Part 1 or 3:
SEC Concept Release:
Short Sales
Securities and Exchange Commission
17 CFR PART 240
Release No. 34-42037; File No. S7-24-99
RIN 3235-AH84
Short Sales
Agency: Securities and Exchange Commission.
Action: Concept release; Request for comments.
Summary: The Securities and Exchange Commission is seeking public comment on the regulation of short sales of securities. In this release, we seek comment on, among other things: lifting the limits on short sales of exchange listed securities under advancing market conditions;providing an exception for actively traded securities; focusing short sale restrictions on certain market events and trading strategies; removing short sale restrictions on hedging transactions; revising short sale regulation in response to certain market developments; revising the definition of "short sale"; extending short sale regulation to non-exchange listed securities; and eliminating short sale regulation altogether.
Dates: Comments must be received on or before [insert date that is 60 days after date of publication in the Federal Register].
Addresses: Persons wishing to submit written comments should send three copies to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0609. Comments also may be submitted electronically at the following E-mail address: rule-comments@sec.gov. All comment letters should refer to File No. S7-24-99. Comments submitted by E-mail should include this file number in the subject line. Comment letters received will be available for public inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, N.W., Washington, D.C. 20549. Electronically submitted comment letters will be posted on the Commission's Internet web site (http://www.sec.gov).
For Further Information Contact: Any of the following attorneys in the Office of Risk Management and Control, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549, at (202) 942-0772: James Brigagliano, Alan Reed, or Michael Trocchio.
Supplementary Information
I. Introduction
The Securities and Exchange Commission (Commission) adopted Rule 10a-1 [1] (short sale rule or Rule) under the Securities Exchange Act of 1934 (Exchange Act)[2] at a time when the securities markets had less trading volume and simpler trading strategies than current markets. Since the adoption of the short sale rule, securities trading has increased drastically in volume, velocity, and complexity. There have also been substantial improvements in market transparency and surveillance mechanisms. Short sale regulation, however, has remained fundamentally unchanged. This separation between Rule 10a-1 and the markets has resulted in frequent requests for relief from the short sale rule and suggestions for modification of it. Our goal is to examine ways to modernize our approach to provide the most appropriate regulatory structure for short sales.
Among other things, we propose to assess whether the restrictions of Rule 10a-1 produce benefits to the markets that are proportionate to the costs associated with those restrictions. We believe that a comprehensive assessment of Rule 10a-1 is necessary to achieve this goal. Therefore, we are seeking public comment on the regulation of short selling. In particular, we solicit comment on eight concepts related to the regulation of short sales of securities:
suspending the short sale rule when the security or market is above a threshold price;
providing an exception for actively traded securities;
focusing short sale restrictions on certain market events and trading strategies;
excepting hedging transactions from short sale regulation;
revising short sale regulation in response to certain market developments;
revising the definition of "short sale";
extending the short sale rule to non-exchange listed securities; and
eliminating Rule 10a-1.
The comments we receive will assist us in determining whether to propose changes to the short sale rule and in tailoring the scope of any such changes.
A. Background
A short sale[3] is the sale of a security that the seller does not own or that the seller owns but does not deliver. In order to deliver the security to the purchaser, the short seller will borrow the security, typically from a broker-dealer or an institutional investor. The short seller later closes out the position by returning the security to the lender, typically by purchasing equivalent securities on the open market. In general, short selling is utilized to profit from an expected downward price movement, or to hedge the risk of a long position in the same security or in a related security.
Short selling provides the market with two important benefits: market liquidity and pricing efficiency. Substantial market liquidity is provided through short selling by market professionals, such as market makers, block positioners, and specialists, who facilitate the operation of the markets by offsetting temporary imbalances in the supply and demand for securities. To the extent that short sales are effected in the market by securities professionals, such short sale activities, in effect, add to the trading supply of stock available to purchasers and reduce the risk that the price paid by investors is artificially high because of a temporary contraction of supply.
Short selling also can contribute to the pricing efficiency of the equities markets. Efficient markets require that prices fully reflect all buy and sell interest. When a short seller speculates on a downward movement in a security, his transaction is a mirror image of the person who purchases the security based upon speculation that the security's price will rise. Both the purchaser and the short seller hope to profit by buying the security at one price and selling at a higher price. The strategies primarily differ in the sequence of transactions. Market participants who believe a stock is overvalued may engage in short sales in an attempt to profit from a perceived divergence of prices from true economic values. Such short sellers add to stock pricing efficiency because their transactions inform the market of their evaluation of future stock price performance. This evaluation is reflected in the resulting market price of the security. Arbitrageurs also contribute to pricing efficiency by utilizing short sales to profit from price disparities between a stock and a derivative security, such as a convertible security or an option on that stock. For example, an arbitrageur may purchase a convertible security and sell the underlying stock short to profit from a current price differential between two economically similar positions.[4]
Although short selling serves useful market purposes, it also may be used as a tool for manipulation.[5] One example is the "bear raid" where an equity security is sold short in an effort to drive down the price of the security by creating an imbalance of sell-side interest. Many people blamed "bear raids" for the 1929 stock market crash and the market's prolonged inability to recover from the crash.[6] Short selling was one of the central issues studied by Congress before enacting the Exchange Act, but Congress made no determinations about its permissibility.[7] Instead, Congress gave the Commission broad authority to regulate short sales in order to stop short selling abuses. [8]
B. Current Regulation of Short Selling
1. Rule 10a-1
Section 10(a) of the Exchange Act gives the Commission plenary authority to regulate short sales of securities registered on a national securities exchange, as necessary to protect investors.[9] After conducting an inquiry into the effects of concentrated short selling during the market break of 1937, the Commission adopted Rule 10a-1 under that grant of authority.[10] The core provisions of the Rule are largely the same today as when they were adopted.
Paragraph (a) of Rule 10a-1 generally covers short sales in any security registered on a national securities exchange (listed securities) if trades of the security are reported pursuant to an "effective transaction reporting plan" and if information as to such trades is made available in accordance with such plan on a real-time basis to vendors of market transaction information.[11] Paragraph (b) applies to short sales on a national exchange in securities that are not covered by paragraph (a). Short sales of securities not registered on an exchange and transactions in securities covered by paragraph (b) that are effected in the OTC market are not subject to the Rule.[12]
Rule 10a-1(a)(1) provides that, subject to certain exceptions, a listed security may be sold short: (i) at a price above the price at which the immediately preceding sale was effected (plus tick), or (ii) at the last sale price if it is higher than the last different price (zero-plus tick). Conversely, short sales are not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions. The operation of these provisions is commonly described as the "tick test." The reference price for the tick test is either the last transaction price reported pursuant to an effective transaction reporting plan[13] or on a particular exchange.[14] Both the New York Stock Exchange, Inc. (NYSE) and the American Stock Exchange LLC (Amex) have elected to use the prices of trades on their own floors for the tick test.[15]
The Commission adopted the tick test after considering the effects of short selling in downward moving markets.[16] In adopting this approach, the Commission sought to achieve three objectives:
(i) allowing relatively unrestricted short selling in an advancing market;
(ii) preventing short selling at successively lower prices, thus eliminating short selling as a tool for driving the market down; and
(iii) preventing short sellers from accelerating a declining market by exhausting all remaining bids at one price level, causing successively lower prices to be established by long sellers.[17]
These objectives continue to be the foundation for Rule 10a-1. They represent the Commission's goal to prevent short selling that could manipulate or depress the market for a security, irrespective of the intention of the short seller.[18] Because Congress granted specific statutory authority to regulate short sales, the Commission adopted a rule that restricts certain types of short sales. Thus, a person can violate the rule without manipulative or fraudulent intent.
A number of exceptions have been incorporated into Rule 10a-1 for a range of activities that are not deemed to present the concerns that the Rule was designed to address.[19] The Commission has also granted relief from the Rule in specific situations that did not appear to present the opportunity for abuse that the Rule was designed to prevent.[20] Recently, the Commission has received a variety of additional requests for relief from the Rule. Some of these requests, if granted, would result in fundamental changes in the operation of the Rule. We think public comment on these proposals would assist us in evaluating them. Therefore, we have reflected the requests in this release.
2. Short Selling Over-the-Counter Securities
Rule 10a-1 only covers short sales of securities listed or traded on an exchange.[21] In 1986, the NASD commissioned a study of short sales in the Nasdaq market.[22] This study concluded that adopting restrictions similar to the tick test for Nasdaq securities would impose a restraint on trading. However, the NASD proposed a short sale rule covering Nasdaq National Market System (NMS) securities, [23] citing a competitive disadvantage between the NASD and the exchanges.[24] In 1994, the Commission approved the NASD's rule.[25] It is currently designated as NASD Rule 3350.[26]
NASD Rule 3350 prohibits short sales by NASD members in NMS securities at or below the current best (inside) bid as shown on the Nasdaq screen when that bid is lower than the previous best (inside) bid (this is referred to as the "bid test"). It contains certain exemptions, including an exemption for qualified Nasdaq market makers, options market makers, and warrant market makers. Rule 3350 also includes exceptions similar to those provided under Rule 10a-1. The NASD also requires members to report regularly to the NASD their total short positions in all customer and proprietary firm accounts.[27]
In 1996, the NASD produced a study of the economic impact of the Nasdaq short sale rule.[28] This study concluded that the Nasdaq short sale rule is effective in restricting short sale activity at the inside bid during large price declines and has no adverse effects on market quality. It stated that "the Nasdaq Short Sale Rule meets its intended objective - to slow down the piling-on of short sales when prices fall - with very little adverse impact on normal short sale activity on Nasdaq."[29]
C. Previous Reviews of Short Selling
1. The 1963 Special Study
In 1963, the Commission included an examination of short selling in response to the request by Congress for a study of the securities markets.[30] One purpose of the Special Study was to determine "the relationships between changes in short positions and subsequent price trends."[31] The Special Study observed that the ratio of short sales to total volume increases in a declining market. It concluded that the short sale rules did not prevent the harmful effects of short selling that the rules were designed to prevent. The Special Study recommended improvements in short sale data collection.
2. The 1976 Proposing Release
In 1976, the Commission ordered a public investigation and proposed temporary rules related to short selling. [32] The Commission stated that the proceedings were "intended to be the first step in a thorough and comprehensive reexamination of short sale regulation in the light of changing market and regulatory conditions and to provide a framework for public discussion of the issues."[33]
These proposals were intended to enable the Commission to collect data regarding the effects of unrestricted short-selling on the markets. The 1976 Release noted the problems of insufficient data that the Special Study faced in 1963. It added that "the availability of data with respect to short selling continues to be inadequate to establish meaningful conclusions" regarding the general effects of short selling or the efficacy of short sale regulation.[34] The Commission believed that it was possible that no conclusive statistical evidence regarding the short or long-term effects of short selling could be gathered while Rule 10a-1 limited short selling activity, and that some type of suspension of the existing short sale rules might be necessary. Accordingly, the Commission proposed alternative temporary rules that would have suspended the tick test in varying degrees.
The Commission proposed three alternative temporary rules. The first alternative would have suspended the operation of the short sale rule for all securities registered, or admitted to unlisted trading privileges, on a national securities exchange. The second alternative would have suspended the operation of the tick test only for equity securities (other than warrants, rights, or options) that are registered, or admitted to unlisted trading privileges, on more than one national securities exchange and for which transactions are reported in the consolidated system. The final alternative would have suspended the operation of the tick test only for the fifty most active equity securities (other than warrants, rights, or options) during the 12 calendar months preceding the effective date of the rule.
The Commission received 12 comment letters in response to the 1976 Proposals.[35] Eight commenters, including the NYSE and Amex, strongly opposed any suspension of the tick test. The common sentiment against the proposed changes was that the short sale rule provides important protection for investors that should not be removed. The NYSE's reasons for opposing any changes in short sale regulation are representative of the comments against adopting any of the proposals. The NYSE believed the most damaging consequences of the changes would be: (1) wider day-to-day price fluctuations; (2) disadvantages for public customers who could not withdraw limit orders to purchase before market professionals sold short; (3) accelerated price declines and increased volatility; (4) distortions in the markets for secondary and tertiary stocks; and (5) impaired market liquidity because block positioners would be discouraged from taking positions. Two commenters thought that the Commission needed more information before eliminating the tick test. AT&T, the only issuer to comment, opposed the revision or elimination of Rule 10a-1 because of the potential increase in the volatility of its stock. One commenter thought that all short sales should be unregulated.[36]
In 1980, the Commission withdrew the proposals, principally due to the public comments opposing the elimination of the tick test. [37]
3. 1991 Congressional Report on Short Selling
In 1991, the House Committee on Government Operations released a report on short selling.[38] The House Report stated that the "effects of short selling on the securities markets are not widely understood," and that "[m]any people have questioned the effectiveness of the present uptick rule and, by implication at least, question whether any purpose would be served by implementing a similar rule for NASDAQ trading." [39]
The House Report made numerous findings and recommendations, including that: (1) short selling plays an important and constructive functional role in the equity market; (2) the uptick rule acts as a price stabilizing force and should be retained; (3) short sale regulation should be extended to the Nasdaq system; (4) many complaints about short selling are not soundly based and may be the result of a poor understanding of short selling; (5) "a pattern of abusive and destructive rumor mongering, targeted specifically at companies in the equity securities of which some short-selling investors have established major short positions, appear[ed] to be occurring;" (6) a large part of the problem with equity securities targeted by short sellers is the psychological misperception that short sellers possess much greater manipulative power than they really do; (7) a method for collecting daily short-selling activity and weekly short interest data from broker-dealers should be developed and this information should be available electronically to the market in aggregate form; and (8) Congress should enact a reporting requirement for large individual short positions.[40]
Since the House Report, a number of changes have occurred that impact its findings. The NASD adopted a short sale rule covering NMS securities. Both the NYSE and the NASD adopted rules requiring members to report data on their short sale activities. In 1991, the Commission published a concept release requesting comment on reporting material short positions.[41] The Commission has not taken any further action on this matter.
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