customer is deemed to own the securities being sold would be minimal
because Rule 200(g)(1) currently requires that broker-dealers must
ascertain whether the customer is ``deemed to own'' the securities
being sold before marking a sell order ``long.'' \94\ Today's proposed
amendment would require that the broker-dealer take the additional step
of documenting the present location of the securities being sold.
Broker-dealers could, however, need to put mechanisms in place to
facilitate efficient documenting of the information required by the
proposed amendment.
---------------------------------------------------------------------------

    \94\ See 17 CFR 242.200(g).
---------------------------------------------------------------------------

Request for Comment

    The Commission seeks comment generally on all aspects of the
proposed amendment to Rule 200(g) of Regulation SHO. In addition, we
seek comment on the following:
     Is the proposed documentation requirement appropriate? If
not, why not?
     Commenters that responded to the request for comment
regarding documentation of long sales in the 2006 Proposing Release
stated that market participants already have in place procedures to
ensure that orders to sell shares are properly marked. What are those
procedures and how do they ensure that orders are properly marked? How
do broker-dealers currently comply with the ``deemed to own''
requirement of Rule 200(g)(1) of Regulation SHO?
     One commenter that responded to the request for comment
regarding documentation of long sales in the 2006 Proposing Release
stated that the requirement would be inconsistent with the goal of
fostering liquidity.\95\ To what extent, if any, would the proposed
amendment impact liquidity in securities being sold long? Please
explain.
---------------------------------------------------------------------------

    \95\ See letter from Millennium, supra note 75.
---------------------------------------------------------------------------

     The ``locate'' requirement of Rule 203(b)(1) of Regulation
SHO contains an exception for market makers. Should market makers also
have an exception for the proposed long sale documentation requirement?
Please explain.
     Should we specify the proposed format of the
documentation? Should the proposed documentation be on the order ticket
or elsewhere? Please provide recommended alternatives and estimates of
the costs of various alternatives.
     Under what circumstances, if any, should we allow the
documentation to be generated post-trade?
     In addition to proposing documentation of the present
location of the securities being sold, should we require additional
documentation requirements to those proposed, such as requiring broker-
dealers to make a record reflecting the basis for believing that the
securities are in good deliverable form, and the basis for believing
that the securities will be in the broker-dealer's possession or
control no later than settlement of the transaction?
     The Commission has previously stated that it may be
unreasonable for a broker-dealer to treat a sale as long where orders
marked ``long'' from the same customer repeatedly require borrowed
shares for delivery or result in fails to deliver.\96\ A broker-dealer
also may not treat a sale as long if the broker-dealer knows or has
reason to know that the customer borrowed the shares being sold.\97\
Should broker-dealers be required to take additional steps to determine
whether or not the seller is deemed to own the securities being sold in
conjunction with documenting the present location of the securities?
---------------------------------------------------------------------------

    \96\ See Adopting Release, 69 FR at 48019, n.111.
    \97\ See id.
---------------------------------------------------------------------------

     The proposed amendment would impose an obligation on
broker-dealers to inquire into the present location of securities being
sold and to document that location. To what extent would this proposed
requirement impact the accuracy of marking by broker-dealers? To what
extent would this proposed requirement impact the level of fails to

deliver in a security, such as fails to deliver due to mismarking? To
what extent would this proposed requirement impact compliance with
other short sale-related regulations, such as the locate requirement of
Regulation SHO and Rule 105 of Regulation M?
     Should any trades be excepted from the proposed
documentation requirement? For example, under former NASD Rule 3370(b)
broker-dealers did not have to document long sales if the securities
were on deposit in good deliverable form with certain depositories, if
instructions had been forwarded to the depository to deliver the
securities against payment (``DVP trades''). Should we consider
including or specifically excluding an exception for DVP trades? Should
any other trades be specifically included or excluded from the proposed
documentation requirement?
     Former NASD Rule 3370(b) required broker-dealers making an
affirmative determination that a customer was long to make a notation
on the order ticket at the time an order was taken regarding the
conversation with the customer as to the present location of the
securities, whether they were in good deliverable form, and the
customer's ability to deliver them to the member within three business
days. The proposed amendment would require broker-dealers to document
only the present location of the securities being sold long. To what
extent would the requirements of the proposed amendment impose costs,
such as personnel, systems, or surveillance costs on market
participants that are any different from such costs imposed on market
participants to comply with former NASD Rule 3370(b)?
     Most broker-dealers allow investors to submit orders
electronically. Do these systems automatically verify the location of
shares for long sales before routing the orders for execution? If so,
how much would it cost for broker-dealers to adjust their systems to
record the location of the securities being sold on the trade record?
If not, what changes would the proposed documentation requirement
require and how much would it cost for broker-dealers to adjust their
systems to verify and document the location of the shares for long
sales? To what extent do investors communicate order requests via other
means, such as by telephone or in person? How do the costs of the
proposed documentation requirement differ for these order requests
versus electronic order submissions?
     Some investors have direct access to alternative trading
systems. Are alternative trading systems already programmed to verify
the location of the shares in orders marked as long sales? If not, to
what extent, if any, should alternative trading systems be responsible
for meeting this requirement? How much would it cost?
     Some broker-dealers sponsor direct access to exchanges for
preferred clients. To what extent do these broker-dealers currently
document the location of shares for long sales that their clients send
directly to exchanges? What costs are associated with such
documentation?
     Do algorithmic trading systems \98\ present any problems
for compliance with the proposed amendment? Are there any other current
market practices that present problems for compliance with
documentation requirements?
---------------------------------------------------------------------------

    \98\ An algorithmic trading program detects trading
opportunities for the strategies input by investors and responds to
them by placing and managing orders on behalf of those investors.
---------------------------------------------------------------------------

V. General Request for Comment

    The Commission seeks comment generally on all aspects of the
proposed amendments to Regulation SHO under the Exchange Act, including
the proposed alternatives to the proposal to eliminate the options
market maker exception. Commenters are requested to provide empirical
data to support their views and arguments related to the proposals
herein. In addition to the questions posed above, commenters are
welcome to offer their views on any other matter raised by the proposed
amendments to Regulation SHO. With respect to any comments, we note
that they are of the greatest assistance to our rulemaking initiative
if accompanied by supporting data and analysis of the issues addressed
in those comments and if accompanied by alternative suggestions to our
proposals where appropriate.

VI. Paperwork Reduction Act

    Certain provisions of the proposed amendments to Regulation SHO
would impose new ``collection of information'' requirements within the
meaning of the Paperwork Reduction Act of 1995 (``PRA'') \99\ which the
Commission has submitted to the Office of Management and Budget
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR
1320.11. 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. OMB has not yet assigned a
control number to the new collection of information.
---------------------------------------------------------------------------

    \99\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

A. Summary of Collections of Information

    The proposed amendment to eliminate the options market maker
exception to the close-out requirement of Regulation SHO would not
impose a new ``collection of information'' within the meaning of the
PRA. The two proposed alternatives to elimination of the options market
maker exception and the proposed amendment to Rule 200(g) of Regulation
SHO would impose a new ``collection of information'' within the meaning
of the PRA.
i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
    The proposed alternatives to elimination of the options market
maker exception would both require that options market makers and
participants of a registered clearing agency document that any fail to
deliver positions that have not been closed out are excepted from the
close-out requirement of Regulation SHO because the fails to deliver
resulted from short sales effected by a registered options market maker
to establish or maintain a hedge on options series in a portfolio that
were created before the security became a threshold security. This
would be a new collection of information because Regulation SHO does
not currently require documentation to show eligibility for the options
market maker exception.
ii. Proposed Amendment to Rule 200(g)(1)
    The proposed amendment to Rule 200(g)(1) of Regulation SHO would
require that brokers and dealers marking orders as ``long'' sales
document the present location of the securities.
    Under Rule 200(g)(1), a broker-dealer may mark an order to sell
``long'' only if the seller is deemed to own the security being sold
pursuant to paragraphs (a) through (f) of Rule 200,\100\ and either the
security is in the physical possession or control of the broker or
dealer or it is reasonably expected that the security will be in the
physical possession or control of the broker or dealer no later than
the settlement of the transaction.\101\ Thus, in marking a sell order
``long,'' a broker or dealer must determine whether the customer is
``deemed to own'' the securities being sold.
---------------------------------------------------------------------------

    \100\ Rule 200(a) defines the term ``short sale,'' while Rules
200(b) through 200(f) set forth circumstances in which a seller is
deemed to own securities. See 17 CFR 242.200(a)-(f).
    \101\ 17 CFR 242.200(g)(1).
---------------------------------------------------------------------------

    This would be a new collection of information because Regulation
SHO

does not currently require documentation by brokers and dealers when
marking sell orders as ``long.''

B. Proposed Use of Information

i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
    The information that would be required by the proposed alternatives
to elimination of the options market maker exception would assist the
Commission in fulfilling its mandate under the Exchange Act to prevent
fraudulent, manipulative, and deceptive acts and practices. The
Commission and SROs would use the information collected to monitor
whether or not the options market maker exception to the close-out
requirement of Regulation SHO is being applied consistently with the
rule. The information required by the proposed amendment would provide
a record that would aid surveillance for compliance with this limited
exception to Regulation SHO's close-out requirement.
ii. Proposed Amendment to Rule 200(g)(1)
    The information that would be required by the proposed amendment to
Rule 200(g)(1) would assist the Commission in fulfilling its mandate
under the Exchange Act to prevent fraudulent, manipulative, and
deceptive acts and practices. Such a documentation requirement would
aid in ensuring the correct marking of sell orders. To the extent that
the seller is unable to provide the present location of the securities
being sold, the broker-dealer would have reason to believe that the
seller is not ``deemed to own'' the securities being sold and that the
securities would not be in its physical possession or control no later
than settlement of the transaction and, therefore, that the broker-
dealer would be required to mark the sale ``short'' rather than
``long.'' \102\ We believe that this documentation requirement could
also reduce the number of fails to deliver because, after making the
inquiry into the present location of the securities being sold, a
broker-dealer would know whether or not it needed to obtain securities
for delivery.
---------------------------------------------------------------------------

    \102\ See id.
---------------------------------------------------------------------------

    In addition, we are concerned that broker-dealers marking orders
``long'' may not be making a determination prior to marking the order
that the seller is ``deemed to own'' the security being sold. Rule
200(g)(1) currently requires that broker-dealers ascertain whether the
customer is ``deemed to own'' the securities being sold before marking
a sell order ``long.'' \103\ We believe that a documentation
requirement would help ensure that the broker-dealer marking the sale
``long'' has inquired into, and determined that, the seller is ``deemed
to own'' the securities being sold because the broker-dealer would be
required to document the present location of the securities being sold.
---------------------------------------------------------------------------

    \103\ See id.
---------------------------------------------------------------------------

    We also believe that the documentation requirement would enable the
Commission and SROs to examine for compliance with the long sale
marking provisions of Rule 200(g) more effectively because this
documentation requirement would provide a record that the seller is
``deemed to own'' the securities being sold in compliance with that
rule. We also believe that the documentation requirement would aid the
Commission and SROs in reviewing for mismarking designed to avoid
compliance with other rules and regulations of the federal securities
laws, such as the ``locate'' requirement of Regulation SHO,\104\ and
Rule 105 of Regulation M.\105\
---------------------------------------------------------------------------

    \104\ See supra note 92.
    \105\ See supra note 93.
---------------------------------------------------------------------------

C. Respondents

i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
    The documentation requirement of the proposed alternatives to
elimination of the options market maker exception would apply to all
participants of a registered clearing agency and options market makers
who have not closed out a fail to deliver position in a threshold
security because it resulted from short sales effected by the
registered options market maker to establish or maintain a hedge on
options series in a portfolio that were created before the security
became a threshold security.
ii. Proposed Amendment to Rule 200(g)(1)
    The proposed amendment to Rule 200(g)(1) of Regulation SHO would
require that brokers and dealers marking orders as ``long'' sales
document the present location of the securities. Thus, the amendment
would apply to all brokers-dealers registered with the Commission as
they could all execute long sales. The Commission's Office of Economic
Analysis (``OEA'') estimates that at year-end 2006 there are
approximately 5,808 active brokers-dealers registered with the
Commission.\106\
---------------------------------------------------------------------------

    \106\ This number is based on OEA's review of 2006 FOCUS Report
filings reflecting registered brokers-dealers. This number does not
include broker-dealers that are delinquent with FOCUS Report
filings.
---------------------------------------------------------------------------

D. Total Annual and Recordkeeping Burdens

i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
    The proposed alternatives to elimination of the options market
maker exception would require that options market makers and
participants of a registered clearing agency document that any fail to
deliver positions that have not been closed out are excepted from the
close-out requirement of Regulation SHO because the fails to deliver
resulted from short sales effected by a registered options market maker
to establish or maintain a hedge on options series in a portfolio that
were created before the security became a threshold security.
    We estimate that it would take an options market maker no more than
approximately 0.16 hours (10 minutes) to document that a fail to
deliver position has not been closed out due to its eligibility for the
options market maker exception.\107\ We understand that eligibility for
the options market maker exception would likely be determined on a
daily basis, rather than on a trade by trade basis. Based on data from
the first quarter of 2006,\108\ for purposes of this PRA, we estimate
that, on average, there would be approximately 75 securities each day
that are (i) on a threshold securities list, and (ii) have open
interest in exchange traded options. On average, we estimate there
would be approximately 5 options market makers engaged in delta hedging
these options.\109\ Thus, we estimate that on average, options market
makers would have to document compliance with the proposed alternatives
to the elimination of the options market maker exception 94,500 times
per year (5 options market makers checking for compliance once per day
on 75 securities, multiplied by 252 trading

days in a year). Thus, the total approximate estimated annual burden
documentation). A reasonable estimate for the paperwork compliance for
the proposed alternatives for each options market maker would be
approximately 3,024 burden hours (18,900 instances of documentation per
---------------------------------------------------------------------------

    \107\ We do not believe that the documentation requirement is
complex. We understand that options market makers receive daily
trading reports from NSCC reflecting an options market maker's
trading activity for that day. Options market makers should be able
to use such information to document eligibility for the exception
from the close-out requirement of Regulation SHO. Because options
market makers receive these daily trading reports, we estimate that
it would take an options market maker no more than approximately 10
minutes to document that a fail to deliver position has not been
closed out due to its eligibility for the options market maker
exception.
    \108\ We used the first quarter of 2006 because this is the most
recent period over which we have access to option open interest
data.
    \109\ This estimate is based on there being 5 options exchanges
that have a specialist or specialist-like structure and an
estimation that each exchange would have 1 options market maker
actively engaged in hedging threshold securities with listed
options.
---------------------------------------------------------------------------

    We estimate that it would take a participant of a registered
clearing agency no more than approximately 0.16 hours (10 minutes) to
document that a fail to deliver position has not been closed out due to
its eligibility for the options market maker exception.\110\ If a
participant of a registered clearing agency had a fail to deliver
position in a threshold security and after twelve consecutive
settlement days the participant determined whether or not the fail to
deliver position was excepted from Regulation SHO's close-out
requirement due to hedging activity by a registered options market
maker, we estimate that a participant of a registered clearing agency
would have to make such determination with respect to approximately
three threshold securities per day.\111\ We understand that there are
currently approximately sixteen participants of a registered clearing
agency that clear transactions for options market makers.\112\ Thus, we
estimate that on average, a participant of a registered clearing agency
would have to document compliance with the proposed alternatives to the
elimination of the options market maker exception 12,096 times per year
(16 participants checking for compliance once per day on three
securities, multiplied by 252 trading days in a year). Thus, the total
approximate estimated annual burden hour per year would be
reasonable estimate for the paperwork compliance for the proposed
alternatives for each participant would be approximately 120 burden
documentation).
---------------------------------------------------------------------------

    \110\ We do not believe that the documentation requirement is
complex. Such documentation requirement could involve a participant
of a registered clearing agency contacting a registered options
market maker for which it clears transactions to determine whether
or not trading activity by the registered options market maker was
responsible for the fail to deliver position and whether or not the
fail to deliver position resulted from short sales effected by the
registered options market maker to establish or maintain a hedge on
options series in a portfolio that were created before the security
became a threshold security. After making such determination, the
proposed amendment would require that the participant document this
information. We estimate that such procedures would take a
participant of a registered clearing agency no more than
approximately 10 minutes to complete.
    \111\ We estimated that a participant would make such a
determination for approximately 3 threshold securities per day based
on data from the first quarter of 2006. We used the first quarter of
2006 because this is the most recent period over which we have
access to option open interest data.
    \112\ This number is based on information received from the
Options Clearing Corporation.
---------------------------------------------------------------------------

ii. Proposed Amendment to Rule 200(g)(1)
    The proposed amendment to Rule 200(g)(1) of Regulation SHO would
require that brokers and dealers marking orders as ``long'' sales
document the present location of the securities. We estimate that all
of the approximately 5,808 registered broker-dealers may effect sell
orders in securities covered by Regulation SHO and, therefore, would be
required to comply with the proposed documentation requirement.
    For purposes of the PRA, OEA has estimated that a total of
2,750,000,000 trades are executed annually.\113\ Of these 2,750,000,000
trades, OEA estimates that approximately 75%, that is, 2,062,500,000,
of these trades would be ``long'' sales.\114\ This would be an average
of approximately 355,114 annual long sales by each respondent. In
addition, because we believe that the documentation process is or will
be automated, we estimate that it would take a registered broker-dealer
approximately 0.000139 hours (0.5 seconds) to document the present
location of the securities being sold.\115\
---------------------------------------------------------------------------

    \113\ In calendar year 2006, there were approximately 2.099
billion trades in NYSE and Nasdaq-listed stocks. In addition, there
were approximately 2.114 billion trades in over-the-counter bulletin
board (``OTCBB'') traded stocks. OEA estimates that if we were to
include Amex-listed and pink sheet stocks, the total annual trades
would be approximately 2.75 billion trades.
    \114\ See Office of Economic Analysis U.S. Securities and
Exchange Commission, Economic Analysis of the Short Sale Price
Restrictions Under the Regulation SHO Pilot (Sept. 14, 2006),
available at http://www.sec.gov/about/economic/shopilot091506/draft_reg_sho_pilot_report.pdf
.

    \115\ In the 2003 Proposing Release, we stated that we thought
it was reasonable that it would only take 0.5 seconds or 0.000139
hours to mark an order ``long,'' ``short,'' or ``short exempt.'' See
2003 Proposing Release, 68 FR at 63000. We believe it is reasonable
that it would take a similar amount of time to document the present
location of the securities being sold, if the documentation process
were automated. In addition, we note that Regulation SHO requires
broker-dealers executing short sales to document compliance with the
``locate'' requirements of Rule 203(b)(1) of Regulation SHO, i.e.,
prior to accepting or effecting a short sale in an equity security,
a broker-dealer must document that it 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. Thus,
broker-dealers should already have in place systems similar to those
necessary to document the present location of the securities being
sold for purposes of long sales.
---------------------------------------------------------------------------

    Thus, the total approximate estimated annual burden hour per year
trade). A reasonable estimate for the paperwork compliance for the
proposed amendment for each broker-dealer would be approximately 49
    To the extent that broker-dealers need to automate the
documentation process, we anticipate that such broker-dealers would
spend varying amounts of time reprogramming systems, integrating
systems, and potentially updating front-end software. Some broker-
dealers may spend very little time automating the documentation
process, while changes at other broker-dealers might be more involved.
On average, we estimate that reprogramming burdens at a broker-dealer
would be approximately 16 hours (or two days) with one programmer.\116\
If broker-dealers hired new computer programmers at $67/hour, this
aggregate of $6,226,176 across all broker-dealers.\117\
---------------------------------------------------------------------------

    \116\ We believe that most of the relevant information is
already stored in electronic form and, therefore, we do not believe
that the automation process would be difficult or time-consuming to
implement. Hence, we estimate that automation would on average take
no longer than approximately 16 hours (2 days) to complete.
    \117\ The $67/hour figure for a computer programmer is based on
the salary for a Senior Computer Operator from the SIA Report on
Office Salaries in the Securities Industry 2006, modified to account
for an 1800-hour work-year and multiplied by 2.93 to account for
bonuses, firm size, employee benefits and overhead.
---------------------------------------------------------------------------

E. Collection of Information is Mandatory

i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
    The proposed collection of information for the proposed
alternatives to elimination of the options market maker exception would
be mandatory for a participant of a registered clearing agency and
options market maker where a fail to deliver position has not been
closed out because the fails to deliver resulted from short sales
effected by a registered options market maker to establish or maintain
a hedge on options series in a portfolio that were created before the
security became a threshold security.
ii. Proposed Amendment to Rule 200(g)(1)
    The proposed collection of information would be mandatory for a

broker-dealer marking a sell order as ``long'' pursuant to Rule
200(g)(1).

F. Confidentiality

i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
    The proposed collection of information for the proposed
alternatives to elimination of the options market maker exception would
be retained by participants of a registered clearing agency and options
market makers and provided to the Commission and SRO examiners upon
request, but not subject to public availability.
ii. Proposed Amendment to Rule 200(g)(1)
    The proposed collection of information under the proposed amendment
to Rule 200(g)(1) would be retained by the broker-dealer and provided
to the Commission and SRO examiners upon request, but would not be
subject to public availability.

G. Record Retention Period

i. Proposed Alternatives to Elimination of the Options Market Maker
Exception
    The proposed alternatives to elimination of the options market
maker exception do not contain any new record retention requirements.
All registered broker-dealers that would be subject to the proposed
alternatives are currently required to retain records in accordance
with Rule 17a-4 of the Exchange Act.\118\
---------------------------------------------------------------------------

    \118\ 17 CFR 240.17a-4.
---------------------------------------------------------------------------

    As discussed above, participants of a registered clearing agency
include entities not registered as broker-dealers, such as banks, U.S.
exchanges, and clearing agencies.\119\ Although we do not believe that
participants of a registered clearing agency other than broker-dealers
would trigger the obligations of the proposed alternatives, all banks
subject to the proposed alternatives would be required to retain
records in compliance with any existing or future record retention
requirements established by the banking agencies. All U.S. exchanges
and clearing agencies subject to the proposed alternatives would be
required to retain records in compliance with Rule 17a-1 of the
Exchange Act.\120\
---------------------------------------------------------------------------

    \119\ See supra note 22.
    \120\ 17 CFR 240.17a-1.
---------------------------------------------------------------------------

ii. Proposed Amendment to Rule 200(g)(1)
    The proposed amendment to Rule 200(g)(1) does not contain any new
record retention requirements. All registered broker-dealers that would
be subject to the proposed amendment are currently required to retain
records in accordance with Rule 17a-4 of the Exchange Act.\121\
---------------------------------------------------------------------------

    \121\ Id. at 240.17a-4.
---------------------------------------------------------------------------

H. Request for Comment

    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to: (i) Evaluate whether the proposed collection of
information is necessary for the proper performance of the functions of
the agency, including whether the information shall have practical
utility; (ii) evaluate the accuracy of the Commission's estimate of the
burden of the proposed collection of information; (iii) determine
whether there are ways to enhance the quality, utility, and clarity of
the information to be collected; and (iv) evaluate whether there are
ways to minimize the burden of the collection of information on those
who are to respond, including through the use of automated collection
techniques or other forms of information technology.
    Persons submitting comments on the collection of information
requirements should direct them to the Office of Management and Budget,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Washington, DC 20503, and
should also send a copy of their comments to Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090, with reference to File No. S7-19-07.
Requests for materials submitted to OMB by the Commission with regard
to this collection of information should be in writing, with reference
to File No. S7-19-07, and be submitted to the Securities and Exchange
Commission, Records Management, Office of Filings and Information
Services, 100 F Street, NE., Washington, DC 20549-1090. As OMB is
required to make a decision concerning the collections of information
between 30 and 60 days after publication, a comment to OMB is best
assured of having its full effect if OMB receives it within 30 days of
publication.

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

    The Commission is considering the costs and the benefits of the
proposed amendments to Regulation SHO. The Commission is sensitive to
these costs and benefits, and encourages commenters to discuss any
additional costs or benefits beyond those discussed here, as well as
any reductions in costs. In particular, the Commission requests comment
on the potential costs for any modification to both computer systems
and surveillance mechanisms and for information gathering, management,
and recordkeeping systems or procedures, as well as any potential
benefits resulting from the proposals for registrants, issuers,
investors, brokers or dealers, other securities industry professionals,
regulators, and other market participants. Commenters should provide
analysis and data to support their views on the costs and benefits
associated with the proposed amendments to Regulation SHO.

A. Elimination of the Options Market Maker Exception

1. Benefits
    The proposed amendment would eliminate the options market maker
exception in Rule 203(b)(3)(iii) of Regulation SHO. In particular, as a
transition measure, the proposal would require that any previously-
excepted fail to deliver position in a threshold security on the
effective date of the amendment be closed out within 35 consecutive
settlement days of the effective date of the amendment. If a security
becomes a threshold security after the effective date of the amendment,
any fails to deliver that result or resulted from short sales effected
by a registered options market maker to establish or maintain a hedge
on any options positions created before the security became a threshold
security would be subject to Rule 203(b)(3)'s mandatory 13 consecutive
settlement day close-out requirement, similar to any other fail to
deliver position in a threshold security.
    On July 14, 2006, the Commission published proposed amendments to
the options market maker exception contained in Regulation SHO to limit
the duration of the exception.\122\ We proposed to narrow the options
market maker exception at that time because we have observed a small
number of threshold securities with substantial and persistent fail to
deliver positions that are not being closed out under existing delivery
and settlement guidelines and we believed that these persistent fail to
deliver positions were attributable, in part, to the options market
maker exception in Regulation SHO.\123\
---------------------------------------------------------------------------

    \122\ See 2006 Proposing Release, 71 FR 41710.
    \123\ See id. at 41712; Regulation SHO Re-Opening Release, 72 FR
at 15079-15080.
---------------------------------------------------------------------------

    As a result of the comment process, however, we learned that
commenters were concerned that the proposed

amendments to the options market maker exception could be costly and
difficult to implement or possibly unworkable because options market
makers typically use hedges to manage the risk of an entire inventory,
not just a specific options position.
    We remain concerned that large and persistent fails to deliver are
not being closed out due to the options market maker exception in
Regulation SHO and that these fails to deliver may have a negative
effect on the market in these securities. For example, large and
persistent fails to deliver may deprive shareholders of the benefits of
ownership, such as voting and lending. In addition, where a seller of
securities fails to deliver securities on trade settlement date, in
effect the seller unilaterally converts a securities contract (which
should settle within the standard 3-day settlement period) into an
undated futures-type contract, to which the buyer may not have agreed,
or that would have been priced differently. Moreover, sellers that fail
to deliver securities on settlement date may enjoy fewer restrictions
than if they were required to deliver the securities within a
reasonable period of time, and such sellers may attempt to use this
additional freedom to engage in trading activities that deliberately
depress the price of a security.
    In addition, many issuers and investors continue to express concern
about extended fails to deliver in connection with ``naked'' short
selling.\124\ To the extent that large and persistent fails to deliver
may be indicative of manipulative ``naked'' short selling, which could
be used as a tool to drive down a company's stock price, fails to
deliver may undermine the confidence of investors.\125\ These
investors, in turn, may be reluctant to commit capital to an issuer
they believe to be subject to such manipulative conduct.\126\ In
addition, issuers may believe that they have suffered unwarranted
reputational damage due to investors' negative perceptions regarding
large and persistent fails to deliver.\127\ Thus, large and persistent
fails to deliver may result in an increase in artificial market
influences on a security's price.\128\
---------------------------------------------------------------------------

    \124\ See, e.g., supra note 8 (citing to comment letters from
issuers and investors discussing extended fails to deliver in
connection with ``naked'' short selling).
    \125\ See, e.g., supra note 9 (citing to comment letters
discussing the impact of fails to deliver on investor confidence).
    \126\ See, e.g., supra note 10 (citing to comment letters
expressing concern regarding the impact of potential ``naked'' short
selling on capital formation).
    \127\ See supra note 11.
    \128\ See also, 2006 Proposing Release, 71 FR at 41712
(discussing the impact of large and persistent fails to deliver on
the market). See also, 2003 Proposing Release, 68 FR at 62975
(discussing the impact of ``naked'' short selling on the market).
---------------------------------------------------------------------------

    Also, as part of the comment process to the proposed amendments to
the options market maker exception as set forth in the 2006 Proposing
Release, some commenters' statements indicated to us that the current
options market maker exception might not be sufficiently narrowly
tailored to limit the extent to which options market makers can claim
an exception to the close-out requirement of Regulation SHO. Thus, we
determined to re-propose amendments to the options market maker
exception that would eliminate the exception and, thereby, reduce the
number of large and persistent fails to deliver in threshold
securities.
    Consistent with the Commission's investor protection mandate, the
proposed amendment would benefit investors by facilitating the receipt
of shares so that more investors receive the benefits associated with
share ownership, such as the use of the shares for voting and lending
purposes. The proposal could enhance investor confidence as they make
investment decisions by providing investors with greater assurance that
securities would be delivered as expected. An increase in investor
confidence in the market could facilitate investment.
    The proposed amendment should also benefit issuers. A high level of
persistent fails to deliver in a security could be perceived by
potential investors negatively and could affect their decision about
making a capital commitment.\129\ Some issuers could believe that they
have endured unwarranted reputational damage due to investors' negative
perceptions regarding a security having a large fail to deliver
position and becoming a threshold security.\130\ Thus, issuers could
believe the elimination of the options market maker exception would
restore their good name. Some issuers could also believe that large and
persistent fails to deliver indicate that they have been the target of
potentially manipulative conduct as a result of ``naked'' short
selling.\131\ Thus, elimination of the options market maker could
decrease the possibility of artificial market influences and,
therefore, could contribute to price efficiency.
---------------------------------------------------------------------------

    \129\ See, e.g., supra note 10 (citing to comment letters
expressing concern regarding the impact of potential ``naked'' short
selling on capital formation).
    \130\ See, e.g., supra note 11.
    \131\ See, e.g., supra note 8 (citing to comment letters from
issuers and investors discussing extended fails to deliver in
connection with ``naked'' short selling).
---------------------------------------------------------------------------

    We solicit comment on any additional benefits that could be
realized with the proposed amendment, including both short-term and
long-term benefits. We solicit comment regarding other benefits to
market efficiency, pricing efficiency, market stability, market
integrity, and investor protection.
2. Costs
    To comply with Regulation SHO when it became effective in January
2005, market participants needed to modify their recordkeeping systems
and surveillance mechanisms. In addition, market participants should
have retained and trained the necessary personnel to ensure compliance
with the rule. Thus, the infrastructure necessary to comply with the
proposed amendment should already be in place because the proposed
amendment, if adopted, would require that all fails to deliver be
closed out in accordance with the 13 consecutive settlement day
mandatory close-out requirement of Regulation SHO. The only fails to
deliver not subject to Regulation SHO's mandatory close-out requirement
would be those fails to deliver that would be previously-excepted from
the close-out requirement and, therefore, eligible for the one-time 35
day phase-in period of the proposed amendment. Thus, any changes to
personnel, computer hardware and software, recordkeeping or
surveillance costs should be minimal.
    In the 2006 Proposing Release we requested comment regarding the
costs of the proposed amendments to the options market maker exception
and how those costs would affect liquidity in the options markets.
Commenters who opposed the proposal to narrow the options market maker
exception stated that the amendments would disrupt the markets because
they would not provide sufficient flexibility to permit efficient
hedging by options market makers, would unnecessarily increase risks
and costs to hedge, and would adversely impact liquidity and result in
higher costs to customers.\132\ These commenters stated that they
believe the proposed amendments would likely discourage options market
makers from making markets in illiquid securities since the risk
associated in maintaining the hedges in these option positions would be
too great.\133\ Moreover, these

commenters stated that the reluctance of options market makers to make
markets in threshold securities would result in wider spreads in such
securities to account for the increased costs of hedging, to the
detriment of investors.\134\
---------------------------------------------------------------------------

    \132\ See, e.g., letter from CBOE, supra note 31.
    \133\ See id.
    \134\ See letter from Citigroup, supra note 31.
---------------------------------------------------------------------------

    Although we recognize commenters' concerns that a mandatory close-
out requirement for fails to deliver in threshold securities underlying
options positions could potentially impact options market makers'
willingness to provide liquidity in threshold securities, make it more
costly for options market makers to accommodate customer buy orders, or
result in wider bid-ask spreads or less depth, for the reasons
discussed below, we believe that such an impact, if any, would be
minimal.
    First, we believe that the potential effects, if any, of a
mandatory close-out requirement would be minimal because the number of
securities that would be impacted by a mandatory close-out requirement
would be small. Regulation SHO's close-out requirement is narrowly
tailored in that it targets only those securities where the level of
fails to deliver is high (0.5% of total shares outstanding and 10,000
shares or more) for a continuous period (five consecutive settlement
days).\135\ Requiring close out only for securities with large and
persistent fails to deliver limits the overall market impact. In
addition, as noted by one commenter, a small number of securities that
meet the definition of a ``threshold security'' have listed options,
and those securities form a very small percentage of all securities
that have options traded on them.\136\ Moreover, the current options
market maker exception only excepts from Regulation SHO's mandatory 13
consecutive settlement day close-out requirement those fail to deliver
positions that result from short sales effected by registered options
market makers to establish or maintain a hedge on options positions
established before the underlying security became a threshold security.
Thus, it does not apply to fails to deliver resulting from short sales
effected to establish or maintain a hedge on options positions
established after the underlying security became a threshold security.
Because the current options market maker exception has a very limited
application, the overall impact of its removal on liquidity, hedging
costs, spreads, and depth should be relatively small.
---------------------------------------------------------------------------

    \135\ See supra note 7 (discussing the number of threshold
securities as of March 31, 2007).
    \136\ See letter from Options Exchanges, supra note 49.
---------------------------------------------------------------------------

    Second, to the extent that a mandatory close-out requirement could
potentially impact options market makers' willingness to provide
liquidity in threshold securities, make it more costly for options
market makers to accommodate customer buy orders, or result in wider
bid-ask spreads or less depth, we believe that any such potential
effects would likely be mitigated by the fact that even though fails to
deliver that were previously-excepted from the close-out requirement of
Regulation SHO would not be permitted to continue indefinitely, such
fails to deliver would not have to be closed out immediately, or even
within the standard 3-day settlement period. Instead, under Rule
203(b)(3)'s 13 consecutive settlement day close-out requirement, fails
to deliver in threshold securities would have an extended period of
time within which to be closed out. An extended close-out requirement
would provide options market makers with some flexibility in conducting
their hedging activities in that it would allow them to not close out a
fail to deliver position or pre-borrow to maintain a hedge in a
threshold security for 13 consecutive settlement days.
    Third, as noted above, Regulation SHO's current options market
maker exception is limited to only those fail to deliver positions that
result from short sales effected by registered options market makers to
establish or maintain a hedge on options positions established before
the underlying security became a threshold security. Thus, it does not
apply to fails to deliver resulting from short sales effected to
establish or maintain a hedge on options positions established after
the underlying security became a threshold security. In evaluating the
application of the current mandatory close-out requirement of
Regulation SHO for all non-excepted fail to deliver positions, we have
not become aware of any evidence that the current close-out requirement
for non-excepted fails to deliver in threshold securities has impacted
options market makers' willingness to provide liquidity in threshold
securities, made it more costly for options market makers to
accommodate customer orders, or resulted in wider bid-ask spreads or
less depth. Similarly, all fails to deliver in threshold securities
resulting from long or short sales of securities in the equities
markets must be closed out in accordance with Regulation SHO's
mandatory 13 consecutive settlement day close-out requirement, and we
are not aware that such a requirement has impacted the willingness of
market makers to make markets in securities subject to the close-out
requirement, or led to decreased liquidity, wider spreads, or less
depth in these securities. Thus, we believe that the impact of
requiring that fails to deliver in threshold securities resulting from
short sales to hedge options positions created before the security
became a threshold security be closed out would similarly be minimal,
if any.
    Fourth, to the extent that a mandatory close-out requirement for
all fails to deliver resulting from hedging activity in the options
markets could potentially impact liquidity, hedging costs, depth, or
spreads, or impact the willingness of options market makers to make a
market in certain securities, we believe that such effects are
justified by our belief, as discussed in more detail below, that fails
to deliver resulting from hedging activities by options market makers
should be treated similarly to fails to deliver resulting from sales in
the equities markets so that market participants trading threshold
securities in the options markets do not receive an advantage over
those trading such securities in the equities markets.
    Fifth, to the extent that a mandatory close-out requirement for all
fails to deliver resulting from hedging activity in the options markets
could potentially impact liquidity, hedging costs, depth, or spreads,
or impact the willingness of options market makers to make a market in
certain securities, we believe that these potential effects are
justified by the benefits of requiring that fails to deliver in all
threshold securities be closed out within specific time-frames rather
than being allowed to continue indefinitely. As discussed above, large
and persistent fails to deliver can deprive shareholders of the
benefits of ownership, such as voting and lending. They can also be
indicative of potentially manipulative conduct, such as abusive
``naked'' short selling. The deprivation of the benefits of ownership,
as well as the perception that abusive ``naked'' short selling is
occurring in certain securities, can undermine the confidence of
investors. These investors, in turn, may be reluctant to commit capital
to an issuer they believe to be subject to manipulative conduct.
    In the 2006 Proposing Release, we sought comment on whether the
proposed amendments would promote capital formation, including whether
the proposed increased short sale restrictions would affect investors'
decisions to invest in certain equity securities. Commenters expressed
concern about ``naked'' short selling

causing a drop in an issuer's stock price and that it may limit an
issuer's ability to access the capital markets.\137\ We believe that,
by requiring that all fails to deliver in threshold securities be
closed out within specific time-frames rather than allowing them to
continue indefinitely, there would be a decrease in the number of
threshold securities with persistent and high levels of fails to
deliver. If persistence on the threshold securities lists leads to an
unwarranted decline in investor confidence about the security, the
proposed amendments should improve investor confidence about the
security. We also believe that the proposed amendments should lead to
greater certainty in the settlement of securities which should
strengthen investor confidence in the settlement process.
---------------------------------------------------------------------------

    \137\ See, e.g., letter from Feeney, supra note 10.
---------------------------------------------------------------------------

    Due to our concerns about the potentially negative market impact of
large and persistent fails to deliver, and the fact that we continue to
observe a small number of threshold securities with fail to deliver
positions that are not being closed out under existing delivery and
settlement requirements, we adopted amendments to eliminate Regulation
SHO's grandfather provision that allowed fails to deliver resulting
from long or short sales of equity securities to persist indefinitely
if the fails to deliver occurred prior to the security becoming a
threshold security.\138\ We believe that once a security becomes a
threshold security, fails to deliver in that security must be closed
out, regardless of whether or not the fails to deliver resulted from
sales of the security in connection with the options or equities
markets.
---------------------------------------------------------------------------

    \138\ See Securities Exchange Act Release No. 56212 (Aug. 7,
2007); see also 2006 Proposing Release, 71 FR at 41711-41712.
---------------------------------------------------------------------------

    Moreover, we believe that fails to deliver resulting from hedging
activities by options market makers should be treated similarly to
fails to deliver resulting from sales in the equities markets so that
market participants trading threshold securities in the options markets
do not receive an advantage over those trading such securities in the
equities markets. We are also concerned that the current options market
maker exception might allow for a regulatory arbitrage not permitted in
the equities markets. For example, an options market maker who sells
short to hedge put options purchased by a market participant unable to
locate shares for a short sale in accordance with Rule 203(b)(2) of
Regulation SHO may not have to close out any fails to deliver that
result from such short sales under the current options market maker
exception. The ability of options market makers to sell short and never
have to close out a resulting fail to deliver position, provided the
short sale was effected to hedge options positions created before the
security became a threshold security, runs counter to the goal of
similar treatment for fails to deliver resulting from sales of
securities in the options and equities markets, because no such ability
is available in the equity markets.\139\
---------------------------------------------------------------------------

    \139\ See Securities Exchange Act Release No. 56212 (Aug. 7,
2007).
---------------------------------------------------------------------------

    In addition, we believe the proposed 35 consecutive settlement day
phase-in period should not result in market disruption, such as
increased volatility or short squeezes, because it would provide time
for participants of a registered clearing agency, or options market
makers for which they clear transactions, to close out previously-
excepted fail to deliver positions in an orderly manner, particularly
because participants and options market makers could begin closing out
previously-excepted fail to deliver positions at any time before the
proposed 35 day phase-in period. The 35 day phase-in period may result
in some systems and surveillance-related costs, but these costs should
be one-time rather than ongoing costs because the phase-in period would
expire 35 settlement days after the effective date of the proposed
amendment, if adopted.
    Also, the proposed pre-borrow requirement for fail to deliver
positions that are not closed out within the applicable time-frames set
forth in the proposed amendment would result in limited, if any, costs
to participants of a registered clearing agency, and options market
makers for which they clear transactions. The proposed pre-borrow
requirement is similar to the pre-borrow requirement of Rule
203(b)(3)(iii) of Regulation SHO, as originally adopted. Thus,
participants of a registered clearing agency, and any options market
maker for which it clears transactions, must already comply with such a
requirement if a fail to deliver position has not been closed out in
accordance with Regulation SHO's mandatory close-out requirement.
Accordingly, these entities should already have in place the personnel,
recordkeeping, systems, and surveillance mechanisms necessary to comply
with the proposed pre-borrow requirement.
    We seek comment about any other costs and cost reductions
associated with the proposed amendment or alternative suggestions.
Specifically:
     What would be the costs of the proposed elimination of the
options market maker exception? How would the proposed elimination of
the options market maker exception affect the liquidity of securities
with options traded on them? Would the proposed elimination of the
options market maker exception mean that fewer market makers would be
willing to make markets in securities with options traded on them, and
could the proposed amendment increase transaction costs for securities
with options traded on them? Would such an effect, if any, be more
severe for liquid or illiquid securities? Would it lead to fewer listed
options?
     How much would this proposed amendment to the options
market maker exception affect the compliance costs for small, medium,
and large participants of a registered clearing agency and for options
market makers (e.g., personnel or system changes)? We seek comment on
the costs of compliance that could arise as a result of the proposed
amendment. For instance, to comply with the proposed amendment, would
these entities be required to:
     Purchase new systems or implement changes to existing
systems? Would changes to existing systems be significant? What would
be the costs associated with acquiring new systems or making changes to
existing systems? How much time would be required to fully implement
any new or changed systems?
     Change existing records? What changes would need to be
made? What would be the costs associated with any changes? How much
time would be required to make any changes?
     Increase staffing and associated overhead costs? Would
entities subject to the proposed amendment have to hire more staff? How
many, and at what experience and salary level? Could existing staff be
retrained? What would be the costs associated with hiring new staff or
retraining existing staff? If retraining were required, what other
costs could be incurred, e.g., would retrained staff be unable to
perform existing duties in order to comply with the proposed amendment?
Would other resources need to be re-dedicated to comply with the
proposed amendment?
     Implement, enhance or modify surveillance systems and
procedures? Please describe what would be needed, and what costs would
be incurred.
     Establish and implement new supervisory or compliance
procedures, or modify existing procedures? What would be the costs
associated with such changes? Would new compliance or

supervisory personnel be needed? What would be the costs of obtaining
such staff?
     Are there any costs that market participants could incur
as a result of the proposed 35 consecutive settlement day phase-in
period? Would the costs of a phase-in period be too significant to
justify having one? Would a phase-in period create examination or
surveillance difficulties? If so, how? What would be the costs and
economic tradeoffs associated with longer or shorter phase-in periods?
     What would be the costs associated with including the pre-
borrow requirement for the proposed amendment to the options market
maker exception?

B. Alternatives to Eliminating the Options Market Maker Exception

1. Benefits
    Due to the fact that large and persistent fails to deliver are not
being closed out under existing delivery and settlement requirements
and the fact that we are concerned that these fails to deliver may have
a negative impact on the market for those securities, we believe that
the options market maker exception to the mandatory close-out
requirement of Rule 203(b)(3) of Regulation SHO should be eliminated.
    In part, in anticipation of commenters stating that a limited
options market maker exception is necessary we are requesting comment
regarding two specific limited alternatives to elimination of the
options market maker exception. Each of the proposed alternatives would
provide for a 35 consecutive settlement day phase-in period similar to
the phase-in period discussed above in connection with the proposed
elimination of the options market maker exception for securities that
are threshold securities on the effective date of the amendment and
that have previously-excepted fail to deliver positions. The phase-in
period would reduce any potential market disruption, such as increased
volatility or short squeezes, from having to close-out previously-
excepted fail to deliver positions because it would provide time for
participants of a registered clearing agency to close out previously-
excepted fail to deliver positions in an orderly manner, particularly
because participants could begin closing out these fail to deliver
positions at any time before the proposed 35 day phase-in period.
    In addition, in response to comments about the proposed amendments
to the options market maker exception in the 2006 Proposing Release
that those proposed amendments would be costly and difficult to
implement because portfolio hedging is the industry practice, the
proposed alternatives would apply to fails to deliver resulting from
short sales effected by a registered options market maker to establish
or maintain a hedge on any options series, rather than an options
position, created before an underlying security became a threshold
security. Thus, the proposed alternatives would be more in line with
industry practice and, therefore, less costly and difficult to
implement than the commenters believed the proposed amendment in the
2006 Proposing Release would be.
    The first alternative would require that a participant of a
registered clearing agency that has a fail to deliver position in a
threshold security that results or resulted from a short sale by a
registered options market maker to establish or maintain a hedge on any
options series within a portfolio that were created before the security
became a threshold security close out the entire fail to deliver
position, including any adjustments to that position, within 35
consecutive settlement days of the security becoming a threshold
security. After the 35 consecutive settlement days has expired, any
additional fails to deliver would be subject to the 13 consecutive
settlement day close-out requirement of Rule 203(b)(3) of Regulation
SHO. In addition, the proposed first alternative would impose a pre-
borrow requirement similar to the pre-borrow requirement of Rule
203(b)(3)(iv) of Regulation SHO.
    The second alternative would require that a participant of a
registered clearing agency that has a fail to deliver position in a
threshold security that results or resulted from a short sale by a
registered options market maker to establish or maintain a hedge on any
options series in a portfolio that were created before the security
became a threshold security to close out the entire fail to deliver
position, including any adjustments to that position, within the
earlier of: (i) 35 Consecutive settlement days from the date on which
the security became a threshold security, or (ii) 13 consecutive
settlement days from the last date on which all options series within
the portfolio that were created before the security became a threshold
security expire or are liquidated. After the 35 or 13 consecutive
settlement days has expired, any additional fails to deliver would be
subject to the 13 consecutive settlement day close-out requirement of
Rule 203(b)(3) of Regulation SHO. In addition, the proposed amendment
would impose a pre-borrow requirement similar to the pre-borrow
requirement of Rule 203(b)(3)(iv) of Regulation SHO.
    Similar to elimination of the options market maker exception, by
proposing to require that all fails to deliver be closed out within
specific time-frames, the proposed alternatives would reduce large and
persistent fails to deliver. In addition, by proposing to require that
shares be delivered to a buyer within a reasonable period of time, the
proposed alternatives would result in shareholders receiving the
benefits of ownership. Sellers would also be less able to unilaterally
convert securities contracts into undated futures-type contracts to
which the buyer would not have agreed, or that would have been priced
differently. In addition, the delivery requirements of the proposed
alternatives would enhance investor confidence as they make investment
decisions by providing investors with greater assurance that securities
would be delivered as expected.\140\ An increase in investor confidence
in the market could facilitate investment. The proposed alternatives
could benefit issuers because investors may be more willing to commit
capital where fails levels are lower.\141\ In addition, some issuers
could believe that a reduction in fails to deliver could reverse
unwarranted reputational damage potentially caused by large and
persistent fails to deliver and what they believe might be an
indication of manipulative trading activities, such as ``naked'' short
selling.\142\ Thus, the proposed requirement that all fails to deliver
be closed out within specific time-frames, as would be required by the
proposed alternatives, could decrease the possibility of artificial
market influences and, therefore, could contribute to price efficiency.
---------------------------------------------------------------------------

    \140\ See, e.g., supra note 9 (citing to comment letters
discussing the impact of fails to deliver on investor confidence).
    \141\ See, e.g., supra note 10 (citing to comment letters
expressing concern regarding the impact of potential ``naked'' short
selling on capital formation).
    \142\ See, e.g., supra note 11.
---------------------------------------------------------------------------

    The proposed alternatives would also require that participants of a
registered clearing agency and options market makers document that any
fails to deliver in threshold securities that have not been closed out
in accordance with the 13 consecutive settlement days close-out
requirement of Rule 203(b)(3) of Regulation SHO qualify for the options
market maker exception. The proposed alternatives would require both
options market makers and participants of a registered clearing agency
that rely on the options market maker exception to not close out a fail

to deliver position in accordance with the mandatory close-out
requirement of Rule 203(b)(3) of Regulation SHO to obtain, prepare, and
keep documentation demonstrating that a fail to deliver position has
not been closed out because it qualified for the exception. We
anticipate such documentation could include, among other things, when
the series being hedged was created, when the underlying security
became a threshold security, and the age of the fail to deliver
position that is not being closed out.
    A documentation requirement would enable the Commission and the
SROs to monitor more easily whether or not the options market maker
exception is being applied correctly. In addition, the information
would provide a record that would aid surveillance for compliance with
this limited exception to Regulation SHO's close-out requirement.
    We solicit comment on any additional benefits that could be
realized with the proposed alternatives, including both short-term and
long-term benefits. We solicit comment regarding other benefits to
market efficiency, pricing efficiency, market stability, market
integrity, and investor protection.
2. Costs
    To comply with Regulation SHO when it became effective in January
2005, market participants needed to modify their recordkeeping,
systems, and surveillance mechanisms. In addition, market participants
should have retained and trained the necessary personnel to ensure
compliance with the rule. Thus, for the most part the infrastructure
necessary to comply with the proposed alternatives should already be in
place because the proposed alternatives, if adopted, would require that
all fails to deliver be closed out in accordance with specific time-
frames similar to the mandatory 13 consecutive settlement day close-out
requirement of Regulation SHO. In addition, similar to the current
options market maker exception in Regulation SHO, the proposed
alternatives would only except from the mandatory close-out requirement
of Rule 203(b)(3) those fails to deliver that resulted from short sales
by a registered options market maker in connection with options created
before the security became a threshold security.
    The proposed alternatives, however, would result in some increased
recordkeeping, systems, and surveillance costs. The proposed
alternatives would require that participants of a registered clearing
agency, and options market makers for which they clear transactions,
have the necessary recordkeeping, systems, and surveillance mechanisms
in place to track whether a fail to deliver position resulted from a
short sale effected by a registered options market maker to maintain or
establish a hedge on option series created before the security became a
threshold security. In addition, under the first proposed alternative,
these entities would need to have systems and surveillance mechanisms
in place to ensure that such fails to deliver are closed out within 35
consecutive settlement days of the security becoming a threshold
security. Under the second proposed alternative, these entities would
need to have systems and surveillance mechanisms in place to determine
whether the fails to deliver would be required to be closed out within
the earlier of 13 consecutive settlement days of all options series
within the portfolio expiring or being liquidated, or within 35
consecutive settlement days of the security becoming a threshold
security. Thus, participants of a registered clearing agency, and
options market makers for which they clear, could incur costs in
meeting these requirements.
    In addition, the proposed alternatives would allow for a one-time
35 consecutive settlement day phase-in period for previously-excepted
fail to deliver positions. Although any personnel, computer hardware
and software, recordkeeping, or surveillance costs, associated with
complying with this proposed phase-in period would not be an ongoing
cost, entities subject to the requirement could incur some one-time
costs in complying with this proposed requirement.
    Any costs associated with compliance with the proposed pre-borrow
requirement for fail to deliver positions that are not closed out
within the applicable time-frames set forth in the proposed
alternatives should be limited, if any. The proposed pre-borrow
requirements in the proposed alternatives are similar to the pre-borrow
requirement of Rule 203(b)(3)(iii) of Regulation SHO, as originally
adopted. Thus, participants of a registered clearing agency, and any
broker-dealers for which it clears transactions, must already comply
with such a requirement if a fail to deliver position has not been
closed out in accordance with Regulation SHO's mandatory close-out
requirement. Accordingly, these entities should already have in place
the personnel, recordkeeping, systems, and surveillance mechanisms
necessary to comply with the proposed pre-borrow requirement.
    As discussed above in connection with costs regarding the proposed
elimination of the options market maker exception, although we
recognize commenters' concerns that a mandatory close-out requirement
for fails to deliver in threshold securities underlying options
positions could potentially impact options market makers' willingness
to provide liquidity in threshold securities, make it more costly for
options market makers to accommodate customer orders, or result in
wider bid-ask spreads or less depth,\143\ we believe the mandatory
close-out requirements of each of the proposed alternatives would
similarly minimally impact, if at all, liquidity, hedging costs,
spreads, or depth in the securities subject to the close-out
requirements of the proposed alternatives, or the willingness of
options market makers to make markets in such securities.
---------------------------------------------------------------------------

    \143\ See, e.g., letters from CBOE, supra note 31; Citigroup,
supra note 31.
---------------------------------------------------------------------------

    We believe that these potential effects of the close-out
requirements of the proposed alternatives would be minimal, if any,
because the number of securities that would be impacted by the close-
out requirements of the proposed alternatives would be small. The
proposed alternatives would apply only to those threshold securities
with listed options \144\ and would only impact fails to deliver in
those securities that resulted from short sales by registered options
market makers to hedge options series that were created before rather
than after the security became a threshold security because all other
fails to deliver in threshold securities are subject to Regulation
SHO's current mandatory 13 consecutive settlement day close-out
requirement.
---------------------------------------------------------------------------

    \144\ See letter from Options Exchanges, supra note 49
(discussing the number of threshold securities with listed options).
---------------------------------------------------------------------------

    In addition, the proposed alternatives would provide options market
makers with flexibility in conducting their hedging activities because
they would each allow an extended period of time (i.e., 35 consecutive
settlement days for purposes of Alternative 1 and 13 or 35 consecutive
settlement days for purposes of Alternative 2) within which to close
out all fails to deliver in threshold securities. As discussed above in
connection with the proposed amendment to eliminate the options market
maker exception, we believe that even a 13 consecutive settlement day
close-out requirement would result in minimal impact on the willingness
of

options market makers to make markets, liquidity, hedging costs, depth,
and spreads because it would allow options market makers flexibility in
conducting their hedging activities by permitting fails to deliver to
remain open for an extended period of time (i.e., 13 consecutive
settlement days) rather than, for example, requiring that such fails to
deliver be closed out immediately, or even within the standard 3-day
settlement period. During the period of time that the fail to deliver
position can remain open, options market makers would be able to
continue any hedging activity without having to close out the fail to
deliver position or pre-borrow to maintain the hedge.
    In addition, we believe the proposed 35 consecutive settlement day
phase-in period should not result in market disruption, such as
increased volatility or short squeezes, because it would provide time
for participants of a registered clearing agency to close out
previously-excepted fail to deliver positions in an orderly manner,
particularly because participants could begin closing out previously-
excepted fail to deliver positions at any time before the proposed 35
day phase-in period.
    As discussed above in connection with the costs associated with
elimination of the options market maker exception, to the extent that
the mandatory close-out requirements of the proposed alternatives could
potentially impact liquidity, hedging costs, depth, or spreads, or
impact the willingness of options market makers to make markets in
securities subject to the proposed alternatives, we believe such
effects are justified by our belief that fails to deliver resulting
from hedging activities by options market makers should be treated
similarly to fails to deliver resulting from sales in the equities
markets so that market participants trading threshold securities in the
options markets do not receive an advantage over those trading such
securities in the equities markets. In addition, we believe that such
potential costs would be justified by the benefits, as discussed above,
of requiring that all fails to deliver be closed out within specific
time-frames rather than being allowed to continue indefinitely.
    Although the proposed alternatives would lessen the potential
negative impact on the market of large and persistent fails to deliver
similar to the proposed elimination of the options market maker
exception because they would require that fails to deliver in threshold
securities eventually be closed out, we believe that the proposed
elimination of the options market maker exception would achieve this
goal more effectively because under the proposed elimination of the
options market maker exception, all fails to deliver in threshold
securities would have to be closed out within Regulation SHO's
mandatory 13 consecutive settlement day close-out requirement. The
proposed alternatives, however, would each allow a longer period of
time for fail to deliver positions to be closed out. Specifically, the
first alternative would allow certain fails to deliver to be closed out
within 35 consecutive settlement days of the security becoming a
threshold security. Under the second alternative, although some fails
to deliver would be required to be closed out in less than 35
consecutive settlement days, other fails to deliver would not have be
closed out until 35 consecutive settlement days from the security
becoming a threshold security.
    The proposed alternatives would also impose recordkeeping costs not
imposed by the proposed amendment to eliminate the options market maker
exception. The documentation requirement of the proposed alternatives
would require options market makers and participants of a registered
clearing agency to obtain, prepare, and keep documentation
demonstrating that a fail to deliver position has not been closed out
because it was eligible for the exception. This documentation
requirement could result in these entities incurring costs related to
personnel, recordkeeping, systems and surveillance mechanisms. For
example, as discussed in detail in Section VI.D.i. above, for purposes
of the PRA, we estimate that it would take each options market maker or
participant of a registered clearing agency no more than approximately
10 minutes to document that a fail to deliver position has not been
closed out due to its eligibility for the options market maker
exception. In addition, we estimate that the total annual hour burden
per year for each options market maker subject to the documentation
requirement would be 3,024 burden hours. We estimate that the total
annual hour burden per year for each participant of a registered
clearing agency subject to the documentation requirement would be 120
burden hours.
    We request specific comment on the systems changes to computer
hardware and software, or surveillance costs that would be necessary to
implement the proposed alternatives. Specifically:
     What would be the costs and benefits of the proposed
alternatives to elimination of the options market maker exception? For
instance, what would be the costs of the proposed alternatives if
either of the alternatives were to reduce the willingness of options
market makers to make markets in securities that could become threshold
securities or in threshold securities?
     What would be the costs associated with including the pre-
borrow requirement for the proposed alternatives to the options market
maker exception? What would be the costs of excluding a pre-borrow
requirement for these proposals?
     What costs would be associated with the documentation
requirement of the proposed alternatives?
     Based on the current requirements of Regulation SHO, what
have been the costs and benefits of the current options market maker
exception?
     What would be the specific costs associated with any
technical or operational challenges that options market makers would
face in complying with the proposed alternatives?
     Would the proposed alternatives create any costs, such as
costs associated with systems, surveillance, or recordkeeping
modifications that may be needed for participants to track fails to
deliver subject to the proposed alternatives? If there were any costs
associated with tracking fails to deliver would these costs justify the
benefits of providing firms with additional time to close out fails to
deliver resulting from short sales effected to establish or maintain a
hedge on options series that were created before the security becomes a
threshold security?
     How much would the proposed alternatives affect compliance
costs for small, medium, and large participants of a clearing agency or
options market maker for which they clear transactions (e.g., personnel
or system changes)? We seek comment on the costs of compliance that may
arise. For instance, to comply with the proposed alternatives, would
these entities be required to:
     Purchase new systems or implement changes to existing
systems? Would changes to existing systems be significant? What would
be the costs associated with acquiring new systems or making changes to
existing systems? How much time would be required to fully implement
any new or changed systems?
     Change existing records? What changes would need to be
made? What would be the costs associated with any changes? How much
time would be required to make any changes?
     Increase staffing and associated overhead costs? Would
entities subject to the proposed alternatives have to hire more staff?
How many, and at what

experience and salary level? Could existing staff be retrained? What
would be the costs associated with hiring new staff or retraining
existing staff? If retraining were required, what other costs could be
incurred, e.g., would retrained staff be unable to perform existing
duties in order to comply with the proposed amendment? Would other
resources need to be re-dedicated to comply with the proposed
amendment?
     Implement, enhance or modify surveillance systems and
procedures? Please describe what would be needed, and what costs would
be incurred.
     Establish and implement new supervisory or compliance
procedures, or modify existing procedures? What would be the costs
associated with such changes? Would new compliance or supervisory
personnel be needed? What would be the costs of obtaining such staff?
     Are there any costs that participants could incur as a
result of the proposed 35 consecutive settlement day phase-in period?
Would the costs of a phase-in period be too significant to justify
having one? Would a phase-in period create examination or surveillance
difficulties? If so, how? What would be the costs and economic
tradeoffs associated with longer or shorter phase-in periods?

C. Proposed Amendment to Rule 200(g)(1) of Regulation SHO

1. Benefits
    We are proposing for comment a documentation requirement for
broker-dealers marking orders to sell ``long'' pursuant to Regulation
SHO that would require such broker-dealers to document the present
location of the securities being sold. We believe that such a proposed
documentation requirement would aid in ensuring the correct marking of
sell orders. To the extent that the seller is unable to provide the
present location of the securities being sold, the broker-dealer would
have reason to believe that the seller is not ``deemed to own'' the
securities being sold and that the securities would not be in its
physical possession or control no later than settlement of the
transaction and, therefore, that the broker-dealer would be required to
mark the sale ``short'' rather than ``long.'' \145\ We believe that
this proposed documentation requirement could also reduce the number of
fails to deliver because, after making the inquiry into the present
location of the securities being sold, a broker-dealer would know
whether or not it needed to obtain securities for delivery.
---------------------------------------------------------------------------

    \145\ See 17 CFR 242.200(g).
---------------------------------------------------------------------------

    We are concerned that broker-dealers marking orders ``long'' may
not be making a determination prior to marking the order that the
seller is ``deemed to own'' the security being sold. Rule 200(g)(1)
currently requires that broker-dealers ascertain whether the customer
is ``deemed to own'' the securities being sold before marking a sell
order ``long.'' \146\ Thus, we believe that the proposed documentation
requirement would help ensure that the broker-dealer marking the sale
``long'' has inquired into, and determined that, the seller is ``deemed
to own'' the securities being sold because the broker-dealer would be
required to document the present location of the securities being sold.
---------------------------------------------------------------------------

    \146\ See id.
---------------------------------------------------------------------------

    We also believe that the proposed documentation requirement would
enable the Commission and SROs to more easily examine for compliance
with the long sale marking provisions of Rule 200(g) more effectively
because this proposed documentation requirement would provide a record
that the seller is ``deemed to own'' the securities being sold in
compliance with that rule. We also believe that the proposed
documentation requirement would aid the Commission and SROs in
reviewing for mismarking designed to avoid compliance with other rules
and regulations of the federal securities laws, such as the ``locate''
requirement of Regulation SHO,\147\ and Rule 105 of Regulation M.\148\
---------------------------------------------------------------------------

    \147\ See supra, note 92.
    \148\ See supra, note 93.
---------------------------------------------------------------------------

2. Costs
    In response to our request for comment in the 2006 Proposing
Release regarding a long sale documentation requirement, commenters
stated that pre-trade documentation would unnecessarily impair
efficiency as broker-dealers already have procedures to ensure orders
are marked properly based on information provided by customers and
their own books and records, and that documentation requirements would
add substantial cost.\149\ One commenter also stated that compliance
with such pre-trade documentation requirements would require a complete
revamping of front end systems.\150\ Another commenter stated that the
requirements would be inconsistent with the goal of fostering
liquidity.\151\
---------------------------------------------------------------------------

    \149\ See letters from MFA, supra note 75; UBS, supra note 31;
Knight, supra note 75.
    \150\ See letter from SIA, supra note 31.
    \151\ See letter from Millennium, supra note 75.
---------------------------------------------------------------------------

    Although commenters stated that pre-trade documentation for long
sales would be inconsistent with the goal of fostering liquidity, would
unnecessarily impair efficiency, and would add substantial cost, we
believe that such costs, to the extent that there are any, would be
justified by the benefits of a documentation requirement, as discussed
above.
    In addition, we note that under former NASD Rule 3370(b), NASD
member firms making an affirmative determination that a customer was
long were required to make a notation on the order ticket at the time
an order was taken which reflected the conversation with the customer
as to the present location of the securities, whether they were in good
deliverable form, and the customer's ability to deliver them to the
member within three business days.\152\ Thus, many broker-dealers
should already be familiar with a documentation requirement and one
method that could be used to comply with such a requirement. Such
familiarity should help reduce any costs associated with implementing
the proposed documentation requirement. In addition, unlike with former
NASD Rule 3370(b), the proposed amendment would not specify the format
or methodology of the proposed documentation requirement. The absence
of such specifications should help reduce costs to broker-dealers that
would have to comply with this proposal because broker-dealers would be
able to determine the most cost effective format and methodology for
meeting the proposed documentation requirement.
---------------------------------------------------------------------------

    \152\ Brokers and dealers that were members of the NASD were
obligated to comply with former NASD Rule 3370(b) prior to the
adoption of Regulation SHO.
---------------------------------------------------------------------------

    We believe that any costs that would arise from the proposed
requirement that a broker-dealer must document the present location of
securities being sold long when making the determination that a
customer is deemed to own the securities being sold would be minimal
because Rule 200(g)(1) currently requires that broker-dealers must
ascertain whether the customer is ``deemed to own'' the securities
being sold before marking a sell order ``long.'' \153\ Today's proposed
amendment would require that the broker-dealer take the additional step
of documenting the present location of the securities being sold.
Broker-dealers could, however, need to put mechanisms in place to
facilitate efficient documenting of the

information required by the proposed amendment.
---------------------------------------------------------------------------

    \153\ See 17 CFR 242.200(g)(1).
---------------------------------------------------------------------------

    As discussed above in Section VI.D.ii., the paperwork burden is
estimated at approximately 49 burden hours for each broker-dealer
registered with the Commission, if the documentation process were
automated. To the extent that broker-dealers need to automate the
documentation process, we anticipate that such broker-dealers would
spend varying amounts of time reprogramming systems, integrating
systems, and potentially updating front-end software. Some broker-
dealers may spend very little time automating the documentation
process, while changes at other broker-dealers might be more involved.
On average, we estimate that reprogramming burdens at a broker-dealer
would be approximately 16 hours (or two days) with one programmer. This
aggregate of $6,226,176 across all broker-dealers.\154\
---------------------------------------------------------------------------

    \154\ The $67/hour figure for a computer programmer is based on
the salary for a Senior Computer Operator from the SIA Report on
Office Salaries in the Securities Industry 2006, modified to account
for an 1800-hour work-year and multiplied by 2.93 to account for
bonuses, firm size, employee benefits and overhead.
---------------------------------------------------------------------------

    The Commission does not believe there are any additional costs to
this proposal; however we seek any data supporting any additional costs
not mentioned. In addition, we request specific comment on any systems
changes to computer hardware and software, or surveillance costs that
might be necessary to implement the proposed amendment. Specifically:
     What would be the costs and benefits of the proposed
documentation requirement?
     Would the proposed amendment create any costs, such as
costs associated with systems, surveillance, or recordkeeping
modifications that may be needed for broker-dealers to document the
present location of shares being sold? If there were any costs
associated with the proposed documentation requirement would these
costs justify the benefits of better ensuring compliance with federal
securities laws?
     How much would the proposed amendment affect compliance
costs for small, medium, and large broker-dealers (e.g., personnel or
system changes)? We seek comment on the costs of compliance that may
arise. For instance, to document the location of shares being sold,
would these entities be required to:
     Purchase new systems or implement changes to existing
systems? Would changes to existing systems be significant? What would
be the costs associated with acquiring new systems or making changes to
existing systems? How much time would be required to fully implement
any new or changed systems?
     Change existing records? What changes would need to be
made? What would be the costs associated with any changes? How much
time would be required to make any changes?
     Increase staffing and associated overhead costs? Would
entities subject to the proposed amendment have to hire more staff? How
many, and at what experience and salary level? Could existing staff be
retrained? What would be the costs associated with hiring new staff or
retraining existing staff? If retraining were required, what other
costs could be incurred, e.g., would retrained staff be unable to
perform existing duties in order to comply with the proposed amendment?
Would other resources need to be re-dedicated to comply with the
proposed amendment?
     Implement, enhance or modify surveillance systems and
procedures? Please describe what would be needed, and what costs would
be incurred.
     Establish and implement new supervisory or compliance
procedures, or modify existing procedures? What would be the costs
associated with such changes? Would new compliance or supervisory
personnel be needed? What would be the costs of obtaining such staff?

VIII. Consideration of Burden and Promotion of Efficiency, Competition,
and Capital Formation

    Section 3(f) of the Exchange Act requires the Commission, whenever
it engages in rulemaking and is required to consider or determine
whether an action is necessary or appropriate in the public interest,
to consider whether the action would promote efficiency, competition,
and capital formation.\155\ In addition, Section 23(a)(2) of the
Exchange Act requires the Commission, when making rules under the
Exchange Act, to consider the impact such rules would have on
competition.\156\ Exchange Act Section 23(a)(2) prohibits the
Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.
---------------------------------------------------------------------------

    \155\ 15 U.S.C. 78c(f).
    \156\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    We believe the proposed amendments, including the proposed
alternatives, would have minimal impact on the promotion of price
efficiency. In the 2006 Proposing Release we sought comment on whether
the proposals would promote price efficiency, including whether the
proposals might impact liquidity and the potential for manipulative
short squeezes. One commenter stated that the Commission's concern over
potential short squeezes is ``misplaced,'' as this is a risk short
sellers assume when they sell short.\157\ Other commenters stated,
however, that the proposed amendment to the options market maker
exception would disrupt the markets because they would not provide
sufficient flexibility to permit efficient hedging by options market
makers, would unnecessarily increase risks and costs to hedge, and
would adversely impact liquidity and result in higher costs to
customers.\158\ These commenters stated that they believe the proposed
amendments would likely discourage options market makers from making
markets in illiquid securities since the risk associated in maintaining
the hedges in these option positions would be too great.\159\ Moreover,
these commenters stated that the reluctance of options market makers to
make markets in threshold securities would result in wider spreads in
such securities to account for the increased costs of hedging, to the
detriment of investors.\160\
---------------------------------------------------------------------------

    \157\ See letter from H. Glenn Bagwell, Jr., dated Sept. 19,
2006.
    \158\ See, e.g., letter from CBOE, supra note 31.
    \159\ See id.
    \160\ See letter from Citigroup, supra note 31.
---------------------------------------------------------------------------

    Although we recognize commenters' concerns that a mandatory close-
out requirement for fails to deliver in threshold securities underlying
options positions could potentially impact options market makers'
willingness to provide liquidity in threshold securities, make it more
costly for options market makers to accommodate customer orders, or
result in wider bid-ask spreads or less depth,\161\ we believe that the
proposed elimination of the options market maker exceptions, and the
mandatory close-out requirements of the proposed alternatives, would
minimally impact, if at all, liquidity, hedging costs, spreads, or
depth in the securities subject to these proposals, or the willingness
of options market makers to make markets in such securities.
---------------------------------------------------------------------------

    \161\ See, e.g., letters from CBOE, supra note 31; Citigroup,
supra note 31.
---------------------------------------------------------------------------

    We believe that these potential effects of the elimination of the
options market maker exception, or the proposed close-out requirements
of the proposed alternatives would be minimal, if any, because the
number of securities that would be impacted by these proposals

would be relatively small. The proposal would apply only to those
threshold securities with listed options\162\ and would only impact
fails to deliver in those securities that resulted from short sales by
registered options market makers to hedge options series (or options
positions in the case of the proposed elimination of the current
options market maker exception) that were created before, rather than
after, the security became a threshold security because all other fails
to deliver in threshold securities are currently subject to Regulation
SHO's mandatory 13 consecutive settlement day close-out requirement.
---------------------------------------------------------------------------

    \162\ See letter from Options Exchanges, supra note 49
(discussing the number of threshold securities with listed options).
---------------------------------------------------------------------------

    In addition, as discussed above in connection with the proposed
amendment to eliminate the options market maker exception, we believe
that even a 13 consecutive settlement day close-out requirement would
result in minimal impact on the willingness of options market makers to
make markets, liquidity, hedging costs, depth, and spreads of a
mandatory close-out requirement because it would allow options market
makers flexibility in conducting their hedging activities by permitting
fails to deliver to remain open for an extended period of time (i.e.,
13 consecutive settlement days) rather than, for example, requiring
that such fails to deliver be closed out immediately, or even within
the standard 3-day settlement period. The close-out requirements of the
proposed alternatives would provide options market makers with even
greater flexibility in conducting their hedging activities because they
would each allow even longer periods of time than the 13 consecutive
settlement days allowed by current Rule 203(b)(3) of Regulation SHO
(i.e., 35 consecutive settlement days for purposes of proposed
Alternative 1, and 13 or 35 consecutive settlement days for purposes of
proposed Alternative 2) within which to close out all fails to deliver
in threshold securities.
    In addition, we believe the proposed 35 consecutive settlement day
phase-in period for each of the proposals should not result in market
disruption, such as increased volatility or short squeezes, because it
would provide time for participants of a registered clearing agency to
close out previously-excepted fail to deliver positions in an orderly
manner, particularly because participants could begin closing out
previously-excepted fail to deliver positions at any time before the
proposed 35 day phase-in period.
    To the extent that a mandatory close-out requirement could
potentially impact liquidity, hedging costs, depth, or spreads, or
impact the willingness of options market makers to make markets in
securities subject to such a requirement, we believe such effects are
justified by our belief that fails to deliver resulting from hedging
activities by options market makers should be treated similarly to
fails to deliver resulting from sales in the equities markets so that
market participants trading threshold securities in the options markets
do not receive an advantage over those trading such securities in the
equities markets. In addition, we believe that such potential costs
would be justified by the benefits, as discussed below, of requiring
that all fails to deliver be closed out within specific time-frames
rather than being allowed to continue indefinitely.
    The proposed amendment to Rule 200(g) of Regulation SHO to require
broker-dealers to document the present location of securities being
sold in connection with an order marked ``long'' would promote price
efficiency by reducing non-compliance with short sale-related
regulations, such as Rule 105 of Regulation M, that we believe are
beneficial to pricing efficiency.
    In addition, we believe that the proposed amendments, including the
alternative proposals, would have minimal impact on the promotion of
capital formation. Large and persistent fails to deliver can deprive
shareholders of the benefits of ownership, such as voting and lending.
They can also be indicative of potentially manipulative conduct, such
as abusive ``naked'' short selling. The deprivation of the benefits of
ownership, as well as the perception that abusive ``naked'' short
selling is occurring in certain securities, can undermine the
confidence of investors. These investors, in turn, may be reluctant to
commit capital to an issuer they believe to be subject to such
manipulative conduct. In the 2006 Proposing Release, we sought comment
on whether the proposed amendments would promote capital formation,
including whether the proposed increased short sale restrictions would
affect investors' decisions to invest in certain equity securities.
Commenters expressed concern about the potential impact of ``naked''
short selling on capital formation claiming that ``naked'' short
selling causes a drop in an issuer's stock price that may limit the
issuer's ability to access the capital markets.\163\ Another commenter
submitted a theoretical economic study concluding that ``naked'' short
selling is economically similar to other short selling.\164\
---------------------------------------------------------------------------

    \163\ See, e.g., letter from Feeney, supra note 10.
    \164\ See comment letter from J.B. Heaton, Bartlit Beck Herman
Palenchar & Scott LLP, dated May 1, 2007.
---------------------------------------------------------------------------

    By requiring that all fails to deliver in threshold securities be
closed out within specific time-frames rather than allowing them to
continue indefinitely, we believe that there would be a decrease in the
number of threshold securities with persistent and high levels of fails
to deliver. If persistence on the threshold securities lists leads to
an unwarranted decline in investor confidence about the security, the
proposed amendments should improve investor confidence about the
security. We also believe that the proposed amendments should lead to
greater certainty in the settlement of securities which should
strengthen investor confidence in the settlement process. The reduction
in fails to deliver and the resulting reduction in the number of
securities on the threshold securities lists could result in increased
investor confidence.
    The proposed amendment to eliminate the options market maker
exception and the proposed alternatives also would not impose any
burden on competition not necessary or appropriate in furtherance of
the purposes of the Exchange Act. By eliminating the options market
maker exception, or, alternatively, adopting a limited options market
maker exception, the Commission believes the proposals would promote
competition by requiring similarly situated participants of a
registered clearing agency, or options market makers for which they
clear transactions, to close out fails to deliver in threshold
securities within similar time-frames.
    The Commission requests comment on whether the proposed amendment
to eliminate the options market maker exception, the proposed
alternatives, and the proposed amendment to Rule 200(g) of Regulation
SHO, would promote efficiency, competition, and capital formation.

IX. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \165\ we must advise the Office of
Management and Budget as to whether the proposed regulation constitutes
a ``major'' rule. Under

SBREFA, a rule is considered ``major'' where, if adopted, it results or
is likely to result in:
---------------------------------------------------------------------------

    \165\ Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
---------------------------------------------------------------------------

     An annual effect on the economy of $100 million or more
(either in the form of an increase or a decrease);
     A major increase in costs or prices for consumers or
individual industries; or
     Significant adverse effect on competition, investment or
innovation.
    If a rule is ``major,'' its effectiveness will generally be delayed
for 60 days pending Congressional review. We request comment on the
potential impact of the proposed amendments on the economy on an annual
basis. Commenters are requested to provide empirical data and other
factual support for their view to the extent possible.

X. Initial Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility
Analysis (``IRFA''), in accordance with the provisions of the
Regulatory Flexibility Act (``RFA''),\166\ regarding the proposed
amendments to Rules 200 and 203 of Regulation SHO under the Exchange
Act.
---------------------------------------------------------------------------

    \166\ 5 U.S.C. 603.
---------------------------------------------------------------------------

A. Reasons for the Proposed Action

    On July 14, 2006, the Commission published proposed amendments to
the options market maker exception contained in Regulation SHO to limit
the duration of the exception.\167\ We proposed to narrow the options
market maker exception at that time because we have observed a small
number of threshold securities with substantial and persistent fail to
deliver positions that are not being closed out under existing delivery
and settlement requirements, and we believe that these persistent fail
to deliver positions are attributable, in part, to the current options
market maker exception in Regulation SHO.\168\
---------------------------------------------------------------------------

    \167\ 2006 Proposing Release, 71 FR 41710.
    \168\ See id. at 41712; Regulation SHO Re-Opening Release, 72 FR
at 15079-15080.
---------------------------------------------------------------------------

    As a result of the comment process, however, we learned that the
amendment, as proposed, could be very costly and difficult to implement
or possibly unworkable because options market makers typically use
hedges to manage the risk of an entire inventory, not just a specific
options position. In addition, some commenters' statements indicated to
us that options market makers may be interpreting the current options
market maker exception more broadly than the Commission intended and
possibly in violation of the exception. We also remain concerned that
large and persistent fails to deliver may have a negative effect on the
market in these securities. Although high fails levels exist only for a
small percentage of securities, these fails to deliver could
potentially impede the orderly functioning of the market for such
securities, particularly less liquid securities. For example, a
significant level of fails to deliver in a security may have adverse
consequences for shareholders who may be relying on delivery of those
shares for voting and lending purposes, or may otherwise affect an
investor's decision to invest in that particular security. In addition,
a seller that fails to deliver securities on settlement date
effectively unilaterally converts a securities contract into an undated
futures-type contract, to which the buyer might not have agreed, or
that might have been priced differently.
    Thus, we determined to re-propose amendments to the options market
maker exception that would eliminate the exception. In addition, we are
requesting comment regarding two specific alternatives to our proposal
to eliminate the options market maker exception that would require
fails to deliver in threshold securities underlying options to be
closed out within specific time-frames. By re-proposing amendments to
the options market maker exception we seek additional information
regarding the options markets that might assist us in determining
whether or not to eliminate the options market maker exception.
    We are also proposing an amendment to the long sale marking
provisions of Rule 200(g)(1) of Regulation SHO that would require that
broker-dealers marking orders to sell ``long'' document the present
location of the securities. We believe that such a proposed
documentation requirement would aid in ensuring the correct marking of
sell orders. To the extent that the seller is unable to provide the
present location of the securities being sold, the broker-dealer would
have reason to believe that the seller is not ``deemed to own'' the
securities being sold and that the securities would not be in its
physical possession or control no later than settlement of the
transaction and, therefore, that the broker-dealer would be required to
mark the sale ``short'' rather than ``long.'' \169\ We believe that
this proposed documentation requirement could also reduce the number of
fails to deliver because, after making the inquiry into the present
location of the securities being sold, a broker-dealer would know
whether or not it needed to obtain securities for delivery.
---------------------------------------------------------------------------

    \169\ See 17 CFR 242.200(g).
---------------------------------------------------------------------------

    We are concerned that broker-dealers marking orders ``long'' may
not be making a determination prior to marking the order that the
seller is ``deemed to own'' the security being sold. Rule 200(g)(1)
currently requires that broker-dealers ascertain whether the customer
is ``deemed to own'' the securities being sold before marking a sell
order ``long.'' \170\ Thus, we believe that the proposed documentation
requirement would help ensure that the broker-dealer marking the sale
``long'' has inquired into, and determined that, the seller is ``deemed
to own'' the securities being sold because the broker-dealer would be
required to document the present location of the securities being sold.
---------------------------------------------------------------------------

    \170\ See id.
---------------------------------------------------------------------------

    We also believe that the proposed documentation requirement would
enable the Commission and SROs to more easily examine for compliance
with the long sale marking provisions of Rule 200(g) more effectively
because this proposed documentation requirement would provide a record
that the seller is ``deemed to own'' the securities being sold in
compliance with that rule. We also believe that the proposed
documentation requirement would aid the Commission and SROs in
reviewing for mismarking designed to avoid compliance with other rules
and regulations of the federal securities laws, such as the ``locate''
requirement of Regulation SHO,\171\ and Rule 105 of Regulation M.\172\
---------------------------------------------------------------------------

    \171\ See supra, note 92.
    \172\ See supra, note 93.
---------------------------------------------------------------------------

B. Objectives

    Our proposals regarding the options market maker exception are
intended to further reduce the number of persistent fails to deliver in
threshold securities. The proposed amendment to eliminate the options
market maker exception, and the alternative proposals, are designed to
help reduce persistent and large fail to deliver positions which may
have a negative effect on the market in these securities and also could
be used to facilitate manipulative trading strategies.
    Although high fails levels exist only for a small percentage of
issuers,\173\ they could impede the orderly functioning of the market
for such issuers, particularly issuers of less liquid securities. For
example, a significant level of fails to deliver in a security may have
adverse consequences for shareholders who may be relying on delivery of
those shares for

voting and lending purposes, or may otherwise affect an investor's
decision to invest in that particular security. In addition, a seller
that fails to deliver securities on settlement date effectively
unilaterally converts a securities contract into an undated futures-
type contract, to which the buyer might not have agreed, or that would
have been priced differently.
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    \173\ See supra note 7.
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    To allow market participants sufficient time to comply with the new
close-out requirements, the proposed amendment to eliminate the options
market maker exception and the proposed alternatives would include a
one-time 35 consecutive settlement day phase-in period following the
effective date of the amendment. The phase-in period would provide
participants flexibility in closing out previously-excepted fail to
deliver positions.
    By proposing an amendment to Rule 200(g)(1) of Regulation SHO that
would require broker-dealers to document the present location of
securities a customer is deemed to own, we intend to aid surveillance
for compliance with the marking requirements of Rule 200(g). In
addition, such a requirement would help to ensure that broker-dealers
only mark orders ``long'' after making a determination that a customer
actually owns the securities being sold.

C. Legal Basis

    Pursuant to the Exchange Act and, particularly, Sections 2, 3(b),
9(h), 10(a), 11A, 15, 17(a), 19, 23(a) thereof, 15 U.S.C. 78b, 78c,
78i, 78j, 78k-l, 78o, 78q, 78s, 78w(a), the Commission is proposing
amendments to Sec. Sec.  242.200 and 242.203 of Regulation SHO.

D. Small Entities Subject to the Rule

    The entities covered by these proposals would include small
entities that are participants of a registered clearing agency,
including small registered options market makers for which the
participant clears trades or for which it is responsible for
settlement. In addition, the entities covered by these proposals would
include small entities that are market participants that effect sales
subject to the requirements of Regulation SHO. Most small entities
subject to the proposed amendments, including the proposed
alternatives, would be registered broker-dealers. Although it is
impossible to quantify every type of small entity covered by these
proposals, Paragraph (c)(1) of Rule 0-10 \174\ states that the term
``small business'' or ``small organization,'' when referring to a
broker-dealer, means a broker or dealer that had total capital (net
worth plus subordinated liabilities) of less than $500,000 on the date
in the prior fiscal year as of which its audited financial statements
were prepared pursuant to Sec.  240.17a-5(d); and is not affiliated
with any person (other than a natural person) that is not a small
business or small organization. As of 2006, the Commission estimates
that there were approximately 894 registered broker-dealers that
qualified as small entities as defined above.\175\
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    \174\ 17 CFR 240.0-10(c)(1).
    \175\ These numbers are based on the Commission's Office of
Economic Analysis's review of 2006 FOCUS Report filings reflecting
registered broker dealers. This number does not include broker-
dealers that are delinquent on FOCUS Report filings.
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    As noted above, the entities covered by these amendments will
include small entities that are participants of a registered clearing
agency. As of May 2007, approximately 90% of participants of the NSCC,
the primary registered clearing agency responsible for clearing U.S.
transactions, were registered as broker-dealers. Participants not
registered as broker-dealers include such entities as banks, U.S.-
registered exchanges, and clearing agencies. Although these entities
are participants of a registered clearing agency, generally these
entities do not engage in the types of activities that would implicate
the close-out requirements of Regulation SHO. Such activities of these
entities include creating and redeeming Exchange Traded Funds, trading
in municipal securities, and using NSCC's Envelope Settlement Service
or Inter-city Envelope Settlement Service. These activities rarely lead
to fails to deliver and, if fails to deliver do occur, they are small
in number and are usually cleaned up within a day. Thus, such fails to
deliver would not trigger the close-out provisions of Regulation SHO.
    The federal securities laws do not define what is a ``small
business'' or ``small organization'' when referring to a bank. The
Small Business Administration regulations define ``small entities'' to
include banks and savings associations with total assets of $165
million or less.\176\ As of May, 2007 no bank that was a participant of
the NSCC was a small entity because none met this criteria.
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    \176\ See 13 CFR 121.201.
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    Paragraph (e) of Rule 0-10 under the Exchange Act \177\ states that
the term ``small business'' or ``small organization,'' when referring
to an exchange, means any exchange that: (1) Has been exempted from the
reporting requirements of Rule 11Aa3-1 under the Exchange Act; and (2)
is not affiliated with any person (other than a natural person) that is
not a small business or small organization, as defined by Rule 0-10. No
U.S. registered exchange is a small entity because none meets these
criteria. There is one national securities association (NASD) that is
subject to these amendments. NASD is not a small entity as defined by
13 CFR 121.201.
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    \177\ 17 CFR 240.0-10(e).
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    Paragraph (d) of Rule 0-10 under the Exchange Act \178\ states that
the term ``small business'' or ``small organization,'' when referring
to a clearing agency, means a clearing agency that: (1) Compared,
cleared and settled less than $500 million in securities transactions
during the preceding fiscal year (or in the time that it has been in
business, if shorter); (2) had less than $200 million in funds and
securities in its custody or control at all times during the preceding
fiscal year (or in the time that it has been in business, if shorter);
and (3) is not affiliated with any person (other than a natural person)
that is not a small business or small organization as defined by Rule
0-10. No clearing agency that is subject to the requirements of
Regulation SHO is a small entity because none meets these criteria.
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    \178\ 17 CFR 240.0-10(d).
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E. Reporting, Recordkeeping, and Other Compliance Requirements

    The proposed amendment to eliminate the options market maker
exception, and the proposed alternatives, would impose some new or
additional reporting, recordkeeping, or compliance costs on broker-
dealers that are small entities. In order to comply with Regulation SHO
when it became effective in January, 2005, entities needed to modify
their systems and surveillance mechanisms. Thus, the infrastructure
necessary to comply with the proposed amendments regarding elimination
of the options market maker exception should already be in place. Any
additional changes to the infrastructure should be minimal. In
addition, entities that would be subject to the mandatory 13
consecutive settlement day close-out requirement of Rule 203(b)(3) of
Regulation SHO should already have systems in place to close out non-
excepted fails to deliver as required by Regulation SHO. These
entities, however, could be required to modify their systems and
surveillance mechanisms to ensure compliance with the proposed
alternatives to eliminating the options market maker exception.
    These entities could also be required to put in place mechanisms to
facilitate communications between participants

of a registered clearing agency and options market makers to meet the
documentation requirements of the proposed alternatives. We solicit
comment on what new recordkeeping, reporting or compliance requirements
could arise as a result of the proposed amendment to eliminate the
options market maker exception and the proposed alternatives to
elimination that would require fails to deliver in threshold securities
underlying options to be closed out within specific time-frames.
    The proposed amendment to Rule 200(g)(1) that would require that
broker-dealers document the present location of securities a customer
is deemed to own prior to marking an order to sell ``long'' could
impose some new or additional reporting, recordkeeping, or compliance
costs on broker-dealers that are small entities. We believe, however,
that such costs should be minimal. Rule 200(g)(1) currently requires
that broker-dealers must determine whether the customer is ``deemed to
own'' the securities being sold before marking a sell order ``long.''
Today's proposed amendment would require that the broker-dealer take
the additional step of documenting the present location of the
securities being sold. Broker-dealers may, however, need to put
mechanisms in place to facilitate efficient documenting of the
information that would be required by the proposed amendment.
    Moreover, we note that under former NASD Rule 3370(b), NASD member
firms making an affirmative determination that a customer was long were
required to make a notation on the order ticket at the time an order
was taken which reflected the conversation with the customer as to the
present location of the securities, whether they were in good
deliverable form, and the customer's ability to deliver them to the
member within three business days. Thus, many broker-dealers that are
small entities should already be familiar with a documentation
requirement and with one method that could be used to comply with such
a requirement. We solicit comment, however, on what new recordkeeping,
reporting or compliance requirements may arise as a result of the
proposed amendment to Rule 200(g)(1) of Regulation SHO.

F. Duplicative, Overlapping or Conflicting Federal Rules

    The Commission believes that there are no federal rules that
duplicate, overlap, or conflict with the proposed amendments.

G. Significant Alternatives

    The RFA directs the Commission to consider significant alternatives
that would accomplish the stated objective, while minimizing any
significant adverse impact on small issuers and broker-dealers.
Pursuant to Section 3(a) of the RFA,\179\ the Commission must consider
the following types of alternatives: (a) The establishment of differing
compliance or reporting requirements or timetables that take into
account the resources available to small entities; (b) the