1 Regulating Short Sales in the 21 st Century Houman B. Shadab Associate Professor of Law New York Law School

2 Reading Questions What is a short sale and why are they undertaken? What is the difference between a covered and a naked short sale? What regulations of general application apply to short sales? What price test applied to short sales before Regulation SHO was adopted? What emergency actions did the SEC and other regulators take with respect to short sales in 2008? How has Regulation SHO been amended since its adoption in 2004? What price test currently applies to short sales? What locate and close out rules currently attempt to prevent fails to deliver and abusive naked short sales? What are the exceptions to the close out requirements? How are approaches taken by non-U.S. regulators to short sales different than that taken by the SEC?

3 Short Sales Long sales contrasted Purpose of short sales Goals of short sale regulation Prevent fraud and enforce antifraud regime Prevent insider trading Prevent artificial depression of stock prices Prevent manipulative price declines and exacerbating price declines

4 U.S. Short Sale Regulation Background Regulation pursuant to 1934 Securities and Exchange Act Rule 10a-1 price test (tick test) Erosion of Rule 10a-1 Governmental studies Market developments

5 Tick Test Elimination Regulation SHO initially suspended Rule 10a-1 tick test in 2004 and eliminated tick test entirely in Regulation SHO imposed new locate and close out rules to prevent abuse naked short sales.

6 Covered Versus Naked Short Sales Covered short sale Naked short sale Failure to borrow Failure to deliver Three-day settlement date (T+3)

Temporary Emergency Actions In response to concerns about abusive naked short sales during the market volatility of 2008, the SEC undertook several temporary emergency actions, including: Strict T+3 close-out requirements Prohibition of short sales in nearly 800 financial company stocks Institutional investor disclosure of certain short sale positions confidentially to the SEC Non-U.S. regulators undertook similar temporary actions in 2008.

8 Current Short Sale Regulation: Antifraud Regime Exchange Act Rule 10b-5 and other rules. Prohibits misrepresentations in connection with short sales. Prohibits insider trading with short sales. Prohibits the use of short sales to implement a scheme of market manipulation such as through abusive naked short selling that drives down market prices.

9 Current Short Sale Regulation: Price Test Regulation SHO amended in February Combines a circuit breaker approach with an alternative uptick rule. Rule: if the price of an exchange-listed equity security declines by 10 percent or more in one day, absent an exception Rule 201 prohibits a national securities exchange, alternative trading system, or other trading center from effecting a short sale unless the price is above the current national best bid. Exceptions and marking trades short exempt.

10 Current Short Sale Regulation: Locate and Close Out Requirements Rule 203 locate requirement. Rule 10b-21 antifraud rule specifically targeting abusive naked short sellers. Rule 204 close out requirement (2009). Generally requires a clearing broker with a failure to deliver position to purchase or borrow the security and close out the position by the beginning of the settlement day after the trades settlement date. Exceptions Pre-borrow requirement Pre-close out credit Clearing broker may allocate fail to broker-dealer

11 Conclusion SEC short sale regulation remained static for its first 70 years but will likely change more frequently in the future. Changes will come in response to: Rapid developments in market microstructure Differences of opinion among SEC Commissioners Academic and other commentator scrutiny Periods of extended share price volatility or stability Market participants should not the expect the current approach to short sale regulation to remain the same.