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93-53 SEC Approves Amendments Relating to Close Outs of Short Sales and Bona Fide Fully Hedged or Arbitraged Positions

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Executive Summary

On July 14, 1993, the Securities and Exchange Commission (SEC) approved a new Section 71 of the Uniform Practice Code (UPC) requiring members to close out short sales in Nasdaq® securities that meet a certain clearing short-position threshold. In addition, the SEC approved amendments to the Interpretation of the Board of Governors relating to the Prompt Receipt and Delivery of Securities (Interpretation) setting forth examples of fully hedged and arbitraged positions relating to exemptions from the various short-sale requirements of the NASD® rules.

The amendments take effect October 12, 1993. The text of the amendments follows this Notice.

Background

In July 1986, the NASD issued a report detailing a study of short-sale practices in Nasdaq securities (Pollack study). As a result of recommendations contained in the Pollack study, the NASD took a number of regulatory initiatives regarding short selling. The NASD now requires members to: (1) mark all sale transactions either "long" or "short"; (2) make an affirmative determination that they will receive delivery of a security from a customer or that they can borrow a security for a customer before accepting a short sale from a customer; (3) make an affirmative determination that they can borrow the security before effecting a short sale for their own account (certain transactions in corporate debt securities, bona fide market-making activities, and fully hedged or arbitraged positions are exempt); (4) buy-in for cash or guaranteed delivery Nasdaq securities, if the buyer is not an NASD member, on failure of a clearing corporation to effect delivery pursuant to a buy-in notice; and (5) report, as of the 15th of each month, aggregate short positions in all customer and proprietary accounts in securities listed on The Nasdaq Stock MarketSM. In addition, the NASD has proposed a rule change to prohibit short sales of Nasdaq National Market® securities at or below the current inside bid when that bid is lower than the previous inside bid.

In addition to these changes, the Pollack study recommended that the NASD address the fail-to-deliver/fail-to-receive problem created by naked short selling.1 The Pollack study indicated that the lack of an automatic mechanism for preventing the build-up of short positions at clearing corporations carried the potential for serious problems, especially in times of market stress. As a result of Pollock study recommendations and member comment, the NASD proposed that members close out short sales in certain securities.

Description of the Rule Change

New Section 71 of the UPC requires the short seller's broker/dealer to close out a short sale of specific securities 10 days after the normal settlement date if delivery of securities has not occurred and the transaction is not exempt. Securities subject to the close-out requirement are those with an aggregate "clearing" short position of 10,000 shares or more that equals or exceeds one half of one percent of the total shares outstanding. The NASD will identify these securities daily based on data from the National Securities Clearing Corporation (NSCC) and will compile a "restricted list."2 Any subsequent short-sale transaction in a security on the list that is not completed by delivery of shares within the prescribed time frames will be subject to mandatory closeout if a "fail-to-deliver" situation exists 10 days after normal settlement date.

The rule applies to customer and proprietary short sales, but exempts "bona fide" market-making activities and short sales that result in a "bona fide" fully hedged or arbitraged position.3 For example, the close-out rule applies if a broker/dealer sells a restricted security short from its proprietary account to another broker/dealer and fails to deliver the security within 10 days of normal settlement date. The rule also applies if the firm makes the same transaction for a customer.4 However, if the short sale is part of a bona fide market-making transaction or if the sale of a restricted security results in a fully hedged or fully arbitraged position, it is exempt from the mandatory close-out requirement.

In response to certain comments submitted to the SEC about persistent open clearing positions, the NASD noted that short selling isn't the only reason certain securities have unsettled trades at clearing corporations for lengthy periods. Other reasons include a member firm's segregation requirements under SEC Rule l5c3-3, transfer delays, or some characteristic of the security that prevents delivery.5 The NASD concluded that nearly all stocks that develop large, persistent fails-to-deliver conditions at clearing corporations would be covered by the close-out rule because the rule focuses on persistent rather than temporary fail-to-deliver situations.

In response to concerns regarding possible evasion of the rule by selling assets used to hedge an exempted short position, the NASD found that hedged positions accounted for less than 2 percent of the total shares of reported short interest in the stocks covered by its analysis. The NASD Market Surveillance Department will monitor compliance with the rule, and previous violations of short-sale rules have been subject to disciplinary action by the Market Surveillance Committee. The close-out rule will add substantially to the ability of the NASD to eliminate naked short selling as a regulatory problem and will address the few cases where unsettled trades may create regulatory or market concern.

In response to comments concerning the restrictive warrant hedging exemptions, the NASD believes that easing the rule would create a substantial loophole. Transactions envisioned by certain commenters would enable short selling without the need to close out transactions under the rule. A warrant price near zero would permit virtually unlimited short selling, with no delivery requirement. While normally the number of shares necessary to establish a hedge could be determined by calculating a hedge ratio, only 80-90 securities will be subject to the rule on a given date and those that are subject to the rule are for the most part thinly traded, making calculation of a hedge ratio inefficient. In addition, basing the exemption on a hedge ratio would severely complicate surveillance of compliance with the rule as well as increase compliance and surveillance costs. The rule attempts to balance the need to require delivery of a certain class of securities with the desirable warrant-hedging function.

Accordingly, Section 71 provides that short positions offset by long positions in corresponding convertible debentures, options, or warrants with a "call" feature are "bona fide fully hedged," provided the corresponding position is "in the money" (i.e., the strike/conversion price is below the current market value of the security) and exercisable or convertible within 90 days.6 Section 71 also provides that short positions offset by warrants that are "out of the money" are exempt from the close-out procedures up to the value of the warrant.7

Conclusion

As mentioned in the Pollack study, the fail-to-deliver/fail-to-receive problem could cause serious difficulties in a lengthy bear market. Large, unsettled trades can disrupt market mechanisms. Public customers' reasonable expectations that their securities have been delivered should be met. Additionally, naked short selling can present substantial manipulative concerns. While naked short sellers must deposit margin with either their broker/dealer or with a clearing corporation, they enjoy greater leverage than if they had to close out their short positions within a reasonable time frame. The ability of naked short sellers to employ this leverage to effect "bear raids" supports the decision to impose additional discipline on naked short selling via a close-out requirement.

Thus, the rule change will assist in preventing manipulation of Nasdaq securities through excessive naked short selling. As originally recommended in the Pollack study, a buy in or close-out requirement will add to the stability of the marketplace by assuring that securities are available to cover short positions, especially in times of volatility. Such a requirement also will help enhance the integrity of The Nasdaq Stock Market. In addition, the close-out rule may help to prevent short-selling abuses that could harm investors and the public interest.

Questions concerning this Notice may be directed to Dorothy L. Kennedy, Assistant Director, Nasdaq Operations, at (212) 8584030 until August 20, 1993; after August 23, 1993, call (203) 3759609.


1 In fail-to-deliver or fail-to-receive transactions the normal clearance and settlement process is interrupted by a failure to either receive or deliver the security in question.

2 Nasdaq Level 2 and Level 3 Workstations will see a short-sale restriction indicator ("UPC 71" will appear below the name of the company) on their bid/ask screens and a list of restricted securities will be available on line. Further, the NASD will make each day's list available on request via FAX or mail to any person calling the NASD Market Operations Department at (212) 858-4340 until August 20, 1993; after August 20, 1993, call (203) 375-9609.

3 The new rules include guidelines for the use of the exemption from the short-sale requirements for bona fide fully hedged and arbitraged transactions provided in new Section 71 and in Section 2(b) of the Interpretation. The guidelines are for illustrative purposes and are not intended to limit the NASD's ability to determine the scope of the terms "bona fide fully hedged" and "bona fide fully arbitraged."

4 A member firm that enters a short-sale transaction in a restricted security for a customer is obliged to inform that customer of the mandatory close-out requirement. Even if the security is subsequently dropped from the restricted list, the trade must be closed out. On the other hand, if the security is placed on the list after the trade is executed, close out would not be required.

5 An analysis of the factors affecting fails-to-deliver to the NSCC and the fluctuations in such fails-to-deliver indicated that when fails-to-deliver develop in stocks at NSCC, the dominant reasons are high average daily volume and (inversely related) the amount of float in the security. The analysis further suggested that the existence of fails-to-deliver at NSCC confirms little or nothing about short sales, unless the fail-to-deliver condition is large and persistent.

6 For example, as set forth in Section 71, a short position of EFGH (44 1/8) would be exempt if the investor also holds a corresponding call option with a strike price of 40 that is exercisable within 90 days.

7 For example, as set forth in Section 71, a short position of 100 shares of IJKL (1 1/2) offset by 100 IJKL warrants (2 1/4 - 2 3/4), each exercisable into one share of IJKL at a price of 2, would receive a partial exemption up to 16 shares (25 divided by 1 1/2).


Text of New Rule to the Uniform Practice Code

(Note: New language is underlined.)

Sec. 71. Mandatory Close-Out for Short Sales

A contract involving a short sale in Nasdaq securities described in subparagraph (a) below, for the account of a customer or for a member's own account, which has not resulted in delivery by the broker-dealer representing the seller within 10 business days after the normal settlement date, must be closed by the broker-dealer representing the seller by purchasing for cash or guaranteed delivery securities of like kind and quantity.

(a) This requirement shall apply to Nasdaq securities, as published by the Association, which have clearing short positions of 10,000 shares or more and that are equal to at least one-half (1/2) of one percent of the issue's total shares outstanding.
(b) This mandatory close-out requirement shall not apply to bona fide market making transactions and transactions that result in bona fide fully hedged or bona fide fully arbitraged positions.

Text of Amendment to Article III, Section 1 of the NASD Rules of Fair Practice Interpretation of the Board of Governors on Prompt Receipt and Delivery of Securities

(5) "Bona Fide Fully Hedged" and "Bona Fide Fully Arbitraged"

In determining the availability of the exemption provided in Section (2)(b) above and in Section 71 of the Uniform Practice Code from short sale requirements for "bona fide fully hedged" and "bona fide fully arbitraged" transactions, the following guidelines shall apply. These guidelines are for illustrative purposes and are not intended to limit the Association's ability to determine the proper scope of the terms "bona fide fully hedged" or "bona fide fully arbitraged" pursuant to this provision, on a case-by-case basis.
(a) Bona fide fully hedged

The following transactions shall be considered bona fide fully hedged:
1. Short a security and long a convertible debenture, preferred or other security which has a conversion price at or in the money and is convertible within ninety days into the short security.

Example: Long ABCD Company 9% convertible subordinated debentures due 1998. Each debenture is convertible into common at $27.90 per share of common equal to 35.842 shares of common per IM debenture.
  • With the price of the ABCD at 8 3/4 - 9 and a short position of 100 shares of ABCD the short position would not be exempt.

  • If the price of ABCD was $28 with a short position of 100 shares, 35 shares would be exempt and the remaining 65 shares would not be exempt.
2. Short a security and long a call which has a strike price at or in the money and which is exercisable within 90 calendar days into the underlying short security.

Example: Long 1 call of EFGH (44 1/8) with a strike price of 40 expiring within 90 calendar days.
  • With the circumstances as above 100 shares would be exempt.

  • If the strike price was 50 a short position of 100 shares would not be exempt.

  • With any strike price and the call expiring in more than 90 days any short of the common would not be exempt.
3. Short a security and long a position in warrants or rights which are exercisable within 90 days into the short security. To the extent that the long warrants or rights are "out of the money" then the short position shall be exempt up to the market value of the long warrants or rights.

Example: Long 100 warrants of IJKL (IJKLW: 2 1/4 - 2 3/4). Each warrant is exercisable into 1 share of common at $2. (IJKL: 4 - 4 1/2).
  • With the circumstances as above a short position of 100 shares would be exempt.

  • If the price of IJKL is $1.50 and the market value of long warrants is 1/4, a short position of 16 shares would be exempt.
(b) Bona fide fully arbitraged

The following transactions shall be considered bona fide fully arbitraged:
1. Long a security purchased in one market together with a short position from an offsetting sale of the same security in a different market at as nearly the same time as practicable for the purpose of taking advantage of a difference in price in the two markets.

Example: Purchase 100 shares of EFGH on the London Stock Exchange and simultaneously effect a short sale of 100 shares of EFGH on Nasdaq.
  • Under the above circumstances, the 100 share short position would be exempt.
2. Long a security which is without restriction other than the payment of money exchangeable or convertible within 90 calendar days of the purchase into a second security together with a short position from an off-setting sale of the second security at or about the same time for the purpose of taking advantage of a concurrent disparity in the prices of the two securities.

Example: Long 100 shares of MNOP (MNOP: 51 - 51 1/4) which is being acquired by ORST Corp. (ORST: 52 1/8 - 52 3/8) at the rate of 1.15 shares per MNOP share.
  • If the exchange is to take place within 90 days then a short of 115 shares of ORST would be exempt from the mandatory buy-in. Also, if the exchange was to take place at a date later than 90 days, all short positions in the above example would be subject to the mandatory buy-in.
(c) The transaction date of the shortsale shall govern when a fully hedged or fully arbitraged position exists.

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