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January 2, 2007

REG SHO'S Grandfather Clause to Get the Boot?

By Peter Chapman

Market makers are protesting a Securities and Exchange Commission proposal to tighten up its short sale rules.

Top wholesalers Knight Capital Group, UBS Securities and Bernard L. Madoff Investment Securities are voicing their concerns in letters and in public forums over an SEC proposal to scrap an exception to Regulation SHO.

The two-year-old Reg SHO is the first major update of short sale regulation in the U.S. since 1938. It addresses failures to deliver and price tests.

"This is going to have a serious impact on our ability to make markets," Mark Madoff, co-director of trading at the family-owned firm, said of the SEC's plan. He spoke on a panel at the Security Traders Association's annual conference.

At issue is the regulator's plan to eliminate the so-called "grandfather" exemption of Reg SHO's Rule 203(b)(3). This loophole allows a market maker to avoid delivering a security he has sold short. The exemption applies only to certain securities under specific circumstances.

Rule 203(b)(3) requires broker-dealers to close out their short positions in so-called "threshold" securities if they have failed to deliver the security to the buyer within 13 settlement days.

Threshold securities are those that have relatively high rates of non-delivery. They are typically less-liquid stocks that can be difficult to buy or borrow.

The self-regulatory organizations publish daily lists of their threshold securities. In total, about 300 names make the lists on any given day. They include exchange-listed as well as OTCBB stocks.

Currently, a broker-dealer is exempted from Rule 203(b)(3) if it shorts a security that became a threshold security in the days following the trade.

The exemption was granted to help market makers provide liquidity in thinly traded names without fear they will suddenly be forced to close out short positions.

Reg SHO has reduced the number of fails to deliver-the National Securities Clearing Corporation estimates only one percent of all trades result in fails to deliver-but the SEC wants to go further.

It believes most of the remaining fails-to-deliver stem from the exceptions for pre-threshold securities and options market makers.

"In fine-tuning Reg SHO," SEC commissioner Roel Campos remarked in a speech this summer, "our efforts are targeted at protecting a small universe of thinly-capitalized securities from abusive trading wherein the level of fails to deliver can harm the market for the security."

Knight, one of the largest market makers of thinly-traded securities, disagrees. It told the SEC that eliminating the ability of market makers to satisfy investor needs "will undoubtedly lead to less liquidity, greater volatility, and widening of spreads."

The elimination, according to the Securities Industry and Financial Markets Association (SIFMA), would also lead to a rash of short squeezes. And preventing short squeezes was why the SEC created the grandfather exemption in the first place, it said. A short squeeze occurs when shorts are forced to buy in their positions.

Michael Wolk, a Washington-based attorney with Foley & Larder, and an expert on Nasdaq issues who often represents the Security Traders Association, repeated SIFMA's position.

"The reason the grandfather exemption came about," Wolk explained at the STA's annual bash, "was because it was felt that a requirement that firms automatically close out their positions or borrow would cause wild price movements if everyone closed out their positions at the same time. Nothing has changed since [the SEC] first felt that way."

In its efforts to tighten up Reg SHO, the SEC is also considering rescinding an exemption for options market makers. At presstime, it had not made a decision on either issue.