Questions the SEC was asking for Public COmment in 1997:
Q1. Does Rule 10a-1 permit relatively unrestricted short selling in an advancing market? If not, please provide specific examples to demonstrate that this objective is not currently met.
Q2. Does more short selling occur in an advancing market or a declining one?
Q3. Should the threshold price for suspending the tick test be the previous closing price of the security?
Q4. Should the threshold price correlate to a point change or a percentage change in the price of a security?
Q5. Would volatile markets create complexity for this structure as short sellers must continually take into account the market price of the security to determine whether short selling is restricted?
Q6. If the security's price moves below the threshold price, should the tick test remain in effect during the trading session even if the price subsequently moves above the threshold price?
Q7. Is there another price or manner of determining a more effective threshold for this purpose?
Q8. Could a short seller initiate downward momentum on the price of a security through short selling down to the threshold price? If so, could this momentum cause the depressing effect on the market for a security that Rule 10a-1 is intended to prevent?
Q9. Is it appropriate or preferable to base short sale regulation on general market movements, rather than the price of individual securities?
B. Providing an Exception for Actively Traded Securities
Some of the Commission's anti-manipulation rules assume that highly liquid securities are less vulnerable to manipulation and abuse than securities that are less liquid. For example, Rule 101 of Regulation M has an exception for securities with a public float value of at least $150 million and an average daily trading volume of at least $1 million. A similar approach may be effective for regulating short sales.
Q10. Are highly liquid securities less vulnerable to the abuses that Rule 10a-1 is designed to prevent?
Q11. Are the Regulation M requirements for liquidity under the exception in Rule 101(c)(1) adequate standards for this purpose? If not, what values would work better for this purpose?
Q12. Rule 10a-1 is not focused solely on preventing manipulative activity. Is it appropriate to use these anti-manipulation approaches in the short sale context?
C. Focusing Short Sale Restrictions on Certain Market Events and Trading Strategies
Certain market events and trading strategies may make a security more vulnerable to abusive short sale activity. The Commission previously has recognized that certain events increase the potential for short selling abuse.50 Specific market events related to an issuer or a security (such as a pending merger or acquisition) may cause this increased vulnerability. Also, there may be certain times in a trading day when there is a heightened concern about manipulation.51 We, therefore, request comment on whether short selling should continue to be regulated or even prohibited during specific market conditions.
Q13. Are there corporate events (e.g., mergers, acquisitions, or tender offers) that make a security vulnerable to abusive short selling?
Q14. Are there other cyclical, or regular market events (e.g., option expiration dates or the opening and closing of a trading session) that make a security vulnerable to abusive short selling?
Q15. Are there other trading abuses or manipulations involving short sales under unusual market conditions that Rule 10a-1 currently does not address? If so, could the Rule be amended to prevent these abuses?
Q16. Should short selling be prohibited for a period preceding a significant corporate or market event?
Q17. If the Rule was eliminated, should restrictions continue to apply preceding a significant corporate or market event?
D. Excepting Hedging Transactions From Short Sale Regulation
Today, short selling is integral to many complex trading strategies involving a variety of sophisticated financial instruments. Short sales are often used in these strategies to hedge a position in another security or a related financial instrument. Short positions and short sales related to such hedges are treated the same under Rule 10a-1 as any other short activity. Complying with Rule 10a-1 potentially increases transaction costs on persons using short hedging because of delays caused by waiting for upticks. The risks of a particular strategy, therefore, also may increase as a result of the Rule. We seek comment on whether hedged short positions should be excluded from calculating a person's net position. We also seek comment on whether we should propose adding an exception to Rule 10a-1 that would cover short sales conducted exclusively for the purpose of establishing a bona fide hedge.52
Q18. Is the definition of "bona fide hedge" currently used by the Commission appropriate and adequate?
We have received a number of inquiries seeking relief from Rule 10a-1 for short sales that are part of a bona fide hedge. Proponents argue that it is unlikely that short sales used to create bona fide hedges present a threat of manipulation because gains from the short position would be offset by losses in an equivalent security, i.e., they are "economically neutral."53 Rule 10a-1 currently may inhibit such short sales even though they present little risk of the abuses that it was designed to guard against. We have provided exceptions from and interpretations of Rule 10a-1 for economically neutral short sales that do not present an incentive for abuse.
Rule 10a-1 presently provides exceptions for:
(i) bona fide arbitrage54 undertaken to profit from a current difference between a convertible security and the underlying common stock;55 and
(ii) bona fide arbitrage undertaken to profit from a current difference between the price of a security in the United States and its price abroad.56
Both of these exceptions allow short sales without compliance with the tick test, where the sales are to take advantage of temporary price differentials between related securities or different markets.
Rule 10a-1 also has a limited exception for block positioning activities by broker-dealers.57 This exception permits a broker-dealer selling securities that it acquired as a block positioner to disregard, in determining whether it is net long or net short, proprietary short positions to the extent those short positions are the subject of one or more offsetting positions created in the course of bona fide arbitrage, risk arbitrage,58 or bona fide hedge activities. The Commission relied upon the premise that the short positions excluded from the calculation are not subject to the same potential for abuse as short positions that are not linked to an offsetting position.
We recently granted relief for certain specialist activities that expands on the aggregation relief discussed above. 59 The exemptions provide greater flexibility where short positions are subject to bona fide hedges. As with the block positioner exception and the Merrill Lynch Letter, 60 the exemptions exclude hedged short positions from the calculation of a net position. In addition, the short sales were limited to the specialists' performance of obligatory market functions.
Using a rationale similar to that underlying the limited exception for block positioning activities, our staff took a limited no-action position to facilitate unwinding certain index arbitrage positions with a long stock component. This relief from the tick test applies to broker-dealers unwinding long index arbitrage positions. As with block positioners, this no-action position was limited to circumstances where the sale of securities was deemed a short sale solely as a result of the netting of the index arbitrage long position with one or more short positions created in the course of arbitrage or hedging activities. These securities positions were considered economically neutral, and the unwinding of the index arbitrage position was not thought to involve the types of abuses that Rule 10a-1 was designed to prevent. In these contexts, the staff assumed that economically neutral transactions do not present the incentive to engage in short sales in a manner that would cause or accelerate a decline in the market, because any gain from the short stock would be offset by a loss in the security or securities making up the bona fide hedge or arbitrage position.61
Q19. Should the Commission exclude hedged short positions for the purposes of determining what a person's net position is under Rule 3b-3?
Q20. Should long stock positions that are fully hedged be excluded from the calculation of a person's net position in that stock?
In addition, we have received requests for relief from Rule 10a-1 to permit short sales that are part of trading strategies conducted to establish bona fide hedges. Many of the strategies use statistical formulas or relationships between or among securities to determine the offsetting transaction for the hedge. For example, the purchaser of a convertible security may short the underlying security to hedge against a potential decline in the price of the underlying security. The short sales used in these strategies are distinguishable from short sales that reflect an opinion about the current or future market price of a security.
A broad array of financial instruments can be hedged using short sales of securities. These instruments may not be related to the security sold short, but they nonetheless are economically equivalent. Because of the potential variety of instruments that may be hedged with short sales, we believe that an exception would have to be crafted broadly enough to afford flexibility. For example, the Rule could except short sales that are conducted to offset "qualified financial contracts" (QFC), using the definition in the Federal Deposit Insurance Corporation Act that includes "any securities contract, forward contract, repurchase agreement, swap agreement, and any similar agreement...."62
Q21. Should a broad exception covering short sales offset by equivalent securities be proposed? If so, what securities should be considered equivalent?
Q22. Is "economic neutrality" the proper basis for such an exception? If not, what types of relationships (using a short hedge) that appear to be economically neutral present a potential for manipulation that Rule 10a-1 is designed to prevent?
The relationship between a short position and the instrument hedged by the short position will vary according to custom and practice. Firms that are more tolerant of risk may not fully hedge a position. Instead, they may use a ratio hedge that reflects their tolerance of risk. Such hedging techniques may be difficult for regulatory agencies to evaluate and determine whether a particular hedge should be viewed as a bona fide hedge.63
Q23. Should an exception for hedging transactions be limited to transactions or positions that involve a complete hedge? If so, how should a complete hedge be defined and measured?
Q24. What type of surveillance should the Commission consider for monitoring short sales conducted as part of economically neutral transactions?
E. Revising the Short Sale Rule in Response to Certain Market Developments
If Rule 10a-1 is retained (in whole or in part), certain basic adjustments may be required to keep pace with changes to the operation of the national securities exchanges. We request comments on two potential changes: expansion of trading hours into after-hours trading sessions and conversion to price quotations using a decimal format. Please comment on any other changes to the operation of the national securities exchanges or alternative trading systems (ATSs) that you believe may affect the regulation of short selling.
1. After-hours Trading Sessions
Securities trading is rapidly expanding beyond the regular trading hours of 9:30 a.m. to 4 p.m. This evolution is manifested by the proliferation of trading in ATSs and consideration of extended trading sessions by both the NYSE and Nasdaq. As in regular hours trading, short sellers could add liquidity and contribute to pricing efficiency in after-hours trading.
The tick test of Rule 10a-1 currently operates relative to the last reported price on the Consolidated Tape. If the Consolidated Tape does not operate after the close of regular trading hours, short sales can only be executed at a price above the closing price on the Consolidated Tape for the security (or, at the closing price if that price was an uptick). This result could greatly limit the ability to execute short sales in after hours trading.
We note that Rule 10a-1 permits exchanges to use the price of the last transaction on the exchange, rather than the last price reported to the Consolidated Tape, as the last reported price. Thus, an exchange operating an after-hours session could rely on this provision. ATSs cannot rely on this provision. Thus, short sales through ATSs must use the last price reported to the Consolidated Tape.
Q25. If the Consolidated Tape does not operate during after hours trading, should we consider adopting an exception to permit each ATS to use the last transaction in its system as the reference price?
Q26. What impact would multiple permissible prices at which short sales could be executed have on the effectiveness of short sale regulation?
Q27. If a number of ATSs all operated using their internal prices for Rule 10a-1 compliance, each could produce a different "closing" price at the close of trading on the ATS. How would multiple after-hours "last sale" prices affect the first trade in the morning trading session when the Consolidated Tape recommences operation?
2. Decimalization
We also note that the securities industry is targeting June 30, 2000, as the date when price quotations will be expressed in terms of decimals rather than fractions. Decimal pricing may result in exchanges setting the Minimum Price Variation (MPV) (i.e., the smallest amount by which the price of a security can change), which today is 1/16 ($.0625) for most equity securities, at one cent or potentially even smaller. A further result of the use of smaller MPVs is that the short sale rule may be triggered by a change in price that, on a percentage basis, could reflect an extremely small decrease in the price of the security. For example, the average price per share traded on the NYSE for June 1999 was approximately 45 7/8. In an environment where the MPV is 1/16, a decrease in the share price by 1/16 (.136%) would trigger the short sale rule. In an environment where the MPV is one cent, the short sale rule would be triggered by a decrease of the share price by 1/100 (.02%).
At least one study has analyzed the effects of smaller spreads on the operation of Rule 10a-1.64 The study concludes that smaller increments, such as one cent, would improve execution quality for certain short sales and hurt others.
Q28. How did the recent decrease in the MPV from 1/8 to 1/16 affect short selling?
Q29. How will the potential use of a smaller MPV affect the operation of Rule 10a-1?
Q30. Is a price change as small as one penny per share the type of market impact that the short sale rule is designed to prevent?
Q31. Would the use of a smaller MPV support modifying or eliminating Rule 10a-1?
Q32. Should Rule 10a-1 be altered to remain effective with respect to smaller MPV?
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)?
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