns in response to the 2006 
Regulation SHO Proposed Amendments. See, e.g., letter from 
Congressman Tom Feeney--Florida, U.S. House of Representatives, 
dated Sept. 25, 2006; see also letter from Zix Corporation, dated 
Sept. 19, 2006 (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.'').
    \42\ 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 2003 Regulation SHO Proposing 
Release, 68 FR at 62975. 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 Exchange Act 
Release No. 47978 (June 4, 2003), 68 FR 35037 (June 11, 2003).
    \43\ 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; Proposing 
Release, 73 FR at 15378 (providing additional discussion of the 
impact of fails to deliver on the market); see also 2003 Regulation 
SHO Proposing Release, 68 FR at 62975 (discussing the impact of 
``naked'' short selling on the market).
---------------------------------------------------------------------------

    Strengthening rules that address ``naked'' short selling will 
provide increased confidence in the markets. Since the issuance of the 
July Emergency Order, members of the public have repeatedly expressed 
their concerns about a loss of confidence in the markets. For example, 
one commenter stated that ``financial confidence is critically 
important'' for companies to do business.\44\ Another commenter stated 
that ``existing laws should be enforced, but further steps should be 
taken to prevent any further erosion of the investing publics [sic] 
confidence.'' \45\
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    \44\ See Comment of Ron Heller (July 21, 2008) (``Heller'') 
(commenting on the Emergency Order).
    \45\ See Comment of Ronald L. Rourk (July 21, 2008) (``Rourk'') 
(commenting on the proposal to eliminate Regulation SHO's options 
market maker exception).
---------------------------------------------------------------------------

    We are concerned about the ability of short sellers to use 
``naked'' short selling as a tool to manipulate the prices of 
securities.\46\ Thus, in conjunction with our other short selling 
initiatives aimed at further reducing fails to deliver and addressing 
abusive ``naked'' short selling, we have adopted Rule 10b-21 
substantially as proposed.
---------------------------------------------------------------------------

    \46\ See, e.g., Commission press release, dated July 13, 2008, 
announcing that the Commission's Office of Compliance Inspections 
and Examinations, as well as FINRA and New York Stock Exchange 
Regulation, Inc., will immediately conduct examinations aimed at the 
prevention of the intentional spreading of false information 
intended to manipulate securities prices. See http://www.sec.gov/
news/press/2008/2008-140.htm. In addition, in April of this year, 
the Commission charged Paul S. Berliner, a trader, with securities 
fraud and market manipulation for intentionally disseminating a 
false rumor concerning The Blackstone Group's acquisition of 
Alliance Data Systems Corp (``ADS''). The Commission alleged that 
this false rumor caused the price of ADS stock to plummet, and that 
Berliner profited by short selling ADS stock and covering those 
sales as the false rumor caused the price of ADS stock to fall. See 
http://www.sec.gov/litigation/litreleases/2008/lr20537.htm.
---------------------------------------------------------------------------

    Proposed Rule 10b-21 was narrowly tailored to 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,\47\ or purchaser 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.\48\ We 
received over 700 comment letters in response to the Proposing Release.
---------------------------------------------------------------------------

    \47\ 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.
    \48\ See Proposed Rule 10b-21.
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    The comment letters were from numerous entities, including issuers, 
retail investors, broker-dealers, SROs, associations, members of 
Congress, and other elected officials.\49\ Many commenters supported 
our goals of further addressing potentially abusive ``naked'' short 
selling and fails to deliver, while not necessarily agreeing with the 
Commission's approach. For example, some commenters argued for more 
stringent short sale regulation.\50\ Others urged us to take stronger 
enforcement action against abusive ``naked'' short sellers under the 
current federal securities laws rather than, or in addition to, 
adopting Rule 10b-21.\51\

[[Page 61671]]

Some commenters asked that if we adopt Rule 10b-21 as proposed, we 
provide certain clarifications regarding the application of the 
rule.\52\ We highlight in the discussion below some of the main issues, 
concerns, and suggestions raised in the comment letters.
---------------------------------------------------------------------------

    \49\ The comment letters are available on the Commission's 
Internet Web Site at http://www.sec.gov/comments/s7-08-08/
s70808.shtml.
    \50\ See, e.g., letter from Arik B. Fetscher, Esq., dated April 
2, 2008; letter from Fred Adams, Jr., Chairman and Chief Executive 
Officer, Cal-Maine Foods, Inc., dated May 19, 2008; letter from 
David T. Hirschman, President and Chief Executive Officer, Center 
for Capital Markets Competitiveness, United States Chamber of 
Commerce, dated May 20, 2008 (``Chamber of Commerce''); letter from 
Wallace E. Boston, Jr., President and Chief Executive Officer, 
American Public Education, Inc., dated May 20, 2008; letter from 
Kurt N. Schacht, Executive Director, and Linda L. Rittenhouse, 
Senior Policy Analyst, CFA Institute Centre for Financial Market 
Integrity, dated June 17, 2008; letter from Guillaume Cloutier, 
dated July 25, 2008; letter from Shunliang Wang, dated July 27, 
2008; letter from Scott Bridgford, dated July 29, 2008; letter from 
Keith Kottwitz, dated Aug. 1, 2008.
    \51\ See, e.g., letter from Tony J. Akin, Jr., Financial 
Advisor, dated March 31, 2008; letter from Gary D. Owens, CEO, OYO 
Geospace, dated April 22, 2008; letter from Daniel J. Popeo, 
Chairman & General Counsel, and Paul D. Kamenar, Senior Executive 
Counsel, Washington Legal Foundation, dated May 20, 2008; letter 
from David Hughes, dated July 17, 2008; letter from Dave Morgan, 
dated July 25, 2008; letter from Seth Bradley, dated July 30, 2008; 
letter from Michael Kianka, dated Aug. 1, 2008.
    \52\ See, e.g., letter from James J. Angel, Associate Professor 
of Finance, Georgetown University, dated May 17, 2008 (``Angel''); 
letter from Heather Traeger, Assistant Counsel, Investment Company 
Institute, dated May 20, 2008; letter from Dr. Robert J. Shapiro, 
Chairman, Sonecon, LLC, and former U.S. Under Secretary of Commerce, 
dated May 20, 2008 (``Shapiro''); letter from Ira D. Hammerman, 
Managing Director and General Counsel, Securities Industry and 
Financial Markets Association, dated May 22, 2008 (``SIFMA''); 
letter from Michael R. Trocchio, Bingham McCutchen LLP, dated July 
14, 2008 (``Bingham''); letter from MFA.
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III. Discussion of Rule 10b-21

A. Rule 10b-21

    After careful consideration of the comments, we are adopting Rule 
10b-21 substantially as proposed. Rule 10b-21 specifies that it is 
unlawful for any person to submit an order to sell an equity security 
if such person deceives a broker-dealer, participant of a registered 
clearing agency,\53\ or purchaser 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.\54\ 
Scienter is a necessary element for a violation of the rule.\55\ Some 
commenters questioned whether, similar to Regulation SHO, proposed Rule 
10b-21 would apply only to equity securities.\56\ In response to these 
comments, we clarify that as proposed and adopted, Rule 10b-21 applies 
only to equity securities.\57\
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    \53\ See supra note 47 (defining the terms ``participant'' and 
``registered clearing agency'' for purposes of the rule).
    \54\ See Rule 10b-21.
    \55\ 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)). Some commenters stated they believe that Rule 10b-
21 should require a finding of ``intentional deception'' to best 
achieve our goals without deterring legitimate short selling. See, 
e.g., letter from MFA; another commenter, however, requested that we 
confirm that the concept of scienter, for purposes of Rule 10b-21, 
is identical to established precedent under Section 10(b) of the 
Exchange Act and Rule 10b-5 thereunder. See letter from SIFMA. We 
intend the scienter requirement of Rule 10b-21 to be the same as 
that required under Rule 10b-5.
    \56\ See, e.g., letter from MFA.
    \57\ See, e.g., Proposing Release, 73 FR at 15380; see also Rule 
10b-21.
---------------------------------------------------------------------------

    Rule 10b-21 will 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.\58\ Rule 10b-21 will prohibit 
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 Rule 10b-21 is to reduce 
fails to deliver, violation of the rule will occur only if a fail to 
deliver results from the relevant transaction.
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    \58\ As proposed, the rule referenced ``the date delivery is 
due.'' To provide specificity as to when delivery is due for 
purposes of the rule, we are modifying this language to ``settlement 
date'' and defining ``settlement date'' as ``the business day on 
which delivery of a security and payment of money is to be made 
through the facilities of a registered clearing agency in connection 
with the sale of a security.'' See Rule 10b-21(b).
---------------------------------------------------------------------------

    For purposes of Rule 10b-21, broker-dealers (including market 
makers) acting for their own accounts will be considered sellers. For 
example, a broker-dealer effecting short sales for its own account will 
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.\59\
---------------------------------------------------------------------------

    \59\ See supra note 22; 2007 Regulation SHO Final 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 introducing 
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.\60\ 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.\61\ 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 makes a representation to a broker-dealer for purposes of Rule 
10b-21.\62\
---------------------------------------------------------------------------

    \60\ See 17 CFR 242.203(b)(3)(1).
    \61\ See 2004 Regulation SHO Adopting Release, 69 FR at 48014.
    \62\ Broker-dealers offer DMA to some 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 will be liable under Rule 10b-21 if the 
seller also fails to deliver securities by the date delivery is due. 
For example, a seller will be liable for a violation of 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 will 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.
    One commenter recommended that the rule focus on whether there is a 
fail to deliver in the Continuous Net Settlement (``CNS'') system, 
rather than on a seller's failure to deliver the securities sold.\63\ 
The majority of equity trades in the United States are cleared and 
settled through systems administered by clearing agencies registered 
with the Commission. The NSCC clears and settles the majority of equity 
securities trades conducted on the exchanges and in the over the 
counter market. NSCC clears and settles trades through the CNS system, 
which nets the securities delivery and payment obligations of all of 
its members. The majority of NSCC's members are broker-

[[Page 61672]]

dealers.\64\ NSCC notifies its members of their securities delivery and 
payment obligations daily. In addition, NSCC guarantees the completion 
of all transactions and interposes itself as the contraparty to both 
sides of the transaction. This commenter noted that a seller's clearing 
broker generally bears the responsibility to meet the firm's CNS 
delivery requirement and that it is difficult for a broker-dealer to 
determine which customer transactions or accounts give rise to a fail 
to deliver in the CNS system. We note, however, that Rule 10b-21 as 
proposed was not based on whether a fail to deliver occurred in CNS. 
Rather, the rule as proposed was concerned with whether an individual 
seller delivered securities that it sold. Along those lines, another 
commenter stated that the proposed rule should require a failure to 
deliver by the seller.\65\
---------------------------------------------------------------------------

    \63\ See letter from SIFMA.
    \64\ As of July 31, 2008 approximately 91% of members of the 
NSCC were registered as broker-dealers.
    \65\ See letter from Bingham.
---------------------------------------------------------------------------

    We have determined to adopt the rule as proposed. The rule targets 
the misconduct of sellers. As discussed above, sellers should promptly 
deliver the securities they have sold and purchasers have the right to 
the timely receipt of securities that they have purchased. Thus, Rule 
10b-21's focus is on whether or not there is a fail to deliver by the 
seller, rather than on whether or not there is a fail to deliver in the 
CNS system. Because fails to deliver in the CNS system are netted with 
pending deliveries, some sellers may be able to postpone delivery if 
another customer's purchase is received the same day. Thus, a person 
engaging in abusive ``naked'' short selling may be able to avoid 
detection for a period of time. This would undermine our goal of 
addressing abusive ``naked'' short selling.

B. Seller's Reliance on a Broker-Dealer or ``Easy to Borrow'' Lists

    Rule 10b-21 provides that it shall be unlawful for any person to 
submit an order to sell an equity security if such person deceives a 
broker-dealer, participant of a registered clearing agency, or 
purchaser regarding its intention or ability to deliver the security on 
the date delivery is due.\66\ Thus, as we discussed in the Proposing 
Release,\67\ if 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.'' \68\
---------------------------------------------------------------------------

    \66\ See Rule 10b-21.
    \67\ See Proposing Release, 73 FR at 15379.
    \68\ 2004 Regulation SHO Adopting Release, 69 FR at 48014.
---------------------------------------------------------------------------

C. Bona Fide Market Makers

    As we discussed in the Proposing Release,\69\ 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.\70\ 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.
---------------------------------------------------------------------------

    \69\ See Proposing Release, 73 FR at 15379.
    \70\ See 2004 Regulation SHO Adopting Release, 69 FR at 48015, 
n. 67; see also 2008 Regulation SHO Final Amendments, supra note 22 
(providing interpretive guidance regarding bona fide market making 
activities for purposes of Regulation SHO).
---------------------------------------------------------------------------

D. ``Long'' Sales

    Under Rule 10b-21, a seller will 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.\71\ As we discussed 
in the Proposing Release,\72\ a seller will be liable for a violation 
of 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 \73\ 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.
---------------------------------------------------------------------------

    \71\ See Rule 10b-21.
    \72\ See Proposing Release, 73 FR at 15379.
    \73\ 17 CFR 242.200(a)-(f).
---------------------------------------------------------------------------

    Broker-dealers acting for their own accounts will also be liable 
under Rule 10b-21 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.\74\
---------------------------------------------------------------------------

    \74\ Such broker-dealers will also be liable under Regulation 
SHO Rule 203(a).
---------------------------------------------------------------------------

    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.

E. Rule 10b-21 and Other Antifraud Provisions of the Federal Securities 
Laws

    One commenter stated that it believes proposed Rule 10b-21 is 
unnecessary ``because the Commission already has ample existing 
authority, under Section 10(b) of the Exchange Act and Rule 10b-5 
thereunder, to prosecute manipulative and/or fraudulent activity, 
including the type of activity that proposed Rule 10b-21 seeks to 
address.'' \75\ Other commenters urged us to use less formal means than 
rulemaking to address our concerns regarding misrepresentations in the 
order entry process.\76\ For

[[Page 61673]]

instance, these commenters suggested that the Commission or its staff 
could convey this message through FAQs, staff bulletins, and 
speeches.\77\ We have determined, however, that the negative effects of 
abusive ``naked'' short selling on market confidence warrant formal 
Commission action.
---------------------------------------------------------------------------

    \75\ See letter from SIFMA; see also letter from Bingham 
(stating that ``[t]he Firms agree that the illicit conduct the 
Commission seeks to address through [proposed Rule 10b-21] is 
already illegal''); letter from MFA.
    \76\ See, e.g., letter from Bingham; letter from MFA; but, c.f., 
letter from Chamber of Commerce (noting that although the activity 
covered by proposed Rule 10b-21 is already a violation of the 
antifraud provisions of the federal securities laws, ``[e]mphasizing 
that such deceit violates these laws may deter some of this activity 
in the future'').
    \77\ See, e.g., letter from Bingham.
---------------------------------------------------------------------------

    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 a rule further evidencing the 
illegality of these activities will focus the attention of market 
participants on such activities. Rule 10b-21 will also further evidence 
that the Commission believes such deceptive activities are detrimental 
to the markets and will provide a measure of predictability for market 
participants.
    Some commenters sought clarification as to how this rule was 
different from Rule 10b-5.\78\ We note that the set of factors that 
will serve as the basis for a violation of Rule 10b-21 as adopted are 
not determinative of a person's obligations under the general antifraud 
provisions of the federal securities laws. Accordingly, and in order to 
clarify the continued applicability of the general antifraud provisions 
outside of the strict context of Rule 10b-21, we have added a 
preliminary note to the rule as adopted, which states: ``This rule is 
not intended to limit, or restrict, the applicability of the general 
antifraud provisions of the federal securities laws, such as section 
10(b) of the Act and rule 10b-5 thereunder.'' We added this preliminary 
note because we believe it is important to underscore that Rule 10b-21 
is not meant, in any way, to limit the general antifraud provisions of 
the federal securities laws. Additionally, this preliminary note 
provides much needed public clarity in answer to the confusion voiced 
by many commenters.
---------------------------------------------------------------------------

    \78\ See, e.g., letter from MFA; see also letter from SIFMA 
(seeking clarification as to whether the level of scienter in the 
proposed rule differs from that of Rule 10b-5).
---------------------------------------------------------------------------

    Similarly, we are modifying the proposed rule text slightly to add 
the word ``also,'' as follows: ``It shall also 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 an equity 
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 or before the settlement date, and 
such person fails to deliver the security on or before the settlement 
date.''
    We believe the adding the word ``also'' in the rule text further 
clarifies that Rule 10b-21 does not affect the operation of Rule 10b-5 
or other antifraud rules, but is instead intended to supplement the 
existing antifraud rules.
    Commenters also raised questions whether there would be a private 
right of action for a violation of proposed Rule 10b-21.\79\ We note 
that the courts have held that a private right of action exists with 
respect to Rule 10b-5 provided the essential elements constituting a 
violation of the rule are met.\80\ Thus, a private plaintiff able to 
prove all those elements in a situation covered by Rule 10b-21 would be 
able to assert a claim under Section 10(b) of the Exchange Act and Rule 
10b-5 thereunder.
---------------------------------------------------------------------------

    \79\ See, e.g., letter from SIFMA. Another commenter stated that 
``[t]he Commission should make explicitly clear that the adoption of 
Proposed Rule 10b-21 does not create a private right of action for 
violations of the rule. * * *'' See letter from Bingham.
    \80\ See, e.g., Superintendent of Insurance v. Bankers Life & 
Cas. Co., 404 U.S. 6, 13, n. 9 (1971); Ernst & Ernst, 425 at 196 
(citing prior cases).
---------------------------------------------------------------------------

F. Aiding and Abetting Liability

    In the Proposing Release, we stated that ``[a]lthough the proposed 
rule is primarily aimed at sellers that deceive specified persons about 
their intention or ability to deliver shares or about their locate 
source and ownership of shares, as with any rule, broker-dealers could 
be liable for aiding and abetting a customer's fraud under the proposed 
rule.'' \81\ One commenter stated that broker-dealers should not be 
held responsible for policing their customer's compliance with their 
own legal requirements.\82\ Another commenter urged us to specifically 
state that reliance by a broker-dealer on a customer representation 
regarding long/short status or receipt of a locate does not rise to the 
level of scienter required for aiding and abetting liability.\83\ This 
commenter also asked us to make clear that broker-dealers who merely 
o