In four releases published on October 14 and 15, 2008, the Securities and Exchange Commission ("SEC" or "Commission") took action aimed at reducing fails to deliver and potentially abusive "naked" short sales. In addition, the Commission has extended through an interim final temporary rule the requirement that institutional investment managers provide certain reports to the SEC about their short sales and short positions in equity securities. The releases extend many of the actions that the Commission implemented by emergency order in September,¹ subject to certain modifications discussed below.

The four releases adopt the following rules and guidance:

I. New Antifraud Provision. Rule 10b-21 under the Securities Exchange Act of 1934 ("Exchange Act"), implemented pursuant to emergency order in September, is adopted as a final rule that is effective today. The rule deems it fraudulent for any person to sell an equity security if it deceives a person participating in the transaction about its intention or ability to deliver the security by settlement and in fact fails to deliver the security by settlement.

II. Hard Delivery Requirement. Interim final temporary Rule 204T under Regulation SHO imposes enhanced delivery requirements on sales of equity securities. The rule is substantially similar to the version of the rule implemented by emergency order in September, although it does include some modifications. The interim final temporary rule, which is effective today, will remain in effect until July 31, 2009. Comments are due on December 16, 2008.

III. Short Sale Disclosure. Interim final temporary Rule 10a-3T extends with some significant modifications the requirement, imposed by emergency order in September, that certain institutional investment managers file Form SH to report short sales and positions in section 13(f) securities. The interim final temporary rule and temporary Form SH are effective from October 18, 2008, until August 1, 2009. Comments will be due 60 days after publication in the Federal Register.

IV. Bona Fide Market Making. New guidance addresses what constitutes bona fide market making activity for purposes of the market maker exemption from the locate requirement of Regulation SHO.

V. Options Market Makers. The close-out requirement in Regulation SHO has been amended to eliminate permanently the exception for options market makers that sell short to hedge options positions established before the securities became threshold securities.

I. New Antifraud Provision

The SEC adopted as final Exchange Act Rule 10b-21, which seeks to curb "naked" short sales by deeming fraudulent certain deceptive activity in connection with such sales.² The rule, which was proposed in March of this year, also was in effect pursuant to the Commission's emergency order in September.³ The rule is specifically intended to cover sellers' deception of their broker-dealers about a locate source or ownership of shares. Under Rule 10b-21, it is fraudulent for any person to submit an order to sell an equity security if such person:

a) deceives a person participating in the transaction (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

b) fails to deliver the security on or before the settlement date.⁴

The adopting release responds to several concerns that commenters raised regarding the rule's scope and operation. The rule as adopted, like the version implemented by the September Emergency Order, specifically applies only to equity securities. In addition, the Commission emphasizes in the release, as well as in a preliminary note to the rule text, that the rule is not intended to limit or restrict the applicability of the general antifraud provisions of the federal securities laws. The Commission notes that conduct that violates Rule 10b-21 also may violate Rule 10b-5 if the standards of the latter rule are met. The Commission states in a footnote that it intends "the scienter requirement of Rule 10b-21 to be the same as that required under Rule 10b-5."⁵

For purposes of Rule 10b-21, a seller that provides a locate source to a broker-dealer in connection with a short sale thereby represents to the broker-dealer that it has contacted the source and reasonably believes that the source can or intends to deliver the securities by the settlement date of the short sale. Similarly, a seller makes such a representation when it enters a short sale order into a broker-dealer's direct market access or sponsored access system with any information identifying a locate source that the seller has obtained. In contrast, a seller that relies upon its broker-dealer to comply with the locate requirement under Regulation SHO, including relying in good faith on the broker-dealer's "Easy to Borrow" list, does not make a representation about its intention or ability to deliver the security being sold short. A seller that causes a broker-dealer to mark a sell order "long" may also be liable under the rule, if the seller knows or recklessly disregards either that it is not "deemed to own" the security in accordance with Regulation SHO or that the security is not or cannot reasonably be expected to be in the broker-dealer's physical possession or control by the date delivery is due.

The adopting release states that a broker-dealer, including a market maker, acting for its own account will be considered a seller subject to the rule. As a specific example, the release states that "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."⁶ On the other hand, according to the SEC, a market maker that has an exception from the locate requirement under Regulation SHO would not be making a representation about its intention or ability to deliver the security by settlement. In addition, a broker-dealer that marks an order for its own account "long" may be liable under Rule 10b-21 if it knows or recklessly disregards either that it is not "deemed to own" the security in accordance with Regulation SHO or that the security is not or cannot reasonably be expected to be in the broker-dealer's physical possession or control by the date delivery is due.

Apart from potential primary liability for broker-dealers under the rule, the adopting release reiterates that there may be situations in which a broker-dealer could be liable for aiding and abetting a customer's fraud under Rule 10b-21. The release further states, however, that the rule "does not impose any additional liability or requirements on any person, including broker-dealers, beyond those of any existing Exchange Act rule."⁷

II. Hard Delivery Requirement

Interim final temporary Rule 204T under Regulation SHO imposes enhanced delivery requirements on sales of equity securities that occur on or after October 17, 2008.⁸ The newly adopted rule is substantially similar to the version of the rule implemented by the September Emergency Order, with some modifications to address technical and operational concerns.⁹ The interim final temporary rule will remain in effect until July 31, 2009. Comments are due on December 16, 2008.

A. Requirements

1. Close-Out Requirement

Under Rule 204T, clearing firms must settle sales of equity securities that clear through a registered clearing agency by delivering shares by the close of business on settlement date (generally T+3). In the event of a failure to deliver, the fail must be closed out by the clearing firm no later than the beginning of trading on the day after settlement date (the "Close-Out Date," generally T+4) through a purchase or borrow of securities of like kind and quantity. To fulfill this close-out obligation, the firm must take affirmative action to purchase or borrow the shares, and it may not rely on shares it receives or will receive on the Close-Out Date to offset this obligation, although it may rely on its net delivery obligation as reflected in its notification from National Securities Clearing Corporation on the morning of the day after settlement date (generally T+4). The rule allows the clearing firm until the beginning of trading on the third day after settlement (generally T+6) to effect a close-out in connection with a failure to deliver if it can demonstrate that the failure to deliver resulted from a long sale.

Consistent with prior guidance, to the extent that the clearing firm can identify in a timely manner the introducing broker-dealer(s) to which the fail to deliver position is attributable, it may allocate the close-out obligation to the responsible broker-dealer(s). Where the clearing firm has reasonably allocated the close-out obligation, only the relevant broker-dealer(s) must comply with the pre-borrow requirement, as described below.

2. Pre-Borrow Requirement

If a clearing firm fails to comply with the close-out requirement, the clearing firm--and any introducing broker-dealer, to the extent it submits its short sales to that clearing firm for clearance and settlement--may not accept a short sale order in the relevant security or effect a short sale in the security for its own account, unless it first borrows or enters into a bona fide agreement to borrow the security. This pre-borrow requirement also applies to an introducing broker-dealer that is a market maker otherwise entitled to rely on the market maker exception from the locate requirement, unless the market maker can show that it does not have an open fail-to-deliver position at the time of any additional short sales. The restriction remains in place until the clearing firm closes out the fail position by purchasing securities of like kind and quantity, and the purchase has been cleared and settled.

3. Notification Requirement

To facilitate the pre-borrow requirement, the interim final temporary rule also imposes a notification requirement on a clearing firm that has a fail-to-deliver position that has not been closed out in accordance with the rule. Specifically, the firm must notify its introducing brokers (a) that it has a fail-to-deliver position in an equity security at a registered clearing agency that has not been closed out in accordance with Rule 204T, and (b) when the firm's purchase to close out the fail has cleared and settled. The notification means that introducing brokers will be on notice that the pre-borrow requirement applies to short sales in a particular security, as well as when it ceases to apply. The Commission does not provide guidance regarding how clearing firms should fulfill their notification obligations.

B. Exceptions

1. Pre-Fail Credit Exception

The interim final temporary rule includes a provision allowing for "pre-fail credit" to avoid the close-out and pre-borrow requirements. This provision is consistent with guidance that the Division of Trading and Markets provided under the September Emergency Order.¹⁰ Specifically, to qualify for pre-fail credit, a broker-dealer must purchase securities before the start of regular trading hours on the Close-Out Date to close out an open short position, and:

1. The purchase must be bona fide;
2. The purchase must be executed on or after trade date, but no later than the end of regular trading hours on the settlement date;
3. The purchase must cover the entire amount of the open short position; and
4. The broker-dealer must be able to demonstrate through its books and records that it has a net long or net flat position on the settlement day for which it is seeking to show that it has purchased shares to close its open short position.¹¹

If any fail is not closed out within the specified period, the clearing firm and any introducing broker from which it receives trades for clearance and settlement will be prohibited from effecting any short sales in the security for any customer or proprietary account unless the security is pre-borrowed. This pre-borrow requirement would remain in effect until the fail is resolved through settled purchases.

2. Certification Exception from Pre-Borrow Requirement for Introducing Firms

The interim final temporary rule also permits an introducing firm to avoid the pre-borrow requirement if it provides timely certification to the clearing firm that it has not incurred a fail to deliver position on settlement date for a long or short sale in an equity security for which the participant has a fail to deliver position at a registered clearing agency or that the introducing broker-dealer qualifies for "pre-fail credit" with respect to the position.

3. Exception for Market Makers

In accordance with the Division's Rule 204T Guidance, the interim final temporary rule includes an exception for market makers. Specifically, where a fail to deliver is attributable to bona fide market making activities by a registered market maker, options market maker, or other market maker obligated to quote in the over-the-counter markets, the clearing firm must close out the position by the beginning of regular trading hours on T+6, rather than T+3. In addition, the rule's pre-borrow requirement does not apply to a market maker that can show it does not have an open fail-to-deliver position at the time of any additional short sales. Unlike the Division's Rule 204T Guidance, however, newly adopted Rule 204T does not require a market maker to which a fail to deliver is attributable to attest in writing that the fail position was established solely to satisfy bona fide market making obligations. The SEC concluded that the costs of requiring such written attestation was unwarranted, although it noted that a broker-dealer relying on the market-making exception must be able to demonstrate its eligibility for the exception and compliance with its conditions.

4. Exception for Rule 144 Sales

As in the September Emergency Order, newly adopted Rule 204T also includes an exception for sales of equity securities pursuant to Rule 144 of the Securities Act of 1933. The exception provides that a clearing firm with a fail-to-deliver position in such a security for 35 consecutive days after the settlement date must, by the beginning of regular trading hours on the thirty-sixth consecutive settlement day, close out the position by purchasing securities of like kind and quantity. The 35-day period applicable to Rule 144 securities is intended to be consistent with other accommodations under Regulation SHO for sales of such securities. Fail-to-deliver positions not closed out within this time frame will trigger Rule 204T's pre-borrow requirement.

C. Policies and Procedures; Request for Comment

The Commission states in the release adopting Rule 204T that it intends to examine clearing firms' policies and procedures to determine whether they monitor for delivery by settlement date. The Commission specifically requests comment on whether it should adopt a rule requiring clearing firms to have such policies and procedures. In addition, comment is solicited with respect to all aspects of the rule, including the potential applicability to transactions involving debt securities and the appropriateness of various time parameters.¹²

III. Short Sale Disclosure

On October 15, the Commission issued a release adopting interim final temporary Rule 10a-3T, which extends with some modifications the requirement, imposed by emergency order in September, that certain institutional investment managers file Form SH to report short sales in section 13(f) securities.¹³ The interim final temporary rule and temporary Form SH are effective from October 18, 2008, until August 1, 2009. Comments will be due 60 days after publication of the release in the Federal Register.

Rule 10a-3T requires that certain institutional money managers file Form SH following any Sunday to Saturday calendar week in which the manager has effected a short sale in a section 13(f) security other than options.¹⁴ The manager must file the form on the last business day of the ensuing calendar week. A manager is subject to the Form SH reporting requirement if it filed, or was required to file, a Form 13F for the most recent calendar quarter.¹⁵

Filing is not required with respect to a security if, on each calendar day during the relevant week, the start of day short position, the gross number of securities sold short during the day, and the end of day short position constitute less than 0.25% of the class of securities issued by the issuer and the fair market value of these three figures is less than $10 million. In addition, the Commission clarifies that, consistent with staff guidance regarding the Form SH Emergency Orders, short sales need not be reported on Form SH where they occur as part of certain scenarios in which customer orders are handled on a riskless principal basis. Specifically, a short sale need not be reported on Form SH if it occurs in connection with a broker-dealer's attempt to execute on a riskless principal basis a sale order of a customer who has a net long position in the section 13(f) security or a purchase order of a section 13(f) security.

The filing requirements of interim final temporary Rule 10a-3T differ in several respects from the requirements under the Form SH Emergency Orders, as follows:

1. The weekly filing deadline is the last business day--rather than the first business day--of the calendar week following a calendar week in which short sales are effected.
2. Form SH filings no longer need to include the value of the securities sold short, the largest intraday short position, or the time of day of the largest intraday short position.
3. Form SH filings must include all short positions, including those effected prior to September 22, 2008.
4. The fair market value prong of the de minimis exception is increased from $1 million to $10 million.
5. Filers must submit to the Commission an XML tagged data file (rather than an ASCII or HTML formatted file) with the required data.
6. Whether an institutional investment manager is subject to the rule depends on whether it filed, or was required to file, a Form 13F for the most recent calendar quarter, rather than only the quarter ended June 30, 2008.¹⁶

Two transitional provisions apply to Form SH reports due on October 24 and October 31, 2008.¹⁷ Specifically, Rule 10a-3T applies to reports filed on those dates, except that an institutional investment manager required to file:

1. May exclude disclosure of short positions due to short sales before September 22, 2008 (the effective date of the Form SH Emergency Orders). If such short sales are excluded, the manager need not report short positions that otherwise would be reportable if the short position constitutes less than 0.25% of the class of securities issued by the issuer and the fair market value of the short position is less than $1 million.
2. May file Form SH on EDGAR as the form was filed pursuant to the Form SH Emergency Orders, rather than in XML format in accordance with the special filing instructions posted on the SEC's website.

The Commission requests comment on several aspects of the rule, including the following:

• Whether the rule covers the appropriate category of short sellers;
• Whether there may be better ways to collect information about short sales;
• Whether the Commission should require short sellers to maintain specific information with respect to short sales;
• Whether the Commission should require public notice filings for short sale activity or positions crossing a specified threshold (such as 5% of the public float);
• Whether the rule should apply to short sales involving other securities and financial instruments;
• Whether the threshold exception and the riskless principal exception are appropriate, whether these exceptions should be modified in any way, and whether there should be an exemption for short positions with a hedging purpose;
• Whether the information required by Form SH should be altered in any way;
• Whether Form SH reporting should be required beyond August 1, 2009;
• Whether Form SH filings should be made public, with or without a delay; and
• Whether Form SH filings should be made with a different frequency, such as daily or bi-weekly, monthly, or quarterly.

IV. Bona Fide Market Making

The Commission also provided guidance regarding what constitutes bona fide market making activity for purposes of the market maker exemption from Regulation SHO's locate requirement. According to the new guidance, which incorporates and reiterates guidance provided when Regulation SHO was adopted,¹⁹ factors that may indicate bona fide market making activities include:

1. The market maker incurs economic or market risk with respect to the securities (e.g., by putting capital at risk through continuous two-sided quotes; providing liquidity to the market; taking the other side of trades where short-term imbalances in customer orders occur; or attempting to prevent excess volatility). The Commission also states that if a market maker does not incur market risk with respect to a transaction or related group of transactions, this lack of risk may indicate that the market maker is not engaged in bona fide market making activities.
2. A pattern of trading in which purchases and sales occur in roughly comparable amounts to provide liquidity to customers or other broker-dealers. According to the Commission, this may include selling short into a declining market.
3. Continuous quotations that are at or near the market on both sides, provided that the quotations are generally accessible to the public and that the market maker therefore can be considered to be holding itself out as willing to buy and sell a security for its own account on a regular or continuous basis.

Consistent with the adopting release for Regulation SHO, the Commission reiterates that the issue of what qualifies as bona fide market making depends on the particular facts and circumstances. Bona fide market making generally does not include:

1. Trading that is related to the broker-dealer's speculative selling strategies or investment purposes and is disproportionate to the broker-dealer's usual market making activities in the security.
2. Trading that attempts to transfer to a client the benefit of the market maker's exemption from the locate requirement.
3. Quotations that are at or near the market on only one side.
4. A pattern of short sales away from the market maker's posted quotes.

V. Options Market Makers

The Commission also issued a final rule release amending Regulation SHO's close-out requirement to eliminate the exception for options market makers that sell short to hedge options positions established before the securities became threshold securities.²⁰ With the permanent elimination of the exception, effective October 17, options market makers continue to be subject to the same requirements applicable to them under the September Emergency Order.²¹

As in the September Emergency Order, the final rule amendments allow for a close-out period of 35 consecutive settlement days for existing fail-to-deliver positions that previously had been excepted from the rule's close-out requirement. The Commission has specified that, for any fails to deliver in threshold securities being closed out pursuant to the September Emergency Order, the 35-day period will continue to run from September 17 rather than starting over with the permanent rule change on October 17. For any fails to deliver in securities that became or become threshold securities after September 17, options market makers are subject to the same close-out provisions of Regulation SHO applicable to other market participants.

VI. Conclusion

In light of these new rules and guidance, firms may want to review how they have complied with the relevant emergency orders. Firms may need to change their policies and procedures to address the extended applicability of the rules, as well as relevant changes from the emergency orders. In particular, the Commission already has noted that it intends to examine how clearing firms' policies and procedures are monitoring for timely delivery of securities. In addition, firms may want to consider whether their practices are adequate to ensure they can demonstrate that their reliance on particular exceptions (e.g., market maker reliance on the locate exception) is appropriate.

Finally, firms affected by the interim final temporary rules may wish to consider submitting comments to the Commission.

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

1 The Commission allowed the temporary ban on short selling the securities of financial institutions to expire on October 8, 2008.

2 Exchange Act Release No. 58,774 (Oct. 14, 2008).

3 See Exchange Act Release No. 57,511 (Mar. 17, 2008) (proposing release); Exchange Act Release No. 58,572 (Sept. 17, 2008) ("September Emergency Order"); Exchange Act Release No. 58,711 (Oct. 1, 2008) (extending September Emergency Order).

4 The rule defines settlement date as the business day on which delivery of the security being sold and payment of money for the security is to be made through the facilities of a registered clearing agency. This definition is consistent with the definition applicable to the rule as imposed by the Commission's emergency order of September 17, 2008.

5 Exchange Act Release No. 58,774, at fn. 55.

6 Id. at 16.

7 Id. at 24.

8 Exchange Act Release No. 58,773.

9 See Exchange Act Release No. 58,572; Exchange Act Release No. 58,711.

10 Division of Trading and Markets: Guidance Regarding the Commission's Emergency Order Concerning Rules to Protect Investors against "Naked" Short Selling Abuses, revised Sept. 22, 2008 ("Division's Rule 204T Guidance"), available here.

11 Interim Final Temporary Rule 204T(e).

12 In addition, the SEC requested comment on, among other things, whether the rule should permit borrowing securities to close out a fail-to-deliver position resulting from a long sale, rather than requiring a purchase to close out such a position; whether the locate requirement of Regulation SHO should be amended or eliminated in light of Rule 204T's close-out requirement; whether the rule should include a de minimis exception; and whether the rule should include an exception for fails to deliver due to mechanical aspects of corporate events, such as equity offers and tender offers.

13 Exchange Act Release No. 58,785 (Oct. 15, 2008). See also Exchange Act Release No. 58,591 (Sept. 18, 2008); Exchange Act Release No. 58,591A (Sept. 21, 2008); Exchange Act Release No. 58,724 (Oct. 2, 2008) (collectively, "Form SH Emergency Orders").

14 Exchange Act Rule 13f-1(c) defines "section 13(f) securities" as securities of a class described in Exchange Act Section 13(d)(1) that are admitted to trading on a national securities exchange or quoted on the automated quotation system of a registered securities association. To identify section 13(f) securities, an institutional investment manager may rely on the Official List of Section 13(f) Securities, which is available here.

15 A firm is required to file a Form 13F if it exercises investment discretion with respect to accounts holding Section 13(f) securities that have an aggregate fair market value on the last trading day of any month of any calendar year of at least $100 million.

16 An institutional investment manager that was not required to file Form 13F for the quarter ended June 30, 2008, but was required to file Form 13F for the quarter ended September 30, 2008, will now be required to file Form SH if it has engaged in short sales in a 13(f) security in the relevant weekly reporting period. The first such period is October 12 to 18, 2008.

17 Under the new filing requirements effective October 18, 2008, the October 24 and October 31, 2008, filings will cover the weeks of October 12 and October 19, respectively. All aspects of Rule 10a-3T will apply to subsequent filings.

18 Exchange Act Release No. 58,775 (Oct. 14, 2008). The Commission notes that this exemption also applies to block positioners (as defined in Exchange Act Rule 3b-8(c)) engaged in bona fide block positioning activities.

19 See Exchange Act Release No. 50,103 (July 28, 2004) (adopting Regulation SHO).

20 Exchange Act Release No. 58,775 (Oct. 14, 2008). The elimination of this exception was proposed in Exchange Act Release No. 56,213 (Aug. 7, 2007).

21 See Exchange Act Release No. 58,572; Exchange Act Release No. 58,711.