SEC Adopts Final “Naked” Short Selling Anti-Fraud Rule

October 22, 2008
On October 14, 2008, the Securities and Exchange Commission (“SEC”) adopted Rule 10b-21 (the “Rule”) under the Securities Exchange Act of 1934 (the “Exchange Act”) as an anti-fraud measure to address concerns about abusive “naked” short selling of equity securities.1 The Rule holds short sellers, including brokers-dealers selling short for their own accounts, liable for deceiving broker- dealers, participants of a registered clearing agency, or purchasers about their intention or ability to deliver equity securities in time for settlement and thereafter failing to deliver such securities on or before the settlement date.
The SEC has adopted the Rule to target short sellers who deceive their broker-dealers about sources of borrowable equity securities for the purpose of complying with the “locate” requirements of Regulation SHO or deliberately misrepresent to broker-dealers their ownership of shares. A primary aim of the Rule is to reduce the incidences of “fails to deliver” securities and the negative impact fails to deliver may have on the market for such securities.
Key Elements of the Rule
The key element of the Rule is deception about intention or ability to deliver in connection with a sale, i.e., scienter.2 When a seller deceives one of the enumerated persons about the seller’s intention to deliver, the seller violates the Rule. The violative conduct can include deception about share ownership, the source of shares to be delivered, or ability of the source to deliver the securities on or before the settlement date.
In the Adopting Release, the SEC provided examples of seller deception. For example, a seller would be liable under the Rule if the seller:
  • represented that it had identified a source of borrowable securities without having contacted the source to determine the availability of shares for delivery in time for settlement, and then failed to deliver the securities; 
  • contacted the source, learned that the source did not have sufficient shares that could be delivered by settlement, misrepresented that the source had sufficient shares for delivery in time for settlement, and then failed to deliver the securities by the settlement date; or 
  • contacted the source, learned that the source had sufficient shares for delivery by settlement, and then failed to instruct the source to deliver the shares in time for settlement, resulting in a fail to deliver the securities by the settlement date. 

Failure to Deliver

As noted in the examples above, to violate the Rule the seller must fail to deliver. If the seller deceives a broker- dealer, clearing agency participant, or purchaser with respect to its intention or ability to deliver the equity security by the settlement or delivery date, the seller must also fail to deliver the equity security on or before settlement date. This additional requirement is imposed because the principal purpose of the Rule is to reduce or eliminate fails to deliver and, absent a resulting fail to deliver, the harm sought to be addressed by the Rule would not exist.

Bona Fide Market Makers

The SEC noted that a market maker that is engaging in bona fide market making activities is not subject to the Rule because it does not make any representations as to its ability to or intent to deliver equity securities on the settlement date in light of the fact that it is excepted from the locate requirement of Regulation SHO. Market makers are excepted from the locate requirement and from liability under the Rule for bona fide market making activities “because market makers are needed to facilitate customer orders in a fast moving market without possible delays associated with complying with the locate requirement.”3

Reliance on Broker-Dealer or “Easy to Borrow” Lists

In the Adopting Release, the SEC indicates that a seller relying upon its broker-dealer to comply with the locate requirement of Regulation SHO does not represent that it can or intends to deliver securities on the date that delivery is due. For example, if a seller relies on its broker-dealer to arrange to borrow a security or if a seller relies in good faith on a broker-dealer’s “Easy to Borrow” list, the seller would not be deemed to have acted deceptively with respect to its ability or intention to deliver securities and would therefore not violate the Rule.

Long Sales

A seller, including a broker-dealer acting for its own account, may also be held in violation of the Rule for deceptions in connection with “long” sales. A seller will be liable for such a violation if, along with failing to deliver the security by the settlement date, the seller:

  • causes a broker-dealer to mark an order to sell a security long; and 
  • either: 
    • knows or recklessly disregards that it is not “deemed to own” the security being sold;4 or 
    • knows or recklessly disregards that the security being sold is not, or cannot reasonably be expected to be, in the broker- dealer’s physical possession or control by the date delivery is due. 

A seller that submits an order to sell securities that are held in a margin account may reasonably expect that the securities will be in the broker-dealer’s physical possession and control by settlement date even if the broker-dealer has loaned out the securities pursuant to the margin agreement.

Aiding and Abetting Liability

The primary focus of the Rule is on sellers. However, as is the case with any Exchange Act rule, the SEC mayseek to hold broker-dealers and associated individuals liable for aiding and abetting (in a civil injunctive context) or “causing” (in an administrative context) a customer’s fraud under the Rule. The Rule does not impose any additional liability or requirements on broker-dealers beyond those of any existing Exchange Act rule, however.

Impact of the Rule on Other Anti-Fraud Provisions and Private Actions

The Rule provides the SEC with another means of protecting the integrity of the financial markets, but does not affect the application of existing anti-fraud rules, including Rule 10b-5. The preliminary note to the Rule states:

This rule is not intended to limit, or restrict, the applicability of the general anti-fraud provisions of the federal securities laws, such as section 10(b) of the [Exchange Act] and rule 10b-5 thereunder.

Although a plaintiff may not have the right to bring a private suit under the Rule, if the plaintiff is able to prove all the elements of a violation of the Rule, the plaintiff may have a private right of action and assert a claim under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. (There is, however, no aiding or abetting or causing liability available to plaintiffs in a private action.)


1) See “Naked” Short Selling Antifraud Rule, SEC Rel. No. 34-58774 (Oct. 14, 2008) (the “Adopting Release”). The Rule became effective on October 17, 2008.
2) The SEC explains in footnote 55 of the Adopting Release that the scienter requirement of the Rule is the same as that required under Rule 10b-5. See Ernst & Ernst v. Hochfelder, et. al., 425 US 185 (1976) (defining scienter as “a mental state embracing the intent to deceive, manipulate or defraud”); see also Dolphin & Bradbury v. SEC, 512 F.3d 634 (D.C. Cir. Jan. 11, 2008) (quoting Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977)) (explaining that scienter may be established by a showing of either knowing conduct or by “an ‘extreme departure from the standards of ordinary care . . . which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it’”). Although this is a high standard, because the Rule provides notice of specific problematic conduct, it may make it easier for the SEC to prove scienter as an evidentiary matter .
3) Adopting Release at 20, text at n. 70.
4) See Rules 200(a) through (f) of Regulation SHO define when a person is “deemed to own” a security.

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