SEC Votes 5-0 to Eliminate All Short Sale Price Tests and Makes and Proposes Other Amendments to Regulation SHO

At its open meeting held June 13, 2007 (the “Open Meeting”), the Securities and Exchange Commission (the “SEC” or “Commission”) voted unanimously to:

• Remove Rule 10a-1 under the Securities Exchange Act of 1934 (the “Exchange Act”) and amend Regulation SHO to provide that no tick test or other price test, including any price tests of any self-regulatory organization (“SRO”), shall apply to short sales of any securities;
  
  
• Amend Regulation SHO to eliminate the “grandfather provision” so that fail to deliver positions existing at the time a security became a “threshold security” would no longer be exempted from Regulation SHO’s close-out requirement;
  
  
• Amend Regulation SHO to extend the grace period before a broker-dealer is required to close out fail to deliver positions resulting from sales of threshold securities pursuant to Rule 144 under the Securities Act of 1933 (the “Securities Act”) to 35 settlement days (from the otherwise applicable settlement grace period of 13 days);
  
  
• Re-propose for comment the elimination of the options market maker exception to Regulation SHO’s close-out requirement, along with two alternatives providing for the close-out of options market makers’ fail to deliver positions in threshold securities within specified time frames; and
  
  
• Propose for comment amendments to Regulation SHO to require that broker-dealers marking a sale as “long” document the present location of the securities being sold.
  

Although the agenda for the Open Meeting also listed consideration of a pending proposal to amend Rule 105 of Regulation M (which applies to short sales in connection with public offerings), that topic was not addressed at the meeting and, we understand, will instead be discussed at the Commission’s next open meeting scheduled for June 20, 2007.

Short Sale Price Tests:

Since 1938, Exchange Act Rule 10a-1 has imposed a price test (the “tick test”) to restrict short selling in declining markets. Rule 10a-1 generally applies to securities listed on a national securities exchange and provides, subject to certain exceptions, that covered securities may only be sold short (a) at a price above the price at which the immediately preceding sale was effected (a “plus tick”) or (b) at the last sale price if it is higher than the last different price (a “zero-plus tick”). Pursuant to an exemption designed to maintain the status quo while the short sale price tests were reviewed, Nasdaq-listed securities did not become subject to Rule 10a-1 when Nasdaq was approved to operate as a national securities exchange. Instead, Nasdaq Global Market securities traded on Nasdaq or over-the-counter and reported to the NASD are subject to a “bid test” under Nasdaq Rule 3350 or NASD Rule 5100, which prohibit short sales of such securities at or below the current best (inside) bid displayed in the National Market System when the current best (inside) bid is below the preceding best (inside) bid in the security. Nasdaq Capital Market securities and unlisted securities (including unlisted securities quoted on the OTC Bulletin Board and in the Pink Sheets) are not subject to any short sale price test.

Pursuant to Rule 202T of Regulation SHO, the Commission created a “Pilot Program” temporarily suspending the application of short sale price tests to certain transactions so that the usefulness of the price tests could be studied. Effective May 2, 2005, the Pilot Program suspended the application of short sale price tests to (a) any short sales of approximately one third of the securities in the Russell 3000 index, (b) short sales of securities in the Russell 1000 index between 4:15 p.m. and the open of the consolidated tape on the following day, and (c) short sales of any other securities between the close of the consolidated tape and the open of the consolidated tape on the following day. The data generated by the Pilot Program was the subject of a study by the SEC’s Office of Economic Analysis and of several academic studies, which were reported and discussed at a roundtable last September. These studies found little empirical justification for maintaining price test restrictions.

At the Open Meeting, the Commission voted to remove Exchange Act Rule 10a-1 and amend Regulation SHO to provide that “no short sale price test, including any short sale price test of any self-regulatory organization, shall apply to short sales of any security.” (The Commission also amended Regulation SHO to require all sales to be marked “long” or “short”, eliminating the requirement to mark as “short exempt” short sales made in reliance on an exemption from Rule 10a-1 or any SRO short sale price test.) These amendments will become effective immediately upon their publication in the Federal Register. Although all existing price tests will be eliminated when these amendments become effective, Director of the Division of Market Regulation Erik Sirri noted that an SRO may file a proposal with the Commission to have a short sale price test if there is a need in the future for such a price test.

Regulation SHO Close-out and Pre-borrowing Requirements:

Rule 203(b)(3) of Regulation SHO generally requires any registered clearing agency participant that has a fail to deliver position in a threshold security at the clearing agency for 13 consecutive settlement days, to “immediately thereafter close out the fail to deliver position by purchasing securities of like kind and quantity.” (Under Regulation SHO, a “threshold security” is defined as an equity security of an issuer that is registered or for which its issuer is required to file reports with the Commission and for which there is an aggregate fail to deliver position for five consecutive settlement days at a registered clearing agency of at least 10,000 shares and 0.5% of the issue’s outstanding shares.) Under Rule 203(b)(3)(iii), until the participant closes out such fail to deliver position, the participant and any broker-dealer for which it clears transactions may not effect further short sales in that threshold security without borrowing or entering into a bona fide agreement to borrow the security (“pre-borrowing”).

Elimination of Regulation SHO Grandfather Provision:

Rule 203(b)(3)(i) (the “grandfather provision”) presently provides that the close-out and pre-borrowing requirements do not apply to the amount of a fail to deliver position in a threshold security that the participant had on the settlement day immediately preceding the day on which the security became a threshold security. At the Open Meeting, the Commission voted to eliminate the grandfather provision and apply the Regulation SHO close-out and pre-borrowing requirements without regard to when the participant established its fail to deliver position. This amendment will become effective 60 days from the date of its publication in the Federal Register. Participants in registered clearing agencies that have “grandfathered” fail to deliver positions on the date the amendment becomes effective will be allowed 35 settlement days in which to close-out such fail to deliver position.

Extension of Grace Period for Fails Resulting from Sales Pursuant to Securities Act Rule 144:

The Commission also voted at the Open Meeting to amend Regulation SHO to allow fail to deliver positions in threshold securities sold pursuant to Securities Act Rule 144 to persist for 35 settlement days (rather than 13 settlement days) before requiring them to be closed out. This amendment will become effective 60 days from the date of its publication in the Federal Register. The longer time period was adopted because the process of de-legending the securities may take more than 13 settlement days. This time period is also similar to that provided by Rule 203(b)(2)(ii) of Regulation SHO, which permits a broker-dealer to effect a short sale of a security the seller is deemed to own and which the broker-dealer is reasonably informed will be delivered as soon as all restrictions on delivery are removed, but which requires the broker-dealer to borrow securities or close out the short if the seller has not delivered the securities within 35 days after the trade date.

Re-proposal of the Elimination of the Options Market Maker Exemption:

Rule 203(b)(3)(ii) (the “options market maker exemption”) presently provides that the close-out and pre-borrowing requirements do not apply to the amount of a fail to deliver position in a threshold security “that is attributed to short sales by a registered options market maker, if and to the extent that the short sales are effected by the registered options market maker to establish or maintain a hedge on options positions that were created before the security became a threshold security.” In July 2006, the Commission proposed to narrow this exemption by requiring close-out of such fail to deliver positions following the liquidation or expiration of the related options position. See SEC Release No. 34-54154 (July 14, 2006), 71 Fed. Reg. 41710, 41714-15 (July 21, 2006). In the comment process, the Commission learned of the difficulty in applying this proposal to options market makers that hedge their positions on a portfolio basis, rather than attributing each short sale to a particular options position. In order to simplify their proposal and to create greater parity between the cash and options markets, the staff of the Division of Market Regulation recommended, and the Commission approved, proposing for comment the complete elimination of the options market maker exemption (after a 35 settlement day implementation period). Also approved to be proposed for comment are two alternatives providing for an extended grace period before the Regulation SHO close-out requirement becomes applicable to fail to deliver positions attributable to short sales by registered options market makers to create or maintain a hedge on options positions created before the security became a threshold security. Rather than the otherwise applicable 13 settlement day grace period, the first alternative would provide for a 35 settlement day grace period. The second alternative would provide for a grace period of the lesser of 35 settlement days after the scheduled settlement date and 13 settlement days from the time at which all of the preexisting options positions that were hedged had expired.

Long Locate Requirement:

Under Rule 200(g), a broker-dealer may mark a sale “long” only if the seller is deemed to own the security and either the security is in the physical possession or control of the broker-dealer or it is reasonably expected that the security will be in the physical possession or control of the broker-dealer no later than the settlement of the transaction. At the Open Meeting, the Commission voted to propose that broker-dealers marking a sale “long” also be required to document the present location of the security being sold.

Technical Amendment:

The Commission also voted to change the market decline condition in the index arbitrage provision (Rule 200(e)(3) of Regulation SHO) to refer to the NYSE Composite Index, rather than the Dow Jones Industrial Average, in order to be consistent with changes to “circuit breakers” in the New York Stock Exchange’s Rule 80A. This amendment will become effective 60 days from the date of its publication in the Federal Register.

Future Initiatives:

Commission Chairman Christopher Cox announced that he had asked the staff of the Division of Market Regulation to consider whether the market would benefit from further rule-making to address abusive naked short selling. Chairman Cox also announced that he had requested the staff to report on the level of fails in existence before and after the effectiveness of the rule changes approved at the Open Meeting.

At the prompting of Commissioner Annette Nazareth, the Division of Market Regulation staff present at the Open Meeting discussed plans to make available in the near future information about the level of fails received from The Depository Trust Company. The staff currently plans to make quarterly disclosures of aggregate fails data on a security-by-security basis, presented in a manner that would not identify any particular firm’s position.

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The summary above is based on remarks at the Open Meeting and the Commission’s press release; the Commission’s full release, including the text of the proposed amendments, is not yet available. The webcast of the Open Meeting may be found at http://sec.gov/news/openmeetings.shtml.

Please feel free to contact any of your regular contacts at the firm or any of our partners and counsel listed under Capital Markets in the “Our Practice” section of our website if you have any questions.

CLEARY GOTTLIEB STEEN & HAMILTON LLP