Sean O'Malley, a partner in the business law department and a member of the financial services and investment management groups at US law firm Goodwin Procter, says the SEC's amendments to and published guidance regarding its emergency order on 'naked' short selling of certain financial stocks answer some of the many questions of interpretation raised by the order, but others remain unaddressed.
On the evening of July 18, the Securities and Exchange Commission issued amendments clarifying and providing certain relief regarding the emergency order it issued on July 15, regarding 'naked' short sales of the securities of 19 specified financial firms, including Fannie Mae and Freddie Mac.
The order went into effect after midnight EST on Monday, July 21, and terminates at 11:59 pm on Tuesday, July 29, although the SEC can, and has indicated it may, extend the order for up to 30 days. The SEC staff have also issued frequently-asked questions.
The July 15 order
Citing 'extraordinary and unusual circumstances', the SEC issued the July 15 order following a week in which Fannie Mae and Freddie Mac were the subject of numerous rumours regarding their solvency, and the prices of their stocks suffered dramatic decreases attributable in part to significant short selling activity. The SEC stated that the order was intended to 'eliminate any possibility that naked short selling may contribute to the disruption of markets in' the specified securities.
The main operative provision of the order requires that 'no person may effect a short sale [in any of the specified securities] ... 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'.
This is a substantial change from the current 'locate' requirement of Regulation SHO, which applies to brokers or dealers effecting short sales for customers or for their own proprietary accounts and permits a broker or dealer to comply with the rule either (i) by borrowing the security, or entering into a bona-fide arrangement to borrow the security, or (ii) having 'reasonable grounds to believe' that the security can be borrowed for delivery on settlement date.
While it seemed clear from the order that a broker could no longer rely on a reasonable belief that a customer had 'located' shares for delivery on a short sale of a specified security, numerous other interpretive questions and issues were left open. The SEC's amendments and FAQs answer some of those questions, but others remain unaddressed.
Amendments to the order and FAQs
The amendments to the order and the FAQs provide the following relief, guidance and additional clarifications:
1. When engaging in bona-fide market-making and hedging, registered equities market makers, option market-makers, ETF market-makers, specialists and block positioners as well as 'other market makers obligated to quote in the over-the-counter market' are exempted from the order's borrow or arrange-to-borrow requirements with respect to short sales in (i) the specified securities, (ii) derivative securities based on specified securities, including standardized options, and (iii) ETFs of which any of the specified securities are a component. However, the requirement imposed by the order that the specified securities be delivered by settlement date is still fully applicable to each of these categories of persons.
2. An 'arrangement to borrow' means a bona fide agreement to borrow the security whereby the security being borrowed is set aside at the time of the arrangement solely for the person requesting the security.
3. A broker effecting a short sale for a customer in a specified security can rely upon an assurance from the customer that the customer has borrowed or arranged to borrow the security from another identified source, provided the broker (i) documents that it is relying on the customer's assurance and (ii) has reasonable grounds to believe that the customer has borrowed or arranged to borrow the security.
4. While a broker is required by the order to document compliance with the borrow and arrangement-to-borrow requirement of the order, it may use the same processes and procedures to document compliance with the order as used for compliance with the 'locate' requirements of Regulation SHO.
5. If a person has borrowed or arranged to borrow a specified security prior to effecting a short sale in that security, the borrow or arrangement-to-borrow may be reapplied by that person's broker for short sales following a buy-to-cover trade in that same security on the same trading day.
6. The order applies to any short sale transaction in a specified security if the short sale is agreed to in the US, even if the trade is booked overseas. The order also applies to any short sale of a specified security involving a customer located in the US as well as any broker-dealer who uses any means or instrumentalities of interstate commerce in the US to effect short sales in a specified security.
7. The order does not apply to short sales effected pursuant to (i) Rule 144 of the Securities Act of 1933, or (ii) underwriters or members of a syndicate or group participating in distributions of the relevant securities in connection with an over-allotment of securities, or any lay-off sale through a rights or a standby underwriting commitment.
Analysis and remaining issues
The order, as amended, represents a fairly remarkable and dramatic intervention by the SEC into the operation and functioning of the US equity markets. It is curious that only 19 financial firms were selected for this protection, and it remains to be seen how the order or a future rule may expand the coverage of this emergency action.
In this regard, we understand that certain banking and other financial industry groups are pushing to have the list of financial firms covered by the order expanded to include regional banks and other financial firms beyond the 19 firms dubbed 'substantial financial firms' by the SEC in the order.
We note further that the SEC is still in discussions with industry groups and market participants and may amend the operative provisions of the order further or provide additional relief. In addition, we note that the SEC in the FAQs explains how anyone can comment on 'any potential rulemaking the Commission may undertake to expand the duration of the naked short sale protections or the number of companies covered.' We see this as indicative of the SEC's future intentions to adopt an emergency rule covering all publicly-traded equities in the United States.
The order also represents a stark change of regulatory position with respect to who is directly liable for the locate/borrowing requirements associated with short selling. Unlike Regulation SHO, which imposes the locate or borrow requirement only on brokers or dealers effecting short sales, the order's requirement to borrow or arrange to borrow applies to any person who shorts a specified security, meaning that hedge funds, mutual funds, banks and other investors who short those securities are now subject to direct enforcement action with respect to the borrowing requirements (we note that these persons were always directly liable for manipulative or fraudulent short selling practices, such as misleading their brokers regarding the sources of a locate or whether they were long a security).
Of course, customers can still rely on brokers to borrow or arrange to borrow specified securities when placing short sale orders with their brokers, but it seems likely that brokers are now going to demand that customers who short specified securities (based on the customer's own borrow or arrangement-to-borrow) provide brokers with some kind of written or electronic evidence or other strong basis to believe that the customer has in fact borrowed or arranged to borrow the securities.
Despite assurances in the amendments that brokers can rely upon the same processes and procedures for documenting 'locates' under the order as for Regulation SHO, it remains to be seen if the order will result in recordkeeping and documentation battles between brokers and customers, particularly given the current regulatory environment where short selling activities are in the direct line of regulatory fire. At a minimum, the safest course appears for both short sellers and their brokers to document all sources of borrows and arrangements to borrow specified securities.
Further, although the FAQs make it clear that shares must by 'set aside' for the 'sole' use of a borrower for such borrower to be deemed to have 'arranged to borrow' the security in compliance with the order, there is still room for interpretation as to what exactly constitutes a 'set aside,' or even an 'arrangement-to-borrow' for that matter.
In this regard, we note that traditional 'pay-for-hold' arrangements entered into between borrowers and lending agents may not be sufficient unless such arrangements also include some type of express set aside condition or term pursuant to which the securities held for the borrower cannot be lent out to other customers of the lending agent.
The order raises other difficult practical, accounting and recordkeeping issues for borrowers and lending agents, such as the form these arrangements must take, whether segregation or 'blocking' of securities is required, and how revenue and rebates are to be allocated amongst the parties.
Of additional concern is that, without more specific guidance regarding what exactly constitutes a 'set aside,' a borrower has no assurance that a particular arrangement will not be retroactively deemed by the SEC to not constitute an adequate arrangement-to-borrow if a lender recalls the loaned securities (which is normally the right of the lender under traditional securities lending agreements) and the borrower fails to deliver on a short sale because shares that were arranged to be borrowed are no longer available to the borrower for delivery on settlement date.
We believe that a valid 'pay-for-hold' arrangement whereby a borrower pays a fee for the lender to hold or 'set aside' shares should be sufficient, even if the lender recalls the lent securities before the borrower requests them under the agreement. This needs to be addressed by the SEC, however.