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94-83 NASD Provides Additional Guidance Concerning The Operation Of The NASD Short-Sale Rule

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On August 25, 1994, the NASD issued Special Notice to Members 94-68 (Special Notice) dealing with the NASD's recently approved short-sale rule (Rule). In that Special Notice, the NASD set forth a description of the Rule, provided answers to questions concerning the operation of the Rule, and included the final text of the short-sale rule. In addition, the NASD separately issued ACT Notice 94-1 describing new rules applicable to the reporting of short sales through The Nasdaq Stock Market, Inc., Automated Confirmation Transaction (ACTSM) service. Since the Special Notice was issued and the Rule became effective on September 6, the NASD has received additional questions concerning the operation of the Rule. Accordingly, this Notice provides answers to these and other questions in an attempt to enhance member-firm compliance with the Rule. As with the Special Notice dealing with the Rule, the NASD hopes this Notice is helpful to the membership in understanding the new obligations that apply to them as a result of the Rule. The NASD also recognizes that additional assistance may be needed to respond to specific areas of concern to the membership. Inquiries should be directed to the staff members listed after the "Questions And Answers" section below.

Questions And Answers

Question #1: To determine whether a short sale is a "legal" short sale (that is, a non-exempt short sale effected at a price 1/16th above the bid on a down bid), should members refer to the "gross" price at which the short sale is reported to and disseminated by the NASD exclusive of any markdown or should the reference price be the "net" price inclusive of any markdown?
Answer: The reported price generally is the "benchmark" price to determine whether a non-exempt short sale is a legal short sale when there is a down bid, not the "net" price incorporating any markdown. For example, if the market is 10–10 1/4 and the 10 bid is a down bid, a transaction reported at 10 1/16 would be a legal short sale, even if there were a markdown of 1/16 on the sale. However, if a firm were to modify its practices in dealing with a customer or group of customers after implementation of the Rule such that it commenced charging markdowns or commenced charging larger mark-downs so that it could effect and report short sales for its customers at higher "gross" prices while trading at virtually the same "net" price, then the NASD would deem such conduct to be a violation of the short-sale rule and Interpretation C thereto.

For example, the NASD understands that members often trade on a "net" basis with large, institutional clients. If a member were to deviate from this practice by charging such customers a markdown when they are effecting short sales, the NASD would presume that the member is assessing the markdown to facilitate the customer's short-sale transaction. Moreover, if a member were to assess a markdown on a short sale by a customer who had previously traded with the firm exclusively on a "net" basis and, thereafter, immediately sell the stock at the bid, the NASD's presumption that the short sale was effected in violation of the Rule would be even stronger.
Question #2: Is it a violation of the Rule to effect a short sale at a price below the bid when the bid is an "up" bid?
Answer: No. The Rule only constrains the execution of short sales when there is a down bid. However, depending on the circumstances, the NASD may deem such activity to be a manipulative act or practice inconsistent with just and equitable principles of trade and a violation of the SEC's anti-fraud rule. The NASD also notes that members should be aware that the execution of a short sale for a customer at a price below the best inside bid may raise concerns that the member did not adequately discharge its best execution obligation with respect to that order. Nevertheless, the NASD acknowledges that it is conceivable that large, institutional-size sell orders may receive best execution even if they are effected at prices below the inside bid.
Question #3: When executing a customer's limit order to sell short, does compliance with the NASD's Limit Order Protection Interpretation supersede compliance with the Rule?
Answer: If a customer's limit order to sell short is activated by a member's sale transaction, the customer's short-sale order still must be effected in compliance with the Rule. For example, assuming the market for XYZ is 10–10 1/4 and the 10 bid is a down bid, if a market maker were to execute a customer's market order to buy XYZ at 10 1/4 while holding a customer's limit order to sell XYZ short at 10, the market maker would not be able to immediately execute the limit order. While the market maker's execution of the market order would activate execution of the limit order under the NASD Limit Order Protection Interpretation, the Rule would preclude the market maker from executing the limit order at 10 because the 10 bid in XYZ is a down bid. If the inside bid for XYZ were to decline to 9 7/8, however, then the limit order could be executed in the event of a subsequent sale by the market maker at the offer because the short sale would be effected at a price at least a 1/16th above the inside bid.

Members should not confuse the answer to this question with the answer to Question #10 in the Special Notice. Question #10 in the Special Notice addressed the situation where a market maker would be selling short on a down bid to fill a customer's limit order to buy at the bid. In that case, the NASD concluded that the market maker's obligation to comply with the Limit Order Protection Interpretation superseded the member's obligation to comply with the Rule.
Question #4: If a qualified market maker receives an order to sell 20,000 shares of XYZ short when the market for XYZ is 10–10 1/4 on a down bid, would it be a violation of the Rule if the market maker were to sell 20,000 shares of XYZ at the 10 bid and subsequent lower bids in reliance on its exemption from the Rule and then turn around and buy the 20,000 shares from its customer at 1/16th of a point above the new, lower "down" bid?
Answer: Yes. The NASD would view the market maker's short sales as an impermissible use of the market-maker exemption and an attempt to avoid application of the Rule to its customer's short sale.
Question #5: If a qualified market maker effects short sales in anticipation of selling pressure in a stock or in anticipation of a general decline in the market, are the short sales exempt from the Rule?
Answer: If a qualified market maker reasonably believes that the price of a stock is going to decline because of specific news about the stock, a general decline in market prices, or otherwise, then the qualified market maker can effect short sales at down bids in an attempt to "liquify" itself to facilitate customer selling interest in the stock. However, as noted in Question #6 above, if a marketmaker were to effect short sales at down bids after having received a customer's short-sale order, the NASD would view such short sales as an impermissible use of the market-maker exemption. In the event a qualified market maker receives a customer order to sell short during a declining market or while the market maker has a reasonable belief that the price of the stock is declining, it will involve a facts-and-circumstances analysis to determine whether the market makers' short sales are attributable to the facilitation of the customer's short-sale order or the result of bona fide market-making activity.
Question #6: Are sale transactions that are "short against the box"1 subject to the Rule?
Answer: Yes. Section 48(1)(1) of the NASD Rules of Fair Practice provides that the term short sale means "any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller." Accordingly, if a customer intends to satisfy its settlement obligation for a sale transaction with borrowed stock, then that sale transaction is subject to the Rule, regardless of whether the customer has a long position in the stock.
Question #7: If a member facilitates a customer transaction in a standardized equity or stock index option, is it eligible for an exemption from the rule to effect hedging short-sale transactions?
Answer: With respect to the facilitation of customer transactions in standardized equity options, a member is eligible for an exemption from the Rule for short sales made in connection with hedging activities associated with the facilitation of such transactions, provided the short sales hedge, and in fact serve to hedge, an existing offsetting standardized options position or an offsetting options position that was created in a transaction(s) contemporaneous with the short sale and provided the member is a qualified market maker in the stock underlying the option.2

With respect to the facilitation of customer transactions in standardized index options, a member is eligible for an exemption from the Rule for short sales made in connection with hedging activities associated with the facilitation of such transactions, provided the short sales hedge, and in fact serve to hedge, the corresponding stock index options position and the underlying stock index option is a qualified stock index under Section 48(h)(2)(d) of the NASD Rules of Fair Practice.3 Members do not have to be a qualified market maker in each of the Nasdaq National Market® stocks underlying a qualified stock index to be eligible for the exemption from the Rule for hedging short-sale transactions.

In sum, Nasdaq market makers are afforded treatment comparable to that afforded "qualified options market makers" under the rule when hedging standardized options positions with short sales. In addition, as noted above, this interpretation only applies to Nasdaq market makers hedging customer facilitation transactions in standardized options.
Question #8: If a member is a registered market maker in a convertible bond or holds itself out as a market maker in a convertible bond, is it eligible for an exemption from the rule if it effects short sales in the underlying security to hedge transactions in the convertible bonds?
Answer: If a member establishes a convertible bond position during the course of bona fide market-making activity and the member is a qualified market maker in the stock underlying the bond, the member can effect short sales in the underlying security to hedge such bond positions. Members are directed to Questions 33 – 39 of the Special Notice for guidance on when short sales in the corresponding stock are deemed to be hedges of bona fide market making transactions in the related convertible bond and when they are considered arbitrage transactions unrelated to normal market-making activity.
Question #9: Are there any circumstances under which a qualified market maker would ever have to mark an ACT report "short sale" or "sell short exempt?"
Answer: Yes. Even though a qualified market maker does not have to append a short-sale indicator to its ACT Report when it is selling short, when a qualified market maker is buying from a customer who is selling short, the market maker must indicate in its ACT Report that the sale was a short sale. In addition, if a customer of a qualified market maker is effecting a short sale that is exempt from the Rule, the market maker must indicate on its ACT Report that the sale was "sell short exempt." For example, if the customer is an options market maker effecting a hedging short-sale transaction in reliance on the options market-maker exemption to the Rule, the market maker would have to mark its ACT Report "sell short exempt." Similarly, if a customer of a qualified market maker effected a short sale in reliance on the "special arbitrage exemption" afforded investors in Section 48(c)(6) of the Rule (or any other exemption afforded investors), then the marker maker would have to mark its ACT Report "sell short exempt."

Members are directed to ACT Notice 94-1 for further guidance on how to mark their ACT Reports to reflect short sales.
Question #10: Do non-qualified market makers have to append a "sell short" designator to their ACT Reports when effecting short sales?
Answer: Yes. A "sell short" designator is required for all proprietary short sales by members who are not qualified market makers. In addition, as noted in Question #9 above, if a customer of a market maker is selling short or selling short in reliance on an exemption from the Rule, the market maker must indicate on its ACT Report that the sale was a short sale or an exempt short sale.
Question #11: If a member has an arrangement with a customer whereby it will buy stock from a customer at a higher price to accommodate a short sale by the customer at a price a 1/16th above the bid on a down bid (short-sale accommodation differential) in return for the ability to recoup the short-sale accommodation differential when selling that stock to the customer in the future, would such an arrangement violate the Rule?
Answer: Short sales effected pursuant to an arrangement involving any price modifications, rebates, discounts, or other remuneration that is designed to circumvent application of the Rule would be in violation of the Rule.
Question #12: If a non-qualified market maker has a short position of 10,000 shares in XYZ and it purchases 1,000 shares of XYZ, is it "long" the 1,000 shares of XYZ it just purchased?
Answer: No. Members must net out long positions and short positions in the same stock to determine if they are net long or short. In this case, the purchase of the 1,000 shares of XYZ merely lowered the market maker's net short position in XYZ to 9,000 shares from 10,000 shares. Any subsequent resale of the 1,000 shares would be considered a short sale and subject to the Rule.
Question #13: If a non-qualified market maker effects a short sale because of a SOESSM transaction, does the market maker have to report that sale as a short sale?
Answer: No. Because SOES automatically executed the short sale for the market maker and reported the transaction, the market maker has no reporting obligation with respect to the short sale.
Question #14: After a merger or acquisition involving an exchange of stock has been publicly announced and not yet consummated or terminated, the Rule provides that a market maker may register and begin entering quotations in either or both of the two affected securities and immediately become a qualified market maker in either or both of the issues. The Rule also provides that if the market maker withdraws on an unexcused basis from any stock in which it has so registered within 20 days of so registering, the market maker will not be eligible for immediate designation as a qualified market maker for any merger or acquisition announced within three months subsequent to such unexcused withdrawal. If a merger or acquisition is consummated or terminated within 20 days of a market maker's registration in either or both of the effected securities, may the market maker withdraw from either or both of the securities before the balance of the 20 days has elapsed without being subject to the "three month" waiting provision?
Answer: Yes. If the merger or acquisition is consummated or terminated before the 20-day period elapses, the market maker may withdraw from either or both of the stocks upon such termination or consummation of the merger or acquisition and not be subject to the three-month waiting period.
Question #15: If a non-market maker effects a short-sale transaction with a market maker, can the member use the "browse/accept" feature of ACT to compare the trade for clearance and settlement purposes?
Answer: Yes. The member can use the "browse/accept" feature, provided the member updates the ACT Report to append a "short sale" or "short sale exempt" indicator with the symbols "S" or "X", respectively. This answer is a clarification of the answer to Question #31 in the Special Notice. In the answer to Question #31, the NASD stated that members would be "unable to use the ACT 'browse/accept' feature to compare trades in ACT for clearance and settlement purposes." This statement was incorrect, as members can use the "browse/accept" feature so long as they mark their ACT Reports appropriately during the acceptance process. If the member were to use the "browse/accept" feature without marking the ACT Report to appropriately reflect the short sale, however, it would be a violation of the ACT Rules.

Questions regarding this Notice should be directed to NASD Market Surveillance, at (301) 590-6080; Glen Shipway, Senior Vice President, Nasdaq Market Operations, at (203) 385-6250; or Thomas R. Gira, Assistant General Counsel, at (202) 728-8957.


1 A sale transaction that is "short against the box" is one where an investor owns the stock sold but intends to deliver borrowed stock to satisfy its settlement obligation.

2 Consistent with Section 48(h)(2)(a)(i) of the NASD Rules of Fair Practice, the phrase contemporaneously established includes transactions occurring simultaneously with the short sale as well as transactions occurring within the same brief period of time.

3 Section 48(h)(2)(d) provides that "a 'qualified stock index' shall mean any stock index that includes one or more Nasdaq National Market securities, provided that more than 10% of the weight of the index is accounted for by Nasdaq National Market securities and provided further that the qualification of an index as a qualified stock index shall be reviewed as of the end of each calendar quarter, and the index shall cease to qualify if the value of the index represented by one or more Nasdaq National Market securities is less than 8% at the end of any subsequent calendar quarter."


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