Important Notice to Traders
Good afternoon. I am going to post this on the few threads on which I regularly post as I think it may hold serious implications for several traders. It comes from a few discussions I have had with traders and how they are currently handling their short transactions. I will also be following this up with a post about improving short performance. It was quiet weekend<G>!
If you would like to discuss this in greater detail, I will be doing so on the Trading Desk thread, Subject 15612
In reading it, please understand the following:
1. I present this based on my current understanding of the rules and regulations, that I have tried to get an exact answer from the NASD, that several sources corroborated my sentiments, that it is virtually impossible to get an exact answer from any regulatory body, that rules and regulations of any society are usually taken from case law rather than the plain language of the law;
2. That I do not intend to upset or offend anyone yet simply feel that some might be missing out on the rules and those that are familiar with this ruling, yet are simply ignoring it should evaluate the return on investment relative to the fact that they are misunderstanding the Sec rules and being found guilty of violating SEC and NASD regulations.
The topic involves short selling and establishing what many call a "boxed" position. The box would occur as such:
Investor A goes long 1000 ABCD in their margin account, lets call it a type 2 account. At a later time, the investor sells short the position in their short account, type 3 account. These sub-accounts are all part of their main brokerage account. After completing these two transactions, the investors account would look as such:
Account Shares Position
- Margin 2 1000 ABCD
- Short 3 -1000 ABCD
The investor is essentially flat to the market, not effected by the movement in the stock because for whatever gain the short position appreciates, the investor loses dollar for dollar in the margin account.
There are perceived reasons for doing this. Yet it is my contention and the position of the NASD that there are no valid or legal reasons for continuing to box positions. In fact doing so would be considered a violation of SEC and NASD regulations:
1. Deferring capital gains. The IRS did away with the short against the box position which allowed a trader to establish a boxed position for tax purposes. In maintaining the long position in the type 2, margin, account and maintaining the short position in the type 3 account, the investor avoided paying taxes until the two positions were netted through a request by the investor. The "short against the box" advantage was disallowed by the IRS last year.
I think most investors know that the IRS disallowed the box rule. Yet it is the following which is the crux of this post.
Many investors initiate boxed positions for the sake of easing the shorting of securities. For instance, there are two perceived advantages to the boxed positions.
2. Investors feel that in having a long position in the margin account and a short position in the short account, the investor can avoid the upbid or uptick rule in the event the investor desires to later short the position again. The upbid and uptick rules are significant and can make shorting stocks quite difficult. The investor feels they can simply sell the long position avoiding the shorting requirements.
3. As well, investors feel that having a long position in the margin account and a short position in the short account, the investor can avoid the difficulty in borrow securities as they would be able to simply sell the long position. Many times, it is nearly impossible to obtained stock to short. Thus, the investor feels that by maintaining these two positions, and simply selling the long position, the investor can avoid borrowing the position.
Both of these assumptions are wrong. Not only are they wrong, they are violative of SEC and NASD rules.
Take a look at the following:
nasdr.com
This URL directly addresses these issues. I will cut some of the important text into this message at the footer. Long and Short positions, within the same account, amongst accounts of common control or other unified control, must be netted for purposes of meeting Short-Sale Requirements.
Thus , the client long 1000 and short 1000 is essentially flat. Any subsequent sales, regardless of the placement of the positions within the margin and short accounts, requires full satisfaction of the short requirement rules. The stock must be borrowed and must be shorted inline with the respective upbid or uptick rules.
This should make for a good discussion.
***FROM THE NASD's WEBSITE****
NASD Notice to Members 98-65 NASD Reminds Members Of Obligations Relating To The Short-Sale Rule Executive Summary In 1994, the National Association of Securities Dealers, Inc. (NASD®) Rule 3350 (Short-Sale Rule) was adopted to stop market-destabilizing speculative short sales in Nasdaq National Market® (NNM) securities. To prevent this conduct, the Short-Sale Rule prohibits member firms from executing customer short sales and non-Market Maker proprietary short sales in an NNM security at or below the current inside bid when the current inside bid is lower than the previous inside bid. It has come to the attention of NASD Regulation, Inc. (NASD RegulationSM) that certain NASD members may be assisting customers in the circumvention of this Rule. Specifically, these members are failing to net security positions of related accounts for customers who maintain accounts in their name and exercise control over a second related account, usually held in a family member's name. The failure to net these positions has permitted these customers, which operate the two accounts with a single investment strategy, to avoid application of the Short- Sale Rule. Members are required to net all positions for accounts that are related or under common control in order to determine whether a sale is long or short and subject to the Short-Sale Rule requirements. NASD Regulation is committed to ensuring strict adherence to the Short-Sale Rule and will carefully review whether firms have engaged in the conduct described in this Notice in examinations and investigations. Violations of the Short-Sale Rule will be vigorously pursued. Questions concerning this Notice should be directed to David Katz, Assistant Chief Counsel, Market Regulation, NASD Regulation, at (301) 208-3074. Overview The NASD adopted the Short-Sale Rule to prevent speculative short selling in NNM securities from accelerating a decline in the price of a security and to stop a form of manipulation known as “bear raiding” or “piling on.” Piling on occurs when short sellers exert pressure on a stock's price, forcing the price to drop precipitously, frequently within a single trading day. The Short-Sale Rule prohibits member firms from executing customer short sales and non-Market Maker proprietary short sales in an NNM security at or below the current inside bid when the current inside bid is lower than the previous inside bid.1 To determine whether a sale is long or short, members must adhere to the definition of a “short sale” contained in the Securities and Exchange Commission (SEC) Rule 3b-3, which is incorporated into the NASD's Short-Sale Rule. Under SEC Rule 3b-3 and NASD Rule 3350, the term “short sale” means 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. To determine whether the seller is long or short overall, the seller must net all positions in the security. This includes netting positions held in accounts that are related or under common control. Rule Prohibits Circumvention The Short-Sale Rule also prohibits a member from knowingly, or with reason to know, effecting sales for the account of a customer or for its own account for the purpose of avoiding the rule.2 With this Notice, the NASD wishes to clarify that a member would be deemed to be in violation of the Short-Sale Rule if the member or an associated person knowingly assists customers in the following scheme: • A customer maintains one account (a “long account”) that is used to buy and sell various securities several times in a single day. The long account typically begins and ends each day with a long position of 1,000 shares in each security held in that account. The customer also cross guarantees for Regulation T and margin purposes a second account (a “short account”), usually held by a family member or related person. That account holds offsetting short positions of 1,000 shares in the same securities that are held in the long account. In contrast to the long account, the short account generally does not change positions in the securities. At the beginning and end of each day, the combined positions in both accounts for each of the securities is flat. During the trading day, the customer buys and sells securities out of the long account, creating the false appearance of alternating long and flat positions in the securities in the long account. When the two accounts are appropriately combined and treated as one, short sales occur on a regular basis and often result in transactions occurring on down-bids in violation of the NASD's Short-Sale Rule. NASD Regulation will view trades in accounts like those described above as occurring in related or controlled accounts and must be netted for purposes of compliance with the Short-Sale Rule. Accounts will be deemed to be related or controlled if the customer exercises discretion over the account, cross guarantees the account for Regulation T or margin purposes, or has been granted a power of attorney to execute transactions in the account. NASD Regulation will also consider other facts and circumstances such as whether the account belongs to a family member or related person and whether a similar pattern of activity is occurring in other customer accounts. NASD Regulation will closely watch for the above described conduct and for similar schemes that attempt to circumvent application of the Rule. Members should instruct their associated persons not to accept orders for execution where customers are operating two accounts in order to avoid the Rule. A finding of such abuses will result in possible disciplinary action. Endnotes 1 NASD Rule 3350(a). 2 NASD Rule 3350(e). © 1998, National Association of Securities Dealers, Inc. (NASD). All rights reserved. |
