SEC Eliminates Option Market-Maker Exception to Close-Out Requirement of Regulation SHO

October 27, 2008

The Securities and Exchange Commission (“SEC”) adopted a final rule (“Final Rule”) on October 17, 2008 that makes permanent its September Emergency Order eliminating the options market-maker exception to the close- out requirement of Regulation SHO and also provides new guidance regarding what constitutes bona-fide market making activity for purposes of the market-maker exemption from the locate requirement of Regulation SHO.1 The Final Rule is one of three measures adopted that day that are intended to prevent “naked” short sales.2 The Final Rule and the other measures adopted with it are part of a coordinated effort between the SEC and other regulators aimed at curbing abusive and manipulative market activities in light of the ongoing credit crisis.3

One of the companion measures being adopted by the SEC in conjunction with the Final Rule is new temporary Rule 204T.4 Prior to this rule being adopted, Regulation SHO’s close-out requirement generally required short sellers in equity securities to borrow or locate the securities to borrow before selling and imposed additional requirements on broker-dealers with respect to certain securities, known as “threshold securities,” in which a substantial number of fails to deliver had occurred. The new Rule 204T goes further because its close- out requirement applies to all sales that result in a fail to deliver, rather than just transactions in threshold securities.5 Furthermore, with the adoption of the Final Rule, the SEC has decided to eliminate the “options market-maker” exception of Rule 203(b)(3) of Regulation SHO, which previously permitted options market makers to sell securities even if they had not borrowed them or located them to borrow in order to close out an option exercise.

Specifically, the Final Rule is intended to reduce the number of settlement “fails to deliver.” A “naked” short sale occurs when the seller does not own, locate, borrow, or otherwise arrange to deliver the security on settlement date. Extensive naked short selling in a company’s stock is believed by some to be abusive, and large numbers of fails to deliver can create downward pressure on the price of the company’s stock. Naked short sales could permit more shares of a company to be sold short than actually exist.

Many issuers and investors have raised concerns that naked short sales and the resulting fails to deliver have undermined the confidence of investors and their willingness to commit capital to issuers that may be subject to such manipulative conduct.6 Furthermore, some have expressed concern that issuers may suffer reputational damage due to investors’ negative perceptions regarding fails to deliver in the issuer’s security, causing an adverse impact on the price.7 By reducing the number of fails to deliver, the SEC hopes to enhance the operation, integrity, and stability of the markets and to reduce significantly potential short- selling abuses.8

Under the Final Rule, all fails to deliver, whether in the options market or the equity market, will be treated the same and will be required to be closed out in accordance with Regulation SHO. Previously, for example, an options market maker who sold short to hedge put options purchased by a market participant who was unable to locate shares for a short sale may not have been required to close out any resulting fails to deliver, in reliance on the options market-maker exception.9 The SEC stated in the Release that it views this activity to run counter to the “goal of requiring that all fails to deliver in threshold securities be closed out.”10 By eliminating the distinction between the regulation of the equity and options markets, the SEC aims to reduce the possibility of market participants engaging in this type of regulatory arbitrage going forward.

A 35-day phase-in period will apply to currently excepted fail-to-deliver positions to allow participants to close out these positions. However, this phase-in period will not apply to positions that participants already have begun to close out in reliance on the September Emergency Order.

Separately, the Final Rule also provides guidance regarding what constitutes “bona-fide market making activity” for purposes of complying with the “locate” requirement of Rule 203(b)(1) of Regulation SHO. Rule 203(b)(1) requires a broker-dealer to “locate” a security before engaging in a short sale transaction, but provides certain exceptions when a market maker is engaged in “bona-fide” activities. The Final Rule further clarifies bona-fide market making activity to include situations where the market maker is: 1) taking on economic or market risk with respect to the security; 2) engaging in a pattern of trading that includes both purchases and sales in roughly comparable amounts; and 3) issuing continuous market quotes that are both accessible to the general public and at or near the market on both sides of the transaction. The Final Rule reiterates that to determine whether or not a market maker is engaging in bona-fide market making activity depends on the facts and circumstances of the particular activity.

Furthermore, the Final Rule clarifies that bona-fide market making activity does not include: 1) activity that is related to “speculative selling strategies or investment purposes of the broker-dealer and is disproportionate to the usual market making patterns or practices of the broker-dealer in that security;” 2) issuing quotations that have a one-sided disparity between the bid-offer price posted and the market price; and 3) engaging in a continuous pattern of executing short sales away from the market maker’s posted quotes.11


1) Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments, SEC Rel. No. 34-58572 ( Sept. 17, 2008).
2) Amendments to Regulation SHO, SEC Rel. No. 34-58775 (October 17, 2008); see “Naked” Short Selling Antifraud Rule, SEC Rel. No. 34-58774 (October 17, 2008); Amendments to Regulation SHO, SEC Rel. No. 34-58773 (October 17, 2008) (requiring registered clearing agency participants to deliver securities by the settlement date or to immediately purchase or borrow securities to close out the fail to deliver position by no later than the beginning of trading on the next settlement day after incurring the fail to deliver position). A “naked” short sale is when a party sells a stock it does not own and does not locate or arrange to borrow the stock for delivery, thereby resulting in a “fail to deliver.”
3) See Statement of SEC Concerning Short Selling and Issuer Stock Repurchases, October 1, 2008, available at 2008-235.htm (hereinafter “SEC Statement”).
4) Amendments to Regulation SHO, SEC Rel. No 34-58773 (Oct. 14, 2008).
5) See DechertOnPoint, Issue 32 (October 2008).
6) See SEC Statement.
7) Id.
8) Amendments to Regulation SHO, SEC Rel. No. 34-58775 (October 17, 2008).
9) Id.
10) Id.
11) Id.

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