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June 2, 2009

Short Sales: SEC Expected to Rule on Fails

By Nina Mehta

The Securities and Exchange Commission is expected to make permanent an emergency order it instituted last September to reduce naked short selling. The temporary rule, known as Rule 204T, was put in place when markets were in free fall and investors blamed abusive short-selling practices for the decline. The rule expires on July 31.

"I expect the Commission to consider adoption of that [rule]," said James Brigagliano, co-acting director of the SEC's Division of Trading and Markets. He added that the SEC could "adopt it as it exists or in response to comments" from the industry. Brigagliano spoke at a Security Traders Association conference in Washington, D.C., last month.

Kevin Cronin

Rule 204T requires clearing firms, by 9:30 a.m. on the day after settlement date, which is the third day after the trade, or T+3, to close out short sales that did not settle. The SEC added Rule 204T to Regulation SHO to counter naked short selling, in which investors fail to borrow the shares needed for settlement. Abusive naked short selling occurs when investors deliberately don't borrow the shares.

The SEC's rule imposes strict penalties on firms whose internal desks or customers flout the new rule. Until the failed trades settle, those firms must "pre-borrow" (arrange in advance to borrow) shares for new short sales in that name, instead of simply locating the shares. That raises trading costs for those firms.

Richard Ketchum, the newly installed head of the Financial Industry Regulatory Authority, called Rule 204T a success. "It's remarkable how well that has worked," he said at the STA conference. He noted that it was implemented "in a fairly short time when firms didn't even have technology systems in place."

Industry members also support the rule. Kevin Cronin, director of global equity trading at mutual fund giant Invesco, said the problem of naked short selling "has been effectively dealt with through Rule 204T." At last month's SEC roundtable discussion on short selling, Cronin said the rule should be made permanent.

According to the SEC's Office of Economic Analysis, the average daily number of stocks on the "threshold list" of securities (those with large and persistent levels of failures-to-deliver, which represent stock sold short whose shares were never borrowed) decreased to 63 per day in March, down from nearly 600 last July. Overall, the daily fails in all securities declined 81 percent to 0.43 billion shares on March 31, from a high of 2.2 billion shares last July 16. Fails can result from abusive naked short selling as well as operational glitches.

But not everybody thinks the SEC is off the hook. Roel Campos, a former SEC commissioner who is now a partner at law firm Cooley Godward Kronish, credits the SEC with reducing fails. But he doesn't think the agency went far enough. "Failures-to-deliver, a proxy for naked short selling, continue to occur in companies that do not appear on the Regulation SHO threshold list," he wrote in a letter to the SEC on behalf of a dozen issuers. This can happen when the company has a large number of shares outstanding, raising the bar to get on the threshold list. Campos thinks the SEC should require investors to pre-borrow shares for all short sales.

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