17 CFR PART 240

Release No. 34-42037; File No. S7-24-99

RIN 3235-AH84

Short Sales

Agency: Securities and Exchange Commission.

Action: Concept release; Request for comments.

Summary: The Securities and Exchange Commission is seeking public comment on the regulation of short sales of securities. In this release, we seek comment on, among other things: lifting the limits on short sales of exchange listed securities under advancing market conditions;providing an exception for actively traded securities; focusing short sale restrictions on certain market events and trading strategies; removing short sale restrictions on hedging transactions; revising short sale regulation in response to certain market developments; revising the definition of short sale; extending short sale regulation to non-exchange listed securities; and eliminating short sale regulation altogether.

Dates: Comments must be received on or before [insert date that is 60 days after date of publication in the Federal Register ].

www.sec.gov).

For Further Information Contact: Any of the following attorneys in the Office of Risk Management and Control, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W. Washington, D.C. 20549, at (202) 942-0772: James Brigagliano, Alan Reed, or Michael Trocchio.

Supplementary Information

I. Introduction

The Securities and Exchange Commission (Commission) adopted Rule 10a-1 1 (short sale rule or Rule) under the Securities Exchange Act of 1934 (Exchange Act) 2 at a time when the securities markets had less trading volume and simpler trading strategies than current markets. Since the adoption of the short sale rule, securities trading has increased drastically in volume, velocity, and complexity. There have also been substantial improvements in market transparency and surveillance mechanisms. Short sale regulation, however, has remained fundamentally unchanged. This separation between Rule 10a-1 and the markets has resulted in frequent requests for relief from the short sale rule and suggestions for modification of it. Our goal is to examine ways to modernize our approach to provide the most appropriate regulatory structure for short sales.

Among other things, we propose to assess whether the restrictions of Rule 10a-1 produce benefits to the markets that are proportionate to the costs associated with those restrictions. We believe that a comprehensive assessment of Rule 10a-1 is necessary to achieve this goal. Therefore, we are seeking public comment on the regulation of short selling. In particular, we solicit comment on eight concepts related to the regulation of short sales of securities:

extending the short sale rule to non-exchange listed securities; and

The comments we receive will assist us in determining whether to propose changes to the short sale rule and in tailoring the scope of any such changes.

A. Background

A short sale 3 is the sale of a security that the seller does not own or that the seller owns but does not deliver. In order to deliver the security to the purchaser, the short seller will borrow the security, typically from a broker-dealer or an institutional investor. The short seller later closes out the position by returning the security to the lender, typically by purchasing equivalent securities on the open market. In general, short selling is utilized to profit from an expected downward price movement, or to hedge the risk of a long position in the same security or in a related security.

Short selling provides the market with two important benefits: market liquidity and pricing efficiency. Substantial market liquidity is provided through short selling by market professionals, such as market makers, block positioners, and specialists, who facilitate the operation of the markets by offsetting temporary imbalances in the supply and demand for securities. To the extent that short sales are effected in the market by securities professionals, such short sale activities, in effect, add to the trading supply of stock available to purchasers and reduce the risk that the price paid by investors is artificially high because of a temporary contraction of supply.

Short selling also can contribute to the pricing efficiency of the equities markets. Efficient markets require that prices fully reflect all buy and sell interest. When a short seller speculates on a downward movement in a security, his transaction is a mirror image of the person who purchases the security based upon speculation that the security’s price will rise. Both the purchaser and the short seller hope to profit by buying the security at one price and selling at a higher price. The strategies primarily differ in the sequence of transactions. Market participants who believe a stock is overvalued may engage in short sales in an attempt to profit from a perceived divergence of prices from true economic values. Such short sellers add to stock pricing efficiency because their transactions inform the market of their evaluation of future stock price performance. This evaluation is reflected in the resulting market price of the security. Arbitrageurs also contribute to pricing efficiency by utilizing short sales to profit from price disparities between a stock and a derivative security, such as a convertible security or an option on that stock. For example, an arbitrageur may purchase a convertible security and sell the underlying stock short to profit from a current price differential between two economically similar positions. 4

Although short selling serves useful market purposes, it also may be used as a tool for manipulation. 5 One example is the bear raid where an equity security is sold short in an effort to drive down the price of the security by creating an imbalance of sell-side interest. Many people blamed bear raids for the 1929 stock market crash and the market’s prolonged inability to recover from the crash. 6 Short selling was one of the central issues studied by Congress before enacting the Exchange Act, but Congress made no determinations about its permissibility. 7 Instead, Congress gave the Commission broad authority to regulate short sales in order to stop short selling abuses. 8

B. Current Regulation of Short Selling

Section 10(a) of the Exchange Act gives the Commission plenary authority to regulate short sales of securities registered on a national securities exchange, as necessary to protect investors. 9 After conducting an inquiry into the effects of concentrated short selling during the market break of 1937, the Commission adopted Rule 10a-1 under that grant of authority. 10 The core provisions of the Rule are largely the same today as when they were adopted.

Paragraph (a) of Rule 10a-1 generally covers short sales in any security registered on a national securities exchange (listed securities) if trades of the security are reported pursuant to an effective transaction reporting plan and if information as to such trades is made available in accordance with such plan on a real-time basis to vendors of market transaction information. 11 Paragraph (b) applies to short sales on a national exchange in securities that are not covered by paragraph (a). Short sales of securities not registered on an exchange and transactions in securities covered by paragraph (b) that are effected in the OTC market are not subject to the Rule. 12

Rule 10a-1(a)(1) provides that, subject to certain exceptions, a listed security may be sold short: (i) at a price above the price at which the immediately preceding sale was effected (plus tick), or (ii) at the last sale price if it is higher than the last different price (zero-plus tick). Conversely, short sales are not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions. The operation of these provisions is commonly described as the tick test. The reference price for the tick test is either the last transaction price reported pursuant to an effective transaction reporting plan 13 or on a particular exchange. 14 Both the New York Stock Exchange, Inc. (NYSE) and the American Stock Exchange LLC (Amex) have elected to use the prices of trades on their own floors for the tick test. 15

The Commission adopted the tick test after considering the effects of short selling in downward moving markets. 16 In adopting this approach, the Commission sought to achieve three objectives:

allowing relatively unrestricted short selling in an advancing market;