SEC Issues Emergency Rules Regarding Short Selling and Stock Repurchases

In an effort to increase public confidence in the market, on September 17 and 18, 2008, the U.S. Securities and Exchange Commission (SEC) promulgated new emergency rules that strengthen the ban on naked short selling, temporarily halt short selling in financial stocks, temporarily require money managers to report new short sales, and temporarily ease existing restrictions on issuers repurchasing their securities. The new rules become effective between Thursday, September 18, 2008 and Monday, September 22, 2008. Despite strong comments from Congress, the SEC has not reinstituted the uptick rule for short-sale transactions.

Background Information on Naked Short Selling

In an ordinary short sale, a short seller borrows a stock and sells it. The borrowed stock is then repaid in the future by buying the stock in the market. In a naked short-sale transaction, the seller does not actually borrow the stock and fails to deliver it to the buyer. This failure to obtain the stock allows naked short selling to force prices down far lower than what would be possible in legitimate short-sale transactions. In 2005, the SEC adopted Regulation SHO, which requires that broker-dealers have reasonable grounds to believe that shares will be available for a given short sale so that the shares will be delivered on the delivery date. The new rules further tighten Regulation SHO. The text of the new rules can be found at: http://www.sec.gov/rules/other/2008/34-58572.pdf.

New Rules on Naked Short Selling

Short Sale Closeout Requirement and Penalties for Violation
The SEC has added new provisions to Regulation SHO requiring that short sellers and their broker-dealers deliver securities by the close of business on the settlement date (three days after the sale transaction date or T+3). If a short sale violates this closeout requirement, then any broker-dealer acting on the short seller’s behalf will be prohibited from further short sales in the same security unless the shares are not only located but also pre-borrowed. The prohibition on the broker-dealer’s activity applies to all short sales of the same security for any customer, and not simply the short sales of the naked short seller.

Rule 10b-21 Short Selling Anti-Fraud Rule
The SEC also has adopted Rule 10b-21, which expressly targets fraudulent short-selling transactions. The new rule covers short sellers who deceive broker-dealers or any other market participants. The new rule makes clear that lying about the intention or ability to deliver securities in time for settlement and failing to deliver the securities constitutes an unlawful manipulative or deceptive device or contrivance.

Ban on Short Selling in Financial Stocks

The SEC has imposed an immediate ban on short-selling transactions involving the securities of financial institutions. The ban will last through October 2, 2008, but the SEC may extend the ban up to a period not to exceed 30 days. The SEC has published a list of 799 financial institutions covered by the ban. The list was prepared on a best-effort basis based upon companies listed under the Standard Industrial Classification (SIC) codes for banks, insurance companies, and securities firms. The SEC’s emergency orders established certain limited exceptions for market makers. The SEC enacted its ban in concert with the United Kingdom’s Financial Services Authority, which imposed a similar ban in its markets. The text of the new rules can be found at: http://www.sec.gov/rules/other/2008/34-58592.pdf.

Money Managers to Report New Short Sales

Citing concerns about possible price movements based upon unfounded rumors, the SEC has temporarily instituted a new rule that requires institutional money managers to report short sales. Money managers that exercise investment discretion with respect to accounts holding Section 13(f) securities (publicly traded securities) that filed or were required to file a Form 13F for the quarter ended June 30, 2008, must now file new Form SH with the SEC. This impacts all money managers who managed accounts as of June 30, 2008, having an aggregate fair market value of at least $100,000,000. Form SH will be required on the first business day of every week immediately following a week in which the money manager effected a short sale. If no short sales occurred, no form will need to be filed. Earlier short sales will not need to be reported, and short sales in options are exempted from reporting. In addition, managers need not report a short position otherwise reportable if the short position constitutes less than one-quarter of one percent (0.25 percent) of the issued and outstanding shares of that particular class of securities and the fair market value of the short position is less than $1,000,000. The following information will be required for each security sold short:

• The number and value of securities sold short
• The opening short position
• The closing short position
• The largest intraday short position
• The time of the largest intraday short position

The first Form SH must be filed on September 29, 2008 for short-selling transactions that occur on September 22, 2008 or thereafter. Since the SEC’s temporary order expires on October 2, 2008, the September 29, 2008 filing will be the only filing that is required unless the SEC extends its order. The text of the new rules can be found at: http://www.sec.gov/rules/other/2008/34-58591.pdf.

Easing of Restrictions on Issuer Repurchases

Recognizing that issuer repurchases represent an important source of liquidity during times of market volatility, the SEC has temporarily amended Rule 10b-18 for the time period of September 19, 2008 through October 2, 2008. Rule 10b-18 provides issuers a safe harbor from liability for market manipulation if repurchases are done in conformity with the requirements of Rule 10b-18. Specifically, the SEC has suspended the time of purchase rules that prohibited purchases from the opening purchase as well as from the last 10 to 30 minutes before the closing of trading, depending upon the trading volume of the security. The SEC also has temporarily increased the volume of permitted purchases to now be up to 100 percent of the average daily trading volume, calculated based upon the average daily trading volume during the four calendar weeks preceding the week in which the purchase is to be effected. The text of the new rules can be found at: http://www.sec.gov/rules/other/2008/34-58588.pdf.

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