Amendments to Regulation SHO, 38266-38293 [E9-18185]

Agencies

• SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 74, Number 146 (Friday, July 31, 2009)]
[Rules and Regulations]
[Pages 38266-38293]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E9-18185]



[[Page 38265]]

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Part II





Securities and Exchange Commission





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17 CFR Parts 200 and 242



Amendments to Regulation SHO; Final Rule

Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules 
and Regulations

[[Page 38266]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 200 and 242

[Release No. 34-60388; File No. S7-30-08]
RIN 3235-AK22


Amendments to Regulation SHO

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
finalizing amendments to Regulation SHO under the Securities Exchange 
Act of 1934 (``Exchange Act'') by making permanent amendments contained 
in Interim Final Temporary Rule 204T (``temporary Rule 204T'') of 
Regulation SHO, with some modifications to address commenters' 
concerns. These amendments are intended to help further our goal of 
reducing fails to deliver by maintaining the reductions in fails to 
deliver achieved by the adoption of temporary Rule 204T, as well as 
other actions taken by the Commission. In addition, these amendments 
are intended to help further our goal of addressing abusive ``naked'' 
short selling in all equity securities. These goals will be furthered 
by requiring that, subject to certain limited exceptions, if a 
participant of a registered clearing agency has a fail to deliver 
position at a registered clearing agency it must immediately purchase 
or borrow securities to close out the fail to deliver position by no 
later than the beginning of regular trading hours on the settlement day 
following the day the participant incurred the fail to deliver 
position. Failure to comply with the close-out requirement of this 
final rule is a violation of the rule. In addition, a participant that 
does not comply with this close-out requirement, and any broker-dealer 
from which it receives trades for clearance and settlement, will not be 
able to short sell the security either for itself or for the account of 
another, unless it has previously arranged to borrow or borrowed the 
security, until the fail to deliver position is closed out.

DATES: Effective Date: July 31, 2009.

FOR FURTHER INFORMATION CONTACT: Jo Anne Swindler, Acting Associate 
Director; Josephine Tao, Assistant Director; Victoria Crane, Branch 
Chief; David Bloom and Christina M. Adams, Special Counsels; Matthew 
Sparkes or Katrina Wilson, Staff Attorneys, Office of Trading Practices 
and Processing, Division of Trading and Markets, at (202) 551-5720, at 
the Commission, 100 F Street, NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION: We are adding Rule 204 of Regulation SHO [17 
CFR 242.204] under the Exchange Act and removing Rule 204T of 
Regulation SHO [17 CFR 242.204T] under the Exchange Act.

I. Introduction

    In October 2008, we adopted temporary Rule 204T of Regulation SHO 
as an interim final temporary rule, with an expiration date of July 31, 
2009.\1\ As discussed in more detail below, temporary Rule 204T 
strengthens the close-out requirements of Regulation SHO for failures 
to deliver securities (known as ``fails'' or ``fails to deliver'') \2\ 
resulting from sales of any equity security. Our adoption of temporary 
Rule 204T followed a series of other steps aimed at reducing fails to 
deliver and addressing potentially abusive ``naked'' short selling.\3\
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    \1\ See Exchange Act Release No. 58733 (Oct. 14, 2008), 73 FR 
61706 (Oct. 17, 2008) (``Rule 204T Adopting Release'').
    \2\ Fails to deliver occur when a seller fails to deliver 
securities to the buyer when delivery is due. See infra note 16 and 
accompanying text.
    \3\ See infra Section II (discussing other Commission actions 
aimed at reducing fails to deliver and addressing potentially 
abusive ``naked'' short selling).
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    In addition, at the time that we adopted temporary Rule 204T, we 
noted our concerns about the sudden and unexplained declines in the 
prices of equity securities generally and the deterioration in investor 
confidence in our financial markets.\4\ Such price declines can give 
rise to questions about the underlying financial condition of an 
entity, which in turn can create a crisis of confidence even without a 
fundamental underlying basis.\5\ This crisis of confidence can impair 
the liquidity and ultimate viability of an entity, with potentially 
broad market consequences.\6\ Thus, we also adopted temporary Rule 204T 
to further our goal of preventing substantial disruption in the 
securities markets by providing a powerful disincentive to those who 
might otherwise engage in potentially abusive ``naked'' short 
selling.\7\
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    \4\ See Rule 204T Adopting Release, 73 FR 61707.
    \5\ See id.
    \6\ See id.
    \7\ See id.
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    Preliminary results from the Commission's Office of Economic 
Analysis (``OEA'') indicate that our various actions to further reduce 
fails to deliver and, thereby, address potentially abusive ``naked'' 
short selling are having their intended effect. For example, these 
preliminary results indicate a significant downward trend in the number 
of fails to deliver in all equity securities since, among other 
actions, the adoption of temporary Rule 204T.\8\ These results provide, 
among other things, that in comparing a pre- to post-temporary Rule 
204T adoption period,\9\ the average daily number of fails to deliver 
for all equity securities has declined from 1.1 billion to 478 million 
for a total decline of 56.6 percent. In addition, the average daily 
number of threshold securities declined from 480 securities to 108 
securities in comparing the pre- to post-temporary Rule 204T adoption 
period, a decline of 77.5%.\10\
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    \8\ See Memorandum from OEA Re: Impact of Recent SHO Rule 
Changes on Fails to Deliver, November 26, 2008 at https://www.sec.gov/comments/s7-30-08/s73008-37.pdf; see also Memorandum 
from OEA Re: Impact of Recent SHO Rule Changes on Fails to Deliver, 
March 20, 2009 at https://www.sec.gov/comments/s7-30-08/s73008-107.pdf; Memorandum from OEA Re: Impact of Recent SHO Rule Changes 
on Fails to Deliver, April 16, 2009 (``OEA April 2009 Memorandum'') 
at https://www.sec.gov/comments/s7-30-08/s73008-121.pdf.
    \9\ The OEA April 2009 Memorandum defined the pre-Rule period as 
the period from January 1, 2008 to September 22, 2008, and the post-
Rule period as September 23, 2008 to March 31, 2009. The post-Rule 
period was also post elimination of the options market maker 
exception to Regulation SHO's close-out requirement in Rule 
203(b)(3) of Regulation SHO. See OEA April 2009 Memorandum; see also 
infra notes 38-41 and accompanying text.
    \10\ See OEA April 2009 Memorandum.
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    Due to the positive impact that temporary Rule 204T,\11\ as well as 
other recent Commission actions, are having on reducing fails to 
deliver and after considering the comments received to temporary Rule 
204T, we are adopting the provisions of that rule in a permanent rule, 
Rule 204 of Regulation SHO, with some limited modifications to refine 
provisions and address commenters' concerns.\12\ In general, as 
discussed in more detail below, we are maintaining the structure of 
temporary Rule 204T, while making some

[[Page 38267]]

adjustments to promote its workability.\13\
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    \11\ We note in this regard that at a public Roundtable to 
Examine Short Sale Price Test and Circuit Breaker Restrictions held 
on May 5, 2009 (the ``Short Sale Price Test Roundtable''), a number 
of participants of the Roundtable commented on the success of 
temporary Rule 204T at reducing fails to deliver and urged the 
Commission to adopt temporary Rule 204T as a permanent rule. See, 
e.g., https://www.sec.gov/spotlight/shortsales/roundtable050509/shortsalesroundtable050509-transcript.txt.
    \12\ We received approximately 120 comment letters in response 
to the Rule 204T Adopting Release. The comment letters are available 
on the Commission's Internet Web site at https://www.sec.gov/comments/s7-30-08/s73008.shtml. Further, as noted above, a number of 
participants at the Commission's Short Sale Price Test Roundtable 
expressed views about temporary Rule 204T. See e.g., https://www.sec.gov/spotlight/shortsales/roundtable050509/shortsalesroundtable050509-transcript.txt. See also comments to the 
Short Sale Price Test Roundtable at https://www.sec.gov/comments/4-581/4-581.shtml.
    \13\ See infra Section III (discussing Rule 204 of Regulation 
SHO and commenters' concerns).
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    We believe that Rule 204 of Regulation SHO will continue to help 
further our goal of reducing fails to deliver by maintaining the 
reductions in fails to deliver achieved by the adoption of temporary 
Rule 204T, as well as other actions taken by the Commission. In 
addition, these amendments are intended to help further our goal of 
addressing potentially abusive ``naked'' short selling. These goals 
will be furthered by, among other things, requiring that securities are 
purchased or borrowed to close out any fail to deliver position 
resulting from a short sale of an equity security by no later than the 
beginning of regular trading hours on the settlement day following the 
date on which the fail to deliver position occurred. Similar to 
temporary Rule 204T of Regulation SHO, Rule 204 will continue to 
provide a disincentive to those who might otherwise engage in 
potentially abusive ``naked'' short selling.

II. Background

    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.\14\ Short sales 
normally are settled by the delivery of a security borrowed by or on 
behalf of the seller. In a ``naked'' short sale, however, the short 
seller does not borrow securities in time to make delivery to the buyer 
within the standard three-day settlement period.\15\ As a result, the 
seller fails to deliver securities to the buyer when delivery is 
due.\16\ Sellers sometimes intentionally fail to deliver securities as 
part of a scheme to manipulate the price of a security,\17\ or possibly 
to avoid borrowing costs associated with short sales, especially when 
the costs of borrowing stock are high.
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    \14\ 17 CFR 242.200(a).
    \15\ See Exchange Act Release No. 50103 (July 28, 2004), 69 FR 
48008, 48009 n. 10 (Aug. 6, 2004) (``2004 Regulation SHO Adopting 
Release'').
    \16\ Generally, investors complete or settle their security 
transactions within three settlement days. This settlement cycle is 
known as T+3 (or ``trade date plus three days''). T+3 means that 
when a trade occurs, the participants to the trade deliver and pay 
for the security at a clearing agency three settlement days after 
the trade is executed so the brokerage firm can exchange those funds 
for the securities on that third settlement day. 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 
settlement day following the trade (or T+1). 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; see also Exchange Act Release No. 
56212 (Aug. 7, 2007), 72 FR 45544, n. 2 (Aug. 14, 2007) (``2007 
Regulation SHO Final Amendments'').
    \17\ 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); SEC v. Rhino Advisors, Inc. and Thomas Badian, Civ. 
Action No. 03 civ 1310 (RO) (S.D.N.Y); see also 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 case involving stock of Sedona Corporation); 2004 Regulation 
SHO Adopting Release, 69 FR 48016, n.76; Exchange Act Release No. 
58774 (Oct. 14, 2008), 73 FR 61666 (Oct. 17, 2008) (``Anti-Fraud 
Rule Adopting Release'').
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    We have been concerned about reducing fails to deliver and 
addressing ``naked'' short selling, in particular, potentially abusive 
``naked'' short selling, for some time. As we have stated on several 
prior occasions, we believe that 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.\18\ 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.\19\
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    \18\ See, e.g., Rule 204T Adopting Release, 73 FR 61709; 
Exchange Act Release No. 57511 (Mar. 17, 2008), 73 FR 15376, 15377 
(Mar. 31, 2008) (``Anti-Fraud Rule Proposing Release'').
    \19\ See, e.g., Rule 204T Adopting Release, 73 FR 61709; 2007 
Regulation SHO Final Amendments, 72 FR 45544; Exchange Act Release 
No. 54154 (July 14, 2006), 71 FR 41710, 41712 (July 21, 2006) 
(``2006 Regulation SHO Proposed Amendments''); Exchange Act Release 
No. 56213 (Aug. 7, 2007), 72 FR 45558, 45558-45559 (Aug. 14, 2007) 
(``2007 Regulation SHO Proposed Amendments''); Anti-Fraud Rule 
Proposing Release, 73 FR 15378.
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    For example, large and persistent fails to deliver may deprive 
shareholders of the benefits of ownership, such as voting and 
lending.\20\ 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.\21\ Moreover, sellers that fail to deliver 
securities on settlement date may attempt to use this additional 
freedom to engage in trading activities to improperly depress the price 
of a security. By not borrowing securities and, therefore, not making 
delivery within the standard three-day settlement period, the seller 
has additional freedom because it does not incur the costs of 
borrowing.
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    \20\ See id.
    \21\ See id.
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    In addition, 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,\22\ which were designed to 
further reduce the number of persistent fails to deliver in certain 
equity securities by eliminating Regulation SHO's ``grandfather'' 
exception and limit the duration of the rule's options market maker 
exception, we received a number of comments that expressed concerns 
about ``naked'' short selling and extended delivery failures.\23\ 
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 \24\ and in response to 
the Rule 204T Adopting Release.\25\
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    \22\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
    \23\ 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; letter from John Royce, dated April 30, 2007; 
letter from Michael Read, dated April 29, 2007; letter from Robert 
DeVivo, dated April 26, 2007; letter from Ahmed Akhtar, dated April 
26, 2007.
    \24\ 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 (``Raybould''); letter from Mary Helburn, Executive 
Director, National Coalition Against Naked Shorting, dated Sept. 12, 
2007 (``NCANS'').
    \25\ See e.g., letter from Roel Campos, dated Mar. 25, 2009 
(``Campos''); letter from the Risk Management Association, dated 
Dec. 23, 2008; letter from Professor James Angel, Ph.D, CFA, dated 
Dec. 17, 2008 (``Angel''); letter from Patrick Byrne, Ph.D., dated 
Dec. 16, 2008; letter from the American Bankers Association, dated 
Dec. 16, 2008 (``ABA''); letter from Fairfax Financial Holdings, 
Ltd., dated Oct. 16, 2008.
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    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,\26\ such fails to deliver may

[[Page 38268]]

undermine the confidence of investors.\27\ These investors, in turn, 
may be reluctant to commit capital to an issuer they believe to be 
subject to such manipulative conduct.\28\ 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.\29\ Unwarranted reputational damage caused by fails 
to deliver might have an adverse impact on the security's price.\30\
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    \26\ See supra note 17 (discussing a 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. Mar. 27, 1991) (alleged manipulation 
by sales representative by directing or inducing customers to sell 
stock short in order to depress its price); U.S. v. Russo, 74 F.3d 
1383, 1392 (2d Cir. 1996) (short sales were sufficiently connected 
to the manipulation scheme as to constitute a violation of Exchange 
Act Section 10(b) and Rule 10b-5).
    \27\ In response to the Rule 204T Adopting Release, we received 
comment letters discussing the impact of fails to deliver on 
investor confidence. See e.g., letter from David Patch, dated Mar. 
19, 2009; letter from Charles J. Greiner, dated Mar. 11, 2009. In 
response to the 2007 Regulation SHO Proposed Amendments, commenters 
discussed the impact of fails to deliver on investor confidence. 
See, e.g., letter from NCANS. 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 (``Blumenthal'').
    \28\ In response to the Rule 204T Adopting Release, 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 Campos (noting that ``[i]n its most benign form, 
naked short selling is a hidden tax on equity markets, our largest 
wealth creation mechanism. At its worst, it is a violent force of 
wealth destruction that affects all market participants.''); letter 
from Patrick Byrne Ph.D., Chairman and Chief Executive Officer, 
Overstock.com Inc., dated Dec. 16, 2008 (stating that ``more needs 
to be done to correct the problem of naked short selling and to 
prevent more companies from being taken down by those that use it as 
a tool for manipulation.''); see also letter from ABA. Commenters 
expressed similar concerns in response to the 2007 Regulation SHO 
Proposed Amendments. See, e.g., letter from Robert K. Lifton, 
Chairman and CEO, Medis Technologies, Inc., dated Sept. 12, 2007 
(``Medis''); letter from NCANS. Commenters also 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 (``Feeney''); see also 
letter from Zix Corporation, dated Sept. 19, 2006 (``Zix'') (stating 
that ``[m]any investors attribute the Company's frequent re-
appearances on the Regulation SHO list to manipulative short selling 
and frequently demand that the Company ``do something'' about the 
perceived manipulative short selling. This perception that 
manipulative short selling of the Company's securities is 
continually occurring has undermined the confidence of many of the 
Company's investors in the integrity of the market for the Company's 
securities.'').
    \29\ Due in part to such concerns, some issuers have taken 
actions to attempt to make transfer of their securities ``custody 
only,'' (i.e., certificating the securities and prohibiting 
ownership by a securities intermediary) thus preventing transfer of 
their stock to or from securities intermediaries such as the 
Depository Trust Company (``DTC'') or broker-dealers. See Exchange 
Act Release No. 48709 (Oct. 28, 2003), 68 FR 62972, at 62975 (Nov. 
6, 2003). Some issuers have attempted to withdraw their issued 
securities on deposit at DTC in order to make 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. See Exchange Act Release No. 47978 (June 
4, 2003), 68 FR 35037 (June 11, 2003).
    \30\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41712; 
2007 Regulation SHO Final Amendments, 72 FR 45545; 2007 Regulation 
SHO Proposed Amendments, 72 FR 45558-45559; Anti-Fraud Rule 
Proposing Release, 73 FR 15378; Rule 204T Adopting Release, 73 FR 
61709-61710 (providing discussion of the impact of fails to deliver 
on the market); see also 2003 Regulation SHO Proposing Release, 68 
FR 62975 (Nov. 6, 2003) (discussing the impact of ``naked'' short 
selling on the market).
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    Although the majority of trades settle within T+3,\31\ we adopted 
Regulation SHO \32\ on July 28, 2004, in part to address problems 
associated with persistent fails to deliver securities and potentially 
abusive ``naked'' short selling. For example, Regulation SHO requires 
broker-dealers to ``locate'' securities that the broker-dealer 
reasonably believes can be delivered within the standard three-day 
settlement period.\33\
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    \31\ According to the National Securities Clearing Corporation 
(``NSCC''), 99% (by dollar value) of all trades settle within T+3. 
Thus, on an average day, only approximately 1% (by dollar value) of 
all trades, including equity, debt, and municipal securities fail to 
settle on time.
    \32\ 17 CFR 242.200. Regulation SHO became effective on January 
3, 2005.
    \33\ 17 CFR 242.203(b)(1). Rule 203(b)(1) of Regulation SHO 
requires 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).'' This is known as the 
``locate'' requirement. Market makers engaged in bona fide market 
making in the security at the time they effect the short sale are 
excepted from this requirement. In connection with this ``locate'' 
requirement, as well as other provisions of Regulation SHO that 
require a reasonableness determination (i.e., Rules 200(g)(1) and 
203(a)(2)(ii)), we remind any broker-dealer subject to such 
provisions that they have an affirmative obligation to obtain and 
consider information from their own records and/or from the records 
of another source helpful to making the reasonableness 
determinations required by such rules. Such information may include, 
but is not limited to, information regarding a customer's prior 
assurances regarding a locate source, its share ownership, or 
delivery of shares by settlement date. See 17 CFR 242.203(b)(1), 
242.200(g)(1), 203(a)(2)(ii). See also 2004 Regulation SHO Adopting 
Release, 69 FR 48014, n. 58, 48019 at n. 111.
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    Another requirement of Regulation SHO aimed at potentially abusive 
``naked'' short selling and reducing fails to deliver in certain equity 
securities is the rule's ``close-out'' requirement. Since Regulation 
SHO was adopted it has required participants \34\ of a registered 
clearing agency,\35\ which includes broker-dealers, to purchase shares 
to close out fails to deliver in securities with large and persistent 
fails to deliver, i.e., ``threshold securities.'' \36\ Until the 
position is closed out, the participant responsible for the fail to 
deliver position and any broker-dealer from which it receives trades 
for clearance and settlement may not effect further short sales in that 
threshold security without first borrowing or arranging to borrow the 
security.\37\
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    \34\ For purposes of Regulation SHO, the term ``participant'' 
has the same meaning as in section 3(a)(24) of the Exchange Act. See 
15 U.S.C. 78c(a)(24).
    \35\ The term ``registered clearing agency'' means a clearing 
agency, as defined in Section 3(a)(23)(A) 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) and 78q-1, respectively; see also 2004 
Regulation SHO Adopting Release, 69 FR 48031. 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 Continuous Net Settlement 
(``CNS'') system, which nets the securities delivery and payment 
obligations of all of its members. NSCC notifies its members of 
their securities delivery and payment obligations daily. In 
addition, NSCC guarantees the completion of all transactions and 
interposes itself as the contraparty to both sides of the 
transaction. We intend to closely monitor fails to deliver resulting 
from trades that are not cleared and settled through the CNS system.
    \36\ Rule 203(c)(6) of Regulation SHO defines a ``threshold 
security'' as any equity security of an issuer that is registered 
pursuant to Section 12 of the Exchange Act (15 U.S.C. 78l) or for 
which the issuer is required to file reports pursuant to Section 
15(d) of the Exchange Act (15 U.S.C. 78o(d)) for which there is an 
aggregate fail to deliver position for five consecutive settlement 
days at a registered clearing agency of 10,000 shares or more, and 
that is equal to at least 0.5% of the issue's total shares 
outstanding; and is included on a list disseminated to its members 
by a self-regulatory organization (``SRO''). See 17 CFR 
242.203(c)(6).
    \37\ See 17 CFR 242.203(b)(3)(iv).
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    As adopted, Regulation SHO included two major exceptions to the 
close-out requirement: The ``grandfather'' provision and the ``options 
market maker'' exception. The ``grandfather'' provision 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 thirteen consecutive settlement day close-out 
requirement.

[[Page 38269]]

    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 threshold securities with fail to deliver positions that 
were not being closed out under existing delivery and settlement 
requirements, effective on October 15, 2007, we adopted an amendment to 
Regulation SHO that eliminated the ``grandfather'' provision.\38\
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    \38\ See 2007 Regulation SHO Final Amendments, 72 FR 45544. 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 on 
December 5, 2007.
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    The options market maker exception excepted 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. On September 17, 2008, we adopted and made 
immediately effective, as an emergency rule, an amendment to Rule 
203(b)(3) of Regulation SHO to eliminate the options market maker 
exception to the rule's close-out requirement.\39\ Following the 
issuance of the September Emergency Order, we adopted amendments making 
permanent the elimination of the options market maker exception.\40\ As 
we discussed in the 2008 Regulation SHO Final Amendments, we believed 
it was appropriate to eliminate the options market maker exception in 
part because substantial levels of fails to deliver continued to 
persist in threshold securities and it appeared that a significant 
number of these fails to deliver were as a result of the options market 
maker exception.\41\
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    \39\ See Exchange Act Release No. 58572 (Sept. 17, 2008), 73 FR 
54875 (Sept. 23, 2008) (``September Emergency Order'').
    \40\ See Exchange Act Release No. 58775 (Oct. 14, 2008), 73 FR 
61690 (Oct. 17, 2008) (``2008 Regulation SHO Final Amendments''); 
see also 2007 Regulation SHO Proposed Amendments, 72 FR 45558; 2006 
Regulation SHO Proposed Amendments, 71 FR 41710; Exchange Act 
Release No. 58107 (July 7, 2008), 73 FR 40201 (July 14, 2008) 
(``2008 Regulation SHO Re-Opening Release'').
    \41\ See 2008 Regulation SHO Final Amendments, 73 FR 61690; see 
also 2008 Regulation SHO Re-Opening Release, 73 FR 40201.
---------------------------------------------------------------------------

    In adopting temporary Rule 204T of Regulation SHO pursuant to the 
September Emergency Order and subsequently pursuant to the Rule 204T 
Adopting Release, we strengthened further the close-out requirements of 
Regulation SHO by applying close-out requirements to fails to deliver 
resulting from sales of all equity securities and reducing the time-
frame within which fails to deliver must be closed out.\42\
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    \42\ In addition to these amendments to Regulation SHO, recently 
we have taken other actions aimed at reducing fails to deliver and 
addressing potentially abusive ``naked'' short selling. For example, 
in July 2008, we published an emergency order under section 12(k) of 
the Exchange Act (the ``July Emergency Order'') that temporarily 
restricted ``naked'' short selling in the publicly traded securities 
of nineteen financial institutions. See Exchange Act Release No. 
58166 (July 15, 2008), 73 FR 55169 (July 21, 2008) (imposing 
borrowing and delivery requirements on short sales of the equity 
securities of nineteen financial companies); see also Exchange Act 
Release No. 58248 (July 29, 2008), 73 FR 45257 (Aug. 4, 2008) 
(extending the July Emergency Order such that it expired on August 
12, 2008). In September 2008, we published an emergency order that 
temporarily banned short selling in the publicly traded securities 
of approximately 1,000 financial institutions (the ``Short Sale 
Ban''). See Exchange Act Release No. 58592 (Sept. 18, 2008), 73 FR 
55169 (Sept. 24, 2008); see also Exchange Act Release No. 58611 
(Sept. 21, 2008), 73 FR 55556 (Sept. 25, 2008) (amending the Short 
Sale Ban). The Short Sale Ban expired on October 8, 2008. In 
addition, in the September Emergency Order, we adopted and made 
immediately effective a ``naked'' short selling anti-fraud rule, 
Rule 10b-21, aimed at sellers, including broker-dealers acting for 
their own accounts, who deceive certain specified persons about 
their intention or ability to deliver securities in time for 
settlement and that fail to deliver securities by settlement date. 
See September Emergency Order. Following the issuance of the 
September Emergency Order, we adopted final amendments making Rule 
10b-21 permanent. See Anti-Fraud Rule Adopting Release, 73 FR 61666; 
see also Anti-Fraud Rule Proposing Release, 73 FR 15376. In 
addition, on April 8, 2009, we proposed amendments to Regulation SHO 
that, if adopted, would add a short sale price test restriction or 
short sale circuit breaker rule to Regulation SHO. See Exchange Act 
Release No. 59748 (Apr. 10, 2009), 74 FR 18042 (Apr. 20, 2009) (the 
``Short Sale Price Test Proposing Release'').
---------------------------------------------------------------------------

    As noted above, since the adoption of temporary Rule 204T and the 
elimination of Regulation SHO's options market maker exception, we have 
seen a significant reduction in the number of fails to deliver in all 
equity securities. To continue advancing our goal of reducing fails to 
deliver by maintaining the reductions in fails to deliver achieved by 
the adoption of temporary Rule 204T, as well as other actions taken by 
the Commission, and addressing potentially abusive ``naked'' short 
selling, we are adopting the substance of temporary Rule 204T in a 
permanent rule, Rule 204. We continue to believe that strengthening the 
close-out requirements of Regulation SHO will further help to protect 
and enhance the operation, integrity, and stability of the markets, as 
well as help reduce potential short selling abuses.

III. Discussion of Rule 204 of Regulation SHO

    As discussed in more detail below, we are maintaining the structure 
of temporary Rule 204T with limited modifications to address 
commenters' concerns. In discussing the provisions of Rule 204, we 
highlight below some of the main issues, concerns, and suggestions 
raised by commenters.\43\
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    \43\ See supra note 12.
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A. Rule 204's Close-Out Requirement

1. Close-Out Period
    In Rule 204(a), we are adopting the close-out requirements of 
temporary Rule 204T(a) without modification. Temporary Rule 204T(a) 
provides that a participant of a registered clearing agency must 
deliver securities to a registered clearing agency for clearance and 
settlement on a long or short sale in any equity security by settlement 
date, or if a participant of a registered clearing agency has a fail to 
deliver position at a registered clearing agency in any equity security 
for a long or short sale transaction in that equity security, the 
participant shall, by no later than the beginning of regular trading 
hours \44\ on the settlement day \45\ following the settlement date 
(i.e., T+4), immediately close out the fail to deliver position by 
borrowing or purchasing securities of like kind and quantity.\46\
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    \44\ ``Regular trading hours'' has the same meaning as in Rule 
600(b)(64) of Regulation NMS. Rule 600(b)(64) provides that 
``Regular trading hours means the time between 9:30 a.m. and 4:00 
p.m. Eastern Time, or such other time as is set forth in the 
procedures established pursuant to Sec.  242.605(a)(2).''
    \45\ The term ``settlement day'' is defined in Rule 203(c)(5) of 
Regulation SHO as: ``* * * any business day on which deliveries of 
securities and payments of money may be made through the facilities 
of a registered clearing agency.'' 17 CFR 242.203(c)(5).
    \46\ See temporary Rule 204T(a).
---------------------------------------------------------------------------

    Under certain circumstances, temporary Rule 204T provides 
additional time during which fails to deliver may be closed out. 
Specifically, temporary Rule 204T(a)(1) and (a)(3) provide that, 
subject to certain conditions, fails to deliver resulting from long 
sales or certain bona fide market making activity must be closed out by 
no later than the beginning of regular trading hours on the third 
settlement day after settlement date (i.e., T+6).\47\
---------------------------------------------------------------------------

    \47\ In addition, temporary Rule 204T(a)(2) provides that fails 
to deliver resulting from sales of securities pursuant to Rule 144 
of the Securities Act of 1933 (``Rule 144 Securities'') must be 
closed out by no later than the beginning of regular trading hours 
on the thirty-sixth consecutive settlement day following settlement 
date (i.e., T+39).
---------------------------------------------------------------------------

    In response to our requests for comment, a number of commenters 
expressed concerns regarding the time periods within which fails to 
deliver must be closed out under temporary Rule 204T. Commenters 
expressed concern that temporary Rule 204T's

[[Page 38270]]

requirement to close-out fails to deliver by no later than the 
beginning of regular trading hours can create buying pressure at the 
open, that may temporarily distort the price of the security.\48\ To 
minimize the market impact of the close-out requirement, commenters 
suggested allowing participants to close out fails to deliver by the 
end of regular trading hours, or the close of business on the New York 
Stock Exchange (``NYSE''), rather than by no later than the beginning 
of regular trading hours.\49\ In requesting additional time during the 
day to close out fails to deliver, one commenter noted that such a 
change ``would significantly alleviate the market pressures associated 
with execution of potentially large purchases at the opening of 
trading--a time when markets are particularly susceptible to price 
fluctuations.'' \50\ This commenter also stated that, as a practical 
matter, ``transactions effected at market open to close-out open fail 
positions are no different from those effected later on in the trading 
session because both are part of the same clearance and settlement 
cycle. Thus, providing this relief would not add any delay of 
consequence to the close-out process.'' \51\
---------------------------------------------------------------------------

    \48\ See, e.g., letter from Stuart Kaswell, Executive Vice 
President and General Counsel, Managed Funds Association, dated Dec. 
15, 2008 (``MFA''); letter from Edward J. Joyce, President and Chief 
Operating Officer, Chicago Board Options Exchange, dated Dec. 23, 
2008 (``CBOE''); letter from Amal Aly, Managing Director and 
Associate General Counsel, SIFMA, dated Dec. 16, 2008 (``SIFMA''); 
letter from Eric Swanson, General Counsel, BATS Exchange, Inc., 
dated Dec. 29, 2008 (``BATS''); letter from Michael P. McAuley, 
Chair, RMA Committee on Securities Lending, dated Dec. 23, 2008 
(``RMA''); letter from Stefan Gavell, Executive Vice President and 
Head of Regulatory Industry Affairs, State Street Corporation, dated 
Dec. 16, 2008 (``State Street'').
    \49\ See, e.g., letters from SIFMA; MFA; State Street; BATS; 
letter from A. Peter Allman-Ward, Executive Vice President and CFO, 
Wedbush Morgan Securities, Inc., dated Dec. 15, 2008 (``Wedbush'').
    \50\ Letter from SIFMA.
    \51\ See id.
---------------------------------------------------------------------------

    Other commenters requested additional days within which to close 
out fails to deliver in connection with short sales. For example, some 
commenters requested that the Commission extend the close-out period 
for fails to deliver resulting from short sales to three settlement 
days after the fail occurs, consistent with the close-out period for 
fails to deliver resulting from long sales and market making 
activity.\52\ Other commenters requested that the Commission extend the 
close-out requirement for fails to deliver resulting from all sales to 
five settlement days after the fail to deliver position occurs.\53\ 
These commenters stated that the additional time to close out fails to 
deliver would allow the majority of trades to clear and settle on their 
own within a few days following the regular settlement date (i.e, 
T+3).\54\
---------------------------------------------------------------------------

    \52\ See e.g., letter from Peter Kovac, Chief Operating Officer 
and Financial and Operations Principal, EWT, LLC, dated Nov. 25, 
2008 (``EWT''); letter from James S. Chanos, Chairman, Coalition of 
Private Investment Companies, dated Dec. 16, 2008 (``Coalition of 
Private Investment Companies''); letters from SIFMA; MFA; State 
Street.
    \53\ See, e.g., letter CBOE; letter from Boston Options 
Exchange, Chicago Board Options Exchange, International Securities 
Exchange, NASDAQ Options Market, NASDAQ OMX PHLX, NYSE Alternext US, 
NYSE Arca, and The Options Clearing Corporation, dated Dec. 19, 2008 
(``Options Exchanges'').
    \54\ See, e.g., letters from SIFMA; MFA; State Street; CBOE; 
Options Exchanges; Coalition of Private Investment Companies.
---------------------------------------------------------------------------

    Some commenters expressed concerns about the effect of the close-
out requirements of temporary Rule 204T on securities lending.\55\ For 
example, one commenter stated that the compressed time-frame for 
closing out fails to deliver under temporary Rule 204T ``has generated 
over-buying and borrowing of securities that would otherwise settle in 
the normal course, thus impairing liquidity by tying up shares that 
would otherwise be available to natural buyers and sellers.'' \56\ This 
commenter also noted that in practice fails to deliver resulting from 
sales of securities on loan, which are considered ``long'' sales, are 
often closed out in accordance with the time-frames for fails to 
deliver resulting from short sales rather than long sales because 
temporary Rule 204T does not provide sufficient time to determine 
whether or not a fail to deliver position resulted from a long or short 
sale.\57\ According to this commenter, such purchasing activity acts as 
a disincentive to lending and causes institutions to question their 
participation in lending programs.\58\
---------------------------------------------------------------------------

    \55\ As stated in the Rule 204T Adopting Release, if a person 
that has loaned a security to another person sells the security and 
a bona fide recall of the security is initiated within two business 
days after trade date, the person that has loaned the security will 
be ``deemed to own'' the security for purposes of Rule 200(g)(1) of 
Regulation SHO, and such sale will not be treated as a short sale 
for purposes of temporary Rule 204T. In addition, a broker-dealer 
may mark such orders as ``long'' sales provided such marking is also 
in compliance with Rule 200(c) of Regulation SHO. See Rule 204T 
Adopting Release, 73 FR 61713, n. 70.
    \56\ Letter from SIFMA.
    \57\ See letter from SIFMA; see also letter from RMA; letter 
from Heather Traeger, Assistant Counsel, Investment Company 
Institute, dated Dec. 16, 2008 (``ICI'').
    \58\ See letter from SIFMA; see also letter from RMA 
(recommending the extension of the close-out period for fails to 
deliver for all sales to settlement date plus three days (i.e., T+6) 
``to ensure that beneficial owners selling on-loan positions are not 
compromised by close-outs of long sales on T+4'').
---------------------------------------------------------------------------

    Other commenters stated that where the holder of a long position 
sells securities that have been financed through a securities loan, the 
close-out requirements of temporary Rule 204T may not provide 
sufficient time for the securities to be recalled and delivered in time 
for settlement of the sale transaction.\59\ These commenters stated, 
among other things, that temporary Rule 204T's requirement that 
securities be delivered by no later than the beginning of regular 
trading hours does not allow for the completion of the securities 
lending cycle, which may not occur until the close of the DTC 
settlement window on the third settlement day after settlement date 
(i.e., T+6).\60\
---------------------------------------------------------------------------

    \59\ See letters from EWT; BATS; RMA; ICI; Wedbush.
    \60\ See letters from EWT; BATS; RMA; ICI. EWT stated that a 
recall typically occurs to assure that the securities are returned 
on the settlement date for the sale transaction. If the securities 
are not returned by that date, the lender may initiate a buy-in 
process designed to obtain the securities as promptly as possible. 
This buy-in is intended to result in delivery of the securities 
after three business days, such that the lender will not complete 
the buy-in process until the close of the DTC settlement window on 
the third business day following initiation of the buy-in process. 
Accordingly, this commenter recommended, among other things, that we 
should: (1) either (a) create an exception for fails to deliver 
where the securities are loaned but have been recalled or (b) 
confirm that the issuance of a bona fide loan recall notice is a 
valid form of close-out for a fail to deliver; or (2) extend the 
close-out period from settlement date plus three days (i.e., T+6), 
to settlement date plus six days (i.e., T+9) for fails to deliver 
resulting from long sales. See also letter from RMA (stating that 
due to operational complexity and the number of market participants 
involved in the sale of an ``on-loan position,'' it is commonplace 
for a sale to be settled during the day on T+6).
---------------------------------------------------------------------------

    As noted above, the close-out requirements of temporary Rule 204T 
are advancing our goal of further reducing fails to deliver, as 
evidenced in part by preliminary results from OEA regarding its impact 
on the number of fails to deliver.\61\ Thus, we are adopting as a 
permanent rule the structure of the close-out requirements of temporary 
Rule 204T. Specifically, Rule 204(a) provides that a participant of a 
registered clearing agency must deliver securities to a registered 
clearing agency for clearance and settlement on a long or short sale in 
any equity security by settlement date, or if a participant of a 
registered clearing agency has a fail to deliver position at a 
registered clearing agency in any equity security for a long or short 
sale transaction in that equity security, the participant shall, by no 
later than the beginning of regular trading hours \62\ on the 
settlement day \63\

[[Page 38271]]

following the settlement date, immediately close out the fail to 
deliver position by borrowing or purchasing securities of like kind and 
quantity.\64\
---------------------------------------------------------------------------

    \61\ See supra note 8, and accompanying text.
    \62\ See supra note 44 (discussing the definition of the term 
``regular trading hours'' for purposes of Regulation SHO).
    \63\ See supra note 45 (discussing the definition of the term 
``settlement day'' for purposes of Regulation SHO).
    \64\ See Rule 204(a).
---------------------------------------------------------------------------

    In addition, as discussed in more detail below, we are adopting in 
Rule 204(a)(1) and (a)(3) the close-out requirements of temporary Rule 
204T(a)(1) and (a)(3) for fails to deliver resulting from long sales 
and certain bona fide market making activity so that such fails to 
deliver must be closed out by no later than the beginning of regular 
trading hours on the close-out date (i.e., T+6) for such fails to 
deliver.\65\
---------------------------------------------------------------------------

    \65\ In addition, as discussed in Section III.E. below, we are 
adopting the close-out requirements of Rule 204(a)(2) for fails to 
deliver resulting from sales of Rule 144 Securities so that such 
fails to deliver must be closed out by no later than the beginning 
of regular trading hours on the applicable close-out date.
---------------------------------------------------------------------------

    Although we recognize commenters' concerns regarding the potential 
market impact of the close-out requirements of temporary Rule 204T, 
particularly at the market open, we believe that these potential 
effects are justified by the benefits of retaining the strict close-out 
requirements of temporary Rule 204T. As discussed above, since the 
adoption of temporary Rule 204T, and other actions taken by the 
Commission aimed at reducing fails to deliver, there has been a 
significant reduction in fails to deliver. To maintain these declines, 
we believe it is necessary at this time to continue to require that 
participants close out fails to deliver by no later than the beginning 
of regular trading hours on the applicable close-out date. We believe 
that the strict close-out requirements of the temporary rule have 
helped reduce fails to deliver by providing a disincentive to those 
who, but for the rule, may have failed to deliver securities by 
settlement date. In addition, we note that participants have been 
operating pursuant to the close-out requirements of the temporary rule, 
as adopted, and appear to have adjusted to its requirements.\66\
---------------------------------------------------------------------------

    \66\ In discussing the requirement to purchase securities by no 
later than the beginning of regular trading hours on the applicable 
close-out date, some commenters discussed the ability to use, among 
other mechanisms, volume weighted average price (``VWAP'') orders 
entered at the beginning of the day to more effectively manage their 
buy-in risk. See, e.g., letters from Duncan L. Niederaurer, CEO, 
NYSE Euronext and Richard G. Ketchum, NYSE Regulation, Inc., dated 
Dec. 16, 2008 (``NYSE''); ICI. We note that if a participant has a 
fail to deliver position at a registered clearing agency that it 
must close out in accordance with Rule 204 of Regulation SHO, the 
participant may satisfy the close-out requirement to purchase 
securities of like kind and quantity with a VWAP order provided: (i) 
the order to purchase the equity security on a VWAP basis is 
irrevocable and received by no later than the beginning of regular 
trading hours on the applicable close-out date; and (ii) the final 
execution price of any such transaction is not determined until 
after the close of regular trading hours when the VWAP value is 
calculated and the execution is on an agency basis.
---------------------------------------------------------------------------

    We believe that continuing to require that fails to deliver be 
closed out on the day immediately following the day on which the fail 
to deliver occurs is consistent with our goal of reducing fails to 
deliver by maintaining the reductions in fails to deliver achieved by 
the adoption of temporary Rule 204T, as well as other actions taken by 
the Commission, and addressing ``naked'' short selling and, in 
particular, potentially abusive ``naked'' short selling. Although 
extending the time-frames within which fails to deliver must be closed 
out may allow for ordinary course settlement, as several commenters 
contend, we believe that the close-out requirements of Rule 204 are 
necessary to continue to help encourage delivery by settlement date and 
achieve our goal of not allowing fails to deliver to persist.\67\
---------------------------------------------------------------------------

    \67\ See supra note 16 (discussing the standard three-day 
settlement cycle).
---------------------------------------------------------------------------

    As we discussed in the Rule 204T Adopting Release, we believe that 
delivery on sales should be made by settlement date.\68\ In the Rule 
204T Adopting Release, we noted that the vast majority of fails to 
deliver are closed out within five days after T+3.\69\ In addition, in 
that release we referenced a recent analysis by OEA that found that 
more than half of all fails to deliver and more than 70% of all fail to 
deliver positions are closed out within two settlement days after 
T+3.\70\ We also noted in that release, however, that although this 
information shows that delivery is being made, it demonstrates that 
often delivery is not being made until several days following the 
standard three-day settlement cycle.
---------------------------------------------------------------------------

    \68\ See Rule 204T Adopting Release, 73 FR 61712-61713.
    \69\ See id.
    \70\ See id. at n. 68. We note that OEA's analysis examined the 
period from January to July 2008 and used the age of the fail to 
deliver position as reported by the NSCC. The NSCC data included 
only securities with at least 10,000 shares in fails to deliver. 
These numbers also included securities that were not subject to the 
close-out requirement in Rule 203(b)(3) of Regulation SHO, which 
applies only to ``threshold securities'' as defined in Rule 
203(c)(6) of Regulation SHO.
---------------------------------------------------------------------------

    In addition, as discussed above, fails to deliver may be part of a 
scheme to manipulate the price of a security. We are also concerned 
about the negative effect that fails to deliver and potentially abusive 
``naked'' short selling may have on the market and the broader economy, 
including on investor confidence.\71\ The close-out requirements of 
Rule 204 help address these concerns by prohibiting the persistence of 
fails to deliver.
---------------------------------------------------------------------------

    \71\ See, e.g., Anti-Fraud Rule Adopting Release, 73 FR 61666.
---------------------------------------------------------------------------

    We understand, however, that fails to deliver may occur from long 
sales within the first two settlement days after settlement date for 
legitimate reasons.\72\ 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.\73\
---------------------------------------------------------------------------

    \72\ See Rule 204T Adopting Release, 73 FR 61713.
    \73\ See id.
---------------------------------------------------------------------------

    Thus, in Rule 204(a)(1), we are adopting, with certain limited 
modifications, the provisions of temporary Rule 204T(a)(1) relating to 
closing out fails to deliver resulting from long sales. Specifically, 
Rule 204(a)(1) provides that if a participant of a registered clearing 
agency has a fail to deliver position at a registered clearing agency 
in any equity security and the participant can demonstrate on its books 
and records that such fail to deliver position resulted from a long 
sale, the participant shall by no later than the beginning of regular 
trading hours on the third consecutive settlement day following the 
settlement date immediately close out the fail to deliver position by 
purchasing or borrowing securities of like kind and quantity.\74\
---------------------------------------------------------------------------

    \74\ See Rule 204(a)(1).
---------------------------------------------------------------------------

    In response to a request for comment, some commenters requested 
that we provide additional flexibility to the close-out requirements of 
temporary Rule 204T(a)(1) by allowing participants to borrow as well as 
purchase securities to close out such fails to deliver.\75\ In 
temporary Rule 204T(a)(1), we required a participant to purchase 
securities to close out fails to deliver resulting from long sales to 
be consistent with the close-out requirements of Rule 203(b)(3) of 
Regulation SHO which require that a participant that has a fail to 
deliver position in a threshold security for thirteen consecutive 
settlement days immediately thereafter close out the fail to deliver 
position by purchasing securities of like kind and quantity.\76\
---------------------------------------------------------------------------

    \75\ See e.g., letters from SIFMA; EWT; MFA; State Street; BATS; 
Wedbush; Angel.
    \76\ See 17 CFR 242.203(b)(3). Some commenters requested 
clarification regarding a broker-dealer's obligations under FINRA 
Rule 11810 (the ``FINRA Buy-In Rule'') and the close-out 
requirements of temporary Rule 204T. See, e.g., letter from Joseph 
Zangri, Chief Compliance Officer, Bloomberg Tradebook, LLC (Dec. 16, 
2008) (``Bloomberg''). We note that because the requirements of Rule 
204 apply to broker-dealers involved in the sell-side of a 
transaction, whereas the FINRA Buy-In Rule sets forth procedures 
applicable to a purchaser that chooses to buy-in a seller, we 
believe that these rules apply separate and distinct obligations on 
market participants and, therefore, are not in conflict.

---------------------------------------------------------------------------

[[Page 38272]]

    Commenters stated that borrowing securities serves the same purpose 
as purchasing securities to close out fails to deliver.\77\ In 
addition, commenters noted that allowing a borrow to close out such 
fails would be consistent with the close-out requirements for short 
sales. After considering the comments received, we provide in Rule 
204(a)(1) the ability for a participant to close out a fail to deliver 
position resulting from a long sale by purchasing or borrowing 
securities.\78\ We believe that such an amendment is consistent with 
our goal of reducing fails to deliver by maintaining the reductions in 
fails to deliver achieved by the adoption of temporary Rule 204T, as 
well as other actions taken by the Commission, because it will provide 
additional flexibility to participants in closing out fail to deliver 
positions.\79\ Permitting a borrow as well as a purchase will also make 
the close-out requirements of Rule 204(a)(1) consistent with the close-
out requirements of Rule 204(a).
---------------------------------------------------------------------------

    \77\ See e.g., letter from MFA.
    \78\ See Rule 204(a)(1). Although Rule 204(a)(1) permits 
borrowing to close out a fail to deliver position resulting from a 
long sale, broker-dealers must also comply with Rule 203(a) of 
Regulation SHO. Rule 203(a)(1) provides that, unless an exception 
applies, ``[i]f a broker or dealer knows or has reasonable grounds 
to believe that the sale of an equity security was or will be 
effected pursuant to an order marked ``long,'' such broker or dealer 
shall not lend or arrange for the loan of any security for delivery 
to the purchaser's broker after the sale, or fail to deliver a 
security on the date delivery is due.'' 17 CFR 242.203(a).
    \79\ See letter from CBOE (stating that the close-out procedures 
under temporary Rule 204T for fails to deliver attributable to bona 
fide market making activity should be amended to permit borrows or 
purchases throughout the close-out period).
---------------------------------------------------------------------------

    As we stated with respect to Rule 204T's close-out requirements, 
under Rule 204's close-out requirements for fails to deliver resulting 
from long or short sales, a participant must take affirmative action to 
close out a fail to deliver position by purchasing or borrowing 
securities.\80\ Thus, a participant may not offset the amount of its 
fail to deliver position with shares that the participant receives or 
will receive during the applicable close-out date (i.e., during T+4 or 
T+6, as applicable).\81\ In addition, as we stated in the Rule 204T 
Adopting Release, to meet its close-out obligation a participant also 
must be able to demonstrate on its books and records that on the 
applicable close-out date, it purchased or borrowed shares in the full 
quantity of its fail to deliver position and, therefore, that the 
participant has a net flat or net long position on its books and 
records on the applicable close-out date (i.e., during T+4 or T+6, as 
applicable).\82\
---------------------------------------------------------------------------

    \80\ See Rule 204T Adopting Release, 73 FR 61710.
    \81\ In determining its close-out obligation, a participant may 
rely on its net delivery obligation as reflected in its notification 
from NSCC regarding its securities delivery and payment obligations, 
provided such notification is received prior to the beginning of 
regular trading hours on the applicable close-out date. See Rule 
204T Adopting Release, 73 FR 61711, at n. 46 (and accompanying 
text).
    \82\ See Rule 204T Adopting Release, 73 FR 61711. Both temporary 
Rule 204T and Rule 204 require that a participant purchase or borrow 
shares, as applicable, to close out a fail to deliver position. 
Accordingly, the purchase or b