[Federal Register: October 17, 2008 (Volume 73, Number 202)]
[Rules and Regulations]
[Page 61690-61706]
[DOCID:fr17oc08-7]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 241 and 242

[Release No. 34-58775; File No. S7-19-07]
RIN 3235-AJ57

Amendments to Regulation SHO

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is
adopting amendments to Regulation SHO under the Securities Exchange Act
of 1934 (``Exchange Act''). The amendments are intended to further
reduce the number of persistent fails to deliver in certain equity
securities by eliminating the options market maker exception to the
close-out requirement of Regulation SHO. As a result of the amendments,
fails to deliver in threshold securities that result from hedging
activities by options market makers will no longer be excepted from
Regulation SHO's close-out requirement. The Commission is also
providing guidance regarding bona fide market making activities for
purposes of the market maker exception to Regulation SHO's locate
requirement.

DATES: Effective Date: October 17, 2008.

FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Associate
Director, Josephine J. Tao, Assistant Director, Victoria L. Crane,
Branch Chief, Joan M. Collopy, Special Counsel, Christina M. Adams and
Matthew Sparkes, Staff Attorneys, Office of Trading Practices and
Processing, Division of Trading and Markets, at<PHONE_NUMBER>, at the
Securities and Exchange Commission, 100 F Street, NE., Washington, DC
20549-6628.

SUPPLEMENTARY INFORMATION: The Commission is amending Rule 203 of
Regulation SHO [17 CFR 242.203] under the Exchange Act.

I. Introduction

    To further Regulation SHO's goal of reducing fails to deliver in
equity

securities, the Commission is adopting its proposal \1\ to eliminate
the options market maker exception to the close-out requirement of
Regulation SHO.\2\ As discussed in detail below, we believe that
eliminating the exception, and thereby imposing additional delivery
requirements on securities with a substantial amount of fails to
deliver, will help to protect and enhance the operation, integrity, and
stability of the markets, as well as reduce potential short selling
abuses.
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    \1\ See Exchange Act Release No. 56213 (Aug. 7, 2007), 72 FR
45558 (Aug. 14, 2007) (``Reproposal''); see also Exchange Act
Release No. 54154 (July 14, 2006), 71 FR 41710 (July 21, 2006)
(``2006 Regulation SHO Proposed Amendments''); Exchange Act Release
No. 58107 (July 7, 2008), 73 FR 40201 (July 14, 2008) (``2008
Regulation SHO Re-Opening Release'').
    \2\ 17 CFR 242.200; see also Securities Exchange Act Release No.
50103 (July 28, 2004), 69 FR 48008 (Aug. 6, 2004) (``2004 Regulation
SHO Adopting Release'').
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II. Background

A. Regulation SHO

    Regulation SHO, which became fully effective on January 3, 2005,
sets forth the regulatory framework governing short sales.\3\ Among
other things, Regulation SHO imposes a close-out requirement to address
failures to deliver stock on trade settlement date \4\ and to target
potentially abusive ``naked'' short selling \5\ in certain equity
securities.\6\ While the majority of trades settle on time,\7\
Regulation SHO is intended to address those situations where the level
of fails to deliver for the particular stock is so substantial that it
might impact the market for that security.\8\
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    \3\ Rule 200(a) of Regulation SHO defines a short sale as ``any
sale of a security which the seller does not own or any sale which
is consummated by the delivery of a security borrowed by, or for the
account of, the seller.'' 17 CFR 242.200(a).
    \4\ Generally, investors complete or settle their security
transactions within three business days. This settlement cycle is
known as T+3 (or ``trade date plus three days''). T+3 means that
when a trade occurs, the participants to the trade deliver and pay
for the security at a clearing agency three business days after the
trade is executed. The three-day settlement period applies to most
security transactions, including stocks, bonds, municipal
securities, mutual funds traded through a brokerage firm, and
limited partnership interests that trade on an exchange. Government
securities and stock options settle on the next business day
following the trade. In addition, Rule 15c6-1 prohibits broker-
dealers from effecting or entering into a contract for the purchase
or sale of a security that provides for payment of funds and
delivery of securities later than the third business day after the
date of the contract unless otherwise expressly agreed to by the
parties at the time of the transaction. 17 CFR 240.15c6-1; Exchange
Act Release No. 33023 (Oct. 7, 1993), 58 FR 52891 (Oct. 13, 1993).
However, failure to deliver securities on T+3 does not violate Rule
15c6-1.
    \5\ We have previously noted that abusive ``naked'' short
selling, while not defined in the federal securities laws generally
refers to selling short without having stock available for delivery
and intentionally failing to deliver stock within the standard three
day settlement cycle. See 2004 Regulation SHO Adopting Release, 69
FR at 48009, n.10; Exchange Act Release No. 56212 (Aug. 7, 2007), 72
FR at 45544, n.3 (Aug. 14, 2007) (``2007 Regulation SHO Final
Amendments''); Exchange Act Release No. 57511 (March 17, 2008), 73
FR 15376 (March 21, 2008) (``Naked Short Selling Anti-Fraud Rule
Proposing Release'').
    \6\ In 2003, the Commission settled a case against certain
parties relating to allegations of manipulative short selling in the
stock of Sedona Corporation. The Commission alleged that the
defendants profited from engaging in massive ``naked'' short selling
that flooded the market with Sedona stock, and depressed its price.
See Rhino Advisors, Inc. and Thomas Badian, Lit. Rel. No. 18003
(Feb. 27, 2003); see also, SEC v. Rhino Advisors, Inc. and Thomas
Badian, Civ. Action No. 03 civ 1310 (RO) (S.D.N.Y); see also,
Securities Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR
62972, 62975 (Nov. 6, 2003) (``2003 Regulation SHO Proposing
Release'') (describing the alleged activity in the case involving
stock of Sedona Corporation); 2004 Regulation SHO Adopting Release,
69 FR at 48016, n.76.
    \7\ According to the National Securities Clearing Corporation
(``NSCC''), 99% (by dollar value) of all trades settle on time.
Thus, on an average day, approximately 1% (by dollar value) of all
trades, including equity, debt, and municipal securities fail to
settle. The vast majority of these fails are closed out within five
days after T+3.
    \8\ These fails to deliver may arise from either short or long
sales of securities. There may be legitimate reasons for a fail to
deliver. For example, human or mechanical errors or processing
delays can result from transferring securities in custodial or other
form rather than book-entry form, thereby causing a fail to deliver
on a long sale within the normal three-day settlement period. In
addition, broker-dealers that make markets in a security (``market
makers'') and who sell short thinly-traded, illiquid stock in
response to customer demand may encounter difficulty in obtaining
securities when the time for delivery arrives. The Commission's
Office of Economic Analysis (``OEA'') estimates that, on an average
day between May 1, 2007 and July 31, 2008 (i.e., the time period
that includes all full months after the Commission started receiving
price data from NSCC), trades in ``threshold securities,'' as
defined in Rule 203(b)(c)(6) of Regulation SHO, that fail to settle
within T+3 account for approximately 0.3% of dollar value of trading
in all equity securities.
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    Although high fails levels exist only for a small percentage of
issuers,\9\ we believe that all sellers of securities should promptly
deliver, or arrange for delivery of, securities to the respective
buyer, and that all buyers of securities have a right to expect prompt
delivery of securities purchased. In addition, as we have stated on
several prior occasions, we are concerned about the negative effect
that fails to deliver may have on the markets and shareholders.\10\ For
example, fails to deliver may deprive shareholders of the benefits of
ownership, such as voting and lending.\11\ In addition, where a seller
of securities fails to deliver securities on settlement date, in effect
the seller unilaterally converts a securities contract (which is
expected to settle within the standard three-day settlement period)
into an undated futures-type contract, to which the buyer might not
have agreed, or that might have been priced differently.\12\
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    \9\ The average daily number of securities on a threshold list
(as defined infra note 22) in July 2008 was approximately 523
securities, which comprised 0.6% of all equity securities, including
those that are not covered by Regulation SHO. Regulation SHO's
close-out requirement applies to any equity security of an issuer
that is registered under Section 12 of the Exchange Act, or that is
required to file reports pursuant to Section 15(d) of the Exchange
Act.
    \10\ See 2007 Regulation SHO Final Amendments, 72 FR at 45544;
2006 Regulation SHO Proposed Amendments, 71 FR at 41712; Reproposal,
72 FR at 45558-45559; ``Naked'' Short Selling Anti-Fraud Rule
Proposing Release, 73 FR at 15378.
    \11\ See id.
    \12\ See id.
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    Moreover, sellers that fail to deliver securities on settlement
date may enjoy fewer restrictions than if they were required to deliver
the securities in a timely manner, and such sellers may attempt to use
this additional freedom to engage in trading activities that are
designed to improperly depress the price of a security.\13\ In
addition, by not borrowing securities and, therefore, not making
delivery within the standard three-day settlement period, the seller
avoids the costs of borrowing.
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    \13\ See Reproposal, 72 FR at 45559.
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    In addition, issuers and investors have repeatedly expressed
concerns about fails to deliver in connection with manipulative
``naked'' short selling. For example, in response to proposed
amendments to Regulation SHO in 2006 \14\ designed to further reduce
the number of persistent fails to deliver in certain equity securities
by eliminating Regulation SHO's ``grandfather'' provision, and limiting
the duration of the rule's options market maker exception, the
Commission received a number of comments that expressed concerns about
``naked'' short selling and extended delivery failures.\15\ Commenters
continued to express these concerns in response to the Reproposal.\16\
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    \14\ See 2006 Regulation SHO Proposed Amendments, supra note 1.
    \15\ See, e.g., letter from Patrick M. Byrne, Chairman and Chief
Executive Officer, Overstock.com, Inc., dated Sept. 11, 2006; letter
from Daniel Behrendt, Chief Financial Officer, and Douglas Klint,
General Counsel, TASER International, dated Sept. 18, 2006; letter
from John Royce, dated April 30, 2007; letter from Michael Read,
dated April 29, 2007; letter from Robert DeVivo, dated April 26,
2007 (``DeVivo''); letter from Ahmed Akhtar, dated April 26, 2007.
    \16\ See, e.g., letter from Jack M. Wedam, dated Oct. 16, 2007;
letter from Michael J. Ryan, Executive Director and Senior Vice
President, Center for Capital Markets Competitiveness, U.S. Chamber
of Commerce, dated Sept. 13, 2007 (``U.S. Chamber of Commerce'');
letter from Robert W. Raybould, CEO Enteleke Capital Corp., dated
Sept. 12, 2007 (``Raybould''); letter from Mary Helburn, Executive
Director, National Coalition Against Naked Shorting, dated Sept. 11,
2007 (``NCANS'').

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    To the extent that fails to deliver might be part of manipulative
``naked'' short selling, which could be used as a tool to drive down a
company's stock price,\17\ such fails to deliver may undermine the
confidence of investors.\18\ These investors, in turn, may be reluctant
to commit capital to an issuer they believe to be subject to such
manipulative conduct.\19\ In addition, issuers may believe that they
have suffered unwarranted reputational damage due to investors'
negative perceptions regarding fails to deliver in the issuer's
security.\20\ Unwarranted reputational damage caused by fails to
deliver might have an adverse impact on the security's price.\21\
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    \17\ See supra, note 6 (discussing a case in which we alleged
that the defendants profited from engaging in massive ``naked''
short selling that flooded the market with the company's stock, and
depressed its price); see also S.E.C. v. Gardiner, 48 S.E.C. Docket
811, No. 91 Civ. 2091 (S.D.N.Y. March 27, 1991) (alleged
manipulation by sales representative by directing or inducing
customers to sell stock short in order to depress its price); U.S.
v. Russo, 74 F.3d 1383, 1392 (2d Cir. 1996) (short sales were
sufficiently connected to the manipulation scheme as to constitute a
violation of Exchange Act Section 10(b) and Rule 10b-5).
    \18\ In response to the Reproposal, we received comment letters
discussing the impact of fails to deliver on investor confidence.
See, e.g., letter from NCANS. Commenters expressed similar concerns
in response to the 2006 Regulation SHO Proposed Amendments. See,
e.g., letter from Mary Helburn, Executive Director, National
Coalition Against Naked Shorting, dated Sept. 30, 2006 (``NCANS
2006''); letter from Richard Blumenthal, Attorney General, State of
Connecticut, dated Sept. 19, 2006 (``Blumenthal'').
    \19\ In response to the Reproposal, we received comment letters
expressing concern about the impact of potential ``naked'' short
selling on capital formation, claiming that ``naked'' short selling
causes a drop in an issuer's stock price and may limit the issuer's
ability to access the capital markets. See, e.g., letter from Robert
K. Lifton, Chairman and CEO, Medis Technologies, Inc., dated Sept.
12, 2007 (``Medis''); letter from NCANS. Commenters expressed
similar concerns in response to the 2006 Regulation SHO Proposed
Amendments. See, e.g., letter from Congressman Tom Feeney--Florida,
U.S. House of Representatives, dated Sept. 25, 2006 (``Feeney'');
see also letter from Zix Corporation, dated Sept. 19, 2006 (``Zix'')
(stating that ``[m]any investors attribute the Company's frequent
re-appearances on the Regulation SHO list to manipulative short
selling and frequently demand that the Company ``do something''
about the perceived manipulative short selling. This perception that
manipulative short selling of the Company's securities is
continually occurring has undermined the confidence of many of the
Company's investors in the integrity of the market for the Company's
securities.'').
    \20\ Due in part to such concerns, some issuers have taken
actions to attempt to make transfer of their securities ``custody
only,'' thus preventing transfer of their stock to or from
securities intermediaries such as the Depository Trust Company
(``DTC'') or broker-dealers. See Exchange Act Release No. 48709
(Oct. 28, 2003), 68 FR 62972, at 62975 (Nov. 6, 2003). Some issuers
have attempted to withdraw their issued securities on deposit at
DTC, which makes the securities ineligible for book-entry transfer
at a securities depository. See id. Withdrawing securities from DTC
or requiring custody-only transfers would undermine the goal of a
national clearance and settlement system that is designed to reduce
the physical movement of certificates in the trading markets. See
id. We note, however, that in 2003 the Commission approved a DTC
rule change clarifying that its rules provide that only its
participants may withdraw securities from their accounts at DTC, and
establishing a procedure to process issuer withdrawal requests. See
Securities Exchange Act Release No. 47978 (June 4, 2003), 68 FR
35037 (June 11, 2003).
    \21\ See 2006 Regulation SHO Proposed Amendments, 71 FR at
41712; 2007 Regulation SHO Final Amendments, 72 FR at 45544;
Reproposal, 72 FR at 45558-45559; ``Naked'' Short Selling Anti-Fraud
Rule Proposing Release, 73 FR at 15378 (providing additional
discussion of the impact of fails to deliver on the market); see
also 2003 Regulation SHO Proposing Release, 68 FR at 62975
(discussing the impact of ``naked'' short selling on the market).
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B. Amendments to Regulation SHO's Close-Out Requirement

    Regulation SHO's close-out requirement, which is contained in Rule
203(b)(3) of Regulation SHO, applies only to securities in which a
substantial amount of fails to deliver have occurred (also known as
``threshold securities'').\22\ Specifically, the close-out requirement
requires a participant of a clearing agency registered with the
Commission \23\ to take immediate action to close out a fail to deliver
position in a threshold security in the Continuous Net Settlement
(``CNS'') \24\ system that has persisted for 13 consecutive settlement
days by purchasing securities of like kind and quantity.\25\ In
addition, if the failure to deliver has persisted for 13 consecutive
settlement days, Rule 203(b)(3)(iv) prohibits the participant, and any
broker-dealer for which it clears transactions, including market
makers, from accepting any short sale orders or effecting further short
sales in the particular threshold security without borrowing, or
entering into a bona-fide arrangement to borrow, the security until the
participant closes out the fail to deliver position by purchasing
securities of like kind and quantity.\26\
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    \22\ A threshold security is defined in Rule 203(c)(6) as any
equity security of an issuer that is registered pursuant to section
12 of the Exchange Act (15 U.S.C. 78l) or for which the issuer is
required to file reports pursuant to section 15(d) of the Exchange
Act (15 U.S.C. 78o(d)): (i) For which there is an aggregate fail to
deliver position for five consecutive settlement days at a
registered clearing agency of 10,000 shares or more, and that is
equal to at least 0.5% of the issue's total shares outstanding; and
(ii) that is included on a list (``threshold securities list'')
disseminated to its members by a self-regulatory organization
(``SRO''). See 17 CFR 242.203(c)(6). Currently, each SRO provides
the threshold securities list for those securities for which the SRO
is the primary market.
    \23\ For purposes of Regulation SHO, the term ``participant''
has the same meaning as in section 3(a)(24) of the Exchange Act. See
15 U.S.C. 78c(a)(24). The term ``registered clearing agency'' means
a clearing agency, as defined in section 3(a)(23) of the Exchange
Act, that is registered as such pursuant to section 17A of the
Exchange Act. See 15 U.S.C. 78c(a)(23)(A), 78q-1 and 15 U.S.C. 78q-
1(b), respectively. See also 2004 Regulation SHO Adopting Release,
69 FR at 48031. As of July 31, 2008 approximately 91% of
participants of the NSCC, the primary registered clearing agency
responsible for clearing U.S. transactions, were registered as
broker-dealers. Those participants not registered as broker-dealers
include such entities as banks, U.S.-registered exchanges, and
clearing agencies. Although these entities are participants of a
registered clearing agency, generally these entities do not engage
in the types of activities that would implicate the close-out
requirements of Regulation SHO. Such activities of these entities
include creating and redeeming Exchange Traded Funds, trading in
municipal securities, and using NSCC's Envelope Settlement Service
or Inter-city Envelope Settlement Service. These activities rarely
lead to fails to deliver and, if fails to deliver do occur, they are
small in number and are usually closed out within a day. Thus, such
fails to deliver would not trigger the close-out provisions of
Regulation SHO.
    \24\ The majority of equity trades in the United States are
cleared and settled through systems administered by clearing
agencies registered with the Commission. The NSCC clears and settles
the majority of equity securities trades conducted on the exchanges
and over the counter. NSCC clears and settles trades through the CNS
system, which nets the securities delivery and payment obligations
of all of its members. NSCC notifies its members of their securities
delivery and payment obligations daily. In addition, NSCC guarantees
the completion of all transactions and interposes itself as the
contraparty to both sides of the transaction. While NSCC's rules do
not authorize it to require member firms to close out or otherwise
resolve fails to deliver, NSCC reports to the SROs those securities
with fails to deliver of 10,000 shares or more. The SROs use NSCC
fails data to determine which securities are threshold securities
for purposes of Regulation SHO.
    \25\ 17 CFR 242.203(b)(3).
    \26\ Id. at (b)(3)(iv). It is possible under Regulation SHO that
a close out by a participant of a registered clearing agency may
result in a fail to deliver position at another participant if the
counterparty from which the participant purchases securities fails
to deliver. However, Regulation SHO prohibits a participant of a
registered clearing agency, or a broker-dealer for which it clears
transactions, from engaging in ``sham close outs'' by entering into
an arrangement with a counterparty to purchase securities for
purposes of closing out a fail to deliver position and the purchaser
knows or has reason to know that the counterparty will not deliver
the securities, and which thus creates another fail to deliver
position. See id. at (b)(3)(vii); 2004 Regulation SHO Adopting
Release, 69 FR at 48018 n.96. In addition, we note that borrowing
securities, or otherwise entering into an arrangement with another
person to create the appearance of a purchase would not satisfy the
close-out requirement of Regulation SHO. For example, the purchase
of paired positions of stock and options that are designed to create
the appearance of a bona fide purchase of securities but that are
nothing more than a temporary stock lending arrangement would not
satisfy Regulation SHO's close-out requirement.
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    As adopted in August 2004, Rule 203(b)(3) of Regulation SHO
included two exceptions to the mandatory close-out requirement. The
first was the ``grandfather'' provision, which excepted fails to
deliver established prior to a security becoming a threshold
security.\27\ The second was the ``options

market maker exception,'' which excepted any fail to deliver in a
threshold security resulting from short sales effected by a registered
options market maker to establish or maintain a hedge on options
positions that were created before the underlying security became a
threshold security.\28\
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    \27\ See 2004 Regulation SHO Adopting Release, 69 FR at 48031.
The ``grandfathered'' status applied in two situations: (i) To fail
to deliver positions occurring before January 3, 2005, Regulation
SHO's effective date; and (ii) to fail to deliver positions that
were established on or after January 3, 2005 but prior to the
security appearing on a threshold securities list.
    \28\ See 2004 Regulation SHO Adopting Release, 69 FR at 48031.
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    At the time of Regulation SHO's adoption, the Commission stated
that it would monitor the operation of Regulation SHO to determine
whether grandfathered fail to deliver positions were being cleared up
under the existing delivery and settlement guidelines or whether any
further regulatory action with respect to the close out provisions of
Regulation SHO was warranted.\29\ In addition, with respect to the
options market maker exception, the Commission noted that it would take
into consideration any indications that this provision was operating
significantly differently from the Commission's original
expectations.\30\
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    \29\ See id. at 48018.
    \30\ See id. at 48019.
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    Based, in part, on the results of examinations conducted by the
Commission's staff and the SROs since Regulation SHO's adoption, as
well as the persistence of certain securities on threshold securities
lists, on July 14, 2006, the Commission proposed amendments to
Regulation SHO,\31\ which were intended to reduce the number of
persistent fails to deliver in certain equity securities by eliminating
the ``grandfather'' provision and narrowing the options market maker
exception contained in that rule. In addition, in March 2007, the
Commission re-opened the comment period to the 2006 Regulation SHO
Proposed Amendments for thirty days to provide the public with an
opportunity to comment on a summary of the National Association of
Securities Dealers, Inc.'s (``NASD's'') (n/k/a Financial Industry
Regulatory Authority, Inc.) analysis that the NASD had submitted to the
public file on March 12, 2007. In addition, the notice regarding the
re-opening of the comment period directed the public's attention to
summaries of data collected by the Commission's Office of Compliance
Inspections and Examinations and the New York Stock Exchange LLC
(``NYSE'').\32\
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    \31\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
    \32\ See Securities Exchange Act Release No. 55520 (March 26,
2007), 72 FR 15079 (March 30, 2007) (``2007 Regulation SHO Re-
Opening Release'').
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    On June 13, 2007, we approved the adoption of the amendment, as
proposed, to eliminate the ``grandfather'' provision of Regulation
SHO.\33\ With respect to the options market maker exception, however,
in response to comments to the 2006 Regulation SHO Proposed Amendments,
we reproposed amendments to eliminate the exception.\34\ In addition,
the Commission sought comment on two alternative proposals that would
require options market maker fails to deliver to be closed out within
specific time-frames.\35\ The Reproposal also included an amendment to
Regulation SHO that would require brokers-dealers marking a sale as
``long'' to document the present location of the securities being sold.
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    \33\ See 2007 Regulation SHO Final Amendments, 72 FR 45544.
    \34\ See Reproposal, 72 FR 45558.
    \35\ See id.
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    We received over 1,000 comment letters in response to the
Reproposal.\36\ Some commenters urged the Commission to obtain
empirical data to demonstrate the relationship between fails to deliver
and the options market maker exception before determining whether
additional rulemaking was necessary.\37\ In particular, commenters
urged the Commission to obtain data relating to the impact of the
elimination of the ``grandfather'' provision and connecting fails to
deliver to the options market maker exception.\38\ In response, the
Commission staff obtained data from SROs, options market makers, and
clearing agency participants that shows extensive use of the options
market maker exception to Regulation SHO's close-out requirement and
the resulting fails to deliver that were not closed out during 2006,
2007, and 2008. In addition, OEA provided data which indicates that
since the elimination of the ``grandfather'' provision, fails to
deliver in threshold securities with options traded on them
(``optionable threshold securities'') have increased significantly. The
Commission made this data available to the public for review and
comment by including it in a Commission release and re-opening the
comment period to the Reproposal on July 7, 2008.\39\ The comment
period ended on August 13, 2008.
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    \36\ The comment letters are available on the Commission's
Internet Web Site at http://www.sec.gov/comments/s7-19-07/
s71907.shtml.
    \37\ See, e.g., Comments of Keith F. Higgins, Committee on
Federal Regulation of Securities, American Bar Association, Section
of Business Law, dated Oct. 5, 2007 (``ABA''); comments of John
Gilmartin and Ben Londergan, Group One Trading, LP, dated Sept. 28,
2007; see also comments of Gerald D. O'Connell, Susquehanna
Investment Group, dated Oct. 11, 2007 (``Susquehanna'').
    \38\ See letter from ABA.
    \39\ See 2008 Regulation SHO Re-Opening Release, 73 FR 40201.
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    As discussed below, after considering the comments received, the
data, and the purposes underlying Regulation SHO, we are adopting
amendments to eliminate the options market maker exception, as
proposed.\40\ At this time, we are not acting on the proposed
amendments to Rule 200(g) of Regulation SHO regarding long sale
documentation. Instead, in a companion release we have adopted a
``naked'' short selling anti-fraud rule that, in part, targets sellers'
representations regarding long sales.\41\ In addition, we note that we
have adopted an interim final temporary rule, Rule 204T, which
strengthens the delivery requirements for sales of all equity
securities.\42\ Under temporary Rule 204T, fail to deliver positions
resulting from short sales of all equity securities by options market
makers must be closed out by no later than the beginning of regular
trading hours on the settlement day after the fail to deliver position
occurs.\43\ In conjunction with these short sale-related initiatives,
and our goal of further reducing fails to deliver and

addressing potentially abusive ``naked'' short selling, we believe that
we must eliminate Regulation SHO's options market maker exception.
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    \40\ On September 17, 2008, we issued an emergency order
pursuant to Section 12(k)(2) of the Exchange Act in which we adopted
and made immediately effective the elimination of the options market
maker exception to Regulation SHO's close-out requirement. See
Exchange Act Release No. 58572 (Sept. 17, 2008) (the ``September
Emergency Order''). The September Emergency Order expires on October
17, 2008. This release makes permanent the amendments to Rule
203(b)(3) of Regulation SHO contained in the September Emergency
Order.
    \41\ See Exchange Act Release No. 58774 (Oct. 14, 2008); see
also, September Emergency Order, supra note 40 (adopting and making
immediately effective Rule 10b-21, a ``naked'' short selling anti-
fraud rule).
    \42\ See Exchange Act Release No. 58773 (Oct. 14, 2008)
(``Interim Final Temporary Rule''); see also, September Emergency
Order, supra note 40 (adding to Regulation SHO, and making
immediately effective, temporary Rule 204T, imposing enhanced
delivery requirements for sales of all equity securities).
    \43\ See id. The Interim Final Temporary Rule includes a limited
exception from its delivery requirements for registered market
makers, options market makers, or other market makers obligated to
quote in the over-the-counter market. Specifically, temporary Rule
204T(a)(3) provides that if a participant of a registered clearing
agency has a fail to deliver position at a registered clearing
agency in any equity security that is attributable to bona fide
market making activities by a registered market maker, options
market maker, or other market maker obligated to quote in the over-
the-counter market, the participant shall, by no later than the
beginning of regular trading hours on the third consecutive
settlement day following the settlement date, immediately close out
the fail to deliver position by purchasing securities of like kind
and quantity.
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III. Options Market Maker Exception

A. Discussion of Comments to the Reproposal and 2008 Regulation SHO Re-
Opening Release

    The Commission received comment letters from numerous entities,
including issuers, individual retail investors, options market makers,
SROs, elected officials, and academics.\44\ Although the comment
letters are publicly available to be read in their entirety, we
highlight below some of the main issues, concerns, and suggestions
raised in the letters.
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    \44\ See, e.g., letter from Patrick M. Byrne, Chairman and Chief
Executive Officer, Overstock.com, Inc., dated Oct. 1, 2007
(``Overstock''); letter from NCANS; letter from James H. Bramble,
Vice President & General Counsel, USANA Health Sciences, Inc., dated
Aug. 31, 2007 (``USANA''); letter from Paul Rivett, Vice President
and Chief Legal Officer, Fairfax Financial Holdings, Ltd., dated
Sept. 12, 2007 (``Fairfax Financial''); letter from Medis; letter
from U.S. Chamber of Commerce; letter from Thomas Vallarino, dated
Sept. 17, 2007; letter from Mark L. Shurtleff, Attorney General,
State of Utah, dated Sept. 13, 2007; James J. Angel, Ph.D., CFA,
Associate Professor of Finance, Georgetown University, dated Sept.
10, 2007 (``Angel''); letter from Ira D. Hammerman, Senior Vice
President and General Counsel, SIFMA, dated Sept. 26, 2007
(``SIFMA''); letter from ABA; letter from Edward J. Joyce, President
and Chief Operating Officer, Chicago Board Options Exchange, dated
Sept. 17, 2007 (``CBOE''); letter from Gerard S. Citera, Chadbourne
& Parke LLP, dated Sept. 13, 2007 (``UBS''); letter from Charles
Mogilevsky, Managing Director, Citigroup Derivatives Markets, Inc.,
dated Sept. 14, 2007 (``Citigroup''); letter from The American Stock
Exchange, Boston Options Exchange, CBOE, International Securities
Exchange, NYSE/Arca, The Options Clearing Corporation, Philadelphia
Stock Exchange, dated Sept. 19, 2007 (``Options Exchanges''); letter
from Susquehanna.
---------------------------------------------------------------------------

    Several commenters supported the proposal to eliminate the options
market maker exception. One commenter stated that it believes that the
current options market maker exception ``harms investors and issuers,
hinders the formation of capital, and is fatally flawed as written''
and that it should be eliminated.\45\ Another commenter stated that the
options market maker exception ``is a well known tool of manipulators
and must be removed to ensure a level playing field for public
companies and their shareholders.'' \46\ One commenter that supported
the amendments noted that ``options market makers should factor the
cost of borrowing stock and selling short into the price of the put
options being sold.'' \47\ Commenters also stated that 13 consecutive
settlement days was more than sufficient to close out a fail to deliver
relating to an options position.\48\
---------------------------------------------------------------------------

    \45\ See letter from NCANS.
    \46\ See letter from USANA; see also letter from Fairfax
Financial (stating that the exception should be eliminated due to
its ``detrimental impact on issuers and their shareholders and also
because such exception is susceptible to significant abuse'').
    \47\ See letter from Fairfax Financial.
    \48\ See, e.g., letter from U.S. Chamber of Commerce.
---------------------------------------------------------------------------

    Commenters who opposed the proposed amendments generally criticized
the impact of elimination on options market making risk, quote depths,
spread widths, and market liquidity in threshold securities and
securities that might become threshold securities. Among other things,
they stated that the options market maker exception is integral to the
options market maker's ability to make markets and manage risk and
that, without the exception, making continuous markets would be very
difficult, particularly in longer-dated options.\49\ One commenter
suggested that ``withdrawing or greatly reducing the exception would
cause varying losses of liquidity in over 20% of listed options and
their underlying stocks.'' \50\ Another commenter stated that ``[i]f
the exception is eliminated or narrowed in the manner proposed, [it]
anticipates [options market makers] would be reluctant or even unable
to effectively make markets on securities if they cannot be certain of
their ability to establish and maintain an effective hedge and manage
their risk through selling stock.'' \51\ Another commented that ``[t]he
uncertainty, time, processing and expense necessary to pre-borrow when
effecting a short sale, as well as the uncertainty and expense caused
by a close out of a hedge, will by its nature adversely affect the
[options market makers'] pricing of the option.'' \52\
---------------------------------------------------------------------------

    \49\ See letter from CBOE.
    \50\ See letter from Susquehanna.
    \51\ See id; see also letter from Options Exchanges; Citigroup.
    \52\ See letter from Citigroup.
---------------------------------------------------------------------------

    Some commenters who opposed elimination of the exception argued
that options market makers, unlike equity market makers, should have an
exception to Regulation SHO's close-out requirement because there are
distinct differences between options market making and market making in
the underlying stock. For example, one commenter stated that the risk
to an options market maker of trading options on a threshold security
is higher than that of a stock specialist because in the equity markets
there is often a natural flow of buyers and sellers to trade against
each other without the stock specialist having to take a position.\53\
According to the commenter, options market makers routinely have to
take the other side of customer trades in the options transaction and
must hedge the residual risk. This commenter also noted that when an
options market maker must close out a fail to deliver position, it may
have to worry about the risk and exposure for the options positions
that were previously offset by the stock position.
---------------------------------------------------------------------------

    \53\ See letter from CBOE.
---------------------------------------------------------------------------

    Other commenters stated that equity market makers ``can freely
hedge an equity position in a threshold security with a short options
position, but, if the options market maker exception is eliminated,
options market makers would face restrictions in their ability to hedge
options positions with the underlying equity.'' \54\ These commenters
stated that the ability to keep open a fail to deliver position is
particularly important with longer-term options positions where the
options market maker must maintain the hedge for extended periods of
time.\55\ In such circumstances, these commenters stated that often the
only available and/or economically feasible hedge is the underlying
security.
---------------------------------------------------------------------------

    \54\ See letter from Options Exchanges.
    \55\ See, e.g., letter from Citigroup.
---------------------------------------------------------------------------

    Some commenters also stated that the one-time 35 consecutive
settlement day phase-in period was ``particularly troubling because it
would not be sufficient to account for pre-existing options positions
that were assumed in reliance on the [options market maker
exception].'' \56\ In particular, these commenters expressed concerns
about increased costs and risks associated with having to close out
previously-exempted fails to deliver relating to the hedging of longer-
term options positions, such as Long-term Equity Anticipation
Securities (``LEAPS''),\57\ that were not anticipated at the time the
options positions were originally taken.\58\
---------------------------------------------------------------------------

    \56\ See letter from CBOE; see also letter from Options
Exchanges.
    \57\ LEAPS are long-term stock or index options. LEAPS, like all
options, are available in two types, calls and puts, with expiration
dates up to three years in the future. See http://www.cboe.com/
LearnCenter/glossary_g-l.aspx#L (defining LEAPS).
    \58\ See, e.g., letter from CBOE; Options Exchanges; Citigroup.
---------------------------------------------------------------------------

    Some commenters also opposed the proposed alternatives. For
example, one commenter stated that the ``35-day window afforded options
market makers to fail would simply create opportunities for
sophisticated market participants to employ complex derivative
strategies to roll failed positions from one period to the next.'' \59\
Other commenters preferred the proposed 35 day close out

alternative to elimination of the options market maker exception.\60\
Some commenters, however, requested that the Commission extend the
proposed alternative 35 day close-out requirement to 42 days \61\ or
even 45 days,\62\ to allow for 2 options expirations before a fail to
deliver position must be closed out.
---------------------------------------------------------------------------

    \59\ See letter from Overstock.
    \60\ See, e.g., letter from CBOE; Options Exchanges; UBS.
    \61\ See, e.g., letter from CBOE; Options Exchanges.
    \62\ See letter from Susquehanna.
---------------------------------------------------------------------------

    We also received a number of comment letters in response to the
2008 Regulation SHO Re-Opening Release, most of which urged the
Commission to take action on the proposed amendments to eliminate the
options market maker exception.\63\ In contrast, one commenter noted
that it does not believe that there is evidence of a significant
problem with extended fails to deliver or, if such a problem exists,
evidence that it is attributable to the options market maker
exception.\64\ In addition, this commenter stated that it believes
``[t]he perceived benefits of modifying the exception * * * would not
outweigh the costs associated and burden placed on OMMs and options
market they support.'' \65\
---------------------------------------------------------------------------

    \63\ Comment letters are available on the Commission's Internet
Web site at http://www.sec.gov/comments/s7-19-07/s71907.shtml.
    \64\ See letter from Edward J. Joyce, President and Chief
Operating Officer, Chicago Board Options Exchange, dated Aug. 15,
2008 (``CBOE 2008'').
    \65\ See id.
---------------------------------------------------------------------------

    As discussed in detail below, although we recognize commenters'
concerns that elimination of the options market maker exception may
place costs and burdens on options market makers, we believe that such
potential effects are justified by the benefits that are expected to
result from requiring that all fails to deliver in threshold securities
be closed out within specific time-frames rather than being allowed to
continue indefinitely.

B. Discussion of Amendments

    After careful consideration of the comments, we are adopting
amendments to eliminate the options market maker exception to
Regulation SHO's close-out requirement. Specifically, as a result of
the amendments, all fails to deliver in a threshold security resulting
from short sales by a registered options market maker effected to
establish or maintain a hedge on options positions established before
the security became a threshold security will, like all other fails to
deliver in threshold securities, have to be closed out in accordance
with the close-out requirements of Regulation SHO.\66\
---------------------------------------------------------------------------

    \66\ Accordingly, the amendments remove the options market maker
exception from Rule 203(b)(3)(iii) of Regulation SHO, as adopted. We
note that we have adopted on an interim final temporary basis,
temporary Rule 204T that strengthens the delivery requirements of
Regulation SHO for sales of all equity securities such that fails to
deliver must be closed out by no later than the beginning of regular
trading hours on the settlement day following the day the
participant incurred the fail to deliver position. The temporary
rule has a limited exception from this close-out requirement for
options market makers. See Interim Final Temporary Rule, supra at
notes 42 and 43.
---------------------------------------------------------------------------

    The amendments include a one-time 35 consecutive settlement day
phase-in period, as proposed.\67\ Under this provision of the
amendments, any previously excepted fail to deliver position in a
threshold security on the effective date of the amendments, including
any adjustments to that fail to deliver position, must be closed out
within 35 consecutive settlement days of the effective date of the
amendments.\68\ We chose 35 settlement days because 35 days was used in
Regulation SHO as adopted in August 2004, and in Regulation SHO, as
amended.\69\
---------------------------------------------------------------------------

    \67\ See Adopted Rule 203(b)(3)(iii).
    \68\ If the security is a threshold security on the effective
date of the amendments, participants of a registered clearing agency
will have to close out that position within 35 consecutive
settlement days, regardless of whether the security becomes a non-
threshold security after the effective date of the amendments.
    \69\ See 2004 Regulation SHO Adopting Release, 69 FR at 48031;
2007 Regulation SHO Final Amendments, 72 FR at 45557.
---------------------------------------------------------------------------

    In the September Emergency Order, we adopted and made immediately
effective the elimination of the options market maker exception to
Regulation SHO's close-out requirement.\70\ Thus, if there was a fail
to deliver position at a registered clearing agency in a security that
was a threshold security on the effective date of the September
Emergency Order, participants of a registered clearing agency had to
close out that position within 35 consecutive settlement days,
regardless of whether the security became a non-threshold security
after the effective date of the September Emergency Order. Because this
release makes the elimination of the options market maker exception as
set forth in the September Emergency Order permanent, and because the
amendments contained in this release are effective on the expiration
date of the September Emergency Order (i.e., October 17, 2008), any
fails to deliver in threshold securities that were being closed out
pursuant to the 35 consecutive settlement day phase-in period as set
forth in the September Emergency Order will not receive an additional
35 consecutive settlement days from October 17, 2008 in which to be
closed out. Instead, the 35 consecutive settlement days will continue
to run from the effective date of the September Emergency Order. Any
fails to deliver in securities that became threshold securities after
the effective date of the September Emergency Order and that are still
threshold securities on the effective date of these amendments, must be
closed out in accordance with the current close-out requirements of
Regulation SHO, rather than within 35 consecutive settlement days of
the effective date of these amendments.\71\
---------------------------------------------------------------------------

    \70\ See supra note 40.
    \71\ For the duration of temporary Rule 204T, fails to deliver
in all equity securities, regardless of whether or not the security
is a threshold security, must be closed out in accordance with the
requirements of the temporary rule.
---------------------------------------------------------------------------

    Although, as noted above, some commenters stated that the one-time
35 consecutive settlement day phase-in period was ``particularly
troubling because it would not be sufficient to account for pre-
existing options positions that were assumed in reliance on the
[options market maker exception]'' \72\, we believe that a 35
consecutive settlement day phase-in period allows participants
sufficient time to close out any previously excepted fail to deliver
positions with limited disruption to the market and helps foster market
stability because it provides participants with a sufficient length of
time to effect purchases to close out these positions in an orderly
manner.
---------------------------------------------------------------------------

    \72\ See, e.g., letter from CBOE.
---------------------------------------------------------------------------

    We are also adopting our proposal that if the fail to deliver
position persists for 35 consecutive settlement days from the effective
date of the amendment, a participant of a registered clearing agency
(and any broker-dealer for which it clears transactions, including any
market maker), is prohibited from accepting any short sale orders or
effecting further short sales in the particular threshold security
without borrowing, or entering into a bona-fide arrangement to borrow,
the security until the participant closes out the entire fail to
deliver position by purchasing securities of like kind and
quantity.\73\ Due to the requirements of the September Emergency Order,
this provision of the amendments is applicable to those fails to
deliver that may be closed out within 35 consecutive settlement days of
the effective date of the September Emergency Order but are not closed
out within that time-frame.
---------------------------------------------------------------------------

    \73\ See Adopted Rule 203(b)(3)(v).

---------------------------------------------------------------------------

    If a security becomes a threshold security after the effective date
of the amendments, any fails to deliver that result or resulted from
short sales effected by a registered options market maker to establish
or maintain a hedge on options positions that were created before the
security became a threshold security will be subject to Regulation
SHO's close-out requirements, similar to any other fail to deliver
position in a threshold security.\74\
---------------------------------------------------------------------------

    \74\ See 17 CFR 242.203(b)(3); see also Interim Final Temporary
Rule, supra notes 42 and 43 (amending Regulation SHO to strengthen
the delivery requirements for sales of all equity securities).
---------------------------------------------------------------------------

    We believe that it is appropriate to eliminate Regulation SHO's
options market maker exception because substantial levels of fails to
deliver continue to persist in threshold securities and it appears that
a significant number of these fails to deliver are as a result of the
options market maker exception.\75\ As noted above, the Commission
staff obtained data from SROs, options market makers, and clearing
agency participants that shows extensive use of the options market
maker exception to Regulation SHO's close-out requirement and the
resulting fails to deliver that were not closed out during 2006, 2007,
and 2008.\76\ For example, the data showed that as of January 31, 2008,
a participant that settles and clears for a large segment of the
options market claimed the options market maker exception to the close-
out requirement in 16 threshold securities for a total of 6,365,158
fails to deliver. As of February 29, 2008, the data indicated that this
participant claimed the options market maker exception in 20 threshold
securities for a total of 6,963,949 fails to deliver. In addition,
according to data provided by FINRA for 2007 relating to a participant
that settles and clears for a large segment of the options market, fail
to deliver positions not closed out by the participant due to it
claiming the options market maker exception ranged from 35,655 fails to
deliver in one month that year, to as much as 5,621,982 in another
month that year. According to a review conducted by several SROs
between May to July 2006, there were 598 exceptions claimed, covering
58 threshold securities for a total of 11,759,799 fails to deliver.\77\
---------------------------------------------------------------------------

    \75\ See 2008 Regulation SHO Re-Opening Release, 73 FR 40201.
    \76\ See id.
    \77\ See id.
---------------------------------------------------------------------------

    In addition, following the elimination of the ``grandfather''
exception to Regulation SHO's close-out requirement, data collected by
OEA indicates that although fails to deliver overall decreased
slightly, fails to deliver in optionable threshold securities increased
significantly. The ``grandfather'' exception was eliminated as of
October 15, 2007 with a one-time phase in period which expired on
December 5, 2007. The sample data used by OEA compares two time
periods: April 9, 2007-October 14, 2007, which is defined as the ``pre-
amendment period'' and December 10, 2007-March 31, 2008, which is
defined as the ``post-amendment period.'' Specifically, the results of
OEA's analysis of fails to deliver before and after the elimination of
Regulation SHO's ``grandfather'' exception show that: \78\
---------------------------------------------------------------------------

    \78\ See id; see also Memorandum from the Commission's Office of
Economic Analysis (dated June 9, 2008), which is available on the
Commission's Internet Web site at http://www.sec.gov/comments/s7-19-
07/s71907-562.pdf (the ``OEA Memorandum'').
---------------------------------------------------------------------------

     The average daily number of optionable threshold
securities increased by 25.0%.
     The average daily number of new fail to deliver positions
in optionable threshold securities increased by 45.3%.
     For fails aged more than 17 days in optionable threshold
securities, the average daily dollar value of fails to deliver
increased by 73.4%.
     For fails aged more than 17 days in optionable threshold
securities, the average daily number of fail to deliver positions
increased by 30.7%.
     The average daily number of optionable threshold
securities with fails aged more than 17 days increased by 40.9%.
    The data shows a 25 percent increase in the number of optionable
threshold securities and a substantial increase in fails to deliver in
optionable threshold securities when comparing the pre- and post-
amendment periods. As the OEA Memorandum notes ``[o]ne explanation of
these results is that the investors who previously failed to deliver in
the equity market have now moved to the options market to establish a
synthetic position. Since the option market makers still enjoy an
exception to the close-out rule and tend to hedge their positions in
the equity markets, the fails may now be coming from the option market
makers instead of the equity investors themselves.'' \79\
---------------------------------------------------------------------------

    \79\ See OEA Memorandum.
---------------------------------------------------------------------------

    As discussed above, commenters opposing the proposed amendments
criticized the impact of the proposals on options market making risk,
quote depths, spread widths, and market liquidity, particularly in
threshold securities and securities that might become threshold
securities.\80\ Although we recognize these commenters' concerns
regarding a mandatory close-out requirement for fails to deliver in
threshold securities underlying options positions, for the reasons
outlined below, we believe these potential effects are justified by the
benefits of requiring that fails to deliver in all threshold securities
be closed out within specific time-frames rather than being allowed to
continue indefinitely. In addition, we believe the overall market
impact of these potential effects, if any, will be minimal.
---------------------------------------------------------------------------

    \80\ See, e.g., letter from Citigroup.
---------------------------------------------------------------------------

    First, as discussed above, large and persistent fails to deliver
can deprive shareholders of the benefits of ownership, such as voting
and lending. They can also be indicative of potentially manipulative
conduct, such as abusive ``naked'' short selling. The deprivation of
the benefits of ownership, as well as the perception that abusive
``naked'' short selling is occurring in certain securities, can
undermine the confidence of investors. These investors, in turn, may be
reluctant to commit capital to an issuer they believe to be subject to
manipulative conduct.
    In the Reproposal, we sought comment on whether the proposed
amendments would promote capital formation, including whether the
proposed increased short sale restrictions would affect investors'
decisions to invest in certain equity securities. Commenters expressed
concern about ``naked'' short selling causing a drop in an issuer's
stock price and that it may limit an issuer's ability to access the
capital markets.\81\ We believe that, by requiring that all fails to
deliver in threshold securities be closed out within specific time-
frames rather than allowing them to continue indefinitely, there will
be a decrease in the number of threshold securities with persistent and
high levels of fails to deliver. If persistence on the threshold
securities lists leads to an unwarranted decline in investor confidence
about the security, the amendments should improve investor confidence
about the security.\82\ We also believe that the amendments should lead
to greater certainty in the settlement of securities which should
strengthen investor confidence in the settlement process. The reduction
in fails to deliver and the resulting reduction in the number of
securities on the threshold securities

lists could result in increased investor confidence.
---------------------------------------------------------------------------

    \81\ See supra note 19.
    \82\ See letter from Overstock.
---------------------------------------------------------------------------

    Thus, by eliminating the options market maker exception so that all
fails to deliver in threshold securities that result from short sales
effected to maintain or establish a hedge on options positions will
have to be closed out in accordance with Regulation SHO's close-out
requirements, we expect a reduction in the number of threshold
securities with large and persistent fails to deliver and, thereby,
offsetting any potential negative impact of such fails to deliver on
the market for these securities.\83\
---------------------------------------------------------------------------

    \83\ See 17 CFR 242.203(b)(3); see also Interim Final Temporary
Rule, supra notes 42 and 43 (amending Regulation SHO to strengthen
the delivery requirements for sales of all equity securities).
---------------------------------------------------------------------------

    Second, while we recognize commenters' concerns that on a security-
by-security basis the impact on options market maker costs, liquidity,
quote depths, and spread widths may vary considerably, and in some
cases, might be large,\84\ we believe the overall market impact of the
amendments will be minimal because the number of securities that will
be impacted by the amendments will be relatively small. As previously
noted by one commenter, a small number of securities that meet the
definition of a ``threshold security'' have listed options, and those
securities form a very small percentage of all securities that have
options traded on them.\85\ In addition, OEA estimates that in July
2008, 451 (13.6%) of the 3,326 securities with options classes trading
on at least one options market appeared on a threshold securities list
for at least one day that month. Even though these securities may form
a small percentage of all securities that have options traded on them,
we are still concerned that these fails to deliver can have a
disproportionate impact on the markets and shareholders.
---------------------------------------------------------------------------

    \84\ See, e.g., letter from Options Exchanges.
    \85\ For example, in its letter, Susquehanna noted that in June
2007, 174 (8%) of the 2,242 stocks with options classes trading on
the CBOE, appeared on a threshold list for at least one day that
month. See letter from Susquehanna.
---------------------------------------------------------------------------

    Moreover, the options market maker exception only excepted from
Regulation SHO's mandatory 13 consecutive settlement day close-out
requirement those fail to deliver positions resulting from short sales
effected by registered options market makers to establish or maintain a
hedge on options positions established before the underlying security
became a threshold security. Thus, it did not apply to fails to deliver
resulting from short sales effected to establish or maintain a hedge on
options positions established after the underlying security became a
threshold security. Because the options market maker exception had a
very limited application, the overall impact of its removal on
liquidity, hedging costs, spreads, and depth, should be relatively
small. Nevertheless, we understand commenters' concerns that on a
security-by-security basis the impact on options market maker costs
might, in some cases, be large. However, on balance, we believe such
costs are justified by the benefits that are expected to result from
requiring that all fails to deliver in threshold securities be closed
out within specific time-frames rather than being allowed to continue
indefinitely.
    Third, some commenters noted concerns about having to close out
fails to deliver in connection with the hedging of longer-term options
because such fails may have been open for months or years.\86\ These
commenters suggested that with respect to such fails to deliver, the
close-out requirement be tied to the expiration or liquidation of such
options. However, this would mean that these fails to deliver could
persist for months or years. We believe that all fails to deliver in
threshold securities must be closed out in a timely manner. Longer-term
options can have expiration periods that extend for years. To tie the
close out of a fail to deliver position resulting from a hedge of such
options to the liquidation or expiration of such options would
undermine this goal. As discussed above, large and persistent fails to
deliver can deprive shareholders of the benefits of ownership, such as
voting and lending. We also believe that all sellers of securities
should promptly deliver, or arrange for delivery of, securities to the
respective buyer and all buyers of securities have a right to expect
prompt delivery of securities purchased.
---------------------------------------------------------------------------

    \86\ See, e.g., letter from CBOE; Options Exchanges; Citigroup.
---------------------------------------------------------------------------

    In addition, the 35 consecutive settlement day phase-in period of
the amendments allows participants sufficient time to close out any
previously excepted fail to deliver positions that may have been open
for months or years as a result of hedging activity in connection with
longer-term options. The phase-in period limits the disruption to the
market and helps foster market stability because it provides
participants with a sufficient length of time to effect purchases to
close out these positions in an orderly manner.
    Fourth, the potential impact of the amendments on options market
making risk, quote depths, spread widths, and market liquidity will be
limited because, as noted above, Regulation SHO's options market maker
exception applied only to those fail to deliver positions that resulted
from short sales effected by registered options market makers to
establish or maintain a hedge on options positions established before
the underlying security became a threshold security. Thus, it did not
apply to fails to deliver resulting from short sales effected to
establish or maintain a hedge on options positions established after
the underlying security became a threshold security. Some commenters
stated that they believe there has been harm to the markets under the
current close out structure of Regulation SHO.\87\ As we noted in the
Reproposal, however, in examining the application of the mandatory
close-out requirement of Rule 203(b)(3) of Regulation SHO for all non-
excepted fail to deliver positions, it does not appear that Rule
203(b)(3)'s close-out requirement for non-excepted fails to deliver in
threshold securities has impacted options market makers' willingness to
provide liquidity in threshold securities or securities likely to
become threshold securities, or substantially impacted option market
maker risk, quote depths, or spread widths.
---------------------------------------------------------------------------

    \87\ See, e.g., letter from CBOE; see also letter from
Overstock.
---------------------------------------------------------------------------

    In addition, we note that options market makers may only need to
hedge via a short sale in the equity markets for a small fraction of
their total trading activity. Academic research suggests that non-
market maker option open interest tends to heavily favor the upside,
which implies that the customary hedge for the typical option market
making position is a long equity position rather than a short equity
position.\88\ More recent data from January to July 2008 also suggests
an upside bias in option open interest.\89\
---------------------------------------------------------------------------

    \88\ See Lakonishok, Poteshman, and Lee, ``Investor Behavior and
the Options Markets,'' Working Paper 10264 (2004) (http://
www.nber.org/papers/w10264.pdf.).
    \89\ Data from The Options Clearing Corporation web site shows
that call open interest generally exceeded put open interest by
about 10% on the average day during January to July 2008.
---------------------------------------------------------------------------

    Fifth, while commenters may believe that a mandatory close-out
requirement for all fails to deliver resulting from hedging activity in
the options markets may potentially impact liquidity, hedging costs,
depth, or spreads, or impact the willingness of options market makers
to make markets in certain securities, we believe that such effects are
justified by our belief that fails to deliver resulting from hedging
activities by options market makers

should be treated similarly to fails to deliver resulting from sales in
the equities markets so that market participants trading threshold
securities in the options markets do not receive an advantage over
those trading such securities in the equities markets.
    As discussed above, commenters who opposed elimination of the
exception argued that options market makers, unlike equity market
makers, should have an exception to Regulation SHO's close-out
requirement because there are distinct differences between options
market making and market making in the underlying stock. We do not
believe that for purposes of the close-out requirement of Regulation
SHO, options and equity market makers should be treated differently.
Due to our concerns about the potentially negative market impact of
large and persistent fails to deliver, and the fact that we continue to
observe a small number of threshold securities with fail to deliver
positions that are not being closed out under existing delivery and
settlement requirements, we adopted amendments to eliminate Regulation
SHO's ``grandfather'' provision that allowed fails to deliver resulting
from long or short sales of equity securities to persist indefinitely
if the fails to deliver occurred prior to the security becoming a
threshold security.\90\ We believe that once a security becomes a
threshold security, fails to deliver in that security must be closed
out, regardless of whether or not the fails to deliver resulted from
sales of the security in connection with the options or equities
markets.
---------------------------------------------------------------------------

    \90\ See 2007 Regulation SHO Final Amendments, 72 FR 45544; see
also 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
---------------------------------------------------------------------------

    Moreover, we are concerned that the options market maker exception
might have allowed for a regulatory arbitrage not permitted in the
equities markets.\91\ For example, an options market maker who sells
short to hedge put options purchased by a market participant unable to
locate shares for a short sale in accordance with Rule 203(b)(2) of
Regulation SHO may not have to close out any fails to deliver that
result from such short sales under the options market maker exception.
The ability of options market makers to sell short and never have to
close out a resulting fail to deliver position, provided the short sale
was effected to hedge options positions created before the security
became a threshold security, runs counter to the goal of requiring that
all fails to deliver in threshold securities be closed out.
---------------------------------------------------------------------------

    \91\ See Reproposal, 72 FR at 45563.
---------------------------------------------------------------------------

    In addition, we note that although the proposed alternatives could
lessen the potential negative impact of large and persistent fails to
deliver, we believe that complete elimination of the options market
maker exception would achieve this goal more effectively. By
eliminating the options market maker exception, all fails to deliver in
threshold securities will have to be closed out in accordance with
Regulation SHO's close-out requirements.\92\ The proposed alternatives,
however, would each allow a longer period of time for fail to deliver
positions to be closed out. Specifically, the first alternative would
allow certain fails to deliver to be closed out within 35 consecutive
settlement days of the security becoming a threshold security. Under
the second alternative, although some fails to deliver would be
required to be closed out in less than 35 consecutive settlement days,
other fails to deliver would not have to be closed out until 35
consecutive settlement days from the security becoming a threshold
security.\93\
---------------------------------------------------------------------------

    \92\ See 17 CFR 242.203(b)(3); see also Interim Final Temporary
Rule, supra notes 42 and 43 (amending Regulation SHO to strengthen
the delivery requirements for sales of all equity securities).
    \93\ See Reproposal, 72 FR at 45589-45590.
---------------------------------------------------------------------------

    As we discussed in the Reproposal,\94\ we believe that the options
market maker exception should be eliminated, rather than limited as in
the proposed alternatives, because large and persistent fails to
deliver are not being closed out under existing delivery requirements
and because we are concerned that these fails to deliver may have a
negative impact on the market for those securities. In addition, as
noted in the Reproposal, we believe that fails to deliver resulting
from hedging activities by options market makers should be treated
similarly to fails to deliver resulting from sales in the equities
markets so that market participants trading threshold securities in the
options markets do not receive an advantage over those trading such
securities in the equities markets. Thus, we have determined that the
proposed alternatives are not feasible or in the public interest to act
upon at this time.
---------------------------------------------------------------------------

    \94\ See id. at 45566-45567.
---------------------------------------------------------------------------

IV. Bona-Fide Market Making

    We are also taking the opportunity to provide guidance regarding
issues that have arisen regarding what is bona-fide market making for
purposes of complying with the market maker exception to the ``locate''
requirement of Rule 203(b)(1) of Regulation SHO. The 2004 Regulation
SHO Adopting Release provides guidance as to what is bona-fide market
making. We are reiterating that guidance and providing additional
guidance in this adopting release.
    Rule 203(b)(1) provides that ``[a] broker or dealer may not accept
a short sale order in an equity security from another person, or effect
a short sale in an equity security for its own account, unless the
broker or dealer has: (i) Borrowed the security, or entered into a
bona-fide arrangement to borrow the security; or (ii) Reasonable
grounds to believe that the security can be borrowed so that it can be
delivered on the date delivery is due; and (iii) Documented compliance
with this paragraph (b)(1).'' \95\ This is known as the ``locate''
requirement. Rule 203(b)(2)(iii) excepts market makers engaged in bona-
fide market making activities from the locate requirement. The
Commission adopted this narrow exception to the locate requirement
because such market makers may need to facilitate customer orders in a
fast moving market without possible delays associated with complying
with the locate requirement.\96\
---------------------------------------------------------------------------

    \95\ 17 CFR 242.203(b).
    \96\ See 2004 Regulation SHO Adopting Release, 69 FR at 48015,
n. 67; see also Emergency Order Pursuant to Section 12(k)(2) of the
Securities Exchange Act of 1934 Taking Temporary Action to Respond
to Market Developments, Exchange Act Release No. 58166 (July 15,
2008); Amendment to Emergency Order Pursuant to Section 12(k)(2) of
the Securities Exchange Act of 1934 Taking Temporary Action to
Respond to Market Developments, Exchange Act Release No. 58190 (July
18, 2008) (excepting from the Emergency Order bona fide market
makers).
---------------------------------------------------------------------------

    The term ``market maker'' includes any specialist permitted to act
as a dealer, any dealer acting in the capacity of a block positioner,
and any dealer who, with respect to a security, holds itself out (by
entering quotations in an inter-dealer quotation system or otherwise)
as being willing to buy and sell such security for its own account on a
regular or continuous basis.\97\ Moreover, as the Commission has stated
previously, a market maker engaged in bona-fide market making is a
``broker-dealer that deals on a regular basis with other broker-
dealers, actively buying and selling the subject security as well as
regularly and continuously placing quotations in a quotation medium on
both the bid and ask side of the market.'' \98\ We note that block
positioners, to the extent they engage in bona fide block positioning
activities,

may also rely on this exception from the locate requirement in
connection with such activities. Rule 3b-8(c) of the Exchange Act (17
CFR 240.3b-8(c)) defines a ``qualified block positioner'' as a dealer
that: (1) Is a broker or dealer registered pursuant to Section 15 of
the Exchange Act; (2) is subject to and in compliance with Rule 15c3-1
of the Exchange Act (17 CFR 240.15c3-1); (3) has and maintains minimum
net capital, as defined in Rule 15c3-1, of $1,000,000; and (4) except
when such activity is unlawful, meets all of the following conditions:
(i) Engages in the activity of purchasing long or selling short, from
time to time, from or to a customer (other than a partner or a joint
venture or other entity in which a partner, the dealer, or a person
associated with such dealer, as defined in Section 3(a)(18) of the
Exchange Act, participates) a block of stock with a current market
value of $200,000 or more in a single transaction, or in several
transactions at approximately the same time, from a single source to
facilitate a sale or purchase by such customer, (ii) has determined in
the exercise of reasonable diligence that the block could not be sold
to or purchased from others on equivalent or better terms, and (iii)
sells the shares comprising the block as rapidly as possible
commensurate with the circumstances.
---------------------------------------------------------------------------

    \97\ See 2004 Regulation SHO Adopting Release, 69 FR at 48015,
n. 66 (citing to Section 3(a)(38) of the Exchange Act).
    \98\ See Exchange Act Release No. 32632 (July 14, 1993), 58 FR
39072, 39074 (July 21, 1993).
---------------------------------------------------------------------------

    As discussed below, in the 2004 Regulation Adopting Release, we
provided examples of the types of activities that would indicate that a
market maker is not engaged in bona fide market making activities. In
addition to reiterating that guidance, we are also providing examples
of the types of activities that would indicate that a market maker is
engaged in bona fide market making activities for purposes of claiming
the exception to Regulation SHO's locate requirement.
    Although determining whether or not a market maker is engaged in
bona-fide market making would depend on the facts and circumstances of
the particular activity, factors that indicate a market maker is
engaged in bona-fide market making activities may include, for example,
whether the market maker incurs any economic or market risk with
respect to the securities (e.g., by putting their own capital at risk
to provide continuous two-sided quotes in markets). In fulfilling its
obligations as a market maker, a market maker engaged in bona-fide
market making may provide liquidity to a security's market, take the
other side of trades when there are short-term buy-and-sell-side
imbalances in customer orders, or attempt to prevent excess volatility.
Such activities will result in the market maker assuming some risk.
Thus, if the market maker does not incur any market risk with respect
to a transaction or related set of transactions, the market maker may
not be engaged in bona-fide market making activities.\99\
---------------------------------------------------------------------------

    \99\ For example, if a market maker sells stock (short) together
with a synthetic short position (e.g., a conversion) to a client and
the client then sells the stock (long) retaining the synthetic short
position, the effect would be as if the market maker had ``rented''
its exemption to the client. Such transactions or other transactions
that have the same effect will not be considered bona-fide market
making activity.
---------------------------------------------------------------------------

    A pattern of trading that includes both purchases and sales in
roughly comparable amounts to provide liquidity to customers or other
broker-dealers would generally be an indication that a market maker is
engaged in bona-fide market making activity. Thus, even selling short
into a declining market may be an indication that a market maker is
engaged in bona-fide market making activity. Continuous quotations that
are at or near the market on both sides and that are communicated and
represented in a way that makes them widely accessible to investors and
other broker-dealers are also an indication that a market maker is
engaged in bona-fide market making activity. However, as noted above, a
market maker must hold itself out as being willing to buy and sell a
security for its own account on a regular or continuous basis. Thus, a
market maker's quotes must be generally accessible to the public for a
market maker to be considered as holding itself out as being willing to
buy and sell a security for its own account on a regular or continuous
basis, and therefore, to be engaged in bona-fide market making
activity.
    While determining whether or not a market maker is engaged in bona-
fide market making would depend on the facts and circumstances of the
particular activity, there are clear examples of what types of
activities would not be bona-fide market making activities. For
example, the Commission has stated that bona-fide market making does
not include 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.\100\ Likewise, where a market maker posts continually at
or near the best offer, but does not also post at or near the best bid,
the market maker's activities would not generally qualify as bona-fide
market making.\101\ Moreover, a market maker that continually executes
short sales away from its posted quotes would generally not be
considered to be engaging in bona-fide market making.\102\ For purposes
of qualifying for the locate exception in Regulation SHO, a market
maker must also be a market maker in the security being sold, and must
be engaged in bona-fide market making in that security at the time of
the short sale.\103\
---------------------------------------------------------------------------

    \100\ See 2004 Regulation SHO Adopting Release, 69 FR at 48015.
    \101\ See id.
    \102\ See id.
    \103\ See Rule 203(b)(1) and (b)(2)(iii).
---------------------------------------------------------------------------

V. Other Matters

    The Administrative Procedure Act also generally requires that an
agency publish an adopted rule in the Federal Register 30 days before
it becomes effective.\104\ This requirement, however, does not apply if
the agency finds good cause for making the rule effective sooner.\105\
---------------------------------------------------------------------------

    \104\ See 5 U.S.C. Sec.  553(d).
    \105\ Id.
---------------------------------------------------------------------------

    As noted above, in the September Emergency Order, we adopted, and
made immediately effective, amendments to Rule 203(b)(3) of Regulation
SHO to eliminate the options market maker exception to Regulation SHO's
close-out requirement. The September Emergency Order expires on October
17, 2008. We believe that the amendments contained in this adopting
release should be effective on October 17, 2008 so that the elimination
of the options market maker exception becomes permanent when the
September Emergency Order expires. In addition, we believe that the
amendments should become effective on October 17, 2008 so that fails to
deliver resulting from short sales in both the equity and options
markets receive similar treatment under the close-out requirements of
Regulation SHO, and to further reduce fails to deliver and address
potentially abusive ``naked'' short selling. Thus, the Commission finds
good cause to make the amendments effective on October 17, 2008.

VI. Paperwork Reduction Act

    The amendments to Regulation SHO do not contain a ``collection of
information'' requirement within the meaning of the Paperwork Reduction
Act of 1995 (``PRA'').\106\
---------------------------------------------------------------------------

    \106\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

VII. Consideration of Costs and Benefits of Proposed Amendments to
Regulation SHO

    We are sensitive to the costs and benefits of our rules and we have

considered the costs and the benefits of the amendments to Regulation
SHO. In order to assist us in evaluating the costs and benefits, in the
Reproposal, we encouraged commenters to discuss any costs or benefits
that the amendments might impose. In particular, we requested comment
on the potential costs for any modifications to both computer systems
and surveillance mechanisms and for information gathering, management,
and recordkeeping systems or procedures, as well as any potential
benefits resulting from the amendments for registrants, issuers,
investors, brokers or dealers, other securities industry professionals,
regulators, and other market participants. Commenters were encouraged
to provide analysis and data to support their views on the costs and
benefits associated with the amendments to Regulation SHO.

A. Benefits

    The amendments to Rule 203(b)(3) of Regulation SHO are intended to
further reduce the number of persistent fails to deliver in threshold
securities by eliminating the options market maker exception to
Regulation SHO's close-out requirement. As a result of the amendments,
all fails to deliver in a threshold security resulting from short sales
by a registered options market maker effected to establish or maintain
a hedge on options positions established before the security became a
threshold security will, like all other fails to deliver in threshold
securities, have to be closed out in accordance with Regulation SHO's
close-out requirements.\107\
---------------------------------------------------------------------------

    \107\ See 17 CFR 242.203(b)(3); see also Interim Final Temporary
Rule, supra notes 42 and 43 (amending Regulation SHO to strengthen
the delivery requirements for sales of all equity securities).
---------------------------------------------------------------------------

    We are concerned that large and persistent fails to deliver are not
being closed out due to the options market maker exception in
Regulation SHO, and that these fails to deliver may have a negative
effect on the market in these securities.\108\ For example, large and
persistent fails to deliver may deprive shareholders of the benefits of
ownership, such as voting and lending.\109\ In addition, where a seller
of securities fails to deliver securities on trade settlement date, in
effect the seller unilaterally converts a securities contract (which
should settle within the standard 3-day settlement period) into an
undated futures-type contract, to which the buyer may not have agreed,
or that would have been priced differently.\110\ Moreover, sellers that
fail to deliver securities on settlement date may enjoy fewer
restrictions than if they were required to deliver the securities in a
timely manner, and such sellers may attempt to use this additional
freedom to engage in trading activities that deliberately depress the
price of a security.\111\ In addition, by not borrowing securities and,
therefore, not making delivery within the standard three-day settlement
period, the seller avoids the costs of borrowing.
---------------------------------------------------------------------------

    \108\ See 2007 Regulation SHO Final Amendments, 72 FR at 45544;
2006 Regulation SHO Proposed Amendments, 71 FR at 41712; Reproposal,
72 FR at 45558-45559; ``Naked'' Short Selling Anti-Fraud Rule
Proposing Release, 73 FR at 15378.
    \109\ See id.
    \110\ See id.
    \111\ See id.
---------------------------------------------------------------------------

    Thus, consistent with the Commission's investor protection mandate,
the amendments will benefit investors by facilitating the receipt of
shares so that more investors receive the benefits associated with
share ownership, such as the use of the shares for voting and lending
purposes. The amendments will also enhance investor confidence as they
make investment decisions by providing investors with greater assurance
that securities will be delivered as expected. An increase in investor
confidence in the market should facilitate investment.
    The amendments will also benefit issuers. A high level of
persistent fails to deliver in a security may be perceived by potential
investors negatively and may affect their decision about making a
capital commitment.\112\ For example, in response to the Reproposal,
one commenter stated that it believes that the current options market
maker exception ``harms investors and issuers, hinders the formation of
capital, and is fatally flawed as written'' and that it should be
eliminated.\113\ Some issuers may believe that they have endured
unwarranted reputational damage due to investors' negative perceptions
regarding a security having a large fail to deliver position and
becoming a threshold security.\114\ Thus, issuers may believe the
elimination of the options market maker exception will restore their
good name. Some issuers may also believe that large and persistent
fails to deliver indicate that they have been the target of potentially
manipulative conduct as a result of ``naked'' short selling.\115\ Thus,
elimination of the options market maker exception should decrease the
possibility of artificial market influences and, therefore, should
contribute to price efficiency.
---------------------------------------------------------------------------

    \112\ See, e.g., supra note 19 (citing to comment letters
expressing concern regarding the impact of potential ``naked'' short
selling on capital formation).
    \113\ See letter from NCANS.
    \114\ See, e.g., supra note 18; see also letter from Fairfax
Financial (stating that the exception should be eliminated due to
its ``detrimental impact on issuers and their shareholders and also
because such exception is susceptible to significant abuse'').
    \115\ See, e.g., supra note 19 (citing to comment letters from
issuers and investors discussing extended fails to deliver in
connection with ``naked'' short selling).
---------------------------------------------------------------------------

B. Costs

    To comply with Regulation SHO when it became effective in January
2005, market participants needed to modify their recordkeeping systems
and surveillance mechanisms. In addition, market participants should
have retained and trained the necessary personnel to ensure compliance
with the rule. Thus, the infrastructure necessary to comply with the
amendments should already be in place because the amendments will
require that all fails to deliver be closed out in accordance with the
close-out requirements of Regulation SHO.\116\ The only fails to
deliver not subject to Regulation SHO's mandatory close-out
requirements will be those fails to deliver that would be previously-
excepted from the close-out requirement and, therefore, eligible for
the one-time 35 consecutive settlement day phase-in period of the
amendments.\117\ Thus, we anticipate that any changes to personnel,
computer hardware and software, recordkeeping or surveillance costs
will be minimal.
---------------------------------------------------------------------------

    \116\ See 17 CFR 242.203(b)(3); see also Interim Final Temporary
Rule, supra notes 42 and 43 (amending Regulation SHO to strengthen
the delivery requirements for sales of all equity securities).
    \117\ See Adopted Rule 203(b)(3)(iii).
---------------------------------------------------------------------------

    In the Reproposal, we requested comment regarding the costs of the
proposed amendments to the options market maker exception and how those
costs would affect liquidity in the options markets. As discussed
above, commenters opposing the proposed amendments criticized the
impact of the proposals on options market making risk, quote depths,
spread widths, and market liquidity, particularly in threshold
securities and securities that might become threshold securities. These
commenters stated that the current exception is integral to the options
market maker's ability to make markets and manage risk and that,
without the exception, making continuous markets would be very
difficult, particularly in longer-dated options.\118\ One commenter
suggested that ``withdrawing or greatly reducing the exception would
cause varying losses of liquidity in over 20% of listed

options and their underlying stocks.'' \119\ Another commenter stated
that ``[i]f the exception is eliminated or narrowed in the manner
proposed, [it] anticipates [options market makers] would be reluctant
or even unable to effectively make markets on securities if they cannot
be certain of their ability to establish and maintain an effective
hedge and manage their risk through selling stock.'' \120\ Another
commented that ``[t]he uncertainty, time, processing and expense
necessary to pre-borrow when effecting a short sale, as well as the
uncertainty and expense caused by a close out of a hedge, will by its
nature adversely affect the [options market makers'] pricing of the
option.'' \121\ However, one commenter noted that ``options market
makers should factor the cost of borrowing stock and selling short into
the price of the put options being sold.'' \122\ Another commenter
noted that ``[o]ptions market makers should have to pay to borrow stock
like everyone else does. Most options market makers are excellent risk
managers, and they can manage the risk that stock borrowing costs can
fluctuate. Any additional costs involved will rightfully be passed to
those who trade options.'' \123\
---------------------------------------------------------------------------

    \118\ See letter from CBOE.
    \119\ See letter from Susquehanna.
    \120\ See id.; see also letter from Options Exchanges;
Citigroup.
    \121\ See letter from Citigroup.
    \122\ See letter from Fairfax Financial.
    \123\ See letter from Angel.
---------------------------------------------------------------------------

    Although we recognize commenters' concerns that a mandatory close-
out requirement for fails to deliver in threshold securities underlying
options positions, for the reasons outlined below, we believe these
potential effects are justified by the benefits of requiring that fails
to deliver in all threshold securities be closed out within specific
time-frames rather than being allowed to continue indefinitely. In
addition, we believe the overall market impact of these potential
effects, if any, will be minimal.
    First, as discussed above, large and persistent fails to deliver
can deprive shareholders of the benefits of ownership, such as voting
and lending. They can also be indicative of potentially manipulative
conduct, such as abusive ``naked'' short selling. The deprivation of
the benefits of ownership, as well as the perception that abusive
``naked'' short selling is occurring in certain securities, can
undermine the confidence of investors. These investors, in turn, may be
reluctant to commit capital to an issuer they believe to be subject to
manipulative conduct.
    In the Reproposal, we sought comment on whether the proposed
amendments would promote capital formation, including whether the
proposed increased short sale restrictions would affect investors'
decisions to invest in certain equity securities. Commenters expressed
concern about ``naked'' short selling causing a drop in an issuer's
stock price and that it may limit an issuer's ability to access the
capital markets.\124\ We believe that, by requiring that all fails to
deliver in threshold securities be closed out within specific time-
frames rather than allowing them to continue indefinitely, there will
be a decrease in the number of threshold securities with persistent and
high levels of fails to deliver. If persistence on the threshold
securities lists leads to an unwarranted decline in investor confidence
about the security, the amendments should improve investor confidence
about the security.\125\ We also believe that the reduction in fails to
deliver and the resulting reduction in the number of securities on the
threshold securities lists should strengthen investor confidence and
increase certainty in the settlement process.
---------------------------------------------------------------------------

    \124\ See supra note 19.
    \125\ See letter from Overstock.
---------------------------------------------------------------------------

    Thus, by eliminating the options market maker exception so that all
fails to deliver in threshold securities that result from short sales
effected to maintain or establish a hedge on options positions will
have to be closed out in accordance with Regulation SHO's close-out
requirements,\126\ we expect a reduction in the number of threshold
securities with large and persistent fails to deliver and, thereby,
offsetting any potential negative impact of such fails to deliver on
the market for these securities.
---------------------------------------------------------------------------

    \126\ See 17 CFR 242.203(b)(3); see also Interim Final Temporary
Rule, supra notes 42 and 43 (amending Regulation SHO to strengthen
the delivery requirements for sales of all equity securities).
---------------------------------------------------------------------------

    Second, while we recognize commenters' concerns that on a security-
by-security basis the impact on options market maker costs, liquidity,
quote depths, and spread widths may vary considerably, and in some
cases, might be large,\127\ we believe the overall market impact of the
amendments will be minimal because the number of securities that will
be impacted by the amendments will be relatively small. As previously
noted by one commenter, a small number of securities that meet the
definition of a ``threshold security'' have listed options, and those
securities form a very small percentage of all securities that have
options traded on them.\128\ In addition, OEA estimates that in July
2008, 451 (13.6%) of the 3,326 securities with options classes trading
on at least one options market appeared on a threshold securities list
for at least one day that month. Even though these securities may form
a small percentage of all securities that have options traded on them,
we are still concerned that these fails to deliver can have a
disproportionate impact on the markets and shareholders.
---------------------------------------------------------------------------

    \127\ See, e.g., letter from Options Exchanges.
    \128\ See supra note 85.
---------------------------------------------------------------------------

    Moreover, the options market maker exception only excepted from
Regulation SHO's mandatory 13 consecutive settlement day close-out
requirement only those fail to deliver positions that resulted from
short sales effected by registered options market makers to establish
or maintain a hedge on options positions established before the
underlying security became a threshold security. Thus, it does not
apply to fails to deliver resulting from short sales effected to
establish or maintain a hedge on options positions established after
the underlying security became a threshold security. Because the
options market maker exception has a very limited application, we
anticipate that the overall impact of its removal on liquidity, hedging
costs, spreads, and depth should be relatively small. Nevertheless, we
understand commenters' concerns that on a security-by-security basis
the impact on options market maker costs might, in some cases, be
large. However, on balance, we believe such costs are justified by the
benefits that are expected to result from requiring that all fails to
deliver in threshold securities be closed out within specific time-
frames rather than being allowed to continue indefinitely.
    Third, some commenters noted concerns about having to close out
fails to deliver in connection with the hedging of longer-term options
because such fails may have been open for months or years.\129\ These
commenters suggested that with respect to such fails to deliver, the
close-out requirement be tied to the expiration or liquidation of such
options. However, this would mean that these fails to deliver could
persist for months or years. We believe that all fails to deliver in
threshold securities must be closed out in a timely manner. Longer-term
options can have expiration periods that extend for years. To tie the
close out of a fail to deliver position resulting from a hedge of such
options to the liquidation or expiration

of such options would undermine this goal. As discussed above, large
and persistent fails to deliver can deprive shareholders of the
benefits of ownership, such as voting and lending. We also believe that
all sellers of securities should promptly deliver, or arrange for
delivery of, securities to the respective buyer and all buyers of
securities have a right to expect prompt delivery of securities
purchased.
---------------------------------------------------------------------------

    \129\ See, e.g., letter from CBOE; Options Exchanges; Citigroup.
---------------------------------------------------------------------------

    In addition, the 35 consecutive settlement day phase-in period of
the amendments allows participants sufficient time to close out any
previously excepted fail to deliver positions that may have been open
for month or years as a result of hedging activity in connection with
longer-term options. The phase-in period limits the disruption to the
market and helps foster market stability because it provides
participants with a sufficient length of time to close out these
positions in an orderly manner.
    Fourth, the potential impact of the amendments on options market
making risk, quote depths, spread widths, and market liquidity will be
limited because, as noted above, Regulation SHO's options market maker
exception applied only to those fail to deliver positions that resulted
from short sales effected by registered options market makers to
establish or maintain a hedge on options positions established before
the underlying security became a threshold security. Thus, it does not
apply to fails to deliver resulting from short sales effected to
establish or maintain a hedge on options positions established after
the underlying security became a threshold security. Some commenters
stated that they believe there has been harm to the markets under the
current close out structure of Regulation SHO.\130\ As we noted in the
Reproposal, however, in examining the application of the mandatory
close-out requirement of Rule 203(b)(3) of Regulation SHO for all non-
excepted fail to deliver positions, it does not appear that Rule
203(b)(3)'s close-out requirement for non-excepted fails to deliver in
threshold securities has impacted options market makers' willingness to
provide liquidity in threshold securities or securities likely to
become threshold securities, or substantially impacted option market
maker risk, quote depths, or spread widths.
---------------------------------------------------------------------------

    \130\ See, e.g., letter from CBOE; see also letter from
Overstock.
---------------------------------------------------------------------------

    We also note that option market makers may only need to hedge via a
short sale in the equity markets for a small fraction of their total
trading activity. Academic research suggests that non-market maker
option open interest tends to heavily favor the upside, which implies
that the customary hedge for the typical option market making position
is a long equity position rather than a short equity position.\131\
More recent data from January to July 2008 also suggests an upside bias
in option open interest.\132\
---------------------------------------------------------------------------

    \131\ See supra note 88.
    \132\ See supra note 89.
---------------------------------------------------------------------------

    Fifth, while commenters may believe that a mandatory close-out
requirement for all fails to deliver resulting from hedging activity in
the options markets may potentially impact liquidity, hedging costs,
depth, or spreads, or impact the willingness of options market makers
to make markets in certain securities, we believe that such potential
effects are justified by our belief that fails to deliver resulting
from hedging activities by options market makers should be treated
similarly to fails to deliver resulting from sales in the equities
markets so that market participants trading threshold securities in the
options markets do not receive an advantage over those trading such
securities in the equities markets.
    As discussed above, commenters who opposed elimination of the
exception argued that options market makers, unlike equity market
makers, should have an exception to Regulation SHO's close-out
requirement because there are distinct differences between options
market making and market making in the underlying stock. We do not
believe that for purposes of the close-out requirement of Regulation
SHO, options and equity market makers should be treated differently.
Due to our concerns about the potentially negative market impact of
large and persistent fails to deliver, and the fact that we continue to
observe a small number of threshold securities with fail to deliver
positions that are not being closed out under existing delivery and
settlement requirements, we adopted amendments to eliminate Regulation
SHO's ``grandfather'' provision that allowed fails to deliver resulting
from long or short sales of equity securities to persist indefinitely
if the fails to deliver occurred prior to the security becoming a
threshold security.\133\ We believe that once a security becomes a
threshold security, fails to deliver in that security must be closed
out, regardless of whether or not the fails to deliver resulted from
sales of the security in connection with the options or equities
markets.
---------------------------------------------------------------------------

    \133\ See 2007 Regulation SHO Final Amendments, 72 FR 45544; see
also 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
---------------------------------------------------------------------------

    Moreover, we are concerned that the options market maker exception
might have allowed for a regulatory arbitrage not permitted in the
equities markets.\134\ For example, an options market maker who sells
short to hedge put options purchased by a market participant unable to
locate shares for a short sale in accordance with Rule 203(b)(2) of
Regulation SHO may not have to close out any fails to deliver that
result from such short sales under the options market maker exception.
The ability of options market makers to sell short and never have to
close out a resulting fail to deliver position, provided the short sale
was effected to hedge options positions created before the security
became a threshold security, runs counter to the goal of requiring that
all fails to deliver in threshold securities be closed out.
---------------------------------------------------------------------------

    \134\ Reproposal, 72 FR at 45563.
---------------------------------------------------------------------------

    Also, the pre-borrow requirement of Adopted Rule 203(b)(3)(v) for
fail to deliver positions that are not closed out within the applicable
time-frame set forth in the amendments will result in limited, if any,
costs to participants of a registered clearing agency, and options
market makers for which they clear transactions.\135\ The pre-borrow
requirement is similar to the pre-borrow requirement of Rule
203(b)(3)(iv) of Regulation SHO relating to fails to deliver that have
not been closed out in accordance with the 13 consecutive settlement
day close-out requirement of Regulation SHO.\136\ Thus, participants of
a registered clearing agency, and any options market maker for which it
clears transactions, must already comply with such a requirement if a
fail to deliver position has not been closed out in accordance with
Regulation SHO's mandatory close-out requirement. Accordingly, these
entities should already have in place the personnel, recordkeeping,
systems, and surveillance mechanisms necessary to comply with the
adopted pre-borrow requirement. While the pre-borrow requirement may be
costly in each instance it is used, pre-borrowing is not necessary if a
close-out is completed on time and, therefore, may be used only rarely.
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    \135\ See Adopted Rule 203(b)(3)(v).
    \136\ See 17 CFR 242.203(b)(3)(iv).
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VIII. Consideration of Burden and Promotion of Efficiency, Competition,
and Capital Formation

    Section 3(f) of the Exchange Act requires the Commission, whenever
it engages in rulemaking and is required to

consider or determine whether an action is necessary or appropriate in
the public interest, to consider whether the action would promote
efficiency, competition, and capital formation.\137\ In addition,
Section 23(a)(2) of the Exchange Act requires the Commission, when
making rules under the Exchange Act, to consider the impact such rules
would have on competition.\138\ Exchange Act Section 23(a)(2) prohibits
the Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.
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    \137\ 15 U.S.C. 78c(f).
    \138\ 15 U.S.C. 78w(a)(2).
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    We believe the amendments will have minimal impact on the promotion
of price efficiency. In the Reproposal, we sought comment on whether
the amendments would promote price efficiency. Commenters expressed
concern that failures to deliver due to the options market maker
exception harm pricing efficiency in the equity markets.\139\ Other
commenters stated that the proposed amendments to the options market
maker exception would disrupt the markets because they would not
provide sufficient flexibility to permit efficient hedging by options
market makers, would unnecessarily increase risks and costs to hedge,
and would adversely impact liquidity and result in higher costs to
customers.\140\ These commenters stated that they believe the proposed
amendments would likely discourage options market makers from making
markets in illiquid securities since the risk associated in maintaining
the hedges in these option positions would be too great.\141\ Moreover,
these commenters stated that the reluctance of options market makers to
make markets in threshold securities would result in wider spreads in
such securities to account for the increased costs of hedging, to the
detriment of investors.\142\
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    \139\ See, e.g., letter from Overstock.
    \140\ See, e.g., letter from Options Exchanges.
    \141\ See id.
    \142\ See letter from Citigroup.
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    We recognize commenters' concerns that a mandatory close-out
requirement for fails to deliver in threshold securities underlying
options positions may potentially impact options market makers'
willingness to provide liquidity in threshold securities, make it more
costly for options market makers to accommodate customer orders, or
result in wider bid-ask spreads or less depth.\143\ For the reasons
discussed below, however, we believe that the overall impact of these
potential effects, if any, will be minimal.
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    \143\ See, e.g., letter from CBOE.
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    We believe that the overall market impact of the amendments will be
minimal because the number of securities that will be impacted by the
amendments will be relatively small. The amendments apply only to those
threshold securities with listed options. As previously noted by one
commenter, a small number of securities that meet Regulation SHO's
definition of a ``threshold security'' have listed options, and those
securities form a very small percentage of all securities that have
options traded on them.\144\ In addition, the amendments will only
impact fails to deliver in those securities that resulted from short
sales by registered options market makers to hedge options positions
that were created before, rather than after, the security became a
threshold security because all other fails to deliver in threshold
securities are already subject to Regulation SHO's close-out
requirements.\145\
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    \144\ See supra note 85.
    \145\ See 17 CFR 242.203(b)(3); see also Interim Final Temporary
Rule, supra notes 42 and 43 (amending Regulation SHO to strengthen
the delivery requirements for sales of all equity securities).
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    Because the options market maker exception has a very limited
application, we anticipate that the overall impact of its removal on
liquidity, hedging costs, spreads, and depth will be relatively small.
Nevertheless, we understand commenters' concerns that on a security-by-
security basis the impact on options market maker costs might, in some
cases, be large. However, on balance, we believe such costs are
justified by the benefits that are expected to result from requiring
that all fails to deliver in threshold securities be closed out within
specific time-frames rather than being allowed to continue
indefinitely.
    We also note that option market makers may only need to hedge via a
short sale in the equity markets for a small fraction of their total
trading activity. Academic research suggests that non-market maker
option open interest tends to heavily favor the upside, which implies
that the customary hedge for the typical option market making position
is a long equity position rather than a short equity position.\146\
More recent data from January to July 2008 also suggests an upside bias
in option open interest.\147\
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    \146\ See supra note 88.
    \147\ See supra note 89.
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    In addition, the 35 consecutive settlement day phase-in period of
the amendments allows participants sufficient time to close out any
previously excepted fail to deliver positions that may have been open
for months or years as a result of hedging activity in connection with
longer-term options. The phase-in period limits the disruption to the
market, and helps foster market stability by providing participants
with a sufficient length of time to close out these positions in an
orderly manner. Some of the commenters to the Reproposal also noted
that 13 consecutive settlement days was more than sufficient to close
out a fail to deliver relating to an options position.\148\
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    \148\ See, e.g., letter from U.S. Chamber of Commerce.
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    While commenters may believe that a mandatory close-out requirement
may potentially impact liquidity, hedging costs, depth, or spreads, or
impact the willingness of options market makers to make markets in
securities subject to such a requirement, we believe such potential
effects are justified by our belief that fails to deliver resulting
from hedging activities by options market makers should be treated
similarly to fails to deliver resulting from sales in the equities
markets so that market participants trading threshold securities in the
options markets do not receive an advantage over those trading such
securities in the equities markets. In addition, we believe that such
potential costs are justified by the benefits of requiring that all
fails to deliver be closed out rather than being allowed to continue
indefinitely.
    We also believe that the amendments will have minimal impact on the
promotion of capital formation. Large and persistent fails to deliver
can deprive shareholders of the benefits of ownership, such as voting
and lending. They can also be indicative of potentially manipulative
conduct, such as abusive ``naked'' short selling. The deprivation of
the benefits of ownership, as well as the perception that abusive
``naked'' short selling is occurring in certain securities, can
undermine the confidence of investors. These investors, in turn, may be
reluctant to commit capital to an issuer they believe to be subject to
such manipulative conduct.
    In the Reproposal, we sought comment on whether the proposed
amendments would promote capital formation, including whether the
proposed increased short sale restrictions would affect investors'
decisions to invest in certain equity securities. Commenters expressed
concern about the potential impact of

``naked'' short selling on capital formation claiming that ``naked''
short selling causes a drop in an issuer's stock price that may limit
the issuer's ability to access the capital markets.\149\ Another
commented that the options market maker exception ``is a well known
tool of manipulators and must be removed to ensure a level playing
field for public companies and their shareholders.'' \150\ In addition,
one commenter stated that it believes that the current options market
maker exception ``harms investors and issuers, hinders the formation of
capital, and is fatally flawed as written'' and that it should be
eliminated.\151\
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    \149\ See, e.g., supra note 19 (citing to comment letters
expressing concern regarding the impact of potential ``naked'' short
selling on capital formation).
    \150\ See letter from USANA; see also letter from Fairfax
Financial (stating that the exception should be eliminated due to
its ``detrimental impact on issuers and their shareholders and also
because such exception is susceptible to significant abuse'').
    \151\ See letter from NCANS.
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    By requiring that all fails to deliver in threshold securities be
closed out rather than allowing them to continue indefinitely, we
believe that there will be a decrease in the number of threshold
securities with persistent and high levels of fails to deliver. If
persistence on the threshold securities lists leads to an unwarranted
decline in investor confidence about the security, the amendments
should improve investor confidence about the security. We also believe
that the amendments will lead to greater certainty in the settlement of
securities which should strengthen investor confidence in the
settlement process. The reduction in fails to deliver and the resulting
reduction in the number of securities on the threshold securities lists
may result in increased investor confidence.
    The amendments to eliminate the options market maker exception will
also not impose any burden on competition not necessary or appropriate
in furtherance of the purposes of the Exchange Act. By eliminating the
options market maker exception, the Commission believes the amendments
will promote competition by requiring similarly situated participants
of a registered clearing agency, including broker-dealers for which
they clear transactions, to close out fails to deliver in all threshold
securities within similar time-frames.\152\ One commenter, in
particular, noted that the options market maker exception ``is a well
known tool of manipulators and must be removed to ensure a level
playing field for public companies and their shareholders.'' \153\
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    \152\ Academic research suggests that the ability for all option
market makers to fail when hedging actually creates a competitive
advantage for large option market makers over small option market
makers. See, e.g., Evans, Richard B., Reed, Adam V., Geczy,
Christopher Charles and Musto, David K. ``Failure is an Option:
Impediments to Short Selling and Options Prices,'' Rev. Financ.
Stud. (January 2008). The elimination of the options market maker
exception, therefore, will remove this competitive advantage.
    \153\ See letter from USANA; see also letter from Fairfax
Financial (stating that the exception should be eliminated due to
its ``detrimental impact on issuers and their shareholders and also
because such exception is susceptible to significant abuse'').
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    As discussed above, commenters who opposed elimination of the
exception argued that options market makers, unlike equity market
makers, should have an exception to Regulation SHO's close-out
requirement because there are distinct differences between options
market making and market making in the underlying stock. We do not
believe that for purposes of the close-out requirement of Regulation
SHO, options and equity market makers should be treated differently.
Due to our concerns about the potentially negative market impact of
large and persistent fails to deliver, and the fact that we continue to
observe a small number of threshold securities with fail to deliver
positions that are not being closed out under existing delivery and
settlement requirements, we adopted amendments to eliminate Regulation
SHO's ``grandfather'' provision that allowed fails to deliver resulting
from long or short sales of equity securities to persist indefinitely
if the fails to deliver occurred prior to the security becoming a
threshold security.\154\ We believe that once a security becomes a
threshold security, fails to deliver in that security must be closed
out, regardless of whether or not the fails to deliver resulted from
sales of the security in connection with the options or equities
markets.
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    \154\ See 2007 Regulation SHO Final Amendments, 72 FR 45544; see
also 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
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    Moreover, we are concerned that the options market maker exception
might allow for a regulatory arbitrage not permitted in the equities
markets.\155\ For example, an options market maker who sells short to
hedge put options purchased by a market participant unable to locate
shares for a short sale in accordance with Rule 203(b)(2) of Regulation
SHO may not have to close out any fails to deliver that result from
such short sales under the options market maker exception. The ability
of options market makers to sell short and never have to close out a
resulting fail to deliver position, provided the short sale was
effected to hedge options positions created before the security became
a threshold security, runs counter to the goal of requiring that all
fails to deliver in threshold securities be closed out.
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    \155\ See Reproposal, 72 FR at 45563.
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IX. Final Regulatory Flexibility Analysis

    The Commission has prepared a Final Regulatory Flexibility Analysis
(``FRFA''), in accordance with the provisions of the Regulatory
Flexibility Act (``RFA''),\156\ regarding the amendments to Regulation
SHO, Rule 203, under the Exchange Act. An Initial Regulatory
Flexibility Analysis (``IRFA'') was prepared in accordance with the RFA
and was included in the Reproposal. We solicited comments on the IRFA.
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    \156\ 5 U.S.C. 604.
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A. Reasons for and Objectives of the Amendments

    The amendments to Rule 203(b)(3) of Regulation SHO are intended to
further reduce the number of persistent fails to deliver in threshold
securities by eliminating the options market maker exception to
Regulation SHO's close-out requirement. As a result of the amendments,
all fails to deliver in a threshold security resulting from short sales
by a registered options market maker effected to establish or maintain
a hedge on options positions established before the security became a
threshold security will, like all other fails to deliver in threshold
securities, have to be closed out in accordance with the close-out
requirements of Regulation SHO.\157\
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    \157\ See 17 CFR 242.203(b)(3); see also Interim Final Temporary
Rule, supra notes 42 and 43 (amending Regulation SHO to strengthen
the delivery requirements for sales of all equity securities).
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    We are concerned that persistent, large fail positions may have a