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May 16, 2007

Naked Short Positions Still Under SEC Scrutiny

By Peter Chapman

Should market makers be able to maintain uncovered short sale positions in certain so-called threshold securities indefinitely?

The Securities and Exchange Commission still hasn't made up its mind. It originally OK'd the idea, in early 2005, but then flip-flopped last September.

In March, it reopened the comment period covering its proposal to rescind an exception to its Regulation SHO that allowed dealers to maintain certain so-called "naked" short-sale positions indefinitely. Reg SHO, which covers short-sale tick tests as well as naked short sales, is in pilot phase.

The new comment period, now ended, was undertaken to make some previously confidential data available to the public.

However, the release of the data only proves that Reg SHO is working well and that there is no need to rescind the exception for certain threshold securities, according to one big market maker.

"The data shows that Reg SHO has indeed worked," said Len Amoruso, Knight Capital Group's chief compliance officer and co-head of the office of general counsel. "The data seem to support the fact that you don't need to eliminate the grandfather clause."

Reg SHO's grandfather clause permits market makers to maintain open short positions in securities that landed on an exchange's "threshold" list after they put on the position.

A threshold list covers the names of securities sold short but not delivered within the standard three business days. The grandfather provision makes it possible for dealers to take on a risky short position when handling a customer order without fear that they might have to close the position at a loss.

Critics complain that brokers should not be allowed to sell stock and not deliver the securities within the three-day settlement period. The debate has grown heated in recent years.

The information just made available by the SEC was gathered by the NASD and covers Nasdaq threshold securities. It is about two years old. The data show that 58 securities out of 379 remained on the threshold list eight months into the Reg SHO pilot, which began in January 2005. On a recent day in April, Amoruso noted, only 12 securities were on Nasdaq's list.

The drop means Reg SHO is working, according to Amoruso. "Dealers are closing out their fails," he explained. "The fails are not extending for as long as they used to. Firms may not be as aggressive in putting on short positions."

Despite the decline, the SEC still appears inclined to eliminate the grandfather clause. Chairman Christopher Cox, testifying before a congressional committee on the SEC's fiscal year 2008 budget, told the representatives that naked short selling is a significant concern for the regulator.

Reg SHO "has been inadequate to shut down the problem," Cox said. "We are in the process right now of tightening up our rules on that."

The SEC has received hundreds of letters from angry Americans decrying naked short selling. The SEC told Traders Magazine it will make a final decision in "late spring."