Former Rule 10a-1(e)(3) contained a limited exception for odd-lot
dealers registered in the security and third market makers. The
exception allowed short sales by odd-lot dealers registered in the
security and by third market makers of covered securities to fill
customer odd lot orders. Former Rule 10a-1(e)(4) provided an exception
under the rule for any sale to liquidate an odd-lot position by a
single round lot sell order that changed the broker-dealer's position
by no more than a unit of trading.
    We believe that a provision that would allow a broker-dealer to
mark a short sale order ``short exempt'' if it has a reasonable basis
to believe that the

short sale order is by a market maker to off-set a customer odd-lot
order or liquidate an odd-lot position which changes such broker-
dealer's position by no more than a unit of trading would continue to
be of utility under the proposed modified uptick rule because it would
not be in conflict with the goals of the proposed rule.
    Thus, the provision in proposed Rule 201(d)(2) parallels the
exceptions in subsections (e)(3) and (e)(4) of former Rule 10a-1. In
addition, however, we propose extending the provision to cover all
market makers acting in the capacity of an odd-lot dealer. When former
Rule 10a-1 was adopted, odd-lot dealers dealt exclusively with odd-lot
transactions, and were so registered. Today, market makers registered
in a security typically also act as odd-lot dealers of the security.
Thus, we propose to broaden the provision in proposed Rule 201(d)(2) to
all broker-dealers acting as ``market makers'' in odd lots.\153\
---------------------------------------------------------------------------

    \153\ Section 3(a)(38) of the Exchange Act defines a ``market
maker,'' and includes specialists. See 15 U.S.C. 78c(a)(38).
---------------------------------------------------------------------------

    We believe that this provision would be appropriate. Because odd-
lot transactions by market makers to facilitate customer orders are not
of a size that could facilitate a downward movement in the market, we
do not believe that proposed Rule 201(d)(2) would adversely affect the
goals of short sale regulation that the proposed modified uptick rule
seeks to advance. Thus, we believe that a broker-dealer should be able
to mark such orders ``short exempt'' so that those acting in the
capacity of a ``market maker,'' with the commensurate negative and
positive obligations, would be able to off-set a customer odd-lot order
and liquidate an odd-lot position without a trading center's policies
and procedures preventing the execution or display of such orders at a
down-bid price.
d. Domestic Arbitrage
    Proposed Rule 201(d)(3) would provide that a broker-dealer may mark
``short exempt'' short sale orders associated with certain bona fide
domestic arbitrage transactions. Subsection (e)(7) of former Rule 10a-1
contained an exception related to domestic arbitrage.\154\ That
exception applied to bona fide arbitrage undertaken to profit from a
current difference in price between a convertible security and the
underlying common stock.\155\ The term ``bona fide arbitrage''
describes an activity undertaken by market professionals in which
essentially contemporaneous purchases and sales are effected in order
to lock in a gross profit or spread resulting from a current
differential in pricing of two related securities.\156\ For example, a
person may sell short securities to profit from a current price
differential based upon a convertible security that entitles him to
acquire an equivalent number of securities of the securities sold
short. We continue to believe that bona fide arbitrage activities are
beneficial to the markets because they tend to reduce pricing
disparities between related securities.\157\ Thus, bona fide arbitrage
transactions promote market efficiency.
---------------------------------------------------------------------------

    \154\ See Securities Exchange Act Release No. 1645 (Apr. 8,
1938).
    \155\ See Securities Exchange Act Release No. 42037 (Oct. 20,
1999), 64 FR 57996 (Oct. 28, 1999) (``1999 Concept Release'').
    \156\ 1999 Concept Release, 64 FR at n.54 and accompanying text
(discussing the domestic arbitrage exception under former Rule 10a-
1). See also Section 220.6(b) of Regulation T which states that the
term ``bona fide arbitrage'' means: ``(1) A purchase or sale of a
security in one market together with an offsetting sale or purchase
of the same security in a different market at as nearly the same
time as practicable for the purpose of taking advantage of a
difference in prices in the two markets; or (2) A purchase of a
security which is, without restriction other than the payment of
money, exchangeable or convertible within 90 calendar days of the
purchase into a second security together with an offsetting sale of
the second security at or about the same time, for the purpose of
taking advantage of a concurrent disparity in the prices of the two
securities.'' 12 CFR 220.6(b). See also Securities Exchange Act
Release No. 15533 (Jan. 29, 1979), 44 FR 6084 (Jan. 31, 1979)
(interpretation concerning the application of Section 11(a)(1) to
bona fide arbitrage).
    \157\ See Securities Exchange Act Release No. 15533 (Jan. 29,
1979), 44 FR 6084 (Jan. 31, 1979) (interpretation concerning the
application of Section 11(a)(1) to bona fide arbitrage).
---------------------------------------------------------------------------

    Proposed Rule 201(d)(3) would parallel the exception in former Rule
10a-1(e)(7). Specifically, proposed Rule 201(d)(3) would provide that a
broker-dealer may mark a short sale order of a covered security ``short
exempt'' if the broker-dealer has a reasonable basis to believe that
the short sale order is ``for a good faith account by a person who owns
another security by virtue of which he is, or presently will be,
entitled to acquire an equivalent number of securities of the same
class as the securities sold, provided such sale, or the purchase which
such sale offsets, is effected for the bona fide purpose of profiting
from the difference between the price of the security sold and the
security owned and that such right of acquisition was originally
attached to or represented by another security or was issued to all the
holders of any such securities of the issuer.'' \158\
---------------------------------------------------------------------------

    \158\ Proposed Rule 201(d)(3).
---------------------------------------------------------------------------

    The domestic arbitrage exception in former Rule 10a-1 was intended
to be consistent with the arbitrage provision of Regulation T.\159\
Thus, consistent with that provision, former Rule 10a-1(e)(7) referred
to a ``special arbitrage account'' and not a ``good faith account.''
\160\ The Federal Reserve Board amended Regulation T in 1998 to
eliminate the ``special arbitrage account'' and allow the functions
formerly effected in that account to be effected in a ``good faith
account.'' Thus, proposed Rule 201(d)(3) also refers to a ``good faith
account.'' We note, however, that we request specific comment regarding
whether or not the use of a ``good faith account'' or any other
separate account continues to be appropriate or necessary for purposes
of this proposed Rule 201(d)(3).
---------------------------------------------------------------------------

    \159\ See 12 CFR 220.6.
    \160\ Section 220.3(b) of Regulation T, titled ``Separation of
accounts,'' generally provides that requirements for an account may
not be met by considering items in any other account. Further,
Regulation T identifies three types of customer accounts--cash
accounts, margin accounts and good faith accounts--in which customer
transactions may be booked. A broker-dealer can extend credit to
customers through a margin account or a good faith account.
Generally, positions held in a good faith account are subject to
good faith margin, whereas positions held in a margin account are
subject to the margin requirements otherwise set forth in Regulation
T and SRO margin requirements.
---------------------------------------------------------------------------

    Because allowing domestic arbitrage at a down-bid price would
potentially promote market efficiency, the proposed modified uptick
rule would include a limited provision to allow broker-dealers to mark
short sale orders ``short exempt'' provided the broker-dealer has a
reasonable basis to believe that the conditions in proposed Rule
201(d)(3) have been met. Thus, the proposed rule is designed to permit
the execution or display on a down-bid price of such orders in
connection with bona fide arbitrage transactions involving convertible,
exchangeable, and other rights to acquire the securities sold short,
where such rights of acquisition were originally attached to, or
represented by, another security, or were issued to all the holders of
any such class of securities of the issuer.
e. International Arbitrage
    Proposed Rule 201(d)(4) would provide that a broker-dealer may mark
``short exempt'' short sale orders associated with certain
international arbitrage transactions. Former Rule 10a-1(e)(8) included
an international arbitrage exception that was adopted in 1939.\161\ In
adopting the exception, the Commission stated that it was necessary

to facilitate ``transactions which are of a true arbitrage nature,
namely, transactions in which a position is taken on one exchange which
is to be immediately covered on a foreign market.'' \162\ We believe
likewise that such transactions would have utility under the proposed
modified uptick rule. As discussed above in connection with domestic
arbitrage, bona fide arbitrage transactions promote market efficiency
because they equalize prices at an instant in time in different markets
or between relatively equivalent securities. Thus, we do not believe
that permitting broker-dealers to mark these orders ``short exempt''
would undermine the goals of short sale price test regulation.
---------------------------------------------------------------------------

    \161\ See Securities Exchange Act Release No. 2039 (Mar. 10,
1939), 4 FR 1209 (Mar. 14, 1939).
    \162\ See id.
---------------------------------------------------------------------------

    Proposed Rule 201(d)(4) would parallel the exception contained in
former Rule 10a-1(e)(8). Specifically, proposed Rule 201(d)(4) would
provide that a broker-dealer may mark a short sale order of a covered
security ``short exempt'' if the broker-dealer has a reasonable basis
to believe that the short sale order is ``for a good faith account
submitted to profit from a current price difference between a security
on a foreign securities market and a security on a securities market
subject to the jurisdiction of the United States, provided that the
short seller has an offer to buy on a foreign market that allows the
seller to immediately cover the short sale at the time it was made.''
\163\
---------------------------------------------------------------------------

    \163\ Proposed Rule 201(d)(4).
---------------------------------------------------------------------------

    In proposed Rule 201(d)(4), we have simplified the language of
former Rule 10a-1(e)(8) to make it more understandable.\164\ In
addition, we have changed the reference in former Rule 10a-1(e)(8) from
a ``special international arbitrage account'' to a ``good faith
account.'' As discussed above in connection with the domestic arbitrage
provision of proposed Rule 201(d)(3), this revision is necessary to
make the proposed provision consistent with the arbitrage provision in
Regulation T. We note, however, that we request specific comment
regarding whether or not the use of a ``good faith account'' or any
other separate account continues to be appropriate or necessary for
purposes of proposed Rule 201(d)(4).
---------------------------------------------------------------------------

    \164\ Former Rule 10a-1(e)(8) provided that the short sale price
test restrictions of that rule shall not apply to: ``Any sale of a
security registered on, or admitted to unlisted trading privileges
on, a national securities exchange effected for a special
international arbitrage account for the bona fide purpose of
profiting [sic] from a current difference between the price of such
security on a securities market not within or subject to the
jurisdiction of the United States and on a securities market subject
to the jurisdiction of the United States; provided the seller at the
time of such sale knows or, by virtue of information currently
received, has reasonable grounds to believe that an offer enabling
him to cover such sale is then available to him such foreign
securities market and intends to accept such offer immediately.''
---------------------------------------------------------------------------

    In addition, we have incorporated language from the exception in
former Rule 10a-1(e)(12) that provided that, for purposes of the
international arbitrage exception, a depository receipt for a security
shall be deemed to be the same security represented by the receipt.
This language was originally included in the Commission's 1939 release
adopting the international arbitrage exception, but was incorporated
separately in former Rule 10a-1(e)(12).\165\ We likewise believe this
language is appropriate and should be incorporated into proposed Rule
201(d)(4). We seek comment, however, regarding whether for purposes of
the international arbitrage provision, a depository receipt for a
security should be deemed to be the same security represented by the
receipt.
---------------------------------------------------------------------------

    \165\ See supra note 161.
---------------------------------------------------------------------------

    As with the exception in former Rule 10a-1(e)(8), proposed Rule
201(d)(4) would apply only to bona fide arbitrage transactions. Thus,
this provision would only be applicable if at the time of the short
sale there is a corresponding offer in a foreign securities market, so
that the immediate covering purchase would have the effect of
neutralizing the short sale. We believe proposed Rule 201(d)(4) would
be necessary to facilitate arbitrage transactions in which a position
is taken in a security in the U.S. market, and which is to be
immediately covered in a foreign market.\166\
---------------------------------------------------------------------------

    \166\ We note that the requirement that the transaction be
``immediately'' covered on a foreign market requires the foreign
market to be open for trading at the time of the transaction. See
2003 Regulation SHO Proposing Release, 68 FR at 62986.
---------------------------------------------------------------------------

f. Over-Allotments and Lay-Off Sales
    Proposed Rule 201(d)(5) would provide that a broker-dealer may mark
``short exempt'' short sale orders by underwriters or syndicate members
participating in a distribution in connection with an over-allotment,
and any short sale orders with respect to lay-off sales by such persons
in connection with a distribution of securities through a rights or
standby underwriting commitment.
    Former Rule 10a-1(e)(10) contained an exception for over-allotment
and lay-off sales.\167\ Although the exception was not adopted until
1974, the Commission's approval of the concept of excepting over-
allotments and lay-off sales from short sale rules is long-
standing.\168\ In addition, we note that recently we excepted these
sales from the July Emergency Order, which among other things required
that short sellers borrow or arrange to borrow securities prior to
effecting a short sale, stating that it was not necessary for the Order
to cover such sales because such activity is covered by Regulation M
under the Exchange Act,\169\ an anti-manipulation rule.\170\ In
accordance with the long-standing Commission position regarding these
sales, we are including through proposed Rule 201(d)(5) a provision for
short sale orders in connection with over-allotment and lay-off sales
that would parallel the exception in former Rule 10a-1(e)(10).
---------------------------------------------------------------------------

    \167\ See Securities Exchange Act Release No. 11030 (Sept. 7,
1974), 39 FR 35570 (Oct. 2, 1974).
    \168\ See, e.g., Securities Exchange Act Release No. 3454 (July
6, 1946), in which the Commission approved the NYSE's special
offering plan, which permitted short sales in the form of over-
allotments to facilitate market stabilization.
    \169\ 17 CFR 242.100 et seq.
    \170\ See Securities Exchange Act Release No. 58190 (July 18,
2008), 73 FR 42837 (July 23, 2008) (amending the July Emergency
Order to include exceptions for certain short sales).
---------------------------------------------------------------------------

g. Riskless Principal Transactions
    Proposed Rule 201(d)(6) would provide that a broker-dealer may mark
``short exempt'' short sale orders where broker-dealers are
facilitating customer buy orders or sell orders where the customer is
net long, and the broker-dealer is net short but is effecting the sale
as riskless principal.\171\
---------------------------------------------------------------------------

    \171\ See proposed Rule 201(d)(6).
---------------------------------------------------------------------------

    In 2005, the Commission granted exemptive relief under former Rule
10a-1 for any broker-dealer that facilitates a customer buy or long
sell order on a riskless principal basis.\172\ In granting the relief,
the Commission noted representations made in the letter requesting
relief that in the situation where the amount of securities that the
broker-dealer purchases for the customer may not be sufficient to give
the broker-dealer an overall net ``long'' position, former Rule 10a-1
would constrain the ability of the broker-dealer to fill the customer
buy order. Further, the Commission noted representations in the letter
requesting relief that because such short sales would be effected only
in response to a customer buy order, this should vitiate any concerns
about such sales having a depressing impact on the security's
price.\173\
---------------------------------------------------------------------------

    \172\ See letter from James A. Brigagliano to Ira Hammerman,
Senior Vice President and General Counsel, Securities Industry
Association, dated July 18, 2005 (``Riskless Principal Letter'').
    \173\ See id.
---------------------------------------------------------------------------

    In addition, the Commission noted representations made in the
letter

requesting relief that where a broker-dealer is facilitating a customer
long sale order in a riskless principal transaction, because the
ultimate seller is long the shares being sold, these transactions
present none of the potential abuses that former Rule 10a-1 was
designed to address.\174\ The Commission also noted representations
that the application of former Rule 10a-1 to riskless principal
transactions involving a customer long sale can inhibit the broker-
dealer's ability to provide timely (or any) execution to such customer
long sale. Specifically, if the broker-dealer has a net short position,
the broker-dealer will be restricted from executing its own principal
trade to complete the first leg of the riskless principal
transaction.\175\ Thus, compliance with former Rule 10a-1 would
adversely affect a broker-dealer's ability to provide best execution to
a customer order.\176\
---------------------------------------------------------------------------

    \174\ See id.
    \175\ See id.
    \176\ See id.
---------------------------------------------------------------------------

    Consistent with the relief granted in the Riskless Principal
Letter, we believe that including a provision to permit a broker-dealer
to mark ``short exempt'' short sale orders in connection with riskless
principal transactions would be appropriate and would not undermine our
goals in proposing short sale price test regulation. In particular, we
note that such a provision would facilitate a broker-dealer's ability
to provide best execution to customer orders. Accordingly, taken
together proposed Rules 201(a)(6) and (d)(6) would parallel the
conditions for relief in the Riskless Principal Letter.\177\
---------------------------------------------------------------------------

    \177\ These conditions are also consistent with the definition
of ``riskless principal transactions'' under Rule 10b-18 of the
Exchange Act. See 17 CFR 240.10b-18(a)(12).
---------------------------------------------------------------------------

    Specifically, proposed Rule 201(a)(6) would define the term
``riskless principal'' to mean ``a transaction in which a broker or
dealer, after having received an order to buy a security, purchases the
security as principal at the same price to satisfy the order to buy or,
after having received an order to sell, sells the security as principal
at the same price to satisfy the order to sell.'' \178\ Proposed Rule
201(d)(6) would provide that a broker-dealer may mark a short sale
order ``short exempt'' if the broker-dealer has a reasonable basis to
believe that the short sale order is to effect the execution of a
customer purchase or the execution of a customer ``long'' sale on a
riskless principal basis and provided the sell order is given the same
per-share price at which the broker-dealer bought shares to satisfy the
facilitated order, exclusive of any explicitly disclosed markup or
markdown, commission equivalent or other fee.\179\ In addition,
proposed Rule 201(d)(6) would require the broker-dealer, if it marks an
order ``short exempt'' under this provision, to have policies and
procedures in place to assure that, at a minimum: the customer order
was received prior to the offsetting transaction; the offsetting
transaction is allocated to a riskless principal or customer account
within 60 seconds of execution; and that it has supervisory systems in
place to produce records that enable the broker-dealer to accurately
and readily reconstruct, in a time-sequenced manner, all orders on
which the broker-dealer relies pursuant to this provision.\180\
---------------------------------------------------------------------------

    \178\ In addition to being consistent with the conditions in the
Riskless Principal Letter and Rule 10b-18 of the Exchange Act, this
definition is consistent with the definition of ``riskless
principal'' in FINRA Rule 6642.
    \179\ This requirement is also consistent with FINRA's trade
reporting rules which require a riskless principal transaction in
which both legs are executed at the same price to be reported once,
in the same manner as an agency transaction, exclusive of any
markup, markdown, commission equivalent, or other fee. See FINRA
Rule 6380A(d)(3)(B).
    \180\ See proposed Rule 201(d)(6).
---------------------------------------------------------------------------

    We believe that proposed Rule 201(d)(6) would provide broker-
dealers with additional flexibility to facilitate customer orders and
provide best execution. In addition, we believe that the conditions set
forth in proposed Rule 201(d)(6) would provide a mechanism for the
surveillance of the provision's use by linking it to specific incoming
orders and executions, and by requiring broker-dealers to establish
procedures for handling such transactions. These requirements would
help ensure that broker-dealers are complying with proposed Rule
201(d)(6).
h. Transactions on a Volume-Weighted Average Price Basis
    Proposed Rule 201(d)(7) would provide that a broker-dealer may mark
``short exempt'' certain sale orders executed on a volume-weighted
average price (``VWAP'') basis. Under former Rule 10a-1, the Commission
granted limited relief from that rule in connection with short sales
executed on a VWAP basis.\181\ The relief was limited to VWAP
transactions that are arranged or ``matched'' before the market opens
at 9:30 a.m., but are not assigned a price until after the close of
trading when the VWAP value is calculated. The Commission granted the
exemptions based, in part, on the fact that these VWAP short sale
transactions appeared to pose little risk of facilitating the type of
market effects that former Rule 10a-1 was designed to prevent.\182\ In
particular, the Commission noted that the pre-opening VWAP short sale
transactions do not participate in or affect the determination of the
VWAP for a particular security.\183\ Moreover, the Commission stated
that all trades used to calculate the day's VWAP would continue to be
subject to former Rule 10a-1.\184\
---------------------------------------------------------------------------

    \181\ See e.g. letter from Larry E. Bergmann, Senior Associate
Director, Division of Market Regulation, SEC, to Edith Hallahan,
Counsel, Phlx, dated March 24, 1999; letter from Larry E. Bergmann,
Senior Associate Director, Division of Market Regulation, SEC, to
Soo J. Yim, Wilmer, Cutler & Pickering, dated December 7, 2000;
letter from James Brigagliano, Assistant Director, Division of
Market Regulation, SEC, to Andre E. Owens, Schiff Hardin & Waite,
dated March 30, 2001; letter from James Brigagliano, Assistant
Director, Division of Market Regulation, SEC, to Sam Scott Miller,
Esq., Orrick, Herrington & Sutcliffe LLP, dated May 12, 2001; letter
from James Brigagliano, Assistant Director, Division of Market
Regulation, SEC, to William W. Uchimoto, Esq., Vie Institutional
Services, dated February 12, 2003.
    \182\ See id.
    \183\ See id.
    \184\ See id.
---------------------------------------------------------------------------

    Consistent with the relief granted under former Rule 10a-1, we
propose providing that a broker-dealer may mark ``short exempt''
certain short sale orders executed at the VWAP. Proposed Rule 201(d)(7)
would differ from the relief granted under former Rule 10a-1, however,
in that it would not be limited to VWAP transactions that are arranged
or ``matched'' before the market opens at 9:30 a.m., or that are not
assigned a price until after the close of trading when the VWAP value
is calculated. We believe this restriction would not be necessary
because VWAP short sale transactions appear to pose little risk of
facilitating the type of market effects that a short sale price test
restriction would be designed to prevent. In addition, in accordance
with proposed Rule 201(d)(7), no short sale orders used to calculate
the VWAP may be marked ``short exempt.'' \185\ This would help limit
any potential for manipulation.
---------------------------------------------------------------------------

    \185\ See proposed Rule 201(b)(7).
---------------------------------------------------------------------------

    Thus, pursuant to proposed Rule 201(d)(7), a broker-dealer may mark
a short sale order of a covered security ``short exempt'' if the
broker-dealer has a reasonable basis to believe that the short sale
order is for the sale of a covered security at the VWAP that meets the
following conditions: \186\ (1) The VWAP for the covered security is
calculated by: Calculating the values for every regular way trade
reported in the consolidated system for the security during the regular
trading session, by multiplying each such price by the total

number of shares traded at that price; compiling an aggregate sum of
all values; and dividing the aggregate sum by the total number of
reported shares for that day in the security; (2) the transactions are
reported using a special VWAP trade modifier; (3) no short sales used
to calculate the VWAP are marked ``short exempt''; (4) the VWAP matched
security qualifies as an ``actively traded security'' (as defined under
Rules 101(c)(1) and 102(d)(1) of Regulation M), or where the subject
listed security is not an ``actively traded security,'' the proposed
short sale transaction will be permitted only if it is conducted as
part of a basket transaction of twenty or more securities in which the
subject security does not comprise more than 5% of the value of the
basket traded; (5) the transaction is not effected for the purpose of
creating actual, or apparent, active trading in or otherwise affecting
the price of any security; and (6) a broker or dealer will act as
principal on the contra-side to fill customer short sale orders only if
the broker-dealer's position in the subject security, as committed by
the broker-dealer during the pre-opening period of a trading day and
aggregated across all of its customers who propose to sell short the
same security on a VWAP basis, does not exceed 10% of the covered
security's relevant average daily trading volume, as defined in
Regulation M.\187\
---------------------------------------------------------------------------

    \186\ See proposed Rule 201(d)(7).
    \187\ 17 CFR 242.100(b).
---------------------------------------------------------------------------

    Except as discussed above, the conditions set forth in proposed
Rule 201(d)(7) parallel the conditions contained in the exemptive
relief from former Rule 10a-1 granted for VWAP short sale transactions.
We believe that these conditions worked well in restricting the
exemptive relief to situations that generally would not raise the harms
that short sale price tests are designed to prevent. We believe they
would be similarly effective in serving that function today and,
therefore, should be incorporated into proposed Rule 201(d)(7).
i. Decision Not To Propose That a Broker-Dealer May Mark an Order
``Short Exempt'' in Connection With Bona Fide Market Making Activity
    Former Rule 10a-1(e)(5) provided a limited exception from the
restrictions of that rule for ``[a]ny sale * * * by a registered
specialist or registered exchange market maker for its own account on
any exchange with which it is registered for such security, or by a
third market maker for its own account over-the-counter, (i) Effected
at a price equal to or above the last sale, regular way, reported for
such security pursuant to an effective transaction reporting plan. * *
* Provided, however, That any exchange, by rule, may prohibit its
registered specialist and registered exchange market makers from
availing themselves of the exemption afforded by this paragraph (e)(5)
if that exchange determines that such action is necessary or
appropriate in its market in the public interest or for the protection
of investors.'' Unless prohibited by exchange rule, this exception was
intended to permit registered specialists or market makers to protect
customer orders against transactions in other markets in the
consolidated system by allowing them to sell short at a price equal to
the last trade price reported to the consolidated system, even if that
sale was on a minus or zero-minus tick.\188\ Although former Rule 10a-1
included this exception for market makers, exchanges adopted rules that
prohibited their registered specialists and market makers from availing
themselves of this exception.\189\ In addition, former Rule 10a-1 did
not contain a general exception for short selling in connection with
bona fide market making activities.\190\
---------------------------------------------------------------------------

    \188\ See Securities Exchange Act Release No. 11030 (Sept. 27,
1974), 39 FR 35570 (Oct. 2, 1974). Former Rule 10a-1(a)(1)(i)
referenced the last sale price reported to an effective transaction
reporting plan, but former Rule 10a-1(a)(2) also permitted an
exchange to make an election to use the last sale price reported in
that exchange market. Certain exchanges, such as the NYSE,
implemented short sale price test rules consistent with former Rule
10a-1(a)(2). See, e.g., former NYSE Rule 440B.
    \189\ See id.
    \190\ We note, however, that NASD's bid test contained an
exception for short sales executed by qualified market makers in
connection with bona fide market making. When, however, the
Commission approved NASD's bid test and the market maker exception
to the bid test it noted concerns that the market maker exception
could create opportunities for abusive short selling. See 1994 NASD
Bid Test Approval, 59 FR 34885. See also supra notes 125 and 136
(discussing NASD Rule 3350).
---------------------------------------------------------------------------

    Consistent with former Rule 10a-1, the proposed modified uptick
rule would not permit a broker-dealer to mark a short sale order
``short exempt'' if the broker-dealer is engaging in bona fide market
making activity. By requiring trading centers to have policies and
procedures reasonably designed to prevent the execution or display of a
short sale order at a down-bid price, the proposed modified uptick rule
might help prevent short selling, including potentially abusive or
manipulative short selling, from being used as a tool to drive down a
market and from being used to accelerate a declining market by
exhausting all remaining bids at one price level, and causing
successively lower prices to be established by long sellers. By seeking
to advance these goals, the proposed modified uptick rule might help
restore investor confidence.
    As set forth above, paragraphs (c) and (d) of proposed Rule 201
would permit a broker-dealer to mark a short sale order ``short
exempt'' under certain circumstances.\191\ Further, if an order is
marked ``short exempt,'' proposed Rule 201(b)(1)(ii) provides that a
trading center's policies and procedures must be reasonably designed to
permit the execution or display of such order without regard to whether
the order is at a down-bid price.\192\ We have proposed these
provisions to facilitate the proposed modified uptick rule's
workability, while at the same time, not undermine our goals in
proposing short sale price test restrictions.
---------------------------------------------------------------------------

    \191\ See proposed Rule 201(c) and 201(d).
    \192\ See proposed Rule 201(b)(1)(ii).
---------------------------------------------------------------------------

    We believe that permitting broker-dealers to mark ``short exempt''
short sale orders in connection with bona fide market making activity
may undermine the goals of our proposed short sale price test
restrictions at this time. In particular, we believe that for the
proposed modified uptick rule to have the effect of helping to prevent
declines in securities prices and restore investor confidence,
provisions relating to when a broker-dealer may mark an order ``short
exempt'' should be limited in scope.
    In addition, we note that the proposed provision that would allow
broker-dealers to mark short sale orders as ``short exempt'' in
connection with riskless principal transactions would provide broker-
dealers with flexibility to facilitate customer orders. A trading
center's policies and procedures would also be designed to permit the
execution or display of short sale orders at the offer. Additionally,
in an advancing market, in accordance with proposed Rule 201(b)(1), a
trading center's policies and procedures would be reasonably designed
to permit the execution or display of short sale orders at the current
national best bid and, therefore, in an advancing market, market makers
could provide liquidity to the markets and meet purchasing demand.\193\
For all these reasons, we do not believe it would be appropriate to
provide that a broker-dealer may mark an order ``short exempt'' where
the short

sale order is in connection with bona fide market making activity.
---------------------------------------------------------------------------

    \193\ See also McCormick, D. Timothy and Zeigler, Bram, 1997,
The Nasdaq short sale rule: Analysis of market quality effects and
the market maker exemption. Working paper, NASD Economic Research,
p. 28 (finding that market makers' short sales at the bid or below
on down-bids amounted to only 1.17% of their trading).
---------------------------------------------------------------------------

    We seek comment, however, on the importance of a market maker
provision in the context of a market maker's role in providing
liquidity, including the extent to which market makers would need to
sell short at or below the current national best bid in their market
making capacity. We also seek comment on the extent to which the
proposed riskless principal provision, as well as any other proposed
provisions, would address concerns regarding the need for a more
general market maker provision. In addition, we seek comment regarding
what conditions should apply if a general market maker provision were
added to when a broker-dealer may mark an order ``short exempt'' under
the proposed modified uptick rule. We also seek comment on whether a
general market maker exception should be limited to registered market
makers.
3. Proposed Modified Uptick Rule and After-Hours Trading
    Regular trading hours in the U.S. are from 9:30 a.m. to 4 p.m.
Eastern Time (``ET'').\194\ A high volume of trading occurs, however,
outside of these regular trading hours. Accordingly, the Commission
interpreted former Rule 10a-1 to apply to all trades in covered
securities, whenever they occurred.\195\ By its terms, former Rule 10a-
1 used as a reference point the last sale price reported to the
consolidated tape. Thus, after the consolidated tape ceased to operate,
the rule prevented any person from effecting a short sale in a listed
security at a price lower than the last sale reported to the
consolidated tape.\196\ Although former Rule 10a-1 applied in the
after-hours market, we do not believe that the proposed modified uptick
rule should apply to covered securities during periods that the
national best bid is not collected, calculated and disseminated.
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    \194\ See, e.g., Rule 600(64) of Regulation NMS, defining the
term ``regular trading hours.''
    \195\ See 2003 Regulation SHO Proposing Release, 68 FR at 62997
(stating that the Commission interprets former Rule 10a-1 to apply
to all trades in listed securities whenever they occur).
    \196\ We note, however, that NASD did not extend its short sale
price test rule to the after-hours market. See NASD Head Trader
Alert 2000-55.
---------------------------------------------------------------------------

    As discussed above, market information for quotes in NMS stocks is
disseminated pursuant to two different national market system plans,
the CQ Plan, and Nasdaq UTP Plan.\197\ Quotation information is made
available pursuant to the CQ Plan between 9 a.m. and 6:30 p.m. ET,
while one or more participants is open for trading. In addition,
quotation information is made available pursuant to the CQ Plan during
any other period in which any one or more participants wish to furnish
quotation information to the Plan.\198\ Quotation information is made
available by the Nasdaq UTP Plan between 9:30 a.m. and 4 p.m. ET. The
Nasdaq UTP Plan also collects, processes, and disseminates quotation
information between 4 a.m. and 9:30 a.m. (ET), and after 4 p.m. when
any participant is open for trading, until 8 p.m. ET.\199\
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    \197\ See supra note 107. See also 17 CFR 242.603(b). Rule 603
of Regulation NMS requires that every national securities exchange
on which an NMS stock is traded and national securities association
shall act jointly pursuant to one or more effective national market
system plans to disseminate consolidated information, including a
national best bid and national best offer, on quotations for and
transactions in NMS stocks.
    \198\ See http://www.nyxdata.com/cta.
    \199\ See http://www.utpdata.com/docs/UTP_PlanAmendment.pdf.
---------------------------------------------------------------------------

    During the time periods in which these Plans do not operate, real-
time quote information is not collected, calculated and disseminated.
We do not believe that it would further the goals of short sale price
test regulation to apply the proposed modified uptick rule when the
national best bid is not being collected, calculated and disseminated
on a real-time basis. Thus, the proposed modified uptick rule would
only apply at times when quotation information and, therefore, the
national best bid, is collected, processed, and disseminated pursuant
to a national market system plan. Thus, proposed Rule 201(f) limits
application of the proposed modified uptick rule to times when ``a
national best bid for [an] NMS stock is calculated and disseminated on
a current and continuing basis by a plan processor pursuant to an
effective national market system plan.'' \200\ However, we seek comment
on these issues.
---------------------------------------------------------------------------

    \200\ See proposed Rule 201(e).
---------------------------------------------------------------------------

B. Proposed Uptick Rule

1. Operation of the Proposed Uptick Rule
    As an alternative to proposing a short sale price test based on the
national best bid, we are proposing a modified version of former Rule
10a-1 to provide the public with an opportunity to comment on the
utility of such a price test, especially in light of the recent changes
in market conditions.\201\ The proposed uptick rule would use the last
sale price as the reference point for short sale orders.
---------------------------------------------------------------------------

    \201\ See supra Section II, discussing the history of short sale
price test regulation in the United States and changes in market
conditions and resulting erosion of investor confidence.
---------------------------------------------------------------------------

    Specifically, the proposed uptick rule would provide that ``[n]o
person shall, for his own account or for the account of any other
person, effect a short sale of any covered security, if trades in such
security are reported pursuant to an effective transaction reporting
plan \202\ and information as to such trades is made available in
accordance with such plan on a real-time basis to vendors of market
transaction information: (i) Below the price at which the last sale
thereof, regular way, was reported pursuant to an effective transaction
reporting plan; or (ii) At such price unless such price is above the
next preceding different price at which a sale of such security,
regular way, was reported pursuant to an effective transaction
reporting plan.'' \203\ Thus, under the proposed uptick rule, no short
sale order may be effected below the last sale price. Short sale orders
may be effected at the last sale price only if the last sale price is
above the last different price. Otherwise, all short sale orders must
be effected above the last sale price.
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    \202\ Proposed Rule 201(a)(3) provides that the term
``transaction reporting plan'' shall have the same meaning as in
Sec.  242.600(22) of Regulation NMS.
    \203\ Proposed Rule 201(b).
---------------------------------------------------------------------------

    The following transactions illustrate the operation of the proposed
uptick rule:
[GRAPHIC] [TIFF OMITTED] TP17AP09.008

    The first execution at 47.04 is a plus tick since it is higher than
the previous last trade price of 47.00. The next transaction at 47.04
is a zero-plus tick since there is no change in trade price but the
last change was a plus tick. Short sales could be executed at 47.04 or
above in both of these cases. The final two transactions at 47.00 are
minus and zero-minus transactions, respectively. Short sales in these
two circumstances would have to be effected at a price above 47.00 in
order to comply with proposed uptick rule.
    Similar to the proposed modified uptick rule, the proposed uptick
rule would apply to any ``covered security,'' which is defined as an
``NMS stock'' under Rule 600(a)(47) of Regulation NMS. Rule 600(a)(47)
of Regulation NMS defines an ``NMS stock'' as ``any NMS security other
than an option.'' \204\ Rule 600(a)(46) of Regulation NMS defines an
``NMS security'' as ``any security or class of securities for which
transaction reports are collected, processed, and made available
pursuant to an effective transaction reporting plan, or an effective
national market system plan for reporting transactions in listed
options.'' \205\ As a result, the proposed uptick rule would
effectively cover all securities, other than options, listed on a
national securities exchange whether traded on an exchange or in the
OTC market. It would not include non-NMS stocks quoted on the OTC
Bulletin Board or elsewhere in the OTC market.
---------------------------------------------------------------------------

    \204\ 17 CFR 242.600(a)(47).
    \205\ 17 CFR 242.600(a)(46).
---------------------------------------------------------------------------

    We are not proposing to apply the proposed uptick rule to non-NMS
stocks quoted on the OTC Bulletin Board or elsewhere in the OTC market
because these securities were not subject to former Rule 10a-1. We
recognize, however, that issuers of non-NMS stocks, which often are
less actively traded securities than NMS stocks, may believe that they
are particularly vulnerable to abusive short selling. Thus, we seek
specific comment regarding whether the proposed uptick rule or some
other form of price test should apply to these types of securities.
    As discussed above in connection with the proposed modified uptick
rule, the scope of securities covered by the proposed uptick rule would
be similar to the scope of securities covered by former Rule 10a-1.
Former Rule 10a-1(a) applied to securities registered on, or admitted
to unlisted trading privileges on, a national securities exchange, if
trades of the security were reported pursuant to an effective
transaction reporting plan and information regarding such trades was
made available in accordance with such plan on a real-time basis to
vendors of market transaction information. All securities that would
have been subject to former Rule 10a-1 would also be subject to the
proposed uptick rule. In addition, certain securities, such as
securities traded on Nasdaq, that were not subject to former Rule 10a-
1, would be subject to the proposed uptick rule.\206\
---------------------------------------------------------------------------

    \206\ See supra note 106. We note that former Rule 10a-1(b)
applied the restrictions of former Rule 10a-1 to short sales on a
national securities exchange in securities for which trades were not
reported pursuant to an ``effective transaction reporting plan,'' as
defined in Rule 600 of Regulation NMS, and for which information as
to such trades was not made available in accordance with such plan
on a real-time basis to vendors of market transaction information.
Former Rule 10a-1(b) provided, in part: ``No person shall, for his
own account or for the account of any other person, effect on a
national securities exchange a short sale of any security not
covered by paragraph (a) of this rule, 1. below the price at which
the last sale thereof, regular way, was effected on such exchange,
or 2. at such price unless such price is above the next preceding
different price at which a sale of such security, regular way, was
effected on such exchange.'' A similar provision would not be
applicable to the proposed uptick rule because the proposed uptick
rule applies to all NMS stocks, which, by definition, include only
those stocks for which trades are collected, processed, and made
available pursuant to an effective transaction reporting plan. See
17 CFR 242.600(b)(47) and (b)(46).
---------------------------------------------------------------------------

    As discussed in more detail above, the Commission eliminated former
Rule 10a-1 and prohibited any SRO from having a price test in an effort
in part to modernize and simplify short sale regulation in light of
current trading systems and strategies used in the marketplace. In
supporting its elimination of former Rule 10a-1, the Commission noted
that the increased demand for exemptions from the Rule, and the
disjointed application of short sale price tests had limited the reach
of short sale price test restrictions, created confusion and compliance
difficulties as well as an un-level playing field among market
participants. In addition, the Commission noted that decimal increments
had resulted in a rule that was no longer suited to the wide variety of
trading strategies and systems used in the marketplace. The Commission
also discussed that following its study of the effects of removing
short sale price tests, OEA had found little empirical justification
for maintaining former Rule 10a-1 and that, on balance, elimination of
short sale price test restrictions for pilot stocks had not had a
deleterious effect on market quality based on the examination of
transactions during the period covered by the Pilot.\207\
---------------------------------------------------------------------------

    \207\ See 2006 Price Test Elimination Proposing Release, 71 FR
at 75073.
---------------------------------------------------------------------------

    Similar to the proposed modified uptick rule, the proposed uptick
rule is designed to allow relatively unrestricted short selling in an
advancing market. In addition, it is designed to restrict short selling
at successively lower prices and, thereby, might help prevent short
selling, including potentially abusive or manipulative short selling,
from being used as a tool for driving the market down or from being
used to accelerate a declining market by exhausting all remaining bids
at one price level, causing successively lower prices to be established
by long sellers. In addition, the proposed uptick rule, similar to the
proposed modified uptick rule, would not result in the type of
disparate short sale regulation that existed under former Rule 10a-1
because proposed Rule 201(d) would include a requirement that no SRO
shall have any rule that is not in conformity with, or conflicts with,
the short sale price test requirements of the proposed uptick rule.
Another potential advantage to the proposed uptick rule is that market
participants would be familiar with the test because it would be based
on former Rule 10a-1 which was in existence for almost 70 years, and
was only recently eliminated.
    At the same time, some of the reasons cited by the Commission for
eliminating former Rule 10a-1, which are unique to the proposed uptick
rule as a price test based on the last sale price, remain today. For
example, as discussed in more detail below, as a short sale price test
that is based on the last sale price, the proposed uptick rule includes
a number of exceptions necessary to accommodate the various trading
strategies and systems used in today's marketplace. For example, the
proposed uptick rule includes an exception for automated trading
systems that utilize passive pricing and trading systems that offer
price improvement based on the national best bid. The proposed uptick
rule also includes an exception to allow market makers or specialists
publishing two-sided quotes to sell short at the offer to facilitate
customer market or marketable limit buy orders regardless of the last
sale price.
    In addition, as noted above in connection with our discussion of
the proposed modified uptick rule, we believe the spread of more fully
automated markets may make a test based on the last sale price less
effective at regulating short selling than a test based on the national
best bid due to delays in reporting of last sale price information and
because last sale price information is published in reporting sequence
and not trade sequence. Such trade reporting may create up-ticks and
down-ticks that may not accurately

reflect price movements in the security for purposes of the proposed
uptick rule. Because last trade prices can be reported out of sequence,
for various reasons, we believe bids may be a more accurate reflection
of current prices for a security.
    Although former Rule 10a-1 was only recently eliminated, we
recognize that due to the extensive systems changes that have occurred
in the last couple of years in response to Regulation NMS, programming
systems for the proposed uptick rule may be burdensome. For example, we
note that at the same time that we proposed and subsequently adopted
amendments to eliminate former Rule 10a-1, market participants were
programming their systems to comply with Regulation NMS. It is our
understanding that some market participants may not have included in
their programming coding that would have allowed for the application of
short sale price test restrictions at that time.\208\
---------------------------------------------------------------------------

    \208\ In connection with the elimination of former Rule 10a-1
and all short sale price test restrictions, we noted that commenters
to the proposed amendments to eliminate all short sale price test
restrictions discussed potential reprogramming costs that market
participants may incur if the proposed amendments were not effective
prior to the date for which all automated trading centers were
required to have fully operational Regulation NMS-compliant trading
systems, i.e., July 9, 2007 (the ``Regulation NMS Compliance
Date''). For example, we noted that the Securities Industry
Financial Markets Assn. (``SIFMA'') urged the Commission to take
steps to eliminate price test restrictions prior to the Regulation
NMS Compliance Date to alleviate the need for firms to, in the
course of instituting programming changes to meet the new
requirements of Regulation NMS, program systems to comply with price
test restrictions, only to be required to reverse such programming
costs shortly thereafter. After considering these comments, we made
the elimination of short sale price test restrictions immediately
effective to provide market participants with sufficient notice and
time prior to the Regulation NMS Compliance Date to reprogram their
systems without regard to the then-current short sale price test
restrictions. See 2007 Price Test Adopting Release, 72 FR at 36356,
36359.
---------------------------------------------------------------------------

    Although the proposed uptick rule does not take a policies and
procedures approach, it is likely that market participants would use a
policies and procedures approach as part of their efforts to comply
with the proposed prohibition. As such, for either proposed approach
(prohibition or policies and procedures), market participants could
consider whether to build off the policies and procedures they already
have in place under Regulation NMS. As discussed above in connection
with the proposed modified uptick rule, trading centers have been
required to develop policies and procedures in accordance with
Regulation NMS that would be similar to the types of policies and
procedures that would be required under the proposed modified uptick
rule.
    The proposed uptick rule may be more burdensome to apply than the
proposed modified uptick rule, however, because the prohibition
approach of the proposed uptick rule would not allow any short sale at
an impermissible price, even if in error or inadvertent, unless an
exception applies. If the Commission were to decide to provide an
exception for inadvertent errors, that could reduce the differences
between the two proposed approaches. In addition, the proposed uptick
rule could follow a policies and procedures approach similar to the
approach discussed in connection with the proposed modified uptick
rule. Such a policies and procedures approach would require that market
participants continuously surveil for compliance and take prompt
remedial steps to limit the execution or display of short sales at
impermissible prices.
    As discussed above, we are proposing a short sale price test based
on the last sale price, and, in particular, we are proposing a
modernized version of former Rule 10a-1 to provide the public with the
opportunity to comment on this test in light of changes that have
occurred in market conditions and investor confidence since the
elimination of former Rule 10a-1 in mid-2007. Because we want to
provide the public with the opportunity to comment on a short sale
price test similar to former Rule 10a-1, we are not proposing a
policies and procedures type of approach in connection with the
proposed uptick rule because this would be a substantial change from
how former Rule 10a-1 was applied. We note, however, that some
commenters may believe that a policies and procedures approach similar
to the approach discussed under the proposed modified uptick rule that
references the last sale price, rather than the national best bid,
might be preferable to either the proposed modified uptick rule or the
proposed uptick rule. Thus, we seek specific comment regarding such an
approach.
    If we were to adopt the proposed uptick rule, we are proposing that
there would be a three month implementation period such that market
participants would have to comply with the proposed uptick rule three
months following the effective date of the proposed uptick rule. We
believe that a proposed implementation period of three months after the
effective date would provide market participants with sufficient time
in which to modify their systems and procedures in order to comply with
the requirements of the proposed uptick rule. Among other things, we
believe this period would be a reasonable period because market
participants would be familiar with the changes to their trading
systems necessary to implement the proposed uptick rule as the proposed
uptick rule would be similar to former Rule 10a-1. The addition of an
implementation period should help alleviate potential disruptive
effects of the proposal.
    We realize, however, that a shorter or longer implementation period
may be manageable or preferable. Thus, we seek specific comment as to
what length of implementation period would be necessary or appropriate,
and why, such that market participants would be able to meet the
proposed short sale price test restrictions, if adopted.
2. Exceptions to Proposed Uptick Rule
    Paragraph (c) of Rule 201 of the proposed uptick rule sets forth
exceptions to the proposed rule to promote its workability. Rule 201(c)
of the proposed uptick rule would include exceptions that parallel
provision set forth in proposed Rule 201(d) of the proposed modified
uptick rule pursuant to which a broker-dealer may mark an order ``short
exempt'' for purposes of that proposed rule. Thus, proposed Rule 201(c)
of the proposed uptick rule would also include exceptions for: (i) A
seller's delay in delivery as set forth in Section III.A.2.b above;
(ii) odd lots, as set forth in Section III.A.2.c. above; (iii) domestic
arbitrage, as set forth in Section III.A.2.d. above; (iv) international
arbitrage, as set forth in Section III.A.2.e. above; (v) over-
allotments and lay-off sales, as set forth in Section III.A.2.f. above;
(vi) transactions on a VWAP basis, as set forth in Section III.A.2.h
above; and (vii) riskless principal transactions as set forth in
Section III.A.2.g. above. We believe that the rationale for these
provisions under the proposed modified uptick rule would be equally
applicable to the proposed uptick rule. Thus, we do not repeat the
discussions of these provisions in connection with our discussion
regarding the proposed uptick rule.
    The following discussion sets forth the rationale regarding
exceptions that would be unique to the proposed uptick rule. The
exceptions contained in paragraph (c) of proposed Rule 201 are based
upon exceptions contained in former Rule 10a-1 and exemptive relief
granted pursuant to that rule. These exceptions and exemptions, as
applicable, had been in place under former Rule 10a-1 for several
years. We are not aware of any reason that the

rationales underlying these exceptions and exemptions would not still
hold true today. Moreover, due to the limited scope of the proposed
exceptions and exemptions, we do not believe that they would undermine
the Commission's stated goals for proposing short sale price test
restrictions.
    Thus, the exceptions in proposed Rule 201(c) parallel exceptions to
and exemptive relief granted under former Rule 10a-1. As set forth in
more detail below, however, we seek comment regarding each of these
exceptions, including whether or not these exceptions would be
appropriate or necessary under the proposed modified uptick rule
particularly in light of trading systems and strategies used in today's
marketplace.
a. Error in Marking a Short Sale
    Proposed Rule 201(c)(2) would provide an exception from the
proposed uptick rule where a broker-dealer effects a sale order marked
``long'' by another broker-dealer, but the order was mis-marked such
that it should have been marked as a ``short'' sale order.
Specifically, proposed Rule 201(c)(2) provides that the proposed uptick
rule shall not apply to ``[a]ny sale by a broker or dealer of a covered
security for an account in which it has no interest, pursuant to an
order marked long.'' \209\
---------------------------------------------------------------------------

    \209\ Proposed Rule 201(c)(2).
---------------------------------------------------------------------------

    The broker-dealer that marks the order ``long'' must comply with
the order marking requirements of Rule 200(g) of Regulation SHO.\210\
Subsection (e)(2) of former Rule 10a-1 contained an exception for mis-
marked short sales. The exception was included in former Rule 10a-1
when the rule was adopted in 1938 and was provided to ``avoid
implicating in any violation of the rules a member whose participation
in the violation [was] unwitting and unintentional.'' \211\ The
exception in proposed Rule 201(c)(2) would avoid implicating the
broker-dealer effecting the sale where the broker-dealer's
participation in the violation was neither knowing nor reckless.\212\
---------------------------------------------------------------------------

    \210\ See 17 CFR 242.200(g).
    \211\ See Former Rule 10a-1 Adopting Release, 3 FR 213.
    \212\ Knowledge may be inferred where a broker-dealer has
previously accepted orders marked ``long'' from the same
counterparty that required borrowed shares for delivery or that
resulted in a ``fail to deliver.'' See 2004 Regulation SHO Adopting
Release, 69 FR at 48019, n.111 (stating that ``[i]t may be
unreasonable for a broker-dealer to treat a sale as long where
orders marked `long' from the same customer repeatedly require
borrowed shares for delivery or result in `fails to deliver.' A
broker-dealer also may not treat a sale as long if the broker-dealer
knows or has reason to know that the customer borrowed shares being
sold.'').
---------------------------------------------------------------------------

b. Electronic Trading Systems
    Proposed Rule 201(c)(8) would provide an exception from the
proposed uptick rule for sales of securities in certain electronic
trading systems that match and execute trades at various times and at
independently-derived prices, such as at the mid-point of the NBBO. The
Commission granted limited exemptive relief in connection with these
systems under former Rule 10a-1 because matches could potentially occur
at a price below the last sale price.\213\ Similarly, under the
proposed uptick rule, matches could potentially occur at a price below
the last sale price and, therefore, violate the provisions of proposed
Rule 201(b) prohibiting short sales on a minus or zero-minus tick,
absent an exception.
---------------------------------------------------------------------------

    \213\ See e.g., supra note 26.
---------------------------------------------------------------------------

    This exception provides that the proposed uptick rule shall not
apply to any sale of a covered security in an electronic trading system
that matches buying and selling interest at various times throughout
the day if: (1) Matches occur at an externally derived price within the
existing market and above the current national best bid; (2) sellers
and purchasers are not assured of receiving a matching order; (3)
sellers and purchasers do not know when a match will occur; (4) persons
relying on the exception are not represented in the primary market
offer or otherwise influence the primary market bid or offer at the
time of the transaction; (5) transactions in the electronic trading
system are not made for the purpose of creating actual, or apparent,
active trading in, or depressing or otherwise manipulating the price
of, any security; (6) the covered security qualifies as an ``actively-
traded security'' (as defined in Rules 101(c)(1) and 102(d)(1) of
Regulation M), or where the subject listed security is not an
``actively-traded security,'' the proposed short sale transaction will
be permitted only if it is conducted as part of a basket transaction of
twenty or more securities in which the subject security does not
comprise more than 5% of the value of the basket traded; and (7) during
the period of time in which the electronic trading system may match
buying and selling interest, there is no solicitation of customer
orders, or any communication with customers that the match has not yet
occurred.\214\
---------------------------------------------------------------------------

    \214\ See Proposed Rule 201(c)(8).
---------------------------------------------------------------------------

    The conditions set forth in the exception in proposed Rule
201(c)(8) parallel the conditions provided in the exemptive relief
granted under former Rule 10a-1. Consistent with the relief granted
under former Rule 10a-1 and the rationales provided in granting such
relief, we believe it is appropriate to propose an exception to the
proposed uptick rule for short sales submitted to these electronic
trading systems because such rationales still hold true today. In
particular, we note that due to the passive nature of pricing and the
lack of price discovery, trades executed through these systems
generally would not involve the types of abuses that the proposed
uptick rule would be designed to prevent.
c. Trade-Throughs
    Proposed Rules 201(c)(10) and (11) would provide exceptions from
the requirements of the proposed uptick rule that would help address
any potential conflict between the proposed uptick rule and the Quote
Rule under the Exchange Act.\215\ These exceptions parallel the
exceptions contained in former Rule 10a-1(e)(5)(ii) and (e)(11),
respectively.
---------------------------------------------------------------------------

    \215\ See 17 CFR 242.602.
---------------------------------------------------------------------------

    Former Rule 10a-1(e)(5)(ii) was added to former Rule 10a-1 to
address a potential conflict between the operation of former Rule 10a-1
and the ``firm quote requirement'' of the Quote Rule \216\ in
situations where execution of an offer quotation by a broker-dealer
would be rendered unlawful because of a trade-through,\217\ even though
the offer had been at a price permitted under former Rule 10a-1 at the
time that the broker-dealer had communicated it to its exchange or
association for inclusion in the consolidated quotation system.\218\
---------------------------------------------------------------------------

    \216\ At the time the Commission adopted former Rule 10a-
1(e)(5)(ii), the Quote Rule was included in Rule 11Ac1-1 under the
Exchange Act. The Quote Rule is now in Rule 602 of Regulation NMS.
See 17 CFR 242.602.
    \217\ A ``trade-through'' generally means the purchase or sale
of a security at a price that is lower than a protected bid or
higher than a protected offer. See 17 CFR 242.600(a)(77) (defining
the term ``trade-through'' for purposes of Regulation NMS).
    \218\ The following example from the release adopting the
exception illustrates the potential conflict: A market maker who
currently has a short position in XYZ stock communicates an offer
which, if executed against at that time, would be in compliance with
Rule 10a-1, e.g., at a price of 20\1/8\ when the last trade price
reported in the consolidated system is also 20\1/8\. There is a
``trade through'' of the market maker's offer on another trading
venue that causes an up-tick to be reported in the consolidated
system at 20\1/4\. Finally, a buy order is sent to the market maker
after the trade through at 20\1/4\ has been reported. In order to
ensure compliance with 10a-1, the market maker must refuse to
execute the order at his offer of 20\1/8\ because doing so would
result in a short sale being effected on an impermissible minus
tick, however, in refusing to effect the trade, he would arguably
violate the ``firm quote requirement'' of the Quote Rule. In
addition, when a market maker ``backs away'' from an order, he may,
in effect be revealing that he had a short position in the security,
thus making it more difficult to liquidate that position at
favorable prices. See Securities Exchange Act Release No. 17314
(Nov. 20, 1980), 45 FR 79018 (Nov. 28, 1980).

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

    To resolve this potential conflict, the Commission adopted the
exception in subsection (e)(5)(ii) of former Rule 10a-1 to permit
market makers to execute transactions at their offer following a trade-
through, and (e)(11) to permit non-market makers to effect a short sale
at a price equal to the price associated with their most recently
communicated offer up to the size of that offer \219\ provided the
offer was at a price, when communicated, that was permissible under
former Rule 10a-1. The (e)(11) exception was added in response to
several comments that, in addition to orders for their own account,
specialists and other floor members also often represent as part of
their displayed quotation orders of other market participants (e.g.,
public agency orders or proprietary orders of non-market makers) that
also might be ineligible for execution under former Rule 10a-1
following a trade-through in another market.\220\
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    \219\ The Commission explained in the release that the scope of
the exception in former Rule 10a-1(e)(11) was limited to the size of
the broker-dealer's displayed offer because the need for the
exception only arises to the extent that the broker-dealer's
obligations under the Quote Rule may conflict with former Rule 10a-
1. Because the firm quote requirement of the Quote Rule only applies
to a broker-dealer's displayed offer, it was deemed appropriate to
limit the exception to the size of the displayed offer. See supra
note 218 at n.20.
    \220\ This concern was illustrated in the release adopting the
amendments with the following example: A specialist who is short XYZ
stock quotes an offer for 1,000 shares at 20\1/8\ at a time when the
last sale reported in the consolidated system was such that the
offer, if executed at that time, would be in compliance with Rule
10a-1. This offer for 1,000 shares consists of 300 shares offered by
the specialist, a 400-share limit order in the specialist's book,
and an offer from the crowd at the specialist's post for 300 shares,
all at 20\1/8\. A trade through of this offer occurs on another
exchange and an up-tick is reported in the consolidated system at
20\1/4\. A buy order for 1,000 shares at 20\1/8\ is then sent to the
exchange--after the trade through at 20\1/4\ is reported. Without
(e)(11), filling the complete order for 1,000 shares would not be
permissible, since (e)(5)(ii), by its terms, applied only to a sale
by a market maker for its own account. See supra note 218 at n.18.
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    We believe that the rationale for adopting the exceptions in former
Rule 10a-1(e)(5)(ii) and (e)(11) and proposed in subsections (c)(10)
and (c)(11) of the proposed uptick rule, namely resolving a conflict
between a short sale price test based on the last sale price and the
Quote Rule would exist under the proposed uptick rule. Thus, the
proposed exceptions would parallel the exceptions in former Rule 10a-
1(e)(5)(ii) and (e)(11).\221\
---------------------------------------------------------------------------

    \221\ See Proposed Rule 201(c)(10) and (c)(11).
---------------------------------------------------------------------------

    Specifically, proposed Rule 201(c)(10) would provide that the
restrictions of the proposed uptick rule shall not apply to: ``[A]ny
sale of a covered security (except a sale to a stabilizing bid
complying with Sec.  242.104 of Regulation M) by a registered
specialist or registered exchange market maker for its own account on
any exchange with which it is registered for such security, or by a
third market maker for its own account over-the-counter, (i) Effected
at a price equal to the most recent offer communicated for the security
by such registered specialist, registered exchange market maker or
third market maker to an exchange or a national securities association
(``association'') pursuant to Sec.  242.602 of this chapter, if such
offer, when communicated, was equal to or above the last sale, regular
way, reported for such security pursuant to an effective transaction
reporting plan. Provided, however, (ii) That any self-regulatory
organization, by rule, may prohibit its registered specialist and
registered exchange market makers from availing themselves of the
exemption afforded by this paragraph (c)(10) if that self-regulatory
organization determines that such action is necessary or appropriate in
its market in the public interest or for the protection of investors.''
\222\
---------------------------------------------------------------------------

    \222\ See Proposed Rule 201(c)(10).
---------------------------------------------------------------------------

    We believe that the rationale for adopting former Rule 10a-
1(e)(5)(ii) still holds true today and, therefore, we have incorporated
the language of that exception into proposed Rule 201(c)(10).
Consistent with former Rule 10a-1(e)(5)(ii), the proposed exception
would include language that would permit SROs to prohibit registered
specialists and registered exchange market makers from availing
themselves of this exception. We note that under former Rule 10a-1,
SROs such as the NYSE prohibited registered specialists and registered
exchange market makers from availing themselves of this exception.\223\
We believe it would be appropriate to continue to provide this option
to SROs.
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    \223\ See former NYSE Rule 440B.
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    Proposed Rule 201(c)(11) would provide that the restrictions of the
proposed uptick rule shall not apply to: ``[A]ny sale of a covered
security (except a sale to a stabilizing bid complying with Sec.
242.104 of this chapter) by any broker or dealer, for his own account
or for the account of any other person, effected at a price equal to
the most recent offer communicated by such broker or dealer to an
exchange or association pursuant to Sec.  242.602 of this chapter in an
amount less than or equal to the quotation size associated with such
offer, if such offer, when communicated, was: (i) Above the price at
which the last sale, regular way, for such security was reported
pursuant to an effective transaction reporting plan; or (ii) At such
last sale price, if such last sale price is above the next preceding
different price at which a sale of such security, regular way, was
reported pursuant to an effective transaction reporting plan.'' We
believe that the rationale for adopting former Rule 10a-1(e)(11) still
holds true today and, therefore, we have incorporated the language of
that exception into proposed Rule 201(c)(10).
d. Facilitation of Customer Buy Orders
    Proposed Rule 201(c)(12) would provide for an exception from the
proposed uptick rule for short sales by registered market makers or
specialists publishing two-sided quotes to sell short at the offer to
facilitate customer market and marketable buy limit orders regardless
of the last sale price.\224\ We believe that this exception would be
necessary because some third market makers in exchange-listed
securities offer trade execution for eligible customer orders at a
price equal to or better than the national best offer. Under the
proposed uptick rule, if the national best offer were below the
previous last reported sale in a security and the third market maker or
specialist has a short position, sales at the national best offer would
violate the proposed uptick rule. The proposed exception would provide
limited relief in a decimals environment to registered market makers
and specialists so that they could provide liquidity in response to
customer buy limit orders. Because this relief is limited to short
selling only at the national best offer and only in response to
customer buy limit orders we believe that it would not undermine the
goals of short sale price test regulation, including helping to prevent
short selling from being used as a tool to drive the market down.
---------------------------------------------------------------------------

    \224\ See proposed Rule 201(c)(12). This exception parallels
exemptive relief provided by the Commission under former Rule 10a-1.
---------------------------------------------------------------------------

3. Proposed Uptick Rule and After-Hours Trading
    As discussed above in connection with the proposed modified uptick
rule, the Commission interpreted former Rule 10a-1 to apply to all
trades in covered securities, whenever they occurred. By its terms,
former Rule 10a-1 used as a reference point the last sale price
reported to the consolidated tape. Thus, after the consolidated tape
ceased to operate, the rule prevented any person from effecting a short
sale in a listed

security at a price lower than the last sale reported to the
consolidated tape.\225\ Although former Rule 10a-1 applied in the
after-hours market, similar to the proposed modified uptick rule, we do
not believe that the proposed uptick rule should apply to covered
securities while last sale price information is not collected,
processed, and disseminated.\226\
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    \225\ We note, however, that NASD did not extend its short sale
price test rule to the after-hours market. See NASD Head Trader
Alert 2000-55.
    \226\ See supra Section III.A.2. (discussing our belief that the
proposed modified uptick rule should not apply when the national
best bid is not collected, processed, and disseminated on a real-
time basis).
---------------------------------------------------------------------------

    As discussed above, last sale price information for NMS stocks is
disseminated pursuant to a national market system plan, the CTA
Plan.\227\ The CTA Plan disseminates last sale price information during
the hours in which any of its participants that regularly reports to
the Plan is open for trading. In addition, the Plan disseminates last
sale price information at other times during which any of its exchange
participants is open for trading.\228\ During times in which the CTA
Plan does not collect, process, and disseminate last sale price
information, real-time last sale price information is not available.
For the same reasons discussed in connection with the proposed modified
uptick rule, we do not believe that it would further the goals of short
sale price test regulation to apply the proposed uptick rule when last
sale price information is not being collected and disseminated on a
real-time basis. Thus, proposed Rule 201(e) limits application of the
proposed uptick rule to times when ``a last sale price for [an] NMS
stock is collected and disseminated on a current and continuing basis
by a plan processor pursuant to an effective national market system
plan.'' \229\
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    \227\ See 17 CFR 242.603(b). Rule 603 of Regulation NMS requires
that every national securities exchange on which an NMS stock is
traded and national securities association shall act jointly
pursuant to one or more effective national market system plans to
disseminate consolidated information, including a national best bid
and national best offer, on quotations for and transactions in NMS
stocks.
    \228\ See http://www.nyxdata.com/cta.
    \229\ See proposed Rule 201(e).
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C. The Proposed Circuit Breaker Rules

    We also are proposing for comment, as an alternative to the
proposed price test restrictions, circuit breaker rules. The proposed
circuit breaker halt rule would, when triggered by a specified decline
in the price of a particular security, temporarily prohibit any person
from selling short a particular NMS stock during severe market declines
in that security, subject to certain exceptions. The proposed circuit
breaker modified uptick rule would, when triggered by a specified
decline in the price of a particular security, temporarily impose the
proposed modified uptick rule for that security.
    As discussed above, questions persist about the reasons for the
rapid speed of steep declines in the prices of securities. A short
selling circuit breaker rule would be designed to target only those
securities that experience rapid severe intraday declines and,
therefore, might help to prevent short selling from being used to drive
the price of a security down or to accelerate the decline in the price
of those securities.
    In line with the Commission's position that market impediments
should be minimized, a short selling circuit breaker when applied might
benefit the market as a narrowly tailored response to extraordinary
circumstances.\230\ Unlike the market wide circuit breakers that halt
all trading, a short selling circuit breaker would apply only to those
individual securities that are facing a severe intraday decline in
share price. A short selling circuit breaker could be structured in a
number of ways. We set forth below three forms of circuit breakers.
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    \230\ See Securities Exchange Act Release No. 39846 (Apr. 9,
1998), 63 FR 18477 (Apr. 15, 1998) (order approving proposals by
Amex, BSE, CHX, NASD, NYSE, and Phlx) (``1998 Release'').
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1. Background on Circuit Breakers
    To protect investors and the markets, the Commission has approved
proposals to restrict or halt trading if key market indexes fall by
specified amounts. For example, the Commission approved such proposals
from various exchanges (``SRO Circuit Breakers'') in response to the
October 1987 market break. These measures were designed to permit
brief, coordinated cross-market halts to provide opportunities during a
severe market decline to re-establish equilibrium between buying and
selling interests in an orderly fashion, and help to ensure that market
participants have a reasonable opportunity to become aware of, and
respond to, significant price movements.\231\
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    \231\ See Securities Exchange Act Release No. 26198 (Oct. 19,
1988), 53 FR 41637 (Oct. 24, 1988) (approving rules of the Amex,
CBOE, NASD, NYSE).
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    Currently, all stock exchanges and FINRA have rules or policies to
implement coordinated circuit breaker halts.\232\ The options markets
also have rules applying circuit breakers.\233\ The futures exchanges
that trade index futures contracts have adopted circuit breaker halt
procedures in conjunction with their price limit rules for index
products.\234\ Finally, security futures products are required to have
cross-market circuit breaker regulatory halt procedures in place.\235\
In addition, the Commission has authority under Section 12(k)(1) of the
Exchange Act to suspend trading in the securities of individual
issuers.\236\ Moreover, SROs have rules or policies in place to
coordinate individual security trading halts corresponding to
significant news events.\237\ Information on the securities subject to
SRO regulatory trading halts is disseminated to market participants
through the Common Messaging System (``CMS'') and other electronic
media.\238\
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    \232\ See 1998 Release supra note 230. See also NYSE Rule 80B.
The circuit breaker procedures call for cross-market trading halts
when the Dow Jones Industrial Average (DJIA) declines by 10 percent,
20 percent, and 30 percent from the previous day's closing value.
See e.g., BATS Exchange Rule 11.18.
    \233\ See Amex Rule 950 (applying Amex Rule 117, Trading Halts
Due to Extraordinary Market Volatility, to options transactions);
CBOE Rule 6.3B; ISE Rule 703; NYSE Arca Options Rule 7.5; and Phlx
Rule 133.
    \234\ See, e.g., CME Rule 35102.I. The CME will implement a
trading halt on S&P 500 Index futures contracts if a NYSE Rule 80B
trading halt is imposed in the primary securities market. Trading of
S&P 500 Index futures contracts will resume upon lifting of the NYSE
Rule 80B trading halt.
    \235\ See Securities Exchange Act Release No. 45956 (May 17,
2002), 67 FR 36740 (May 24, 2002).
    \236\ See 15 U.S.C. 78l(k)(1).
    \237\ See, e.g., FINRA Rule 6120.
    \238\ For example, in addition to disseminating news of trading
halts through the CMS, Nasdaq publishes a daily list of securities
subject to trading halts indicating the name of the issuer, the time
the halt was initiated, and where applicable, the times at which
quoting and trading may resume.
---------------------------------------------------------------------------

    The current SRO Circuit Breakers impose percentage based triggers
that result in trading halts of varying lengths, dependent on the
DJIA's rate of decline.\239\ Unlike the original SRO

Circuit Breakers, which used set point values to determine when a
trading halt should be imposed, the current SRO Circuit Breakers are
governed by percentage based declines tied to specific point values
that are calculated at the beginning of each calendar quarter using the
average daily DJIA closing for the previous month.\240\
---------------------------------------------------------------------------

    \239\ See 1998 Release 63 FR 18477 supra note 230 and
accompanying text (The SRO Circuit Breakers, as adopted in 1988,
called for a one-hour trading halt if the DJIA declined by 250
points from the previous day's close, and a two-hour halt in the
event of a 400 point decline.). See Securities Exchange Act Release
No. 26198 (Oct. 19, 1988), 53 FR 41637 (Oct.24, 1988) (approving
rules of the Amex, CBOE, NASD, NYSE). The original circuit breaker
parameters were amended in 1996 to limit the duration of trading
halts, and again in 1997 after it was determined that the 250 and
400 point thresholds were too low given the substantial increase in
the value of the DJIA in the years following implementation of 1988
policies. The 1997 amendments increased the SRO Circuit Breakers'
``trigger values'' to 350 and 500 points respectively for the one-
hour and two-hour trading halt scenarios. See Securities Exchange
Act Release No. 38221 (Jan. 31, 1997) 62 FR 5871 (Feb. 7, 1997). The
Commission approved the various Exchanges' circuit breaker revisions
on a one year pilot basis. The SRO Circuit Breakers were revised
again in 1998 to put into place circuit breakers triggered by
certain percentage declines. See Securities Exchange Act Release No.
39846 (Apr. 9, 1998) 63 FR 18477 (Apr. 15, 1998).
    \240\ See id.
---------------------------------------------------------------------------

    Under the current SRO Circuit Breakers, a 10% decline prior to 2
p.m. will result in a one hour trading halt. Should the 10% decline
occur after 2 p.m. but prior to 2:30 p.m., exchanges must halt trading
for 30 minutes. If the 10% threshold is crossed after 2:30 p.m.,
trading will not be halted. A 20% decline in the DJIA will result in a
two-hour trading halt, if the decline occurs prior to 1 p.m. and a one-
hour trading halt if the threshold is reached between 1 p.m., and 2
p.m. If the DJIA declines by 20% after 2 p.m., under the current
circuit breaker rules, trading will halt for the remainder of the day.
Should the market decline by 30% at any point, trading will halt for
the remainder of the day.\241\ The coordinated cross-market trading
halts provided by the SRO Circuit Breakers operate only during
significant market declines and are intended to substitute orderly,
pre-planned halts for the ad hoc and destabilizing halts which can
occur when market liquidity is exhausted.\242\
---------------------------------------------------------------------------

    \241\ See 1998 Release, 63 FR 18477 supra note 230.
    \242\ See Circuit Breaker Report by the Staff of the President's
Working Group on Financial Markets (Aug. 18, 1998) (Circuit Breaker
Report), n. 33.
---------------------------------------------------------------------------

    The SRO Circuit Breakers focus on market indexes rather than on the
market for an individual security. The SRO Circuit Breakers apply a
market-wide trading halt, rather than a halt in an individual security,
or a short selling halt. The proposed circuit breaker rules, in
contrast, would temporarily restrict only short selling (and only) in
an individual NMS security that suffers a severe price decline.
    We believe that either a short sale price test restriction or a
circuit breaker rule may be appropriate to address the recent change in
market conditions and erosion of investor confidence. As discussed
above, investors have become increasingly concerned about sudden and
excessive declines in prices that appear to be unrelated to issuer
fundamentals.\243\ Circuit breakers that are triggered by severe
declines in the price of individual securities may be a targeted
response to address these concerns.
---------------------------------------------------------------------------

    \243\ See supra Section II.C. (discussing investor confidence).
---------------------------------------------------------------------------

2. Proposed Circuit Breaker Halt Rule
    We are proposing a short selling circuit breaker that, when
triggered by a severe price decline in a particular security, would
prohibit any person from selling short that security, wherever it is
traded, while the circuit breaker is in effect, subject to certain
exceptions.
    While the Commission does not favor market closings as a general
matter, the proposed circuit breaker halt rule would not be as broad as
a market-wide trading halt. Furthermore, the Commission has recognized
that circumstances may infrequently call for a trading pause that
allows participants to reassess conditions.\244\ We believe that a
pause in short selling resulting from a significant decline in the
price of an individual equity security might provide a similar measure
of stability.
---------------------------------------------------------------------------

    \244\ See 1998 Release, 63 FR 18477 supra note 230.
---------------------------------------------------------------------------

    We seek comment on whether it would be appropriate for the
Commission to impose a circuit breaker that when triggered would halt
all short selling in an individual equity security, wherever it is
traded, for the remainder of the trading day if the price of the
security has declined by at least 10% from the prior day's closing
price for that security, as measured by the closing price of the
security on the consolidated system. Like the proposed modified uptick
rule and the proposed uptick rule, we propose that it would apply to
all NMS stocks as that term is defined under Rule 600(a)(47) of
Regulation NMS.\245\ We seek comment regarding the scope of a potential
circuit breaker's application and to which securities it might most
appropriately apply.
---------------------------------------------------------------------------

    \245\ See proposed Rule 201(a)(1).
---------------------------------------------------------------------------

    We preliminarily believe that a 10% decline in a security's price
as measured from the prior day's closing price, as reported in the
consolidated system, would be an appropriate level at which to trigger
a circuit breaker that results in a short selling halt. As discussed
above, such a percentage decline would be consistent with the current
SRO Circuit Breakers.\246\ The 10% threshold for a circuit breaker
that, when triggered, results in a short selling halt in an individual
security would reflect the format of current SRO Circuit Breakers and
use a trigger based on a fluctuating value, the share price, to strike
a balance between the need to halt short selling in moments of severe
decline in a security's price and the market participant's expectation
that its short selling strategy will be available in an efficient and
open marketplace. We note that a group of national securities exchanges
recommended a 10% decline threshold in connection with a short selling
circuit breaker combined with a short sale price test restriction.\247\
Another commenter supported a 10% minimum threshold, but also
recommended a ``rolling'' circuit breaker that when triggered would
impose short selling halts of varying lengths, depending on the level
of decline in the price of an individual equity security.\248\ We
recognize that a lesser or greater percentage decline or some other
measure of decline may be appropriate, and seek comment on that
question.
---------------------------------------------------------------------------

    \246\ See 1998 Release, 63 FR 18477 supra note 230 and
accompanying text.
    \247\ See National Exchanges letter, supra note 63.
    \248\ See letter from Credit Suisse, supra note 122.
---------------------------------------------------------------------------

    As described in more detail below, the price decline would be based
on the security's price during the trading day as reported in the
consolidated system as compared to the prior day's closing price as
reported in the consolidated system. The prior day's closing price
would be the last price reported during regular trading hours \249\ the
prior day.
---------------------------------------------------------------------------

    \249\ ``Regular trading hours'' has the same meaning as in Rule
600(b)(64) of Regulation NMS. Rule 600(b)(64) provides that
``Regular trading hours means the time between 9:30 a.m. and 4 p.m.
Eastern Time, or such other time as is set forth in the procedures
established pursuant to Sec.  242.605(a)(2).''
---------------------------------------------------------------------------

    The proposed circuit breaker halt rule would, once triggered by a
10% decline in the price of a security from the prior day's closing
price on any trading day, impose a short selling halt in the individual
security at times when the last sale price is calculated and
disseminated in the consolidated system. We based the time period on
the calculation and dissemination of last sale price because the
circuit breaker is triggered by a percentage decline in the security's
intra-day last sale price relative to the prior day's last sale price
at the end of regular trading hours on the prior day.
    In addition, to avoid market disruption that may occur if a circuit
breaker is triggered late in the trading day, the proposed circuit
breaker rules would not be triggered if the specified market decline
threshold is reached in an NMS security within thirty minutes of the
end of regular trading hours. Former NYSE Rules 80A(a) and 80A(b)
provided that a circuit breaker would not trigger program trading
restrictions after 3:25 p.m., or approximately thirty-five minutes
before the close. We seek comment as to whether thirty minutes is an
appropriate balance to ensure that

the goals of the proposed rule would be met while also reducing the
potential for market disruption toward the close of regular trading
hours.
    We believe that a short selling halt that persists at times when
the last sale price is calculated and disseminated following a 10%
decline in a security's price might be appropriate. We are concerned
that a short selling halt for a lesser time might not provide
sufficient time to re-establish equilibrium between buying and selling
interest in the individual security in an orderly fashion. We also
believe that a short selling halt for this length of time might be
necessary to help ensure that market participants have a reasonable
opportunity to become aware of, and respond to, a significant decline
in a security's price. We seek comment below, however, regarding
whether a longer or shorter short selling halt would be appropriate, or
whether it would be appropriate to impose a short selling halt on a
rolling basis as suggested by an industry commenter.\250\
---------------------------------------------------------------------------

    \250\ See letter from Credit Suisse supra note 122.
---------------------------------------------------------------------------

    We are also seeking comment on the potential costs and benefits of
a short selling circuit breaker that when triggered results in a
temporary halt on short selling. The Commission has previously noted
that circuit breakers may benefit the market by allowing participants
an opportunity to reevaluate circumstances and respond to
volatility.\251\ Unlike the proposed modified uptick rule and the
proposed uptick rule, this proposed circuit breaker halt rule would
halt all short selling for an individual security for the specified
period of time. In discussing a short selling circuit breaker, one
commenter noted that such a measure could address the issue of ``bear
raids'' while limiting the market impact that may arise from other
forms of short sale price test restrictions.\252\ The Commission has
long held the view that coordinated circuit breakers might restore
investor confidence during times of substantial uncertainty.\253\ We
believe the proposed circuit breaker halt rule might produce similar
benefits.
---------------------------------------------------------------------------

    \251\ See 1998 Release, 63 FR 18477.
    \252\ See Brown Letter supra note 55.
    \253\ See 1998 Release, 63 FR 18477 supra note 230.
---------------------------------------------------------------------------

    We recognize, however, that there are potential costs associated
with implementation of a short selling circuit breaker that when
triggered results in a temporary short selling halt. As discussed
below, we anticipate that market participants charged with
implementation of such a short selling circuit breaker would have to
invest human and financial resources to update systems as necessary for
compliance. Furthermore, as discussed above, short selling is an
important tool in price discovery and the provision of liquidity to the
market, and we recognize that imposition of a short selling circuit
breaker that when triggered imposes short selling halts could restrict
otherwise legitimate short selling activity during periods of extreme
volatility.
    We also understand there are concerns about a potential ``magnet
effect'' that could arise as an unintended consequence of a circuit
breaker that halts short selling and results in short sellers driving
down the price of an equity security in a rush to execute short sales
before the circuit breaker is triggered. One commenter noted that a
short sale circuit breaker could exacerbate downward pressure on stocks
as their value reached the threshold level.\254\ Another commenter,
however, in discussing the issue of a ``magnet effect'' cited empirical
studies that question whether a circuit breaker would result in
artificial pressure on the price of individual securities.\255\ We are
also concerned about another type of ``magnet effect'' in which short
selling demand is built up until the circuit breaker is lifted.
---------------------------------------------------------------------------

    \254\ See letter to Mary Schapiro, Chairman, from Direct Edge,
dated March 30, 2009.
    \255\ See letter from Credit Suisse supra note 122.
---------------------------------------------------------------------------

    Similar to the short sale price test restrictions, the proposed
circuit breaker halt rule would apply to NMS securities other than
options. However, we seek comment below on whether such a rule should
also apply to non-NMS securities.
    The proposed circuit breaker halt rule would include exceptions
substantially identical to exceptions that were included in the Short
Sale Ban Emergency Order,\256\ as amended by the Commission on
September 21, 2008 (``September 21, 2008 Amended Order'')
(collectively, the ``Short Sale Ban'').\257\ We believe the proposed
circuit breaker halt rule should include exceptions that mirror certain
of the exceptions in the Short Sale Ban because the proposed rule
shares the same goal of prohibiting short selling that might exacerbate
a price decline during a period of sudden and excessive price declines,
while being designed to maintain functions that, for example, would be
necessary to help provide adequate liquidity. Short sales effected
under these exceptions would be marked ``short exempt.''
---------------------------------------------------------------------------

    \256\ See Short Sale Ban Emergency Order, 73 FR 55169-02 (Sept.
24, 2008).
    \257\ See September 21, 2008 Amendment, 73 FR 55556-01 (Sept.
25, 2008).
---------------------------------------------------------------------------

    The proposed circuit breaker halt rule could operate in place of,
or in addition to, a short sale price test restriction. For instance,
in addition to the imposition of a permanent, market-wide price test
restriction, a circuit breaker halt rule could also prohibit any person
from selling short any security that suffers a severe price decline.
a. Market Makers and Options Market Makers Engaged in Bona Fide Market
Making Activities
    The Short Sale Ban excepted registered market makers, block
positioners, or other market makers obligated to quote in the over-the-
counter market, if they were selling short a publicly traded security
covered by the Short Sale Ban as part of bona fide market making in
such security.\258\ The purpose of the exception was to permit market
makers to continue to provide liquidity to the markets, facilitate
orders including customer buy orders, and otherwise comply with their
obligations as market makers.
---------------------------------------------------------------------------

    \258\ See id.
---------------------------------------------------------------------------

    The term ``market maker'' includes any specialist permitted to act
as a dealer, any dealer acting in the capacity of a block positioner,
and any dealer who, with respect to a security, holds itself out (by
entering quotations in an inter-dealer quotation system or otherwise)
as being willing to buy and sell such security for its own account on a
regular or continuous basis.\259\ As the Commission has stated
previously, a market maker engaged in bona fide market making is a
``broker-dealer that deals on a regular basis with other broker-
dealers, actively buying and selling the subject security as well as
regularly and continuously placing quotations in a quotation medium on
both the bid and ask side of the market.'' \260\ We recently provided
guidance on bona fide market making for purposes of Regulation SHO Rule
203(b), and believe that such guidance would also be appropriate with
regard to a market maker exception for the proposed circuit breaker
halt rule.\261\ We believe it is appropriate to include a market maker
exception for this proposed alternative because a halt in short selling
in a security would, during the period of the halt, have far greater
effects on liquidity and legitimate price discovery activity than the
proposed modified uptick rule or proposed uptick

rule, which, as discussed above, are each based on a trading unit
increment.
---------------------------------------------------------------------------

    \259\ See 2004 Regulation SHO Adopting Release, 69 FR at 48015,
n. 66 (citing to Section 3(a)(38) of the Exchange Act).
    \260\ See Exchange Act Release No. 32632 (July 14, 1993), 58 FR
39072, 39074 (July 21, 1993).
    \261\ See Exchange Act Release No. 58775 (Oct. 14, 2008); 73 FR
61690 (Oct. 17, 2008).
---------------------------------------------------------------------------

b. Bona Fide Market Making in Derivatives
    The Short Sale Ban also included an exception for any person that
is a market maker that effects a short sale as part of bona fide market
making and hedging activity related directly to bona fide market making
in derivatives on the publicly traded securities of any security
covered by the Short Sale Ban.\262\ Under the Short Sale Ban, this
exception applied to all market makers, including over-the-counter
market makers, and to bona fide market making and hedging activity
related directly to bona fide market making in exchange traded funds
and exchange traded notes of which securities included in the Short
Sale Ban were a component. We stated that the purpose of the exception
was to permit market makers to continue to provide liquidity to the
markets.\263\ Similarly, we believe such an exception would be
appropriate for the proposed circuit breaker halt rule.
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    \262\ See Short Sale Ban Emergency Order, 73 FR 55169-02.
    \263\ See id.
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    During the period that the Short Sale Ban was effective, to help
ensure that the exception would not result in increased short exposure
in securities covered by the Short Sale Ban, we limited the exception
so that if a customer or counterparty position in a derivative security
based on the security was established after the effectiveness of the
September 21 Amended Order, a market maker could not effect the short
sale if the market maker knew that the customer's or counterparty's
transaction would result in the customer or counterparty establishing
or increasing an economic net short position (i.e., through actual
positions, derivatives, or otherwise) in the issued share capital of a
firm covered by the Short Sale Ban. This provision was included to
address potential circumvention of the Short Sale Ban during the
several weeks that it was in effect.\264\ However, we do not believe
such a provision is necessary for the proposed circuit breaker halt
rule because the rule as proposed only contemplates a one-day (or less
than one day depending on when during the day the circuit breaker is
triggered) prohibition on short selling of any NMS security that
becomes subject to the circuit breaker.
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    \264\ See September 21, 2008 Amendment, 73 FR 55556-01.
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c. Options and Futures Contract Expiration
    The Short Sale Ban included an exception to allow short sales that
occurred as a result of automatic exercise or assignment of an equity
option held prior to effectiveness of the Short Sale Ban due to
expiration of the option.\265\ It also allowed short sales that
occurred as a result of the expiration of futures contracts held prior
to effectiveness of the Short Sale Ban.\266\
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    \265\ See Short Sale Ban Emergency Order, 73 FR 55169-02.
    \266\ See id.
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    We propose including a similar exception for the proposed circuit
breaker halt rule for short sales that occur as a result of automatic
exercise or assignment of an equity option held before a circuit
breaker on a particular security is triggered and a short selling halt
is imposed in that security due to expiration of the option. We are
also proposing an exception to the proposed circuit breaker halt rule
to allow short sales that occur as a result of the expiration of
futures contracts held before a circuit breaker is triggered in a
particular security.
    Persons that purchased or sold options prior to the effectiveness
of a circuit breaker halt entered into such transactions with the
expectation that they would be able to fulfill their contractual
obligations and receive the benefits of their bargain in return.
Generally, options contracts are purchased or sold prior to the day in
which a circuit breaker might be triggered. Therefore, providing an
exception to the proposed circuit breaker halt rule to allow such
persons to continue to rely on their pre-existing transactions until
completion does not raise the concerns that the proposed circuit
breaker halt rule is intended to address. As with the Short Sale Ban,
we propose to limit this exception to automatic exercises and
assignments to prevent it from being abused by more discretionary
options exercises.
d. Exception for Assignment To Call Writers Upon Exercise of an Option
    To allow for creation of long call options, the Short Sale Ban
included an exception to permit short sales that occur as a result of
assignment to call writers upon exercise.\267\ When options are
exercised, call writers may be required to sell short in order to
satisfy their obligations. Because call writers do not have discretion,
and because the short sales are effected in order to fill buying
demand, we believe that including this exception in the proposed
circuit breaker halt rule would benefit the markets while not opening
the door to the abuses that the proposed rule is intended to address.
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    \267\ See September 21, 2008 Amendment, 73 FR 55556-01.
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e. Owned Securities
    The Short Sale Ban provided that sales of Rule 144 securities were
excepted from its requirements because Rule 144 securities are owned
securities and do not raise the concerns that the Short Sale Ban was
designed to address.\268\ We believe a similar exception for securities
that a seller is deemed to own under Rule 200(b) should be included in
the proposal.
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    \268\ See id.
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    Rule 200(g)(1) of Regulation SHO provides that a sale can be marked
``long'' only if the seller is deemed to own the security being sold
and either (i) the security is in the broker-dealer's physical
possession or control, or (ii) it is reasonably expected that the
security will be in the broker-dealer's physical possession or control
by settlement of the transaction.\269\ Thus, even where a seller owns a
security, if delivery will be delayed, such as in the sale of formerly
restricted securities pursuant to Rule 144 of the Securities Act of
1933, or 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, such sales must
be marked ``short.'' \270\ As a result, during a halt triggered by a
circuit breaker, sellers would be permitted to sell securities that
although owned, are subject to the provisions of Regulation SHO
governing short sales due solely to the seller being unable to deliver
the security to its broker-dealer prior to settlement based on
circumstances outside the seller's control.
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    \269\ See 17 CFR 242.200(g)(1).
    \270\ See id.
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    Although the Short Sale Ban only excepted Rule 144 securities, we
believe that other securities considered ``deemed to own'' for purposes
of Rule 200(b) should also be excepted from the proposed circuit
breaker halt rule because these are owned securities that do not raise
the same concerns that the proposed rule is designed to address.
3. Proposed Circuit Breaker Price Test Rules
    We are also proposing a short selling circuit breaker that, when
triggered by a severe decline in the price of a particular security,
would impose short sale price restrictions for that security

wherever it is traded for the remainder of the trading day. Such a
circuit breaker would be imposed in place of a permanent, market-wide
short sale price test restriction.
    Similar to the reasons stated in the discussion above regarding the
proposed circuit breaker halt rule, a circuit breaker price test rule
would be triggered by a 10% intraday decline in the price of an
individual equity security from the prior day's closing price as
reported in the consolidated system. We preliminarily believe that a
10% decline in a security's price as measured from the prior day's
closing price, as reported in the consolidated system, would be an
appropriate level at which to trigger a circuit breaker that results in
a short sale price test restriction. As discussed above, such a
percentage decline would be consistent with the current SRO Circuit
Breakers.\271\ We recognize that a lesser or greater percentage decline
or some other measure of decline may be appropriate.
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    \271\ See 1998 Release, 63 FR 18477 supra note 230 and
accompanying text.
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    We also seek comment regarding the form of the short sale price
test restrictions that could be imposed when the proposed circuit
breaker is triggered. Such a circuit breaker when triggered could
impose a short sale price test restriction in the form of the proposed
modified uptick rule based on the national best bid, or in the form of
the proposed uptick rule based on the last sale price of the individual
security. This would include the same proposed short sale price test
and provisions that would be used in the proposed modified uptick and
proposed uptick rules, permitting certain sales to occur
notwithstanding the price limitations otherwise applicable under the
two proposed rules.\272\ We believe these provisions would be justified
for the same reasons described regarding the proposed modified uptick
rule and the proposed uptick rule, respectively.\273\
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    \272\ See Section III.A. and III.B. (discussing the operation of
the proposed modified uptick rule and the proposed uptick rule
respectively).
    \273\ See Sections III.A.2. and III.B.2. (discussing the short
exempt provisions of the proposed modified uptick rule and proposed
uptick rule, respectively).
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    As described in more detail below, the price decline would be based
on the security's price during the trading day as reported in the
consolidated system as compared to the prior day's closing price as
reported in the consolidated system. The prior day's closing price
would be the last price reported during regular trading hours \274\ the
prior day.
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    \274\ ``Regular trading hours'' has the same meaning as in Rule
600(b)(64) of Regulation NMS. Rule 600(b)(64) provides that
``Regular trading hours means the time between 9:30 a.m. and 4 p.m.
Eastern Time, or such other time as is set forth in the procedures
established pursuant to Sec.  242.605(a)(2).''
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    The proposed circuit breaker modified uptick rule would, once
triggered by a 10% decline in the price of a security from the prior
day's closing price, impose the modified uptick rule in the individual
security at times when the national best bid is calculated and
disseminated in the consolidated system, for the remainder of the
trading day. We based the time period on the calculation and
dissemination of the national best bid in the consolidated system
because the proposed modified uptick rule is based on the national best
bid as calculated and disseminated in the consolidated system.
    Similarly, the proposed circuit breaker uptick rule would, once
triggered by a 10% decline in the price of a security from the prior
day's closing price on any trading day, impose the uptick rule in the
individual security at times when the last sale price is calculated and
disseminated in the consolidated system. We based the time period on
the calculation and dissemination of the last sale price because the
proposed uptick rule is based on the last sale price as calculated and
disseminated in the consolidated system.
    To avoid market disruption that may occur if a circuit breaker is
triggered late in the trading day, the proposed circuit breaker rules
would not be triggered if the specified market decline threshold is
reached in an NMS security within thirty minutes of the end of regular
trading hours. Former NYSE Rules 80A(a) and 80A(b) provided that a
circuit breaker would not trigger program trading restrictions after
3:25 p.m., or approximately thirty-five minutes before the close of
regular trading hours. As with the proposed circuit breaker halt rule,
we seek comment as to whether thirty minutes is an appropriate balance
to ensure that the goals of the proposed rule would be met while also
reducing the potential for market disruption toward the close of
regular trading hours.
    We believe that the temporary imposition of the proposed modified
uptick rule, after a circuit breaker is triggered, that operates at
times when the national best bid is disseminated following a 10%
decline in a security's price might be appropriate. Similarly, we
believe that the temporary imposition of the proposed uptick rule,
after a circuit breaker is triggered, that operates at times when the
last sale price is calculated and disseminated following a 10% decline
in a security's price might be appropriate. We seek comment below,
however, regarding whether longer or shorter time periods would be
appropriate.
    We are seeking comment on the potential benefits and costs of the
proposed circuit breaker price test rule. We believe that such a rule
might be a narrowly tailored means to help restore investor confidence
and stabilize the market for individual securities. Such a rule might
also help prevent short selling, including potentially abusive or
manipulative short selling, from being used as a tool for driving the
market down or from being used to accelerate a declining market by
exhausting all remaining bids at one price level, causing successively
lower prices to be established by long sellers. Further, we note that
allowing short selling to continue with price test restrictions once
the circuit breaker is triggered might have a lesser impact on
legitimate short selling and normal market activity including price
discovery and the provision of liquidity than a circuit breaker that
triggers a short selling halt. We also believe that a circuit breaker
rule that triggers a price test restriction, because it is based on a
trading increment of a penny as opposed to a short sale halt, may also
alleviate some concerns over the possibility of artificial downward
pressure that might arise from a ``magnet effect'' prior to reaching
the trigger threshold.
    We recognize that a short selling circuit breaker that, when
triggered, imposes short sale price test restrictions for the remainder
of the trading day, would result in costs on market participants
responsible for implementing and assuring compliance with the
requirements of such restrictions. There might be significant
operational costs associated with reprogramming systems to comply with
short sale price test restrictions, and we anticipate that these costs
might be greater than those required to comply with a short selling
circuit breaker that, when triggered, imposes halts on short selling in
individual securities. There might also be requirements for additional
staff and costs associated with personnel hiring and training related
to maintaining and ensuring compliance with any short sale price test
restrictions.\275\
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    \275\ See, e.g., Credit Suisse letter, supra note 122.
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    Further, we recognize that short sale price test restrictions
imposed as a result of a circuit breaker might result in many of the
same costs discussed in detail in Section IX pertaining to the
implementation of market-wide short

sale price test restrictions.\276\ Those costs might include a
reduction of the benefit of legitimate short selling and a subsequent
reduction in the quantity of short selling, which we have noted might
lead to a decrease in market quality and price discovery, less
protection against upward stock price manipulations, a less efficient
allocation of capital, an increase in trading costs, and a decrease in
liquidity.\277\ We are seeking comment on the extent of these and other
costs associated with a circuit breaker that when triggered imposes
short sale price test restrictions.
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    \276\ See Section IX (discussing costs and benefits of the
proposed modified uptick rule and the proposed uptick rule).
    \277\ See Section IX.B.
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    The proposed circuit breaker price test rule would result in either
the proposed modified uptick rule or the proposed uptick rule, for the
remainder of the trading day, as each proposed rule is described above.
For instance, a circuit breaker resulting in the proposed modified
uptick rule would require that trading centers establish, maintain, and
enforce policies and procedures reasonably designed to prevent short
selling on a downbid in a security where the circuit breaker has been
triggered by a severe decline in the price of that NMS security.
Broker-dealers could mark certain short sale orders ``short-exempt''
under the conditions set forth above. A circuit breaker that resulted
in the proposed uptick rule would, when triggered by a decline in the
price of a particular security, prohibit any person from selling short
that security on a downtick. This would be a more limited approach than
a short sale price test rule that is in place at all times and thus
might result in fewer of the potential disadvantages that would result
from a short sale price test that was in place at all times.
    Under the proposed circuit breaker price test rule, a price test
would not be in place on a permanent and market-wide basis for all
securities. Under the proposed circuit breaker that results in the
proposed modified uptick rule, trading centers would need to establish
and maintain reasonable policies and procedures in advance so that they
are able to comply with the proposed circuit breaker rule whenever
triggered. It would not be reasonable for a trading center to wait
until the circuit breaker is triggered to begin establishing policies
and procedures to prevent the execution or display of the particular
security on a downbid. Thus, a circuit breaker that triggers the
proposed modified uptick rule would result in some immediate upfront
costs to trading centers.
    In the Solicitation of Comments, we seek comment on whether the
short sale price test restrictions should remain in place for a longer
or shorter period of time, whether a 10% decline would be an
appropriate trigger for the circuit breaker proposals, or if for
example, a 5% or 20% threshold might be more appropriate, and what
additional costs may be associated with a proposed circuit breaker
price test rule.

IV. Request for Comment

    In addition to the specific requests for comment found throughout
this proposing release, we seek comment generally from all members of
the public on all aspects of the proposed amendments to Rules 200(g)
and 201 of Regulation SHO. We request that commenters provide empirical
data to support their views and arguments related to these proposals.
In addition to the questions set forth above, commenters are welcome to
offer their views on any other matter raised by the proposed amendments
to Regulation SHO. Specifically, are there any other possible
restrictions on short selling that the Commission should consider,
particularly ones that might be helpful in a severe market decline?
Questions Regarding Proposed Short Sale Price Tests Generally
    1. Should short sales be subject to a short sale price test
restriction, or should we continue to rely on current short sale
regulations and anti-fraud and anti-manipulation provisions of the