A Regulatory Policy Dilemma: Short Sale Restrictions and Investor Confidence

Introduction. It has been a little over seven months since the failure of Lehman Brothers, a watershed event in our financial markets that was followed by the additional shock waves caused by the bailout of AIG. U.S. and foreign regulators have urged a fresh review of the basic assumptions underlying the existing regulatory framework in light of the current crisis. The regulation of short selling is one topic hotly debated by policymakers.¹ While the enhanced liquidity and pricing efficiency benefits of short selling have been long acknowledged, they are being reassessed in light of revived concerns by markets, regulators, politicians and others that unconstrained short selling can result in self-perpetuating downward spirals in prices.² The United Kingdom's Financial Services Authority ("FSA"), for example, has questioned whether "additional liquidity is always and in all markets beneficial."³ Notwithstanding prior economic studies questioning the need for or effectiveness of short sale price controls, there is a growing concern among some that investor confidence has been shaken by short selling activities. What is the appropriate regulatory response given recent extreme market conditions and mounting concerns over investor confidence?

This is precisely the policy conundrum currently facing the Securities and Exchange Commission ("SEC" or "Commission"). After months of laboring under the intense scrutiny of Congress and the popular media, on April 10, 2009, the SEC published for comment a release proposing five alternative short selling restrictions.⁴ Two alternatives can be characterized as price restrictions; the other three alternatives can be classified as circuit breaker restrictions (collectively, "short sale restrictions"). These proposals would amend Rules 200 and 201 under Regulation SHO. Comments on the five alternative short sale proposals are due on or before June 19, 2009.

The five alternative proposed rules on which the SEC invites public comment are:

I. Proposed Modified Uptick Rule. This rule would be based on the national best bid, and would restrict the display or execution of short sales on a down-bid price.⁵ As proposed, the modified uptick rule would be a market-wide, permanent price restriction on short sales.

II. Proposed Uptick Rule. This rule would be based on the last sale price or "tick," and would restrict short sales except at a plus tick or a "zero-plus" tick. As proposed, the uptick rule would be a market-wide, permanent price restriction on short sales.

III. Proposed Circuit Breaker Halt Rule. This rule would impose a temporary ban on short selling in a particular security in the event of a severe decline in the price of the security. Such a rule could be imposed in lieu of, or as a supplement to, a short sale price restriction.

IV. Proposed Circuit Breaker with Modified Uptick Rule. This rule would temporarily impose a short sale price test for a particular security based on the national best bid in the event of a severe decline in the price of the security.

V. Proposed Circuit Breaker with Uptick Rule. This rule would temporarily impose a short sale price test for a particular security based on the last sale price (i.e., tick) in the event of a severe decline in the price of the security.

While the issues raised by short selling are difficult, they are hardly novel. In July 2007, the SEC eliminated Exchange Act Rule 10a-1 (i.e., the so-called uptick rule, which applied to exchange-listed securities)⁶ and prohibited self-regulatory organizations ("SROs") from imposing price restrictions on short sales (e.g., Nasdaq's former Rule 3350 bid test).⁷ The SEC based this decision on internal and external studies,⁸ suggesting that price restrictions on short sales had limited benefits in light of market developments (e.g., increased market transparency and real time market surveillance).⁹

Notwithstanding its prior studies and earlier elimination of short sale price tests, the Commission notes that the proposed rule changes are motivated by extreme market conditions and the resulting deterioration in investor confidence. Perhaps because of its prior assessment of this issue, the SEC makes numerous requests throughout the Proposing Release for additional empirical data on the impact of short sale price restrictions—and for data on the impact of such restrictions in extreme market conditions in particular. The Commission also acknowledges that the proposed short sale price restrictions would dampen the benefits of legitimate short selling by adversely affecting the cost of short selling, quote depths, spread widths, market liquidity, executions, and pricing efficiency.¹⁰ In fact, the Commission cites the Summary Pilot Report by its Office of Economic Analysis ("OEA"), which generally concluded that former Rule 10a-1 did not prevent short sales in extreme down markets and did not limit short selling in up markets.¹¹ The Proposing Release also notes two more recent analyses by the OEA examining the impact that a short sale price restriction might have had during a thirteen day period in September 2008. Although noting the limitations of its analysis, the OEA concluded that a price test likely would have been most restrictive during periods of low volatility, with the greatest impact on short selling in lower priced and more active stocks. The OEA also found that long sellers were primarily responsible for price declines during the period evaluated.¹²

The following sections summarize the five alternative proposed rules published for comment by the SEC. The Commission expressed the preliminary view that a modified uptick rule (based on the national best bid) would have advantages over an uptick rule because the national best bid more accurately reflects the current market for a security.¹³ Market participants that favor the proposed uptick rule should submit comments addressing why the last sale price, as opposed to the national best bid, best reflects the current price.

I. Proposed Modified Uptick Rule

Overview of Proposal. Similar to Nasdaq's former bid test, the proposed modified uptick rule would restrict the display or execution of short sales at a price that is less than the current national best bid, or, if the last differently priced national best bid was greater than the current national best bid, a price that is less than or equal to the current national best bid, absent an exception. Specifically, amended Rule 201 of Regulation SHO would provide that "a trading center shall establish, maintain, and enforce written policies and procedures reasonably designed to prevent the execution or display of a short sale order in a covered security at a down-bid price."¹⁴ Thus, the rule would apply to any "trading center"—any national securities exchange or association operating an SRO trading facility, alternative trading system, OTC market maker, or any other broker-dealer executing trades as principal or crossing orders as agent.¹⁵ "Covered securities" include any "NMS Stock."¹⁶ Thus, the display and execution restrictions would apply to all securities traded on a national securities exchange, wherever traded, when market information is collected, processed, and disseminated in real-time pursuant to a national market system plan.¹⁷ They would not apply to options or non-NMS Stocks quoted on the OTC Bulletin Board or elsewhere.¹⁸

Written Policies and Procedures. Under the proposed modified uptick rule, trading centers would be required to implement written policies and procedures reasonably designed to prevent the execution or display of short sales at impermissible prices, and to surveil trading to evaluate the effectiveness of the policies and procedures. The SEC sets out a number of minimum requirements for adequate policies and procedures under the proposed modified uptick rule, including requirements that such policies and procedures: (1) enable a trading center to monitor, on a real-time basis, the national best bid and whether the current national best bid is an up- or down-bid from the last differently priced national best bid; and (2) permit the execution or display of a short sale order for a covered security marked "short exempt" without regard to whether the order is at a down-bid price.¹⁹ A trading center would need to enforce such policies and procedures, including detecting any latencies in obtaining the national best bid data, by using (1) exception reports to evaluate their trading practices; and (2) "snap shot" records identifying the current national best bid at the time of execution or display of a short sale order, as well as the last differently priced national best bid.²⁰ As noted, trading centers also would have an affirmative duty to conduct regular and periodic surveillance to ensure the effectiveness of their policies and procedures and take prompt action to remedy any deficiencies.²¹

Trading centers also would have the ability to adopt policies and procedures permitting the repricing of orders to comply with the modified uptick rule. For example, if an order were impermissibly priced, a trading center could re-price the order, pursuant to its written policies and procedures, at the lowest permissible price and hold it for later execution at the new price or better. As quoted prices change, the proposed rule allows a trading center to repeatedly re-price and display an order at the lowest permissible price down to the order's original limit order price. The proposed rule would permit a trading center to execute a displayed short sale order at a down-bid price as long as the order was permissibly priced at the time it was displayed.²² Thus, the proposal seeks to allow trading centers flexibility to handle short sale orders efficiently without necessitating the rejection or cancellation of impermissibly priced orders.

Although by its terms the modified uptick rule would require only "trading centers" to have policies and procedures with respect to the display or execution of short sale orders, in practice any broker-dealer seeking to rely on the exception for permissibly priced orders would be required to have policies and procedures relating to the rule. At a minimum, such policies and procedures would involve real-time monitoring of the national best bid and determining whether a short sale order is permissibly priced at the time of submission to the trading center. As with trading centers, broker-dealers relying on this exception would have to surveil for the effectiveness of their policies and procedures.²³

Exceptions to Modified Uptick Rule. The proposed modified uptick rule includes eight exceptions, which parallel the exceptions and exemptions in former Rule 10a-1. In particular, the rule would permit a broker-dealer to mark orders as "short exempt" if the broker-dealer has a reasonable basis to believe that: (1) the short sale order is not at an impermissible price at the time of submission of the order to the trading center,²⁴ (2) the seller owns the security²⁵ and intends to deliver the security as soon as all restrictions on delivery have been removed;²⁶ (3) the seller is a market maker acting in the capacity of an odd-lot dealer, offsetting a customer odd-lot order, or liquidating an odd-lot position of no more than a unit of trading;²⁷ (4) the seller is engaging in bona fide domestic arbitrage involving convertible, exchangeable, or similar types of securities;²⁸ (5) the seller is engaging in international arbitrage to take advantage of a price differential between a domestic and a foreign market and will immediately cover the transaction through a purchase in the foreign market;²⁹ (6) a short sale order represents over-allotment or lay-off sales for an underwriter or syndicate member participating in a distribution; (7) the broker-dealer is acting as riskless principal³⁰ to facilitate an order for a customer that is net long; or (8) the order is for execution at a volume-weighted average price (VWAP).³¹ Noticeably absent from the list of proposed exceptions is an exception for bona fide market making activities, which was an exception to the Nasdaq bid test and a more limited exception in former Rule 10a-1(e)(5).

Requests for Comment. The SEC requests comment on the proposed modified uptick rule, including, among other issues:

Whether the proposed modified uptick rule should apply to additional classes of securities, such as non-NMS stocks trading on the OTC Bulletin Board or elsewhere in the OTC market;
Whether requiring market centers to implement policies and procedures to effect the price restriction, which is similar to the methodology used in connection with the Regulation NMS order protection rule, is the necessary or appropriate approach;
Whether the proposed exceptions are necessary and appropriate, whether exceptions should be granted for other types of activity, such as bona fide market making, and whether entities other than broker-dealers should be able to take advantage of the exceptions;
Whether the proposed modified uptick rule should apply when the national best bid is not being collected, calculated and disseminated on a real-time basis;³²
Whether a penny is the appropriate increment for a permissible short sale;
How market makers might alter their trading strategies in response to the proposed modified uptick rule, if adopted;
The impact the proposed modified uptick rule would have on market liquidity and pricing efficiency;
The impact the proposed modified uptick rule would have on the speed of executions, transaction costs, and order flow; and
The impact the proposed modified uptick rule would have had in recent market conditions, including the effect on investor confidence.

II. Proposed Uptick Rule

Overview of Proposal. The proposed uptick rule would be a "modernized version of former Rule 10a-1,"³³ and, absent an exception, would prohibit short sales at a price that is below the last sale price, or at the last sale price unless such price is above the next preceding different last sale price. This price restriction would apply to all securities traded on a national securities exchange, wherever traded, during market hours when last sale price information is reported and disseminated in real-time. The rule would not apply to options or securities not traded on a national securities exchange. Unlike the proposed modified uptick rule, the proposed uptick rule would be implemented through a prohibition imposed on impermissible short sales, which is consistent with former Rule 10a-1.³⁴ Unlike former Rule 10a-1, the Commission has indicated that it does not believe that the proposed uptick rule should apply when last sale price information is not collected, processed and disseminated.³⁵

Exceptions to Proposed Uptick Rule. The proposed uptick rule incorporates substantially all the exceptions proposed in connection with the modified uptick rule. The proposed uptick rule also would except short sales: (1) effected in certain electronic trading systems that match and execute trades at various times and at independently-derived prices, such as the midpoint of the NBBO;³⁶ 2) by registered market makers or specialists publishing two-sided quotes in connection with the facilitation of customer market or marketable limit buy orders executed at the national best offer; (3) by registered specialists, registered exchange market makers or third market makers effected at a price equal to their most recent offer pursuant to the firm quote rule, if such offer, when communicated, was equal to or above the reported last sale price for the security; and (4) effected by a broker-dealer for an account in which it has no interest where the order was erroneously marked "long" by another broker-dealer.

Requests for Comment. The SEC requests comment on the proposed uptick rule, including, among other issues:

Whether the proposed uptick rule should apply to additional classes of securities, such as non-NMS stocks trading on the OTC Bulletin Board or elsewhere in the OTC market;
Whether applying the rule to all market participants, instead of requiring trading centers to implement policies and procedures, is the necessary or appropriate approach;
Whether the proposed exceptions are necessary and appropriate, and whether exceptions should be granted for other types of activity, such as bona fide market making;
Whether provisions of former Rule 10a-1 and exemptive relief under the former rule that are not included in the proposed uptick rule (e.g., allowance for adjustment to the sale price of a security after the security goes ex-dividend, ex-right, etc.) are necessary or appropriate;
Whether the proposed uptick rule should apply to after-hours trading,
Whether a penny is the appropriate increment for a permissible short sale;
How market makers might alter their trading strategies in response to the proposed uptick rule, if adopted;
The impact the proposed uptick rule would have on market liquidity and pricing efficiency; and
The impact the proposed uptick rule would have had in recent market conditions, including the effect on investor confidence.

III. Proposed Circuit Breaker Halt Rule

Overview of Proposal. The proposed circuit breaker halt rule would represent a more narrowly tailored response to potentially detrimental short selling by imposing a temporary ban on short selling in a particular security in the event of a severe decline in the price of the security.³⁷ The proposed circuit breaker halt rule would apply to all NMS stocks and would halt short selling – only for the specific security suffering a price decline – for the remainder of the trading day if the price of that security traded on a national securities exchange dropped by 10% or more from the prior day's closing price. However, trading halts would not be triggered between 3:30 p.m. and 4 p.m. ET under the proposed rule.

Proposed Exceptions. The Commission proposes several exceptions to the circuit breaker halt rule that are identical to exceptions set forth in its emergency short sale ban order of September 2008.³⁸ These exceptions include short sales: (1) by market makers and options market makers engaged in bona fide market making in the security in question;³⁹ (2) by a market maker that is engaged in bona fide market making or hedging activity related to bona fide market making in derivatives of the security in question (e.g., ETFs);⁴⁰ (3) effected as a result of the automatic exercise or assignment of an equity option held before the halt is triggered; (4) effected as a result of the expiration of futures contracts held before the halt is triggered; (5) effected as a result of assignment to call writers upon exercise; and (6) of securities that the seller is deemed to own at the time of sale (e.g., Rule 144 securities). Note that the proposed exception for bona fide market making or hedging related to derivatives market making is not impeded by a market maker's knowledge of whether a customer or counterparty's transaction would establish or increase the customer or counterparty's net short position.⁴¹

Requests for Comment. The SEC requests comment on the proposed circuit breaker halt rule, including, among other issues:

Whether the proposed circuit breaker halt should be imposed in lieu of, or as a supplement to, a short sale price restriction;
Whether the proposed circuit breaker halt rule should apply to additional classes of securities, such as non-NMS stocks;
Whether 10% is the appropriate intraday price decline at which to trigger the halt, and whether different classifications of securities should be subject to different thresholds;
Whether the halt, once triggered, should be in effect for longer (or shorter) than the remainder of the trading day;
The potential for market participants to rush to execute short sales before a circuit breaker is triggered – the so-called "magnet effect" of a circuit breaker halt;
The provisions, if any, that would be necessary or appropriate to facilitate an orderly re-entry of a security after a halt on short selling;
Whether the proposed exceptions are necessary and appropriate, and whether exceptions should be granted for other types of activity;
The impact the proposed circuit breaker halt rule would have on market liquidity, capital formation, and pricing efficiency; and
The impact the proposed circuit breaker halt rule would have had in recent market conditions, including the effect on investor confidence.

IV. Proposed Circuit Breaker with Modified Uptick Rule

Overview of Proposal. The proposed circuit breaker with modified uptick rule would temporarily impose a short sale price test for a particular security based on the national best bid if there is a severe decline in the price of the security. Specifically, if the price of any security traded on a national securities exchange (excluding options) dropped by 10% or more from the prior day's closing price, short selling in that security, wherever traded, would be subject to the limitations of the modified uptick rule for the remainder of the trading day.⁴² However, the proposed rule would specify that the modified uptick rule would not be imposed if the triggering threshold is reached between 3:30 p.m. and 4 p.m. ET.

Requests for Comment. The SEC requests comment on the proposed circuit breaker with modified uptick rule, including, among other issues:

Whether it would be more appropriate to have the circuit breaker trigger a short sale halt, the uptick rule (e.g., a restriction based on the last sale price), or some other restriction;
Whether the proposed circuit breaker with modified uptick rule should apply to additional classes of securities;
Whether 10% is the appropriate intraday price decline at which to trigger the modified uptick rule, and whether different classifications of securities should be subject to different thresholds;
Whether the modified uptick rule, once triggered, should be in effect for longer (or shorter) than the remainder of the trading day;
Whether the proposed exceptions to the modified uptick rule (enumerated above) are appropriate for a circuit breaker with modified uptick rule;
The impact the proposed circuit breaker with modified uptick rule would have on market liquidity, capital formation, and pricing efficiency; and
The impact the proposed circuit breaker with modified uptick rule would have had in recent market conditions, including the effect on investor confidence.

V. Proposed Circuit Breaker with Uptick Rule

Overview of Proposal. The proposed circuit breaker with uptick rule also would be triggered by a severe decline in the price of a security. Specifically, if the price of any security traded on a national securities exchange dropped by 10% or more from the prior day's closing price, short selling in that security, wherever traded, would be subject to the limitations of the uptick rule for the remainder of the trading day. The proposed rule would not be triggered based on prices reached between 3:30 p.m. and 4 p.m. ET.

Requests for Comment. The SEC requests for comment on the proposed circuit breaker with uptick rule, including, among other issues:

Whether it would be more appropriate to have the circuit breaker trigger a short sale halt, the modified uptick rule (e.g., a restriction based on the national best bid), or some other restriction;
Whether the proposed circuit breaker with uptick rule should apply to additional classes of securities;
Whether 10% is the appropriate intraday price decline at which to trigger the uptick rule, and whether different classifications of securities should be subject to different thresholds;
Whether the uptick rule, once triggered, should be in effect for longer (or shorter) than the remainder of the trading day;
Whether the proposed exceptions to the uptick rule are appropriate for a circuit breaker with uptick rule;
The impact the proposed circuit breaker with uptick rule would have on market liquidity, capital formation, and pricing efficiency; and
The impact the proposed circuit breaker with uptick rule would have had in recent market conditions, including the effect on investor confidence.

VI. Other Elements of the Proposals

All five alternative proposed rules include a provision that would require market participants to mark orders "short exempt" if the seller is relying upon an exception from a short sale restriction.⁴³ The Commission requests comment on whether this order marking requirement is necessary or appropriate, the costs of complying with such a requirement, and whether persons relying an exception to a short sale restriction should be required to identify the specific provision on which they are relying. The Proposing Release also indicates that all five of the alternative proposed rules would apply to any short sale agreed to in the United States, even if executed overseas, unless otherwise excepted.⁴⁴

VII. Implementation Issues

The Commission suggests that three months would be the appropriate implementation period for a short sale price restriction. The Proposing Release does not include a preliminary assessment, however, on the implementation period for a circuit breaker restriction on short sales. For each of the alternative proposed rules, the Commission seeks comment on the implementation period that would allow market participants to program systems changes, develop necessary infrastructure, processes and surveillance mechanisms, and, if required, draft and implement appropriate policies and procedures. The SEC also requests comment on whether, rather than adopting a short sale restriction on a permanent basis, it should introduce a pilot program that would allow for a detailed study of the effects of the preferred rule.⁴⁵

VIII. Conclusion

At an SEC open meeting on April 8, 2009, Chairman Schapiro introduced these short sale proposals as the start of a thoughtful, deliberative process regarding how to promote market stability and restore investor confidence.⁴⁶ The Commission was careful to reserve judgment on whether the elimination of short sale price restrictions in 2007 actually caused or contributed to recent market volatility.⁴⁷ The Commission may consider any comments received not only in determining whether to approve price restrictions, circuit breaker restrictions or other short sale restrictions,⁴⁸ but also in deciding whether to adopt in final form the interim final temporary Rules 204T and 10a3-T,⁴⁹ which are scheduled to expire on July 31 and August 1, 2009, respectively.⁵⁰ As Commissioner Paredes noted in the open meeting on April 8, 2009, the question before the Commission is—what are the incremental benefits and costs of adopting a short sale price test or circuit breaker in light of the steps the SEC has already taken.⁵¹

Appendix

Former SEC Rule 10a-1

Rule 10a−1 −− Short Sales

(a)
(1)

(i) No person shall, for his own account or for the account of any other person, effect a short sale of any security registered on, or admitted to unlisted trading privileges on, a national securities exchange, if trades in such securities are reported pursuant to an "effective transaction reporting plan" as defined in 242.600 of this chapter and information as to such trades is made available in accordance with such plan on a real-time basis to vendors of market transaction information:

(A) Below the price at which the last sale thereof, regular way, was reported pursuant to an effective transaction reporting plan; or

(B) At such price unless such price is above the next proceeding different price at which a sale of such security, regular way, was reported pursuant to an effective transaction reporting plan.

(ii) The provisions of paragraph (a)(1)(i) of this section hereof shall not apply to transactions by any person in Nasdaq securities as defined in 242.600 of this chapter, except for those Nasdaq securities for which transaction reports are collected, processed, and made available pursuant to the plan originally submitted to the Commission pursuant to 240.17a-15 (subsequently amended and redesignated as 240.11Aa3-1 and subsequently redesignated as 242.601 of this chapter), which plan was declared effective as of May 17, 1974.

(2) Notwithstanding subparagraph (1) of this paragraph (a), any exchange, by rule, may require that no person shall, for his own account or the account of any other person, effect a short sale of any such security on that exchange (i) below the price at which the last sale thereof, regular way, was effected on such exchange or (ii) at such price unless such price is above the next preceding different price at which a sale of such securities, regular way, was effected on such exchange, if that exchange determines that such action is necessary or appropriate in its market in the public interest or for the protection of investors, and, if an exchange adopts such a rule, no person shall, for his own account or for the account of any other person, effect a short sale of any such security on such exchange otherwise than in accordance with such rule, and compliance with any such rule of an exchange shall constitute compliance with this paragraph (a).

(3) In determining the price at which a short sale may be effected after a security goes ex –dividend, ex-right, or ex-any other distribution, all sale prices prior to the "ex" date may be reduced by the value of such distribution.

(b) No person shall, for his own account or for the account of any other person, effect on a national securities exchange a short sale of any security not covered by paragraph (a) of this rule, (1) below the price at which the last sale thereof, regular way, was effected on such exchange, or (2) at such price unless such price is above the next preceding different price at which a sale of such security, regular way, was effected on such exchange. In determining the price at which a short sale may be effected after a security goes ex-dividend, ex-right, or ex-any other distribution, all sale prices prior to the "ex" date may be reduced by the value of such distribution.

(d) Reserved.

(e) The provisions of paragraphs (a) and (b) hereof (and of any exchange rule adopted in accordance with paragraph (a) hereof) shall not apply to ––

(1) Any sale by any person, for an account in which he has an interest, if such person owns the security sold and intends to deliver such security as soon as is possible without undue inconvenience or expense;

(2) Any broker or dealer in respect of a sale, for an account in which he has no interest, pursuant to an order to sell which is marked "long";

(3) Any sale by an odd-lot dealer on an exchange with which it is registered for such security, or any over-the-counter sale by a third market maker to offset odd-lot orders of customers;

(4) Any sale by an odd-lot dealer on an exchange with which it is registered for such security, or any over-the-counter sale by a third market maker to liquidate a long position which is less than a round lot, provided such sale does not change the position of such odd-lot dealer or such market maker by more than the unit of trading;

(5) Any sale of a security covered by paragraph (a) of this section (except a sale to a stabilizing bid complying with 242.104 of this chapter) by a registered specialist or registered exchange market maker for its own account on any exchange with which it is registered for such security, or by a third market maker for its own account over-the-counter,

(i) Effected at a price equal to or above the last sale, regular way, reported for such security pursuant to an effective transaction reporting plan; or

(ii) Effected at a price equal to the most recent offer communicated for the security by such registered specialist, registered exchange market maker or third market maker to an exchange or a national securities association ("association") pursuant to 242.602 of this chapter, if such offer, when communicated, was equal to or above the last sale, regular way, reported for such security pursuant to an effective transaction reporting plan:

Provided, however, that any exchange, by rule, may prohibit its registered specialist and registered exchange market makers from availing themselves of the exemption afforded by this paragraph (e)(5) if that exchange determines that such action is necessary or appropriate in its market in the public interest or for the protection of investors;

(6) Any sale of a security covered by paragraph (b) of this section on a national securities exchange (except a sale to a stabilizing bid complying with 242.104 of this chapter) effected with the approval of such exchange which is necessary to equalize the price of such security thereon with the current price of such security on another national securities exchange which is the principal exchange market for such security;

(7) Any sale of a security for a special arbitrage account by a person who then owns another security by virtue of which he is, or presently will be, entitled to acquire an equivalent number of securities of the same class as the securities sold; provided such sale, or the purchase which such sale offsets, is effected for the bona fide purpose of profiting from a current difference between the price of the security sold and the security owned and that such right of acquisition was originally attached to or represented by another security or was issued to all the holders of any such class of securities of the issuer;

(8) Any sale of a security registered on, or admitted to unlisted trading privileges on, a national securities exchange effected for a special international arbitrage account for the bona fide purpose of profiting from a current difference between the price of such security on a securities market not within or subject to the jurisdiction of the United States and on a securities market subject to the jurisdiction of the United States; provided the seller at the time of such sale knows or, by virtue of information currently received, has reasonable grounds to believe that an offer enabling him to cover such sale is then available to him in such foreign securities market and intends to accept such offer immediately;

(9) [Removed and reserved in Release No. 34−32100, effective April 8, 1993, 58 F.R. 18145.]

(10) Any sale by an underwriter, or any member of a syndicate or group participating in the distribution of a security, in connection with an over-allotment of securities, or any lay-off sale by such a person in connection with a distribution of securities through rights or a standby underwriting commitment; or

(11) Any sale of a security covered by paragraph (a) of this section (except a sale to a stabilizing bid complying with 242.104 of this chapter) by any broker or dealer, for his own account or for the account of any other person, effected at a price equal to the most recent offer communicated by such broker or dealer to an exchange or association pursuant to 242.602 of this chapter in an amount less than or equal to the quotation size associated with such offer, if such offer, when communicated, was:

(i) Above the price at which the last sale, regular way, for such security was reported pursuant to an effective transaction reporting plan; or

(ii) At such last sale price, if such last sale price is above the next preceding different price at which a sale of such security, regular way, was reported pursuant to an effective transaction reporting plan.

(12) For the purposes of paragraph (e)(8) of this section, a depositary receipt of a security shall be deemed to be the same security as the security represented by such receipt. For the purposes of paragraphs (e)(3), (4) and (5) of this section, the term "third market maker" shall mean any broker or dealer who holds itself out as being willing to buy and sell a reported security for its own account on a regular and continuous basis otherwise than on an exchange in amounts of less than block size.

(f) This rule shall not prohibit any transaction or transactions which the Commission, upon written request or upon its own motion, exempts, either unconditionally or on specified terms and conditions.

Regulatory History:

Removed and reserved by Release No. 34−55970, effective July 3, 2007, 72 F.R. 55950.
Former NASD Rule 5100

5100. Short Sale Rule

(a) With respect to trades reported to the ADF or a Trade Reporting Facility, no member shall effect a short sale in a Nasdaq Global Market Security (as that term is defined in Rule 4200) otherwise than on an exchange for the account of a customer or for its own account at or below the current national best (inside) bid when the current national best (inside) bid is below the preceding national best (inside) bid in the security. In addition, for a transitional period ending on November 3, 2006, members may use the Nasdaq Exchange best (inside) bid rather than the national best (inside) bid for purposes of the application of this rule, provided that the member has submitted prior written notification to NASD of this selection. Members are required to use the same bid tick test on a firm-wide basis. A member using the Nasdaq Exchange best (inside) bid may not use the national best (inside) bid prior to the end of the transitional period unless the member submits prior written notification to NASD of this change. For the purposes of this rule, the term “customer” includes a non-member broker dealer.

(b) In determining the price at which a short sale may be effected after a security goes ex-dividend, ex-right, or ex-any other distribution, all quotation prices prior to the “ex” date may be reduced by the value of such distribution.

(1) Sales by a registered market maker registered in the security in connection with bona fide market making activity. For purposes of this paragraph, transactions unrelated to normal market making activity, such as index arbitrage and risk arbitrage that are independent from a member’s market making functions, will not be considered bona fide market-making activity.

(2) Any sale by any person, for an account in which he has an interest, if such person owns the security sold and intends to deliver such security as soon as possible without undue inconvenience or expense.

(3) Sales by a member, for an account in that the member has no interest, pursuant to an order to sell that is marked “long.”

(4) Sales by a member to offset odd-lot orders of customers.

(5) Sales by a member to liquidate a long position which is less than a round lot, provided that such sale does not change the position of the member by more than one unit of trading.

(6) Sales by a person of a security for a special arbitrage account if the person then owns another security by virtue of which the person is, or presently will be, entitled to acquire an equivalent number of securities of the same class of securities sold; provided such a sale, or the purchase which such sale offsets, is effected for the bona fide purpose of profiting from a current difference between the price of the security sold and the security owned and that such right of acquisition was originally attached to or represented by another security or was issued to all the holders of any such class of securities of the issuer.

(7) Sales by a person of a security effected for a special international arbitrage account for the bona fide purpose of profiting from a current difference between the price of such security on a securities market not within or subject to the jurisdiction of the United States and on such a securities market subject to the jurisdiction of the United States; provided the person at the time of such sale knows or, by virtue of information currently received, has reasonable grounds to believe that an offer enabling the person to cover such sale is then available to the person in such foreign securities market and intends to accept such offer immediately.

(8) Sales by an underwriter, or any member of a syndicate or group participating in the distribution of a security, in connection with an overallotment of securities, or any layoff sale by such a person in connection with a distribution of securities through rights or a standby underwriting commitment.

(9) Sales of securities as to which all short sale price tests have been suspended by operation of a Pilot Order issued by the Commission pursuant to SEC Rule 202T.

(10) Sales of securities included in the Nasdaq-100 Index.

(d) No member shall effect a short sale for the account of a customer or for its own account indirectly or through the offices of a third party to avoid the application of this rule.

(e) No member shall knowingly, or with reason to know, effect sales for the account of a customer or for its own account to avoid the application of this Rule.

(f) A member that is not currently registered as a market maker in a security and that has acquired a security while acting in the capacity of a block positioner shall be deemed to own such security for the purposes of this Rule notwithstanding that such member may not have a net long position in such security if and to the extent that such member’s short position in such security is the subject of one or more offsetting positions created in the course of bona fide arbitrage, risk arbitrage, or bona fide hedge activities.

(g) For purposes of this Rule, a depositary receipt of a security shall be deemed to be the same security as the security represented by such receipt.

(h) (1) A member shall be permitted, consistent with its quotation obligations, to execute a short sale for the account of an options market maker that would otherwise be in contravention of this Rule, if:

(A) the options market maker is registered with a qualified options exchange as a qualified options market maker in a stock options class on a Nasdaq Global Market security or an options class on a qualified stock index; and

(B) the short sale is an exempt hedge transaction.

(2) For purposes of this paragraph:

(A) (i) An “exempt hedge transaction,” in the context of qualified options market makers in stock options classes, shall mean a short sale in a Nasdaq Global Market security that was effected to hedge, and in fact serves to hedge, an existing offsetting options position or an offsetting options position that was created in a transaction(s) contemporaneous with the short sale, provided that when establishing the short position the options market maker is eligible to receive(s) good faith margin pursuant to Section 220.12 of Regulation T under the Act for that transaction.

(ii) An “exempt hedge transaction,” in the context of qualified options market makers in stock index options classes, shall mean a short sale in a Nasdaq Global Market security that was effected to hedge, and in fact serves to hedge, an existing offsetting stock index options position or an offsetting stock index options position that was created in a transaction(s) contemporaneous with the short sale, provided that:

a. the security sold short is a component security of the index underlying such offsetting index options position;

b. the index underlying such offsetting index options position is a “qualified stock index;” and

c. the dollar value of all exempt short sales effected to hedge the offsetting stock index options position does not exceed the aggregate current index value of the offsetting options position.

(iii) Notwithstanding any other provision of this paragraph (h), any transaction unrelated to normal options market making activity, such as index arbitrage or risk arbitrage that in either case is independent of an options market maker’s market making functions, will not be considered an “exempt hedge transaction.”

(B) A “qualified options market maker” shall mean an options market maker who has received an appointment as a “qualified options market maker” for certain classes of stock options on Nasdaq Global Market securities and/or index options on qualified stock indexes pursuant to the rules of a qualified options exchange.

(C) A “qualified options exchange” shall mean a national securities exchange that has approved rules and procedures providing for:

(i) designating market makers as qualified options market makers, which standards shall be designed to identify options market makers who regularly engage in market making activities in the particular options class(es);

(ii) the surveillance of its market maker’s utilization of the exemption set forth in paragraph (h)(1) to assure that short sales effected by qualified options market makers are exempt hedge transactions and that other non-qualified market makers are not utilizing the exemption; and

(iii) authorization of the Association to withdraw, suspend or modify the designation of a qualified options market maker but only if a qualified options exchange has determined that the qualified options market maker has failed to comply with the terms of the exemption, and that such a withdrawal, suspension or modification of the market maker’s exemption is warranted in light of the substantial, willful, or continuing nature of the violation.

(D) A “qualified stock index” shall mean any stock index that includes one or more Nasdaq Global Market securities, provided that more than 10% of the weight of the index is accounted for by Nasdaq Global Market securities and provided further that the qualification of an index as a qualified stock index shall be reviewed as of the end of each calendar quarter, and the index shall cease to qualify if the value of the index represented by one or more Nasdaq Global Market securities is less than 8% at the end of any subsequent calendar quarter.

(E) “Aggregate current index value” shall mean the current index value times the index multiplier.

(F) A member will not be in violation of paragraph (a) above if the member executes a short sale for the account of an options market maker that is in contravention of this paragraph (h), provided that the member did not know or have reason to know that the options market maker’s short sale was in contravention of this paragraph (h).

(i) (1) A member shall be permitted, consistent with its quotation obligations, to execute a short sale for the account of a warrant market maker that would otherwise be in contravention of this Rule, if:

(A) the warrant market maker is a registered market maker for the warrant; and

(B) the short sale is an exempt hedge transaction that results in a fully hedged position.

(2) For purposes of this paragraph, an “exempt hedge transaction” shall mean a short sale in a Nasdaq Global Market security that was effected to hedge, and in fact serves to hedge, an existing offsetting warrant position or an offsetting warrant position that was created in a transaction(s) contemporaneous with the short sale. Notwithstanding any other provision of this paragraph, any transaction unrelated to normal warrant market making activity, such as index arbitrage or risk arbitrage that in either case is independent of a warrant market maker’s market making functions, will not be considered an “exempt hedge transaction.”

(3) The Association may withdraw, suspend or modify the exemption for a warrant market maker upon determination that the market maker has failed to comply with the terms of the exemption, and that such a withdrawal, suspension or modification of the market maker’s exemption is warranted in light of the substantial, willful or continuing nature of the violation.

(4) A member will not be in violation of paragraph (a) above if the member executes a short sale for the account of a warrant market maker that is in contravention of this paragraph (i), provided that the member did not know or have reason to know that the warrant market maker’s short sale was in contravention of paragraph (i)

(j) Pursuant to the Rule 9600 Series or on the Association’s own motion, the Association may exempt either unconditionally, or on specified terms and conditions, any transaction or class of transactions from the provisions of this Rule.

(k) Definitions:

(1) The term “short sale” shall have the same meaning as contained in SEC Rule 200 adopted pursuant to the Act.

(2) The term “block positioner” shall have the same meaning as contained in SEC Rule 3b-8(c) for “Qualified Block Positioner” adopted pursuant to the Act.

(l) This section shall be in effect until December 15, 2007.

[Adopted by SR-NASD-92-12 eff. Sept. 6, 1994; amended by SR-NASD-95-35 eff. Aug. 30, 1995; amended by SR-NASD-95-58 eff. Nov. 30, 1995; amended by SR-NASD-96-30 eff. July 29, 1996; amended by SR-NASD-96-41 eff. Nov. 1, 1996; amended by SR-NASD-97-28 eff. Aug. 7, 1997; amended by SR-NASD-97-65 eff. Sept. 26, 1997; amended by SR-NASD-98-26 eff. Sept. 29, 2000; amended by SR-NASD-98-26 eff. March 1, 2002, amended by SR-NASD-2002-97 eff. July 29, 2002; amended by SR-NASD-98-26 amm. 13 eff. Dec. 15, 2002; amended by SR-NASD-98-26 amm. 14 & 15 eff. June 16, 2003; amended by SR-NASD-2004-092 eff. June 15, 2004; amended by SR-NASD-2004-187 eff. Dec. 15, 2004; amended by SR-NASD-2005-149 eff. Dec. 15, 2005; amended by SR-NASD-2006-068 eff. June 22, 2006; amended by SR-NASD-2005-087 eff. August 1, 2006; amended by SR-NASD-2006-089 eff. Aug. 1, 2006; amended by SR-NASD-2006-087 eff. Aug. 1, 2006; amended by SR-NASD-2006-076 eff. Oct. 9, 2006; amended by SR-NASD-2006-108 eff. Nov. 27, 2006; amended by SR-NASD- 2007-009 eff. Dec. 16, 2006.]

Selected Notices to Members: 91-2, 92-8, 94-68, 94-83, 97-74, 98-65, 99-28, 99-98, 06-57.

Former IM-5100. Short Sale Rule

(a) (1) In developing a Short Sale Rule for Nasdaq Global Market securities effected otherwise than on an exchange, NASD has adopted an exemption to the Rule for certain market making activity. This exemption is an essential component of the Rule because bona fide market making activity is necessary and appropriate to maintain continuous, liquid markets in Nasdaq Global Market securities. Rule 5100(c)(1) states that short selling prohibitions shall not apply to sales by registered market makers in connection with bona fide market making activity and specifies that transactions unrelated to normal market making activity, such as index arbitrage and risk arbitrage that independent from a member’s market making functions, will not be considered as bona fide market making. Thus, two standards are to be applied: one must be a registered market maker and one must engage in “bona fide” market making activity to take advantage of this exemption. With this interpretation, NASD wishes to clarify for members some of the factors that will be taken into consideration when reviewing market making activity that may not be deemed to be a bona fide market making activity and therefore would not be exempted from the Rule’s application.

(2) First, as the Rule indicates, bona fide market making activity does not include activity that is unrelated to market making functions, such as index arbitrage and risk arbitrage that is independent from a member’s market making functions. While these types of arbitrage activity appear to be suitable for the firm’s overall hedging or risk management concerns, they do not warrant an exemption from the Rule. However, short sales of a security of a company involved in a merger or acquisition will be deemed short sales of a security of a company involved in a merger or acquisition will be deemed bona fide market-making activity if made to hedge the purchase or prospective purchase (based on communicated indications of interest) of another security of a company involved in the merger or acquisition, which purchase was made, or is to be made, in the course of bona fide market making activity. The purchase of a security of a company involved in a merger or acquisition made to hedge a short sale of another security involved in the merger or acquisition, which sale was made in the course of bona fide market making activity, will not cause the sale to be deemed unrelated to normal market-making activity. Short sales made to hedge any such purchases or prospective purchases must be reasonably consistent with the exchange ratio (or exchange ratio formula) specified by the terms of the merger or acquisition.

(3) Similarly, bona fide market making would exclude activity that is related to speculative selling strategies of the member of investment decisions of the firm and is disproportionate to the usual market making patterns or practices of the member in that security. The Association does not anticipate that a firm could properly take advantage of its market maker exemption to effectuate such speculative or investment short selling decisions. Disproportionate short selling in a market making account to effectuate such strategies will be viewed by the Association as inappropriate activity that does not represent bona fide market making and would therefore be in violation of Rule 5100.

(b) With respect to trades reported to the ADF or a Trade Reporting Facility, Rule 5100 requires that no member shall effect a short sale in a Nasdaq Global Market security (as that term is defined in Rule 4200) otherwise than on an exchange for the account of a customer or for its own account at or below the current national best (inside) bid when the current national best (inside) bid is below the preceding national best (inside) bid in the security. For purposes of this rule, the term “customer” includes a non-member broker-dealer. NASD has determined that in order to effect a “legal” short sale when the current best bid is lower than the preceding best bid the short sale must be executed at a price of at least $0.01 above the current inside bid when the current inside spread is $0.01 or greater. The last sale report for such a trade would, therefore, be above the inside bid by at least $0.01.

(c)(1) Rule 5100 prohibits a member from effecting a short sale for the account of a customer or for its own account directly or through the offices of a third party for the purpose of avoiding the application of the Short Sale Rule. Further, the Rule prohibits a member from knowingly, or with reason to know, effecting sales for the account of a customer or for its own account for the purpose of avoiding the Rule. With this interpretation, the Association wishes to clarify some of the circumstances under which a member would be deemed to be in violation of Rule 5100.

(2) For example, in instances where the current best bid is below the preceding best bid, if a market maker alone at the inside best bid were to lower its bid and then raise it to create an “up bid” for the purpose of facilitating a short sale, NASD would consider such activity to be a manipulative act and a violation of NASD’s Short Sale Rule. NASD would also consider it a manipulative act and a violation of the Rule if a market maker with a long stock position were to raise its bid above the inside bid and then lower it to create a “down bid” for the purpose of precluding market participants from selling short. In addition, if a market maker agrees to an arrangement proposed by a member or a customer whereby the market maker raises its bid in order to effect a short sale for the other party and is protected against any loss on the trade or on any other executions effected at its new bid price, the market maker would be deemed to be in violation of Rule 5100. Similarly, a market maker would be deemed in violation of the Rule if it entered into an arrangement with a member or a customer whereby it used its exemption from the rule to sell short at the bid at successively lower prices, accumulating a short position, and subsequently offsetting those sales through a transaction at a prearranged price, for the purpose of avoiding compliance with the rule, and with the understanding that the market maker would be guaranteed by the member or customer against losses on the trades.

(3) The Association believes that members’ activities to circumvent the Rule through indirect actions such as executions with other members or through facilitation of customer orders while being protected from loss are antithetical to the purposes of the Rule. Accordingly, the Association will consider any such activity as a violation of Rule 5100.
[Amended by amended by SR-NASD-97-59 eff. Sept. 26, 1997; amended by SR-NASD-01-09 eff. March 2, 2001; amended by SR-NASD-2002-30 eff. March 1, 2002; amended by SR-NASD-2002-53 eff. April 16, 2002; amended by SR-NASD-2002-97 eff. July 29, 2002; amended by SR-NASD-98-26 amm. 13 eff. Dec. 15, 2002; amended by SR-NASD-2003-11 eff. February 4, 2003; amended by SR-NASD-2003-88 eff. May 31, 2003; amended by RF2003-179 eff. Dec. 1, 2003; amended by SR-NASD-2004-092 eff. June 15, 2004; amended by SR-NASD-2004-150 eff. Oct 4, 2004; amended by SR-NASD-2006-068 eff. June 22, 2006; amended by SR-NASD-2005-087 eff. August 1, 2006; amended by SR-NASD-2006-087 eff. Aug. 1, 2006; amended by SR-NASD-2006-108 eff. Nov. 27, 2006; amended by SR-NASD-2007-009 eff. Dec. 16, 2006.]

Former NASD Rule 3350

3350. Short Sale Rule

(a) (1) With respect to trades executed on or reported to the ADF, no member shall effect a short sale for the account of a customer or for its own account in a Nasdaq National Market security at or below the current national best (inside) bid when the current national best (inside) bid is below the preceding national best (inside) bid in the security.

(2) With respect to trades executed on or reported to Nasdaq, no member shall effect a short sale for the account of a customer or for its own account in a Nasdaq National Market security at or below the current best (inside) bid displayed in the Nasdaq Market Center when the current best (inside) bid is below the preceding best (inside) bid in the security.

(b) In determining the price at which a short sale may be effected after a security goes ex-dividend, ex-right, or ex-any other distribution, all quotation prices prior to the "ex" date may be reduced by the value of such distribution.

(1) Sales by a qualified market maker or an ADF market maker registered in the security on Nasdaq in connection with bona fide market making activity. For purposes of this paragraph, transactions unrelated to normal market making activity, such as index arbitrage and risk arbitrage that are independent from a member’s market making functions, will not be considered bona fide market-making activity.

(3) Sales by a member, for an account in which the member has no interest, pursuant to an order to sell which is marked “long” in which the member does not know, or have reason to know, that the beneficial owners of the account have, or would as a result of such sales have, a short position in the security.

(4) Sales by a member to offset odd-lot orders of customers.

(5) Sales by a member to liquidate a long position which is less than a round lot, provided that such sale does not change the position of the member by more than one unit of trading.

(8) Sales by an underwriter, or any member of a syndicate or group participating in the distribution of a security, in connection with an over-allotment of securities, or any layoff sale by such a person in connection with a distribution of securities through rights pursuant to SEC Rule 10b-8 or a standby underwriting commitment.

(9) Sales of securities as to which all short sale price tests have been suspended by operation of a Pilot Order issued by the Commission pursuant to SEC Rule 202T.

(d) No member shall effect a short sale for the account of a customer or for its own account indirectly or through the offices of a third party to avoid the application of this Rule.

(e) No member shall knowingly, or with reason to know, effect sales for the account of a customer or for its own account to avoid the application of this Rule.

(f) A member that is not currently registered as a Nasdaq or ADF market maker in a security and that has acquired a security while acting in the capacity of a block positioner shall be deemed to own such security for the purposes of this Rule notwithstanding that such member may not have a net long position in such security if and to the extent that such member’s short position in such security is the subject of one or more offsetting positions created in the course of bona fide arbitrage, risk arbitrage, or bona fide hedge activities.

(g) For purposes of this Rule, a depositary receipt of a security shall be deemed to be the same security as the security represented by such receipt.

(A) (1) the options market maker is registered with a qualified options exchange as a qualified options market maker in a stock options class on a Nasdaq National Market security or an options class on a qualified stock index; and

(B) the short sale is an exempt hedge transaction.

(2) For purposes of this paragraph:

(A) (i) An “exempt hedge transaction,” in the context of qualified options market makers in stock options classes, shall mean a short sale in a Nasdaq National Market security that was effected to hedge, and in fact serves to hedge, an existing offsetting options position or an offsetting options position that was created in a transaction(s) contemporaneous with the short sale, provided that when establishing the short position the options market maker is eligible to receive(s) good faith margin pursuant to Section 220.12 of Regulation T under the Act for that transaction.

(ii) An “exempt hedge transaction,” in the context of qualified options market makers in stock index options classes, shall mean a short sale in a Nasdaq National Market security that was effected to hedge, and in fact serves to hedge, an existing offsetting stock index options position or an offsetting stock index options position that was created in a transaction(s) contemporaneous with the short sale, provided that:

a. the security sold short is a component security of the index underlying such offsetting index options position;

b. the index underlying such offsetting index options position is a “qualified stock index;” and

c. the dollar value of all exempt short sales effected to hedge the offsetting stock index options position does not exceed the aggregate current index value of the offsetting options position.

(B) A “qualified options market maker” shall mean an options market maker who has received an appointment as a “qualified options market maker” for certain classes of stock options on Nasdaq National Market securities and/or index options on qualified stock indexes pursuant to the rules of a qualified options exchange.

(C) A “qualified options exchange” shall mean a national securities exchange that has approved rules and procedures providing for:

(ii) the surveillance of its market maker's utilization of the exemption set forth in paragraph (h)(l) to assure that short sales effected by qualified options market makers are exempt hedge transactions and that other non-qualified market makers are not utilizing the exemption; and

(iii) authorization of the Association to withdraw, suspend or modify the designation of a qualified options market maker but only if a qualified options exchange has determined that the qualified options market maker has failed to comply with the terms of the exemption, and that such a withdrawal, suspension or modification of the market maker's exemption is warranted in light of the substantial, willful, or continuing nature of the violation.

(D) A "qualified stock index" shall mean any stock index that includes one or more Nasdaq National Market securities, provided that more than 10% of the weight of the index is accounted for by Nasdaq National Market securities and provided further that the qualification of an index as a qualified stock index shall be reviewed as of the end of each calendar quarter, and the index shall cease to qualify if the value of the index represented by one or more Nasdaq National Market securities is less than 8% at the end of any subsequent calendar quarter.

(E) "Aggregate current index value" shall mean the current index value times the index multiplier.

(F) A member will not be in violation of paragraph (a) above if the member executes a short sale for the account of an options market maker that is in contravention of this paragraph (h), provided that the member did not know or have reason to know that the options market maker's short sale was in contravention of this paragraph (h).

(A) the warrant market maker is a registered Nasdaq or ADF market maker for the warrant; and

(B) the short sale is an exempt hedge transaction that results in a fully hedged position.

(2) For purposes of this paragraph, an "exempt hedge transaction" shall mean a short sale in a Nasdaq National Market security that was effected to hedge, and in fact serves to hedge, an existing offsetting warrant position or an offsetting warrant position that was created in a transaction(s) contemporaneous with the short sale. Notwithstanding any other provision of this paragraph, any transaction unrelated to normal warrant market making activity, such as index arbitrage or risk arbitrage that in either case is independent of a warrant market maker’s market making functions, will not be considered an “exempt hedge transaction.”

(k) Definitions:

(1) The term “short sale” shall have the same meaning as contained in Rule 200 of Regulation SHO.

(2) The term “block positioner” shall have the same meaning as contained in SEC Rule 3b-8(c) for “Qualified Block Positioner” adopted pursuant to the Act, reprinted as follows:

The term "Qualified Block Positioner" means a dealer who: (1) is a broker or dealer registered pursuant to Section 15 of the Act, (2) is subject to and in compliance with Rule 15c3-l, (3) has and maintains minimum net capital, as defined in Rule 15c3-l of $1,000,000 and (4) except when such activity is unlawful, meets all of the following conditions: (i) he engages in the activity of purchasing long or selling short, from time to time, from or to a customer (other than a partner or a joint venture or other entity in which a partner, the dealer, or a person associated with such a dealer, as defined in Section 3(a)(18) of the Act, participates) a block of stock with a current market value of $200,000 or more in a single transaction, or in several transactions at approximately the same time from a single source to facilitate a sale or purchase by such customer, (ii) he has determined in the exercise of reasonable diligence that the block could not be sold to or purchased from others on equivalent or better terms, and (iii) he sells the shares comprising the block as rapidly as possible commensurate with the circumstances.

(3) (A) Until February 1, 1996, the term "qualified market maker" shall mean a registered Nasdaq market maker that has maintained, without interruption, quotations in the subject security for the preceding 20 business days. Notwithstanding the 20-day period specified in this subparagraph, after an offering in a stock has been publicly announced, a registration statement has been filed, or a merger or acquisition involving two issues has been announced, no market maker may register in the stock as a qualified market maker unless it meets the requirements set forth below:

(i) For secondary offerings, the offering has become effective and the market maker has been registered in and maintained quotations without interruption in the subject security for 40 calendar days;

(ii) For initial public offerings, the market maker may register in the offering and immediately become a qualified market maker; provided however, that if the market maker withdraws on an unexcused basis from the security within the first 20 days of the offering, it shall not be designated as a qualified market maker on any subsequent initial public offerings for the next 10 business days;

(iii) After a merger or acquisition involving an exchange of stock has been publicly announced and not yet consummated or terminated, a market maker may immediately register in either or both of the two affected securities as a qualified market maker pursuant to the same-day registration procedures in Rule 4611; provided, however, that if the market maker withdraws on an unexcused basis from any stock in which it has registered pursuant to this paragraph within 20 days of so registering, it shall not be designated as a qualified market maker pursuant to this subparagraph (3) for any subsequent merger or acquisition announced within three months subsequent to such unexcused withdrawal.

(B) For purposes of this subparagraph (3), a market maker will be deemed to have maintained quotations without interruption if the market maker is registered in the security and has continued publication of quotations in the security through Nasdaq on a continuous basis; provided however, that if a market maker is granted an excused withdrawal pursuant to the requirements of Rule 4619, the 20 business day standard will be considered uninterrupted and will be calculated without regard to the period of the excused withdrawal. Beginning February 1, 1996, the term "qualified market maker" shall mean a registered Nasdaq market maker that meets the criteria for a Primary Nasdaq Market Maker as set forth in Rule 4612.

(1) This section shall be in effect until December 15, 2006.

[Adopted by SR-NASD-92-12, eff. Sept. 6, 1994; amended by SR-NASD-95-35 eff. Aug. 30, 1995; amended by SR-NASD-95-58 eff. Nov. 30, 1995; amended by SR-NASD-96-30 eff. July 29, 1996; amended by SR-NASD-96-41 eff. Nov. 1, 1996; amended by SR-NASD-97-28 eff. Aug. 7, 1997; amended by SR-NASD-97-65 eff. Sept 26, 1997; amended by, SR-NASD-98 26 eff. Sept. 29, 2000; amended by SR-NASD-98-26 eff. March 1, 2002; amended by SR-NASD-2002-97 eff. July 29, 2002; amended by SR-NASD-98-26 amm.13 eff. Dec. 15, 2002; amended by SR-NASD-98-26 amm. 14 & 15 eff. June 16 2003; amended by SR-NASD-2004-092 eff. June 15, 2004; amended by SR-NASD-2004-187 eff. Dec. 15, 2004; amended bySR-NASD-2005-149 eff. Dec. l5, 2005.]
Selected Notices to Members: 91-2, 92-8, 94-68, 94-83, 97-74, 98-65, 99-28, 99-98.

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¹ See Global Regulators Take Action to Restrict Short Selling, WilmerHale Client Alert (Nov. 24, 2008), available here (providing an overview of responses by global regulators to concerns about short selling, including short sale bans, partial short sale bans, studies on short sales, and other measures).

² According to one prominent hedge fund manager, George Soros, who rejects the so-called "efficient market hypothesis," Lehman Brothers, AIG and others were "destroyed by bear raids in which the shorting of stocks and buying credit default swaps ("CDS") mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two made a lethal combination." See George Soros, One Way to Stop Bear Raids, Wall St. J., Mar. 23, 2009, available here.

³ See, e.g., U.K. Financial Services Authority (FSA), The Turner Review: A Regulatory Response to the Global Banking Crisis, Mar. 2009, at 112, available here.

⁴ Exchange Act Release No. 59748 (Apr. 10, 2009), 74 Fed. Reg. 18042 (Apr. 20, 2009) ("Proposing Release").

⁵ A "down–bid price" is defined as a price that is less than the current national best bid or, if the last differently priced best bid was greater than the current national best bid, a price that is less than or equal to the current national best bid. Proposing Release at 18050.

⁶ Former Rule 10a-1, 17 C.F.R. 240.10a-1, removed and reserved by Exchange Act Release No. 55970, effective July 3, 2007. See Appendix to this alert for the text of former Rule 10a-1.

⁷ Former NASD Rule 3350. See Appendix to this alert for the text of former NASD Rule 3350 (NASD Rule 5100 after it was renumbered).

⁸ Exchange Act Release No. 42037 (Oct. 20, 1999); Exchange Act Release No. 50104 (July 28, 2004). Information on the public Roundtable in September 2006 is available here. Also, the Commission's staff study of the pilot data in draft from September 2006 and in final form from February 2007 are available here and here.

⁹ Proposing Release at 18053. At the time, the Commission also believed it was reasonable to eliminate price restrictions on short sales in favor of regulatory uniformity and simplicity. Id. The application of the former short sale price tests had become disjointed, with different price tests applying to the same securities trading in different markets. Id. Under the proposed modified uptick rule and the proposed uptick rule, all covered securities, wherever traded, would be subject to one short sale price test and SROs would be precluded from promulgating inconsistent short sale rules. Id. The Commission is considering whether the proposed circuit breaker rules should be SRO rules, so there is no prohibition on SRO short sale rules under the circuit breaker rule proposals.Id.

¹⁰ Id.

¹¹ Proposing Release at 18045. But see discussion of criticism of OEA studies. Proposing Release at 18048 fn. 89.

¹² Proposing Release at 18049; see also U. S. Securities and Exchange Commission Office of Economic Analysis, Analysis of a short sale price test using intraday quote and trade data, Dec. 17, 2008; U. S. Securities and Exchange Commission Office of Economic Analysis, Analysis of Short Selling Activity during the First Weeks of September, 2008, Dec. 16, 2008.

¹³ The Commission notes that bids generally are a more accurate reflection of current prices than last sale prices due to delays and sequencing issues associated with current trade reports. Proposing Release at 18053. The Commission also indicates that a price test based on the national best bid would be easier for firms to implement given the extensive systems changes made by market participants after the adoption of Regulation NMS. Id.

¹⁴ Proposing Release at 18050.

¹⁵ "Trading center" would be defined by reference to the definition in Regulation NMS. See Exchange Act Rule 600(b)(78).

¹⁶ See Exchange Act Rule 600(b)(47) (defining NMS stock as "any NMS security other than an option"); Exchange Rule 600(b)(46) (defining NMS security as "any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options").

¹⁷ Proposing Release at 18050.

¹⁸ Id.

¹⁹A trading center would not be required to have policies and procedures to determine the basis on which a broker-dealer marks an order as "short exempt" under the modified bid test. Proposing Release at 18052.

²⁰ The Commission notes that such "snapshots" of the market would enable trading centers to substantiate that a short sale order was permissibly priced in the case of "flickering" bids–a problem recognized in Regulation NMS. They also would be helpful in dealing with any time lags in receiving data regarding the national best bid from different data sources. Id. It is unclear whether firms will be required to retain all market data snapshots as part of their books and records. In response to a similar issue that arose in connection with the implementation of Regulation NMS, the SEC Staff indicated that firms are not required to maintain comprehensive market data provided they retain a sufficient amount of data to demonstrate the reasonableness of their policies and procedures. U. S. Securities and Exchange Commission Division of Trading and Markets, Responses to Frequently Asked Questions to Rules 611 and 610 of Regulation NMS, FAQ No. 6.03 (Apr. 2008).

²¹ In particular, trading centers would be required to focus on whether executions or displays of short sale orders on impermissible bids are occurring without an applicable exception and whether the trading center has failed to implement and maintain policies and procedures that would have reasonably prevented such impermissible executions or displays of short sale orders. Proposing Release at 18052.

²² This exception for properly displayed short sale orders helps to avoid a conflict between the proposed modified uptick rule and the "Quote Rule" under Rule 602 of Regulation NMS. 17 C.F.R. 602(b)(2) (requiring broker-dealer responsible for communicating a quotation to execute any order to buy or sell presented to it (other than an odd lot order) at a price at least as favorable to such buyer or seller as the broker-dealer's published bid or published offer in any amount up to its published quotation size). Under this exception, a trading center would be able to comply with the modified uptick rule by executing a presented order to buy against its displayed offer to sell even on a down-bid price, as long as the displayed offer to sell was permissibly priced at the time it was first displayed. Proposing Release at 18051.

²³ Proposing Release at 18051-52.

²⁴ As noted above, a broker-dealer would need written policies and procedures to utilize this exception.

²⁵ See 17 C.F.R. 200(g) (delineating ownership of a covered security).

²⁶ This exception is most commonly used for delayed delivery of formerly restricted securities under Rule 144 of the Securities Act of 1933, or where a convertible security, option, or warrant has been tendered for conversion or exchange but the underlying security is not reasonably expected to be received by the settlement date. Proposing Release at 18055.

²⁷ SRO rules define a "unit of trading" or "normal unit of trading." Those terms generally mean 100 shares, i.e., a round lot. See FINRA Rule 6320A(7).

²⁸ The term "bona fide arbitrage" describes an activity undertaken by market professionals in which essentially contemporaneous purchases and sales are effected in order to lock in a gross profit or spread resulting from a current differential in pricing of two related securities. Proposing Release at 18056.

²⁹ For purposes of the international arbitrage exception, a depository receipt for a security is deemed to be the same security represented by the receipt. Proposing Release at 18057. The Commission seeks comment on whether the proposed rule should retain this standard. Id.

³⁰ The proposed modified uptick rule would define "riskless principal" as "a transaction in which a broker or dealer, after having received an order to buy a security, purchases the security as principal at the same price to satisfy the order to buy or, after having received an order to sell, sells the security as principal at the same price to satisfy the order to sell." Proposing Release at 18058.

³¹ This exemption is only available as long as the transaction meets the following requirements: (1) the VWAP for the covered security is calculated by: calculating the values for every regular way trade reported in the consolidated system for the security during the regular trading session, by multiplying each such price by the total number of shares traded at that price; compiling an aggregate sum of all values; and dividing the aggregate sum by the total number of reported shares for that day in the security; (2) the transactions are reported using a special VWAP trade modifier; (3) no short sales used to calculate the VWAP are marked "short exempt;" (4) the VWAP matched security qualifies as an "actively-traded security" under Regulation M or where the subject listed security is not an "actively-traded security," the proposed short sale transaction will be permitted only if it is conducted as part of a basket transaction of twenty or more securities in which the subject security does not comprise more than 5% of the value of the basket traded; (5) the transaction is not effected for the purpose of creating actual, or apparent, active trading in, or otherwise affecting the price of, any security; and (6) a broker or dealer will act as principal on the contra-side to fill customer short sale orders only if the broker-dealer's position in the subject security, as committed by the broker-dealer during the pre-opening period of a trading day and aggregated across all of its customers who propose to sell short the same security on a VWAP basis, does not exceed 10% of the covered security's relevant average daily trading volume, as defined in Regulation M. Proposing Release at 18058-59.

³² For example, should the last national best bid disseminated at the end of a trading session govern short sales when the national best bid is no longer being collected, calculated or disseminated?

³³ The proposed uptick rule would provide that "[n]o person shall, for his own account or for the account of any other person, effect a short sale of any covered security, if trades in such security are reported pursuant to an effective transaction reporting plan and information as to such trades is made available in accordance with such plan on a real-time basis to vendors of market transaction information: (i) Below the price at which the last sale thereof, regular way, was reported pursuant to an effective transaction reporting plan; or (ii) At such price unless such price is above the next preceding different price at which a sale of such security, regular way, was reported pursuant to an effective transaction reporting plan." Proposing Release at 18060.

³⁴ The SEC states that, depending on the public comments, the proposed uptick rule also could follow a policies and procedures approach similar the proposed modified uptick rule. Proposing Release at 18062.

³⁵ Proposing Release at 18064-65.

³⁶ This exception is only available if the sale of a covered security is on an electronic trading system that matches buying and selling interest at various times throughout the day and: (1) matches occur at an externally derived price within the existing market and above the current national best bid; (2) sellers and purchasers are not assured of receiving a matching order; (3) sellers and purchasers do not know when a match will occur; (4) persons relying on the exception are not represented in the primary market offer or otherwise influencing the primary market bid or offer at the time of the transaction; (5) transactions in the electronic trading system are not made for the purpose of creating actual, or apparent, active trading in, or depressing or otherwise manipulating the price of, any security; and (6) the covered security qualifies as an "actively-traded security" (as defined in Rules 101(c)(1) and 102(d)(1) of Regulation M). If the subject listed security is not an "actively-traded security," the proposed short sale transaction will be permitted only under certain restrictive conditions. Proposing Release at 18063.

³⁷ All SROs currently impose circuit breakers based on triggers tied to movements of market indices (not individual securities) that result in market-wide trading halts of varying lengths, depending on the DJIA's rate of decline. FINRA Rule 6120; NYSE Rule 80B; BATS Exchange Rule 11.18; Amex Rule 950 (applying Amex Rule 117, Trading Halts Due to Extraordinary Market Volatility, to options transactions); CBOE Rule 6.3B; ISE Rule 703; NYSE Arca Options Rule 7.5; PHLX Rule 133; and CME Rule 35102.I.

³⁸ See Securities Exchange Act Release No. 58572 (Sept. 17, 2008), 73 Fed. Reg. 54875 (Sept. 23, 2008); Securities Exchange Act Release No. 58592 (Sept. 18, 2008), 73 Fed. Reg. 55169 (Sept. 24, 2008); September 21, 2008 Amendment, 73 Fed. Reg. 55556-01 (Sept. 25, 2008). See also New Short Sale Restrictions Take Effect Today, WilmerHale Client Alert (Sept. 18, 2008), available here; SEC Imposes Additional Limits on Short Selling, WilmerHale Client Alert (Sept. 19, 2008), available here (providing an analysis of the temporary short sale ban imposed by the SEC in September 2008).

³⁹ The term "market maker" is defined by reference to Section 3(a)(38) of the Exchange Act, and the guidance on bona fide market making for purposes of Rule 203 of Regulation SHO is applicable to the market maker exception of the proposed circuit breaker halt rule. Proposing Release at 18067.

⁴⁰ Securities Exchange Act Release No. 58572 (Sept. 17, 2008), 73 Fed. Reg. 54875 (Sept. 23, 2008); Securities Exchange Act Release No. 58592 (Sept. 18, 2008), 73 Fed. Reg. 55169 (Sept. 24, 2008); September 21, 2008 Amendment, 73 Fed. Reg. 55556-01 (Sept. 25, 2008); Proposed Release at 18068.

⁴¹ Id. The scope of the exception thus would be broader than what was permitted under the September 21 order.

⁴² The proposed circuit breaker with modified uptick rule is similar to circuit breaker proposal submitted to the Commission on behalf of several market centers. See Letter from National Securities Exchanges to Chairman Mary Schapiro, U.S. Securities and Exchange Commission, Mar. 24, 2009, available here.

⁴³ Proposing Release at 18049.

⁴⁴ Proposing Release at 18083.

⁴⁵ Proposing Release at 18071.

⁴⁶ See Chairman Mary L. Schapiro, Statement Before the Commission Open Meeting (Apr. 8, 2009), available here.

⁴⁷ See, e.g., Proposing Release at 18048 fn. 84 ("We note that we have no empirical evidence that [2008 and 2009's] falling prices are the result of short selling activity and the lack of short sale price test restrictions."); Id. at fn. 87 ("Stock markets have incurred significant declines in value under former short sale price test restrictions."); Commissioner Troy A. Paredes, Statement Before the Commission Open Meeting (Apr. 8, 2009), (noting that "it is difficult to measure how much the lack of an 'uptick' rule, as opposed to the recession and other stresses and strains burdening the economy, has contributed to the investor confidence deficit"), available here.

⁴⁸ For example, the Proposing Release describes another possible formulation of a short sale restriction: "[S]hould we consider instead a price limit rule that would prohibit short selling in a particular NMS security at a price lower than 10% below the prior day's close? Unlike a circuit breaker rule, a price limit rule would continue to allow short selling at prices above the limit price after the limit has been reached." Proposing Release at 18081.

⁴⁹ See Exchange Act Release No. 58785 (Oct. 15, 2008); Exchange Act Release No. 58773 (Oct. 14, 2008).

⁵⁰ See, e.g., Commissioner Luis A. Aguilar, Statement Before the Commission Open Meeting (Apr. 8, 2009) (noting that "I will be considering this proposal in light of those rules and other actions that the Commission has taken regarding short selling"), available here.

⁵¹ Commissioner Troy A. Paredes, Statement Before the Commission Open Meeting (Apr. 8, 2009), available here.

A Regulatory Policy Dilemma: Short Sale Restrictions and Investor Confidence

A Regulatory Policy Dilemma: Short Sale Restrictions and Investor Confidence

Authors

Andre E. Owens

Authors

Partner

Chair, Broker-Dealer Compliance and Regulation Practice

Co-Chair, Securities and Financial Regulation Practice

A Regulatory Policy Dilemma: Short Sale Restrictions and Investor Confidence

A Regulatory Policy Dilemma: Short Sale Restrictions and Investor Confidence

Authors

Andre E. Owens

Related Solutions

Authors

Partner

Chair, Broker-Dealer Compliance and Regulation Practice

Co-Chair, Securities and Financial Regulation Practice

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