[Federal Register: October 17, 2008 (Volume 73, Number 202)]
[Rules and Regulations]
[Page 61706-61731]
[DOCID:fr17oc08-8]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 242

[Release No. 34-58773; File No. S7-30-08]
RIN 3235-AK22

Amendments to Regulation SHO

AGENCY: Securities and Exchange Commission.

ACTION: Interim final temporary rule; request for comments.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is
adopting an interim final temporary rule under the Securities Exchange
Act of 1934 (``Exchange Act'') to address abusive ``naked'' short
selling in all equity securities by requiring that participants of a
clearing agency registered with the Commission deliver securities by
settlement date, or if the participants have not delivered shares by
settlement date, immediately purchase or borrow securities to close out
the fail to deliver position 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. Failure to comply with the
close-out requirement of the temporary rule is a violation of the
temporary rule. In addition, a participant that does not comply with
this close-out requirement, and any broker-dealer from which it
receives trades for clearance and settlement, will not be able to short
sell the security either for itself or for the account of another,
unless it has previously arranged to borrow or borrowed the security,
until the fail to deliver position is closed out.

DATES: Effective Date: October 17, 2008 until July 31, 2009. Comment
Date: Comments should be received on or before December 16, 2008.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/final.shtml); or
     Send an e-mail to<EMAIL_ADDRESS>Please include
File Number S7-30-08 on the subject line; or
     Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Florence E. Harmon,
Acting Secretary, Securities and Exchange Commission, 100 F Street,
NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-30-08. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/final.shtml).

Comments are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549 on official business days between the hours of 10 a.m. and 3 p.m.
All comments received will be posted without change; we do not edit
personal identifying information from submissions. You should submit
only information that you wish to make available publicly.

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
Commission, 100 F Street, NE., Washington, DC 20549-6628.

SUPPLEMENTARY INFORMATION: We are adopting temporary Rule 204T of
Regulation SHO [17 CFR 242.204T] as an interim final temporary rule. We
are soliciting comments on all aspects of the rule. We will carefully
consider the comments that we receive and intend to respond to them in
a subsequent release.

I. Introduction

    Recently, we have become concerned that there is a substantial
threat of sudden and excessive fluctuations of securities prices and
disruption in the functioning of the securities markets that could
threaten fair and orderly markets. These concerns with respect to
financial institutions are evidenced by our recent publication of
emergency orders under section 12(k) of the Exchange Act in July (the
``July Emergency Order'') \1\ and September of this year (the ``Short
Sale Ban Emergency Order'').\2\ In these orders we noted our concerns
about the possible use of unfounded rumors regarding the stability of
financial institutions by short sellers for the purpose of manipulating
the prices of securities issued by the financial institutions to
increase profits through ``naked'' short selling.\3\
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    \1\ See Exchange Act Release No. 58166 (July 15, 2008), 73 FR
42379 (July 21, 2008) (imposing borrowing and delivery requirements
on short sales of the equity securities of certain financial
institutions).
    \2\ See Exchange Act Release No. 58592 (Sept. 18, 2008), 73 FR
55169 (Sept. 24, 2008) (temporarily prohibiting short selling in the
publicly traded securities of certain financial institutions); see
also Exchange Act Release No. 58611 (Sept. 21, 2008), 73 FR 55556
(Sept. 25, 2008) (amending the Short Sale Ban Emergency Order).
    \3\ ''Naked'' short selling generally refers to selling short
without having borrowed the securities to make delivery. See
Exchange Act Release No. 50103 (July 28, 2004), 69 FR 48008, 48009
n.10 (Aug. 6, 2004) (``2004 Regulation SHO Adopting Release''); see
also Commission press release, dated July 13, 2008, announcing that
the Commission's Office of Compliance Inspections and Examinations,
as well as the Financial Industry Regulatory Authority (``FINRA'')
and New York Stock Exchange Regulation, Inc., (``NYSE'') will
immediately conduct examinations aimed at the prevention of the
intentional spreading of false information intended to manipulate
securities prices. See http://www.sec.gov/news/press/2008/2008-
140.htm. In addition, in April of this year, the Commission charged
Paul S. Berliner, a trader, with securities fraud and market
manipulation for intentionally disseminating a false rumor
concerning The Blackstone Group's acquisition of Alliance Data
Systems Corp (``ADS''). The Commission alleged that this false rumor
caused the price of ADS stock to plummet, and that Berliner profited
by short selling ADS stock and covering those sales as the false
rumor caused the price of ADS stock to fall. See http://www.sec.gov/
litigation/litreleases/2008/lr20537.htm.
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    Our concerns, however, are not limited to just the financial
institutions that were the subject of the July Emergency Order and the
Short Sale Ban Emergency Order. Given the importance of confidence in
our financial markets as a whole, we have become concerned about sudden
and unexplained declines in the prices of equity securities generally.
Such price declines can give rise to questions about the underlying
financial condition of an institution, which in turn can create a
crisis of confidence even without a fundamental underlying basis. This
crisis of confidence can impair the liquidity and ultimate viability of
an institution, with potentially broad market consequences. These
concerns resulted in our issuance on September 17 of this year of an
emergency order under section 12(k) of the Exchange Act (the
``September Emergency Order'').\4\ Pursuant to that emergency order we
imposed enhanced delivery requirements on sales of all equity
securities by adding and making immediately effective a temporary rule
to Regulation SHO, Rule 204T.\5\
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    \4\ See Exchange Act Release No. 58572 (Sept. 17, 2008), 73 FR
54875 (Sept. 23, 2008).
    \5\ See id. The September Emergency Order also made immediately
effective amendments to Rule 203(b)(3) of Regulation SHO that
eliminate the options market maker exception from Regulation SHO's
close-out requirement. It also made immediately effective Rule 10b-
21, a ``naked'' short selling antifraud rule.
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    To further our goal of preventing substantial disruption in the
securities markets, we are adopting Rule 204T as an interim final
temporary rule, with some modifications to address operational and
technical concerns resulting from the requirements of the temporary
rule as adopted in the September Emergency Order. We intend that the
temporary rule will address potentially abusive ``naked'' short selling
by requiring that securities be purchased or borrowed to close out any
fail to deliver position in an equity security by no later than the
beginning of regular trading hours on the settlement day following the
date on which the fail to deliver position occurred. This temporary
rule should provide a powerful disincentive to those who might
otherwise engage in potentially abusive ``naked'' short selling.

II. Background

    Short selling involves a sale of a security that the seller does
not own or a sale which is consummated by the delivery of a security
borrowed by, or for the account of, the seller.\6\ Short sales normally
are settled by the delivery of a security borrowed by or on behalf of
the seller. In a ``naked'' short sale, however, the short seller does
not borrow securities in time to make delivery to the buyer within the
standard three-day settlement period.\7\ As a result, the seller fails
to deliver securities to the buyer when delivery is due (known as a
``fail'' or ``fail to deliver'').\8\ Sellers sometimes intentionally
fail to deliver securities as part of a scheme to manipulate the price
of a security,\9\ or possibly to avoid

borrowing costs associated with short sales, especially when the costs
of borrowing stock are high.
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    \6\ 17 CFR 242.200(a).
    \7\ See 2004 Regulation SHO Adopting Release, 69 FR at 48009
n.10.
    \8\ Generally, investors complete or settle their security
transactions within three settlement 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 settlement days after
the trade is executed so the brokerage firm can exchange those funds
for the securities on that third settlement day. The three-day
settlement period applies to most security transactions, including
stocks, bonds, municipal securities, mutual funds traded through a
brokerage firm, and limited partnerships that trade on an exchange.
Government securities and stock options settle on the next
settlement day following the trade (or T+1). 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; see also Exchange Act Release No.
56212 (Aug. 7, 2007), 72 FR 45544, n. 2 (Aug. 14, 2007) (``2007
Regulation SHO Final Amendments'').
    \9\ In 2003, the Commission settled a case against certain
parties relating to allegations of manipulative short selling in the
stock of a corporation. The Commission alleged that the defendants
profited from engaging in massive ``naked'' short selling that
flooded the market with the 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 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.
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    Although the majority of trades settle within the standard three-
day settlement cycle (``T+3''),\10\ we adopted Regulation SHO \11\ on
July 28, 2004, in part to address problems associated with persistent
fails to deliver securities and potentially abusive ``naked'' short
selling. For example, Regulation SHO requires broker-dealers to
``locate'' securities that the broker-dealer reasonably believes can be
delivered within the standard three-day settlement period.\12\
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    \10\ According to the National Securities Clearing Corporation
(``NSCC''), 99% (by dollar value) of all trades settle within T+3.
Thus, on an average day, approximately 1% (by dollar value) of all
trades, including equity, debt, and municipal securities fail to
settle on time.
    \11\ 17 CFR 242.200. Regulation SHO became effective on January
3, 2005.
    \12\ 17 CFR 242.203(b)(1). Rule 203(b)(1) of Regulation SHO
requires 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).'' This is known as the
``locate'' requirement. Market makers engaged in bona fide market
making in the security at the time they effect the short sale are
excepted from this requirement.
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    Another requirement of Regulation SHO aimed at potentially abusive
``naked'' short selling and reducing fails to deliver in certain equity
securities is the rule's ``close-out'' requirement. Specifically, Rule
203(b)(3) requires participants \13\ of a registered clearing
agency,\14\ which includes broker-dealers, to purchase shares to close
out fails to deliver in securities with large and persistent fails to
deliver, i.e., ``threshold securities.'' \15\ Until the position is
closed out, the participant responsible for the fail to deliver
position and any broker-dealer from which it receives trades for
clearance and settlement may not effect further short sales in that
threshold security without first borrowing or arranging to borrow the
securities.\16\
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    \13\ 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).
    \14\ The term ``registered clearing agency'' means a clearing
agency, as defined in Section 3(a)(23)(A) 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) and 78q-1, respectively; see also 2004
Regulation SHO Adopting Release, 69 FR at 48031. The majority of
equity trades in the United States are cleared and settled through
systems administered by clearing agencies registered with the
Commission. The National Securities Clearing Corporation (``NSCC'')
clears and settles the majority of equity securities trades
conducted on the exchanges and in the over-the-counter market. NSCC
clears and settles trades through the Continuous Net Settlement
(``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.
    \15\ Rule 203(c)(6) of Regulation SHO defines a ``threshold
security'' 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)) 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 is included on a list disseminated to its members
by a self-regulatory organization (``SRO''). See 17 CFR
242.203(c)(6).
    \16\ See 17 CFR 242.203(b)(3)(iv).
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    As adopted, Regulation SHO included two major exceptions to the
close-out requirement: The ``grandfather'' provision and the ``options
market maker'' exception. The ``grandfather'' provision had provided
that fails to deliver established prior to a security becoming a
threshold security did not have to be closed out in accordance with
Regulation SHO's thirteen consecutive settlement day close-out
requirement.
    Due to our concerns about the potentially negative market impact of
large and persistent fails to deliver, and the fact that we continued
to observe threshold securities with fail to deliver positions that are
not being closed out under existing delivery and settlement
requirements, effective on October 15, 2007, we adopted an amendment to
Regulation SHO that eliminated the ``grandfather'' exception to
Regulation SHO's close-out requirement.\17\
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    \17\ See 2007 Regulation SHO Final Amendments, 72 FR 45544. This
amendment also contained a one-time phase-in period that provided
that previously-grandfathered fails to deliver in a security that
was a threshold security on the effective date of the amendment must
be closed out within 35 consecutive settlement days from the
effective date of the amendment. The phase-in period ended on
December 5, 2007.
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    The options market maker exception excepted any fail to deliver
position 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. On September 17, 2008, as part of the
September Emergency Order, we adopted and made immediately effective an
amendment to Rule 203(b)(3) of Regulation SHO to eliminate the options
market maker exception to the rule's close-out requirement.\18\
Following the issuance of the September Emergency Order, we adopted
amendments making permanent the elimination of the options market maker
exception.\19\ As we discussed in the 2008 Regulation SHO Final
Amendments, we believe it was appropriate to eliminate the options
market maker exception in part 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.\20\
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    \18\ See September Emergency Order, supra note 4.
    \19\ See Exchange Act Release No. 58775 (Oct. 14, 2008)
(adopting final amendments to Rule 203(b)(3) of Regulation SHO to
eliminate the options market maker exception from the rule's close-
out requirement) (``2008 Regulation SHO Final Amendments''); see
also Exchange Act Release No. 56213 (Aug. 7, 2007), 72 FR 45558
(Aug. 14. 2007) (``2007 Regulation SHO Proposed Amendments);
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'').
    \20\ See 2008 Regulation SHO Final Amendments, supra note 19;
see also 2008 Regulation SHO Re-Opening Release, 73 FR 40201.
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    In addition to the actions we have taken aimed at reducing fails to
deliver and addressing potentially abusive ``naked'' short selling in
threshold securities, we have also taken action targeting potentially
abusive ``naked'' short selling in both threshold and non-threshold
securities. For example, in the September Emergency Order we adopted
and made immediately effective a ``naked'' short selling anti-fraud
rule, Rule 10b-21, aimed at sellers, including broker-dealers acting
for their own accounts, who deceive certain specified persons about
their intention or ability to deliver securities in time for settlement
and that fail to deliver securities by settlement date.\21\ Following
the issuance of the September Emergency Order, we adopted final
amendments making Rule 10b-21 permanent.\22\
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    \21\ See September Emergency Order, supra note 4.
    \22\ See Exchange Act Release No. 58774 (Oct. 14, 2008) (``Anti-
Fraud Rule Adopting Release''); see also Exchange Act Release No.
57511 (March 17, 2008), 73 FR 15376 (March 21, 2008) (``Anti-Fraud
Rule Proposing Release'').
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    Also, as mentioned above, in the July Emergency Order and the Short
Sale Ban Emergency Order, we took emergency action targeting ``naked''
short selling in the securities of certain financial firms that
included non-threshold securities. Specifically, on July 15, 2008, we
published the July

Emergency Order \23\ that temporarily imposed enhanced requirements on
short sales in the publicly traded securities of certain substantial
financial firms. The July Emergency Order required that, in connection
with transactions in the publicly traded securities of the substantial
financial firms identified in Appendix A to the Emergency Order
(``Appendix A Securities''), no person could effect a short sale in the
Appendix A Securities using the means or instrumentalities of
interstate commerce unless such person or its agent had borrowed, or
arranged to borrow, the security or otherwise had the security
available to borrow in its inventory, prior to effecting such short
sale. The July Emergency Order also required that the short seller
deliver the security on settlement date, prohibiting any fails to
deliver in the Appendix A Securities.\24\
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    \23\ See supra note 1.
    \24\ See id.
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    We issued the July Emergency Order because we were concerned that
false rumors regarding financial institutions of significance in the
U.S. may have fueled market volatility in the securities of some of
these institutions. As we noted in the July Emergency Order, false
rumors can lead to a loss of confidence in our markets. Such loss of
confidence can lead to panic selling, which may be further exacerbated
by ``naked'' short selling. As a result, the prices of securities may
artificially and unnecessarily decline below the price level that would
have resulted from the normal price discovery process. If significant
financial institutions are involved, this chain of events can threaten
disruption of our markets.\25\
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    \25\ We delayed the effective date of the July Emergency Order
to July 21, 2008 to create the opportunity to address, and to allow
sufficient time for market participants to make, adjustments to
their operations to implement the enhanced requirements. Moreover,
in addressing anticipated operational accommodations necessary for
implementation of the July Emergency Order, we issued an amendment
to the July Emergency Order on July 18, 2008. See Exchange Act
Release No. 58190 (July 18, 2008) (excepting from the July Emergency
Order bona fide market makers, short sales in Appendix A Securities
sold pursuant to Rule 144 of the Securities Act of 1933, and certain
short sales by underwriters, or members of a syndicate or group
participating in distributions of Appendix A Securities).
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    On July 29, 2008, we extended the July Emergency Order after
carefully reevaluating the current state of the markets in consultation
with officials of the Board of Governors of the Federal Reserve System,
the Department of the Treasury, and the Federal Reserve Bank of New
York and remaining concerned about the ongoing threat of market
disruption and effects on investor confidence.\26\ Pursuant to the
extension, the July Emergency Order terminated at 11:59 p.m. EDT on
August 12, 2008.
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    \26\ See Exchange Act Release No. 58248 (July 29, 2008), 73 FR
45257 (Aug. 4, 2008).
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    Due to our continued concerns regarding recent market conditions
and that short selling in the securities of a wider range of financial
institutions than those subject to the July Emergency Order may be
causing sudden and excessive fluctuations of the prices of such
securities that could threaten fair and orderly markets, on September
18, 2008, we issued the Short Sale Ban Emergency Order.\27\ The Short
Sale Ban Emergency Order temporarily prohibited any person from
effecting a short sale in the publicly traded securities of certain
financial institutions. On October 2, 2008, we extended the Short Sale
Ban Emergency Order due to our continued concerns regarding the ongoing
threat of market disruption and investor confidence in the financial
markets.\28\ Pursuant to the extension, the Short Sale Ban Emergency
Order terminated at 11:59 p.m. EDT on October 8, 2008.
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    \27\ See supra note 2.
    \28\ See Exchange Act Release No. 58723 (Oct. 2, 2008) (stating
that the Short Sale Ban Emergency Order would terminate the earlier
of (i) three business days from the President's signing of the
Emergency Economic Stabilization Act of 2008 (H.R. 1424), or (ii)
11:59 p.m. E.D.T. on Friday, October 17, 2008).
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    Our concerns are no longer limited to just the financial
institutions that were the subject of the July Emergency Order and the
Short Sale Ban Emergency Order. Given the importance of confidence in
our financial markets as a whole, we have become concerned about sudden
and unexplained declines in the prices of equity securities generally.
These concerns resulted in our adopting and making immediately
effective in the September Emergency Order the enhanced delivery
requirements contained in temporary Rule 204T.\29\ For the reasons
explained in detail herein, today we are adopting the temporary rule as
set forth in the September Emergency Order, with modifications to
address technical and operational concerns resulting from the
requirements of the temporary rule.
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    \29\ See September Emergency Order, supra note 4.
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III. Concerns About ``Naked'' Short Selling

    We have been concerned about ``naked'' short selling and, in
particular, abusive ``naked'' short selling, for some time. As
discussed above, such concerns were a primary reason for our adoption
of Regulation SHO in 2004, the elimination of the ``grandfather'' and
options market maker exceptions to Regulation SHO's close-out
requirement, the adoption of a ``naked'' short selling antifraud rule,
and our recent issuance of the July Emergency Order, Short Sale Ban
Emergency Order, and the September Emergency Order.
    Despite these Commission actions, due to our continuing concerns
about the potential impact of ``naked'' short selling on the weakened
financial markets, we believe it is necessary to immediately adopt as
an interim final temporary rule, temporary rule 204T, with some
modifications to address technical and operational concerns resulting
from the rule's requirements as set forth in the September Emergency
Order. We believe that adoption of temporary rule 204T as an interim
final temporary rule is necessary to further address abusive ``naked''
short selling and, therefore, fails to deliver resulting from such
short sales, in all equity securities. As we have stated on several
prior occasions, we 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.\30\ 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.\31\
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    \30\ See, e.g., Anti-Fraud Rule Proposing Release, 73 FR at
15376.
    \31\ See, e.g., 2007 Regulation SHO Final Amendments, 72 FR at
45544; 2006 Regulation SHO Proposed Amendments, 71 FR at 41712; 2007
Regulation SHO Proposed Amendments, 72 FR at 45558-45559; Anti-Fraud
Rule Proposing Release, 73 FR at 15378.
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    For example, large and persistent fails to deliver may deprive
shareholders of the benefits of ownership, such as voting and
lending.\32\ 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.\33\ Moreover, sellers that fail to deliver
securities on settlement date may attempt to use this additional
freedom to engage in trading activities to improperly depress the price
of a security. For example, by not borrowing securities and, therefore,
not making delivery within the standard three-day settlement period,
the seller does not incur the costs of borrowing.
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    \32\ See id.
    \33\ See id.

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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 \34\ designed to further reduce
the number of persistent fails to deliver in certain equity securities
by eliminating Regulation SHO's ``grandfather'' exception, and limiting
the duration of the rule's options market maker exception, we received
a number of comments that expressed concerns about ``naked'' short
selling and extended delivery failures.\35\ Commenters continued to
express these concerns in response to proposed amendments to eliminate
the options market maker exception to the close-out requirement of
Regulation SHO in 2007.\36\
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    \34\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
    \35\ 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; letter from Ahmed Akhtar, dated April 26, 2007.
    \36\ 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,\37\ such fails to deliver may undermine the
confidence of investors.\38\ These investors, in turn, may be reluctant
to commit capital to an issuer they believe to be subject to such
manipulative conduct.\39\ 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.\40\ Unwarranted reputational damage caused by fails to
deliver might have an adverse impact on the security's price.\41\
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    \37\ See supra note 9 (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).
    \38\ In response to the 2007 Regulation SHO Proposed Amendments,
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'').
    \39\ In response to the 2007 Regulation SHO Proposed Amendments,
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.'').
    \40\ Due in part to such concerns, some issuers have taken
actions to attempt to make transfer of their securities ``custody
only,'' (i.e., certificating the securities and prohibiting
ownership by a securities intermediary) 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 in order to make 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 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 Exchange Act Release No. 47978 (June
4, 2003), 68 FR 35037 (June 11, 2003).
    \41\ See 2006 Regulation SHO Proposed Amendments, 71 FR at
41712; 2007 Regulation SHO Amendments, 72 FR at 45544; 2007
Regulation SHO Proposed Amendments, 72 FR at 45558-45559; Anti-Fraud
Rule Proposing Release, 73 FR at 15378 (providing additional
discussion of the impact of fails to deliver on the market); see
also Exchange Act Release No. 48709 (Oct. 28, 2003), 68 FR 62972,
62975 (Nov. 6, 2003) (discussing the impact of ``naked'' short
selling on the market).
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IV. Discussion of Temporary Rule 204T

A. Rule 204T's Close-Out Requirement

    In these unusual and extraordinary times and in an effort to
prevent substantial disruption to the securities markets, we have
concluded that it is necessary to immediately adopt as an interim final
temporary rule, temporary rule Rule 204T, with some modifications to
address technical and operational concerns resulting from the rule's
requirements as set forth in the September Emergency Order. We believe
that adoption of the temporary rule will substantially restrict the
practice of potentially abusive ``naked'' short selling in all equity
securities by strengthening the delivery requirements for such
securities.\42\
---------------------------------------------------------------------------

    \42\ As noted above, in a ``naked'' short sale, the short seller
does not borrow or arrange to borrow securities in time to make
delivery to the buyer within the standard three-day settlement
period. As a result, the seller fails to deliver securities to the
buyer when delivery is due. See supra note 7 and supporting text.
---------------------------------------------------------------------------

    Specifically, temporary Rule 204T(a) provides that a participant of
a registered clearing agency must deliver securities to a registered
clearing agency for clearance and settlement on a long or short sale in
any equity security by settlement date, or if a participant of a
registered clearing agency has a fail to deliver position at a
registered clearing agency in any equity security for a long or short
sale transaction in that equity security, the participant shall, by no
later than the beginning of regular trading hours \43\ on the
settlement day \44\ following the settlement date, immediately close
out the fail to deliver position by borrowing or purchasing securities
of like kind and quantity.\45\
---------------------------------------------------------------------------

    \43\ ``Regular trading hours'' has the same meaning as in Rule
600(b)(64) of Regulation NMS. Rule 600(b)(64) provides that
``Regular trading hours means the time between 9:30 a.m. and 4 p.m.
Eastern Time, or such other time as is set forth in the procedures
established pursuant to Sec.  242.605(a)(2).''
    \44\ The term ``settlement day'' is defined in Rule 203(c)(5) of
Regulation SHO as: ``* * * any business day on which deliveries of
securities and payments of money may be made through the facilities
of a registered clearing agency.'' 17 CFR 242.203(c)(5).
    \45\ See temporary Rule 204T(a).
---------------------------------------------------------------------------

    Temporary Rule 204T(a)'s close-out requirement requires a
participant of a registered clearing agency that has a fail to deliver
position at a registered clearing agency on the settlement date for a
transaction to immediately borrow or purchase securities to close out
the amount of the fail to deliver position by no later than the
beginning of regular trading hours on the settlement day following the
settlement date (the ``Close-Out Date''). This close-out requirement
requires that the participant take affirmative action to purchase or
borrow securities. Thus, a participant may not offset the amount of its
settlement date fail to deliver position with shares that the
participant receives or will receive on the Close-Out

Date.\46\ To meet its close-out obligation a participant also must be
able to demonstrate on its books and records that on the Close-Out Date
it purchased or borrowed shares in the full quantity of its settlement
date fail to deliver position and, therefore, that the participant has
a net flat or net long position on its books and records in that equity
security on the Close-Out Date.
---------------------------------------------------------------------------

    \46\ In determining its close-out obligation, a participant may
rely on its net delivery obligation as reflected in its notification
from NSCC regarding its securities delivery and payment obligations,
provided such notification is received prior to the beginning of
regular trading hours on the Close-Out Date.
---------------------------------------------------------------------------

    The temporary rule defines a ``settlement date'' as ``the business
day on which delivery of a security and payment of money is to be made
through the facilities of a registered clearing agency in connection
with the sale of a security.'' \47\ This definition is consistent with
Rule 15c6-1 that 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.\48\
---------------------------------------------------------------------------

    \47\ See temporary Rule 204T(f)(1).
    \48\ See 17 CFR 240.15c6-1.
---------------------------------------------------------------------------

    Because most transactions settle by T+3 and because delivery on all
sales should be made by settlement date, participants should consider
having in place policies and procedures to help ensure that delivery is
being made by settlement date. We intend to examine participants'
policies and procedures to determine whether such policies and
procedures monitor for delivery by settlement date.\49\
---------------------------------------------------------------------------

    \49\ Of course, broker-dealers must comply with any applicable
SRO policies and procedures requirements. For example, NASD Rule
3010 contains, among other things, written procedures requirements
for member firms.
---------------------------------------------------------------------------

    Similar to the existing close-out requirement of Rule 203(b)(3) of
Regulation SHO, the temporary rule is based on a participant's fail to
deliver position at a registered clearing agency. As noted above, the
NSCC clears and settles the majority of equity securities trades
conducted on the exchanges and in the over-the-counter markets. 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. Because the temporary rule is based on a
participant's fail to deliver position at a registered clearing agency,
the temporary rule is consistent with current settlement practices and
procedures and with the Regulation SHO framework regarding delivery of
securities.\50\
---------------------------------------------------------------------------

    \50\ See 17 CFR 242.203(b)(3) (Regulation SHO's close-out
requirement). Consistent with current industry practice under
Regulation SHO, with respect to a net syndicate short position
created in connection with a distribution of a security that is part
of a fail to deliver position at a registered clearing agency, the
requirements of temporary Rule 204T shall not apply provided action
is taken to close out the net syndicate short position by no later
than the beginning of regular trading hours on the thirtieth day
after commencement of sales in the distribution. See e.g., Exchange
Act Release No. 58190 (July 18, 2008) (amending the July Emergency
Order to provide an exception from its requirements for fails to
deliver in connection with syndicate offerings).
---------------------------------------------------------------------------

    In addition, similar to Rule 203(b)(3)(vi) of Regulation SHO, the
temporary rule provides that a participant may reasonably allocate its
responsibility to close out a fail to deliver position to another
broker-dealer from which the participant receives trades for clearance
or settlement.\51\ Specifically, temporary Rule 204T(d) provides that
if a participant of a registered clearing agency reasonably allocates a
portion of a fail to deliver position to another registered broker or
dealer for which it clears trades or from which it receives trades for
settlement, based on such broker's or dealer's short position, the
provisions of Rule 204T(a) and (b) relating to such fail to deliver
position shall apply to such registered broker or dealer that was
allocated the fail to deliver position, and not to the participant.\52\
---------------------------------------------------------------------------

    \51\ See 17 CFR 242.203(b)(3)(vi). Rule 203(b)(3)(vi) provides
that ``[i]f a participant of a registered clearing agency reasonably
allocates a portion of a fail to deliver position to another
registered broker or dealer for which it clears trades or for which
it is responsible for settlement, based on such broker or dealer's
short position, then the provisions of this paragraph (b)(3)
relating to such fail to deliver position shall apply to the portion
of such registered broker or dealer that was allocated the fail to
deliver position, and not to the participant.''
    \52\ See temporary Rule 204T(d).
---------------------------------------------------------------------------

    Thus, participants that are able to identify the accounts of
broker-dealers for which they clear or from which they receive trades
for settlement, could allocate the responsibility to close out the fail
to deliver position to the particular broker-dealer account(s) whose
trading activities have caused the fail to deliver position provided
the allocation is reasonable (e.g., the allocation must be timely).
Absent such identification, however, the participant would remain
subject to the close-out requirement.
    Unlike Rule 203(b)(3)(vi) of Regulation SHO, temporary Rule 204T(d)
imposes an additional notification requirement on a broker-dealer that
has been allocated responsibility for complying with the rule's
requirements. Specifically, temporary Rule 204T(d) provides that a
broker or dealer that has been allocated a portion of a fail to deliver
position that does not comply with the provisions of temporary Rule
204T(a) must immediately notify the participant that it has become
subject to the borrowing requirements of temporary Rule 204T(b).\53\ We
are adopting this notification requirement so that participants will
know when a broker-dealer for which they clear and settle trades has
become subject to the temporary rule's borrowing requirements.
---------------------------------------------------------------------------

    \53\ See id.
---------------------------------------------------------------------------

    The temporary rule also differs from the current close-out
requirement of Regulation SHO in that it applies to fails to deliver in
all equity securities rather than only to those securities with a large
and persistent level of fails to deliver, i.e., threshold securities. A
primary purpose of the temporary rule is to prevent the use of
``naked'' short selling as part of a manipulative scheme. To achieve
this purpose, the rule must apply to all equity securities, regardless
of the level or persistence of any fails to deliver in such securities.
In addition, as discussed above, we 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. We believe
this should be the case for sales in all equity securities and are
adopting this temporary rule to further that goal.
    Regulation SHO, as adopted in 2004, was a first step in trying to
reduce persistent fails to deliver and address abusive ``naked'' short
selling. In Regulation SHO, we took a targeted approach, imposing
additional delivery requirements on securities with a substantial and
persistent amount of fails to deliver. As we stated in the 2004
Regulation SHO Adopting Release, we took this targeted approach at that
time in an effort not to burden the vast majority of securities where
there are not similar concerns regarding settlement.\54\ In addition,
Regulation SHO's close-out requirement was adopted to address potential
abuses that may occur with large, extended fails to deliver.\55\ We
also noted in the 2004 Regulation SHO Adopting Release, however, that
we would pay close attention to the operation and efficacy of

the provisions we were adopting at that time and would consider whether
any further action was warranted.\56\
---------------------------------------------------------------------------

    \54\ See 2004 Regulation SHO Adopting Release, 69 FR at 48016.
    \55\ See id. at 48017.
    \56\ See id. at 48018.
---------------------------------------------------------------------------

    Because of continued concerns about the potentially negative market
impact of fails to deliver, and the fact that through our monitoring of
the efficacy of Regulation SHO's close-out requirement we continued to
observe threshold securities with fail to deliver positions that are
not being closed out under existing delivery and settlement
requirements, we eliminated the ``grandfather'' and options market
maker exceptions to Regulation SHO's close-out requirements.\57\
---------------------------------------------------------------------------

    \57\ On June 13, 2007, we adopted amendments to eliminate the
``grandfather'' exception to Regulation SHO's close-out requirement.
On September 17, 2008, in the September Emergency Order, we adopted
amendments to eliminate the options market maker exception, which
amendments were subsequently made permanent. See supra notes 17, 18
and 19.
---------------------------------------------------------------------------

    However, we are concerned that Regulation SHO's current provisions
have not gone far enough in reducing fails to deliver and addressing
potentially abusive ``naked'' short selling.\58\ More is needed to
reduce fails to deliver and to address potentially abusive ``naked''
short selling, especially in light of the current instability and lack
of investor confidence in the financial markets.\59\ In addition,
because Regulation SHO's close-out requirement applies only to
threshold securities, fails to deliver in non-threshold securities
never have to be closed out.\60\ We believe that adoption of temporary
rule 204T as an interim final temporary rule is necessary to curtail
fails to deliver in both threshold and non-threshold securities to
further address abusive ``naked'' short selling in such securities.
---------------------------------------------------------------------------

    \58\ See, e.g., 2007 Regulation SHO Final Amendments, 72 FR
45544 (eliminating the ``grandfather'' exception to Regulation SHO's
close-out requirement due to our observing continued fails to
deliver in threshold securities); 2008 Regulation SHO Final
Amendments, supra note 19 (eliminating the options market maker
exception to Regulation SHO's close-out requirement due to
substantial levels of fails to deliver continuing to persist in
optionable threshold securities).
    \59\ See, e.g., letter from Leland Chan, General Counsel,
California Bankers Association, dated Aug. 21, 2008; letter from
Eric C. Jensen, Esq., Cooley Godward Kronish L.P., dated Aug. 21,
2008; letter from Steven B. Boehm and Cynthia M. Krus, Sutherland
Asbill Brennan LLP, dated July 31, 2008; letter from James J. Angel,
Professor of Finance, Georgetown University, McDonough School of
Business, dated Aug. 20, 2008; letter from Tuan Nguyen, dated Aug.
8, 2008.
    \60\ OEA estimates that fails to deliver in non-threshold
securities averaged approximately 624 million shares or $4.6 billion
in value per day from January to July 2008. These fails account for
approximately 54.5% (56.6%) of all fail to deliver shares (by dollar
value).
---------------------------------------------------------------------------

    As discussed above, due to our concerns about potentially abusive
``naked'' short selling in certain non-threshold securities, we
recently issued the July Emergency Order to temporarily impose enhanced
requirements on short sales in the Appendix A Securities. Following our
issuance of the July Emergency Order, we issued the Short Sale Ban
Emergency Order in which we took the additional step of prohibiting
short selling in the securities of a wider range of financial
institutions than those subject to the July Emergency Order. In
addition, we issued the September Emergency Order which, in part,
imposed enhanced delivery requirements for transactions in all equity
securities and made effective immediately a ``naked'' short selling
antifraud rule. We took these emergency actions because we were
concerned about panic selling in securities due to a loss of confidence
that could be further exacerbated by ``naked'' short selling.
    Following the issuance of the July Emergency Order, members of the
public have repeatedly expressed their concerns about a loss of
confidence in the financial markets.\61\ In addition, since the
termination of the July Emergency Order and the issuance of the Short
Sale Ban Emergency Order and the September Emergency Order, we have
continued our evaluation of the markets and our discussions with the
Federal Reserve, Treasury, and the Federal Reserve Bank of New York
regarding the state of the financial markets. In light of these
processes, we have determined that we must take action to adopt as an
interim final temporary rule, temporary Rule 204T, to substantially
restrict ``naked'' short selling in all equity securities. As with the
July Emergency Order, the Short Sale Ban Emergency Order, and the
September Emergency Order, we are adopting this temporary rule as a
preventative step to help restore market confidence.
---------------------------------------------------------------------------

    \61\ See, e.g., letter from Tom Donohue, President, U.S. Chamber
of Commerce, dated July 15, 2008; letter from Ron Heller, dated July
21, 2008; letter from Ronald L. Rourk, dated July 21, 2008; letter
from Wayne Jett, Managing Principal and Chief Economist at Classical
Capital, LLC, dated July 24, 2008; letter from Edward Herlilhy and
Theodore Levine, Wachtell, Lipton, Rosen and Katz, LLP, dated Sept.
16, 2008; letter from Sen. Hillary Rodham Clinton, dated Sept. 17,
2008; letter from Representative D. Burton, dated Sept. 18, 2008;
letter from Elliott Bossen, Chief Investment Officer at Silverback
Asset Management, dated Sept. 24, 2008.
---------------------------------------------------------------------------

    In addition to applying the temporary rule to fails to deliver in
all equity securities, rather than just threshold securities, the
temporary rule also differs from the close-out requirement of Rule
203(b)(3) of Regulation SHO in that it shortens the close-out period
for such fails to deliver.\62\ For the reasons discussed below, rather
than requiring close out of a fail to deliver position within thirteen
consecutive settlement days (or 10 days after settlement date),
temporary Rule 204T requires a participant to immediately purchase or
borrow shares to close out a fail to deliver position by no later than
the beginning of regular trading hours on the settlement day following
the day on which the fail to deliver position occurs.
---------------------------------------------------------------------------

    \62\ Rule 203(b)(3) of Regulation SHO provides: ``If a
participant of a registered clearing agency has a fail to deliver
position at a registered clearing agency in a threshold security for
thirteen consecutive settlement days, the participant shall
immediately thereafter close out the fail to deliver position by
purchasing securities of like kind and quantity.'' See 17 CFR
242.203(b)(3).
---------------------------------------------------------------------------

    As noted above, trades in most securities generally settle within a
three-day settlement cycle, known as T+3 (or ``trade date plus three
days''). T+3 means that when a trade occurs, the participants to the
trade are expected to deliver and pay for the security at a clearing
agency three settlement days after the trade is executed so the
brokerage firm can exchange those funds for the securities on that
third business day. The three-day settlement period applies to most
security transactions, including stocks, bonds, municipal securities,
mutual funds traded through a brokerage firm, and limited partnerships
that trade on an exchange. Government securities and stock options
typically settle on the next business day following the trade (or
T+1).\63\ We believe that delivery on all sales should be made by
settlement date and, therefore, in temporary Rule 204T we are requiring
that fails to deliver in all equity securities be closed out by no
later than the beginning of regular trading hours on the Close-Out
Date.
---------------------------------------------------------------------------

    \63\ See supra note 8.
---------------------------------------------------------------------------

    In the 2004 Regulation SHO Adopting Release we stated we were
adopting a thirteen consecutive settlement day close-out requirement in
part because the close-out requirement applied to fails to deliver
resulting from long and short sales in threshold securities, and
extending the time period to ten days after settlement date for a
transaction would make the close-out requirement consistent with Rule
15c3-3(m).\64\ In addition, we noted in that release that ten days
after settlement was also the timeframe used at that time in NASD Rule
11830.\65\ We also acknowledged that a shorter timeframe, such as two
days after settlement, may capture many

instances of ordinary course settlement delays.\66\
---------------------------------------------------------------------------

    \64\ See 17 CFR 240.15c3-3(m).
    \65\ See 2004 Regulation SHO Adopting Release, 69 FR at 48017,
n.93.
    \66\ See id.
---------------------------------------------------------------------------

    In addition, we have stated previously that the vast majority of
fails to deliver are closed out within five days after T+3.\67\ In
addition, a recent analysis by our Office of Economic Analysis found
that more than half of all fails to deliver and more than 70% of all
fail to deliver positions are closed out within two settlement days
after T+3.\68\ Although this information shows that delivery is being
made, it demonstrates that often delivery is not being made until
several days following the standard three-day settlement cycle. In
addition, the current close-out requirement for threshold securities
under Regulation SHO and the lack of any close-out requirement for non-
threshold securities under Regulation SHO enables fails to deliver to
persist for many days beyond settlement date. We believe that allowing
fails to deliver to extend out beyond settlement date for a transaction
is too long.
---------------------------------------------------------------------------

    \67\ See, e.g., 2007 Regulation SHO Final Amendments, 72 FR at
45544, n.5.
    \68\ OEA's analysis examined the period from January to July
2008 and used the age of the fail to deliver position as reported by
the NSCC. The NSCC data included only securities with at least
10,000 shares in fails to deliver. We note that these numbers
included securities that were not subject to the close-out
requirement in Rule 203(b)(3) of Regulation SHO, which applies only
to ``threshold securities'' as defined in Rule 203(c)(6) of
Regulation SHO.
---------------------------------------------------------------------------

    We have continuously monitored the extent of fails to deliver and
abusive ``naked'' short selling in the markets. We believe that
allowing fails to deliver in all equity securities to persist for
thirteen consecutive settlement days (10 days after settlement date) if
such securities are threshold securities, or indefinitely if such
securities are not threshold securities, is too long. As discussed
above, fails to deliver may be indicative of a scheme to manipulate the
price of a security. In addition, we are concerned about the negative
effect that fails to deliver and potentially abusive ``naked'' short
selling may have on the market and the broader economy, including on
investor confidence. Temporary Rule 204T addresses these concerns by
requiring a participant to immediately close out a fail to deliver
position by purchasing or borrowing securities by no later than the
beginning of regular trading hours on the Close-Out Date.
    We believe we should act to require earlier close out so that more
sales settle by settlement date. Indeed, we believe that delivery on
all sales should be made by settlement date. As we discuss above, and
as we have stated on several prior occasions, we 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.\69\
Although the temporary rule's close-out requirement may capture some
instances of ordinary course settlement delays, we believe that the
temporary rule's close-out requirement is necessary to help ensure that
fails to deliver in all equity securities settle by settlement date. In
addition, as discussed above, due to our belief that delivery should be
made by settlement date, participants should consider having policies
and procedures in place to monitor for the delivery of securities by
settlement date.
---------------------------------------------------------------------------

    \69\ See supra note 30.
---------------------------------------------------------------------------

    We understand, however, that fails to deliver may occur from long
sales within the first two settlement days after settlement date for
legitimate reasons. 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.
    Thus, temporary Rule 204T(a)(1) includes an exception from the
temporary rule's close-out requirement for fail to deliver positions
resulting from long sales of all equity securities. Specifically,
temporary Rule 204T(a)(1) 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 and the participant
can demonstrate on its books and records that such fail to deliver
position resulted from a long sale, 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.\70\
---------------------------------------------------------------------------

    \70\ See temporary Rule 204T(a)(1). We note that if a person
that has loaned a security to another person sells the security and
a bona fide recall of the security is initiated within two business
days after trade date, the person that has loaned the security will
be ``deemed to own'' the security for purposes of Rule 200(g)(1) of
Regulation SHO, and such sale will not be treated as a short sale
for purposes of temporary Rule 204T. In addition, a broker-dealer
may mark such orders as ``long'' sales provided such marking is also
in compliance with Rule 200(c) of Regulation SHO. Thus, the close-
out requirement of temporary Rule 204T(a)(1) applies to sales of
such securities.
---------------------------------------------------------------------------

B. Borrowing Requirements

    If a participant does not purchase or borrow shares, as applicable,
to close out a fail to deliver position in accordance with temporary
Rule 204T, the participant violates the close-out requirement of the
temporary rule. In addition, the temporary rule imposes on the
participant for its own trades and on all broker-dealers from which
that participant receives trades for clearance and settlement
(including introducing and executing brokers), a requirement to borrow
or arrange to borrow securities prior to accepting or effecting further
short sales in that security.
    Specifically, temporary Rule 204T(b) provides that the participant
and any broker or dealer from which it receives trades for clearance
and settlement, including any market maker that is otherwise entitled
to rely on the exception provided in Rule 203(b)(2)(iii) of Regulation
SHO,\71\ may not accept a short sale order in an equity security from
another person, or effect a short sale order in such equity security
for its own account, to the extent that the broker or dealer submits
its short sales to that participant for clearance and settlement,
without first borrowing the security, 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 and that purchase has cleared and settled at a registered
clearing agency.\72\
---------------------------------------------------------------------------

    \71\ See 17 CFR 242.203(b)(2)(iii) (providing an exception from
Regulation SHO's ``locate'' requirement for short sales effected by
a market maker in connection with bona fide market making activities
in the securities for which the exception is claimed).
    \72\ See temporary Rule 204T(b).
---------------------------------------------------------------------------

    The borrow requirements of temporary Rule 204T(b) are consistent
with the requirements of Rule 203(b)(3)(iv) of Regulation SHO for a
participant that has not closed out a fail to deliver position in a
threshold security that has persisted for thirteen consecutive
settlement days.\73\ Similar to Regulation SHO, the temporary rule is
aimed at addressing potentially abusive ``naked'' short selling. To
that end, we believe it is appropriate to include in the temporary rule
borrow requirements for broker-dealers,

including participants, that sell short a security that has a fail to
deliver position that has not been closed out in accordance with the
requirements of the temporary rule. We believe that the borrow
requirements of temporary Rule 204T(b) will further our goal of
limiting fails to deliver and addressing abusive ``naked'' short
selling by promoting the prompt and accurate clearance and settlement
of securities transactions. By requiring that participants and broker-
dealers from which they receive trades for clearance and settlement
borrow or arrange to borrow securities prior to accepting or effecting
short sales in the security that has a fail to deliver position that
has not been closed out, the temporary rule will help to ensure that
shares will be available for delivery on the short sale by settlement
date and, thereby, help to avoid additional fails to deliver occurring
in the security.
---------------------------------------------------------------------------

    \73\ See 17 CFR 242.203(b)(3)(iv). Rule 203(b)(3)(iv) of
Regulation SHO provides that ``[i]f a participant of a registered
clearing agency has a fail to deliver position at a registered
clearing agency in a threshold security for thirteen consecutive
settlement days, the participant and any broker or dealer for which
it clears transactions, including any market maker that would
otherwise be entitled to rely on the exception provided in paragraph
(b)(2)(iii) of this section, many not accept a short sale order in
the threshold security from another person, or effect a short sale
in the threshold security for its own account, without borrowing the
security 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.''
---------------------------------------------------------------------------

    Unlike the borrow requirements of Rule 203(b)(3)(iv) of Regulation
SHO, however, the borrow requirements of the temporary rule specify
that participants must notify all broker-dealers from which they
receive trades for clearance and settlement that a fail to deliver
position has not been closed out in accordance with temporary Rule
204T. Specifically, temporary Rule 204T(c) provides that the
participant must notify any broker or dealer from which it receives
trades for clearance and settlement, including any market maker that is
otherwise entitled to rely on the exception provided in Rule
203(b)(2)(iii) of Regulation SHO,\74\ (a) that the participant has a
fail to deliver position in an equity security at a registered clearing
agency that has not been closed out in accordance with the requirements
of temporary Rule 204T, and (b) when the purchase that the participant
has made to close out the fail to deliver position has cleared and
settled at a registered clearing agency.\75\
---------------------------------------------------------------------------

    \74\ See 17 CFR 203(b)(2)(iii) (providing for an exception from
the ``locate'' requirement for market makers engaged in bona fide
market making in that security at the time of the short sale).
    \75\ See temporary Rule 204T(c).
---------------------------------------------------------------------------

    We are including this notification requirement in temporary Rule
204T(c) so that all broker-dealers that submit trades for clearance and
settlement to a participant that has a fail to deliver position in a
security that has not been closed out in accordance with temporary Rule
204T will be on notice that short sales in that security to be cleared
or settled through that participant will be subject to the borrow
requirements of temporary Rule 204T(b) until the fail to deliver
position has been closed out.
    The temporary rule, however, includes an exception from the
borrowing requirements for any broker-dealer that can demonstrate that
it was not responsible for any part of the fail to deliver position of
the participant. Specifically, temporary Rule 204T(b)(1) provides that
a broker or dealer shall not be subject to the requirements of
temporary Rule 204T(b) if the broker or dealer timely certifies to the
participant that it has not incurred a fail to deliver position on
settlement date for a long or short sale in an equity security for
which the participant has a fail to deliver position at a registered
clearing agency or that the broker or dealer is in compliance with the
requirements of temporary Rule 204T(e).\76\ We have included this
exception because we do not believe that a broker-dealer should be
subject to the borrowing requirements of the temporary rule if the
broker-dealer can demonstrate that it did not incur a fail to deliver
position in the security on settlement date.
---------------------------------------------------------------------------

    \76\ See temporary Rule 204T(b)(1). Temporary Rule 204T(e) is
discussed in detail below in Section IV.C.
---------------------------------------------------------------------------

    In addition, as noted above, the temporary rule provides that a
participant may reasonably allocate (e.g., the allocation must be
timely) its responsibility to close out a fail to deliver position to
another broker-dealer for which the participant clears or from which
the participant receives trades for settlement. Thus, to the extent
that the participant can identify the broker-dealer(s) that have
contributed to the fail to deliver position, and the participant has
reasonably allocated the close-out obligation to the broker-dealer(s),
the requirement to borrow or arrange to borrow prior to effecting
further short sales in that security will apply to only those
particular broker-dealer(s).

C. Pre-Fail Credit

    To avoid the borrow or arrangement to borrow requirement of
temporary Rule 204T(a), a participant could close-out the fail by
borrowing and delivering securities sufficient to close-out the fail to
deliver position prior to the beginning of regular trading hours on the
Close-Out Date. If, however, the participant does not succeed in
eliminating the fail to deliver position the participant can only close
out that position by immediately borrowing or purchasing securities to
close out the fail to deliver position by no later than the beginning
of regular trading hours on the Close-Out Date in accordance with
temporary Rule 204T.
    To encourage close outs of fail to deliver positions prior to the
Close-Out Date, similar to the September Emergency Order,\77\ temporary
Rule 204T(e) provides that a broker-dealer can satisfy the temporary
rule's close-out requirement by purchasing securities in accordance
with the conditions of that provision (i.e., broker-dealers will
receive ``pre-fail credit'' for the purchase). Specifically, temporary
Rule 204T(e) provides that even if a participant of a registered
clearing agency has not closed out a fail to deliver position at a
registered clearing agency in accordance with temporary Rule 204T(a),
or has not allocated a fail to deliver position to a broker or dealer
in accordance with temporary Rule 204T(d), a broker or dealer shall not
be subject to the requirements of paragraphs (a) or (b) of the
temporary rule if the broker or dealer purchases securities prior to
the beginning of regular trading hours on the Close-Out Date for a long
or short sale to close out an open short position, and if:
---------------------------------------------------------------------------

    \77\ See Exchange Act Release No. 58711 (Oct. 1, 2008) (stating
that in connection with extending the September Emergency Order, the
Commission incorporates and adopts the Division of Trading and
Markets: Guidance Regarding the Commission's Emergency Order
Concerning Rules to Protect Investors Against ``Naked'' Short
Selling Abuses and the Division of Trading and Markets Guidance
Regarding Sale of Loaned but Recalled Securities).
---------------------------------------------------------------------------

    (1) The purchase is bona fide;
    (2) The purchase is executed on, or after, trade date but by no
later than the end of regular trading hours on settlement date for the
transaction;
    (3) The purchase is of a quantity of securities sufficient to cover
the entire amount of the open short position; and
    (4) The broker or dealer can demonstrate that it has a net long
position or net flat position on its books and records on the
settlement day for which the broker or dealer is seeking to demonstrate
that it has purchased shares to close out its open short position.
    To receive pre-fail credit under temporary Rule 204T(e), the
purchase must be ``bona fide.'' Thus, where a broker-dealer enters into
an arrangement with another person to purchase securities, and the
broker-dealer knows or has reason to know that the other person will
not deliver securities in settlement of the transaction, the purchase
will not be considered to be ``bona fide.'' \78\ In addition, the
purchase

must be of a quantity of securities sufficient to cover the entire
amount of the open short position.\79\
---------------------------------------------------------------------------

    \78\ See 17 CFR 203(b)(3)(vii) (discussing bona fide purchases
for purposes of Regulation SHO). 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.
    \79\ See temporary Rule 204T(e)(3).
---------------------------------------------------------------------------

    Temporary Rule 204T(e) also requires that to receive pre-fail
credit, the purchase must be executed on, or after, trade date but by
no later than the end of regular trading hours on the settlement date
of the transaction that resulted in the fail to deliver position at a
registered clearing agency.\80\ The purpose of this provision is to
encourage broker-dealers to close out fail to deliver positions prior
to the beginning of regular trading hours on the Close-Out Date.
---------------------------------------------------------------------------

    \80\ See temporary Rule 204T(e)(2).
---------------------------------------------------------------------------

    In addition, to help ensure that broker-dealers purchase sufficient
shares to close out their fail to deliver positions, temporary Rule
204T(e) requires that the broker-dealer claiming pre-fail credit be net
long or net flat on the settlement day on which the broker-dealer is
claiming pre-fail credit.\81\ In addition, the temporary Rule 204T(e)
requires that the broker-dealer be able to demonstrate that it has
complied with this requirement.\82\ This requirement will enable the
Commission and SROs to monitor more effectively whether or not a
broker-dealer has complied with the requirements of temporary Rule
204T(e).
---------------------------------------------------------------------------

    \81\ See temporary Rule 204T(e)(4).
    \82\ See id.
---------------------------------------------------------------------------

D. Market Makers

    To allow market makers to facilitate customer orders in a fast
moving market, similar to the September Emergency Order,\83\ temporary
rule includes a limited exception from the rule's close-out and
borrowing requirements for fails to deliver attributable to bona fide
market making activities by 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 (individually a ``Market Maker,''
collectively ``Market Makers''), 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.\84\
---------------------------------------------------------------------------

    \83\ See supra note 77.
    \84\ See temporary Rule 204T(a)(3). Unlike the September
Emergency Order, however, the temporary rule does not require a
Market Maker to which a fail to deliver position at a registered
clearing agency is attributable to attest in writing to the market
on which it is registered that the fail to deliver position at issue
was established solely for the purpose of meeting its bona fide
market making obligations and the steps the Market Maker has taken
in an effort to deliver securities to its registered clearing
agency. We believe the costs of such a requirement would outweigh
the benefits. We note, however, that as with any exception, a
broker-dealer would have to evidence eligibility for, and compliance
with, the requirements of the exception.
---------------------------------------------------------------------------

    In addition, similar to the September Emergency Order,\85\ the
temporary rule excepts Market Makers from the borrowing requirements of
temporary Rule 204T(b) if the Market Maker can demonstrate that it does
not have an open fail to deliver position at the time of any additional
short sales. The borrowing requirements of the temporary rule apply to
all broker-dealers from which a participant of a registered clearing
agency receives trades for clearance and settlement. To allow Market
Makers to facilitate customer orders, we do not believe that a Market
Maker should be subject to the temporary rule's borrowing requirements
if the Market Maker does not have an open fail to deliver at the time
of any additional short sales.
---------------------------------------------------------------------------

    \85\ See supra note 77.
---------------------------------------------------------------------------

E. Sales Pursuant to Rule 144

    The temporary rule includes an exception for sales of all equity
securities pursuant to Rule 144 under the Securities Act of 1933
(``Securities Act'').\86\ Specifically, temporary Rule 204T(a)(2)
provides that if a participant of a registered clearing agency has a
fail to deliver position at a registered clearing agency in an equity
security sold pursuant to Rule 144 for thirty-five consecutive
settlement days after the settlement date for a sale in that equity
security, the participant shall, by no later than the beginning of
regular trading hours on the thirty-sixth consecutive settlement day
following the settlement date for the transaction, immediately close
out the fail to deliver position by purchasing securities of like kind
and quantity.\87\
---------------------------------------------------------------------------

    \86\ See 17 CFR 230.144.
    \87\ See temporary Rule 204T(a)(2).
---------------------------------------------------------------------------

    Regulation SHO provides an exception from the ``locate''
requirement of Rule 203(b)(1) for situations where a broker-dealer
effects a short sale on behalf of a customer that is deemed to own the
security pursuant to Rule 200 of Regulation SHO, although, through no
fault of the customer or broker-dealer, it is not reasonably expected
that the security will be in the physical possession or control of the
broker-dealer by settlement date and, therefore, is a ``short'' sale
under the marking requirements of Rule 200(g).\88\ Rule 203(b)(2)(ii)
of Regulation SHO provides that in such circumstances, delivery must be
made on the sale as soon as all restrictions on delivery have been
removed, and in any event no later than 35 days after trade date, at
which time the broker-dealer that sold on behalf of the person must
either borrow securities or close out the open position by purchasing
securities of like kind and quantity.\89\ In addition, recently we
adopted amendments to the close-out requirement of Regulation SHO to
allow fails to deliver resulting from sales of threshold securities
pursuant to Rule 144 to be closed out within 35 rather than 13
consecutive settlement days.\90\
---------------------------------------------------------------------------

    \88\ Pursuant to Rule 200(g)(2) of Regulation SHO, as adopted in
August 2004, generally these sales were marked ``short exempt.'' See
2004 Regulation SHO Adopting Release, 69 FR at 48030-48031; but cf.
Exchange Act Release No. 55970 (June 28, 2007), 72 FR 36348 (July 3,
2007) (removing the ``short exempt'' marking requirement).
    \89\ See 17 CFR 242.203(b)(2)(ii). In the 2004 Regulation SHO
Adopting Release, the Commission stated that it believed that 35
calendar days is a reasonable outer limit to allow for restrictions
on a security to be removed if ownership is certain. In addition,
the Commission noted that Section 220.8(b)(2) of Regulation T of the
Federal Reserve Board allows 35 calendar days to pay for securities
delivered against payment if the delivery delay is due to the
mechanics of the transactions. See 2004 Regulation SHO Adopting
Release, 69 FR at 48015, n.72.
    \90\ See 2007 Regulation SHO Final Amendments, 72 FR at 45550-
45551.
---------------------------------------------------------------------------

    Securities sold pursuant to Rule 144 under the Securities Act are
formerly restricted securities that a seller is ``deemed to own,'' as
defined by Rule 200(a) of Regulation SHO.\91\ The securities, however,
may not be capable of being delivered on the settlement date due to
processing delays related to removal of the restricted legend and,
therefore, sales of these securities frequently result in fails to
deliver.

Consistent with our statements in connection with our recent amendments
to Regulation SHO in connection with closing out fails to deliver in
threshold securities sold pursuant to Rule 144, we believe that a
close-out requirement of 35 consecutive settlement days from settlement
date for fails to deliver resulting from sales of all equity securities
sold pursuant to Rule 144, will permit the orderly settlement of such
sales without the risk of causing market disruption due to unnecessary
purchasing activity (particularly if the purchases are for sizable
quantities of stock). Because the security being sold will be received
as soon as all processing delays have been removed, this additional
time will allow participants to close out fails to deliver resulting
from the sale of the security with the security sold, rather than
having to close out such fail to deliver position by purchasing
securities in the market.\92\
---------------------------------------------------------------------------

    \91\ See 17 CFR 242.200(a).
    \92\ We understand that sellers that own restricted equity
securities that wish to sell pursuant to an effective resale
registration statement under Rule 415 under the Securities Act
experience similar types of potential settlement delays as sales of
securities pursuant to Rule 144 under the Securities Act. Thus,
fails to deliver in such securities may be closed out in accordance
with temporary Rule 204T(a)(2) if the fails to deliver resulted from
sales of securities that were outstanding at the time they were sold
and the sale occurred after a registration has become effective. In
addition, we understand that sales pursuant to broker-assisted
cashless exercises of compensatory options to purchase a company's
stock, may result in potential settlement delays and, therefore,
fails to deliver. Such fails to deliver may be closed out in
accordance with temporary Rule 204T(a)(2).
---------------------------------------------------------------------------

    If, however, a fail to deliver position resulting from the sale of
an equity security pursuant to Rule 144 is not closed out in accordance
with temporary Rule 204T(a)(2), the borrowing requirements of temporary
Rule 204T(b) will apply. Thus, if a participant does not close out a
fail to deliver position at a registered clearing agency in accordance
with temporary Rule 204T(a)(2), the temporary rule prohibits the
participant, and any broker-dealer from which it receives trades for
clearance and settlement, including market makers, from accepting any
short sale orders or effecting further short sales in the particular
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
and that purchase has cleared and settled at a registered clearing
agency.\93\
---------------------------------------------------------------------------

    \93\ See temporary Rule 204T(b).
---------------------------------------------------------------------------

V. Other Matters

    The Administrative Procedure Act generally requires an agency to
publish notice of a proposed rulemaking in the Federal Register.\94\
This requirement does not apply, however, if the agency ``for good
cause finds * * * that notice and public procedure are impracticable,
unnecessary, or contrary to the public interest.'' \95\ Further, the
Administrative Procedure Act also generally requires that an agency
publish an adopted rule in the Federal Register 30 days before it
becomes effective.\96\ This requirement, however, does not apply if the
agency finds good cause for making the rule effective sooner.\97\
---------------------------------------------------------------------------

    \94\ See 5 U.S.C. Sec.  553(b).
    \95\ Id.
    \96\ See 5 U.S.C. Sec.  553(d).
    \97\ Id.
---------------------------------------------------------------------------

    For the reasons discussed throughout this release, we believe that
we have good cause to act immediately to adopt this rule on an interim
final temporary basis. The September Emergency Order, in which we
adopted and made immediately effective temporary Rule 204T expires at
11:59 p.m. EDT on October 17, 2008. As discussed throughout this
release, we have determined it is necessary to act immediately and
adopt this rule on an interim final temporary basis so that temporary
rule 204T remains in effect in the form set forth herein following the
expiration of the September Emergency Order.
    This temporary rule takes effect on October 17, 2008. For the
reasons discussed above, we have acted on an interim final temporary
basis. We emphasize that we are requesting comments on the temporary
rule and will carefully consider the comments we receive and respond to
them in a subsequent release. Moreover, this is a temporary rule, and
will expire on July 31, 2009. Setting a termination date for the rule
will necessitate further Commission action no later than the end of
that period if the Commission intends to continue the same, or similar,
requirements contained in the temporary rule.
    The sunset provision will enable the Commission to assess the
operation of the temporary rule and intervening developments, including
a restoration of stability to the financial markets, as well as public
comments, and consider whether to continue the rule with or without
modification or not at all.
    We find that there is good cause to have the temporary rule take
effect on October 17, 2008 and that notice and public procedure in
advance of effectiveness of the rule are impracticable, unnecessary,
and contrary to the public interest.\98\
---------------------------------------------------------------------------

    \98\ This finding also satisfies the requirements of 5 U.S.C.
808(2), allowing the rules to become immediately effective
notwithstanding the requirements of 5 U.S.C. 801 (if a Federal
agency finds that notice and public comment are ``impractical,
unnecessary, or contrary to the public interest,'' a rule ``shall
take effect at such time as the Federal agency promulgating the rule
determines.'').
---------------------------------------------------------------------------

VI. Request for Comment

    We are requesting comments from all members of the public. We will
carefully consider the comments that we receive and intend to respond
to them in a subsequent release. We seek comment generally on all
aspects of the temporary rule. In addition, we seek comment on the
following:
    [cir] The temporary rule requires participants to immediately close
out a fail to deliver position by no later than the beginning of
regular trading hours on the Close-Out Date. Should we narrow the
close-out requirement further? Should we allow a longer or shorter
period of time within which to close out a fail to deliver position?
What would be the justifications for allowing a shorter or longer
close-out period?
    [cir] Are there any operational or compliance issues related to
complying with the requirement in temporary Rule 204T(a) to immediately
purchase or borrow securities ``by no later than the beginning of
regular trading hours''? Should we allow a participant to take steps to
purchase or borrow securities after the beginning of regular trading
hours on the Close-Out Date to satisfy temporary Rule 204T(a)? If so,
how much time after the beginning of regular trading hours should we
provide? For example, should we allow trading during an opening auction
that commences after the beginning of regular trading hours or should
we provide until noon? Alternatively, should we allow participants to
purchase or borrow securities at any time on the Close-Out Date to
satisfy the temporary rule's close-out requirement? What would be the
costs and benefits of allowing additional time beyond the beginning of
regular trading hours on the Close-Out Date for the participant to
purchase or borrow securities to close out a fail to deliver position?
    [cir] Temporary Rule 204T(f)(1) defines ``settlement date'' as
``the business day on which delivery of a security and payment of money
is to be made through the facilities of a registered clearing agency in
connection with the sale of a security.'' Is this an appropriate
definition of ``settlement date''?
    [cir] Due to our expectation that delivery of securities on all
sales should be made

by settlement date, we state in the release that participants should
consider having in place policies and procedures to monitor for the
delivery of securities by settlement date. Should we adopt a rule
requiring that participants have in place such policies and procedures?
    [cir] Should a de minimus amount of fails to deliver be excepted
from the close-out requirements of the temporary rule? If so, what
should be the de minimus amount?
    [cir] Should the temporary rule be expanded to apply to debt as
well as equity securities? Please explain.
    [cir] The temporary rule requires that a participant purchase
securities by no later than the beginning of regular trading hours on
the third settlement day after the settlement date for a fail to
deliver position resulting from a long sale transaction. What are the
costs associated with purchasing versus borrowing securities to close
out a fail to deliver position? Should we permit participants to close
out a fail to deliver position for long sale transactions by borrowing
as well as purchasing securities? Please explain.
    [cir] The temporary rule allows a participant to close out a fail
to deliver position attributable to bona fide market making activity by
a registered market maker, options market maker, or other market maker
obligated to quote in the over-the-counter market by purchasing
securities of like kind and quantity by no later than the beginning of
regular trading hours on the third settlement day after the settlement
date. Should this close-out period be a shorter or longer time-frame?
Please explain. What would be the costs and benefits of a longer or
shorter close-out period for such fails to deliver?
    [cir] The temporary rule does not include a complete exception from
its close-out requirement for options market makers with fails to
deliver resulting from short sales effected to establish or maintain a
hedge on options positions. We seek comment regarding the impact of the
temporary rule on options market makers that are subject to the close-
out requirement of the temporary rule. For example, we seek comment
regarding the impact of the temporary rule, if any, on liquidity,
spread widths, and quote depth in the securities that are subject to
the temporary rule.
    [cir] The temporary rule allows a participant to close out a fail
to deliver position resulting from a sale of an equity security
pursuant to Rule 144 of the Securities Act by no later than the
beginning of regular trading hours on the thirty-sixth consecutive
settlement day after the settlement date. Are there other types of
sales that encounter settlement delays due to processing requirements
similar to sales of Rule 144 securities that should have an exception
from the close-out requirements of temporary Rule 204T(a)? Please
explain.
    [cir] What impact will the temporary rule have on borrowing costs?
Please explain. What impact will the temporary rule have on legitimate
short selling and market efficiency?
    [cir] An arrangement to borrow means a bona fide agreement to
borrow the security such that the security being borrowed is set aside
at the time of the arrangement solely for the person requesting the
security. Should we define ``arrangement to borrow'' as requiring a
contract between the broker-dealer and the lending source?
    [cir] Should temporary Rule 204T(b) require that participants and
broker-dealers from which participants receive trades for clearance and
settlement borrow securities prior to effecting further short sales,
rather than allowing for either an arrangement to borrow or a borrow?
If a fail to deliver position has not been closed out in accordance
with temporary Rule 204T, should we prohibit the participant, and any
broker-dealer from which it receives trades for clearance and
settlement, from effecting any further short sales until the fail to
deliver position has been closed out?
    [cir] If a participant becomes subject to the requirements of
temporary Rule 204T(b), the participant will be required to borrow or
arrange to borrow securities prior to settlement at a registered
clearing agency of the purchase to close out the fail to deliver
position. What are the costs associated with this requirement?
    [cir] Temporary Rule 204T(c) imposes a notification requirement on
participants. Will such a notification requirement impose operational
or systems costs on participants? What types of communication
mechanisms will participants use to comply with this requirement of the
temporary rule? What will be the costs and benefits of this
notification requirement?
    [cir] The temporary rule allows a broker-dealer to obtain pre-fail
credit if it purchases securities in accordance with the conditions
specified in temporary Rule 204T(e). Are there any operational or
compliance concerns associated with the conditions of temporary Rule
204T(e)? To what extent, if any, will temporary Rule 204T(e) encourage
broker-dealers to close out a fail to deliver position prior to the
Close-Out Date?
    [cir] The temporary rule does not propose amendments to the
``locate'' requirement of Rule 203(b)(1) of Regulation SHO. In addition
to the temporary rule, should we also require that broker-dealers
arrange to borrow, or borrow, equity securities prior to effecting
short sales in those equity securities? How would this impact the
liquidity and availability of such equity securities overall? How would
this affect lending rates for such equity securities?
    [cir] The temporary rule imposes a close-out requirement on fails
to deliver for all equity securities. Due to this hard delivery
requirement is it necessary to retain the ``locate'' requirement of
Regulation SHO for short sales? What are the benefits of continuing to
require that broker-dealers have a reasonable grounds to believe that a
security can be borrowed so that it can be delivered by settlement date
if a participant is required to immediately close out a fail to deliver
position by no later than the beginning of regular trading hours on the
Close-Out Date?
    [cir] The temporary rule does not allow any exceptions for fails to
deliver due to mechanical aspects of corporate events, such as equity
offers, including initial public offerings (``IPOs''),\99\ and tender
offers. Will the temporary rule cause any disruption to these corporate
events? For example, will the temporary rule interfere with the ability
of underwriters to provide price support? Would any disruption warrant
an exception for certain corporate events? If so, should the exception
focus on particular corporate events and why? How much time is needed
for securities subject to such corporate events to be delivered? Would
providing exceptions for such securities create opportunities for price
manipulation?
---------------------------------------------------------------------------

    \99\ See Amy Edwards and Kathleen Weiss Hanley, Short Selling in
Initial Public Offerings (2008) http://ssrn.com/abstract=981242
showing that fails to deliver in IPOs are not from ``naked'' short
selling but instead seem to be related to fails to deliver resulting
from long sales that result from underwriter price support. The
aggregate fails to deliver in these stocks seem to persist for the
typical price support period. Thus, the temporary rule's close-out
requirement could apply to a high proportion of such fails to
deliver, potentially as much as 2.5% of the shares offered on
average. Edwards and Hanley believe that such a result could have a
substantial impact on the aftermarket of IPOs.
---------------------------------------------------------------------------

VII. Paperwork Reduction Act

A. Background

    Temporary Rule 204T contains ``collection of information''
requirements within the meaning of the Paperwork Reduction Act of 1995
(``Paperwork Reduction Act'').\100\ We submitted these requirements to
the

Office of Management and Budget (``OMB'') for review and approval in
accordance with 44 U.S.C. 3507(j) and 5 CFR 1320.13. Separately, we
have submitted the collection of information to OMB for review and
approval in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The
OMB has approved the collection of information on an emergency basis
with an expiration date of April 30, 2009. An agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information unless it displays a currently valid OMB control number.
The title for the collection of information is: ``Temporary Rule 204T''
and the OMB control number for the collection of information is 3235-
0647.
---------------------------------------------------------------------------

    \100\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    Temporary Rule 204T will substantially restrict the practice of
``naked'' short selling in all equity securities by strengthening the
delivery requirements for such securities.\101\ Temporary Rule 204T(a)
amends Regulation SHO to require that participants of a clearing agency
registered with the Commission deliver securities by settlement date,
or if the participants have not delivered shares by settlement date,
the participants must, by no later than the beginning of regular
trading hours on the settlement day following the settlement date (the
``Close-Out Date''), immediately close out the fail to deliver position
by borrowing or purchasing securities of like kind and quantity.
---------------------------------------------------------------------------

    \101\ As noted above, in a ``naked'' short sale, the short
seller does not borrow or arrange to borrow securities in time to
make delivery to the buyer within the standard three-day settlement
period. As a result, the seller fails to deliver securities to the
buyer when delivery is due.
---------------------------------------------------------------------------

    A participant that does not comply with the temporary rule's close-
out requirements will have violated temporary Rule 204T. In addition,
the participant and any broker-dealer from which it receives trades for
clearance and settlement, will not be able to short sell the security
either for itself or for the account of another, unless it has
previously arranged to borrow or has borrowed the security, until the
participant closes out the fail to deliver position by purchasing
securities of like kind and quantity and that purchase has cleared and
settled at a registered clearing agency.\102\
---------------------------------------------------------------------------

    \102\ See temporary Rule 204T(b).
---------------------------------------------------------------------------

    Several provisions under temporary Rule 204T will impose a new
``collection of information'' within the meaning of the Paperwork
Reduction Act. These collections of information are mandatory for
broker-dealers relying on the rule. The information collected will be
retained and/or provided to other entities pursuant to the specific
rule provisions and will be available to the Commission and SRO
examiners upon request. The information collected will aid the
Commission and SROs in monitoring compliance with the rule's
requirements.
1. Allocation Notification Requirement
    Similar to Rule 203(b)(3)(vi) of Regulation SHO, temporary Rule
204T(d) provides that a participant may reasonably allocate its
responsibility to close out a fail to deliver position to another
broker-dealer for which the participant clears or from which the
participant receives trades for settlement.\103\ Unlike Rule
203(b)(3)(vi) of Regulation SHO, however, temporary Rule 204T(d)
imposes an additional notification requirement on a broker-dealer that
has been allocated responsibility for complying with the rule's
requirements (the ``allocation notification requirement'').\104\
---------------------------------------------------------------------------

    \103\ See 17 CFR 242.203(b)(3)(vi). Rule 203(b)(3)(vi) provides
that ``[i]f a participant of a registered clearing agency reasonably
allocates a portion of a fail to deliver position to another
registered broker or dealer for which it clears trades or for which
it is responsible for settlement, based on such broker or dealer's
short position, then the provisions of this paragraph (b)(3)
relating to such fail to deliver position shall apply to the portion
of such registered broker or dealer that was allocated the fail to
deliver position, and not to the participant.''
    \104\ See temporary Rule 204T(d).
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    Specifically, temporary Rule 204T(d) provides that a broker or
dealer that has been allocated a portion of a fail to deliver position
that does not comply with the provisions of temporary Rule 204T(a) must
immediately notify the participant that it has become subject to the
borrowing requirements of temporary Rule 204T(b).\105\ This allocation
notification requirement is designed to help ensure that participants
that receive trades for clearance and settlement from broker-dealers
will be on notice that the broker-dealer is subject to the borrow
requirements of temporary Rule 204T(b) until the fail to deliver
position has been closed out.
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    \105\ See id.
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    Such notification will require a broker-dealer to determine that it
has a fail to deliver that does not comply with the provisions of
temporary Rule 204T(a) and, therefore, has become subject to the
requirements of temporary Rule 204T(b). After making such
determination, the temporary rule requires that the broker-dealer
notify such participant regarding this information.
    We estimate that such procedures will take a broker-dealer no more
than approximately 0.16 hours (10 minutes) to complete. We base this
estimate in part on the fact that, in accordance with Rule
203(b)(3)(vi) of Regulation SHO, participants are permitted to allocate
responsibility to close out a portion of a fail to deliver position to
a broker-dealer that is responsible for the fail to deliver position;
the fact that most broker-dealers already have the necessary
communication mechanisms in place and are already familiar with
notification processes and procedures to comply with the borrowing
requirements of Rule 203(b)(3)(iv) of Regulation SHO for threshold
securities; and the fact that broker-dealers will be able to continue
to use the same communication mechanisms, processes and procedures to
comply with the notification requirement of temporary Rule 204T(b). On
average, participants estimate that currently it takes approximately
0.16 hours (10 minutes) to notify broker-dealers pursuant to Rule
203(b)(3)(iv) of Regulation SHO.\106\
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    \106\ We base this estimate on information provided to our staff
by three small, three medium, and three large registered clearing
agency participants.
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    If a broker-dealer has been allocated a portion of a fail to
deliver position in an equity security and after the beginning of
regular trading hours on the Close-Out Date, the broker-dealer has to
determine whether or not that portion of the fail to deliver position
was not closed out in accordance with temporary Rule 204T(a), we
estimate that a broker-dealer will have to make such determination with
respect to approximately 1.76 equity securities per day.\107\
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    \107\ OEA estimates that there are approximately 9,809 fail to
deliver positions per settlement day. Across 5,561 broker-dealers,
the number of securities per broker-dealer per day is approximately
1.76 equity securities. During the period from January to July 2008,
approximately 4,321 new fail to deliver positions occurred per day.
The NSCC data for this period includes only securities with at least
10,000 shares in fails to deliver. To account for securities with
fails to deliver below 10,000 shares, the figure is multiplied by a
factor of 2.27. The factor is estimated from a more complete data
set obtained from NSCC during the period from September 16, 2008 to
September 22, 2008. It should be noted that these numbers include
securities that were not subject to the close-out requirement of
Rule 203(b)(3) of Regulation SHO.
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    As of December 31, 2007, there were 5,561 registered broker-
dealers. Each of these broker-dealers could clear trades through a
participant of a registered clearing agency and, therefore, become
subject to the notification requirements of temporary Rule 204T(b). We
estimate a total of 2,466,415 notifications in accordance with
temporary Rule 204T(b) across all broker-dealers (that were allocated
responsibility to close out a fail to deliver position) per year

(5,561 broker-dealers notifying participants once per day \108\ on 1.76
securities, multiplied by 252 trading days in a year). The total
estimated annual burden hours per year will be approximately 394,626
burden hours (2,466,415 multiplied by 0.16 hours/notification). We
estimate that the paperwork compliance for the allocation notification
requirement for each broker-dealer will be approximately 71.0 burden
hours per year.
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    \108\ Because failure to comply with the close-out requirements
of temporary Rule 204T(a) is a violation of the temporary rule, we
believe that a broker-dealer would make the notification to a
participant that it is subject to the borrowing requirements of
temporary Rule 204T(b) at most once per day.
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2. Demonstration Requirement for Fails To Deliver on Long Sales
    Temporary Rule 204T(a)(1) includes an exception from temporary
rule's close-out requirement for fail to deliver positions resulting
from long sales of all equity securities. Under this exception, if a
participant has a fail to deliver position at a registered clearing
agency in an equity security and can demonstrate on its books and
records that such fail to deliver position resulted from a long sale
(the ``demonstration requirement for fails to deliver on long sales''),
such participant will have until no later than the beginning of regular
trading hours on the third consecutive settlement day following the
settlement date to immediately close out the fail to deliver position
by purchasing securities of like kind and quantity.\109\
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    \109\ See temporary Rule 204T(a)(1).
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    This provision allows a participant an additional two settlement
days in which to close out the fail to deliver position that resulted
from a long sale, provided that the participant's books and records
reflect the fact that the fail to deliver resulted from a long
sale.\110\
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    \110\ See id.
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    The demonstration requirement will require a participant of a
registered clearing agency to determine whether it has a fail to
deliver position at a registered clearing agency in an equity security
that resulted from a long sale. After making such determination, the
temporary rule requires that the participant demonstrate or reflect
this information in its books and records. We estimate that such
procedures will take a participant of a registered clearing agency no
more than approximately 0.16 hours (10 minutes) to complete.
    We base this estimate on the fact that, to comply with Regulation
SHO's marking requirements, broker-dealers are already required to
ascertain whether a customer is ``deemed to own'' the securities being
sold before marking a sell order ``long'' and, if the securities are
not in the broker-dealer's physical possession or control, whether the
broker-dealer reasonably expects that the shares will be in the broker-
dealer's physical possession or control by settlement date.\111\ This
reasonableness determination includes consideration of whether or not a
prior sale resulted in a fail to deliver position. In addition, broker-
dealers already must comply with the documentation requirement
contained in the ``locate'' requirement of Rule 203(b)(1) of Regulation
SHO. Participants will be able to use similar mechanisms, processes and
procedures to demonstrate compliance with the temporary rule's close-
out requirement for fails to deliver resulting from long sales as they
use for compliance with the current requirements of Regulation SHO.
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    \111\ See 17 CFR 242.200(g)(1).
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    If a participant of a registered clearing agency has a fail to
deliver position in an equity security at a registered clearing agency
and determined that such fail to deliver position resulted from a long
sale, we estimate that a participant of a registered clearing agency
will have to make such determination with respect to approximately 34
securities per day.\112\
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    \112\ OEA estimates approximately 68% of trades are long sales
and applies this percentage to the number of fail to deliver
positions per day. 68% of 50 securities per day is 34 securities per
day. The 68% figure is estimated as 100% minus the proportion of
short sale trades found in the Regulation SHO Pilot Study. See
http://www.sec.gov/news/studies/2007/regshopilot020607.pdf.
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    As of July 31, 2008, there were 197 participants of NSCC, the
primary registered clearing agency responsible for clearing U.S.
transactions that were registered as broker-dealers. We estimate a
total of 1,687,896 demonstrations in accordance with temporary Rule
204T(a)(1) across all participants per year (197 participants checking
for compliance once per day on 34 securities, multiplied by 252 trading
days in a year). The total approximate estimated annual burden hour per
year will be approximately 270,063 burden hours (1,687,896 multiplied
by 0.16 hours/documentation). We estimate that the paperwork burden for
the temporary demonstration provision for each participant will be
approximately 1,371 burden hours per year.
3. Pre-Borrow Notification Requirement
    The borrowing requirements of temporary Rule 204T(b) are similar to
the requirements of Rule 203(b)(3)(iv) of Regulation SHO for a
participant that has failed to close out a fail to deliver position in
a threshold security that has persisted for thirteen consecutive
settlement days.\113\ Unlike the current borrow requirements of Rule
203(b)(3)(iv) of Regulation SHO, however, temporary Rule 204T(c)
specifies that participants must notify all broker-dealers from which
they receive trades for clearance and settlement that a fail to deliver
position has not been closed out in accordance with temporary Rule
204T(a) (the ``pre-borrow notification requirement'').
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    \113\ See 17 CFR 242.203(b)(3)(iv). Rule 203(b)(3)(iv) of
Regulation SHO provides that ``[i]f a participant of a registered
clearing agency has a fail to deliver position at a registered
clearing agency in a threshold security for thirteen consecutive
settlement days, the participant and any broker or dealer for which
it clears transactions, including any market maker that would
otherwise be entitled to rely on the exception provided in paragraph
(b)(2)(iii) of this section, may not accept a short sale order in
the threshold security from another person, or effect a short sale
in the threshold security for its own account, without borrowing the
security 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.''
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    Specifically, temporary Rule 204T(c) provides that the participant
must notify any broker or dealer from which it receives trades for
clearance and settlement, including any market maker that would
otherwise be entitled to rely on the exception provided in Rule
203(b)(2)(iii) of Regulation SHO,\114\ (1) that the participant has a
fail to deliver position in an equity security at a registered clearing
agency that has not been closed out in accordance with the requirements
of temporary Rule 204T(a), and (2) when the purchase that the
participant has made to close out the fail to deliver position has
cleared and settled at a registered clearing agency.\115\
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    \114\ See 17 CFR 203(b)(2)(iii) (providing for an exception from
the ``locate'' requirement for market makers engaged in bona fide
market making in that security at the time of the short sale).
    \115\ See temporary Rule 204T(c).
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    The notification requirement will involve a participant of a
registered clearing agency determining whether it has a fail to deliver
position in an equity security at a registered clearing agency that has
not been closed out in accordance with the requirements of temporary
Rule 204T(a), and when the purchase that the participant has made to
close out the fail to deliver position has cleared and settled at a
registered clearing agency. After making such determinations, the
temporary rule requires that the participant notify such broker-dealer
regarding this information.
    We estimate that such procedures will take a participant of a
registered clearing

agency no more than approximately 0.16 hours (10 minutes) to
complete.\116\ We base this estimate in part on the fact that most
participants already notify broker-dealers for which they receive
orders for clearance and settlement that the participant has a fail to
deliver position in a threshold security that has not been closed out
in order to comply with the borrow requirements of Rule 203(b)(3)(iv)
of Regulation SHO for threshold securities; the fact that most
participants already have the necessary communication mechanisms in
place and are already familiar with notification processes and
procedures to comply with the borrow requirements of Rule 203(b)(3)(iv)
of Regulation SHO for threshold securities; and the fact that
participants will be able to continue to use the same communication
mechanisms, processes and procedures to notify any broker-dealers from
which they receive trades for clearance and settlement of the
information required by the temporary rule's notification requirement
as they use for compliance with Regulation SHO.
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    \116\ We base this estimate on information provided to our staff
by three small, three medium, and three large registered clearing
agency participants.
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    If a participant of a registered clearing agency has a fail to
deliver position in an equity security and after the beginning of
regular trading hours on the Close-Out Date (or, in the case of a fail
to deliver that resulted from a long sale, on the third consecutive
settlement day following the settlement date), the participant has to
determine whether or not the fail to deliver position was closed out in
accordance with temporary Rule 204T(a), we estimate that a participant
of a registered clearing agency will have to make such determination
with respect to approximately 50 equity securities per day.\117\
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    \117\ OEA estimates that there are approximately 9,809 fail to
deliver positions per day. Across 197 broker-dealer participants of
the NSCC, the number of securities per participant per day is
approximately 50 equity securities. During the period from January
to July 2008, approximately 4,321 new fail to deliver positions
occurred per day. The NSCC data for this period includes only
securities with at least 10,000 shares in fails to deliver. To
account for securities with fails to deliver below 10,000 shares,
the figure is grossed-up by a factor of 2.27. The factor is
estimated from a more complete data set obtained from NSCC during
the period from September 16, 2008 to September 22, 2008. It should
be noted that these numbers include securities that were not subject
to the close-out requirement of Rule 203(b)(3) of Regulation SHO.
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    As of July 31, 2008, there were 197 participants of NSCC, the
primary registered clearing agency responsible for clearing U.S.
transactions that were registered as broker-dealers.\118\ We estimate a
total of 2,482,200 notifications in accordance with temporary Rule
204T(c) across all participants per year (197 participants notifying
broker-dealers once per day on 50 securities, multiplied by 252 trading
days in a year). The total estimated annual burden hours per year will
be approximately 397,152 burden hours (2,482,200 @ 0.16 hours/
documentation). We estimate that the paperwork burden for the
notification requirement for each participant will be approximately
2,016 burden hours per year.
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    \118\ 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 will implicate the close-out
requirements of the temporary rule. 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