SEC Proposes to Narrow Exceptions to Regulation SHO’s Close-Out Requirements
On July 14, 2006, the SEC issued a proposal to amend Regulation SHO under the Securities Exchange Act of 1934, which governs short selling of securities. The proposed amendments would narrow the exceptions to the "close-out" requirements of Regulation SHO for options market makers and for grandfathered positions.
Rule 203(b)(3) of Regulation SHO generally requires a broker-dealer to close out any fail to deliver positions in "threshold securities" (e.g., securities for which there is an aggregate fail to deliver position of 10,000 shares or more for five consecutive settlement days at a registered clearing agency) that have persisted for 13 consecutive settlement days. In addition, Rule 203(b)(3) prohibits the broker-dealer from accepting or effecting further short sales in those securities prior to closing out the fail to deliver position, unless it first borrows the security or enters into a bona fide borrowing arrangement to borrow the security. Currently, Rule 203 provides exceptions to the close-out requirement for fails to deliver established prior to a security becoming a threshold security (Rule 203(b)(3)(i), known as the "grandfather exception," and for fails to deliver resulting from short sales effected by a registered options market maker to establish or maintain a hedge on options positions that were created before the underlying security became a threshold security.
The proposed amendments would eliminate the grandfather exception and require that any previously grandfathered fail to deliver positions be closed-out within 35 settlement days of the effective date of the amendments. If the fail to deliver position persisted beyond the 35 settlement day period, the broker-dealer would then be subject to the pre-borrow limitations on accepting or effecting further short sales in the security. If a security became a threshold security after the effective date of the amendments, a broker-dealer would be subject to the 13 day close-out requirement (and the pre-borrow limitations) for any fail to deliver position established before the security became a threshold security.
In addition, the proposed amendments would also limit the duration of the exception for options market makers. Under the proposed amendments, any previously excepted fail to deliver positions resulting from hedges on options positions that existed before the underlying security became a threshold security, but had expired or been liquidated on or before the effective date of the amendments, would have to be closed out within 35 settlement days of the effective date of the amendments. In addition, the proposed amendments provide that if a security became a threshold security after the effective date of the amendment, and if the hedged options position has expired or been liquidated, all fail to deliver positions resulting from short sales used to establish or maintain the hedge would be subject to the closeout requirement and the pre-borrowing limitations on further short selling.
Comments will be due within 60 days of the publication of the proposal in the Federal Register, which could be later this week.
Securities Industry FYI is a service of the Broker-Dealer Practice of Morgan Lewis. If you have any questions concerning these important legal developments, please contact any member of Morgan Lewis’s Broker-Dealer Practice, including:
Washington, D.C.
Mark Fitterman
202.739.5019
mfitterman@morganlewis.com
Theodore R. Lazo
202.739.5250
tlazo@morganlewis.com
New York
Robert Mendelson
212.309.6303
rmendelson@morganlewis.com