New Short Sell Rule

On July 15, 2008 the Securities and Exchange Commission enacted an emergency order for the execution of a short sale, this new rule is trying to curb the abusive powers of “naked” short selling.  Here is a copy of this emergency order:

“It is Ordered that, pursuant to our Section 12(k)(2) powers, in connection with transactions in the publicly traded securities of substantial financial firms, which entities are identified in Appendix A, no person may effect a short sale2 in these securities using the means or instrumentalities of interstate commerce unless such person or its agent has borrowed or arranged to borrow the security or otherwise has the security available to borrow in its inventory prior to effecting such short sale and delivers the security on settlement date.3

In order to allow market participants time to adjust their operations to implement the enhanced requirements, this Order shall take effect at 12:01 a.m. EDT on Monday, July 21, 2008. This Order shall terminate at 11:59 p.m. EDT on Tuesday, July 29, 2008 unless further extended by the Commission. “

¹ This finding of an “emergency” is solely for purposes of Section 12(k)(2) of the Exchange Act and is not intended to have any other effect or meaning or to confer any right or impose any obligation other than set forth in this Order.

² The definition of “short sale” shall be the same definition used in Rule 200(a) of Regulation SHO and the requirements for marking orders “long” or “short” shall be the same as provided in Regulation SHO.

³ Short sales to be effected as a result of a put options exercise are subject to this Order. In addition, we note that short sales used to hedge would also be subject to this Order.

Appendix A

Company Ticker Symbol(s)

BNP Paribas Securities Corp. BNPQF or BNPQY

Bank of America Corporation BAC

Barclays PLC BCS

Citigroup Inc. C

Credit Suisse Group CS

Daiwa Securities Group Inc. DSECY

Deutsche Bank Group AG DB

Allianz SE AZ

Goldman, Sachs Group Inc GS

Royal Bank ADS RBS

HSBC Holdings PLC ADS HBC and HSI

J. P. Morgan Chase & Co. JPM

Lehman Brothers Holdings Inc. LEH

Merrill Lynch & Co., Inc. MER

Mizuho Financial Group, Inc. MFG

Morgan StanleyMS

UBS AG UBS

Freddie Mac FRE

Fannie Mae FNM

Interesting, but what really has changed?  Nothing really on the surface :  “Regulation SHO, which became fully effective on January 3, 2005, sets forth the regulatory framework governing short sales. Among other things, Regulation SHO imposes a close-out requirement to address failures to deliver stock on trade settlement date² and to target potentially abusive ‘‘naked’’ short selling³ in certain equity securities. While the majority of trades settle on time, Regulation SHO is intended to address those situations where the level of fails to deliver for the particular stock is so substantial that it might impact the market for that security.”

2 Generally, investors must complete or settle their security transactions within three business days. This settlement cycle is known as T+3 (or ‘‘trade date plus three days’’). T+3 means that when the investor purchases a security, the purchaser’s payment must be received by its brokerage firm no later than three business days after the trade is executed. When the investor sells a security, the seller must deliver its securities, in certificated or electronic form, to its brokerage firm no later than three business days after the sale. The three-day settlement period applies to most security transactions, including stocks, bonds, municipal securities, mutual funds traded through a brokerage firm, and limited partnerships that trade on an exchange. Government securities and stock options settle on the next business day following the trade. Because the Commission recognized that there are many legitimate reasons why broker-dealers may not deliver securities on settlement date, it adopted Rule 15c6–1, which prohibits broker-dealers from effecting or entering into a contract for the purchase or sale of a security that provides for payment of funds and delivery of securities later than the third business day after the date of the contract unless otherwise expressly agreed to by the parties at the time of the transaction. 17 CFR 240.15c6–1.

However, failure to deliver securities on T+3 does not violate the rule.

3 We have previously noted that abusive ‘‘naked’’ short selling, while not defined in the federal securities laws generally refers to selling short without having stock available for delivery and intentionally failing to deliver stock within the standard three day settlement cycle. See Securities Exchange Act Release No. 54154 (July 14, 2006), 71 FR 41710 (July 21, 2006) (‘‘2006 Proposing Release’’).

But really there is a change, a change in the process at brokerage firms throughout the United States.  The process is subtle but important.  What the SEC now wants is for the Brokerage Firm to locate the specific shares and allocate them to the client shorting the security and decrease the amount available to short on their books.  So what?  Well this change requires a more stringent pre-borrow and allocate process.  Not only must you find the shares but then they must be allocated.  Below I have listed SEC Rule 203 for Locate and Delivery.  When stocks are deemed abundant “easy to borrow” a blanket assurance can be used.  Now these stocks must not only be treated as hard to borrow but the shares must be located and set aside.  This is the important aspect of the new rule change.  Essentially making a short sale in these securities more difficult to find in order to short and then placing a virtual headcount on the shares and reducing the number available for the next client looking to affect a short sale.  Quite powerful, it will be interesting to see if this has the impact that the SEC was hoping for. 

The Professor

http://www.sec.gov/rules/proposed/2007/34-56213fr.pdf