On July 27, 2009 the Securities and Exchange Commission (“SEC”) announced several actions intended to protect against abusive short sales and make more short sale information available to the public.

First, the SEC made permanent an interim final temporary rule, Rule 204T, that seeks to reduce the potential for abusive “naked” short selling in the securities market. The new rule, Rule 204, requires broker-dealers to promptly purchase or borrow securities to deliver on a short sale. The temporary rule, approved by the SEC in the fall of 2008, was set to expire on July 31.

Second, the SEC is working together with several self-regulatory organizations (“SRO”) to make short sale volume and transaction data available through the SRO websites. This effort will result in a substantial increase over the amount of information presently required by another temporary rule, known as Temporary 10a-3T. That rule applies only to certain institutional money managers and does not require public disclosure.

Third, the SEC intends to hold a public roundtable on September 30 to discuss securities lending, pre-borrowing and possible additional short sale disclosures. The roundtable will consider, among other topics, the potential impact of a program requiring short sellers to pre-borrow their securities, possibly on a pilot basis, and adding a short sale indicator to the tapes to which transactions are reported for exchange-listed securities.

“Naked” Short Sales: In a “naked” short sale the investor sells shares “short” without first having borrowed them. Such a transaction is permitted because there is no legal requirement that a short seller actually borrow the shares before effecting a short sale.

Now, before effecting a short sale, Rule 204T requires that the broker-dealer, as opposed to the seller, “locate” an entity that the broker reasonably believes can deliver the shares within three days after the trade – what’s known as T+3. Also, if reasonable, a broker-dealer may rely on a short seller’s assurance that the short seller has located his or her own lender that can deliver shares in time for settlement.

“Fails-to-deliver”: If an investor or its broker-dealer does not deliver shares by T+3, a “failure to deliver” occurs. Where an investor or its broker-dealer neither locates nor delivers shares, a “naked” short sale has occurred.

A “fail to deliver” can occur for legitimate reasons, such as mechanical errors or processing delays. Further, a “fail to deliver” could occur as a result of a long sale – that is the typical buy-sell transaction – as well as a short sale.

“Fails to deliver”, such as failure resulting from potentially abusive “naked” short selling may have a negative effect on shareholders, potentially depriving them of the benefits of ownership such as voting and lending. They also may create a misleading impression of the market for an issuer’s securities.

Adopting Regulation SHO: Due to its concerns regarding persistent “fails to deliver” and potentially abusive “naked” short selling, the SEC adopted Regulation SHO, which became effective in early 2005. This regulation imposes, among other things, the requirement that broker-dealers locate a source of borrowable shares prior to selling short.

In addition, Regulation SHO requires that firms that clear and settle trades must purchase shares to close out these “fails to deliver” within a certain time frame, 13 days. This “close-out” requirement only applies to certain equity securities with large and persistent “fails to deliver”, known as threshold securities.

Rule 204: The SEC has made permanent a temporary rule that was approved in 2008 in response to continuing concerns regarding “fails to deliver” and potentially abusive “naked” short selling. In particular, temporary Rule 204T made it a violation of Regulation SHO and imposes penalties if a clearing firm does not purchase or borrow shares to close-out a “fail to deliver” resulting from a short sale in any equity security by no later than the beginning of trading on the day after the fail first occurs (T+4).

If you have questions about Regulation SHO or short sales, contact any member of Clark Wilson’s Corporate Finance & Securities Group.