United States: Short Sales: New Rules And Recent Enforcement Actions

Originally published December 7, 2004

• Introduction
• Regulation SHO
• Definitional and Order Marking Requirements
• Temporary Suspension of the Price Test
• Locate, Borrowing, and Delivery Requirements
• Enforcement Actions for Violations of Short Sale Regulations
• Rule 105 of Regulation M
• Elimination of The Shelf Offering Exception
• Guidance As To What May Constitute a "Sham Transaction" under Rule 105 of Regulation M 5
• Recent SEC Enforcement Actions for Violations of Rule 105 of Regulation M 6
• Conclusion
• Endnotes

Over the past few years, regulators, issuers, investors, and other market participants have expressed increasing concerns regarding the real or perceived effects of short selling. For example, thinly capitalized issuers whose shares trade on the over-the-counter market often blame short sellers for declines in the prices of their stocks. Recently, these issuers' ire has focused on so-called "naked short sellers" - Rthat is, short sellers who do not locate or borrow shares before selling. Likewise, other market participants have expressed apprehension about conduct involving short sales that may be viewed as disruptive or manipulative. The Securities and Exchange Commission (SEC) and the self-regulatory organizations (SROs) have addressed these concerns both by promulgating new regulations governing short sales and by pursing enforcement actions. This article summarizes the new short sales rules contained in Regulation SHO and the amendments to Regulation M and discusses recent enforcement actions pertaining to short sales.

Section 10(a) of the Securities Exchange Act of 1934 gives the SEC plenary authority to regulate short sales of securities registered on a national securities exchange (listed securities). Pursuant to this and other authority, the SEC and, with SEC approval, the SROs, have promulgated several significant rules regulating short sales. One such rule is SEC Rule 10a-1, which generally regulates the price at which short sales may be made. Other rules are NASD Rule 3370 and NYSE Rule 440C.10, which require that the selling broker be in a position to complete the short sale transaction before effecting a short sale.

In 2003, the SEC proposed several changes to the existing regulation of short sales. Among other things, the SEC proposed to change the current rules controlling when short sales are permitted and addressed certain concerns raised by naked short selling and selling short in advance of a public offering. Certain of the proposed changes were adopted in Regulation SHO "Regulation of Short Sales" which was released by the SEC on July 28, 2004, and published in the Federal Register on August 6, 2004. See 69 Fed. Reg. 48008 (2004). Regulation SHO consists of three rules: Rule 200, Rule 202T, and Rule 203. With the release of Regulation SHO, the SEC also adopted an amendment to Rule 105 of Regulation M, which governs short sales in connection with a public offering, and issued interpretive guidance addressing sham transactions designed to evade Regulation M.

Rule 200 of Regulation SHO contains various definitional and order marking requirements. Rule 200(a) defines a "short sale" as any sale of a security that the seller does not own or any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. Rule 200(b)-(f) specifies when a person is deemed to own a security. In a departure from the current rules, but in accord with the position taken by the Commission's staff in a noaction letter, Rule 200(f) allows broker-dealers to aggregate their net positions in a security in each independent trading unit, rather than in the firm as a whole, if certain requirements are met.

In Rule 200(g), the SEC imposes order-marking requirements on trades in all equity securities, and not just in listed securities, which previously were covered by Rule 10a-1. Rule 200(g) requires that orders be marked long, short, or short-exempt. A sell order can be marked long when the seller owns the security being sold and the security either is in the physical possession or control of the brokerdealer, or it is reasonably expected that the security will be in the physical possession or control of the broker-dealer no later than settlement. All other sell orders must be marked short, unless the seller is relying on an exception to an applicable price test, in which case the sell order should be marked short-exempt.

The compliance date for Rule 200 is January 3, 2005.

SEC Rule 10a-1 generally provides that a listed security can be sold short only on a plus tick (that is, at a price above the immediately preceding sale price) or a zeroplus tick (that is, at the last sale price if it is higher than the last different price). Similarly, NASD Rule 3350 generally prohibits members from effecting short sales at a price that is at or below the current best bid for transactions in Nasdaq National Market System securities made on either SuperMontage or the NASD's Alternative Display Facility (ADF). Rule 3350 does not apply to Nasdaq SmallCap, OTCBB, or other securities traded over the counter. There is an exemption in the rule for bona fide market-making activity.

Rule 202T of Regulation SHO gives the SEC the authority to designate securities for which, or time periods during which, the short sale price test of Rule 10a-1(a) or the price tests of the SROs will not apply. The purpose of this rule is to give the SEC the ability to evaluate the overall effectiveness of short-sale price restrictions. On July 28, 2004, the SEC issued Release No. 50104 which will suspend the operation of the short sale price provisions for certain securities for a one-year period commencing on January 3, 2005. The Release specifies approximately 1,000 securities for which the short-sale price rules will not apply. The Release also permits short selling of certain other securities during after-hours trading without complying with price rules during the one-year period.

One of the reasons that the SEC promulgated Regulation SHO was to address growing concerns regarding naked short selling. The SEC recognized that naked short selling can have a number of negative effects on the market, particularly when the seller fails to deliver the securities to the buyer for an extended period of time. When this happens on a broad scale, the failures to deliver can be greater than the total public float. Naked short sellers have more leverage than short sellers who borrow securities prior to selling because they can sell more shares short faster and with lower administrative cost. The SEC pointed out that naked short sellers might use this leverage to engage in trading activities that deliberately depress the price of a security.

The SROs currently regulate whether a short seller must first borrow shares before selling short. NYSE Rule 440C.10 generally provides that no NYSE member should fail to deliver against a short sale on a national securities exchange until diligent efforts have been made to borrow the necessary securities to make delivery. The NYSE comments to this rule state that no short sale order should be accepted or entered unless prior arrangements to borrow the stock have been made or there are other acceptable assurances that delivery can be made on the settlement date. NASD Rule 3370 generally provides that no member may sell a stock short unless it makes an affirmative determination that the member can borrow the shares by the settlement date. The affirmative determination must be annotated in writing. There is an exemption for bona fide market-making activities.

The NASD also has rules addressing failures to deliver. For example, NASD Rule 3210 generally prevents a member from selling a security for its own account or buying a security as a broker for a customer if it has a failure to deliver in that security that is 60 days or older. NASD Rule 11830 imposes mandatory close-out and buy-in requirements in certain circumstances.

The SEC addresses these concerns in Rule 203 of Regulation SHO by imposing new uniform requirements for locating, borrowing and delivering securities. For orders marked long, Rule 203(a) generally prohibits a brokerdealer from (1) lending or arranging a loan of any security for delivery to the purchaser's broker after the sale, or (2) failing to deliver a security on the date delivery is due. Exceptions exist for, among other situations, loans between broker-dealers, and instances where the broker-dealer's customer fails to deliver promised securities to the brokerdealer.

With respect to short sales, Rule 203(b) prohibits a brokerdealer from accepting a short sale in an equity security from another person, or effecting a short sale in an equity security for its own account, unless the broker-dealer (1) has borrowed the security, or entered into a bona fide arrangement to borrow the security, or (2) has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. The broker-dealer must document compliance with this requirement. Reasonable grounds to believe that the security can be borrowed may be established by reliance on easy-to-borrow lists, as long as the list is less than 24- hours old and securities on the list are readily available so that it is unlikely that failures to deliver will occur. However, if there are repeated failures to deliver securities included on an easy-to-borrow list, reliance on the list would not constitute reasonable grounds. Moreover, the absence of a security on a hard-to-borrow list will not constitute reasonable grounds to believe that the security can be borrowed by the delivery date.

Certain exceptions to the uniform locate requirement exist. For example, a broker-dealer accepting a short-sale order from another broker-dealer need not comply with the requirement. This is because the broker-dealer submitting the order is required to fulfill the locate requirement. Of course, this exception would not apply if the accepting broker-dealer has contracted to locate the shares for the submitting broker-dealer. Another exception exists for short sales executed by market makers in connection with bona fide market-making activities. However, this exception would not apply where the market-maker enters into an arrangement with another broker-dealer to execute short sales in order to avoid the locate requirement.

Rule 203 also imposes special requirements for trades in threshold securities, which are securities with substantial failures to deliver. Rule 203(c)(6) defines "threshold security" as any equity security for which there is an aggregate failure to deliver position for five consecutive settlement days at a registered clearing agency of 10,000 shares or more that is equal to at least 0.5 percent of the issuer.s total shares outstanding, and such security is included on a list disseminated by an SRO. The exchanges and SROs will be responsible for publishing lists of threshold securities. Rule 203(b)(3) generally requires any participant of a registered clearing agency to take action on all failures to deliver in threshold securities 10 days after the normal settlement date by closing out the failure to deliver by purchasing securities of like kind and quantity. In addition, until the failure to deliver is closed out, there are restrictions on further short sales in the threshold security by the participant and any broker-dealers for which it clears transactions. There is no exception in the rule for market makers.

The compliance date for Rule 203 is January 3, 2005.

Over the last few years, the failure to comply with short sale regulations has led to enforcement actions by the SEC or the SROs. For example, in one matter¹ the SEC affirmed a finding by an NASD hearing panel that a broker-dealer violated NASD Conduct Rule 3370 by executing short sales without making and annotating the affirmative determinations required for each short sale. The brokerdealer executed the short sales despite being told by its clearing broker that it had no shares to loan. However, the broker-dealer argued that it had complied with its obligations by engaging in the common practice of purchasing a sufficient number of shares by the end of the day to cover the short sales. The SEC rejected this argument noting that the fact that a practice is common or widespread in an industry does not make such conduct proper or legal. In another matter², an NASD hearing panel found that a broker-dealer violated Rule 3370 by making short sales without fulfilling the affirmative determination requirement. The panel rejected the brokerdealer's claim that it was engaged in bona fide marketmaking activities and thus exempt from the affirmative determination requirement. The hearing panel also found that the broker-dealer's alleged reliance on a hard-toborrow list did not fulfill the requirement that the brokerdealer make an affirmative determination that it could borrow the shares before making the short sales.

Rule 105 of Regulation M, 17 C.F.R. § 242.105, promulgated pursuant to the Securities Exchange Act of 1934 imposes additional regulations upon short sales made during the limited pre-pricing period prior to an underwritten public offering. The SEC recently has focused renewed attention on this regulation (which became effective in 1997) by eliminating a common exception to the rule, initiating enforcement actions for violations of the Rule and providing interpretative guidance illustrating situations that the SEC considers to be violations of the Rule.

Rule 105 prohibits a short seller from covering short sales with offering securities purchased from an underwriter or broker-dealer participating in the offering prior to the pricing of the offering securities. The Rule applies to all offerings of securities for cash pursuant to a registration statement or a notification on Form 1-A. The Rule's restricted period is the shorter period of (1) the period beginning five business days before the pricing of the offered securities and ending with such pricing; or (2) the period beginning with the initial filing of such registration statement or notification on Form 1-A and ending with the pricing. During this period, a trader may not short-sell a security and then cover the sale with shares it receives in the subsequent offering. The Rule prohibits such transactions irrespective of the short-seller's intent in effecting the short sale.

The Rule is designed to prevent manipulative short selling in anticipation of underwritten public offerings. The SEC's rationale for the restriction is that pre-pricing short sales that are covered with offering shares artificially distort the market price for the security, preventing the market from functioning as an independent pricing mechanism and eroding the integrity of the offering price. Prices of "follow-on offerings" typically are based on a stock's closing price prior to the time of pricing, and thus short sales during the period immediately preceding pricing that reduce the market price can result in a lower offering price. Rule 105 was designed to ensure that offering prices are based upon supply and demand rather than on artificial forces. Rule 105 does not prohibit pre-pricing short sales; it only prohibits the covering of short sales within the restricted period with shares acquired from an underwriter or other broker-dealer participating in the offering.

When Rule 105 originally was adopted, it contained a specific exception for shares issued pursuant to a shelf offering takedown (offerings filed under Rule 415, 17 C.F.R. § 230.415, promulgated pursuant to the Securities Act of 1933). An investor could cover short sales made within the restricted five-day pre-pricing period with shares to be received pursuant to the shelf offering, without violating Rule 105. At the time the shelf offering exception was adopted, the Commission thought that shelf offerings were not as susceptible to manipulation as non-shelf offerings because it believed that potential investors generally were not aware of a takedown from a shelf registration until immediately prior to its occurrence, and thus pre-pricing short sales arguably were not focused on the prospective offering.

The SEC's view of the matter has changed, and it eliminated the shelf offering exception this past September. As explained in its July 28, 2004, Final Rule Release (Release No. 34-50103), which announced the rule change, the SEC determined that since the initial adoption of Rule 105, equity shelf offerings have become commonplace. The Release noted that shelf offerings now have many characteristics of non-shelf offerings. Shelf offerings are likely to utilize the same marketing efforts - road shows and other special selling efforts - that are used with non-shelf offerings, and thus investors often have notice of a shelf offering before it occurs. The SEC also expressed its belief that using offering shares to cover short sales effected prior to the pricing of a shelf offering has the same negative effect as in non-shelf offerings. In light of these developments, the SEC determined that Rule 105's shelf exception presented an increased potential for the type of manipulative conduct that Regulation M is designed to prevent, and thus it eliminated the shelf exemption.

In the same Release, the SEC provided guidance as to trading activity that it will consider to be "sham transactions" - trading activity meant to evade the prohibitions of Rule 105 through transactions structured so as to falsely give the appearance that a short sale covered by offering shares has instead been covered using shares purchased in the open market. The Release provides two "illustrative" examples of transactions designed to evade Rule 105, while noting that the examples are not meant to be exhaustive.

In the first example of a sham transaction, securities are sold short during the pre-pricing restricted period and are covered using offering securities obtained through an arrangement with a third party who acquires the securities in the public offering. The SEC notes that this type of transaction simply attempts to accomplish indirectly what a trader cannot do directly, and thus would be considered a violation of Rule 105.

In the second example, a trader short-sells during the Rule 105 restricted period, receives offering shares, sells the offering shares into the open market, and then contemporaneously or nearly contemporaneously purchases an equivalent number of the same class of shares in the secondary market and uses these shares to cover his open short position. The SEC indicates that it would consider this type of transaction to violate Rule 105 because there is no legitimate economic purpose or substance to the contemporaneous purchase and sale, no genuine change in beneficial ownership, and little or no market risk; the only reason for engaging in such a series of transactions would be to try to mask a violation of Rule 105.

For obvious reasons, it would be wise for traders to take note of the types of short-sale activity the SEC believes to be "illustrative" of sham transactions, and to avoid engaging in these or similar transactions. This is particularly pertinent considering that the SEC recently has prosecuted enforcement actions for violations of Rule 105 arising from activity much like that described by the illustrative examples.

In one matter,³ the SEC penalized a registered investment adviser and two of its employees (the Respondents) for engaging in sham transactions very similar to the second "illustrative" example given in the July 2004 Rules Release. In connection with three offerings by different issuers, the Respondents short-sold stock within the five-day restricted period prior to pricing and then purchased a similar or equal number of shares in each offering. Subsequently, the Respondents placed "cross" limit orders to sell and buy an equal number of each issuer's securities. This placed the Respondents on both sides of the trade; their limit order to sell offering shares was matched to their limit order to buy the same number of shares at the same price. Respondents then immediately used the re-purchased shares to cover their earlier-established open short position. The SEC considered these to be sham transactions that willfully violated Rule 105, and instituted a cease-and-desist proceeding. The Respondents settled the proceeding by consenting to disgorgement of all their profits, paying an additional civil penalty of $25,000 and agreeing to cease and desist from committing or causing any present or future violations of Rule 105 and Section 10(a) of the Exchange Act.⁴

In another recent matter, the SEC filed a civil penalty action⁵ and an administrative cease-and-desist⁶ proceeding against an investment management company and its president, who caused the private investment fund they managed to short-sell an issuer's stock five days before the pricing of its secondary offering and covered the shorts with shares received in the offering. According to the SEC's complaint, the manager, believing that the offering price would be lower than the current market price of the issuer's stock, sold short 10,000 shares five business days prior to the pricing of the secondary offering. Subsequent to placing the short sale, the manager gave one of the co-managing underwriters an "indication of interest" that its fund would participate in the offering. The fund then did in fact receive an allocation of 10,000 shares in the secondary offering, and used the allocated shares to cover its outstanding short position in the stock. The manager settled the parallel actions by consenting to disgorgement of the entirety of its profits from the transaction ($25,788), paying an additional civil penalty of $25,000 and agreeing to cease and desist from committing or causing any present or future violations of Rule 105.

In enacting Regulation SHO, eliminating the shelf offering exception of Rule 105 of Regulation M, pursuing enforcement proceedings against traders who violate short sale regulations, and providing interpretative guidance regarding additional situations which it would consider to be rules violations, the SEC and the SROs are sending a clear signal that they are concerned about manipulative conduct in connection with short sales and will dedicate resources to monitor short sale activity closely. Market participants should be mindful of this increased scrutiny and should carefully evaluate the propriety of all short-sale activity in which they engage.

Perrie M. Weiner is a partner in the law firm of Piper Rudnick LLP, and chair of its Securities Litigation group in Los Angeles. Edward D. Totino and Robert D. Weber are Of Counsel to Piper Rudnick and members of the Los Angeles Securities Litigation group, which represents hedge funds, broker/dealers, issuers, and investors in national litigation involving claims of improper short sales, market manipulation, and securities fraud.

^{1 In the Matter of the Application of Ko Securities, Inc., Release No. 34-48550, 81 S.E.C. Docket 45 (September 2, 2003).}

2 Hearing Panel Decision as to Respondents John Fiero and Fiero Brother, Inc.(December , 2000), affirmed by National Adjudicatory Council on October 28, 2002.

3 In the Matter of Ascend Capital, LLC, Malcolm P. Fairbairn and Emily Wang Fairbairn, Administrative Proceeding File No. 3-11187.

4 See Release No. 48188 (July 17, 2003).

5 Securities and Exchange Commission v. Joseph X. Crivelli, Civil Action No. 1:04CV01247(RMC)(D.D.C.).

6 In the Matter of JC Management and Joseph X. Crivelli, Administrative Proceeding File No. 3-1151.

This article is intended to provide information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.