[Federal Register: July 31, 2009 (Volume 74, Number 146)]
[Rules and Regulations]
[Page 38265-38293]
[DOCID:fr31jy09-10]

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Part II

Securities and Exchange Commission

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17 CFR Parts 200 and 242

Amendments to Regulation SHO; Final Rule

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 200 and 242

[Release No. 34-60388; File No. S7-30-08]
RIN 3235-AK22

Amendments to Regulation SHO

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is
finalizing amendments to Regulation SHO under the Securities Exchange
Act of 1934 (``Exchange Act'') by making permanent amendments contained
in Interim Final Temporary Rule 204T (``temporary Rule 204T'') of
Regulation SHO, with some modifications to address commenters'
concerns. These amendments are intended to help further our goal of
reducing fails to deliver by maintaining the reductions in fails to
deliver achieved by the adoption of temporary Rule 204T, as well as
other actions taken by the Commission. In addition, these amendments
are intended to help further our goal of addressing abusive ``naked''
short selling in all equity securities. These goals will be furthered
by requiring that, subject to certain limited exceptions, if a
participant of a registered clearing agency has a fail to deliver
position at a registered clearing agency it must immediately purchase
or borrow securities to close out the fail to deliver position by no
later than the beginning of regular trading hours on the settlement day
following the day the participant incurred the fail to deliver
position. Failure to comply with the close-out requirement of this
final rule is a violation of the rule. In addition, a participant that
does not comply with this close-out requirement, and any broker-dealer
from which it receives trades for clearance and settlement, will not be
able to short sell the security either for itself or for the account of
another, unless it has previously arranged to borrow or borrowed the
security, until the fail to deliver position is closed out.

DATES: Effective Date: July 31, 2009.

FOR FURTHER INFORMATION CONTACT: Jo Anne Swindler, Acting Associate
Director; Josephine Tao, Assistant Director; Victoria Crane, Branch
Chief; David Bloom and Christina M. Adams, Special Counsels; Matthew
Sparkes or Katrina Wilson, Staff Attorneys, Office of Trading Practices
and Processing, Division of Trading and Markets, at<PHONE_NUMBER>, at
the Commission, 100 F Street, NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION: We are adding Rule 204 of Regulation SHO [17
CFR 242.204] under the Exchange Act and removing Rule 204T of
Regulation SHO [17 CFR 242.204T] under the Exchange Act.

I. Introduction

    In October 2008, we adopted temporary Rule 204T of Regulation SHO
as an interim final temporary rule, with an expiration date of July 31,
2009.\1\ As discussed in more detail below, temporary Rule 204T
strengthens the close-out requirements of Regulation SHO for failures
to deliver securities (known as ``fails'' or ``fails to deliver'') \2\
resulting from sales of any equity security. Our adoption of temporary
Rule 204T followed a series of other steps aimed at reducing fails to
deliver and addressing potentially abusive ``naked'' short selling.\3\
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    \1\ See Exchange Act Release No. 58733 (Oct. 14, 2008), 73 FR
61706 (Oct. 17, 2008) (``Rule 204T Adopting Release'').
    \2\ Fails to deliver occur when a seller fails to deliver
securities to the buyer when delivery is due. See infra note 16 and
accompanying text.
    \3\ See infra Section II (discussing other Commission actions
aimed at reducing fails to deliver and addressing potentially
abusive ``naked'' short selling).
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    In addition, at the time that we adopted temporary Rule 204T, we
noted our concerns about the sudden and unexplained declines in the
prices of equity securities generally and the deterioration in investor
confidence in our financial markets.\4\ Such price declines can give
rise to questions about the underlying financial condition of an
entity, which in turn can create a crisis of confidence even without a
fundamental underlying basis.\5\ This crisis of confidence can impair
the liquidity and ultimate viability of an entity, with potentially
broad market consequences.\6\ Thus, we also adopted temporary Rule 204T
to further our goal of preventing substantial disruption in the
securities markets by providing a powerful disincentive to those who
might otherwise engage in potentially abusive ``naked'' short
selling.\7\
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    \4\ See Rule 204T Adopting Release, 73 FR 61707.
    \5\ See id.
    \6\ See id.
    \7\ See id.
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    Preliminary results from the Commission's Office of Economic
Analysis (``OEA'') indicate that our various actions to further reduce
fails to deliver and, thereby, address potentially abusive ``naked''
short selling are having their intended effect. For example, these
preliminary results indicate a significant downward trend in the number
of fails to deliver in all equity securities since, among other
actions, the adoption of temporary Rule 204T.\8\ These results provide,
among other things, that in comparing a pre- to post-temporary Rule
204T adoption period,\9\ the average daily number of fails to deliver
for all equity securities has declined from 1.1 billion to 478 million
for a total decline of 56.6 percent. In addition, the average daily
number of threshold securities declined from 480 securities to 108
securities in comparing the pre- to post-temporary Rule 204T adoption
period, a decline of 77.5%.\10\
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    \8\ See Memorandum from OEA Re: Impact of Recent SHO Rule
Changes on Fails to Deliver, November 26, 2008 at http://
www.sec.gov/comments/s7-30-08/s73008-37.pdf; see also Memorandum
from OEA Re: Impact of Recent SHO Rule Changes on Fails to Deliver,
March 20, 2009 at http://www.sec.gov/comments/s7-30-08/s73008-
107.pdf; Memorandum from OEA Re: Impact of Recent SHO Rule Changes
on Fails to Deliver, April 16, 2009 (``OEA April 2009 Memorandum'')
at http://www.sec.gov/comments/s7-30-08/s73008-121.pdf.
    \9\ The OEA April 2009 Memorandum defined the pre-Rule period as
the period from January 1, 2008 to September 22, 2008, and the post-
Rule period as September 23, 2008 to March 31, 2009. The post-Rule
period was also post elimination of the options market maker
exception to Regulation SHO's close-out requirement in Rule
203(b)(3) of Regulation SHO. See OEA April 2009 Memorandum; see also
infra notes 38-41 and accompanying text.
    \10\ See OEA April 2009 Memorandum.
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    Due to the positive impact that temporary Rule 204T,\11\ as well as
other recent Commission actions, are having on reducing fails to
deliver and after considering the comments received to temporary Rule
204T, we are adopting the provisions of that rule in a permanent rule,
Rule 204 of Regulation SHO, with some limited modifications to refine
provisions and address commenters' concerns.\12\ In general, as
discussed in more detail below, we are maintaining the structure of
temporary Rule 204T, while making some

adjustments to promote its workability.\13\
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    \11\ We note in this regard that at a public Roundtable to
Examine Short Sale Price Test and Circuit Breaker Restrictions held
on May 5, 2009 (the ``Short Sale Price Test Roundtable''), a number
of participants of the Roundtable commented on the success of
temporary Rule 204T at reducing fails to deliver and urged the
Commission to adopt temporary Rule 204T as a permanent rule. See,
e.g., http://www.sec.gov/spotlight/shortsales/roundtable050509/
shortsalesroundtable050509-transcript.txt.
    \12\ We received approximately 120 comment letters in response
to the Rule 204T Adopting Release. The comment letters are available
on the Commission's Internet Web site at http://www.sec.gov/
comments/s7-30-08/s73008.shtml. Further, as noted above, a number of
participants at the Commission's Short Sale Price Test Roundtable
expressed views about temporary Rule 204T. See e.g., http://
www.sec.gov/spotlight/shortsales/roundtable050509/
shortsalesroundtable050509-transcript.txt. See also comments to the
Short Sale Price Test Roundtable at http://www.sec.gov/comments/4-
581/4-581.shtml.
    \13\ See infra Section III (discussing Rule 204 of Regulation
SHO and commenters' concerns).
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    We believe that Rule 204 of Regulation SHO will continue to help
further our goal of reducing fails to deliver by maintaining the
reductions in fails to deliver achieved by the adoption of temporary
Rule 204T, as well as other actions taken by the Commission. In
addition, these amendments are intended to help further our goal of
addressing potentially abusive ``naked'' short selling. These goals
will be furthered by, among other things, requiring that securities are
purchased or borrowed to close out any fail to deliver position
resulting from a short sale of an equity security by no later than the
beginning of regular trading hours on the settlement day following the
date on which the fail to deliver position occurred. Similar to
temporary Rule 204T of Regulation SHO, Rule 204 will continue to
provide a disincentive to those who might otherwise engage in
potentially abusive ``naked'' short selling.

II. Background

    Short selling involves a sale of a security that the seller does
not own or a sale which is consummated by the delivery of a security
borrowed by, or for the account of, the seller.\14\ Short sales
normally are settled by the delivery of a security borrowed by or on
behalf of the seller. In a ``naked'' short sale, however, the short
seller does not borrow securities in time to make delivery to the buyer
within the standard three-day settlement period.\15\ As a result, the
seller fails to deliver securities to the buyer when delivery is
due.\16\ Sellers sometimes intentionally fail to deliver securities as
part of a scheme to manipulate the price of a security,\17\ or possibly
to avoid borrowing costs associated with short sales, especially when
the costs of borrowing stock are high.
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    \14\ 17 CFR 242.200(a).
    \15\ See Exchange Act Release No. 50103 (July 28, 2004), 69 FR
48008, 48009 n. 10 (Aug. 6, 2004) (``2004 Regulation SHO Adopting
Release'').
    \16\ Generally, investors complete or settle their security
transactions within three settlement days. This settlement cycle is
known as T+3 (or ``trade date plus three days''). T+3 means that
when a trade occurs, the participants to the trade deliver and pay
for the security at a clearing agency three settlement days after
the trade is executed so the brokerage firm can exchange those funds
for the securities on that third settlement day. The three-day
settlement period applies to most security transactions, including
stocks, bonds, municipal securities, mutual funds traded through a
brokerage firm, and limited partnerships that trade on an exchange.
Government securities and stock options settle on the next
settlement day following the trade (or T+1). In addition, Rule 15c6-
1 prohibits broker-dealers from effecting or entering into a
contract for the purchase or sale of a security that provides for
payment of funds and delivery of securities later than the third
business day after the date of the contract unless otherwise
expressly agreed to by the parties at the time of the transaction.
17 CFR 240.15c6-1; Exchange Act Release No. 33023 (Oct. 7, 1993), 58
FR 52891 (Oct. 13, 1993). However, failure to deliver securities on
T+3 does not violate Rule 15c6-1; see also Exchange Act Release No.
56212 (Aug. 7, 2007), 72 FR 45544, n. 2 (Aug. 14, 2007) (``2007
Regulation SHO Final Amendments'').
    \17\ In 2003, the Commission settled a case against certain
parties relating to allegations of manipulative short selling in the
stock of a corporation. The Commission alleged that the defendants
profited from engaging in massive ``naked'' short selling that
flooded the market with the stock, and depressed its price. See
Rhino Advisors, Inc. and Thomas Badian, Lit. Rel. No. 18003 (Feb.
27, 2003); SEC v. Rhino Advisors, Inc. and Thomas Badian, Civ.
Action No. 03 civ 1310 (RO) (S.D.N.Y); see also Exchange Act Release
No. 48709 (Oct. 28, 2003), 68 FR 62972, 62975 (Nov. 6, 2003) (``2003
Regulation SHO Proposing Release'') (describing the alleged activity
in the case involving stock of Sedona Corporation); 2004 Regulation
SHO Adopting Release, 69 FR 48016, n.76; Exchange Act Release No.
58774 (Oct. 14, 2008), 73 FR 61666 (Oct. 17, 2008) (``Anti-Fraud
Rule Adopting Release'').
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    We have been concerned about reducing fails to deliver and
addressing ``naked'' short selling, in particular, potentially abusive
``naked'' short selling, for some time. As we have stated on several
prior occasions, we believe that all sellers of securities should
promptly deliver, or arrange for delivery of, securities to the
respective buyer and all buyers of securities have a right to expect
prompt delivery of securities purchased.\18\ In addition, as we have
stated on several prior occasions, we are concerned about the negative
effect that fails to deliver may have on the markets and
shareholders.\19\
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    \18\ See, e.g., Rule 204T Adopting Release, 73 FR 61709;
Exchange Act Release No. 57511 (Mar. 17, 2008), 73 FR 15376, 15377
(Mar. 31, 2008) (``Anti-Fraud Rule Proposing Release'').
    \19\ See, e.g., Rule 204T Adopting Release, 73 FR 61709; 2007
Regulation SHO Final Amendments, 72 FR 45544; Exchange Act Release
No. 54154 (July 14, 2006), 71 FR 41710, 41712 (July 21, 2006)
(``2006 Regulation SHO Proposed Amendments''); Exchange Act Release
No. 56213 (Aug. 7, 2007), 72 FR 45558, 45558-45559 (Aug. 14, 2007)
(``2007 Regulation SHO Proposed Amendments''); Anti-Fraud Rule
Proposing Release, 73 FR 15378.
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    For example, large and persistent fails to deliver may deprive
shareholders of the benefits of ownership, such as voting and
lending.\20\ In addition, where a seller of securities fails to deliver
securities on settlement date, in effect the seller unilaterally
converts a securities contract (which is expected to settle within the
standard three-day settlement period) into an undated futures-type
contract, to which the buyer might not have agreed, or that might have
been priced differently.\21\ Moreover, sellers that fail to deliver
securities on settlement date may attempt to use this additional
freedom to engage in trading activities to improperly depress the price
of a security. By not borrowing securities and, therefore, not making
delivery within the standard three-day settlement period, the seller
has additional freedom because it does not incur the costs of
borrowing.
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    \20\ See id.
    \21\ See id.
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    In addition, issuers and investors have repeatedly expressed
concerns about fails to deliver in connection with manipulative
``naked'' short selling. For example, in response to proposed
amendments to Regulation SHO in 2006,\22\ which were designed to
further reduce the number of persistent fails to deliver in certain
equity securities by eliminating Regulation SHO's ``grandfather''
exception and limit the duration of the rule's options market maker
exception, we received a number of comments that expressed concerns
about ``naked'' short selling and extended delivery failures.\23\
Commenters continued to express these concerns in response to proposed
amendments to eliminate the options market maker exception to the
close-out requirement of Regulation SHO in 2007 \24\ and in response to
the Rule 204T Adopting Release.\25\
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    \22\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41710.
    \23\ See, e.g., letter from Patrick M. Byrne, Chairman and Chief
Executive Officer, Overstock.com, Inc., dated Sept. 11, 2006
(``Overstock''); letter from Daniel Behrendt, Chief Financial
Officer, and Douglas Klint, General Counsel, TASER International,
dated Sept. 18, 2006; letter from John Royce, dated April 30, 2007;
letter from Michael Read, dated April 29, 2007; letter from Robert
DeVivo, dated April 26, 2007; letter from Ahmed Akhtar, dated April
26, 2007.
    \24\ See, e.g., letter from Jack M. Wedam, dated Oct. 16, 2007;
letter from Michael J. Ryan, Executive Director and Senior Vice
President, Center for Capital Markets Competitiveness, U.S. Chamber
of Commerce, dated Sept. 13, 2007 (``U.S. Chamber of Commerce'');
letter from Robert W. Raybould, CEO Enteleke Capital Corp., dated
Sept. 12, 2007 (``Raybould''); letter from Mary Helburn, Executive
Director, National Coalition Against Naked Shorting, dated Sept. 12,
2007 (``NCANS'').
    \25\ See e.g., letter from Roel Campos, dated Mar. 25, 2009
(``Campos''); letter from the Risk Management Association, dated
Dec. 23, 2008; letter from Professor James Angel, Ph.D, CFA, dated
Dec. 17, 2008 (``Angel''); letter from Patrick Byrne, Ph.D., dated
Dec. 16, 2008; letter from the American Bankers Association, dated
Dec. 16, 2008 (``ABA''); letter from Fairfax Financial Holdings,
Ltd., dated Oct. 16, 2008.
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    To the extent that fails to deliver might be part of manipulative
``naked'' short selling, which could be used as a tool to drive down a
company's stock price,\26\ such fails to deliver may

undermine the confidence of investors.\27\ These investors, in turn,
may be reluctant to commit capital to an issuer they believe to be
subject to such manipulative conduct.\28\ In addition, issuers may
believe that they have suffered unwarranted reputational damage due to
investors' negative perceptions regarding fails to deliver in the
issuer's security.\29\ Unwarranted reputational damage caused by fails
to deliver might have an adverse impact on the security's price.\30\
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    \26\ See supra note 17 (discussing a case in which we alleged
that the defendants profited from engaging in massive ``naked''
short selling that flooded the market with the company's stock, and
depressed its price); see also S.E.C. v. Gardiner, 48 S.E.C. Docket
811, No. 91 Civ. 2091 (S.D.N.Y. Mar. 27, 1991) (alleged manipulation
by sales representative by directing or inducing customers to sell
stock short in order to depress its price); U.S. v. Russo, 74 F.3d
1383, 1392 (2d Cir. 1996) (short sales were sufficiently connected
to the manipulation scheme as to constitute a violation of Exchange
Act Section 10(b) and Rule 10b-5).
    \27\ In response to the Rule 204T Adopting Release, we received
comment letters discussing the impact of fails to deliver on
investor confidence. See e.g., letter from David Patch, dated Mar.
19, 2009; letter from Charles J. Greiner, dated Mar. 11, 2009. In
response to the 2007 Regulation SHO Proposed Amendments, commenters
discussed the impact of fails to deliver on investor confidence.
See, e.g., letter from NCANS. Commenters expressed similar concerns
in response to the 2006 Regulation SHO Proposed Amendments. See,
e.g., letter from Mary Helburn, Executive Director, National
Coalition Against Naked Shorting, dated Sept. 30, 2006 (``NCANS
(2006)''); letter from Richard Blumenthal, Attorney General, State
of Connecticut, dated Sept. 19, 2006 (``Blumenthal'').
    \28\ In response to the Rule 204T Adopting Release, we received
comment letters expressing concern about the impact of potential
``naked'' short selling on capital formation, claiming that
``naked'' short selling causes a drop in an issuer's stock price and
may limit the issuer's ability to access the capital markets. See,
e.g., letter from Campos (noting that ``[i]n its most benign form,
naked short selling is a hidden tax on equity markets, our largest
wealth creation mechanism. At its worst, it is a violent force of
wealth destruction that affects all market participants.''); letter
from Patrick Byrne Ph.D., Chairman and Chief Executive Officer,
Overstock.com Inc., dated Dec. 16, 2008 (stating that ``more needs
to be done to correct the problem of naked short selling and to
prevent more companies from being taken down by those that use it as
a tool for manipulation.''); see also letter from ABA. Commenters
expressed similar concerns in response to the 2007 Regulation SHO
Proposed Amendments. See, e.g., letter from Robert K. Lifton,
Chairman and CEO, Medis Technologies, Inc., dated Sept. 12, 2007
(``Medis''); letter from NCANS. Commenters also expressed similar
concerns in response to the 2006 Regulation SHO Proposed Amendments.
See, e.g., letter from Congressman Tom Feeney--Florida, U.S. House
of Representatives, dated Sept. 25, 2006 (``Feeney''); see also
letter from Zix Corporation, dated Sept. 19, 2006 (``Zix'') (stating
that ``[m]any investors attribute the Company's frequent re-
appearances on the Regulation SHO list to manipulative short selling
and frequently demand that the Company ``do something'' about the
perceived manipulative short selling. This perception that
manipulative short selling of the Company's securities is
continually occurring has undermined the confidence of many of the
Company's investors in the integrity of the market for the Company's
securities.'').
    \29\ Due in part to such concerns, some issuers have taken
actions to attempt to make transfer of their securities ``custody
only,'' (i.e., certificating the securities and prohibiting
ownership by a securities intermediary) thus preventing transfer of
their stock to or from securities intermediaries such as the
Depository Trust Company (``DTC'') or broker-dealers. See Exchange
Act Release No. 48709 (Oct. 28, 2003), 68 FR 62972, at 62975 (Nov.
6, 2003). Some issuers have attempted to withdraw their issued
securities on deposit at DTC in order to make the securities
ineligible for book-entry transfer at a securities depository. See
id. Withdrawing securities from DTC or requiring custody-only
transfers would undermine the goal of a national clearance and
settlement system designed to reduce the physical movement of
certificates in the trading markets. See id. We note, however, that
in 2003 the Commission approved a DTC rule change clarifying that
its rules provide that only its participants may withdraw securities
from their accounts at DTC. See Exchange Act Release No. 47978 (June
4, 2003), 68 FR 35037 (June 11, 2003).
    \30\ See 2006 Regulation SHO Proposed Amendments, 71 FR 41712;
2007 Regulation SHO Final Amendments, 72 FR 45545; 2007 Regulation
SHO Proposed Amendments, 72 FR 45558-45559; Anti-Fraud Rule
Proposing Release, 73 FR 15378; Rule 204T Adopting Release, 73 FR
61709-61710 (providing discussion of the impact of fails to deliver
on the market); see also 2003 Regulation SHO Proposing Release, 68
FR 62975 (Nov. 6, 2003) (discussing the impact of ``naked'' short
selling on the market).
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    Although the majority of trades settle within T+3,\31\ we adopted
Regulation SHO \32\ on July 28, 2004, in part to address problems
associated with persistent fails to deliver securities and potentially
abusive ``naked'' short selling. For example, Regulation SHO requires
broker-dealers to ``locate'' securities that the broker-dealer
reasonably believes can be delivered within the standard three-day
settlement period.\33\
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    \31\ According to the National Securities Clearing Corporation
(``NSCC''), 99% (by dollar value) of all trades settle within T+3.
Thus, on an average day, only approximately 1% (by dollar value) of
all trades, including equity, debt, and municipal securities fail to
settle on time.
    \32\ 17 CFR 242.200. Regulation SHO became effective on January
3, 2005.
    \33\ 17 CFR 242.203(b)(1). Rule 203(b)(1) of Regulation SHO
requires that, ``A broker or dealer may not accept a short sale
order in an equity security from another person, or effect a short
sale in an equity security for its own account, unless the broker or
dealer has: (i) Borrowed the security, or entered into a bona-fide
arrangement to borrow the security; or (ii) Reasonable grounds to
believe that the security can be borrowed so that it can be
delivered on the date delivery is due; and (iii) Documented
compliance with this paragraph (b)(1).'' This is known as the
``locate'' requirement. Market makers engaged in bona fide market
making in the security at the time they effect the short sale are
excepted from this requirement. In connection with this ``locate''
requirement, as well as other provisions of Regulation SHO that
require a reasonableness determination (i.e., Rules 200(g)(1) and
203(a)(2)(ii)), we remind any broker-dealer subject to such
provisions that they have an affirmative obligation to obtain and
consider information from their own records and/or from the records
of another source helpful to making the reasonableness
determinations required by such rules. Such information may include,
but is not limited to, information regarding a customer's prior
assurances regarding a locate source, its share ownership, or
delivery of shares by settlement date. See 17 CFR 242.203(b)(1),
242.200(g)(1), 203(a)(2)(ii). See also 2004 Regulation SHO Adopting
Release, 69 FR 48014, n. 58, 48019 at n. 111.
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    Another requirement of Regulation SHO aimed at potentially abusive
``naked'' short selling and reducing fails to deliver in certain equity
securities is the rule's ``close-out'' requirement. Since Regulation
SHO was adopted it has required participants \34\ of a registered
clearing agency,\35\ which includes broker-dealers, to purchase shares
to close out fails to deliver in securities with large and persistent
fails to deliver, i.e., ``threshold securities.'' \36\ Until the
position is closed out, the participant responsible for the fail to
deliver position and any broker-dealer from which it receives trades
for clearance and settlement may not effect further short sales in that
threshold security without first borrowing or arranging to borrow the
security.\37\
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    \34\ For purposes of Regulation SHO, the term ``participant''
has the same meaning as in section 3(a)(24) of the Exchange Act. See
15 U.S.C. 78c(a)(24).
    \35\ The term ``registered clearing agency'' means a clearing
agency, as defined in Section 3(a)(23)(A) of the Exchange Act, that
is registered as such pursuant to Section 17A of the Exchange Act.
See 15 U.S.C. 78c(a)(23)(A) and 78q-1, respectively; see also 2004
Regulation SHO Adopting Release, 69 FR 48031. The majority of equity
trades in the United States are cleared and settled through systems
administered by clearing agencies registered with the Commission.
The NSCC clears and settles the majority of equity securities trades
conducted on the exchanges and in the over-the-counter market. NSCC
clears and settles trades through the Continuous Net Settlement
(``CNS'') system, which nets the securities delivery and payment
obligations of all of its members. NSCC notifies its members of
their securities delivery and payment obligations daily. In
addition, NSCC guarantees the completion of all transactions and
interposes itself as the contraparty to both sides of the
transaction. We intend to closely monitor fails to deliver resulting
from trades that are not cleared and settled through the CNS system.
    \36\ Rule 203(c)(6) of Regulation SHO defines a ``threshold
security'' as any equity security of an issuer that is registered
pursuant to Section 12 of the Exchange Act (15 U.S.C. 78l) or for
which the issuer is required to file reports pursuant to Section
15(d) of the Exchange Act (15 U.S.C. 78o(d)) for which there is an
aggregate fail to deliver position for five consecutive settlement
days at a registered clearing agency of 10,000 shares or more, and
that is equal to at least 0.5% of the issue's total shares
outstanding; and is included on a list disseminated to its members
by a self-regulatory organization (``SRO''). See 17 CFR
242.203(c)(6).
    \37\ See 17 CFR 242.203(b)(3)(iv).
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    As adopted, Regulation SHO included two major exceptions to the
close-out requirement: The ``grandfather'' provision and the ``options
market maker'' exception. The ``grandfather'' provision had provided
that fails to deliver established prior to a security becoming a
threshold security did not have to be closed out in accordance with
Regulation SHO's thirteen consecutive settlement day close-out
requirement.

    Due to our concerns about the potentially negative market impact of
large and persistent fails to deliver, and the fact that we continued
to observe threshold securities with fail to deliver positions that
were not being closed out under existing delivery and settlement
requirements, effective on October 15, 2007, we adopted an amendment to
Regulation SHO that eliminated the ``grandfather'' provision.\38\
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    \38\ See 2007 Regulation SHO Final Amendments, 72 FR 45544. This
amendment also contained a one-time phase-in period that provided
that previously-grandfathered fails to deliver in a security that
was a threshold security on the effective date of the amendment must
be closed out within 35 consecutive settlement days from the
effective date of the amendment. The phase-in period ended on
December 5, 2007.
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    The options market maker exception excepted any fail to deliver
position in a threshold security resulting from short sales effected by
a registered options market maker to establish or maintain a hedge on
options positions that were created before the underlying security
became a threshold security. On September 17, 2008, we adopted and made
immediately effective, as an emergency rule, an amendment to Rule
203(b)(3) of Regulation SHO to eliminate the options market maker
exception to the rule's close-out requirement.\39\ Following the
issuance of the September Emergency Order, we adopted amendments making
permanent the elimination of the options market maker exception.\40\ As
we discussed in the 2008 Regulation SHO Final Amendments, we believed
it was appropriate to eliminate the options market maker exception in
part because substantial levels of fails to deliver continued to
persist in threshold securities and it appeared that a significant
number of these fails to deliver were as a result of the options market
maker exception.\41\
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    \39\ See Exchange Act Release No. 58572 (Sept. 17, 2008), 73 FR
54875 (Sept. 23, 2008) (``September Emergency Order'').
    \40\ See Exchange Act Release No. 58775 (Oct. 14, 2008), 73 FR
61690 (Oct. 17, 2008) (``2008 Regulation SHO Final Amendments'');
see also 2007 Regulation SHO Proposed Amendments, 72 FR 45558; 2006
Regulation SHO Proposed Amendments, 71 FR 41710; Exchange Act
Release No. 58107 (July 7, 2008), 73 FR 40201 (July 14, 2008)
(``2008 Regulation SHO Re-Opening Release'').
    \41\ See 2008 Regulation SHO Final Amendments, 73 FR 61690; see
also 2008 Regulation SHO Re-Opening Release, 73 FR 40201.
---------------------------------------------------------------------------

    In adopting temporary Rule 204T of Regulation SHO pursuant to the
September Emergency Order and subsequently pursuant to the Rule 204T
Adopting Release, we strengthened further the close-out requirements of
Regulation SHO by applying close-out requirements to fails to deliver
resulting from sales of all equity securities and reducing the time-
frame within which fails to deliver must be closed out.\42\
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    \42\ In addition to these amendments to Regulation SHO, recently
we have taken other actions aimed at reducing fails to deliver and
addressing potentially abusive ``naked'' short selling. For example,
in July 2008, we published an emergency order under section 12(k) of
the Exchange Act (the ``July Emergency Order'') that temporarily
restricted ``naked'' short selling in the publicly traded securities
of nineteen financial institutions. See Exchange Act Release No.
58166 (July 15, 2008), 73 FR 55169 (July 21, 2008) (imposing
borrowing and delivery requirements on short sales of the equity
securities of nineteen financial companies); see also Exchange Act
Release No. 58248 (July 29, 2008), 73 FR 45257 (Aug. 4, 2008)
(extending the July Emergency Order such that it expired on August
12, 2008). In September 2008, we published an emergency order that
temporarily banned short selling in the publicly traded securities
of approximately 1,000 financial institutions (the ``Short Sale
Ban''). See Exchange Act Release No. 58592 (Sept. 18, 2008), 73 FR
55169 (Sept. 24, 2008); see also Exchange Act Release No. 58611
(Sept. 21, 2008), 73 FR 55556 (Sept. 25, 2008) (amending the Short
Sale Ban). The Short Sale Ban expired on October 8, 2008. In
addition, in the September Emergency Order, we adopted and made
immediately effective a ``naked'' short selling anti-fraud rule,
Rule 10b-21, aimed at sellers, including broker-dealers acting for
their own accounts, who deceive certain specified persons about
their intention or ability to deliver securities in time for
settlement and that fail to deliver securities by settlement date.
See September Emergency Order. Following the issuance of the
September Emergency Order, we adopted final amendments making Rule
10b-21 permanent. See Anti-Fraud Rule Adopting Release, 73 FR 61666;
see also Anti-Fraud Rule Proposing Release, 73 FR 15376. In
addition, on April 8, 2009, we proposed amendments to Regulation SHO
that, if adopted, would add a short sale price test restriction or
short sale circuit breaker rule to Regulation SHO. See Exchange Act
Release No. 59748 (Apr. 10, 2009), 74 FR 18042 (Apr. 20, 2009) (the
``Short Sale Price Test Proposing Release'').
---------------------------------------------------------------------------

    As noted above, since the adoption of temporary Rule 204T and the
elimination of Regulation SHO's options market maker exception, we have
seen a significant reduction in the number of fails to deliver in all
equity securities. To continue advancing our goal of reducing fails to
deliver by maintaining the reductions in fails to deliver achieved by
the adoption of temporary Rule 204T, as well as other actions taken by
the Commission, and addressing potentially abusive ``naked'' short
selling, we are adopting the substance of temporary Rule 204T in a
permanent rule, Rule 204. We continue to believe that strengthening the
close-out requirements of Regulation SHO will further help to protect
and enhance the operation, integrity, and stability of the markets, as
well as help reduce potential short selling abuses.

III. Discussion of Rule 204 of Regulation SHO

    As discussed in more detail below, we are maintaining the structure
of temporary Rule 204T with limited modifications to address
commenters' concerns. In discussing the provisions of Rule 204, we
highlight below some of the main issues, concerns, and suggestions
raised by commenters.\43\
---------------------------------------------------------------------------

    \43\ See supra note 12.
---------------------------------------------------------------------------

A. Rule 204's Close-Out Requirement

1. Close-Out Period
    In Rule 204(a), we are adopting the close-out requirements of
temporary Rule 204T(a) without modification. Temporary Rule 204T(a)
provides that a participant of a registered clearing agency must
deliver securities to a registered clearing agency for clearance and
settlement on a long or short sale in any equity security by settlement
date, or if a participant of a registered clearing agency has a fail to
deliver position at a registered clearing agency in any equity security
for a long or short sale transaction in that equity security, the
participant shall, by no later than the beginning of regular trading
hours \44\ on the settlement day \45\ following the settlement date
(i.e., T+4), immediately close out the fail to deliver position by
borrowing or purchasing securities of like kind and quantity.\46\
---------------------------------------------------------------------------

    \44\ ``Regular trading hours'' has the same meaning as in Rule
600(b)(64) of Regulation NMS. Rule 600(b)(64) provides that
``Regular trading hours means the time between 9:30 a.m. and 4:00
p.m. Eastern Time, or such other time as is set forth in the
procedures established pursuant to Sec.  242.605(a)(2).''
    \45\ The term ``settlement day'' is defined in Rule 203(c)(5) of
Regulation SHO as: ``* * * any business day on which deliveries of
securities and payments of money may be made through the facilities
of a registered clearing agency.'' 17 CFR 242.203(c)(5).
    \46\ See temporary Rule 204T(a).
---------------------------------------------------------------------------

    Under certain circumstances, temporary Rule 204T provides
additional time during which fails to deliver may be closed out.
Specifically, temporary Rule 204T(a)(1) and (a)(3) provide that,
subject to certain conditions, fails to deliver resulting from long
sales or certain bona fide market making activity must be closed out by
no later than the beginning of regular trading hours on the third
settlement day after settlement date (i.e., T+6).\47\
---------------------------------------------------------------------------

    \47\ In addition, temporary Rule 204T(a)(2) provides that fails
to deliver resulting from sales of securities pursuant to Rule 144
of the Securities Act of 1933 (``Rule 144 Securities'') must be
closed out by no later than the beginning of regular trading hours
on the thirty-sixth consecutive settlement day following settlement
date (i.e., T+39).
---------------------------------------------------------------------------

    In response to our requests for comment, a number of commenters
expressed concerns regarding the time periods within which fails to
deliver must be closed out under temporary Rule 204T. Commenters
expressed concern that temporary Rule 204T's

requirement to close-out fails to deliver by no later than the
beginning of regular trading hours can create buying pressure at the
open, that may temporarily distort the price of the security.\48\ To
minimize the market impact of the close-out requirement, commenters
suggested allowing participants to close out fails to deliver by the
end of regular trading hours, or the close of business on the New York
Stock Exchange (``NYSE''), rather than by no later than the beginning
of regular trading hours.\49\ In requesting additional time during the
day to close out fails to deliver, one commenter noted that such a
change ``would significantly alleviate the market pressures associated
with execution of potentially large purchases at the opening of
trading--a time when markets are particularly susceptible to price
fluctuations.'' \50\ This commenter also stated that, as a practical
matter, ``transactions effected at market open to close-out open fail
positions are no different from those effected later on in the trading
session because both are part of the same clearance and settlement
cycle. Thus, providing this relief would not add any delay of
consequence to the close-out process.'' \51\
---------------------------------------------------------------------------

    \48\ See, e.g., letter from Stuart Kaswell, Executive Vice
President and General Counsel, Managed Funds Association, dated Dec.
15, 2008 (``MFA''); letter from Edward J. Joyce, President and Chief
Operating Officer, Chicago Board Options Exchange, dated Dec. 23,
2008 (``CBOE''); letter from Amal Aly, Managing Director and
Associate General Counsel, SIFMA, dated Dec. 16, 2008 (``SIFMA'');
letter from Eric Swanson, General Counsel, BATS Exchange, Inc.,
dated Dec. 29, 2008 (``BATS''); letter from Michael P. McAuley,
Chair, RMA Committee on Securities Lending, dated Dec. 23, 2008
(``RMA''); letter from Stefan Gavell, Executive Vice President and
Head of Regulatory Industry Affairs, State Street Corporation, dated
Dec. 16, 2008 (``State Street'').
    \49\ See, e.g., letters from SIFMA; MFA; State Street; BATS;
letter from A. Peter Allman-Ward, Executive Vice President and CFO,
Wedbush Morgan Securities, Inc., dated Dec. 15, 2008 (``Wedbush'').
    \50\ Letter from SIFMA.
    \51\ See id.
---------------------------------------------------------------------------

    Other commenters requested additional days within which to close
out fails to deliver in connection with short sales. For example, some
commenters requested that the Commission extend the close-out period
for fails to deliver resulting from short sales to three settlement
days after the fail occurs, consistent with the close-out period for
fails to deliver resulting from long sales and market making
activity.\52\ Other commenters requested that the Commission extend the
close-out requirement for fails to deliver resulting from all sales to
five settlement days after the fail to deliver position occurs.\53\
These commenters stated that the additional time to close out fails to
deliver would allow the majority of trades to clear and settle on their
own within a few days following the regular settlement date (i.e,
T+3).\54\
---------------------------------------------------------------------------

    \52\ See e.g., letter from Peter Kovac, Chief Operating Officer
and Financial and Operations Principal, EWT, LLC, dated Nov. 25,
2008 (``EWT''); letter from James S. Chanos, Chairman, Coalition of
Private Investment Companies, dated Dec. 16, 2008 (``Coalition of
Private Investment Companies''); letters from SIFMA; MFA; State
Street.
    \53\ See, e.g., letter CBOE; letter from Boston Options
Exchange, Chicago Board Options Exchange, International Securities
Exchange, NASDAQ Options Market, NASDAQ OMX PHLX, NYSE Alternext US,
NYSE Arca, and The Options Clearing Corporation, dated Dec. 19, 2008
(``Options Exchanges'').
    \54\ See, e.g., letters from SIFMA; MFA; State Street; CBOE;
Options Exchanges; Coalition of Private Investment Companies.
---------------------------------------------------------------------------

    Some commenters expressed concerns about the effect of the close-
out requirements of temporary Rule 204T on securities lending.\55\ For
example, one commenter stated that the compressed time-frame for
closing out fails to deliver under temporary Rule 204T ``has generated
over-buying and borrowing of securities that would otherwise settle in
the normal course, thus impairing liquidity by tying up shares that
would otherwise be available to natural buyers and sellers.'' \56\ This
commenter also noted that in practice fails to deliver resulting from
sales of securities on loan, which are considered ``long'' sales, are
often closed out in accordance with the time-frames for fails to
deliver resulting from short sales rather than long sales because
temporary Rule 204T does not provide sufficient time to determine
whether or not a fail to deliver position resulted from a long or short
sale.\57\ According to this commenter, such purchasing activity acts as
a disincentive to lending and causes institutions to question their
participation in lending programs.\58\
---------------------------------------------------------------------------

    \55\ As stated in the Rule 204T Adopting Release, if a person
that has loaned a security to another person sells the security and
a bona fide recall of the security is initiated within two business
days after trade date, the person that has loaned the security will
be ``deemed to own'' the security for purposes of Rule 200(g)(1) of
Regulation SHO, and such sale will not be treated as a short sale
for purposes of temporary Rule 204T. In addition, a broker-dealer
may mark such orders as ``long'' sales provided such marking is also
in compliance with Rule 200(c) of Regulation SHO. See Rule 204T
Adopting Release, 73 FR 61713, n. 70.
    \56\ Letter from SIFMA.
    \57\ See letter from SIFMA; see also letter from RMA; letter
from Heather Traeger, Assistant Counsel, Investment Company
Institute, dated Dec. 16, 2008 (``ICI'').
    \58\ See letter from SIFMA; see also letter from RMA
(recommending the extension of the close-out period for fails to
deliver for all sales to settlement date plus three days (i.e., T+6)
``to ensure that beneficial owners selling on-loan positions are not
compromised by close-outs of long sales on T+4'').
---------------------------------------------------------------------------

    Other commenters stated that where the holder of a long position
sells securities that have been financed through a securities loan, the
close-out requirements of temporary Rule 204T may not provide
sufficient time for the securities to be recalled and delivered in time
for settlement of the sale transaction.\59\ These commenters stated,
among other things, that temporary Rule 204T's requirement that
securities be delivered by no later than the beginning of regular
trading hours does not allow for the completion of the securities
lending cycle, which may not occur until the close of the DTC
settlement window on the third settlement day after settlement date
(i.e., T+6).\60\
---------------------------------------------------------------------------

    \59\ See letters from EWT; BATS; RMA; ICI; Wedbush.
    \60\ See letters from EWT; BATS; RMA; ICI. EWT stated that a
recall typically occurs to assure that the securities are returned
on the settlement date for the sale transaction. If the securities
are not returned by that date, the lender may initiate a buy-in
process designed to obtain the securities as promptly as possible.
This buy-in is intended to result in delivery of the securities
after three business days, such that the lender will not complete
the buy-in process until the close of the DTC settlement window on
the third business day following initiation of the buy-in process.
Accordingly, this commenter recommended, among other things, that we
should: (1) either (a) create an exception for fails to deliver
where the securities are loaned but have been recalled or (b)
confirm that the issuance of a bona fide loan recall notice is a
valid form of close-out for a fail to deliver; or (2) extend the
close-out period from settlement date plus three days (i.e., T+6),
to settlement date plus six days (i.e., T+9) for fails to deliver
resulting from long sales. See also letter from RMA (stating that
due to operational complexity and the number of market participants
involved in the sale of an ``on-loan position,'' it is commonplace
for a sale to be settled during the day on T+6).
---------------------------------------------------------------------------

    As noted above, the close-out requirements of temporary Rule 204T
are advancing our goal of further reducing fails to deliver, as
evidenced in part by preliminary results from OEA regarding its impact
on the number of fails to deliver.\61\ Thus, we are adopting as a
permanent rule the structure of the close-out requirements of temporary
Rule 204T. Specifically, Rule 204(a) provides that a participant of a
registered clearing agency must deliver securities to a registered
clearing agency for clearance and settlement on a long or short sale in
any equity security by settlement date, or if a participant of a
registered clearing agency has a fail to deliver position at a
registered clearing agency in any equity security for a long or short
sale transaction in that equity security, the participant shall, by no
later than the beginning of regular trading hours \62\ on the
settlement day \63\

following the settlement date, immediately close out the fail to
deliver position by borrowing or purchasing securities of like kind and
quantity.\64\
---------------------------------------------------------------------------

    \61\ See supra note 8, and accompanying text.
    \62\ See supra note 44 (discussing the definition of the term
``regular trading hours'' for purposes of Regulation SHO).
    \63\ See supra note 45 (discussing the definition of the term
``settlement day'' for purposes of Regulation SHO).
    \64\ See Rule 204(a).
---------------------------------------------------------------------------

    In addition, as discussed in more detail below, we are adopting in
Rule 204(a)(1) and (a)(3) the close-out requirements of temporary Rule
204T(a)(1) and (a)(3) for fails to deliver resulting from long sales
and certain bona fide market making activity so that such fails to
deliver must be closed out by no later than the beginning of regular
trading hours on the close-out date (i.e., T+6) for such fails to
deliver.\65\
---------------------------------------------------------------------------

    \65\ In addition, as discussed in Section III.E. below, we are
adopting the close-out requirements of Rule 204(a)(2) for fails to
deliver resulting from sales of Rule 144 Securities so that such
fails to deliver must be closed out by no later than the beginning
of regular trading hours on the applicable close-out date.
---------------------------------------------------------------------------

    Although we recognize commenters' concerns regarding the potential
market impact of the close-out requirements of temporary Rule 204T,
particularly at the market open, we believe that these potential
effects are justified by the benefits of retaining the strict close-out
requirements of temporary Rule 204T. As discussed above, since the
adoption of temporary Rule 204T, and other actions taken by the
Commission aimed at reducing fails to deliver, there has been a
significant reduction in fails to deliver. To maintain these declines,
we believe it is necessary at this time to continue to require that
participants close out fails to deliver by no later than the beginning
of regular trading hours on the applicable close-out date. We believe
that the strict close-out requirements of the temporary rule have
helped reduce fails to deliver by providing a disincentive to those
who, but for the rule, may have failed to deliver securities by
settlement date. In addition, we note that participants have been
operating pursuant to the close-out requirements of the temporary rule,
as adopted, and appear to have adjusted to its requirements.\66\
---------------------------------------------------------------------------

    \66\ In discussing the requirement to purchase securities by no
later than the beginning of regular trading hours on the applicable
close-out date, some commenters discussed the ability to use, among
other mechanisms, volume weighted average price (``VWAP'') orders
entered at the beginning of the day to more effectively manage their
buy-in risk. See, e.g., letters from Duncan L. Niederaurer, CEO,
NYSE Euronext and Richard G. Ketchum, NYSE Regulation, Inc., dated
Dec. 16, 2008 (``NYSE''); ICI. We note that if a participant has a
fail to deliver position at a registered clearing agency that it
must close out in accordance with Rule 204 of Regulation SHO, the
participant may satisfy the close-out requirement to purchase
securities of like kind and quantity with a VWAP order provided: (i)
the order to purchase the equity security on a VWAP basis is
irrevocable and received by no later than the beginning of regular
trading hours on the applicable close-out date; and (ii) the final
execution price of any such transaction is not determined until
after the close of regular trading hours when the VWAP value is
calculated and the execution is on an agency basis.
---------------------------------------------------------------------------

    We believe that continuing to require that fails to deliver be
closed out on the day immediately following the day on which the fail
to deliver occurs is consistent with our goal of reducing fails to
deliver by maintaining the reductions in fails to deliver achieved by
the adoption of temporary Rule 204T, as well as other actions taken by
the Commission, and addressing ``naked'' short selling and, in
particular, potentially abusive ``naked'' short selling. Although
extending the time-frames within which fails to deliver must be closed
out may allow for ordinary course settlement, as several commenters
contend, we believe that the close-out requirements of Rule 204 are
necessary to continue to help encourage delivery by settlement date and
achieve our goal of not allowing fails to deliver to persist.\67\
---------------------------------------------------------------------------

    \67\ See supra note 16 (discussing the standard three-day
settlement cycle).
---------------------------------------------------------------------------

    As we discussed in the Rule 204T Adopting Release, we believe that
delivery on sales should be made by settlement date.\68\ In the Rule
204T Adopting Release, we noted that the vast majority of fails to
deliver are closed out within five days after T+3.\69\ In addition, in
that release we referenced a recent analysis by OEA that found that
more than half of all fails to deliver and more than 70% of all fail to
deliver positions are closed out within two settlement days after
T+3.\70\ We also noted in that release, however, that although this
information shows that delivery is being made, it demonstrates that
often delivery is not being made until several days following the
standard three-day settlement cycle.
---------------------------------------------------------------------------

    \68\ See Rule 204T Adopting Release, 73 FR 61712-61713.
    \69\ See id.
    \70\ See id. at n. 68. We note that OEA's analysis examined the
period from January to July 2008 and used the age of the fail to
deliver position as reported by the NSCC. The NSCC data included
only securities with at least 10,000 shares in fails to deliver.
These numbers also included securities that were not subject to the
close-out requirement in Rule 203(b)(3) of Regulation SHO, which
applies only to ``threshold securities'' as defined in Rule
203(c)(6) of Regulation SHO.
---------------------------------------------------------------------------

    In addition, as discussed above, fails to deliver may be part of a
scheme to manipulate the price of a security. We are also concerned
about the negative effect that fails to deliver and potentially abusive
``naked'' short selling may have on the market and the broader economy,
including on investor confidence.\71\ The close-out requirements of
Rule 204 help address these concerns by prohibiting the persistence of
fails to deliver.
---------------------------------------------------------------------------

    \71\ See, e.g., Anti-Fraud Rule Adopting Release, 73 FR 61666.
---------------------------------------------------------------------------

    We understand, however, that fails to deliver may occur from long
sales within the first two settlement days after settlement date for
legitimate reasons.\72\ For example, human or mechanical errors or
processing delays can result from transferring securities in custodial
or other form rather than book-entry form, thereby causing a fail to
deliver on a long sale.\73\
---------------------------------------------------------------------------

    \72\ See Rule 204T Adopting Release, 73 FR 61713.
    \73\ See id.
---------------------------------------------------------------------------

    Thus, in Rule 204(a)(1), we are adopting, with certain limited
modifications, the provisions of temporary Rule 204T(a)(1) relating to
closing out fails to deliver resulting from long sales. Specifically,
Rule 204(a)(1) provides that if a participant of a registered clearing
agency has a fail to deliver position at a registered clearing agency
in any equity security and the participant can demonstrate on its books
and records that such fail to deliver position resulted from a long
sale, the participant shall by no later than the beginning of regular
trading hours on the third consecutive settlement day following the
settlement date immediately close out the fail to deliver position by
purchasing or borrowing securities of like kind and quantity.\74\
---------------------------------------------------------------------------

    \74\ See Rule 204(a)(1).
---------------------------------------------------------------------------

    In response to a request for comment, some commenters requested
that we provide additional flexibility to the close-out requirements of
temporary Rule 204T(a)(1) by allowing participants to borrow as well as
purchase securities to close out such fails to deliver.\75\ In
temporary Rule 204T(a)(1), we required a participant to purchase
securities to close out fails to deliver resulting from long sales to
be consistent with the close-out requirements of Rule 203(b)(3) of
Regulation SHO which require that a participant that has a fail to
deliver position in a threshold security for thirteen consecutive
settlement days immediately thereafter close out the fail to deliver
position by purchasing securities of like kind and quantity.\76\
---------------------------------------------------------------------------

    \75\ See e.g., letters from SIFMA; EWT; MFA; State Street; BATS;
Wedbush; Angel.
    \76\ See 17 CFR 242.203(b)(3). Some commenters requested
clarification regarding a broker-dealer's obligations under FINRA
Rule 11810 (the ``FINRA Buy-In Rule'') and the close-out
requirements of temporary Rule 204T. See, e.g., letter from Joseph
Zangri, Chief Compliance Officer, Bloomberg Tradebook, LLC (Dec. 16,
2008) (``Bloomberg''). We note that because the requirements of Rule
204 apply to broker-dealers involved in the sell-side of a
transaction, whereas the FINRA Buy-In Rule sets forth procedures
applicable to a purchaser that chooses to buy-in a seller, we
believe that these rules apply separate and distinct obligations on
market participants and, therefore, are not in conflict.

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

    Commenters stated that borrowing securities serves the same purpose
as purchasing securities to close out fails to deliver.\77\ In
addition, commenters noted that allowing a borrow to close out such
fails would be consistent with the close-out requirements for short
sales. After considering the comments received, we provide in Rule
204(a)(1) the ability for a participant to close out a fail to deliver
position resulting from a long sale by purchasing or borrowing
securities.\78\ We believe that such an amendment is consistent with
our goal of reducing fails to deliver by maintaining the reductions in
fails to deliver achieved by the adoption of temporary Rule 204T, as
well as other actions taken by the Commission, because it will provide
additional flexibility to participants in closing out fail to deliver
positions.\79\ Permitting a borrow as well as a purchase will also make
the close-out requirements of Rule 204(a)(1) consistent with the close-
out requirements of Rule 204(a).
---------------------------------------------------------------------------

    \77\ See e.g., letter from MFA.
    \78\ See Rule 204(a)(1). Although Rule 204(a)(1) permits
borrowing to close out a fail to deliver position resulting from a
long sale, broker-dealers must also comply with Rule 203(a) of
Regulation SHO. Rule 203(a)(1) provides that, unless an exception
applies, ``[i]f a broker or dealer knows or has reasonable grounds
to believe that the sale of an equity security was or will be
effected pursuant to an order marked ``long,'' such broker or dealer
shall not lend or arrange for the loan of any security for delivery
to the purchaser's broker after the sale, or fail to deliver a
security on the date delivery is due.'' 17 CFR 242.203(a).
    \79\ See letter from CBOE (stating that the close-out procedures
under temporary Rule 204T for fails to deliver attributable to bona
fide market making activity should be amended to permit borrows or
purchases throughout the close-out period).
---------------------------------------------------------------------------

    As we stated with respect to Rule 204T's close-out requirements,
under Rule 204's close-out requirements for fails to deliver resulting
from long or short sales, a participant must take affirmative action to
close out a fail to deliver position by purchasing or borrowing
securities.\80\ Thus, a participant may not offset the amount of its
fail to deliver position with shares that the participant receives or
will receive during the applicable close-out date (i.e., during T+4 or
T+6, as applicable).\81\ In addition, as we stated in the Rule 204T
Adopting Release, to meet its close-out obligation a participant also
must be able to demonstrate on its books and records that on the
applicable close-out date, it purchased or borrowed shares in the full
quantity of its fail to deliver position and, therefore, that the
participant has a net flat or net long position on its books and
records on the applicable close-out date (i.e., during T+4 or T+6, as
applicable).\82\
---------------------------------------------------------------------------

    \80\ See Rule 204T Adopting Release, 73 FR 61710.
    \81\ In determining its close-out obligation, a participant may
rely on its net delivery obligation as reflected in its notification
from NSCC regarding its securities delivery and payment obligations,
provided such notification is received prior to the beginning of
regular trading hours on the applicable close-out date. See Rule
204T Adopting Release, 73 FR 61711, at n. 46 (and accompanying
text).
    \82\ See Rule 204T Adopting Release, 73 FR 61711. Both temporary
Rule 204T and Rule 204 require that a participant purchase or borrow
shares, as applicable, to close out a fail to deliver position.
Accordingly, the purchase or borrow on the applicable close-out date
must be for the full quantity of the fail to deliver position that
is subject to the close-out requirement. In addition, where a
participant subject to the close-out requirement purchases or
borrows securities on the applicable close-out date and on that same
date engages in sale transactions that can be used to re-establish
or otherwise extend the participant's fail position, and for which
the participant is unable to demonstrate a legitimate economic
purpose, the participant will not be deemed to have satisfied the
close-out requirement.
---------------------------------------------------------------------------

    Consistent with temporary Rule 204T, Rule 204 defines a
``settlement date'' as ``the business day on which delivery of a
security and payment of money is to be made through the facilities of a
registered clearing agency in connection with the sale of a security.''
\83\ As we noted in the Rule 204T Adopting Release, this definition is
consistent with Rule 15c6-1 under the Exchange Act that prohibits
broker-dealers from effecting or entering into a contract for the
purchase or sale of a security that provides for payment of funds and
delivery of securities later than the third business day after the date
of the contract unless otherwise expressly agreed to by the parties at
the time of the transaction.\84\
---------------------------------------------------------------------------

    \83\ See Rule 204(g)(1); see also Rule 204T(f)(1).
    \84\ See 17 CFR 240.15c6-1; see also Rule 204T Adopting Release,
73 FR 61711.
---------------------------------------------------------------------------

    Because most transactions settle by T+3 and because delivery on all
sales should be made by settlement date, participants should consider
having in place policies and procedures to help ensure that delivery is
being made by settlement date. As we stated in the Rule 204T Adopting
Release, we intend to examine participants' policies and procedures to
determine whether, among other things, such policies and procedures
require broker-dealers to monitor for delivery by settlement date.\85\
---------------------------------------------------------------------------

    \85\ See Rule 204T Adopting Release, 73 FR 61711. Of course,
broker-dealers must comply with any applicable SRO policies and
procedures requirements. For example, NASD Rule 3010 contains, among
other things, written procedures requirements for member firms.
---------------------------------------------------------------------------

    Consistent with the existing close-out requirements of Rule
203(b)(3) of Regulation SHO and temporary Rule 204T, the close-out
requirements of Rule 204 are based on a participant's fail to deliver
position at a registered clearing agency. As noted above, the NSCC
clears and settles the majority of equity securities trades conducted
on the exchanges and in the over-the-counter markets. NSCC clears and
settles trades through the CNS system, which nets the securities
delivery and payment obligations of all of its members. NSCC notifies
its members of their securities delivery and payment obligations daily.
Because Rule 204 is based on a participant's fail to deliver position
at a registered clearing agency, it is consistent with current
settlement practices and procedures and with the Regulation SHO
framework regarding delivery of securities.\86\
---------------------------------------------------------------------------

    \86\ See temporary Rule 204T; see also 17 CFR 242.203(b)(3).
---------------------------------------------------------------------------

2. Application to All Equity Securities
    Consistent with temporary Rule 204T, the close-out requirements of
Rule 204 apply to fails to deliver in all equity securities. As
discussed in the Rule 204T Adopting Release, this requirement differs
from the close-out requirement of Rule 203(b)(3) of Regulation SHO that
applies the close-out requirements of that rule only to those
securities with a large and persistent level of fails to deliver, i.e.,
threshold securities.\87\
---------------------------------------------------------------------------

    \87\ See Rule 204T Adopting Release, 73 FR 61711; see also 17
CFR 242.203(b)(3).
---------------------------------------------------------------------------

    A purpose of Rule 204 is to help limit the use of ``naked'' short
selling as part of a manipulative scheme. To achieve this purpose, we
are applying the rule to all equity securities, regardless of the level
or persistence of any fails to deliver in such securities. In addition,
as discussed above, we believe that all sellers of equity securities
should promptly deliver, or arrange for delivery of, securities to the
respective buyer and all buyers of securities have a right to expect
prompt delivery of securities purchased. We believe this should be the
case for sales in all equity securities and are adopting this rule to
further that goal.
    We note that in the Rule 204T Adopting Release, we requested
comment regarding whether temporary Rule 204T should be expanded to
apply to debt as well as equity securities. In response, commenters
opposed the extension of temporary Rule 204T to debt securities.\88\
One such commenter stated that the Commission has expressly carved out
debt securities from all short sale regulations, including Regulation
SHO, citing in support the non-manipulative potential associated

with fixed income securities.\89\ This commenter stated that it
believes that certain structured products should also be excluded from
the application of temporary Rule 204T.\90\ This commenter
acknowledged, however, that the ``equity'' status of some structured
products may not be clear and its view that it may not be feasible for
the Commission to make broad-based determinations on whether categories
of securities constitute debt or equity.\91\
---------------------------------------------------------------------------

    \88\ See, e.g., letters from SIFMA; MFA; State Street.
    \89\ See letter from SIFMA (referring to, among other things,
Securities Exchange Act Release No. 56206 (Aug. 6, 2007), 72 FR
45094 (Aug. 10, 2007)).
    \90\ See id.
    \91\ See id.
---------------------------------------------------------------------------

    After considering the comments and because all other provisions of
Regulation SHO apply only to equity securities, at this time, we are
not extending Rule 204 to securities other than equity securities. We
note, however, for those securities for which market participants
believe the ``equity'' status is unclear, we will consider on a case-
by-case basis whether the provisions of Rule 204, and Regulation SHO
more generally, apply.
    Regulation SHO, as adopted in 2004, was a first step in reducing
persistent fails to deliver and addressing abusive ``naked'' short
selling. In Regulation SHO, we took a targeted approach, imposing
additional delivery requirements on securities with a substantial and
persistent amount of fails to deliver. As we stated in the 2004
Regulation SHO Adopting Release, we took this targeted approach at that
time in an effort to address the problem but at the same time not to
burden the vast majority of securities where there are not similar
concerns regarding settlement.\92\ In addition, Regulation SHO's close-
out requirement was adopted to address potential abuses that may occur
with large, extended fails to deliver.\93\ We also noted in the 2004
Regulation SHO Adopting Release, however, that we would pay close
attention to the operation and efficacy of the provisions we were
adopting at that time and would consider whether any further action was
warranted.\94\
---------------------------------------------------------------------------

    \92\ See 2004 Regulation SHO Adopting Release, 69 FR 48016.
    \93\ See id. at 48017.
    \94\ See id. at 48018.
---------------------------------------------------------------------------

    Because of continued concerns about the potentially negative market
impact of fails to deliver, and the fact that through our monitoring of
the efficacy of Regulation SHO's close-out requirement we continued to
observe threshold securities with fail to deliver positions that were
not being closed out, we eliminated the ``grandfather'' and options
market maker exceptions to Regulation SHO's close-out requirements.\95\
---------------------------------------------------------------------------

    \95\ See supra Section II (discussing the elimination of
Regulation SHO's ``grandfather'' and options market maker
exceptions).
---------------------------------------------------------------------------

    However, as we stated in the Rule 204T Adopting Release, we were
concerned that the close-out requirements of Regulation SHO, as
adopted, had not gone far enough in reducing fails to deliver and
addressing potentially abusive ``naked'' short selling.\96\ In light of
the recent instability and lack of investor confidence in the financial
markets,\97\ we believe that the requirements of temporary Rule 204T
should be made permanent to maintain the reduced fails to deliver and
to address potentially abusive ``naked'' short selling.
---------------------------------------------------------------------------

    \96\ See Rule 204T Adopting Release, 73 FR 61711-61712.
    \97\ See, e.g., letter from Leland Chan, General Counsel,
California Bankers Association, dated Aug. 21, 2008; letter from
Eric C. Jensen, Esq., Cooley Godward Kronish L.L.P., dated Aug. 21,
2008; letter from Steven B. Boehm and Cynthia M. Krus, Sutherland
Asbill Brennan LLP, dated July 31, 2008; letter from James J. Angel,
Professor of Finance, Georgetown University, McDonough School of
Business, dated Aug. 20, 2008; letter from Tuan Nguyen, dated Aug.
8, 2008; see also Short Sale Price Test Proposing Release, 74 FR
18042 (proposing short sale price test restrictions and short sale
circuit breaker rules due to recent changes in market conditions and
a deterioration in investor confidence).
---------------------------------------------------------------------------

    We note that one commenter to the Rule 204T Adopting Release
suggested eliminating temporary Rule 204T of Regulation SHO, such that
only the close-out requirements of Rule 203(b)(3) would apply.\98\ If
we were to take such an approach, Regulation SHO's close-out
requirements would apply only to threshold securities and fails to
deliver in such securities would not have to be closed out until such
fails to deliver had persisted for thirteen consecutive settlement
days. As discussed above, we are applying the close-out requirements of
Rule 204 to all equity securities to further our goal of reducing fails
to deliver by maintaining the reductions in fails to deliver achieved
by the adoption of temporary Rule 204T, as well as other actions taken
by the Commission, in both threshold and non-threshold securities and,
thereby, also help continue to address abusive ``naked'' short selling
in such securities. In the Rule 204T Adopting Release, we noted that
prior to its adoption, fails to deliver in non-threshold securities
averaged approximately 624 million shares or $4.6 billion in value per
day from January to July 2008.\99\ Since adoption of the temporary
rule, and in connection with other Commission actions to address fails
to deliver, this number has declined significantly such that from
December 2008 to March 2009, OEA estimates that fails to deliver in
non-threshold securities averaged approximately 307 million shares or
$1.1 billion in value per day. We are applying Rule 204's close-out
requirements to all equity securities to help maintain the benefits
already achieved.
---------------------------------------------------------------------------

    \98\ See letter from CBOE.
    \99\ See Rule 204T Adopting Release, 73 FR 61712, n. 60. We also
noted these fails accounted for approximately 54.5% (56.6%) of all
fail to deliver shares (by dollar value).
---------------------------------------------------------------------------

3. Allocation of a Fail To Deliver Position
    Temporary Rule 204T(d) provides that a participant may reasonably
allocate its responsibility to close out a fail to deliver position to
another broker-dealer from which the participant receives trades for
clearance and settlement.\100\ Consistent with temporary Rule 204T(d),
Rule 204(d) provides for allocation of a fail to deliver position by a
participant to a broker-dealer. Specifically, Rule 204(d) provides that
if a participant of a registered clearing agency reasonably allocates a
portion of a fail to deliver position to another registered broker or
dealer for which it clears trades or from which it receives trades for
settlement, based on such broker's or dealer's short position, the
provisions of Rule 204(a) and (b) relating to such fail to deliver
position shall apply to such registered broker or dealer that was
allocated the fail to deliver position, and not to the
participant.\101\
---------------------------------------------------------------------------

    \100\ See temporary Rule 204T(d); see also 17 CFR
242.203(b)(3)(vi). Rule 203(b)(3)(vi) of Regulation SHO provides
that ``[i]f a participant of a registered clearing agency reasonably
allocates a portion of a fail to deliver position to another
registered broker or dealer for which it clears trades or for which
it is responsible for settlement, based on such broker or dealer's
short position, then the provisions of this paragraph (b)(3)
relating to such fail to deliver position shall apply to the portion
of such registered broker or dealer that was allocated the fail to
deliver position, and not to the participant.''
    \101\ See Rule 204(d).
---------------------------------------------------------------------------

    Thus, participants that are able to identify the accounts of
broker-dealers for which they clear or from which they receive trades
for settlement may allocate the responsibility to close out the fail to
deliver position to the particular broker-dealer account(s) whose
trading activities have caused the fail to deliver position provided
the allocation is reasonable (e.g., the allocation must be timely).
Absent such identification, however, the participant would remain
subject to the close-out requirement.\102\
---------------------------------------------------------------------------

    \102\ One commenter requested that we clarify whether an
allocated broker-dealer may reasonably re-allocate to the broker-
dealer from which it received the trade all or a portion of the fail
to deliver position that it was allocated. This commenter stated
that such re-allocation may continue until the fail position is
allocated to the ultimate initiating broker-dealer. See letter from
Bloomberg. We note that Rule 204(d) applies only to the allocation
by a participant to a registered broker or dealer for which it
clears trades or from which it receives trades for settlement. Thus,
if a participant allocates all or a portion of a fail to deliver
position to a broker-dealer, the close-out requirements of Rule 204
will apply to that allocated broker-dealer. This is consistent with
the allocation provisions of temporary Rule 204T and Rule 203(b)(3)
of Regulation SHO. Rule 204 does not, by its terms, apply to the
allocation of costs by a broker-dealer in connection with meeting
its close-out requirements.

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

    If a participant allocates a fail to deliver position to a broker-
dealer in accordance with Rule 204(d), such that the close-out
requirements of Rule 204(a) apply to that broker-dealer, the broker-
dealer to which the position was allocated must be able to demonstrate
that on the applicable close-out date, it purchased or borrowed shares
in the full quantity of the fail to deliver position allocated to it,
and that it has a net flat or net long position on its books and
records for that security on the applicable close-out date.\103\
---------------------------------------------------------------------------

    \103\ See Rule 204(d); see also supra note 82.
---------------------------------------------------------------------------

    In addition, as discussed above and consistent with temporary Rule
204T, the close-out requirements of Rule 204 require that the allocated
broker-dealer take affirmative action to close out the fail to deliver
position by purchasing or borrowing securities. Thus, a broker-dealer
allocated a fail to deliver position may not offset the amount of its
fail to deliver position with shares that the broker-dealer receives or
will receive during the applicable close-out date (i.e., during T+4 or
T+6, as applicable).\104\
---------------------------------------------------------------------------

    \104\ See supra note 81 and supporting text.
---------------------------------------------------------------------------

    Temporary Rule 204T(d) imposes a notification requirement on a
broker-dealer that has been allocated responsibility for complying with
the rule's requirements. Specifically, temporary Rule 204T(d) provides
that a broker-dealer that has been allocated a portion of a fail to
deliver position that does not comply with the provisions of temporary
Rule 204T(a) must immediately notify the participant that it has become
subject to the borrowing requirements of temporary Rule 204T(b).\105\
In the Rule 204T Adopting Release, we stated that we adopted this
notification requirement so that participants would know when a broker-
dealer for which they clear and settle trades has become subject to the
temporary rule's borrowing requirements.\106\ We did not receive any
comments specific to this notification requirement. We believe that the
reasons for adopting this notification requirement in temporary Rule
204T(d) apply to Rule 204(d) as well. Thus, we have determined to
maintain the requirement under Rule 204(d) that a broker-dealer that
has been allocated a portion of a fail to deliver position that does
not comply with the provisions of Rule 204(a) must immediately notify
the participant that it has become subject to the borrowing
requirements of Rule 204(b).\107\
---------------------------------------------------------------------------

    \105\ See temporary Rule 204T(d).
    \106\ See Rule 204T Adopting Release, 73 FR 61711.
    \107\ See Rule 204(d).
---------------------------------------------------------------------------

 B. Rule 204(b)--Borrowing Requirement

 1. Borrowing Requirement
    We are adopting in Rule 204(b) the requirements of temporary Rule
204T(b) without modification. If a participant does not purchase or
borrow shares, as applicable, to close out a fail to deliver position
in accordance with Rule 204, the participant violates the close-out
requirement of the rule. Rule 204(b), like temporary Rule 204T(b), also
imposes on the participant and on all broker-dealers from which that
participant receives trades for clearance and settlement (including
introducing and executing brokers), a requirement to borrow or arrange
to borrow securities prior to accepting or effecting further short
sales in that security. Specifically, Rule 204(b) provides that the
participant and any broker-dealer from which it receives trades for
clearance and settlement, including any market maker that is otherwise
entitled to rely on the exception provided in Rule 203(b)(2)(iii) of
Regulation SHO,\108\ may not accept a short sale order in an equity
security from another person, or effect a short sale order in such
equity security for its own account, to the extent that the broker-
dealer submits its short sales to that participant for clearance and
settlement, without first borrowing the security, or entering into a
bona-fide arrangement to borrow the security, until the participant
closes out the fail to deliver position by purchasing securities of
like kind and quantity and that purchase has cleared and settled at a
registered clearing agency.\109\
---------------------------------------------------------------------------

    \108\ See 17 CFR 242.203(b)(2)(iii) (providing an exception from
Regulation SHO's ``locate'' requirement for short sales effected by
a market maker in connection with bona fide market making activities
in the securities for which the exception is claimed).
    \109\ See Rule 204(b). The borrow requirements of Rule 204(b)
are also consistent with the requirements of Rule 203(b)(3)(iv) of
Regulation SHO for a participant that has not closed out a fail to
deliver position in a threshold security that has persisted for
thirteen consecutive settlement days. See 17 CFR 242.203(b)(3)(iv).
Rule 203(b)(3)(iv) of Regulation SHO provides that ``[i]f a
participant of a registered clearing agency has a fail to deliver
position at a registered clearing agency in a threshold security for
thirteen consecutive settlement days, the participant and any broker
or dealer for which it clears transactions, including any market
maker that would otherwise be entitled to rely on the exception
provided in paragraph (b)(2)(iii) of this section, many not accept a
short sale order in the threshold security from another person, or
effect a short sale in the threshold security for its own account,
without borrowing the security or entering into a bona fide
arrangement to borrow the security, until the participant closes out
the fail to deliver position by purchasing securities of like kind
and quantity''.
---------------------------------------------------------------------------

    We believe it is appropriate to include in the rule borrow
requirements for broker-dealers, including participants, that sell
short a security for which a fail to deliver position has not been
closed out in accordance with the requirements of the rule. We believe
that the borrow requirements of Rule 204(b) will further our goal of
limiting fails to deliver, thereby addressing abusive ``naked'' short
selling by promoting the prompt and accurate clearance and settlement
of securities transactions. By requiring that participants and broker-
dealers from which they receive trades for clearance and settlement
borrow or arrange to borrow securities prior to accepting or effecting
short sales in the security that has a fail to deliver position that
has not been closed out, the rule will help to ensure that shares will
be available for delivery on the short sale by settlement date and,
thereby, help to avoid additional fails to deliver occurring in the
security.
    One commenter asked for clarification regarding whether a
participant ceases to be subject to the borrow requirements of
temporary Rule 204T(b) if that participant no longer has a fail to
deliver position at a registered clearing agency due the participant
borrowing the securities or the participant receiving securities from
the seller (e.g., in connection with long sales).\110\ Temporary Rule
204T(b) imposes short sale borrowing requirements until the participant
closes out the fail to deliver position by purchasing securities of
like kind and quantity and that purchase has cleared and settled at a
registered clearing agency. Thus, under temporary Rule 204T regardless
of whether a participant borrows or receives delivery of securities,
the requirements of temporary Rule 204T(b) continue to apply until the
participant purchases securities to close out the fail to deliver
position and that purchase has cleared and settled at a registered
clearing agency.
---------------------------------------------------------------------------

    \110\ See letter from SIFMA.
---------------------------------------------------------------------------

    We have incorporated these same requirements into Rule 204(b)
without modification. Rule 204(b) requires the purchase and clearance
and settlement

of shares purchased to help ensure that the fail to deliver position is
closed out before the participant, and broker-dealers from which they
receive trades for clearance and settlement, can accept or effect
additional short sales without first borrowing or arranging to borrow
such securities. Moreover, the provisions of Rule 204(b) are intended
to act as an additional incentive to broker-dealers to deliver
securities by settlement date, and to close out fail to deliver
positions in accordance with the requirements of Rule 204. We believe
that these goals would not be furthered absent the purchase requirement
of Rule 204(b).
    As discussed above in Section III.A.3, Rule 204(d) provides that a
participant may reasonably allocate (e.g., the allocation must be
timely) its responsibility to close out a fail to deliver position to
another broker-dealer for which the participant clears or from which
the participant receives trades for settlement. Thus, to the extent
that the participant can identify the broker-dealer(s) that contributed
to the fail to deliver position, and the participant has reasonably
allocated the close-out obligation to the broker-dealer(s), the
requirement to borrow or arrange to borrow prior to effecting further
short sales in that security will apply to only those particular
broker-dealer(s).
    Rule 204(b), however, includes an exception from the borrowing
requirements for any broker-dealer that can demonstrate that it was not
responsible for any part of the fail to deliver position of the
participant. We have incorporated into Rule 204(b) the language of
temporary Rule 204T(b)(1), without modification. Thus, Rule 204(b)
provides that a broker-dealer shall not be subject to the requirements
of paragraph (b) of Rule 204 if the broker-dealer timely certifies to
the participant that it has not incurred a fail to deliver position on
settlement date for a long or short sale in an equity security for
which the participant has a fail to deliver position at a registered
clearing agency or that the broker-dealer is in compliance with the
requirements of Rule 204(e).\111\ We have included this exception
because we do not believe that a broker-dealer should be subject to the
borrowing requirements of the temporary rule if the broker-dealer can
demonstrate that it did not incur a fail to deliver position in the
security on settlement date, or if it has taken steps, in accordance
with Rule 204(e), to close out the fail to deliver position.
---------------------------------------------------------------------------

    \111\ See Rule 204(b). Rule 204(e) is discussed in detail below
in Section III.C.
---------------------------------------------------------------------------

2. Notification Requirement
    In connection with the borrowing requirements of Rule 204(b), we
are incorporating into Rule 204(c) the notification requirement
contained in temporary Rule 204T(c), without modification. In
accordance with Rule 204(c), participants must notify all broker-
dealers from which they receive trades for clearance and settlement
that a fail to deliver position has not been closed out in accordance
with Rule 204. Specifically, Rule 204(c) provides that the participant
must notify any broker-dealer from which it receives trades for
clearance and settlement, including any market maker that is otherwise
entitled to rely on the exception provided in Rule 203(b)(2)(iii) of
Regulation SHO,\112\ (a) that the participant has a fail to deliver
position in an equity security at a registered clearing agency that has
not been closed out in accordance with the requirements of Rule 204,
and (b) when the purchase that the participant has made to close out
the fail to deliver position has cleared and settled at a registered
clearing agency.\113\
---------------------------------------------------------------------------

    \112\ See supra note 108.
    \113\ See Rule 204(c).
---------------------------------------------------------------------------

    We are including this notification requirement in Rule 204(c) so
that all broker-dealers that submit trades for clearance and settlement
to a participant that has a fail to deliver position in a security that
has not been closed out in accordance with Rule 204 will be on notice
that short sales in that security to be cleared or settled through that
participant will be subject to the borrow requirements of Rule 204(b)
until the fail to deliver position has been closed out, or unless the
broker-dealer can demonstrate, as specified in Rule 204(b), that it is
not responsible for the fail to deliver position.

C. Credit for Early Close-Outs

    To encourage early close outs of fail to deliver positions,
temporary Rule 204T(e) provides that a broker-dealer can satisfy the
temporary rule's close-out requirement by purchasing securities in
accordance with the conditions of that provision (i.e., broker-dealers
will receive ``pre-fail credit'' for the purchase).\114\ Encouraging
early close outs of fail to deliver positions advances our goal of
reducing fails to deliver. Thus, we have incorporated the conditions of
temporary Rule 204T(e) into Rule 204 with some limited modifications to
address commenters' concerns and to provide clarification regarding the
applicability of the conditions.
---------------------------------------------------------------------------

    \114\ See temporary Rule 204T(e).
---------------------------------------------------------------------------

    Specifically, Rule 204(e) provides that even if a participant of a
registered clearing agency has not closed out a fail to deliver
position at a registered clearing agency in accordance with Rule
204(a), or has not allocated a fail to deliver position to a broker-
dealer in accordance with Rule 204(d), a broker-dealer shall not be
subject to the requirements of Rule 204(a) or (b) if the broker-dealer
purchases or borrows \115\ the securities, and complies with the
conditions set forth in Rule 204(e)(1) though (4), as described in more
detail below.
---------------------------------------------------------------------------

    \115\ As discussed in more detail below, in contrast to
temporary Rule 204T(e), Rule 204(e) permits a broker-dealer to
borrow as well as purchase securities to close-out a fail to deliver
position prior to the applicable close-out date.
---------------------------------------------------------------------------

    One commenter requested that we allow a broker-dealer to borrow as
well as purchase shares to obtain credit for closing out a position
prior to the applicable close-out date.\116\ Temporary Rule 204T(e)
provides that a broker-dealer must purchase securities to obtain credit
for closing out a position prior to the applicable close-out date
because under Rule 203(b)(3) of Regulation SHO, we understand that
broker-dealers purchased shares to obtain credit for closing out fails
to deliver in threshold securities prior to the thirteenth consecutive
settlement day of having a fail to deliver position in such security.
We believe, however, that allowing a broker-dealer to borrow as well as
purchase securities to obtain credit for early close-outs is consistent
with our goal of maintaining the benefits already achieved under
temporary Rule 204T, as well as other actions by the Commission, such
as the recent reduction in fails to deliver, by providing broker-
dealers with additional flexibility in closing out fails to deliver. We
also note that allowing a borrow is consistent with the close-out
requirements of Rule 204(a) which permit a participant to close out
fails to deliver on the applicable close-out date by either borrowing
or purchasing securities.\117\
---------------------------------------------------------------------------

    \116\ See letter from SIFMA.
    \117\ See Rule 204(a); see also supra Section III.A.1.
(discussing the close-out requirements of Rule 204(a)).
---------------------------------------------------------------------------

    Consistent with temporary Rule 204T(e)(1), to obtain pre-fail
credit under Rule 204(e), the purchase or borrow must be ``bona fide.''
Thus, where a broker-dealer enters into an arrangement with another
person to purchase or borrow securities, and the broker-dealer knows or
has reason to know that the other person will not deliver securities in
settlement of the

transaction, the purchase or borrow will not be ``bona fide.'' \118\
---------------------------------------------------------------------------

    \118\ See infra Section III.F. (discussing bona fide purchases
and borrows for purposes of the close-out requirements of Rule 204);
see also 17 CFR 203(b)(3)(vii).
---------------------------------------------------------------------------

    Also consistent with temporary Rule 204T(e)(2), Rule 204(e)(2)
provides that to obtain pre-fail credit, i.e., credit for purchases or
borrows to close out fails to deliver resulting from short sales, the
purchase or borrow must be executed after trade date but by no later
than the end of regular trading hours on settlement date (i.e., T+3)
for the transaction. Thus, the purchase or borrow must be executed on
T+1, 2, or 3.
    Temporary Rule 204T(e)(3) provides that the purchase must be of a
quantity of securities sufficient to cover the entire amount of the
broker-dealer's open short position. One commenter stated that it
believes that the broker-dealer should only have to close out its open
fail to deliver position, and not its open short position.\119\ This
commenter noted that a broker-dealer's open short position could far
exceed its open fail to deliver position and, therefore, a requirement
to purchase securities to close out the broker-dealer's entire open
short position would not encourage early close outs of fail to deliver
positions.\120\
---------------------------------------------------------------------------

    \119\ See letter from SIFMA.
    \120\ See id.
---------------------------------------------------------------------------

    The purpose of Rule 204(e) is to encourage broker-dealers to close
out fail to deliver positions prior to the close-out date. Requiring a
broker-dealer to close out its open fail to deliver position prior to
the applicable close-out date is more effective at achieving that goal
than requiring a broker-dealer to close out its open short position
prior to the applicable close-date because a broker-dealer's open short
position could far exceed its open fail to deliver position and,
therefore, requiring close out of the potentially smaller fail to
deliver position only is more likely to encourage broker-dealers to
close out such positions early. Thus, in contrast to temporary Rule
204T(e)(3), Rule 204(e)(3) provides that a broker-dealer must purchase
or borrow a quantity of securities sufficient to cover the entire
amount of that broker-dealer's fail to deliver position at a registered
clearing agency in that security, rather than the entire amount of the
broker-dealer's open short position.\121\
---------------------------------------------------------------------------

    \121\ See Rule 204(e)(3).
---------------------------------------------------------------------------

    In addition, to help ensure that broker-dealers purchase sufficient
shares to close out their fail to deliver positions, Rule 204(e)(4)
incorporates the condition of temporary Rule 204T(e)(4) that the
broker-dealer that is purchasing or borrowing securities must be net
flat or net long in that security on its books and records on the day
of the purchase or borrow.\122\ Consistent with temporary Rule
204T(e)(4), Rule 204(e)(4) requires that the broker-dealer demonstrate
that it has complied with this requirement.\123\ This requirement will
enable the Commission and SROs to monitor more effectively whether or
not a broker-dealer has complied with the requirements of Rule 204(e).
---------------------------------------------------------------------------

    \122\ See Rule 204(e)(4).
    \123\ See id.
---------------------------------------------------------------------------

D. Market Makers

    To allow broker-dealers that are market makers to facilitate
customer orders in a fast moving market, temporary Rule 204T includes a
limited exception from the temporary rule's close-out requirement for
fails to deliver attributable to bona fide market making activities by
registered market makers, options market makers, or other market makers
obligated to quote in the over-the-counter market. Temporary Rule 204T
requires that such fails to deliver are closed out by no later than the
beginning of regular trading hours on the third settlement day
following the settlement date for the transaction (i.e., T+6).\124\
---------------------------------------------------------------------------

    \124\ See temporary Rule 204T(a)(3).
---------------------------------------------------------------------------

    Similar to commenters' discussions regarding extending the close-
out period to the end of the day for fails to deliver subject to the
requirements of temporary Rule 204T(a) and (a)(1), commenters requested
that we extend the market maker close-out period under temporary Rule
204T(a)(3) to the end of regular trading hours on the close-out date to
help reduce buy-in risk.\125\
---------------------------------------------------------------------------

    \125\ See, e.g., letters from NYSE; CBOE; The Specialist
Association (discussing increased volatility at the opening of
trading due to the requirement under temporary Rule 204T that fails
to deliver be closed out by no later than the beginning of regular
trading hours). One commenter recommended that we also extend the
close-out period to five settlement days after settlement date
(i.e., T+8) for fails to deliver resulting from bona fide market
making activity. See letter from CBOE. For the reasons set forth in
section III.A.1 above, discussing generally the close-out periods
under Rule 204, we have determined not to extend the close-out
period to provide additional days to close out such fails to
deliver.
---------------------------------------------------------------------------

    We recognize commenters' concerns regarding the market impact of
temporary Rule 204T's close-out requirements, particularly at the
market open. As discussed above, however, we believe, at this time,
that it is appropriate to adopt temporary Rule 204T's requirement that
fails to deliver, including fails to deliver resulting from market
making activity, are closed out by no later than the beginning of
regular trading hours on the applicable close-out date to help further
our goal of reducing fails to deliver by maintaining the reductions in
fails to deliver achieved by the adoption of temporary Rule 204T, as
well as other actions taken by the Commission, and to maintain the
benefits achieved pursuant to temporary Rule 204T. Thus, Rule 204(a)(3)
provides that if a participant of a registered clearing agency has a
fail to deliver position at a registered clearing agency in any equity
security that is attributable to bona fide market making activities by
a registered market maker, options market maker, or other market maker
obligated to quote in the over-the-counter market, the participant
shall by no later than the beginning of regular trading hours on the
third consecutive settlement day following the settlement date,
immediately close out the fail to deliver position.\126\
---------------------------------------------------------------------------

    \126\ See Rule 204(a)(3).
---------------------------------------------------------------------------

    In contrast to temporary Rule 204T(a)(3), however, Rule 204(a)(3)
permits a participant to borrow securities to close-out a fail to
deliver position. In temporary Rule 204T, we required a participant to
purchase securities to close out fails to deliver attributable to bona
fide market making activity to be consistent with the close-out
requirements of Rule 203(b)(3) of Regulation SHO which require that a
participant that has a fail to deliver position in a threshold security
for thirteen consecutive settlement days immediately thereafter close
out the fail to deliver position by purchasing securities of like kind
and quantity.\127\
---------------------------------------------------------------------------

    \127\ See 17 CFR 242.203(b)(3).
---------------------------------------------------------------------------

    Rule 204(a)(3) permits a borrow as well as a purchase to close out
a fail to deliver position because we believe that such an amendment is
consistent with our goal of maintaining the recent reduction in fails
to deliver because it will provide additional flexibility to
participants in closing out fail to deliver positions.\128\ Permitting
a borrow as well as a purchase will also make the close-out
requirements of Rule 204(a)(3) consistent with the close-out
requirements of Rule 204(a) and (a)(1).
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    \128\ See letter from CBOE (stating that the close-out
procedures under temporary Rule 204T for fails to deliver
attributable to bona fide market making activity should be amended
to permit borrows or purchases throughout the close-out period).
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    As noted above and consistent with temporary Rule 204T, the close-
out requirements of Rule 204 require that a broker-dealer take
affirmative action to close out the fail to deliver position by
purchasing or borrowing securities. Thus, under Rule 204(a)(3), a
market maker may not offset the amount of a fail to deliver position
with shares that

it receives or will receive during the close-out date.\129\
---------------------------------------------------------------------------

    \129\ See supra note 81 and supporting text.
---------------------------------------------------------------------------

    Temporary Rule 204T(b)(2) included an exception from the borrowing
requirements of temporary Rule 204T(b) for market makers that can
demonstrate that they do not have an open short position in the equity
security at the time of any additional short sales.\130\ We do not
believe that a similar exception is necessary under Rule 204(b)
because, as with other broker-dealers, a market maker is excepted from
the borrowing requirements of Rule 204(b) if it timely certifies to the
participant that it has not incurred a fail to deliver position on
settlement date for a long or short sale in an equity security for
which the participant has a fail to deliver position at a registered
clearing agency or that it is in compliance with the requirements of
Rule 204(e). Because Rule 204(b) includes an exception applicable to
all broker-dealers, including market makers, we do not think it is
necessary to maintain a separate exception applicable only to market
makers.
---------------------------------------------------------------------------

    \130\ See temporary Rule 204T(b)(2).
---------------------------------------------------------------------------

E. Sales of Certain Deemed To Own Securities

    Temporary Rule 204T(a)(2) includes an exception from the temporary
rule's close-out requirements for sales of Rule 144 Securities.\131\
Specifically, temporary Rule 204T(a)(2) provides that if a participant
of a registered clearing agency has a fail to deliver position at a
registered clearing agency in an equity security sold pursuant to Rule
144 for thirty-five consecutive settlement days after the settlement
date for a sale in that equity security, the participant shall, by no
later than the beginning of regular trading hours on the thirty-sixth
consecutive settlement day following the settlement date for the
transaction, immediately close out the fail to deliver position by
purchasing securities of like kind and quantity.\132\
---------------------------------------------------------------------------

    \131\ See 17 CFR 230.144.
    \132\ See temporary Rule 204T(a)(2).
---------------------------------------------------------------------------

    Regulation SHO provides an exception from the ``locate''
requirement of Rule 203(b)(1) for situations where a broker-dealer
effects a short sale on behalf of a customer that is deemed to own the
security pursuant to Rule 200 of Regulation SHO, although, through no
fault of the customer or broker-dealer, it is not reasonably expected
that the security will be in the physical possession or control of the
broker-dealer by settlement date and, therefore, is a ``short'' sale
under the marking requirements of Rule 200(g). Rule 203(b)(2)(ii) of
Regulation SHO provides that in such circumstances, delivery must be
made on the sale as soon as all restrictions on delivery have been
removed, and in any event no later than 35 days after trade date, at
which time the broker-dealer that sold on behalf of the person must
either borrow securities or close out the open position by purchasing
securities of like kind and quantity.\133\ In addition, in 2007 we
adopted amendments to the close-out requirement of Regulation SHO to
allow fails to deliver resulting from sales of threshold securities
pursuant to Rule 144 to be closed out within 35 rather than 13
consecutive settlement days.\134\
---------------------------------------------------------------------------

    \133\ See 17 CFR 242.203(b)(2)(ii). In the 2004 Regulation SHO
Adopting Release, the Commission stated that it believed that 35
calendar days is a reasonable outer limit to allow for restrictions
on a security to be removed if ownership is certain. In addition,
the Commission noted that Section 220.8(b)(2) of Regulation T of the
Federal Reserve Board allows 35 calendar days to pay for securities
delivered against payment if the delivery delay is due to the
mechanics of the transactions. See 2004 Regulation SHO Adopting
Release, 69 FR 48015, n.72.
    \134\ See 2007 Regulation SHO Final Amendments, 72 FR 45550-
45551.
---------------------------------------------------------------------------

    We included in temporary Rule 204T an exception for Rule 144
Securities because these securities are formerly restricted securities
that a seller is ``deemed to own,'' as defined by Rule 200(a) of
Regulation SHO.\135\ The securities, however, may not be capable of
being delivered on the settlement date due to processing delays related
to removal of the restricted legend and, therefore, sales of these
securities frequently result in fails to deliver. In addition, this
exception is consistent with our statements in connection with our
recent amendments to Rule 203(b)(3) of Regulation SHO which extended
the close-out requirements of that rule for fails to deliver in
threshold securities sold pursuant to Rule 144.\136\ We limited the
exception in temporary Rule 204T to Rule 144 Securities, rather than
extending the exception to all formerly restricted securities that a
seller is ``deemed to own,'' to remain consistent with Rule 203(b)(3)
of Regulation SHO.
---------------------------------------------------------------------------

    \135\ See 17 CFR 242.200(a).
    \136\ See 2007 Regulation SHO Final Amendments, 72 FR 45550-
45551.
---------------------------------------------------------------------------

    In response to a request for comment, one commenter that discussed
the requirements of temporary Rule 204T(a)(2) relating to fails to
deliver resulting from sales of Rule 144 Securities urged the
Commission to retain the exception, and to extend it to cover sales of
other securities that a person owns, but is unable to deliver on
settlement date.\137\ In particular, the commenter stated that the
exception should apply to the same universe of securities to which the
exception in Rule 203(b)(2)(ii) of Regulation SHO applies.\138\ In
addition, the commenter stated that for those securities subject to the
close-out requirements of temporary Rule 204T(a)(2) and the delivery
requirements of Rule 203(b)(2)(ii) there is confusion as to which time-
frame for closing out fails to deliver resulting from sales of these
securities should apply.\139\ We note, however, that rather than
changing the close-out requirement of temporary Rule 204T(a)(2), this
commenter recommended extending the delivery time-frame of Rule
203(b)(2)(ii) of Regulation SHO to 35 settlement days, rather than
calendar days, from trade date.\140\
---------------------------------------------------------------------------

    \137\ See letter from SIFMA.
    \138\ See id.; see also supra note 133, and accompanying text.
    \139\ See letter from SIFMA.
    \140\ See id.
---------------------------------------------------------------------------

    After considering the comments and to provide consistency between
the delivery requirements of Rule 203(b)(2)(ii) of Regulation SHO and
the close-out requirements of Rule 204, we are adopting in Rule
204(a)(2) the requirements of temporary Rule 204T(a)(2) with some
modifications. Specifically, we are expanding the universe of
securities to which Rule 204(a)(2) will apply. It will apply to fails
to deliver resulting from the sale of an equity security that a person
is ``deemed to own'' pursuant to Rule 200 of Regulation SHO and that
such person intends to deliver as soon as all restrictions on delivery
have been removed.\141\ In addition, we are revising the close-out
period within which a participant must close out fails to deliver
resulting from sales of such securities to be consistent with the
delivery period contained in Rule

203(b)(2)(ii) of Regulation SHO. Accordingly, Rule 204(a)(2) provides
that if a participant of a registered clearing agency has a fail to
deliver position at a registered clearing agency in any equity security
resulting from the sale of a security that a person is deemed to own
pursuant to Rule 200 of Regulation SHO and that such person intends to
deliver as soon as all restrictions on delivery have been removed, the
participant shall, by no later than the beginning of regular trading
hours on the thirty-fifth consecutive calendar day following the trade
date for the transaction, immediately close out the fail to deliver
position by purchasing securities of like kind and quantity.\142\
---------------------------------------------------------------------------

    \141\ Such circumstances could include the situation where a
convertible security, option, or warrant has been tendered for
conversion or exchange, but the underlying security is not
reasonably expected to be received by settlement date. See 2004
Regulation SHO Adopting Release, 69 FR 48015; see also 17 CFR
242.200(b) (defining when a person shall be ``deemed to own'' a
security). Another situation could include the sale of a Rule 144
Security. See Rule 204T Adopting Release, 73 FR 61715. In addition,
we understand that sellers that own restricted equity securities
that wish to sell pursuant to an effective resale registration
statement under Rule 415 under the Securities Act experience similar
types of potential settlement delays as sales of Rule 144
Securities. Thus, fails to deliver in such securities may be closed
out in accordance with Rule 204(a)(2) if the fails to deliver
resulted from sales of securities that were outstanding at the time
they were sold and the sale occurred after a registration has become
effective. In addition, we understand that sales pursuant to broker-
assisted cashless exercises of compensatory options to purchase a
company's stock, may result in potential settlement delays and,
therefore, fails to deliver. Such fails to deliver may be closed out
in accordance with Rule 204(a)(2).
    \142\ See Rule 204(a)(2).
---------------------------------------------------------------------------

    In addition to being consistent with the delivery time-frame under
Rule 203(b)(2)(ii) of Regulation SHO, we believe that a close-out
requirement of 35 consecutive calendar days from trade date for fails
to deliver resulting from sales of such owned securities will permit
the orderly settlement of such sales without the risk of causing market
disruption due to unnecessary purchasing activity (particularly if the
purchases are for sizable quantities of stock). Because the security
being sold will be received as soon as all processing delays have been
removed, this additional time will allow participants to close out
fails to deliver resulting from the sale of the security with the
security sold, rather than having to close out such fail to deliver
position by purchasing securities in the market. In addition, we note
that although a commenter requested that we maintain the close-out
requirement of temporary Rule 204T(a)(2) but amend the delivery time-
frame of Rule 203(b)(2)(ii) of Regulation SHO to 35 settlement rather
than calendar days, we have determined not to make such an amendment
because we believe that 35 calendar days from trade date should be a
sufficient period of time within which delivery can be made on sales of
such securities. We also note that 35 calendar days from trade date is
the delivery time-frame with which broker-dealers have had to comply
since the effective date of Regulation SHO in January 2005, if relying
on the exception in Rule 203(b)(2)(ii) to the rule's locate
requirement. We are not aware that broker-dealers have been unable to
comply with this delivery requirement.
    Although this amendment will provide an extended period of time
within which fails to deliver resulting from sales of certain ``deemed
to own'' securities must be closed out, we believe that such additional
time is warranted and does not undermine our goal of reducing fails to
deliver because these are sales of owned securities that cannot be
delivered by settlement date due solely to processing delays outside
the seller's or broker-dealer's control. Moreover, delivery will be
made on such sales as soon as all restrictions on delivery have been
removed. In addition, Rule 204(b)'s borrowing requirements will help
ensure that, if a fail to deliver position is not closed out in
accordance with Rule 204(a)(2), additional fails to deliver cannot
occur until securities have been purchased to close out the fail to
deliver position and such purchase has cleared and settled. If a
participant does not close out a fail to deliver position at a
registered clearing agency in accordance with Rule 204(a)(2), the rule
prohibits the participant, and any broker-dealer from which it receives
trades for clearance and settlement, including market makers, from
accepting any short sale orders or effecting further short sales in the
particular security without borrowing, or entering into a bona-fide
arrangement to borrow, the security until the participant closes out
the entire fail to deliver position by purchasing securities of like
kind and quantity and that purchase has cleared and settled at a
registered clearing agency.\143\ In addition, we intend to closely
monitor whether fails to deliver are being closed out in accordance
with the requirements of Rule 204(a)(2).
---------------------------------------------------------------------------

    \143\ See Rule 204(b).
---------------------------------------------------------------------------

F. Sham Close-Outs

    In the Rule 204T Adopting Release, we stated that it is possible
under Regulation SHO that a close out by a participant of a registered
clearing agency may result in a fail to deliver position at another
participant if the counterparty from which the participant purchases
securities fails to deliver. We also noted, however, that Regulation
SHO prohibits a participant of a registered clearing agency, or a
broker-dealer for which it clears transactions, from engaging in ``sham
close outs'' by entering into an arrangement with a counterparty to
purchase securities for purposes of closing out a fail to deliver
position and the purchaser knows or has reason to know that the
counterparty will not deliver the securities, and which thus creates
another fail to deliver position.\144\ Because these same concepts
apply to the close-out requirements of Rule 204, we have determined to
include rule text in subparagraph (f) of Rule 204 to provide that a
participant of a registered clearing agency shall not be deemed to have
fulfilled the requirements of Rule 204 where the participant enters
into an arrangement with another person to purchase or borrow
securities as required by Rule 204, and the participant knows or has
reason to know that the other person will not deliver securities in
settlement of the purchase or borrow.\145\
---------------------------------------------------------------------------

    \144\ See Rule 204T Adopting Release, 73 FR 61714, n.78; see
also 17 CFR 242.203(b)(3)(vii); 2004 Regulation SHO Adopting
Release, 69 FR 48018, n.96.
    \145\ See Rule 204(f).
---------------------------------------------------------------------------

G. De Minimis Fail To Deliver Positions

    Some commenters requested that the Commission consider including an
exception from temporary Rule 204T's close-out requirements where a
participant's fail to deliver position at a registered clearing agency
is below a certain amount.\146\ One commenter suggested that such an
exception be voluntary so that firms could decide whether or not to
take advantage of the exception based on their particular business
model and capabilities.\147\ Another commenter noted that de minimis
fails to deliver are particularly likely to occur in connection with
odd lot trading.\148\ This commenter stated that it believes that
permitting a de minimis fail to deliver, particularly in less-than-
round lots, would not undermine the intent of temporary Rule 204T.\149\
Other commenters, in discussing odd lot orders and fails to deliver,
recommended a de minimis exception for fails to deliver of less than
1,000 shares.\150\ One other commenter recommended a de minimis
exception that would except a fail to deliver position from the close-
out requirements if the net value of the fail in the particular
security across all firm accounts is under one million dollars.\151\
---------------------------------------------------------------------------

    \146\ See, e.g., letters from SIFMA; NYSE; Wedbush; Lek
Securities Corporation; CBOE; BATS; EWT; The Specialist Association.
    \147\ See letter from SIFMA.
    \148\ See, e.g., letter from NYSE (stating that by operation of
NYSE and NYSE Alternext rules, odd lot executions take place
automatically, with the designated market maker (``DMM'') acting as
the contra-side to all odd lot trades. As a result, DMMs may sell
short in a de minimis amount automatically and without prior
knowledge. This commenter further stated that if the odd lot trade
occurs in hard-to-borrow or illiquid securities, the DMM may not be
able to avoid failing to deliver).
    \149\ See letter from NYSE.
    \150\ See letters from The Specialist Association; Wedbush.
    \151\ See letter from EWT; see also letter from Lek Securities
Corporation.
---------------------------------------------------------------------------

    A primary goal of Rule 204 is to continue the recent reduction in
fails to deliver. We believe that an exception

from Rule 204's close-out requirements that would permit certain fails
to deliver to persist indefinitely could undermine this goal.
Accordingly, we have determined at this time not to include a de
minimis or odd-lot related exception that would permit such fails to
deliver to not have to be closed out. We will continue to monitor,
however, whether a de minimis or odd-lot related exception is
appropriate.

IV. Administrative Procedure Act

    Section 553(d) of the Administrative Procedure Act (``APA'')
provides that a substantive rule generally may not be made effective
less than 30 days after notice is published in the Federal
Register.\152\ Section 553(d), however, also provides an exception to
the 30-day requirement where an agency finds good cause for providing a
shorter effective date.\153\
---------------------------------------------------------------------------

    \152\ 5 U.S.C. 553(d).
    \153\ See id. at 553(d)(1), (d)(3).
---------------------------------------------------------------------------

    Temporary Rule 204T will expire on July 31, 2009. Rule 204 makes
permanent the provisions of temporary Rule 204T with limited
modifications to address commenters' concerns and to help ensure the
workability of the rule on a permanent basis. Rule 204 is intended to
help maintain the benefits achieved in part by temporary Rule 204T,
such as maintaining the recent reduction in fails to deliver, and
address potentially abusive ``naked'' short selling by strengthening
the close-out requirements of Regulation SHO. A gap between the
expiration of temporary Rule 204T and the effective date of Rule 204
would be contrary to these purposes and goals. Rule 204 in significant
part, moreover, continues the restrictions on short selling that are
currently in place, and with which participants are already familiar.
In addition, the modifications that are made in Rule 204 from Rule 204T
relieve participants of some of the regulatory burdens imposed by
temporary Rule 204T by, for example, allowing participants to close out
fail to deliver positions from long sales and market making activities
by borrowing securities. Thus, the Commission finds that there is good
cause for making Rule 204 effective on July 31, 2009.

V. Amendments to Rule 30-3

    The Commission is adopting an amendment to Rule 30-3 of its Rules
of Organization and Program Management governing delegations of
authority to the Director of the Division of Trading and Markets (the
``Director'').\154\ The amendment delegates to the Director the
authority to grant by order an exemption from the provisions of
Regulation SHO of the Exchange Act, under Section 36 of the Exchange
Act. Such an exemption may be granted either unconditionally, or on
specified conditions.
---------------------------------------------------------------------------

    \154\ See 17 CFR 200.30-3.
---------------------------------------------------------------------------

    Section 36 of the Exchange Act provides that ``the Commission, by
rule, regulation, or order, may conditionally or unconditionally exempt
any person, security, or transaction, or any class or classes of