Post by jannikki on Dec 29, 2005 21:14:01 GMT -4
Coming Up Short
On Share Lending
On January 3, 2005, the Securities and Exchange
Commission’s (SEC) Regulation SHO2 went into effect,
reflecting significant amendments to longstanding
short sale regulations regarding securities trading. Many
short sale regulations have never have been imposed on
exchange-traded funds (ETFs), and this continues to be the
case following Regulation SHO’s enactment. Regulation SHO,
however, imposes a new SEC “locate rule” on both stocks and
ETFs, which requires short sellers to document that they can
borrow ETFs before engaging in a short sale. Depending upon
the ETF or stock, borrowing may be impossible or very expensive.
Without the ability to borrow, market participants will
be restricted from short selling, thereby raising questions
about Regulation SHO’s effect on marketplace liquidity and
pricing efficiency for many stocks and ETFs. Added pressure
is being placed on antiquated industry conventions and a
structure for securities borrowing (aka stock loans) that is
desperately in need of restructuring, transparency, exchange
pricing efficiency and general overhaul. With the number and
types of ETFs expanding rapidly, and with the continued
explosion in trading volumes, an analysis of Regulation SHO’s
impact on both ETFs and equities is critical. This article
reviews and critiques this important new regulation.
Short- Sale Primer
Regulation SHO is the latest move by the SEC to establish
controls over short selling, whose real and perceived abuses
the SEC has been combating for more than 70 years. In enacting
the Securities Exchange Act of 1934 (the “Exchange Act”),
Congress directed the SEC to “purge the market” of short selling
abuses. Congress, however, wisely elected not to prohibit
short selling, but rather provided the SEC with broad authority
to develop regulations that would curb abuse. The SEC
early on adopted Rule 10a-1 under the Exchange Act, prohibiting,
with certain exceptions, exchange-listed securities
from being sold short unless the price of the short sale was
above the price of the immediately preceding sale (a plus
tick), or at the same price if that price was higher than the
price it preceded (a zero-plus tick). These provisions of SEC
Rule 10a-1 are commonly referred to as the “tick test.”
Nasdaq securities were not subject to similar short sale regulations
until the NASD, the self-regulatory organization (SRO)
overseeing Nasdaq securities, adopted Rule 3350 in 1994.
Rule 3350 prohibits short sales in Nasdaq securities at prices
at or below the best current bid price when that bid is lower
than the previous best bid price. This provision of Rule 3350
is commonly referred to as the “bid test.” Both the bid test
and the tick test were developed to preclude short sales in
declining markets.
A brief primer on the mechanics of short sales or short selling
is appropriate. A short sale is the sale of any security that
the seller does not own at the time of the sale. To facilitate
delivery of a security that is being sold short, the seller will
borrow the security, typically from a broker-dealer. The broker-
dealer holds the securities for long investors, who make
their shares available for borrowing. Later, the short seller
closes out, or “covers,” the short position by purchasing the
security in the open market—and these shares are returned
to the long investor. The short seller pays the long investor
for the right to borrow the shares. Such short selling has provided
liquidity and pricing efficiency to the marketplace.
In contrast, short selling can also be used for manipulative
purposes. An example of the improper use of short selling is
what is referred to as the “bear raid.” Here, a stock is aggressively
sold short with the goal of driving down the price
thereby creating downward momentum and negative psychology
in the market. Other investors, not knowing the real
reason for the price decline, may panic and sell their long
positions in the stock, thus exacerbating the decline. After
the raider’s short selling and impact on the security has run
its course, the raider will profit on his scheme by covering his
short sales by buying the stock at the depressed prices.
Like stocks, ETFs are listed on an exchange or Nasdaq and
can be traded intraday. Through ETFs, retail and institutional
investors can buy or sell shares in the collective performance
of an entire stock portfolio as a single security. Unlike stocks,
however, ETFs are exempt from short-sale price test restrictions.
In codifying this ETF exception in Regulation SHO, the
SEC noted that ETFs’ index and derivative nature make their
pricing influenced by the underlying securities’ net asset
value and, that therefore, ETFs are less susceptible to direct
manipulative schemes. The SEC stressed that an ETF’s underlying
securities were not exempt from short-sale price test
restrictions.
Naked Sh o rt Selling
Many issuers and investors have bitterly complained to the
SEC about what is referred to as “naked short selling.” Naked
short selling occurs when a stock or ETF is sold short, but the
seller does not or cannot borrow the security sold, thereby
creating what’s known as a “fail-to-deliver” or a “fail.” There
are potential negative effects on the market from naked short
selling. When fails persist and increase over a period of time,
the quantity of fails in a stock may become greater than the
public float, which would otherwise not be possible if selling
pressure was controlled by the availability of shares to borrow.
The SEC has stated that the impact of allowing a naked
short to persist beyond settlement equates with converting
the sale into an undated futures-type contract, which the
buyer of the stock has not agreed to or, if he did, would have
priced differently. The seller’s failure to deliver may also
impact the rights of the buyer by denying him the right to
vote the stock, because the buyer is not the record holder or
beneficial holder. Additionally, naked short sellers are provided
additional leverage when they are not required to borrow,
because they avoid the costs of borrowing. They are able to
use this additional leverage to engage in higher and more
aggressive levels of trading, which may be used to deliberately
depress the price of an ETF or stock.
Locate And Close-Out Rules
Prior to the adoption of Regulation SHO, short sales were
regulated by a combination of federal and SRO rules. Federal
and SRO regulation of short sales has, and continues to be,
focused upon two primary areas. One area of regulation, as
described earlier, has been the mechanical restriction of short
selling in declining markets by the establishment of the tick
and bid tests. The other area of regulation has been the imposition
of rules requiring the borrowing of securities in
advance of a short sale, and the closing out of short positions
in certain securities after a short sale. For example, the NASD
had a separate rule, Rule 3370, requiring a short seller to
“locate” or “affirmatively determine” that he could borrow a
stock by the settlement date prior to engaging in a short sale
of said stock. Another NASD rule, Rule 11830, established a
“close-out” procedure for certain short positions in specific
securities, requiring short sales to be closed out ten business
days after the normal settlement date if delivery of the borrowed
securities has not occurred.
SRO locate and close-out rules did not apply to ETFs, and
also afforded a number of key exceptions. For example, the
NASD rules contained an express exception for short sales
fully hedged by certain public-company-issued warrants and
rights. This so-called “bona fide hedge exception” provided
important marketplace benefits in the areas of volatility, price
discovery and capitalization, and, properly followed, the
exception did not lead to short selling abuse since the short
sale position is at least fully hedged by the long position in an
offsetting convertible security.
Significantly, Regulation SHO, while co-opting the locate
and close-out rules into SEC regulations, dropped all of the
established NASD bona fide hedge exceptions and mandated
application of the new locate rule to all ETF transactions. By
not extending the same exceptions, the adoption of
Regulation SHO and the repeal of certain SRO rules that
Regulation SHO generally duplicates may have created significant
adverse impacts on ETF trading liquidity. It may also
have adversely impacted capital formation and pricing efficiency,
particularly for small and emerging companies. The
SEC and the securities industry must monitor these matters
as closely as they are monitoring the continued need for a
tick or bid test, which is the primary focus of a pilot program
that started on May 2, 2005.
Understanding Regulation SHO
With the adoption of Regulation SHO, the SEC has begun
to consolidate the rules related to short selling under a single
regulatory framework, primarily the locate and close-out
rules for now. Importantly, in adopting Regulation SHO, the
SEC elected not to implement the uniform bid test that was
in the SEC’s original October 2003 proposal until after it
receives the results from the ongoing pilot program.
Although Regulation SHO did not immediately implement
a single market-wide uniform bid test, it did implement a
number of new and modified regulatory requirements;
• As previously mentioned, broker-dealers must locate or
borrow securities, including ETFs, prior to executing short
sales for their own account or the account of a customer;
• Participants in a registered clearing agency (clearing brokers)
must close-out any fail-to-deliver positions ten business
days after settlement in securities that have a substantial
number of fails-to-deliver and, as a result, are
classified as “threshold securities.”
• Broker-dealers must mark sell orders in all equity securities
either “long,” “short” or “short exempt.”
The bill also established new definitions of ownership for
certain securities for the purpose of determining delivery and
close-out requirements, and eliminated the shelf offering
exception contained in Rule 105 of Regulation M.
Some of the more important aspects of these regulations
are discussed below.
SEC Locate Require m e nt
Rule 203 of Regulation SHO prohibits a broker-dealer from
effecting a short sale for his own account, or the account of
another, unless the broker-dealer has borrowed, agreed to
borrow, or has reason to believe the security in question can
be borrowed to effect delivery when due. Rule 203 contains
some exceptions, the most important of which permits a broker-
dealer to accept a short-sale order from another brokerdealer
without satisfying the locate requirement, and to
accept short sales made by a market maker provided that the
market maker, specialist or options market maker in question
is engaged in bona-fide market making activities. “Bona-fide
market making” narrows the definition of market making to
exclude market makers engaged in trading for speculative or
other investment purposes. For short sales from another broker-
dealer, the broker-dealer giving the order must comply
with the locate requirement. Additionally, the rule requires
broker-dealers to maintain and retain documentation showing
their compliance with the rule.
As previously mentioned, when transforming the locate
rule from an SRO rule to an SEC rule, the SEC dropped certain
bona fide hedge exemptions, including one with respect
to warrants and rights. The latter exemption permitted the
p u rchase of a company’s warrants offset by a short sale of
the company’s stock, without advance re q u i rements to borrow
the stock. The exemption was crafted to promote capital
formation, particularly for small issuers, who frequently
use warrants and rights in public offerings to enhance the
m a r ketability of their common stock. They also have the further
strategic objective of raising additional capital in a highly
efficient manner as the company grows and its stock price
appreciates over time, as the exercise of a warrant or right
infuses immediate capital into the company. When a warrant
holder exercises warrants or rights, the company receives
cash in an amount equaling the number of warrants or rights
exercised times the exe rcise price. This is an extremely efficient
way to raise capital, as secondary offering and/or private
placement legal, accounting, underwriter and placement
agent fees are avoided. Moreover, if warrants and
rights are exercised gradually over time, they can act as
“shock absorbers” to cushion the adverse supply impact that
can be caused by a shelf or secondary offering of stock coming
to the market all at once.
Finally, the SEC declined to include an express exception
from the locate requirements for ETF transactions. In this
regard, several influential SROs had advocated such an exception
on the basis that ETFs have the ability to continuously
create and redeem shares. The SEC had observed high levels
of fails in some ETFs and decided, “[r]ather than providing a
blanket exception from the requirements of Rule 203, we
would prefer instead to address the treatment of ETFs
through the exemptive process. … n considering any
exemptive request, the Commission would evaluate the cause
of large fails in certain ETFs, as well as potential remedies to
resolve such fails, if necessary.”
SEC Close-Out Requirement
Rule 203 requires clearing brokers to close out positions
for which they are responsible in securities designated as
“threshold” securities after ten consecutive days. Threshold
securities are those that have experienced a substantial number
of fails; specifically, five consecutive days of aggregate
fails-to-deliver at a registered clearing agency of 10,000
shares or more per security, or a level of fails equal to at least
one-half of one percent of the issuer’s total shares outstanding.
Threshold securities will be flagged on a list prepared and
distributed by SROs. If a clearing broker has a fail-to-deliver
position for 13 consecutive settlement days, the clearing broker
and any broker-dealer for whom it clears, including any
market maker that would otherwise be able to rely on an
exception, may not effect a short sale for its own account or
for the account of another without complying with the locate
requirement of the rule. As a former NASD rule, the close-out
rule also contained bona fide hedge exemptions. As an SEC
rule, those exemptions have been dropped.
Marking Sell Orders And Ownership De termination
Rule 200 requires broker-dealers to mark all sell orders in
exchange-listed and over-the-counter equity securities as
either “long,” “short” or “short exempt.” Directly related to
marking an order is determining what defines security ownership,
which is necessary to enable investors to calculate
whether they are net long or net short a security when entering
a sell order. The SEC has incorporated the definition of
ownership previously contained in Rule 3b-3 of the Exchange
Act, with some amendments. Regulation SHO also incorporates
the block-positioner exception into Rule 200, because it
directly impacts a broker-dealer’s calculation of its net position.
Rule 200 also codifies the SEC’s prior interpretations
related to the ownership of security futures products and the
ownership of a security. Lastly, although broker-dealers are
required to aggregate positions on a firm-wide basis when
calculating their net positions, the SEC has incorporated into
Regulation SHO its no-action position that permits brokerdealers
to aggregate long and short positions on an independent
trading desk or unit basis provided that certain conditions
are met.
Pilot Prog ra m
In proposing Regulation SHO, the SEC had proposed
adopting Rule 201, which would have established a uniform
“bid” test that would have been applicable to all exchangelisted
and many Nasdaq securities. As proposed, the bid test
would require short sales to be effected at a price at least one
cent above a security’s best consolidated bid at the time of
execution. With the adoption of Regulation SHO, the SEC
elected not to adopt Rule 201 pending the results of a pilot
program to be established by the SEC. Instead, Regulation
SHO provides the SEC with authority to establish a pilot program
that would enable the SEC to assess whether further
changes in short-sale regulations are necessary.
The pilot program commenced on May 2, 2005, and suspends
for one year the application of the SEC and NASD tick
and bid tests to a pilot group of 1000 stocks selected from
the Russell 3000 Index. Fifty percent of those stocks are listed
on the New York Stock Exchange, 47.8 percent are listed
on Nasdaq and 2.2 percent are listed on the American Stock
Exchange. The securities represent a cross-section of various
capital weightings, trading levels and liquidity, which will
allow the SEC to determine how a short-sale tick, bid or other
price test effects different stocks. Originally scheduled to
commence on January 3, 2005, the SEC delayed the pilot to
afford the broker-dealer community additional time to prepare.
The tick and bid tests will continue to apply to nonpilot
group stocks; as previously noted, ETFs already are exempt
from such short-sale price tests.
Impact On ETF Trading
While Regulation SHO is intended to address problems
caused by chronic fails-to- deliver, in many cases it has made it
more expensive for market makers to trade and hedge ETFs,
which can lead to increased costs to investors looking for liquidity.
Depending on the kind of ETF or the index being tracked,
there may be significant costs and minimum requirements to
create an ETF to address a short sale if borrowing is not possible.
Since units of 50,000 shares or more are typically required
to create many ETFs, a market maker who is short, say, 20,000
shares of a Regulation SHO threshold ETF, may be forced to create
much earlier than desirable, often at a higher cost.
Secondly, hedging ETF positions with the underlying basket
(a common practice for ETFs without highly correlated
futures) is more difficult as well, due to the locate re q u i rements
for each of the stocks in the basket. In addition, the
lack of transparency in the stock loan market contributes to
an uneven playing field for market makers, since hard- toborrow
securities or ETFs are typically sourced from the
largest prime bro kers, clearing firms and bro ke r - d e a l e r s .
There f o re, the relationship of a market make r, hedge fund or
bro ker-dealer to the source of supply becomes an even more
important factor during the allocation process of scarce
securities.
Concluding Remark s
The pilot study is well engineered to discern the effects of
removing the tick and bid test rules from a proper sampling
of stocks. Answers derived from the pilot may finally put to
rest the recent debate about whether these rules continue to
be a premier investor protection plan or merely passé prophylactics
that do more harm than good. The pilot, however,
has not been engineered to answer another lively debate:
whether the SEC’s jettisoning of longstanding exceptions to
the locate and close-out rules are having an adverse impact
on the ETF marketplace, as well as the capital formation market,
particularly for small and emerging companies. The SEC
should consider broad exemptive relief for ETFs, and should
look at re-establishing the bona fide hedge exception for a
pilot period or for a select group of stocks, to evaluate the
effect of these exceptions on capital formation. In the meantime,
the SEC has reserved exemptive authority to restore
exceptions from the locate and close-out rules, and has promised
to do so on a case-by-case basis.
C o n g ress and the SEC never outlawed short selling, and
the outcome of the current pilot certainly is not expected
to change this view. The question, however, is whether the
SEC has outlawed short sales through a backdoor approach.
Regulation SHO’s locate and close-out rules are intent on
making it impossible to engage in a short sale unless the
security can effectively be borrowed. Depending upon the
stock or ETF, it may be impossible or very expensive to borro
w. The industry structure, mechanisms and conventions
for stock borrowing or “stock loans” are in desperate need
of transparency, restructuring, exchange pricing efficiency
and general overhaul. Where Congress and the SEC have
t reated the nation’s stock market as the favored child, they
have paid little attention to the orphaned stock/ETF loan
m a r ketplace. Accord i n g l y, there have been no National
M a r ket System (“NMS”) and efficiency reforms in this latter
a rea. Today’s stock/ETF loan marketplace can be likened to
the over-the-counter market before Nasdaq—fragmented
and devoid of both keen competition and pricing efficiency.
Now that Regulation SHO is live, stock/ETF loans must be
a d d ressed by the SEC and the industry immediately, in
a c c o rdance with the lessons learned over the past 30 years
in creating the NMS for securities.
36 November/December 2005
R E C A P T U R I N G (continued from page 16)
10. InterSec’s “EAFE Plus” investment universe measures the performance of asset managers with an EAFE benchmark but with a mandate that gives them freedom to go
beyond the benchmark into non-index stocks and markets. Generally, the investment guideline for such mandates allowed “dabbling” of up to 10 percent in emerging markets.
11. “The Role of Style in International Investment” InterSec Research Corp., February, 2002.
12. There remain quite substantial performance gaps between various international growth and value indexes, although the extreme differences in methodology have been
attenuated over the past few years, especially after MSCI adapted a more sophisticated, multifactor approach to defining value/growth for their flagship global indexes.
13. Steven A. Schoenfeld, “Index-Based Investment in Emerging Stock Markets,” Emerging Markets Quarterly, Spring 1998.
14. The term “Active-Index”or Active Indexing, which is explained in detail in chapter 18 of Active Index Investing (Wiley Finance, 2004), refers to investment approaches which
use index vehicles such as index funds, ETFs and index derivatives in “non-passive” or non-static ways, such as with active size/style/sector/country allocation or systematic
rebalancing among these segments. NTGI’s Emerging Market indexation estimate, includes institutional and retail emerging market index funds and ETFs available in developed
markets (mainly in North America, Europe and Japan). Total estimate does not include indexed assets managed within Emerging Markets (i.e, domestic products such as ETFs,
even if used by foreign investors).
15. For more on the concept of “Indexing at the Core,” see Chapter 30 of Active Index Investing (Wiley Finance, 2004).
16. Survey of Plan Sponsor participants at the Institute for Fiduciary Education’s Market Makers conference, Los Angeles, Calif., June 2005.
Endnotes
1. William Uchimoto’s biography can be found in the Contributors page in the front of this issue. Following are bios of the other contributors:
Michael Traynor is a founding partner at MindCapital Group, LP, a consulting and advisory firm. Previously, he was responsible for new product and business development at
Susquehanna International Group, LLP, focusing on ETFs, index derivatives and other investment products. He has also worked at Vanguad implementing new fund initiatives and
directing the retail and institutional brokerage strategy. Mr. Traynor earned an MBA from Villanova University and is a Chartered Financial Analyst.
James Connolly is an associate at Saul Ewing LLP, where he is a member of the Securities Transactions Practice Group, which focuses on on compliance, market structure and
regulatory matters. Prior to his legal career, Connolly spent more than 20 years serving as vice president of several major investment banking firms, including J.P. Morgan & Co.,
Morgan Stanley & Co. and Nomura Securities International.
Joseph S. Rizzello is a founding partner of MindCapital Group, LP, a consulting and advisory firm. He has more than 30 years of experience in the financial services industry, and
has served in senior positions at the Philadelphia Stock Exchange, The Vanguard Group and Pershing Trading Company, LP. Mr. Rizzello is responsible for the creation of some of
the financial industry’s most successful new products (THAT’s quite a statement), and has designed and implemented highly successful new brokerage businesses and operating
models.
2. The SHO in Regulation SHO is simply shorthand for “short selling,” according to the SEC.
www.investigatethesec.com/MediaLinks.php
On Share Lending
On January 3, 2005, the Securities and Exchange
Commission’s (SEC) Regulation SHO2 went into effect,
reflecting significant amendments to longstanding
short sale regulations regarding securities trading. Many
short sale regulations have never have been imposed on
exchange-traded funds (ETFs), and this continues to be the
case following Regulation SHO’s enactment. Regulation SHO,
however, imposes a new SEC “locate rule” on both stocks and
ETFs, which requires short sellers to document that they can
borrow ETFs before engaging in a short sale. Depending upon
the ETF or stock, borrowing may be impossible or very expensive.
Without the ability to borrow, market participants will
be restricted from short selling, thereby raising questions
about Regulation SHO’s effect on marketplace liquidity and
pricing efficiency for many stocks and ETFs. Added pressure
is being placed on antiquated industry conventions and a
structure for securities borrowing (aka stock loans) that is
desperately in need of restructuring, transparency, exchange
pricing efficiency and general overhaul. With the number and
types of ETFs expanding rapidly, and with the continued
explosion in trading volumes, an analysis of Regulation SHO’s
impact on both ETFs and equities is critical. This article
reviews and critiques this important new regulation.
Short- Sale Primer
Regulation SHO is the latest move by the SEC to establish
controls over short selling, whose real and perceived abuses
the SEC has been combating for more than 70 years. In enacting
the Securities Exchange Act of 1934 (the “Exchange Act”),
Congress directed the SEC to “purge the market” of short selling
abuses. Congress, however, wisely elected not to prohibit
short selling, but rather provided the SEC with broad authority
to develop regulations that would curb abuse. The SEC
early on adopted Rule 10a-1 under the Exchange Act, prohibiting,
with certain exceptions, exchange-listed securities
from being sold short unless the price of the short sale was
above the price of the immediately preceding sale (a plus
tick), or at the same price if that price was higher than the
price it preceded (a zero-plus tick). These provisions of SEC
Rule 10a-1 are commonly referred to as the “tick test.”
Nasdaq securities were not subject to similar short sale regulations
until the NASD, the self-regulatory organization (SRO)
overseeing Nasdaq securities, adopted Rule 3350 in 1994.
Rule 3350 prohibits short sales in Nasdaq securities at prices
at or below the best current bid price when that bid is lower
than the previous best bid price. This provision of Rule 3350
is commonly referred to as the “bid test.” Both the bid test
and the tick test were developed to preclude short sales in
declining markets.
A brief primer on the mechanics of short sales or short selling
is appropriate. A short sale is the sale of any security that
the seller does not own at the time of the sale. To facilitate
delivery of a security that is being sold short, the seller will
borrow the security, typically from a broker-dealer. The broker-
dealer holds the securities for long investors, who make
their shares available for borrowing. Later, the short seller
closes out, or “covers,” the short position by purchasing the
security in the open market—and these shares are returned
to the long investor. The short seller pays the long investor
for the right to borrow the shares. Such short selling has provided
liquidity and pricing efficiency to the marketplace.
In contrast, short selling can also be used for manipulative
purposes. An example of the improper use of short selling is
what is referred to as the “bear raid.” Here, a stock is aggressively
sold short with the goal of driving down the price
thereby creating downward momentum and negative psychology
in the market. Other investors, not knowing the real
reason for the price decline, may panic and sell their long
positions in the stock, thus exacerbating the decline. After
the raider’s short selling and impact on the security has run
its course, the raider will profit on his scheme by covering his
short sales by buying the stock at the depressed prices.
Like stocks, ETFs are listed on an exchange or Nasdaq and
can be traded intraday. Through ETFs, retail and institutional
investors can buy or sell shares in the collective performance
of an entire stock portfolio as a single security. Unlike stocks,
however, ETFs are exempt from short-sale price test restrictions.
In codifying this ETF exception in Regulation SHO, the
SEC noted that ETFs’ index and derivative nature make their
pricing influenced by the underlying securities’ net asset
value and, that therefore, ETFs are less susceptible to direct
manipulative schemes. The SEC stressed that an ETF’s underlying
securities were not exempt from short-sale price test
restrictions.
Naked Sh o rt Selling
Many issuers and investors have bitterly complained to the
SEC about what is referred to as “naked short selling.” Naked
short selling occurs when a stock or ETF is sold short, but the
seller does not or cannot borrow the security sold, thereby
creating what’s known as a “fail-to-deliver” or a “fail.” There
are potential negative effects on the market from naked short
selling. When fails persist and increase over a period of time,
the quantity of fails in a stock may become greater than the
public float, which would otherwise not be possible if selling
pressure was controlled by the availability of shares to borrow.
The SEC has stated that the impact of allowing a naked
short to persist beyond settlement equates with converting
the sale into an undated futures-type contract, which the
buyer of the stock has not agreed to or, if he did, would have
priced differently. The seller’s failure to deliver may also
impact the rights of the buyer by denying him the right to
vote the stock, because the buyer is not the record holder or
beneficial holder. Additionally, naked short sellers are provided
additional leverage when they are not required to borrow,
because they avoid the costs of borrowing. They are able to
use this additional leverage to engage in higher and more
aggressive levels of trading, which may be used to deliberately
depress the price of an ETF or stock.
Locate And Close-Out Rules
Prior to the adoption of Regulation SHO, short sales were
regulated by a combination of federal and SRO rules. Federal
and SRO regulation of short sales has, and continues to be,
focused upon two primary areas. One area of regulation, as
described earlier, has been the mechanical restriction of short
selling in declining markets by the establishment of the tick
and bid tests. The other area of regulation has been the imposition
of rules requiring the borrowing of securities in
advance of a short sale, and the closing out of short positions
in certain securities after a short sale. For example, the NASD
had a separate rule, Rule 3370, requiring a short seller to
“locate” or “affirmatively determine” that he could borrow a
stock by the settlement date prior to engaging in a short sale
of said stock. Another NASD rule, Rule 11830, established a
“close-out” procedure for certain short positions in specific
securities, requiring short sales to be closed out ten business
days after the normal settlement date if delivery of the borrowed
securities has not occurred.
SRO locate and close-out rules did not apply to ETFs, and
also afforded a number of key exceptions. For example, the
NASD rules contained an express exception for short sales
fully hedged by certain public-company-issued warrants and
rights. This so-called “bona fide hedge exception” provided
important marketplace benefits in the areas of volatility, price
discovery and capitalization, and, properly followed, the
exception did not lead to short selling abuse since the short
sale position is at least fully hedged by the long position in an
offsetting convertible security.
Significantly, Regulation SHO, while co-opting the locate
and close-out rules into SEC regulations, dropped all of the
established NASD bona fide hedge exceptions and mandated
application of the new locate rule to all ETF transactions. By
not extending the same exceptions, the adoption of
Regulation SHO and the repeal of certain SRO rules that
Regulation SHO generally duplicates may have created significant
adverse impacts on ETF trading liquidity. It may also
have adversely impacted capital formation and pricing efficiency,
particularly for small and emerging companies. The
SEC and the securities industry must monitor these matters
as closely as they are monitoring the continued need for a
tick or bid test, which is the primary focus of a pilot program
that started on May 2, 2005.
Understanding Regulation SHO
With the adoption of Regulation SHO, the SEC has begun
to consolidate the rules related to short selling under a single
regulatory framework, primarily the locate and close-out
rules for now. Importantly, in adopting Regulation SHO, the
SEC elected not to implement the uniform bid test that was
in the SEC’s original October 2003 proposal until after it
receives the results from the ongoing pilot program.
Although Regulation SHO did not immediately implement
a single market-wide uniform bid test, it did implement a
number of new and modified regulatory requirements;
• As previously mentioned, broker-dealers must locate or
borrow securities, including ETFs, prior to executing short
sales for their own account or the account of a customer;
• Participants in a registered clearing agency (clearing brokers)
must close-out any fail-to-deliver positions ten business
days after settlement in securities that have a substantial
number of fails-to-deliver and, as a result, are
classified as “threshold securities.”
• Broker-dealers must mark sell orders in all equity securities
either “long,” “short” or “short exempt.”
The bill also established new definitions of ownership for
certain securities for the purpose of determining delivery and
close-out requirements, and eliminated the shelf offering
exception contained in Rule 105 of Regulation M.
Some of the more important aspects of these regulations
are discussed below.
SEC Locate Require m e nt
Rule 203 of Regulation SHO prohibits a broker-dealer from
effecting a short sale for his own account, or the account of
another, unless the broker-dealer has borrowed, agreed to
borrow, or has reason to believe the security in question can
be borrowed to effect delivery when due. Rule 203 contains
some exceptions, the most important of which permits a broker-
dealer to accept a short-sale order from another brokerdealer
without satisfying the locate requirement, and to
accept short sales made by a market maker provided that the
market maker, specialist or options market maker in question
is engaged in bona-fide market making activities. “Bona-fide
market making” narrows the definition of market making to
exclude market makers engaged in trading for speculative or
other investment purposes. For short sales from another broker-
dealer, the broker-dealer giving the order must comply
with the locate requirement. Additionally, the rule requires
broker-dealers to maintain and retain documentation showing
their compliance with the rule.
As previously mentioned, when transforming the locate
rule from an SRO rule to an SEC rule, the SEC dropped certain
bona fide hedge exemptions, including one with respect
to warrants and rights. The latter exemption permitted the
p u rchase of a company’s warrants offset by a short sale of
the company’s stock, without advance re q u i rements to borrow
the stock. The exemption was crafted to promote capital
formation, particularly for small issuers, who frequently
use warrants and rights in public offerings to enhance the
m a r ketability of their common stock. They also have the further
strategic objective of raising additional capital in a highly
efficient manner as the company grows and its stock price
appreciates over time, as the exercise of a warrant or right
infuses immediate capital into the company. When a warrant
holder exercises warrants or rights, the company receives
cash in an amount equaling the number of warrants or rights
exercised times the exe rcise price. This is an extremely efficient
way to raise capital, as secondary offering and/or private
placement legal, accounting, underwriter and placement
agent fees are avoided. Moreover, if warrants and
rights are exercised gradually over time, they can act as
“shock absorbers” to cushion the adverse supply impact that
can be caused by a shelf or secondary offering of stock coming
to the market all at once.
Finally, the SEC declined to include an express exception
from the locate requirements for ETF transactions. In this
regard, several influential SROs had advocated such an exception
on the basis that ETFs have the ability to continuously
create and redeem shares. The SEC had observed high levels
of fails in some ETFs and decided, “[r]ather than providing a
blanket exception from the requirements of Rule 203, we
would prefer instead to address the treatment of ETFs
through the exemptive process. … n considering any
exemptive request, the Commission would evaluate the cause
of large fails in certain ETFs, as well as potential remedies to
resolve such fails, if necessary.”
SEC Close-Out Requirement
Rule 203 requires clearing brokers to close out positions
for which they are responsible in securities designated as
“threshold” securities after ten consecutive days. Threshold
securities are those that have experienced a substantial number
of fails; specifically, five consecutive days of aggregate
fails-to-deliver at a registered clearing agency of 10,000
shares or more per security, or a level of fails equal to at least
one-half of one percent of the issuer’s total shares outstanding.
Threshold securities will be flagged on a list prepared and
distributed by SROs. If a clearing broker has a fail-to-deliver
position for 13 consecutive settlement days, the clearing broker
and any broker-dealer for whom it clears, including any
market maker that would otherwise be able to rely on an
exception, may not effect a short sale for its own account or
for the account of another without complying with the locate
requirement of the rule. As a former NASD rule, the close-out
rule also contained bona fide hedge exemptions. As an SEC
rule, those exemptions have been dropped.
Marking Sell Orders And Ownership De termination
Rule 200 requires broker-dealers to mark all sell orders in
exchange-listed and over-the-counter equity securities as
either “long,” “short” or “short exempt.” Directly related to
marking an order is determining what defines security ownership,
which is necessary to enable investors to calculate
whether they are net long or net short a security when entering
a sell order. The SEC has incorporated the definition of
ownership previously contained in Rule 3b-3 of the Exchange
Act, with some amendments. Regulation SHO also incorporates
the block-positioner exception into Rule 200, because it
directly impacts a broker-dealer’s calculation of its net position.
Rule 200 also codifies the SEC’s prior interpretations
related to the ownership of security futures products and the
ownership of a security. Lastly, although broker-dealers are
required to aggregate positions on a firm-wide basis when
calculating their net positions, the SEC has incorporated into
Regulation SHO its no-action position that permits brokerdealers
to aggregate long and short positions on an independent
trading desk or unit basis provided that certain conditions
are met.
Pilot Prog ra m
In proposing Regulation SHO, the SEC had proposed
adopting Rule 201, which would have established a uniform
“bid” test that would have been applicable to all exchangelisted
and many Nasdaq securities. As proposed, the bid test
would require short sales to be effected at a price at least one
cent above a security’s best consolidated bid at the time of
execution. With the adoption of Regulation SHO, the SEC
elected not to adopt Rule 201 pending the results of a pilot
program to be established by the SEC. Instead, Regulation
SHO provides the SEC with authority to establish a pilot program
that would enable the SEC to assess whether further
changes in short-sale regulations are necessary.
The pilot program commenced on May 2, 2005, and suspends
for one year the application of the SEC and NASD tick
and bid tests to a pilot group of 1000 stocks selected from
the Russell 3000 Index. Fifty percent of those stocks are listed
on the New York Stock Exchange, 47.8 percent are listed
on Nasdaq and 2.2 percent are listed on the American Stock
Exchange. The securities represent a cross-section of various
capital weightings, trading levels and liquidity, which will
allow the SEC to determine how a short-sale tick, bid or other
price test effects different stocks. Originally scheduled to
commence on January 3, 2005, the SEC delayed the pilot to
afford the broker-dealer community additional time to prepare.
The tick and bid tests will continue to apply to nonpilot
group stocks; as previously noted, ETFs already are exempt
from such short-sale price tests.
Impact On ETF Trading
While Regulation SHO is intended to address problems
caused by chronic fails-to- deliver, in many cases it has made it
more expensive for market makers to trade and hedge ETFs,
which can lead to increased costs to investors looking for liquidity.
Depending on the kind of ETF or the index being tracked,
there may be significant costs and minimum requirements to
create an ETF to address a short sale if borrowing is not possible.
Since units of 50,000 shares or more are typically required
to create many ETFs, a market maker who is short, say, 20,000
shares of a Regulation SHO threshold ETF, may be forced to create
much earlier than desirable, often at a higher cost.
Secondly, hedging ETF positions with the underlying basket
(a common practice for ETFs without highly correlated
futures) is more difficult as well, due to the locate re q u i rements
for each of the stocks in the basket. In addition, the
lack of transparency in the stock loan market contributes to
an uneven playing field for market makers, since hard- toborrow
securities or ETFs are typically sourced from the
largest prime bro kers, clearing firms and bro ke r - d e a l e r s .
There f o re, the relationship of a market make r, hedge fund or
bro ker-dealer to the source of supply becomes an even more
important factor during the allocation process of scarce
securities.
Concluding Remark s
The pilot study is well engineered to discern the effects of
removing the tick and bid test rules from a proper sampling
of stocks. Answers derived from the pilot may finally put to
rest the recent debate about whether these rules continue to
be a premier investor protection plan or merely passé prophylactics
that do more harm than good. The pilot, however,
has not been engineered to answer another lively debate:
whether the SEC’s jettisoning of longstanding exceptions to
the locate and close-out rules are having an adverse impact
on the ETF marketplace, as well as the capital formation market,
particularly for small and emerging companies. The SEC
should consider broad exemptive relief for ETFs, and should
look at re-establishing the bona fide hedge exception for a
pilot period or for a select group of stocks, to evaluate the
effect of these exceptions on capital formation. In the meantime,
the SEC has reserved exemptive authority to restore
exceptions from the locate and close-out rules, and has promised
to do so on a case-by-case basis.
C o n g ress and the SEC never outlawed short selling, and
the outcome of the current pilot certainly is not expected
to change this view. The question, however, is whether the
SEC has outlawed short sales through a backdoor approach.
Regulation SHO’s locate and close-out rules are intent on
making it impossible to engage in a short sale unless the
security can effectively be borrowed. Depending upon the
stock or ETF, it may be impossible or very expensive to borro
w. The industry structure, mechanisms and conventions
for stock borrowing or “stock loans” are in desperate need
of transparency, restructuring, exchange pricing efficiency
and general overhaul. Where Congress and the SEC have
t reated the nation’s stock market as the favored child, they
have paid little attention to the orphaned stock/ETF loan
m a r ketplace. Accord i n g l y, there have been no National
M a r ket System (“NMS”) and efficiency reforms in this latter
a rea. Today’s stock/ETF loan marketplace can be likened to
the over-the-counter market before Nasdaq—fragmented
and devoid of both keen competition and pricing efficiency.
Now that Regulation SHO is live, stock/ETF loans must be
a d d ressed by the SEC and the industry immediately, in
a c c o rdance with the lessons learned over the past 30 years
in creating the NMS for securities.
36 November/December 2005
R E C A P T U R I N G (continued from page 16)
10. InterSec’s “EAFE Plus” investment universe measures the performance of asset managers with an EAFE benchmark but with a mandate that gives them freedom to go
beyond the benchmark into non-index stocks and markets. Generally, the investment guideline for such mandates allowed “dabbling” of up to 10 percent in emerging markets.
11. “The Role of Style in International Investment” InterSec Research Corp., February, 2002.
12. There remain quite substantial performance gaps between various international growth and value indexes, although the extreme differences in methodology have been
attenuated over the past few years, especially after MSCI adapted a more sophisticated, multifactor approach to defining value/growth for their flagship global indexes.
13. Steven A. Schoenfeld, “Index-Based Investment in Emerging Stock Markets,” Emerging Markets Quarterly, Spring 1998.
14. The term “Active-Index”or Active Indexing, which is explained in detail in chapter 18 of Active Index Investing (Wiley Finance, 2004), refers to investment approaches which
use index vehicles such as index funds, ETFs and index derivatives in “non-passive” or non-static ways, such as with active size/style/sector/country allocation or systematic
rebalancing among these segments. NTGI’s Emerging Market indexation estimate, includes institutional and retail emerging market index funds and ETFs available in developed
markets (mainly in North America, Europe and Japan). Total estimate does not include indexed assets managed within Emerging Markets (i.e, domestic products such as ETFs,
even if used by foreign investors).
15. For more on the concept of “Indexing at the Core,” see Chapter 30 of Active Index Investing (Wiley Finance, 2004).
16. Survey of Plan Sponsor participants at the Institute for Fiduciary Education’s Market Makers conference, Los Angeles, Calif., June 2005.
Endnotes
1. William Uchimoto’s biography can be found in the Contributors page in the front of this issue. Following are bios of the other contributors:
Michael Traynor is a founding partner at MindCapital Group, LP, a consulting and advisory firm. Previously, he was responsible for new product and business development at
Susquehanna International Group, LLP, focusing on ETFs, index derivatives and other investment products. He has also worked at Vanguad implementing new fund initiatives and
directing the retail and institutional brokerage strategy. Mr. Traynor earned an MBA from Villanova University and is a Chartered Financial Analyst.
James Connolly is an associate at Saul Ewing LLP, where he is a member of the Securities Transactions Practice Group, which focuses on on compliance, market structure and
regulatory matters. Prior to his legal career, Connolly spent more than 20 years serving as vice president of several major investment banking firms, including J.P. Morgan & Co.,
Morgan Stanley & Co. and Nomura Securities International.
Joseph S. Rizzello is a founding partner of MindCapital Group, LP, a consulting and advisory firm. He has more than 30 years of experience in the financial services industry, and
has served in senior positions at the Philadelphia Stock Exchange, The Vanguard Group and Pershing Trading Company, LP. Mr. Rizzello is responsible for the creation of some of
the financial industry’s most successful new products (THAT’s quite a statement), and has designed and implemented highly successful new brokerage businesses and operating
models.
2. The SHO in Regulation SHO is simply shorthand for “short selling,” according to the SEC.
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