The Securities and Exchange Commission has voted to lift restrictions on short selling that prevented traders selling borrowed stock if prices were declining, but it has strengthened rules
The Securities and Exchange Commission has voted to lift restrictions on short selling that prevented traders selling borrowed stock if prices were declining, but it has strengthened rules designed to prevent so-called naked shorting, where the vendor has not borrowed the stock being sold.
The US regulator has adopted amendments to Rule 10a-1 and Regulation SHO that will remove Rule 10a-1, which incorporates the tick rule, and any other short sale price test imposed by self-regulatory organisations, which will in future be prohibited from imposing such tests.
The SEC adopted Rule 10a-1 in 1938 after several years of considering the effects of short selling in a declining market. It provides that, subject to certain exceptions, a security may be sold short only at higher price than that of the immediately preceding sale, or at the last sale price if it is higher that the last different price. The tick test applies only to listed securities, other than Nasdaq-listed securities, traded on an exchange or otherwise.
In July 2004 the commission issued a one-year pilot order temporarily suspending the tick test and any short sale price test of any exchange or national securities association for certain securities, in order to study the effectiveness of short sale price tests. Following analysis by the SEC’s Office of Economic Analysis and academic researchers and feedback from the market, a consensus emerged that price test restrictions should be removed because they slightly reduce liquidity and do not appear necessary to prevent manipulation. In addition, the evidence did not provide strong support for extending a price test to either small or thinly-traded securities not currently subject to a price test.
At the same time, the commission has ended certain exemptions to the provisions of Regulation SHO, which went into full effect in January 2005, that aim to reduce persistent failures to deliver stock by the end of the standard three-day settlement period for trades as a result of naked shorting.
Says Erik Sirri, director of the SEC’s division of market regulation: ‘The steps voted on by the commission streamline and tighten short selling provisions so that markets and investors are better served by our rules.’
Regulation SHO imposes a locate requirement, which requires that before accepting or effecting a short sale order, brokers and dealers must borrow securities, make arrangements to borrow securities, or have a reasonable basis to believe that securities can be borrowed in order to make timely delivery.
The regulation also imposes delivery or close-out requirements on designated ‘threshold securities’, equity securities registered or required to file reports with the commission for which there is an aggregate fail to deliver position for five consecutive settlement days at a registered clearing agency of 10,000 shares or more and equal to at least 0.5 per cent of the outstanding shares.
Where a clearing agency participant has a fail to deliver position in threshold securities that persists for 13 consecutive settlement days, the participant must take action to close out the position. Until the position is closed out, the participant, and any broker-dealer for which it clears transactions, including market makers, may not effect further short sales in the threshold security without borrowing or entering into a bona fide arrangement to do so.
The regulation included a grandfather provision under which the requirement to close out fail to deliver positions in threshold securities that remained for 13 consecutive settlement days did not apply to positions established before the security became a threshold security or before the introduction of Regulation SHO. This provision, adopted because the SEC was concerned about creating volatility where large pre-existing fail to deliver positions existed, has now been ended.
