Part 3 of 3:
F. Revising the Definition of -Short Sale- Under Rule 3b-3
The definition of "short sale" set forth in Rule 3b-3 is integrally related to regulating short sales under Rule 10a-1. As with Rule 10a-1, many developments in the securities markets have challenged the current definition.
1. Aggregation
Short sellers are required to net all of their positions to determine whether they are "short" under the definition in Rule 3b-3. Continual netting is cumbersome and impractical for large, multi-service firms. As a result, the staff of the Commission has granted relief to these firms to ease the burdens of complying with Rule 10a-1, while preserving the protections that the rule provides.[65]
Q33. Should we consider changing the definition of "short sale" to reduce the need to aggregate positions within a single entity? Please describe other situations where an alternative to firm-wide aggregation is justified.
2. Strategies for Creating a Temporary "Long" Position
Certain trading strategies have developed that may be used to avoid the restrictions of the short sale rule. Traders employing such strategies enter arrangements with a counterparty to create a position in an equity security that technically is long, but gives the traders no real economic stake in the equity security. Typically, these strategies rely on the provision of Rule 3b-3 that provides that a person has a long position in a security if he has "entered into an unconditional contract, binding on both parties thereto, to purchase [the stock] but has not yet received it."[66] Often, these strategies involve the creation of a married put prior to, or simultaneous with, a sale of the stock.[67] Soon after creating this arrangement (i.e., later in the day), it is unwound when the market participant purchases shares to return to the counterparty.
A potential for abuse exists where the trader aggressively sells the "long" stock position, destabilizing the price of the stock, and soon after repurchases the stock in the market to return to the counterparty. This type of strategy may present a heightened potential for manipulation. While there are legitimate reasons to engage in married puts (or other similar arrangements), we are concerned that they may be used for improper purposes.
Q34. Please describe examples of any manipulative strategies that exploit the current definition of "short sale," and whether regulatory measures should be adopted to combat such strategies.
G. Extending the Short Sale Rule to Non-Exchange Listed Securities
Current short sale regulations cover securities that are either listed on an exchange or traded in the Nasdaq NMS. As a result, they cover securities that are generally characterized by high trading liquidity. In addition, these markets have a relatively high degree of transparency.
Securities traded in the OTC markets (e.g., Nasdaq Small Cap, the NASD's OTCBB, the Pink Sheets) are not subject to short sale restrictions. The staff frequently receives complaints alleging short sale abuses involving securities in the OTC markets. As a corollary to other concepts presented in this release, we seek comment on regulating short sales in this market sector. We recognize that Section 10(a) does not grant specific authority to the Commission to regulate short sales of securities not listed on a national exchange. Thus, regulations that extend short sale regulation to new market sectors would have to be adopted under other available statutory authority.
Q35. Should we consider extending short sale regulation to cover non-exchange listed securities?
Q36. If so, how should the new regulation restrict short sales? Does the current NASD short sale rule provide an applicable model for this purpose?
H. Eliminating Rule 10a-1
As noted above, the need for short sale regulation has often been debated. We believe that the developments in the securities markets noted in this release warrant a general review of Rule 10a-1. Therefore, we are also seeking comment on whether we should consider eliminating Rule 10a-1 as a prophylactic measure and rely on the antifraud and anti-manipulation provisions of the securities laws to address abusive short selling.
One school of thought believes that unrestricted short selling can involve abusive activity that influences market prices for securities. This view was strongly expressed to Congress during its investigations of the securities markets prior to enacting the Exchange Act, which gave the Commission the authority to regulate short sales.[68] Proponents of this view believe that successive short selling by speculators may accelerate the impact of their bearish outlook for a security.[69] In 1963, the Special Study concluded that the aggravating influence of short sales occurred even with regulatory restrictions (which are still in place today).[70] However, data about the actual relationship between short selling and price movements in the securities markets is scarce.[71]
In contrast, a number of commentators have argued that short sale regulation prevents the market from reflecting the true or "efficient" price of a security.[72] These commentators specifically criticize Rule 10a-1 for imposing costs on market participants as they wait for an uptick.[73] We have considered these observations and determined that the concept of eliminating the tick test deserves analysis in light of recent market developments. If we eliminate the Rule, short selling would only be subject to recordkeeping, reporting, and the general antifraud and anti-manipulation rules.[74]
Q37. Are the objectives of Rule 10a-1 legitimate concerns in today's markets?
Q38. Are the provisions of Rule 10a-1 necessary in the securities markets? If so, please give specific examples that demonstrate this need.
Q39. Does Rule 10a-1 continue to serve a valid purpose in a declining market by preventing short sellers from accelerating declines in securities prices, or "depressing" the market?
Q40. Does Rule 10a-1 prevent efficient pricing or slow the incorporation of negative perceptions into an efficient price? Does the need for more efficient pricing, if there is a need, outweigh the protective benefits of Rule 10a-1?
Q41. Is Rule 10a-1 effective in preventing manipulative short selling?
Q42. Would deregulation of short selling lead to an increase of speculation in the market? If so, would this increase disadvantage investors that are not engaged in speculation?
Q43. Does Rule 10a-1 limit price volatility in the securities that it covers?
Q44. Would investors avoid securities, or classes of securities, that they perceive to be vulnerable to abusive short selling? If so, would this result be exacerbated by deregulation of short selling?
Q45. Would antifraud surveillance and enforcement actions be enough to protect investors from abusive short selling?
Q46. If we rescind Rule 10a-1, should we reconsider a recordkeeping and/or disclosure requirement for significant short positions?[75]
Q47. Would dissemination of aggregate open short positions on a daily basis decrease the necessity of Rule 10a-1? What costs would be associated with such a program?
Q48. If we rescind Rule 10a-1, should we consider adopting a rule that requires a seller to identify a source of borrowable shares prior to executing a short sale?
Q49. If we rescind Rule 10a-1, should SROs continue to regulate short selling through their rules?
Q50 If the short sale rule is retained, should we consider ways to regulate short sales of all securities, not just those listed on exchanges (specifically, OTC securities, including those securities quoted in the non-Nasdaq OTC markets)?
Q51. If the short sale rule is retained, should we consider replacing the tick test with a bid test similar to NASD Rule 3350?
Typically, market professionals are able to act quickly in response to news. Eliminating the short sale rule may enable short sellers to act even more rapidly. Open public limit orders may be hit in rapid succession at prices that no longer are attractive to the investors that placed the orders. As a result, these orders may be hit before the investors have the opportunity to cancel them.
Q52. Without the tick test, would market professionals have an unfair advantage over public investor limit orders?
Q53. Would unrestricted short selling increase the risk for certain trading strategies (e.g., block positioning)?
III. Conclusion
The securities markets and short selling activities have changed significantly from the era in which Rule 10a-1 was adopted. We solicit comment on alternative approaches to regulating short sales to determine the appropriate response to these continuing developments.
By the Commission.
Jonathan G. Katz
Secretary
Dated: October 20, 1999
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Footnotes
1 17 CFR 240.10a-1.
2 15 U.S.C. 78a et seq.
3 Rule 3b-3 under the Exchange Act, 17 CFR 240.3b-3, defines a short sale as "any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller." Pursuant to Rule 3b-3, a seller of an equity security subject to Rule 10a-1 must aggregate all positions in that security in order to determine whether the seller has a "net long position." Securities Exchange Act Release No. 20230 (September 27, 1983), 48 FR 45119. See also Letter regarding Rule 10a-1 - Aggregation Units (November 23, 1998) (permitting broker-dealers to net positions for "aggregation units" (rather than firm-wide) for the purpose of complying with Rule 10a-1).
4 Such arbitrage activity is specifically excepted from compliance with the provisions of the short sale rule in paragraph (e)(7) of Rule 10a-1. 17 CFR 240.10a-1(e)(7).
5 See, e.g., S.E.C. v. Gardiner, 48 S.E.C. Docket 811, No. 91 Civ. 2091 (S.D.N.Y. March 27, 1991) (alleged manipulation by sales representative by directing or inducing customers to sell stock short in order to depress its price).
6 See 7 Louis Loss and Joel Seligman, Securities Regulation 3203-04, note 213 (3d ed. 1989).
7 See 2 Securities and Exchange Commission, Report of Special Study of Securities Markets, H.R. Doc. No. 95, 88th Cong., 1st Sess. 247 (1963) (Special Study).
8 Id.
9 15 U.S.C. 78j(a).
10 See Securities Exchange Act Release No. 1548 (January 24, 1938), 3 FR 213. In this release, the Commission also adopted Rule 3b-3.
11 Rule 10a-1 uses the term "effective transaction reporting plan" as defined in Rule 11Aa3-1 (17 CFR 240.11Aa3-1) under the Exchange Act. See 17 CFR 240.10a-1(a)(1)(i).
12 The National Association of Securities Dealers, Inc. (NASD) has adopted a short sale rule that applies to Nasdaq National Market System (NMS) securities. See infra Section I.B.2.
13 17 CFR 240.10a-1(a). An "effective transaction reporting plan" is a plan approved by the Commission for collecting, processing, and disseminating transaction reports in reported securities. See 17 CFR 11Aa3-1(a)(3).
14 17 CFR 240.10a-1(b).
15 NYSE Rule 440B and Amex Rule 7.
16 The tick test replicated the approach used by the NYSE at the time.
17 See Securities Exchange Act Release No. 13091 (December 21, 1976), 41 FR 56530 (1976 Release).
18 See, e.g., SEC v. Tudor Investment Corp., 62 S.E.C. Docket 2269, No. 96 CV 02119 (D.D.C. Sept. 12, 1996) (concentrated short sales of stocks of the Dow Jones Industrial Average (DJIA) seen as significant factor in a drop in value of the DJIA).
19 See 17 CFR 240.10a-1(e)(1) - (13).
20 See, e.g., Letter regarding Instinet Corporation Crossing Network, [1992] Fed. Sec. L. Rep. (CCH) ¶ 76,290 (July 1, 1992); Letter regarding Portfolio System for Institutional Trading, [1991-1992] Fed. Sec. L. Rep. (CCH) ¶ 76,097 (December 31, 1991); Letter regarding Off-Hours Trading by the Amex, [1991] Fed. Sec. L. Rep. (CCH) ¶ 79,802 (August 5, 1991); Letter regarding Operation of Off-Hours Trading by the NYSE, [1991] Fed. Sec. L. Rep. (CCH) ¶ 79,736 (June 13, 1991); Letter regarding Merrill Lynch, Pierce, Fenner & Smith, Inc. (December 17, 1986), published with modifications in Securities Exchange Act Release No. 27938 (April 23, 1990), 55 FR 17949 (Merrill Lynch Letter).
21 However, the Rule applies to transactions in exchange listed securities whether effected on an exchange or in the OTC markets.
22 See Irving Pollack, Short-Sale Regulation of NASDAQ Securities (1986) (Pollack Study).
23 NMS securities are securities of issuers that meet a series of standards similar to those required for listing on an exchange. These securities are distinguished from securities traded on the Nasdaq SmallCap market.
24 See Securities Exchange Act Release No. 34277 (July 6, 1994), 59 FR 34885.
25 Id. In the approval order, the Commission recognized that exchange markets were able to attract customers with claims that their markets protect against potential short selling abuses. However, several commenters cited the Pollack Study, supra note 21, to support their opposition to the NASD short sale rule. Originally approved for only 18 months, the NASD and the Commission have extended Rule 3350 numerous times. Most recently, the Commission approved an extension of the rule until December 31, 1999. Securities Exchange Act Release No. 41568 (June 28, 1999), 64 FR 36416.
26 NASD Manual, Conduct Rules, Rule 3350.
27 NASD Manual, Conduct Rules, Rule 3360.
28 The Economic Impact of the Nasdaq Short Sale Rule, Prepared by D. Timothy McCormick and Lorraine Reilly (1996) (Nasdaq Economic Study).
29 Id. at 30.
30 Special Study, supra note 7, at 246-294.
31 Id. at 248.
32 See 1976 Release, supra note 17.
33 Id. at 56530.
34 Id. at 56534.
35 See Comment letters in Public File No. S7-665, available for inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, N.W., Washington, D.C. 20549.
36 Comment letter from Lynch, Jones & Ryan (March 23, 1977).
37 Securities Exchange Act Release No. 17347 (November 28, 1980), 45 FR 80834.
38 Short-Selling Activity in the Stock Market: Market Effects and the Need for Regulation (Part 1) (House Report), H.R. Rep. No. 102-414 (1991), reprinted in CCH Federal Securities Law Reports Number 1483 Part II (1992).
39 Id. at 1. As discussed above, the NASD adopted its short sale rule in 1994.
40 Id.
41 Securities Exchange Act Release No. 29278 (June 7, 1991), 56 FR 27280, 27281 (1991 Release).
42 See, e.g., Jonathan R. Macey, Mark Mitchell, and Jeffry Netter, Restrictions on Short Sales: an Analysis of the Uptick Rule and its Role in View of the October 1987 Stock Market Crash, 74 Cornell L. Rev. 799 (1989); and J. Randall Woolridge and Amy Dickinson, Short Selling and Common Stock Prices, Financial Analysts Journal, January-February 1994.
43 Arbitrage can involve inherent relationships between securities, such as convertible arbitrage, or statistical relationships, as used in "pairs trading."
44 See, e.g., Letter regarding Optimark (October 31, 1997), included in Public File No. S7-24-99, available for inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, N.W., Washington, D.C. 20549.
45 See Alexander, Gordon J., and Mark Peterson, Short Selling on the New York Stock Exchange and the Effects of the Uptick Rule, Journal of Financial Intermediation, Vol. VIII, Issue 1 (June 1999) (this article concludes that the short sale rule fails to meet its objective to allow relatively unrestricted short selling in advancing markets).
46 This approach to short sale regulation has been suggested by others. See Letter from David A. Rocker to Chairman Arthur Levitt (March 5, 1998), included in Public File No. S7-24-99, available for inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, N.W., Washington, D.C. 20549.
47 Transaction prices in securities covered by Rule 10a-1 must be reported in accordance with Rule 11Aa3-1. 17 CFR 240.10a-1(a)(1)(i).
48 See, e.g., NYSE Rule 80A (which, among other things, imposes certain trading restrictions when the Dow Jones Industrial Average (DJIA) declines or advances by at least the "two-percent value" as calculated in the rule from its previous closing level).
49 See 17 CFR 242.101(c)(1).
50 See Rule 105 of Regulation M (prohibiting a person from purchasing securities in a distribution if he or she has sold that security short within five days prior to the pricing of the distribution). 17 CFR 242.105.
51 Cf. Securities Exchange Act Release No. 17222 (October 17, 1980), 45 FR 70890 (discussing certain time restrictions on issuer repurchases at the opening and closing of trading sessions).
52 For the purposes of Rule 10a-1, the Commission has described a bona fide hedge as largely a matter of custom and practice, but it must involve long and short positions in related securities where one security is exercisable, convertible, or otherwise related by its terms to the other security, and substantially offsets the risk of that security. To be considered bona fide, the hedge must offset most or all of the risk of the security being hedged. See, e.g., Securities Exchange Act Release No. 30772 (June 3, 1992), 57 FR 24415, 24420 (1992 Release) (citing Securities Exchange Act Release No. 15533 (January 29, 1979), 44 FR 6084). We request comment on whether this definition is appropriate or adequate.
53 See Securities Exchange Act Release No. 20230 (September 27, 1983), 48 FR 45119, 45120 note 14.
54 Bona fide arbitrage is "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." See, 1992 Release, supra note 51, at 6089.
55 17 CFR 240.10a-1(e)(7).
56 17 CFR 240.10a-1(e)(8).
57 17 CFR 240.10a-1(e)(13).
58 Risk arbitrage is a transaction effected with a view to profit from the consummation of a merger, acquisition, tender offer or other similar transaction involving a recapitalization.
59 See, e.g., Letter regarding Select Sector SPDRs II (February 12, 1999); Letter regarding Select Sector SPDRs (December 28, 1998).
60 See Merrill Lynch Letter, supra note 20.
61 Securities Exchange Act Release No. 20230 (September 27, 1983), 48 FR 45119, 45120. See also Securities Exchange Act Release No. 20715 (March 13, 1984), 49 FR 9414, 9415; 1992 Release at 24419.
62 12 U.S.C. 1821(e)(8)(D)(i).
63 See Securities Exchange Act Release No. 15533 (January 29, 1979), 44 FR 6084, at 6090.
64 See Alexander, Gordon J. and Mark A. Peterson, Quote Jumping, Minimum Tick Variation, and the Execution of Short Sell Orders, 1999 working paper, included in Public File No. S7-24-99, available for inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, N.W., Washington, D.C. 20549.
65 See supra note 2.
66 17 CFR 240.3b-3(2). See also 1992 Release, supra note 51.
67 Married puts can be used to hedge the price paid for a stock through the simultaneous purchase of a stock and deep-in-the-money puts for the stock.
68 See Special Study, supra note 7, at 247.
69 See Woolridge, supra note 42 (concluding that short sellers do not enjoy unfair profits by forcing the price of a security down through short sales).
70 Special Study, supra note 7, at 293 - 294.
71 See, e.g., 1976 Release, supra note 17, at 56534.
72 See, e.g., Macey, supra note 42.
73 See Alexander, supra note 45.
74 E.g., 15 U.S.C. 78i(a) and 78j(b); 17 CFR 240.10b-5.
75 See 1991 Release, supra note 41.
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