38266 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

1See Exchange Act Release No. 58733 (Oct. 14, 

2008), 73 FR 61706 (Oct. 17, 2008) (‘‘Rule 204T 

Adopting Release’’). 

2Fails to deliver occur when a seller fails to 

deliver securities to the buyer when delivery is due. 

See infra note 16 and accompanying text. 

3See infra Section II (discussing other 

Commission actions aimed at reducing fails to 

deliver and addressing potentially abusive ‘‘naked’’ 

short selling). 

4See Rule 204T Adopting Release, 73 FR 61707. 

5See id. 

6See id. 

7See id. 

8See Memorandum from OEA Re: Impact of 

Recent SHO Rule Changes on Fails to Deliver, 

November 26, 2008 at http://www.sec.gov/ 

comments/s7-30-08/s73008-37.pdf; see also 

Memorandum from OEA Re: Impact of Recent SHO 

Rule Changes on Fails to Deliver, March 20, 2009 

at http://www.sec.gov/comments/s7-30-08/s73008- 

107.pdf; Memorandum from OEA Re: Impact of 

Recent SHO Rule Changes on Fails to Deliver, April 

16, 2009 (‘‘OEA April 2009 Memorandum’’) at 

http://www.sec.gov/comments/s7-30-08/s73008- 

121.pdf. 9The OEA April 2009 Memorandum defined the 

pre-Rule period as the period from January 1, 2008 

to September 22, 2008, and the post-Rule period as 

September 23, 2008 to March 31, 2009. The postRule period was also post elimination of the options 

market maker exception to Regulation SHO’s closeout requirement in Rule 203(b)(3) of Regulation 

SHO. See OEA April 2009 Memorandum; see also 

infra notes 38–41 and accompanying text. 

10See OEA April 2009 Memorandum. 

11We note in this regard that at a public 

Roundtable to Examine Short Sale Price Test and 

Circuit Breaker Restrictions held on May 5, 2009 

(the ‘‘Short Sale Price Test Roundtable’’), a number 

of participants of the Roundtable commented on the 

success of temporary Rule 204T at reducing fails to 

deliver and urged the Commission to adopt 

temporary Rule 204T as a permanent rule. See, e.g., 

http://www.sec.gov/spotlight/shortsales/ 

roundtable050509/shortsalesroundtable050509- 

transcript.txt. 

12We received approximately 120 comment 

letters in response to the Rule 204T Adopting 

Release. The comment letters are available on the 

Commission’s Internet Web site at http:// 

www.sec.gov/comments/s7-30-08/s73008.shtml. 

Further, as noted above, a number of participants 

at the Commission’s Short Sale Price Test 

Roundtable expressed views about temporary Rule 

204T. See e.g., http://www.sec.gov/spotlight/ 

shortsales/roundtable050509/ 

shortsalesroundtable050509-transcript.txt. See also 

comments to the Short Sale Price Test Roundtable 

at http://www.sec.gov/comments/4-581/4- 

581.shtml. 

SECURITIES AND EXCHANGE 

COMMISSION 

17 CFR Parts 200 and 242 

[Release No. 34–60388; File No. S7–30–08] 

RIN 3235–AK22 

Amendments to Regulation SHO 

AGENCY: Securities and Exchange 

Commission. 

ACTION: Final rule. 

SUMMARY: The Securities and Exchange 

Commission (‘‘Commission’’) is 

finalizing amendments to Regulation 

SHO under the Securities Exchange Act 

of 1934 (‘‘Exchange Act’’) by making 

permanent amendments contained in 

Interim Final Temporary Rule 204T 

(‘‘temporary Rule 204T’’) of Regulation 

SHO, with some modifications to 

address commenters’ concerns. These 

amendments are intended to help 

further our goal of reducing fails to 

deliver by maintaining the reductions in 

fails to deliver achieved by the adoption 

of temporary Rule 204T, as well as other 

actions taken by the Commission. In 

addition, these amendments are 

intended to help further our goal of 

addressing abusive ‘‘naked’’ short 

selling in all equity securities. These 

goals will be furthered by requiring that, 

subject to certain limited exceptions, if 

a participant of a registered clearing 

agency has a fail to deliver position at 

a registered clearing agency it must 

immediately purchase or borrow 

securities to close out the fail to deliver 

position by no later than the beginning 

of regular trading hours on the 

settlement day following the day the 

participant incurred the fail to deliver 

position. Failure to comply with the 

close-out requirement of this final rule 

is a violation of the rule. In addition, a 

participant that does not comply with 

this close-out requirement, and any 

broker-dealer from which it receives 

trades for clearance and settlement, will 

not be able to short sell the security 

either for itself or for the account of 

another, unless it has previously 

arranged to borrow or borrowed the 

security, until the fail to deliver position 

is closed out. 

DATES: Effective Date: July 31, 2009. 

FOR FURTHER INFORMATION CONTACT: Jo 

Anne Swindler, Acting Associate 

Director; Josephine Tao, Assistant 

Director; Victoria Crane, Branch Chief; 

David Bloom and Christina M. Adams, 

Special Counsels; Matthew Sparkes or 

Katrina Wilson, Staff Attorneys, Office 

of Trading Practices and Processing, 

Division of Trading and Markets, at 

(202) 551–5720, at the Commission, 100 

F Street, NE., Washington, DC 20549– 

7010. 

SUPPLEMENTARY INFORMATION: We are 

adding Rule 204 of Regulation SHO [17 

CFR 242.204] under the Exchange Act 

and removing Rule 204T of Regulation 

SHO [17 CFR 242.204T] under the 

Exchange Act. 

I. Introduction 

In October 2008, we adopted 

temporary Rule 204T of Regulation SHO 

as an interim final temporary rule, with 

an expiration date of July 31, 2009.1 As 

discussed in more detail below, 

temporary Rule 204T strengthens the 

close-out requirements of Regulation 

SHO for failures to deliver securities 

(known as ‘‘fails’’ or ‘‘fails to deliver’’) 2

resulting from sales of any equity 

security. Our adoption of temporary 

Rule 204T followed a series of other 

steps aimed at reducing fails to deliver 

and addressing potentially abusive 

‘‘naked’’ short selling.3

In addition, at the time that we 

adopted temporary Rule 204T, we noted 

our concerns about the sudden and 

unexplained declines in the prices of 

equity securities generally and the 

deterioration in investor confidence in 

our financial markets.4 Such price 

declines can give rise to questions about 

the underlying financial condition of an 

entity, which in turn can create a crisis 

of confidence even without a 

fundamental underlying basis.5 This 

crisis of confidence can impair the 

liquidity and ultimate viability of an 

entity, with potentially broad market 

consequences.6 Thus, we also adopted 

temporary Rule 204T to further our goal 

of preventing substantial disruption in 

the securities markets by providing a 

powerful disincentive to those who 

might otherwise engage in potentially 

abusive ‘‘naked’’ short selling.7

Preliminary results from the 

Commission’s Office of Economic 

Analysis (‘‘OEA’’) indicate that our 

various actions to further reduce fails to 

deliver and, thereby, address potentially 

abusive ‘‘naked’’ short selling are having 

their intended effect. For example, these 

preliminary results indicate a significant 

downward trend in the number of fails 

to deliver in all equity securities since, 

among other actions, the adoption of 

temporary Rule 204T.8 These results 

provide, among other things, that in 

comparing a pre- to post-temporary Rule 

204T adoption period,9 the average 

daily number of fails to deliver for all 

equity securities has declined from 1.1 

billion to 478 million for a total decline 

of 56.6 percent. In addition, the average 

daily number of threshold securities 

declined from 480 securities to 108 

securities in comparing the pre- to posttemporary Rule 204T adoption period, a 

decline of 77.5%.10

Due to the positive impact that 

temporary Rule 204T,11 as well as other 

recent Commission actions, are having 

on reducing fails to deliver and after 

considering the comments received to 

temporary Rule 204T, we are adopting 

the provisions of that rule in a 

permanent rule, Rule 204 of Regulation 

SHO, with some limited modifications 

to refine provisions and address 

commenters’ concerns.12 In general, as 

discussed in more detail below, we are 

maintaining the structure of temporary 

Rule 204T, while making some 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38267 

13See infra Section III (discussing Rule 204 of 

Regulation SHO and commenters’ concerns). 

14 17 CFR 242.200(a). 

15See Exchange Act Release No. 50103 (July 28, 

2004), 69 FR 48008, 48009 n. 10 (Aug. 6, 2004) 

(‘‘2004 Regulation SHO Adopting Release’’). 

16 Generally, investors complete or settle their 

security transactions within three settlement days. 

This settlement cycle is known as T+3 (or ‘‘trade 

date plus three days’’). T+3 means that when a trade 

occurs, the participants to the trade deliver and pay 

for the security at a clearing agency three settlement 

days after the trade is executed so the brokerage 

firm can exchange those funds for the securities on 

that third settlement day. The three-day settlement 

period applies to most security transactions, 

including stocks, bonds, municipal securities, 

mutual funds traded through a brokerage firm, and 

limited partnerships that trade on an exchange. 

Government securities and stock options settle on 

the next settlement day following the trade (or T+1). 

In addition, Rule 15c6–1 prohibits broker-dealers 

from effecting or entering into a contract for the 

purchase or sale of a security that provides for 

payment of funds and delivery of securities later 

than the third business day after the date of the 

contract unless otherwise expressly agreed to by the 

parties at the time of the transaction. 17 CFR 

240.15c6–1; Exchange Act Release No. 33023 (Oct. 

7, 1993), 58 FR 52891 (Oct. 13, 1993). However, 

failure to deliver securities on T+3 does not violate 

Rule 15c6–1; see also Exchange Act Release No. 

56212 (Aug. 7, 2007), 72 FR 45544, n. 2 (Aug. 14, 

2007) (‘‘2007 Regulation SHO Final Amendments’’). 

17 In 2003, the Commission settled a case against 

certain parties relating to allegations of 

manipulative short selling in the stock of a 

corporation. The Commission alleged that the 

defendants profited from engaging in massive 

‘‘naked’’ short selling that flooded the market with 

the stock, and depressed its price. See Rhino 

Advisors, Inc. and Thomas Badian, Lit. Rel. No. 

18003 (Feb. 27, 2003); SEC v. Rhino Advisors, Inc. 

and Thomas Badian, Civ. Action No. 03 civ 1310 

(RO) (S.D.N.Y); see also Exchange Act Release No. 

48709 (Oct. 28, 2003), 68 FR 62972, 62975 (Nov. 6, 

2003) (‘‘2003 Regulation SHO Proposing Release’’) 

(describing the alleged activity in the case involving 

stock of Sedona Corporation); 2004 Regulation SHO 

Adopting Release, 69 FR 48016, n.76; Exchange Act 

Release No. 58774 (Oct. 14, 2008), 73 FR 61666 

(Oct. 17, 2008) (‘‘Anti-Fraud Rule Adopting 

Release’’). 

18See, e.g., Rule 204T Adopting Release, 73 FR 

61709; Exchange Act Release No. 57511 (Mar. 17, 

2008), 73 FR 15376, 15377 (Mar. 31, 2008) (‘‘AntiFraud Rule Proposing Release’’). 

19See, e.g., Rule 204T Adopting Release, 73 FR 

61709; 2007 Regulation SHO Final Amendments, 72 

FR 45544; Exchange Act Release No. 54154 (July 14, 

2006), 71 FR 41710, 41712 (July 21, 2006) (‘‘2006 

Regulation SHO Proposed Amendments’’); 

Exchange Act Release No. 56213 (Aug. 7, 2007), 72 

FR 45558, 45558–45559 (Aug. 14, 2007) (‘‘2007 

Regulation SHO Proposed Amendments’’); AntiFraud Rule Proposing Release, 73 FR 15378. 

20See id. 

21See id. 

22See 2006 Regulation SHO Proposed 

Amendments, 71 FR 41710. 

23See, e.g., letter from Patrick M. Byrne, 

Chairman and Chief Executive Officer, 

Overstock.com, Inc., dated Sept. 11, 2006 

(‘‘Overstock’’); letter from Daniel Behrendt, Chief 

Financial Officer, and Douglas Klint, General 

Counsel, TASER International, dated Sept. 18, 2006; 

letter from John Royce, dated April 30, 2007; letter 

from Michael Read, dated April 29, 2007; letter 

from Robert DeVivo, dated April 26, 2007; letter 

from Ahmed Akhtar, dated April 26, 2007. 

24See, e.g., letter from Jack M. Wedam, dated Oct. 

16, 2007; letter from Michael J. Ryan, Executive 

Director and Senior Vice President, Center for 

Capital Markets Competitiveness, U.S. Chamber of 

Commerce, dated Sept. 13, 2007 (‘‘U.S. Chamber of 

Commerce’’); letter from Robert W. Raybould, CEO 

Enteleke Capital Corp., dated Sept. 12, 2007 

(‘‘Raybould’’); letter from Mary Helburn, Executive 

Director, National Coalition Against Naked 

Shorting, dated Sept. 12, 2007 (‘‘NCANS’’). 

25See e.g., letter from Roel Campos, dated Mar. 

25, 2009 (‘‘Campos’’); letter from the Risk 

Management Association, dated Dec. 23, 2008; 

letter from Professor James Angel, Ph.D, CFA, dated 

Dec. 17, 2008 (‘‘Angel’’); letter from Patrick Byrne, 

Ph.D., dated Dec. 16, 2008; letter from the American 

Bankers Association, dated Dec. 16, 2008 (‘‘ABA’’); 

letter from Fairfax Financial Holdings, Ltd., dated 

Oct. 16, 2008. 

26See supra note 17 (discussing a case in which 

we alleged that the defendants profited from 

engaging in massive ‘‘naked’’ short selling that 

flooded the market with the company’s stock, and 

Continued 

adjustments to promote its 

workability.13

We believe that Rule 204 of 

Regulation SHO will continue to help 

further our goal of reducing fails to 

deliver by maintaining the reductions in 

fails to deliver achieved by the adoption 

of temporary Rule 204T, as well as other 

actions taken by the Commission. In 

addition, these amendments are 

intended to help further our goal of 

addressing potentially abusive ‘‘naked’’ 

short selling. These goals will be 

furthered by, among other things, 

requiring that securities are purchased 

or borrowed to close out any fail to 

deliver position resulting from a short 

sale of an equity security by no later 

than the beginning of regular trading 

hours on the settlement day following 

the date on which the fail to deliver 

position occurred. Similar to temporary 

Rule 204T of Regulation SHO, Rule 204 

will continue to provide a disincentive 

to those who might otherwise engage in 

potentially abusive ‘‘naked’’ short 

selling. 

II. Background 

Short selling involves a sale of a 

security that the seller does not own or 

a sale which is consummated by the 

delivery of a security borrowed by, or 

for the account of, the seller.14 Short 

sales normally are settled by the 

delivery of a security borrowed by or on 

behalf of the seller. In a ‘‘naked’’ short 

sale, however, the short seller does not 

borrow securities in time to make 

delivery to the buyer within the 

standard three-day settlement period.15

As a result, the seller fails to deliver 

securities to the buyer when delivery is 

due.16 Sellers sometimes intentionally 

fail to deliver securities as part of a 

scheme to manipulate the price of a 

security,17 or possibly to avoid 

borrowing costs associated with short 

sales, especially when the costs of 

borrowing stock are high. 

We have been concerned about 

reducing fails to deliver and addressing 

‘‘naked’’ short selling, in particular, 

potentially abusive ‘‘naked’’ short 

selling, for some time. As we have 

stated on several prior occasions, we 

believe that all sellers of securities 

should promptly deliver, or arrange for 

delivery of, securities to the respective 

buyer and all buyers of securities have 

a right to expect prompt delivery of 

securities purchased.18 In addition, as 

we have stated on several prior 

occasions, we are concerned about the 

negative effect that fails to deliver may 

have on the markets and shareholders.19

For example, large and persistent fails 

to deliver may deprive shareholders of 

the benefits of ownership, such as 

voting and lending.20 In addition, where 

a seller of securities fails to deliver 

securities on settlement date, in effect 

the seller unilaterally converts a 

securities contract (which is expected to 

settle within the standard three-day 

settlement period) into an undated 

futures-type contract, to which the 

buyer might not have agreed, or that 

might have been priced differently.21

Moreover, sellers that fail to deliver 

securities on settlement date may 

attempt to use this additional freedom 

to engage in trading activities to 

improperly depress the price of a 

security. By not borrowing securities 

and, therefore, not making delivery 

within the standard three-day 

settlement period, the seller has 

additional freedom because it does not 

incur the costs of borrowing. 

In addition, issuers and investors 

have repeatedly expressed concerns 

about fails to deliver in connection with 

manipulative ‘‘naked’’ short selling. For 

example, in response to proposed 

amendments to Regulation SHO in 

2006,22 which were designed to further 

reduce the number of persistent fails to 

deliver in certain equity securities by 

eliminating Regulation SHO’s 

‘‘grandfather’’ exception and limit the 

duration of the rule’s options market 

maker exception, we received a number 

of comments that expressed concerns 

about ‘‘naked’’ short selling and 

extended delivery failures.23

Commenters continued to express these 

concerns in response to proposed 

amendments to eliminate the options 

market maker exception to the close-out 

requirement of Regulation SHO in 

2007 24 and in response to the Rule 204T 

Adopting Release.25

To the extent that fails to deliver 

might be part of manipulative ‘‘naked’’ 

short selling, which could be used as a 

tool to drive down a company’s stock 

price,26 such fails to deliver may 


jlentini on DSKJ8SOYB1PROD with RULES2
38268 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

depressed its price); see also S.E.C. v. Gardiner, 48 

S.E.C. Docket 811, No. 91 Civ. 2091 (S.D.N.Y. Mar. 

27, 1991) (alleged manipulation by sales 

representative by directing or inducing customers to 

sell stock short in order to depress its price); U.S. 

v. Russo, 74 F.3d 1383, 1392 (2d Cir. 1996) (short 

sales were sufficiently connected to the 

manipulation scheme as to constitute a violation of 

Exchange Act Section 10(b) and Rule 10b–5). 

27 In response to the Rule 204T Adopting Release, 

we received comment letters discussing the impact 

of fails to deliver on investor confidence. See e.g., 

letter from David Patch, dated Mar. 19, 2009; letter 

from Charles J. Greiner, dated Mar. 11, 2009. In 

response to the 2007 Regulation SHO Proposed 

Amendments, commenters discussed the impact of 

fails to deliver on investor confidence. See, e.g., 

letter from NCANS. Commenters expressed similar 

concerns in response to the 2006 Regulation SHO 

Proposed Amendments. See, e.g., letter from Mary 

Helburn, Executive Director, National Coalition 

Against Naked Shorting, dated Sept. 30, 2006 

(‘‘NCANS (2006)’’); letter from Richard Blumenthal, 

Attorney General, State of Connecticut, dated Sept. 

19, 2006 (‘‘Blumenthal’’). 

28 In response to the Rule 204T Adopting Release, 

we received comment letters expressing concern 

about the impact of potential ‘‘naked’’ short selling 

on capital formation, claiming that ‘‘naked’’ short 

selling causes a drop in an issuer’s stock price and 

may limit the issuer’s ability to access the capital 

markets. See, e.g., letter from Campos (noting that 

‘‘[i]n its most benign form, naked short selling is a 

hidden tax on equity markets, our largest wealth 

creation mechanism. At its worst, it is a violent 

force of wealth destruction that affects all market 

participants.’’); letter from Patrick Byrne Ph.D., 

Chairman and Chief Executive Officer, 

Overstock.com Inc., dated Dec. 16, 2008 (stating 

that ‘‘more needs to be done to correct the problem 

of naked short selling and to prevent more 

companies from being taken down by those that use 

it as a tool for manipulation.’’); see also letter from 

ABA. Commenters expressed similar concerns in 

response to the 2007 Regulation SHO Proposed 

Amendments. See, e.g., letter from Robert K. Lifton, 

Chairman and CEO, Medis Technologies, Inc., dated 

Sept. 12, 2007 (‘‘Medis’’); letter from NCANS. 

Commenters also expressed similar concerns in 

response to the 2006 Regulation SHO Proposed 

Amendments. See, e.g., letter from Congressman 

Tom Feeney—Florida, U.S. House of 

Representatives, dated Sept. 25, 2006 (‘‘Feeney’’); 

see also letter from Zix Corporation, dated Sept. 19, 

2006 (‘‘Zix’’) (stating that ‘‘[m]any investors 

attribute the Company’s frequent re-appearances on 

the Regulation SHO list to manipulative short 

selling and frequently demand that the Company 

‘‘do something’’ about the perceived manipulative 

short selling. This perception that manipulative 

short selling of the Company’s securities is 

continually occurring has undermined the 

confidence of many of the Company’s investors in 

the integrity of the market for the Company’s 

securities.’’). 

29 Due in part to such concerns, some issuers have 

taken actions to attempt to make transfer of their 

securities ‘‘custody only,’’ (i.e., certificating the 

securities and prohibiting ownership by a securities 

intermediary) thus preventing transfer of their stock 

to or from securities intermediaries such as the 

Depository Trust Company (‘‘DTC’’) or brokerdealers. See Exchange Act Release No. 48709 (Oct. 

28, 2003), 68 FR 62972, at 62975 (Nov. 6, 2003). 

Some issuers have attempted to withdraw their 

issued securities on deposit at DTC in order to make 

the securities ineligible for book-entry transfer at a 

securities depository. See id. Withdrawing 

securities from DTC or requiring custody-only 

transfers would undermine the goal of a national 

clearance and settlement system designed to reduce 

the physical movement of certificates in the trading 

markets. See id. We note, however, that in 2003 the 

Commission approved a DTC rule change clarifying 

that its rules provide that only its participants may 

withdraw securities from their accounts at DTC. See 

Exchange Act Release No. 47978 (June 4, 2003), 68 

FR 35037 (June 11, 2003). 

30See 2006 Regulation SHO Proposed 

Amendments, 71 FR 41712; 2007 Regulation SHO 

Final Amendments, 72 FR 45545; 2007 Regulation 

SHO Proposed Amendments, 72 FR 45558–45559; 

Anti-Fraud Rule Proposing Release, 73 FR 15378; 

Rule 204T Adopting Release, 73 FR 61709–61710 

(providing discussion of the impact of fails to 

deliver on the market); see also 2003 Regulation 

SHO Proposing Release, 68 FR 62975 (Nov. 6, 2003) 

(discussing the impact of ‘‘naked’’ short selling on 

the market). 

31According to the National Securities Clearing 

Corporation (‘‘NSCC’’), 99% (by dollar value) of all 

trades settle within T+3. Thus, on an average day, 

only approximately 1% (by dollar value) of all 

trades, including equity, debt, and municipal 

securities fail to settle on time. 

32 17 CFR 242.200. Regulation SHO became 

effective on January 3, 2005. 

33 17 CFR 242.203(b)(1). Rule 203(b)(1) of 

Regulation SHO requires that, ‘‘A broker or dealer 

may not accept a short sale order in an equity 

security from another person, or effect a short sale 

in an equity security for its own account, unless the 

broker or dealer has: (i) Borrowed the security, or 

entered into a bona-fide arrangement to borrow the 

security; or (ii) Reasonable grounds to believe that 

the security can be borrowed so that it can be 

delivered on the date delivery is due; and (iii) 

Documented compliance with this paragraph 

(b)(1).’’ This is known as the ‘‘locate’’ requirement. 

Market makers engaged in bona fide market making 

in the security at the time they effect the short sale 

are excepted from this requirement. In connection 

with this ‘‘locate’’ requirement, as well as other 

provisions of Regulation SHO that require a 

reasonableness determination (i.e., Rules 200(g)(1) 

and 203(a)(2)(ii)), we remind any broker-dealer 

subject to such provisions that they have an 

affirmative obligation to obtain and consider 

information from their own records and/or from the 

records of another source helpful to making the 

reasonableness determinations required by such 

rules. Such information may include, but is not 

limited to, information regarding a customer’s prior 

assurances regarding a locate source, its share 

ownership, or delivery of shares by settlement date. 

See 17 CFR 242.203(b)(1), 242.200(g)(1), 

203(a)(2)(ii). See also 2004 Regulation SHO 

Adopting Release, 69 FR 48014, n. 58, 48019 at n. 

111. 

34For purposes of Regulation SHO, the term 

‘‘participant’’ has the same meaning as in section 

3(a)(24) of the Exchange Act. See 15 U.S.C. 

78c(a)(24). 

35The term ‘‘registered clearing agency’’ means a 

clearing agency, as defined in Section 3(a)(23)(A) of 

the Exchange Act, that is registered as such 

pursuant to Section 17A of the Exchange Act. See 

15 U.S.C. 78c(a)(23)(A) and 78q–1, respectively; see 

also 2004 Regulation SHO Adopting Release, 69 FR 

48031. The majority of equity trades in the United 

States are cleared and settled through systems 

administered by clearing agencies registered with 

the Commission. The NSCC clears and settles the 

majority of equity securities trades conducted on 

the exchanges and in the over-the-counter market. 

NSCC clears and settles trades through the 

Continuous Net Settlement (‘‘CNS’’) system, which 

nets the securities delivery and payment obligations 

of all of its members. NSCC notifies its members of 

their securities delivery and payment obligations 

daily. In addition, NSCC guarantees the completion 

of all transactions and interposes itself as the 

contraparty to both sides of the transaction. We 

intend to closely monitor fails to deliver resulting 

from trades that are not cleared and settled through 

the CNS system. 

36Rule 203(c)(6) of Regulation SHO defines a 

‘‘threshold security’’ as any equity security of an 

issuer that is registered pursuant to Section 12 of 

the Exchange Act (15 U.S.C. 78l) or for which the 

issuer is required to file reports pursuant to Section 

15(d) of the Exchange Act (15 U.S.C. 78o(d)) for 

which there is an aggregate fail to deliver position 

for five consecutive settlement days at a registered 

clearing agency of 10,000 shares or more, and that 

is equal to at least 0.5% of the issue’s total shares 

outstanding; and is included on a list disseminated 

to its members by a self-regulatory organization 

(‘‘SRO’’). See 17 CFR 242.203(c)(6). 

37See 17 CFR 242.203(b)(3)(iv). 

undermine the confidence of 

investors.27 These investors, in turn, 

may be reluctant to commit capital to an 

issuer they believe to be subject to such 

manipulative conduct.28 In addition, 

issuers may believe that they have 

suffered unwarranted reputational 

damage due to investors’ negative 

perceptions regarding fails to deliver in 

the issuer’s security.29 Unwarranted 

reputational damage caused by fails to 

deliver might have an adverse impact on 

the security’s price.30

Although the majority of trades settle 

within T+3,31 we adopted Regulation 

SHO 32 on July 28, 2004, in part to 

address problems associated with 

persistent fails to deliver securities and 

potentially abusive ‘‘naked’’ short 

selling. For example, Regulation SHO 

requires broker-dealers to ‘‘locate’’ 

securities that the broker-dealer 

reasonably believes can be delivered 

within the standard three-day 

settlement period.33

Another requirement of Regulation 

SHO aimed at potentially abusive 

‘‘naked’’ short selling and reducing fails 

to deliver in certain equity securities is 

the rule’s ‘‘close-out’’ requirement. 

Since Regulation SHO was adopted it 

has required participants 34 of a 

registered clearing agency,35 which 

includes broker-dealers, to purchase 

shares to close out fails to deliver in 

securities with large and persistent fails 

to deliver, i.e., ‘‘threshold securities.’’ 36

Until the position is closed out, the 

participant responsible for the fail to 

deliver position and any broker-dealer 

from which it receives trades for 

clearance and settlement may not effect 

further short sales in that threshold 

security without first borrowing or 

arranging to borrow the security.37

As adopted, Regulation SHO included 

two major exceptions to the close-out 

requirement: The ‘‘grandfather’’ 

provision and the ‘‘options market 

maker’’ exception. The ‘‘grandfather’’ 

provision had provided that fails to 

deliver established prior to a security 

becoming a threshold security did not 

have to be closed out in accordance 

with Regulation SHO’s thirteen 

consecutive settlement day close-out 

requirement. 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38269 

38See 2007 Regulation SHO Final Amendments, 

72 FR 45544. This amendment also contained a 

one-time phase-in period that provided that 

previously-grandfathered fails to deliver in a 

security that was a threshold security on the 

effective date of the amendment must be closed out 

within 35 consecutive settlement days from the 

effective date of the amendment. The phase-in 

period ended on December 5, 2007. 

39See Exchange Act Release No. 58572 (Sept. 17, 

2008), 73 FR 54875 (Sept. 23, 2008) (‘‘September 

Emergency Order’’). 

40See Exchange Act Release No. 58775 (Oct. 14, 

2008), 73 FR 61690 (Oct. 17, 2008) (‘‘2008 

Regulation SHO Final Amendments’’); see also 

2007 Regulation SHO Proposed Amendments, 72 

FR 45558; 2006 Regulation SHO Proposed 

Amendments, 71 FR 41710; Exchange Act Release 

No. 58107 (July 7, 2008), 73 FR 40201 (July 14, 

2008) (‘‘2008 Regulation SHO Re-Opening 

Release’’). 

41See 2008 Regulation SHO Final Amendments, 

73 FR 61690; see also 2008 Regulation SHO ReOpening Release, 73 FR 40201. 

42 In addition to these amendments to Regulation 

SHO, recently we have taken other actions aimed 

at reducing fails to deliver and addressing 

potentially abusive ‘‘naked’’ short selling. For 

example, in July 2008, we published an emergency 

order under section 12(k) of the Exchange Act (the 

‘‘July Emergency Order’’) that temporarily restricted 

‘‘naked’’ short selling in the publicly traded 

securities of nineteen financial institutions. See 

Exchange Act Release No. 58166 (July 15, 2008), 73 

FR 55169 (July 21, 2008) (imposing borrowing and 

delivery requirements on short sales of the equity 

securities of nineteen financial companies); see also 

Exchange Act Release No. 58248 (July 29, 2008), 73 

FR 45257 (Aug. 4, 2008) (extending the July 

Emergency Order such that it expired on August 12, 

2008). In September 2008, we published an 

emergency order that temporarily banned short 

selling in the publicly traded securities of 

approximately 1,000 financial institutions (the 

‘‘Short Sale Ban’’). See Exchange Act Release No. 

58592 (Sept. 18, 2008), 73 FR 55169 (Sept. 24, 

2008); see also Exchange Act Release No. 58611 

(Sept. 21, 2008), 73 FR 55556 (Sept. 25, 2008) 

(amending the Short Sale Ban). The Short Sale Ban 

expired on October 8, 2008. In addition, in the 

September Emergency Order, we adopted and made 

immediately effective a ‘‘naked’’ short selling antifraud rule, Rule 10b–21, aimed at sellers, including 

broker-dealers acting for their own accounts, who 

deceive certain specified persons about their 

intention or ability to deliver securities in time for 

settlement and that fail to deliver securities by 

settlement date. See September Emergency Order. 

Following the issuance of the September Emergency 

Order, we adopted final amendments making Rule 

10b–21 permanent. See Anti-Fraud Rule Adopting 

Release, 73 FR 61666; see also Anti-Fraud Rule 

Proposing Release, 73 FR 15376. In addition, on 

April 8, 2009, we proposed amendments to 

Regulation SHO that, if adopted, would add a short 

sale price test restriction or short sale circuit 

breaker rule to Regulation SHO. See Exchange Act 

Release No. 59748 (Apr. 10, 2009), 74 FR 18042 

(Apr. 20, 2009) (the ‘‘Short Sale Price Test 

Proposing Release’’). 

43See supra note 12. 

44 ‘‘Regular trading hours’’ has the same meaning 

as in Rule 600(b)(64) of Regulation NMS. Rule 

600(b)(64) provides that ‘‘Regular trading hours 

means the time between 9:30 a.m. and 4:00 p.m. 

Eastern Time, or such other time as is set forth in 

the procedures established pursuant to 

§ 242.605(a)(2).’’ 

45The term ‘‘settlement day’’ is defined in Rule 

203(c)(5) of Regulation SHO as: ‘‘* * * any 

business day on which deliveries of securities and 

payments of money may be made through the 

facilities of a registered clearing agency.’’ 17 CFR 

242.203(c)(5). 

46See temporary Rule 204T(a). 

47 In addition, temporary Rule 204T(a)(2) 

provides that fails to deliver resulting from sales of 

securities pursuant to Rule 144 of the Securities Act 

of 1933 (‘‘Rule 144 Securities’’) must be closed out 

by no later than the beginning of regular trading 

hours on the thirty-sixth consecutive settlement day 

following settlement date (i.e., T+39). 

Due to our concerns about the 

potentially negative market impact of 

large and persistent fails to deliver, and 

the fact that we continued to observe 

threshold securities with fail to deliver 

positions that were not being closed out 

under existing delivery and settlement 

requirements, effective on October 15, 

2007, we adopted an amendment to 

Regulation SHO that eliminated the 

‘‘grandfather’’ provision.38

The options market maker exception 

excepted any fail to deliver position in 

a threshold security resulting from short 

sales effected by a registered options 

market maker to establish or maintain a 

hedge on options positions that were 

created before the underlying security 

became a threshold security. On 

September 17, 2008, we adopted and 

made immediately effective, as an 

emergency rule, an amendment to Rule 

203(b)(3) of Regulation SHO to 

eliminate the options market maker 

exception to the rule’s close-out 

requirement.39 Following the issuance 

of the September Emergency Order, we 

adopted amendments making 

permanent the elimination of the 

options market maker exception.40 As 

we discussed in the 2008 Regulation 

SHO Final Amendments, we believed it 

was appropriate to eliminate the options 

market maker exception in part because 

substantial levels of fails to deliver 

continued to persist in threshold 

securities and it appeared that a 

significant number of these fails to 

deliver were as a result of the options 

market maker exception.41

In adopting temporary Rule 204T of 

Regulation SHO pursuant to the 

September Emergency Order and 

subsequently pursuant to the Rule 204T 

Adopting Release, we strengthened 

further the close-out requirements of 

Regulation SHO by applying close-out 

requirements to fails to deliver resulting 

from sales of all equity securities and 

reducing the time-frame within which 

fails to deliver must be closed out.42

As noted above, since the adoption of 

temporary Rule 204T and the 

elimination of Regulation SHO’s options 

market maker exception, we have seen 

a significant reduction in the number of 

fails to deliver in all equity securities. 

To continue advancing our goal of 

reducing fails to deliver by maintaining 

the reductions in fails to deliver 

achieved by the adoption of temporary 

Rule 204T, as well as other actions 

taken by the Commission, and 

addressing potentially abusive ‘‘naked’’ 

short selling, we are adopting the 

substance of temporary Rule 204T in a 

permanent rule, Rule 204. We continue 

to believe that strengthening the closeout requirements of Regulation SHO 

will further help to protect and enhance 

the operation, integrity, and stability of 

the markets, as well as help reduce 

potential short selling abuses. 

III. Discussion of Rule 204 of 

Regulation SHO 

As discussed in more detail below, we 

are maintaining the structure of 

temporary Rule 204T with limited 

modifications to address commenters’ 

concerns. In discussing the provisions 

of Rule 204, we highlight below some of 

the main issues, concerns, and 

suggestions raised by commenters.43

A. Rule 204’s Close-Out Requirement 

1. Close-Out Period 

In Rule 204(a), we are adopting the 

close-out requirements of temporary 

Rule 204T(a) without modification. 

Temporary Rule 204T(a) provides that a 

participant of a registered clearing 

agency must deliver securities to a 

registered clearing agency for clearance 

and settlement on a long or short sale 

in any equity security by settlement 

date, or if a participant of a registered 

clearing agency has a fail to deliver 

position at a registered clearing agency 

in any equity security for a long or short 

sale transaction in that equity security, 

the participant shall, by no later than 

the beginning of regular trading hours 44

on the settlement day 45 following the 

settlement date (i.e., T+4), immediately 

close out the fail to deliver position by 

borrowing or purchasing securities of 

like kind and quantity.46

Under certain circumstances, 

temporary Rule 204T provides 

additional time during which fails to 

deliver may be closed out. Specifically, 

temporary Rule 204T(a)(1) and (a)(3) 

provide that, subject to certain 

conditions, fails to deliver resulting 

from long sales or certain bona fide 

market making activity must be closed 

out by no later than the beginning of 

regular trading hours on the third 

settlement day after settlement date (i.e., 

T+6).47

In response to our requests for 

comment, a number of commenters 

expressed concerns regarding the time 

periods within which fails to deliver 

must be closed out under temporary 

Rule 204T. Commenters expressed 

concern that temporary Rule 204T’s 


jlentini on DSKJ8SOYB1PROD with RULES2
38270 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

48See, e.g., letter from Stuart Kaswell, Executive 

Vice President and General Counsel, Managed 

Funds Association, dated Dec. 15, 2008 (‘‘MFA’’); 

letter from Edward J. Joyce, President and Chief 

Operating Officer, Chicago Board Options 

Exchange, dated Dec. 23, 2008 (‘‘CBOE’’); letter 

from Amal Aly, Managing Director and Associate 

General Counsel, SIFMA, dated Dec. 16, 2008 

(‘‘SIFMA’’); letter from Eric Swanson, General 

Counsel, BATS Exchange, Inc., dated Dec. 29, 2008 

(‘‘BATS’’); letter from Michael P. McAuley, Chair, 

RMA Committee on Securities Lending, dated Dec. 

23, 2008 (‘‘RMA’’); letter from Stefan Gavell, 

Executive Vice President and Head of Regulatory 

Industry Affairs, State Street Corporation, dated 

Dec. 16, 2008 (‘‘State Street’’). 

49See, e.g., letters from SIFMA; MFA; State 

Street; BATS; letter from A. Peter Allman-Ward, 

Executive Vice President and CFO, Wedbush 

Morgan Securities, Inc., dated Dec. 15, 2008 

(‘‘Wedbush’’). 

50Letter from SIFMA. 

51See id. 

52See e.g., letter from Peter Kovac, Chief 

Operating Officer and Financial and Operations 

Principal, EWT, LLC, dated Nov. 25, 2008 (‘‘EWT’’); 

letter from James S. Chanos, Chairman, Coalition of 

Private Investment Companies, dated Dec. 16, 2008 

(‘‘Coalition of Private Investment Companies’’); 

letters from SIFMA; MFA; State Street. 

53See, e.g., letter CBOE; letter from Boston 

Options Exchange, Chicago Board Options 

Exchange, International Securities Exchange, 

NASDAQ Options Market, NASDAQ OMX PHLX, 

NYSE Alternext US, NYSE Arca, and The Options 

Clearing Corporation, dated Dec. 19, 2008 (‘‘Options 

Exchanges’’). 

54See, e.g., letters from SIFMA; MFA; State 

Street; CBOE; Options Exchanges; Coalition of 

Private Investment Companies. 

55As stated in the Rule 204T Adopting Release, 

if a person that has loaned a security to another 

person sells the security and a bona fide recall of 

the security is initiated within two business days 

after trade date, the person that has loaned the 

security will be ‘‘deemed to own’’ the security for 

purposes of Rule 200(g)(1) of Regulation SHO, and 

such sale will not be treated as a short sale for 

purposes of temporary Rule 204T. In addition, a 

broker-dealer may mark such orders as ‘‘long’’ sales 

provided such marking is also in compliance with 

Rule 200(c) of Regulation SHO. See Rule 204T 

Adopting Release, 73 FR 61713, n. 70. 

56Letter from SIFMA. 

57See letter from SIFMA; see also letter from 

RMA; letter from Heather Traeger, Assistant 

Counsel, Investment Company Institute, dated Dec. 

16, 2008 (‘‘ICI’’). 

58See letter from SIFMA; see also letter from 

RMA (recommending the extension of the close-out 

period for fails to deliver for all sales to settlement 

date plus three days (i.e., T+6) ‘‘to ensure that 

beneficial owners selling on-loan positions are not 

compromised by close-outs of long sales on T+4’’). 

59See letters from EWT; BATS; RMA; ICI; 

Wedbush. 

60See letters from EWT; BATS; RMA; ICI. EWT 

stated that a recall typically occurs to assure that 

the securities are returned on the settlement date for 

the sale transaction. If the securities are not 

returned by that date, the lender may initiate a buyin process designed to obtain the securities as 

promptly as possible. This buy-in is intended to 

result in delivery of the securities after three 

business days, such that the lender will not 

complete the buy-in process until the close of the 

DTC settlement window on the third business day 

following initiation of the buy-in process. 

Accordingly, this commenter recommended, among 

other things, that we should: (1) either (a) create an 

exception for fails to deliver where the securities 

are loaned but have been recalled or (b) confirm 

that the issuance of a bona fide loan recall notice 

is a valid form of close-out for a fail to deliver; or 

(2) extend the close-out period from settlement date 

plus three days (i.e., T+6), to settlement date plus 

six days (i.e., T+9) for fails to deliver resulting from 

long sales. See also letter from RMA (stating that 

due to operational complexity and the number of 

market participants involved in the sale of an ‘‘onloan position,’’ it is commonplace for a sale to be 

settled during the day on T+6). 

61See supra note 8, and accompanying text. 

62See supra note 44 (discussing the definition of 

the term ‘‘regular trading hours’’ for purposes of 

Regulation SHO). 

63See supra note 45 (discussing the definition of 

the term ‘‘settlement day’’ for purposes of 

Regulation SHO). 

requirement to close-out fails to deliver 

by no later than the beginning of regular 

trading hours can create buying pressure 

at the open, that may temporarily distort 

the price of the security.48 To minimize 

the market impact of the close-out 

requirement, commenters suggested 

allowing participants to close out fails 

to deliver by the end of regular trading 

hours, or the close of business on the 

New York Stock Exchange (‘‘NYSE’’), 

rather than by no later than the 

beginning of regular trading hours.49 In 

requesting additional time during the 

day to close out fails to deliver, one 

commenter noted that such a change 

‘‘would significantly alleviate the 

market pressures associated with 

execution of potentially large purchases 

at the opening of trading—a time when 

markets are particularly susceptible to 

price fluctuations.’’ 50 This commenter 

also stated that, as a practical matter, 

‘‘transactions effected at market open to 

close-out open fail positions are no 

different from those effected later on in 

the trading session because both are part 

of the same clearance and settlement 

cycle. Thus, providing this relief would 

not add any delay of consequence to the 

close-out process.’’ 51

Other commenters requested 

additional days within which to close 

out fails to deliver in connection with 

short sales. For example, some 

commenters requested that the 

Commission extend the close-out period 

for fails to deliver resulting from short 

sales to three settlement days after the 

fail occurs, consistent with the close-out 

period for fails to deliver resulting from 

long sales and market making activity.52

Other commenters requested that the 

Commission extend the close-out 

requirement for fails to deliver resulting 

from all sales to five settlement days 

after the fail to deliver position occurs.53

These commenters stated that the 

additional time to close out fails to 

deliver would allow the majority of 

trades to clear and settle on their own 

within a few days following the regular 

settlement date (i.e, T+3).54

Some commenters expressed concerns 

about the effect of the close-out 

requirements of temporary Rule 204T on 

securities lending.55 For example, one 

commenter stated that the compressed 

time-frame for closing out fails to 

deliver under temporary Rule 204T ‘‘has 

generated over-buying and borrowing of 

securities that would otherwise settle in 

the normal course, thus impairing 

liquidity by tying up shares that would 

otherwise be available to natural buyers 

and sellers.’’ 56 This commenter also 

noted that in practice fails to deliver 

resulting from sales of securities on 

loan, which are considered ‘‘long’’ sales, 

are often closed out in accordance with 

the time-frames for fails to deliver 

resulting from short sales rather than 

long sales because temporary Rule 204T 

does not provide sufficient time to 

determine whether or not a fail to 

deliver position resulted from a long or 

short sale.57 According to this 

commenter, such purchasing activity 

acts as a disincentive to lending and 

causes institutions to question their 

participation in lending programs.58

Other commenters stated that where 

the holder of a long position sells 

securities that have been financed 

through a securities loan, the close-out 

requirements of temporary Rule 204T 

may not provide sufficient time for the 

securities to be recalled and delivered in 

time for settlement of the sale 

transaction.59 These commenters stated, 

among other things, that temporary Rule 

204T’s requirement that securities be 

delivered by no later than the beginning 

of regular trading hours does not allow 

for the completion of the securities 

lending cycle, which may not occur 

until the close of the DTC settlement 

window on the third settlement day 

after settlement date (i.e., T+6).60

As noted above, the close-out 

requirements of temporary Rule 204T 

are advancing our goal of further 

reducing fails to deliver, as evidenced in 

part by preliminary results from OEA 

regarding its impact on the number of 

fails to deliver.61 Thus, we are adopting 

as a permanent rule the structure of the 

close-out requirements of temporary 

Rule 204T. Specifically, Rule 204(a) 

provides that a participant of a 

registered clearing agency must deliver 

securities to a registered clearing agency 

for clearance and settlement on a long 

or short sale in any equity security by 

settlement date, or if a participant of a 

registered clearing agency has a fail to 

deliver position at a registered clearing 

agency in any equity security for a long 

or short sale transaction in that equity 

security, the participant shall, by no 

later than the beginning of regular 

trading hours 62 on the settlement day 63


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38271 

64See Rule 204(a). 

65 In addition, as discussed in Section III.E. 

below, we are adopting the close-out requirements 

of Rule 204(a)(2) for fails to deliver resulting from 

sales of Rule 144 Securities so that such fails to 

deliver must be closed out by no later than the 

beginning of regular trading hours on the applicable 

close-out date. 

66 In discussing the requirement to purchase 

securities by no later than the beginning of regular 

trading hours on the applicable close-out date, some 

commenters discussed the ability to use, among 

other mechanisms, volume weighted average price 

(‘‘VWAP’’) orders entered at the beginning of the 

day to more effectively manage their buy-in risk. 

See, e.g., letters from Duncan L. Niederaurer, CEO, 

NYSE Euronext and Richard G. Ketchum, NYSE 

Regulation, Inc., dated Dec. 16, 2008 (‘‘NYSE’’); ICI. 

We note that if a participant has a fail to deliver 

position at a registered clearing agency that it must 

close out in accordance with Rule 204 of Regulation 

SHO, the participant may satisfy the close-out 

requirement to purchase securities of like kind and 

quantity with a VWAP order provided: (i) the order 

to purchase the equity security on a VWAP basis 

is irrevocable and received by no later than the 

beginning of regular trading hours on the applicable 

close-out date; and (ii) the final execution price of 

any such transaction is not determined until after 

the close of regular trading hours when the VWAP 

value is calculated and the execution is on an 

agency basis. 

67See supra note 16 (discussing the standard 

three-day settlement cycle). 

68See Rule 204T Adopting Release, 73 FR 61712– 

61713. 

69See id. 

70See id. at n. 68. We note that OEA’s analysis 

examined the period from January to July 2008 and 

used the age of the fail to deliver position as 

reported by the NSCC. The NSCC data included 

only securities with at least 10,000 shares in fails 

to deliver. These numbers also included securities 

that were not subject to the close-out requirement 

in Rule 203(b)(3) of Regulation SHO, which applies 

only to ‘‘threshold securities’’ as defined in Rule 

203(c)(6) of Regulation SHO. 

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

FR 61666. 

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

73See id. 

74See Rule 204(a)(1). 

75See e.g., letters from SIFMA; EWT; MFA; State 

Street; BATS; Wedbush; Angel. 

76See 17 CFR 242.203(b)(3). Some commenters 

requested clarification regarding a broker-dealer’s 

obligations under FINRA Rule 11810 (the ‘‘FINRA 

Buy-In Rule’’) and the close-out requirements of 

temporary Rule 204T. See, e.g., letter from Joseph 

Zangri, Chief Compliance Officer, Bloomberg 

Tradebook, LLC (Dec. 16, 2008) (‘‘Bloomberg’’). We 

note that because the requirements of Rule 204 

apply to broker-dealers involved in the sell-side of 

a transaction, whereas the FINRA Buy-In Rule sets 

forth procedures applicable to a purchaser that 

chooses to buy-in a seller, we believe that these 

rules apply separate and distinct obligations on 

Continued 

following the settlement date, 

immediately close out the fail to deliver 

position by borrowing or purchasing 

securities of like kind and quantity.64

In addition, as discussed in more 

detail below, we are adopting in Rule 

204(a)(1) and (a)(3) the close-out 

requirements of temporary Rule 

204T(a)(1) and (a)(3) for fails to deliver 

resulting from long sales and certain 

bona fide market making activity so that 

such fails to deliver must be closed out 

by no later than the beginning of regular 

trading hours on the close-out date (i.e., 

T+6) for such fails to deliver.65

Although we recognize commenters’ 

concerns regarding the potential market 

impact of the close-out requirements of 

temporary Rule 204T, particularly at the 

market open, we believe that these 

potential effects are justified by the 

benefits of retaining the strict close-out 

requirements of temporary Rule 204T. 

As discussed above, since the adoption 

of temporary Rule 204T, and other 

actions taken by the Commission aimed 

at reducing fails to deliver, there has 

been a significant reduction in fails to 

deliver. To maintain these declines, we 

believe it is necessary at this time to 

continue to require that participants 

close out fails to deliver by no later than 

the beginning of regular trading hours 

on the applicable close-out date. We 

believe that the strict close-out 

requirements of the temporary rule have 

helped reduce fails to deliver by 

providing a disincentive to those who, 

but for the rule, may have failed to 

deliver securities by settlement date. In 

addition, we note that participants have 

been operating pursuant to the close-out 

requirements of the temporary rule, as 

adopted, and appear to have adjusted to 

its requirements.66

We believe that continuing to require 

that fails to deliver be closed out on the 

day immediately following the day on 

which the fail to deliver occurs is 

consistent with our goal of reducing 

fails to deliver by maintaining the 

reductions in fails to deliver achieved 

by the adoption of temporary Rule 204T, 

as well as other actions taken by the 

Commission, and addressing ‘‘naked’’ 

short selling and, in particular, 

potentially abusive ‘‘naked’’ short 

selling. Although extending the timeframes within which fails to deliver 

must be closed out may allow for 

ordinary course settlement, as several 

commenters contend, we believe that 

the close-out requirements of Rule 204 

are necessary to continue to help 

encourage delivery by settlement date 

and achieve our goal of not allowing 

fails to deliver to persist.67

As we discussed in the Rule 204T 

Adopting Release, we believe that 

delivery on sales should be made by 

settlement date.68 In the Rule 204T 

Adopting Release, we noted that the 

vast majority of fails to deliver are 

closed out within five days after T+3.69

In addition, in that release we 

referenced a recent analysis by OEA that 

found that more than half of all fails to 

deliver and more than 70% of all fail to 

deliver positions are closed out within 

two settlement days after T+3.70 We also 

noted in that release, however, that 

although this information shows that 

delivery is being made, it demonstrates 

that often delivery is not being made 

until several days following the 

standard three-day settlement cycle. 

In addition, as discussed above, fails 

to deliver may be part of a scheme to 

manipulate the price of a security. We 

are also concerned about the negative 

effect that fails to deliver and 

potentially abusive ‘‘naked’’ short 

selling may have on the market and the 

broader economy, including on investor 

confidence.71 The close-out 

requirements of Rule 204 help address 

these concerns by prohibiting the 

persistence of fails to deliver. 

We understand, however, that fails to 

deliver may occur from long sales 

within the first two settlement days after 

settlement date for legitimate reasons.72

For example, human or mechanical 

errors or processing delays can result 

from transferring securities in custodial 

or other form rather than book-entry 

form, thereby causing a fail to deliver on 

a long sale.73

Thus, in Rule 204(a)(1), we are 

adopting, with certain limited 

modifications, the provisions of 

temporary Rule 204T(a)(1) relating to 

closing out fails to deliver resulting 

from long sales. Specifically, Rule 

204(a)(1) provides that if a participant of 

a registered clearing agency has a fail to 

deliver position at a registered clearing 

agency in any equity security and the 

participant can demonstrate on its books 

and records that such fail to deliver 

position resulted from a long sale, the 

participant shall by no later than the 

beginning of regular trading hours on 

the third consecutive settlement day 

following the settlement date 

immediately close out the fail to deliver 

position by purchasing or borrowing 

securities of like kind and quantity.74

In response to a request for comment, 

some commenters requested that we 

provide additional flexibility to the 

close-out requirements of temporary 

Rule 204T(a)(1) by allowing participants 

to borrow as well as purchase securities 

to close out such fails to deliver.75 In 

temporary Rule 204T(a)(1), we required 

a participant to purchase securities to 

close out fails to deliver resulting from 

long sales to be consistent with the 

close-out requirements of Rule 203(b)(3) 

of Regulation SHO which require that a 

participant that has a fail to deliver 

position in a threshold security for 

thirteen consecutive settlement days 

immediately thereafter close out the fail 

to deliver position by purchasing 

securities of like kind and quantity.76


jlentini on DSKJ8SOYB1PROD with RULES2
38272 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

market participants and, therefore, are not in 

conflict. 

77See e.g., letter from MFA. 

78See Rule 204(a)(1). Although Rule 204(a)(1) 

permits borrowing to close out a fail to deliver 

position resulting from a long sale, broker-dealers 

must also comply with Rule 203(a) of Regulation 

SHO. Rule 203(a)(1) provides that, unless an 

exception applies, ‘‘[i]f a broker or dealer knows or 

has reasonable grounds to believe that the sale of 

an equity security was or will be effected pursuant 

to an order marked ‘‘long,’’ such broker or dealer 

shall not lend or arrange for the loan of any security 

for delivery to the purchaser’s broker after the sale, 

or fail to deliver a security on the date delivery is 

due.’’ 17 CFR 242.203(a). 

79See letter from CBOE (stating that the close-out 

procedures under temporary Rule 204T for fails to 

deliver attributable to bona fide market making 

activity should be amended to permit borrows or 

purchases throughout the close-out period). 

80See Rule 204T Adopting Release, 73 FR 61710. 

81 In determining its close-out obligation, a 

participant may rely on its net delivery obligation 

as reflected in its notification from NSCC regarding 

its securities delivery and payment obligations, 

provided such notification is received prior to the 

beginning of regular trading hours on the applicable 

close-out date. See Rule 204T Adopting Release, 73 

FR 61711, at n. 46 (and accompanying text). 

82See Rule 204T Adopting Release, 73 FR 61711. 

Both temporary Rule 204T and Rule 204 require 

that a participant purchase or borrow shares, as 

applicable, to close out a fail to deliver position. 

Accordingly, the purchase or borrow on the 

applicable close-out date must be for the full 

quantity of the fail to deliver position that is subject 

to the close-out requirement. In addition, where a 

participant subject to the close-out requirement 

purchases or borrows securities on the applicable 

close-out date and on that same date engages in sale 

transactions that can be used to re-establish or 

otherwise extend the participant’s fail position, and 

for which the participant is unable to demonstrate 

a legitimate economic purpose, the participant will 

not be deemed to have satisfied the close-out 

requirement. 

83See Rule 204(g)(1); see also Rule 204T(f)(1). 

84See 17 CFR 240.15c6–1; see also Rule 204T 

Adopting Release, 73 FR 61711. 

85See Rule 204T Adopting Release, 73 FR 61711. 

Of course, broker-dealers must comply with any 

applicable SRO policies and procedures 

requirements. For example, NASD Rule 3010 

contains, among other things, written procedures 

requirements for member firms. 

86See temporary Rule 204T; see also 17 CFR 

242.203(b)(3). 

87See Rule 204T Adopting Release, 73 FR 61711; 

see also 17 CFR 242.203(b)(3). 

88See, e.g., letters from SIFMA; MFA; State 

Street. 

Commenters stated that borrowing 

securities serves the same purpose as 

purchasing securities to close out fails 

to deliver.77 In addition, commenters 

noted that allowing a borrow to close 

out such fails would be consistent with 

the close-out requirements for short 

sales. After considering the comments 

received, we provide in Rule 204(a)(1) 

the ability for a participant to close out 

a fail to deliver position resulting from 

a long sale by purchasing or borrowing 

securities.78 We believe that such an 

amendment is consistent with our goal 

of reducing fails to deliver by 

maintaining the reductions in fails to 

deliver achieved by the adoption of 

temporary Rule 204T, as well as other 

actions taken by the Commission, 

because it will provide additional 

flexibility to participants in closing out 

fail to deliver positions.79 Permitting a 

borrow as well as a purchase will also 

make the close-out requirements of Rule 

204(a)(1) consistent with the close-out 

requirements of Rule 204(a). 

As we stated with respect to Rule 

204T’s close-out requirements, under 

Rule 204’s close-out requirements for 

fails to deliver resulting from long or 

short sales, a participant must take 

affirmative action to close out a fail to 

deliver position by purchasing or 

borrowing securities.80 Thus, a 

participant may not offset the amount of 

its fail to deliver position with shares 

that the participant receives or will 

receive during the applicable close-out 

date (i.e., during T+4 or T+6, as 

applicable).81 In addition, as we stated 

in the Rule 204T Adopting Release, to 

meet its close-out obligation a 

participant also must be able to 

demonstrate on its books and records 

that on the applicable close-out date, it 

purchased or borrowed shares in the full 

quantity of its fail to deliver position 

and, therefore, that the participant has 

a net flat or net long position on its 

books and records on the applicable 

close-out date (i.e., during T+4 or T+6, 

as applicable).82

Consistent with temporary Rule 204T, 

Rule 204 defines a ‘‘settlement date’’ as 

‘‘the business day on which delivery of 

a security and payment of money is to 

be made through the facilities of a 

registered clearing agency in connection 

with the sale of a security.’’ 83 As we 

noted in the Rule 204T Adopting 

Release, this definition is consistent 

with Rule 15c6–1 under the Exchange 

Act that prohibits broker-dealers from 

effecting or entering into a contract for 

the purchase or sale of a security that 

provides for payment of funds and 

delivery of securities later than the third 

business day after the date of the 

contract unless otherwise expressly 

agreed to by the parties at the time of 

the transaction.84

Because most transactions settle by 

T+3 and because delivery on all sales 

should be made by settlement date, 

participants should consider having in 

place policies and procedures to help 

ensure that delivery is being made by 

settlement date. As we stated in the 

Rule 204T Adopting Release, we intend 

to examine participants’ policies and 

procedures to determine whether, 

among other things, such policies and 

procedures require broker-dealers to 

monitor for delivery by settlement 

date.85

Consistent with the existing close-out 

requirements of Rule 203(b)(3) of 

Regulation SHO and temporary Rule 

204T, the close-out requirements of Rule 

204 are based on a participant’s fail to 

deliver position at a registered clearing 

agency. As noted above, the NSCC 

clears and settles the majority of equity 

securities trades conducted on the 

exchanges and in the over-the-counter 

markets. NSCC clears and settles trades 

through the CNS system, which nets the 

securities delivery and payment 

obligations of all of its members. NSCC 

notifies its members of their securities 

delivery and payment obligations daily. 

Because Rule 204 is based on a 

participant’s fail to deliver position at a 

registered clearing agency, it is 

consistent with current settlement 

practices and procedures and with the 

Regulation SHO framework regarding 

delivery of securities.86

2. Application to All Equity Securities 

Consistent with temporary Rule 204T, 

the close-out requirements of Rule 204 

apply to fails to deliver in all equity 

securities. As discussed in the Rule 

204T Adopting Release, this 

requirement differs from the close-out 

requirement of Rule 203(b)(3) of 

Regulation SHO that applies the closeout requirements of that rule only to 

those securities with a large and 

persistent level of fails to deliver, i.e., 

threshold securities.87

A purpose of Rule 204 is to help limit 

the use of ‘‘naked’’ short selling as part 

of a manipulative scheme. To achieve 

this purpose, we are applying the rule 

to all equity securities, regardless of the 

level or persistence of any fails to 

deliver in such securities. In addition, 

as discussed above, we believe that all 

sellers of equity securities should 

promptly deliver, or arrange for delivery 

of, securities to the respective buyer and 

all buyers of securities have a right to 

expect prompt delivery of securities 

purchased. We believe this should be 

the case for sales in all equity securities 

and are adopting this rule to further that 

goal. 

We note that in the Rule 204T 

Adopting Release, we requested 

comment regarding whether temporary 

Rule 204T should be expanded to apply 

to debt as well as equity securities. In 

response, commenters opposed the 

extension of temporary Rule 204T to 

debt securities.88 One such commenter 

stated that the Commission has 

expressly carved out debt securities 

from all short sale regulations, including 

Regulation SHO, citing in support the 

non-manipulative potential associated 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38273 

89See letter from SIFMA (referring to, among 

other things, Securities Exchange Act Release No. 

56206 (Aug. 6, 2007), 72 FR 45094 (Aug. 10, 2007)). 

90See id. 

91See id. 

92See 2004 Regulation SHO Adopting Release, 69 

FR 48016. 

93See id. at 48017. 

94See id. at 48018. 

95See supra Section II (discussing the elimination 

of Regulation SHO’s ‘‘grandfather’’ and options 

market maker exceptions). 

96See Rule 204T Adopting Release, 73 FR 61711– 

61712. 

97See, e.g., letter from Leland Chan, General 

Counsel, California Bankers Association, dated Aug. 

21, 2008; letter from Eric C. Jensen, Esq., Cooley 

Godward Kronish L.L.P., dated Aug. 21, 2008; letter 

from Steven B. Boehm and Cynthia M. Krus, 

Sutherland Asbill Brennan LLP, dated July 31, 

2008; letter from James J. Angel, Professor of 

Finance, Georgetown University, McDonough 

School of Business, dated Aug. 20, 2008; letter from 

Tuan Nguyen, dated Aug. 8, 2008; see also Short 

Sale Price Test Proposing Release, 74 FR 18042 

(proposing short sale price test restrictions and 

short sale circuit breaker rules due to recent 

changes in market conditions and a deterioration in 

investor confidence). 

98See letter from CBOE. 

99See Rule 204T Adopting Release, 73 FR 61712, 

n. 60. We also noted these fails accounted for 

approximately 54.5% (56.6%) of all fail to deliver 

shares (by dollar value). 

100See temporary Rule 204T(d); see also 17 CFR 

242.203(b)(3)(vi). Rule 203(b)(3)(vi) of Regulation 

SHO provides that ‘‘[i]f a participant of a registered 

clearing agency reasonably allocates a portion of a 

fail to deliver position to another registered broker 

or dealer for which it clears trades or for which it 

is responsible for settlement, based on such broker 

or dealer’s short position, then the provisions of 

this paragraph (b)(3) relating to such fail to deliver 

position shall apply to the portion of such 

registered broker or dealer that was allocated the 

fail to deliver position, and not to the participant.’’ 

101See Rule 204(d). 

102One commenter requested that we clarify 

whether an allocated broker-dealer may reasonably 

re-allocate to the broker-dealer from which it 

Continued 

with fixed income securities.89 This 

commenter stated that it believes that 

certain structured products should also 

be excluded from the application of 

temporary Rule 204T.90 This commenter 

acknowledged, however, that the 

‘‘equity’’ status of some structured 

products may not be clear and its view 

that it may not be feasible for the 

Commission to make broad-based 

determinations on whether categories of 

securities constitute debt or equity.91

After considering the comments and 

because all other provisions of 

Regulation SHO apply only to equity 

securities, at this time, we are not 

extending Rule 204 to securities other 

than equity securities. We note, 

however, for those securities for which 

market participants believe the ‘‘equity’’ 

status is unclear, we will consider on a 

case-by-case basis whether the 

provisions of Rule 204, and Regulation 

SHO more generally, apply. 

Regulation SHO, as adopted in 2004, 

was a first step in reducing persistent 

fails to deliver and addressing abusive 

‘‘naked’’ short selling. In Regulation 

SHO, we took a targeted approach, 

imposing additional delivery 

requirements on securities with a 

substantial and persistent amount of 

fails to deliver. As we stated in the 2004 

Regulation SHO Adopting Release, we 

took this targeted approach at that time 

in an effort to address the problem but 

at the same time not to burden the vast 

majority of securities where there are 

not similar concerns regarding 

settlement.92 In addition, Regulation 

SHO’s close-out requirement was 

adopted to address potential abuses that 

may occur with large, extended fails to 

deliver.93 We also noted in the 2004 

Regulation SHO Adopting Release, 

however, that we would pay close 

attention to the operation and efficacy of 

the provisions we were adopting at that 

time and would consider whether any 

further action was warranted.94

Because of continued concerns about 

the potentially negative market impact 

of fails to deliver, and the fact that 

through our monitoring of the efficacy 

of Regulation SHO’s close-out 

requirement we continued to observe 

threshold securities with fail to deliver 

positions that were not being closed out, 

we eliminated the ‘‘grandfather’’ and 

options market maker exceptions to 

Regulation SHO’s close-out 

requirements.95

However, as we stated in the Rule 

204T Adopting Release, we were 

concerned that the close-out 

requirements of Regulation SHO, as 

adopted, had not gone far enough in 

reducing fails to deliver and addressing 

potentially abusive ‘‘naked’’ short 

selling.96 In light of the recent 

instability and lack of investor 

confidence in the financial markets,97

we believe that the requirements of 

temporary Rule 204T should be made 

permanent to maintain the reduced fails 

to deliver and to address potentially 

abusive ‘‘naked’’ short selling. 

We note that one commenter to the 

Rule 204T Adopting Release suggested 

eliminating temporary Rule 204T of 

Regulation SHO, such that only the 

close-out requirements of Rule 203(b)(3) 

would apply.98 If we were to take such 

an approach, Regulation SHO’s closeout requirements would apply only to 

threshold securities and fails to deliver 

in such securities would not have to be 

closed out until such fails to deliver had 

persisted for thirteen consecutive 

settlement days. As discussed above, we 

are applying the close-out requirements 

of Rule 204 to all equity securities to 

further our goal of reducing fails to 

deliver by maintaining the reductions in 

fails to deliver achieved by the adoption 

of temporary Rule 204T, as well as other 

actions taken by the Commission, in 

both threshold and non-threshold 

securities and, thereby, also help 

continue to address abusive ‘‘naked’’ 

short selling in such securities. In the 

Rule 204T Adopting Release, we noted 

that prior to its adoption, fails to deliver 

in non-threshold securities averaged 

approximately 624 million shares or 

$4.6 billion in value per day from 

January to July 2008.99 Since adoption 

of the temporary rule, and in connection 

with other Commission actions to 

address fails to deliver, this number has 

declined significantly such that from 

December 2008 to March 2009, OEA 

estimates that fails to deliver in nonthreshold securities averaged 

approximately 307 million shares or 

$1.1 billion in value per day. We are 

applying Rule 204’s close-out 

requirements to all equity securities to 

help maintain the benefits already 

achieved. 

3. Allocation of a Fail To Deliver 

Position 

Temporary Rule 204T(d) provides that 

a participant may reasonably allocate its 

responsibility to close out a fail to 

deliver position to another broker-dealer 

from which the participant receives 

trades for clearance and settlement.100

Consistent with temporary Rule 

204T(d), Rule 204(d) provides for 

allocation of a fail to deliver position by 

a participant to a broker-dealer. 

Specifically, Rule 204(d) provides that if 

a participant of a registered clearing 

agency reasonably allocates a portion of 

a fail to deliver position to another 

registered broker or dealer for which it 

clears trades or from which it receives 

trades for settlement, based on such 

broker’s or dealer’s short position, the 

provisions of Rule 204(a) and (b) 

relating to such fail to deliver position 

shall apply to such registered broker or 

dealer that was allocated the fail to 

deliver position, and not to the 

participant.101

Thus, participants that are able to 

identify the accounts of broker-dealers 

for which they clear or from which they 

receive trades for settlement may 

allocate the responsibility to close out 

the fail to deliver position to the 

particular broker-dealer account(s) 

whose trading activities have caused the 

fail to deliver position provided the 

allocation is reasonable (e.g., the 

allocation must be timely). Absent such 

identification, however, the participant 

would remain subject to the close-out 

requirement.102


jlentini on DSKJ8SOYB1PROD with RULES2
38274 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

received the trade all or a portion of the fail to 

deliver position that it was allocated. This 

commenter stated that such re-allocation may 

continue until the fail position is allocated to the 

ultimate initiating broker-dealer. See letter from 

Bloomberg. We note that Rule 204(d) applies only 

to the allocation by a participant to a registered 

broker or dealer for which it clears trades or from 

which it receives trades for settlement. Thus, if a 

participant allocates all or a portion of a fail to 

deliver position to a broker-dealer, the close-out 

requirements of Rule 204 will apply to that 

allocated broker-dealer. This is consistent with the 

allocation provisions of temporary Rule 204T and 

Rule 203(b)(3) of Regulation SHO. Rule 204 does 

not, by its terms, apply to the allocation of costs by 

a broker-dealer in connection with meeting its 

close-out requirements. 

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

104See supra note 81 and supporting text. 

105See temporary Rule 204T(d). 

106See Rule 204T Adopting Release, 73 FR 61711. 

107See Rule 204(d). 

108See 17 CFR 242.203(b)(2)(iii) (providing an 

exception from Regulation SHO’s ‘‘locate’’ 

requirement for short sales effected by a market 

maker in connection with bona fide market making 

activities in the securities for which the exception 

is claimed). 

109See Rule 204(b). The borrow requirements of 

Rule 204(b) are also consistent with the 

requirements of Rule 203(b)(3)(iv) of Regulation 

SHO for a participant that has not closed out a fail 

to deliver position in a threshold security that has 

persisted for thirteen consecutive settlement days. 

See 17 CFR 242.203(b)(3)(iv). Rule 203(b)(3)(iv) of 

Regulation SHO provides that ‘‘[i]f a participant of 

a registered clearing agency has a fail to deliver 

position at a registered clearing agency in a 

threshold security for thirteen consecutive 

settlement days, the participant and any broker or 

dealer for which it clears transactions, including 

any market maker that would otherwise be entitled 

to rely on the exception provided in paragraph 

(b)(2)(iii) of this section, many not accept a short 

sale order in the threshold security from another 

person, or effect a short sale in the threshold 

security for its own account, without borrowing the 

security or entering into a bona fide arrangement to 

borrow the security, until the participant closes out 

the fail to deliver position by purchasing securities 

of like kind and quantity’’. 

110See letter from SIFMA. 

If a participant allocates a fail to 

deliver position to a broker-dealer in 

accordance with Rule 204(d), such that 

the close-out requirements of Rule 

204(a) apply to that broker-dealer, the 

broker-dealer to which the position was 

allocated must be able to demonstrate 

that on the applicable close-out date, it 

purchased or borrowed shares in the full 

quantity of the fail to deliver position 

allocated to it, and that it has a net flat 

or net long position on its books and 

records for that security on the 

applicable close-out date.103

In addition, as discussed above and 

consistent with temporary Rule 204T, 

the close-out requirements of Rule 204 

require that the allocated broker-dealer 

take affirmative action to close out the 

fail to deliver position by purchasing or 

borrowing securities. Thus, a brokerdealer allocated a fail to deliver position 

may not offset the amount of its fail to 

deliver position with shares that the 

broker-dealer receives or will receive 

during the applicable close-out date 

(i.e., during T+4 or T+6, as 

applicable).104

Temporary Rule 204T(d) imposes a 

notification requirement on a brokerdealer that has been allocated 

responsibility for complying with the 

rule’s requirements. Specifically, 

temporary Rule 204T(d) provides that a 

broker-dealer that has been allocated a 

portion of a fail to deliver position that 

does not comply with the provisions of 

temporary Rule 204T(a) must 

immediately notify the participant that 

it has become subject to the borrowing 

requirements of temporary Rule 

204T(b).105 In the Rule 204T Adopting 

Release, we stated that we adopted this 

notification requirement so that 

participants would know when a 

broker-dealer for which they clear and 

settle trades has become subject to the 

temporary rule’s borrowing 

requirements.106 We did not receive any 

comments specific to this notification 

requirement. We believe that the 

reasons for adopting this notification 

requirement in temporary Rule 204T(d) 

apply to Rule 204(d) as well. Thus, we 

have determined to maintain the 

requirement under Rule 204(d) that a 

broker-dealer that has been allocated a 

portion of a fail to deliver position that 

does not comply with the provisions of 

Rule 204(a) must immediately notify the 

participant that it has become subject to 

the borrowing requirements of Rule 

204(b).107

B. Rule 204(b)—Borrowing Requirement 

1. Borrowing Requirement 

We are adopting in Rule 204(b) the 

requirements of temporary Rule 204T(b) 

without modification. If a participant 

does not purchase or borrow shares, as 

applicable, to close out a fail to deliver 

position in accordance with Rule 204, 

the participant violates the close-out 

requirement of the rule. Rule 204(b), 

like temporary Rule 204T(b), also 

imposes on the participant and on all 

broker-dealers from which that 

participant receives trades for clearance 

and settlement (including introducing 

and executing brokers), a requirement to 

borrow or arrange to borrow securities 

prior to accepting or effecting further 

short sales in that security. Specifically, 

Rule 204(b) provides that the participant 

and any broker-dealer from which it 

receives trades for clearance and 

settlement, including any market maker 

that is otherwise entitled to rely on the 

exception provided in Rule 203(b)(2)(iii) 

of Regulation SHO,108 may not accept a 

short sale order in an equity security 

from another person, or effect a short 

sale order in such equity security for its 

own account, to the extent that the 

broker-dealer submits its short sales to 

that participant for clearance and 

settlement, without first borrowing the 

security, or entering into a bona-fide 

arrangement to borrow the security, 

until the participant closes out the fail 

to deliver position by purchasing 

securities of like kind and quantity and 

that purchase has cleared and settled at 

a registered clearing agency.109

We believe it is appropriate to include 

in the rule borrow requirements for 

broker-dealers, including participants, 

that sell short a security for which a fail 

to deliver position has not been closed 

out in accordance with the requirements 

of the rule. We believe that the borrow 

requirements of Rule 204(b) will further 

our goal of limiting fails to deliver, 

thereby addressing abusive ‘‘naked’’ 

short selling by promoting the prompt 

and accurate clearance and settlement of 

securities transactions. By requiring that 

participants and broker-dealers from 

which they receive trades for clearance 

and settlement borrow or arrange to 

borrow securities prior to accepting or 

effecting short sales in the security that 

has a fail to deliver position that has not 

been closed out, the rule will help to 

ensure that shares will be available for 

delivery on the short sale by settlement 

date and, thereby, help to avoid 

additional fails to deliver occurring in 

the security. 

One commenter asked for clarification 

regarding whether a participant ceases 

to be subject to the borrow requirements 

of temporary Rule 204T(b) if that 

participant no longer has a fail to 

deliver position at a registered clearing 

agency due the participant borrowing 

the securities or the participant 

receiving securities from the seller (e.g., 

in connection with long sales).110

Temporary Rule 204T(b) imposes short 

sale borrowing requirements until the 

participant closes out the fail to deliver 

position by purchasing securities of like 

kind and quantity and that purchase has 

cleared and settled at a registered 

clearing agency. Thus, under temporary 

Rule 204T regardless of whether a 

participant borrows or receives delivery 

of securities, the requirements of 

temporary Rule 204T(b) continue to 

apply until the participant purchases 

securities to close out the fail to deliver 

position and that purchase has cleared 

and settled at a registered clearing 

agency. 

We have incorporated these same 

requirements into Rule 204(b) without 

modification. Rule 204(b) requires the 

purchase and clearance and settlement 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38275 

111See Rule 204(b). Rule 204(e) is discussed in 

detail below in Section III.C. 

112See supra note 108. 

113See Rule 204(c). 

114See temporary Rule 204T(e). 

115As discussed in more detail below, in contrast 

to temporary Rule 204T(e), Rule 204(e) permits a 

broker-dealer to borrow as well as purchase 

securities to close-out a fail to deliver position prior 

to the applicable close-out date. 

116See letter from SIFMA. 

117See Rule 204(a); see also supra Section III.A.1. 

(discussing the close-out requirements of Rule 

204(a)). 

of shares purchased to help ensure that 

the fail to deliver position is closed out 

before the participant, and brokerdealers from which they receive trades 

for clearance and settlement, can accept 

or effect additional short sales without 

first borrowing or arranging to borrow 

such securities. Moreover, the 

provisions of Rule 204(b) are intended 

to act as an additional incentive to 

broker-dealers to deliver securities by 

settlement date, and to close out fail to 

deliver positions in accordance with the 

requirements of Rule 204. We believe 

that these goals would not be furthered 

absent the purchase requirement of Rule 

204(b). 

As discussed above in Section III.A.3, 

Rule 204(d) provides that a participant 

may reasonably allocate (e.g., the 

allocation must be timely) its 

responsibility to close out a fail to 

deliver position to another broker-dealer 

for which the participant clears or from 

which the participant receives trades for 

settlement. Thus, to the extent that the 

participant can identify the brokerdealer(s) that contributed to the fail to 

deliver position, and the participant has 

reasonably allocated the close-out 

obligation to the broker-dealer(s), the 

requirement to borrow or arrange to 

borrow prior to effecting further short 

sales in that security will apply to only 

those particular broker-dealer(s). 

Rule 204(b), however, includes an 

exception from the borrowing 

requirements for any broker-dealer that 

can demonstrate that it was not 

responsible for any part of the fail to 

deliver position of the participant. We 

have incorporated into Rule 204(b) the 

language of temporary Rule 204T(b)(1), 

without modification. Thus, Rule 204(b) 

provides that a broker-dealer shall not 

be subject to the requirements of 

paragraph (b) of Rule 204 if the brokerdealer timely certifies to the participant 

that it has not incurred a fail to deliver 

position on settlement date for a long or 

short sale in an equity security for 

which the participant has a fail to 

deliver position at a registered clearing 

agency or that the broker-dealer is in 

compliance with the requirements of 

Rule 204(e).111 We have included this 

exception because we do not believe 

that a broker-dealer should be subject to 

the borrowing requirements of the 

temporary rule if the broker-dealer can 

demonstrate that it did not incur a fail 

to deliver position in the security on 

settlement date, or if it has taken steps, 

in accordance with Rule 204(e), to close 

out the fail to deliver position. 

2. Notification Requirement 

In connection with the borrowing 

requirements of Rule 204(b), we are 

incorporating into Rule 204(c) the 

notification requirement contained in 

temporary Rule 204T(c), without 

modification. In accordance with Rule 

204(c), participants must notify all 

broker-dealers from which they receive 

trades for clearance and settlement that 

a fail to deliver position has not been 

closed out in accordance with Rule 204. 

Specifically, Rule 204(c) provides that 

the participant must notify any brokerdealer from which it receives trades for 

clearance and settlement, including any 

market maker that is otherwise entitled 

to rely on the exception provided in 

Rule 203(b)(2)(iii) of Regulation SHO,112

(a) that the participant has a fail to 

deliver position in an equity security at 

a registered clearing agency that has not 

been closed out in accordance with the 

requirements of Rule 204, and (b) when 

the purchase that the participant has 

made to close out the fail to deliver 

position has cleared and settled at a 

registered clearing agency.113

We are including this notification 

requirement in Rule 204(c) so that all 

broker-dealers that submit trades for 

clearance and settlement to a participant 

that has a fail to deliver position in a 

security that has not been closed out in 

accordance with Rule 204 will be on 

notice that short sales in that security to 

be cleared or settled through that 

participant will be subject to the borrow 

requirements of Rule 204(b) until the 

fail to deliver position has been closed 

out, or unless the broker-dealer can 

demonstrate, as specified in Rule 204(b), 

that it is not responsible for the fail to 

deliver position. 

C. Credit for Early Close-Outs 

To encourage early close outs of fail 

to deliver positions, temporary Rule 

204T(e) provides that a broker-dealer 

can satisfy the temporary rule’s closeout requirement by purchasing 

securities in accordance with the 

conditions of that provision (i.e., brokerdealers will receive ‘‘pre-fail credit’’ for 

the purchase).114 Encouraging early 

close outs of fail to deliver positions 

advances our goal of reducing fails to 

deliver. Thus, we have incorporated the 

conditions of temporary Rule 204T(e) 

into Rule 204 with some limited 

modifications to address commenters’ 

concerns and to provide clarification 

regarding the applicability of the 

conditions. 

Specifically, Rule 204(e) provides that 

even if a participant of a registered 

clearing agency has not closed out a fail 

to deliver position at a registered 

clearing agency in accordance with Rule 

204(a), or has not allocated a fail to 

deliver position to a broker-dealer in 

accordance with Rule 204(d), a brokerdealer shall not be subject to the 

requirements of Rule 204(a) or (b) if the 

broker-dealer purchases or borrows 115

the securities, and complies with the 

conditions set forth in Rule 204(e)(1) 

though (4), as described in more detail 

below. 

One commenter requested that we 

allow a broker-dealer to borrow as well 

as purchase shares to obtain credit for 

closing out a position prior to the 

applicable close-out date.116 Temporary 

Rule 204T(e) provides that a brokerdealer must purchase securities to 

obtain credit for closing out a position 

prior to the applicable close-out date 

because under Rule 203(b)(3) of 

Regulation SHO, we understand that 

broker-dealers purchased shares to 

obtain credit for closing out fails to 

deliver in threshold securities prior to 

the thirteenth consecutive settlement 

day of having a fail to deliver position 

in such security. We believe, however, 

that allowing a broker-dealer to borrow 

as well as purchase securities to obtain 

credit for early close-outs is consistent 

with our goal of maintaining the 

benefits already achieved under 

temporary Rule 204T, as well as other 

actions by the Commission, such as the 

recent reduction in fails to deliver, by 

providing broker-dealers with 

additional flexibility in closing out fails 

to deliver. We also note that allowing a 

borrow is consistent with the close-out 

requirements of Rule 204(a) which 

permit a participant to close out fails to 

deliver on the applicable close-out date 

by either borrowing or purchasing 

securities.117

Consistent with temporary Rule 

204T(e)(1), to obtain pre-fail credit 

under Rule 204(e), the purchase or 

borrow must be ‘‘bona fide.’’ Thus, 

where a broker-dealer enters into an 

arrangement with another person to 

purchase or borrow securities, and the 

broker-dealer knows or has reason to 

know that the other person will not 

deliver securities in settlement of the 


jlentini on DSKJ8SOYB1PROD with RULES2
38276 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

118See infra Section III.F. (discussing bona fide 

purchases and borrows for purposes of the close-out 

requirements of Rule 204); see also 17 CFR 

203(b)(3)(vii). 

119See letter from SIFMA. 

120See id. 

121See Rule 204(e)(3). 

122See Rule 204(e)(4). 

123See id. 

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

125See, e.g., letters from NYSE; CBOE; The 

Specialist Association (discussing increased 

volatility at the opening of trading due to the 

requirement under temporary Rule 204T that fails 

to deliver be closed out by no later than the 

beginning of regular trading hours). One commenter 

recommended that we also extend the close-out 

period to five settlement days after settlement date 

(i.e., T+8) for fails to deliver resulting from bona 

fide market making activity. See letter from CBOE. 

For the reasons set forth in section III.A.1 above, 

discussing generally the close-out periods under 

Rule 204, we have determined not to extend the 

close-out period to provide additional days to close 

out such fails to deliver. 

126See Rule 204(a)(3). 

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

128See letter from CBOE (stating that the closeout procedures under temporary Rule 204T for fails 

to deliver attributable to bona fide market making 

activity should be amended to permit borrows or 

purchases throughout the close-out period). 

transaction, the purchase or borrow will 

not be ‘‘bona fide.’’ 118

Also consistent with temporary Rule 

204T(e)(2), Rule 204(e)(2) provides that 

to obtain pre-fail credit, i.e., credit for 

purchases or borrows to close out fails 

to deliver resulting from short sales, the 

purchase or borrow must be executed 

after trade date but by no later than the 

end of regular trading hours on 

settlement date (i.e., T+3) for the 

transaction. Thus, the purchase or 

borrow must be executed on T+1, 2, or 

3. 

Temporary Rule 204T(e)(3) provides 

that the purchase must be of a quantity 

of securities sufficient to cover the 

entire amount of the broker-dealer’s 

open short position. One commenter 

stated that it believes that the brokerdealer should only have to close out its 

open fail to deliver position, and not its 

open short position.119 This commenter 

noted that a broker-dealer’s open short 

position could far exceed its open fail to 

deliver position and, therefore, a 

requirement to purchase securities to 

close out the broker-dealer’s entire open 

short position would not encourage 

early close outs of fail to deliver 

positions.120

The purpose of Rule 204(e) is to 

encourage broker-dealers to close out 

fail to deliver positions prior to the 

close-out date. Requiring a broker-dealer 

to close out its open fail to deliver 

position prior to the applicable closeout date is more effective at achieving 

that goal than requiring a broker-dealer 

to close out its open short position prior 

to the applicable close-date because a 

broker-dealer’s open short position 

could far exceed its open fail to deliver 

position and, therefore, requiring close 

out of the potentially smaller fail to 

deliver position only is more likely to 

encourage broker-dealers to close out 

such positions early. Thus, in contrast 

to temporary Rule 204T(e)(3), Rule 

204(e)(3) provides that a broker-dealer 

must purchase or borrow a quantity of 

securities sufficient to cover the entire 

amount of that broker-dealer’s fail to 

deliver position at a registered clearing 

agency in that security, rather than the 

entire amount of the broker-dealer’s 

open short position.121

In addition, to help ensure that 

broker-dealers purchase sufficient 

shares to close out their fail to deliver 

positions, Rule 204(e)(4) incorporates 

the condition of temporary Rule 

204T(e)(4) that the broker-dealer that is 

purchasing or borrowing securities must 

be net flat or net long in that security 

on its books and records on the day of 

the purchase or borrow.122 Consistent 

with temporary Rule 204T(e)(4), Rule 

204(e)(4) requires that the broker-dealer 

demonstrate that it has complied with 

this requirement.123 This requirement 

will enable the Commission and SROs 

to monitor more effectively whether or 

not a broker-dealer has complied with 

the requirements of Rule 204(e). 

D. Market Makers 

To allow broker-dealers that are 

market makers to facilitate customer 

orders in a fast moving market, 

temporary Rule 204T includes a limited 

exception from the temporary rule’s 

close-out requirement for fails to deliver 

attributable to bona fide market making 

activities by registered market makers, 

options market makers, or other market 

makers obligated to quote in the overthe-counter market. Temporary Rule 

204T requires that such fails to deliver 

are closed out by no later than the 

beginning of regular trading hours on 

the third settlement day following the 

settlement date for the transaction (i.e., 

T+6).124

Similar to commenters’ discussions 

regarding extending the close-out period 

to the end of the day for fails to deliver 

subject to the requirements of temporary 

Rule 204T(a) and (a)(1), commenters 

requested that we extend the market 

maker close-out period under temporary 

Rule 204T(a)(3) to the end of regular 

trading hours on the close-out date to 

help reduce buy-in risk.125

We recognize commenters’ concerns 

regarding the market impact of 

temporary Rule 204T’s close-out 

requirements, particularly at the market 

open. As discussed above, however, we 

believe, at this time, that it is 

appropriate to adopt temporary Rule 

204T’s requirement that fails to deliver, 

including fails to deliver resulting from 

market making activity, are closed out 

by no later than the beginning of regular 

trading hours on the applicable closeout date to help further our goal of 

reducing fails to deliver by maintaining 

the reductions in fails to deliver 

achieved by the adoption of temporary 

Rule 204T, as well as other actions 

taken by the Commission, and to 

maintain the benefits achieved pursuant 

to temporary Rule 204T. Thus, Rule 

204(a)(3) provides that if a participant of 

a registered clearing agency has a fail to 

deliver position at a registered clearing 

agency in any equity security that is 

attributable to bona fide market making 

activities by a registered market maker, 

options market maker, or other market 

maker obligated to quote in the over-thecounter market, the participant shall by 

no later than the beginning of regular 

trading hours on the third consecutive 

settlement day following the settlement 

date, immediately close out the fail to 

deliver position.126

In contrast to temporary Rule 

204T(a)(3), however, Rule 204(a)(3) 

permits a participant to borrow 

securities to close-out a fail to deliver 

position. In temporary Rule 204T, we 

required a participant to purchase 

securities to close out fails to deliver 

attributable to bona fide market making 

activity to be consistent with the closeout requirements of Rule 203(b)(3) of 

Regulation SHO which require that a 

participant that has a fail to deliver 

position in a threshold security for 

thirteen consecutive settlement days 

immediately thereafter close out the fail 

to deliver position by purchasing 

securities of like kind and quantity.127

Rule 204(a)(3) permits a borrow as 

well as a purchase to close out a fail to 

deliver position because we believe that 

such an amendment is consistent with 

our goal of maintaining the recent 

reduction in fails to deliver because it 

will provide additional flexibility to 

participants in closing out fail to deliver 

positions.128 Permitting a borrow as 

well as a purchase will also make the 

close-out requirements of Rule 204(a)(3) 

consistent with the close-out 

requirements of Rule 204(a) and (a)(1). 

As noted above and consistent with 

temporary Rule 204T, the close-out 

requirements of Rule 204 require that a 

broker-dealer take affirmative action to 

close out the fail to deliver position by 

purchasing or borrowing securities. 

Thus, under Rule 204(a)(3), a market 

maker may not offset the amount of a 

fail to deliver position with shares that 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38277 

129See supra note 81 and supporting text. 

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

131See 17 CFR 230.144. 

132See temporary Rule 204T(a)(2). 

133See 17 CFR 242.203(b)(2)(ii). In the 2004 

Regulation SHO Adopting Release, the Commission 

stated that it believed that 35 calendar days is a 

reasonable outer limit to allow for restrictions on 

a security to be removed if ownership is certain. In 

addition, the Commission noted that Section 

220.8(b)(2) of Regulation T of the Federal Reserve 

Board allows 35 calendar days to pay for securities 

delivered against payment if the delivery delay is 

due to the mechanics of the transactions. See 2004 

Regulation SHO Adopting Release, 69 FR 48015, 

n.72. 

134See 2007 Regulation SHO Final Amendments, 

72 FR 45550–45551. 

135See 17 CFR 242.200(a). 

136See 2007 Regulation SHO Final Amendments, 

72 FR 45550–45551. 

137See letter from SIFMA. 

138See id.; see also supra note 133, and 

accompanying text. 

139See letter from SIFMA. 

140See id. 

141Such circumstances could include the 

situation where a convertible security, option, or 

warrant has been tendered for conversion or 

exchange, but the underlying security is not 

reasonably expected to be received by settlement 

date. See 2004 Regulation SHO Adopting Release, 

69 FR 48015; see also 17 CFR 242.200(b) (defining 

when a person shall be ‘‘deemed to own’’ a 

security). Another situation could include the sale 

of a Rule 144 Security. See Rule 204T Adopting 

Release, 73 FR 61715. In addition, we understand 

that sellers that own restricted equity securities that 

wish to sell pursuant to an effective resale 

registration statement under Rule 415 under the 

Securities Act experience similar types of potential 

settlement delays as sales of Rule 144 Securities. 

Thus, fails to deliver in such securities may be 

closed out in accordance with Rule 204(a)(2) if the 

fails to deliver resulted from sales of securities that 

were outstanding at the time they were sold and the 

sale occurred after a registration has become 

effective. In addition, we understand that sales 

pursuant to broker-assisted cashless exercises of 

compensatory options to purchase a company’s 

stock, may result in potential settlement delays and, 

therefore, fails to deliver. Such fails to deliver may 

be closed out in accordance with Rule 204(a)(2). 

it receives or will receive during the 

close-out date.129

Temporary Rule 204T(b)(2) included 

an exception from the borrowing 

requirements of temporary Rule 204T(b) 

for market makers that can demonstrate 

that they do not have an open short 

position in the equity security at the 

time of any additional short sales.130 We 

do not believe that a similar exception 

is necessary under Rule 204(b) because, 

as with other broker-dealers, a market 

maker is excepted from the borrowing 

requirements of Rule 204(b) if it timely 

certifies to the participant that it has not 

incurred a fail to deliver position on 

settlement date for a long or short sale 

in an equity security for which the 

participant has a fail to deliver position 

at a registered clearing agency or that it 

is in compliance with the requirements 

of Rule 204(e). Because Rule 204(b) 

includes an exception applicable to all 

broker-dealers, including market 

makers, we do not think it is necessary 

to maintain a separate exception 

applicable only to market makers. 

E. Sales of Certain Deemed To Own 

Securities 

Temporary Rule 204T(a)(2) includes 

an exception from the temporary rule’s 

close-out requirements for sales of Rule 

144 Securities.131 Specifically, 

temporary Rule 204T(a)(2) provides that 

if a participant of a registered clearing 

agency has a fail to deliver position at 

a registered clearing agency in an equity 

security sold pursuant to Rule 144 for 

thirty-five consecutive settlement days 

after the settlement date for a sale in 

that equity security, the participant 

shall, by no later than the beginning of 

regular trading hours on the thirty-sixth 

consecutive settlement day following 

the settlement date for the transaction, 

immediately close out the fail to deliver 

position by purchasing securities of like 

kind and quantity.132

Regulation SHO provides an 

exception from the ‘‘locate’’ requirement 

of Rule 203(b)(1) for situations where a 

broker-dealer effects a short sale on 

behalf of a customer that is deemed to 

own the security pursuant to Rule 200 

of Regulation SHO, although, through 

no fault of the customer or brokerdealer, it is not reasonably expected that 

the security will be in the physical 

possession or control of the brokerdealer by settlement date and, therefore, 

is a ‘‘short’’ sale under the marking 

requirements of Rule 200(g). Rule 

203(b)(2)(ii) of Regulation SHO provides 

that in such circumstances, delivery 

must be made on the sale as soon as all 

restrictions on delivery have been 

removed, and in any event no later than 

35 days after trade date, at which time 

the broker-dealer that sold on behalf of 

the person must either borrow securities 

or close out the open position by 

purchasing securities of like kind and 

quantity.133 In addition, in 2007 we 

adopted amendments to the close-out 

requirement of Regulation SHO to allow 

fails to deliver resulting from sales of 

threshold securities pursuant to Rule 

144 to be closed out within 35 rather 

than 13 consecutive settlement days.134

We included in temporary Rule 204T 

an exception for Rule 144 Securities 

because these securities are formerly 

restricted securities that a seller is 

‘‘deemed to own,’’ as defined by Rule 

200(a) of Regulation SHO.135 The 

securities, however, may not be capable 

of being delivered on the settlement 

date due to processing delays related to 

removal of the restricted legend and, 

therefore, sales of these securities 

frequently result in fails to deliver. In 

addition, this exception is consistent 

with our statements in connection with 

our recent amendments to Rule 

203(b)(3) of Regulation SHO which 

extended the close-out requirements of 

that rule for fails to deliver in threshold 

securities sold pursuant to Rule 144.136

We limited the exception in temporary 

Rule 204T to Rule 144 Securities, rather 

than extending the exception to all 

formerly restricted securities that a 

seller is ‘‘deemed to own,’’ to remain 

consistent with Rule 203(b)(3) of 

Regulation SHO. 

In response to a request for comment, 

one commenter that discussed the 

requirements of temporary Rule 

204T(a)(2) relating to fails to deliver 

resulting from sales of Rule 144 

Securities urged the Commission to 

retain the exception, and to extend it to 

cover sales of other securities that a 

person owns, but is unable to deliver on 

settlement date.137 In particular, the 

commenter stated that the exception 

should apply to the same universe of 

securities to which the exception in 

Rule 203(b)(2)(ii) of Regulation SHO 

applies.138 In addition, the commenter 

stated that for those securities subject to 

the close-out requirements of temporary 

Rule 204T(a)(2) and the delivery 

requirements of Rule 203(b)(2)(ii) there 

is confusion as to which time-frame for 

closing out fails to deliver resulting 

from sales of these securities should 

apply.139 We note, however, that rather 

than changing the close-out requirement 

of temporary Rule 204T(a)(2), this 

commenter recommended extending the 

delivery time-frame of Rule 203(b)(2)(ii) 

of Regulation SHO to 35 settlement 

days, rather than calendar days, from 

trade date.140

After considering the comments and 

to provide consistency between the 

delivery requirements of Rule 

203(b)(2)(ii) of Regulation SHO and the 

close-out requirements of Rule 204, we 

are adopting in Rule 204(a)(2) the 

requirements of temporary Rule 

204T(a)(2) with some modifications. 

Specifically, we are expanding the 

universe of securities to which Rule 

204(a)(2) will apply. It will apply to fails 

to deliver resulting from the sale of an 

equity security that a person is ‘‘deemed 

to own’’ pursuant to Rule 200 of 

Regulation SHO and that such person 

intends to deliver as soon as all 

restrictions on delivery have been 

removed.141 In addition, we are revising 

the close-out period within which a 

participant must close out fails to 

deliver resulting from sales of such 

securities to be consistent with the 

delivery period contained in Rule 


jlentini on DSKJ8SOYB1PROD with RULES2
38278 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

142See Rule 204(a)(2). 

143See Rule 204(b). 

144See Rule 204T Adopting Release, 73 FR 61714, 

n.78; see also 17 CFR 242.203(b)(3)(vii); 2004 

Regulation SHO Adopting Release, 69 FR 48018, 

n.96. 

145See Rule 204(f). 

146See, e.g., letters from SIFMA; NYSE; Wedbush; 

Lek Securities Corporation; CBOE; BATS; EWT; The 

Specialist Association. 

147See letter from SIFMA. 

148See, e.g., letter from NYSE (stating that by 

operation of NYSE and NYSE Alternext rules, odd 

lot executions take place automatically, with the 

designated market maker (‘‘DMM’’) acting as the 

contra-side to all odd lot trades. As a result, DMMs 

may sell short in a de minimis amount 

automatically and without prior knowledge. This 

commenter further stated that if the odd lot trade 

occurs in hard-to-borrow or illiquid securities, the 

DMM may not be able to avoid failing to deliver). 

149See letter from NYSE. 

150See letters from The Specialist Association; 

Wedbush. 

151See letter from EWT; see also letter from Lek 

Securities Corporation. 

203(b)(2)(ii) of Regulation SHO. 

Accordingly, Rule 204(a)(2) provides 

that if a participant of a registered 

clearing agency has a fail to deliver 

position at a registered clearing agency 

in any equity security resulting from the 

sale of a security that a person is 

deemed to own pursuant to Rule 200 of 

Regulation SHO and that such person 

intends to deliver as soon as all 

restrictions on delivery have been 

removed, the participant shall, by no 

later than the beginning of regular 

trading hours on the thirty-fifth 

consecutive calendar day following the 

trade date for the transaction, 

immediately close out the fail to deliver 

position by purchasing securities of like 

kind and quantity.142

In addition to being consistent with 

the delivery time-frame under Rule 

203(b)(2)(ii) of Regulation SHO, we 

believe that a close-out requirement of 

35 consecutive calendar days from trade 

date for fails to deliver resulting from 

sales of such owned securities will 

permit the orderly settlement of such 

sales without the risk of causing market 

disruption due to unnecessary 

purchasing activity (particularly if the 

purchases are for sizable quantities of 

stock). Because the security being sold 

will be received as soon as all 

processing delays have been removed, 

this additional time will allow 

participants to close out fails to deliver 

resulting from the sale of the security 

with the security sold, rather than 

having to close out such fail to deliver 

position by purchasing securities in the 

market. In addition, we note that 

although a commenter requested that we 

maintain the close-out requirement of 

temporary Rule 204T(a)(2) but amend 

the delivery time-frame of Rule 

203(b)(2)(ii) of Regulation SHO to 35 

settlement rather than calendar days, we 

have determined not to make such an 

amendment because we believe that 35 

calendar days from trade date should be 

a sufficient period of time within which 

delivery can be made on sales of such 

securities. We also note that 35 calendar 

days from trade date is the delivery 

time-frame with which broker-dealers 

have had to comply since the effective 

date of Regulation SHO in January 2005, 

if relying on the exception in Rule 

203(b)(2)(ii) to the rule’s locate 

requirement. We are not aware that 

broker-dealers have been unable to 

comply with this delivery requirement. 

Although this amendment will 

provide an extended period of time 

within which fails to deliver resulting 

from sales of certain ‘‘deemed to own’’ 

securities must be closed out, we 

believe that such additional time is 

warranted and does not undermine our 

goal of reducing fails to deliver because 

these are sales of owned securities that 

cannot be delivered by settlement date 

due solely to processing delays outside 

the seller’s or broker-dealer’s control. 

Moreover, delivery will be made on 

such sales as soon as all restrictions on 

delivery have been removed. In 

addition, Rule 204(b)’s borrowing 

requirements will help ensure that, if a 

fail to deliver position is not closed out 

in accordance with Rule 204(a)(2), 

additional fails to deliver cannot occur 

until securities have been purchased to 

close out the fail to deliver position and 

such purchase has cleared and settled. 

If a participant does not close out a fail 

to deliver position at a registered 

clearing agency in accordance with Rule 

204(a)(2), the rule prohibits the 

participant, and any broker-dealer from 

which it receives trades for clearance 

and settlement, including market 

makers, from accepting any short sale 

orders or effecting further short sales in 

the particular security without 

borrowing, or entering into a bona-fide 

arrangement to borrow, the security 

until the participant closes out the 

entire fail to deliver position by 

purchasing securities of like kind and 

quantity and that purchase has cleared 

and settled at a registered clearing 

agency.143 In addition, we intend to 

closely monitor whether fails to deliver 

are being closed out in accordance with 

the requirements of Rule 204(a)(2). 

F. Sham Close-Outs 

In the Rule 204T Adopting Release, 

we stated that it is possible under 

Regulation SHO that a close out by a 

participant of a registered clearing 

agency may result in a fail to deliver 

position at another participant if the 

counterparty from which the participant 

purchases securities fails to deliver. We 

also noted, however, that Regulation 

SHO prohibits a participant of a 

registered clearing agency, or a brokerdealer for which it clears transactions, 

from engaging in ‘‘sham close outs’’ by 

entering into an arrangement with a 

counterparty to purchase securities for 

purposes of closing out a fail to deliver 

position and the purchaser knows or has 

reason to know that the counterparty 

will not deliver the securities, and 

which thus creates another fail to 

deliver position.144 Because these same 

concepts apply to the close-out 

requirements of Rule 204, we have 

determined to include rule text in 

subparagraph (f) of Rule 204 to provide 

that a participant of a registered clearing 

agency shall not be deemed to have 

fulfilled the requirements of Rule 204 

where the participant enters into an 

arrangement with another person to 

purchase or borrow securities as 

required by Rule 204, and the 

participant knows or has reason to know 

that the other person will not deliver 

securities in settlement of the purchase 

or borrow.145

G. De Minimis Fail To Deliver Positions 

Some commenters requested that the 

Commission consider including an 

exception from temporary Rule 204T’s 

close-out requirements where a 

participant’s fail to deliver position at a 

registered clearing agency is below a 

certain amount.146 One commenter 

suggested that such an exception be 

voluntary so that firms could decide 

whether or not to take advantage of the 

exception based on their particular 

business model and capabilities.147

Another commenter noted that de 

minimis fails to deliver are particularly 

likely to occur in connection with odd 

lot trading.148 This commenter stated 

that it believes that permitting a de 

minimis fail to deliver, particularly in 

less-than-round lots, would not 

undermine the intent of temporary Rule 

204T.149 Other commenters, in 

discussing odd lot orders and fails to 

deliver, recommended a de minimis 

exception for fails to deliver of less than 

1,000 shares.150 One other commenter 

recommended a de minimis exception 

that would except a fail to deliver 

position from the close-out 

requirements if the net value of the fail 

in the particular security across all firm 

accounts is under one million 

dollars.151

A primary goal of Rule 204 is to 

continue the recent reduction in fails to 

deliver. We believe that an exception 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38279 

152 5 U.S.C. 553(d). 

153See id. at 553(d)(1), (d)(3). 

154See 17 CFR 200.30–3. 

155See 15 U.S.C. 78mm(a). 

156See 15 U.S.C. 78mm(a)(2). 

157See 5 U.S.C. 601(2) (for purposes of Regulatory 

Flexibility Act analysis, the term ‘‘rule’’ means any 

rule for which the agency publishes a general notice 

of proposed rulemaking) and 5 U.S.C. 804(3)(C) (for 

purposes of congressional review of agency 

rulemaking, the term ‘‘rule’’ does not include any 

rule of agency organization, procedure, or practice 

that does not substantially affect the rights or 

obligations of non-agency parties). 

158 44 U.S.C. 3501 et seq. 

159 In contrast to temporary Rule 204T(b), Rule 

204(b) does not include an exception from the 

borrowing requirement of the Rule specific to 

market makers. We eliminated this exception 

because, as with other broker-dealers, a market 

maker is excepted from the borrowing requirements 

of Rule 204(b) if it timely certifies to the participant 

that it has not incurred a fail to deliver position on 

settlement date for a long or short sale in an equity 

security for which the participant has a fail to 

deliver position at the registered clearing agency or 

that it is in compliance with the requirements of 

Rule 204(e). Market makers, like all other brokerdealers, will continue to be subject to the 

certification requirements under Rule 204(b). See 

supra Section III.B. (discussing Rule 204(b)). 

160See Rule 204T Adopting Release, 73 FR 

61717–61722. 

from Rule 204’s close-out requirements 

that would permit certain fails to deliver 

to persist indefinitely could undermine 

this goal. Accordingly, we have 

determined at this time not to include 

a de minimis or odd-lot related 

exception that would permit such fails 

to deliver to not have to be closed out. 

We will continue to monitor, however, 

whether a de minimis or odd-lot related 

exception is appropriate. 

IV. Administrative Procedure Act 

Section 553(d) of the Administrative 

Procedure Act (‘‘APA’’) provides that a 

substantive rule generally may not be 

made effective less than 30 days after 

notice is published in the Federal 

Register.152 Section 553(d), however, 

also provides an exception to the 30-day 

requirement where an agency finds good 

cause for providing a shorter effective 

date.153

Temporary Rule 204T will expire on 

July 31, 2009. Rule 204 makes 

permanent the provisions of temporary 

Rule 204T with limited modifications to 

address commenters’ concerns and to 

help ensure the workability of the rule 

on a permanent basis. Rule 204 is 

intended to help maintain the benefits 

achieved in part by temporary Rule 

204T, such as maintaining the recent 

reduction in fails to deliver, and address 

potentially abusive ‘‘naked’’ short 

selling by strengthening the close-out 

requirements of Regulation SHO. A gap 

between the expiration of temporary 

Rule 204T and the effective date of Rule 

204 would be contrary to these purposes 

and goals. Rule 204 in significant part, 

moreover, continues the restrictions on 

short selling that are currently in place, 

and with which participants are already 

familiar. In addition, the modifications 

that are made in Rule 204 from Rule 

204T relieve participants of some of the 

regulatory burdens imposed by 

temporary Rule 204T by, for example, 

allowing participants to close out fail to 

deliver positions from long sales and 

market making activities by borrowing 

securities. Thus, the Commission finds 

that there is good cause for making Rule 

204 effective on July 31, 2009. 

V. Amendments to Rule 30–3 

The Commission is adopting an 

amendment to Rule 30–3 of its Rules of 

Organization and Program Management 

governing delegations of authority to the 

Director of the Division of Trading and 

Markets (the ‘‘Director’’).154 The 

amendment delegates to the Director the 

authority to grant by order an exemption 

from the provisions of Regulation SHO 

of the Exchange Act, under Section 36 

of the Exchange Act. Such an exemption 

may be granted either unconditionally, 

or on specified conditions. 

Section 36 of the Exchange Act 

provides that ‘‘the Commission, by rule, 

regulation, or order, may conditionally 

or unconditionally exempt any person, 

security, or transaction, or any class or 

classes of persons, securities, or 

transactions, from any provision or 

provisions of this chapter or of any rule 

or regulation thereunder, to the extent 

that such exemption is necessary or 

appropriate in the public interest, and is 

consistent with the protection of 

investors.’’ 155

This delegation of authority to the 

Director is intended to conserve 

Commission resources and provide 

market participants needed flexibility 

by allowing the staff, pursuant to 

Section 36(a) of the Exchange Act, to 

review and act by order on applications 

for exemptions from Regulation SHO. 

Pursuant to the amendment, the 

Director may consider and act upon 

appropriate requests for relief from the 

provisions of Regulation SHO, and will 

consider the particular facts and 

circumstances relevant to each such 

request, the potential ramifications of 

granting any exemptive relief, and any 

appropriate conditions to be imposed as 

part of such an exemption. 

The Commission anticipates that the 

delegation of authority will facilitate 

efficient review. Nevertheless, the staff 

may submit matters to the Commission 

for consideration as it deems 

appropriate, and the Commission ‘‘may, 

in its sole discretion, decline to 

entertain any application for an order of 

exemption under this section.’’ 156

The Commission finds, in accordance 

with the Administrative Procedure Act, 

5 U.S.C. 553(b)(3)(A), that this 

amendment to Rule 30–3 relates solely 

to agency organization, procedure and 

practice and thus, notice and the 

opportunity for public comment before 

its effective date are unnecessary. In 

addition, because the amendment to 

Rule 30–3 relates solely to the internal 

processes of the Commission with 

regard to the grant of exemptions from 

the provisions of Regulation SHO, the 

Commission finds, pursuant to Section 

553(d)(3) of the Administrative 

Procedure Act, 5 U.S.C. 553(d)(3), that 

there is good cause for making the 

amendment effective upon publication 

in the Federal Register. For similar 

reasons, the amendment does not 

require an analysis under the Regulatory 

Flexibility Act or analysis of major 

status under the Small Business 

Regulatory Enforcement Fairness Act.157

VI. Paperwork Reduction Act 

Like temporary Rule 204T, several 

provisions under Rule 204 will impose 

a ‘‘collection of information’’ within the 

meaning of the Paperwork Reduction 

Act of 1995 (‘‘Paperwork Reduction 

Act’’).158 These collections of 

information are mandatory. With the 

single exception of the elimination in 

Rule 204 of the exception in temporary 

Rule 204T(b)(2) for market makers from 

the borrowing requirement in Rule 

204(b),159 all collections of information 

from temporary Rule 204T have been 

incorporated into Rule 204 without 

modification. The collection of 

information requirements of temporary 

Rule 204T have not been substantively 

or materially modified in Rule 204; 

therefore, the time and cost estimates for 

compliance with these provisions are 

the same for Rule 204 as our prior time 

and cost estimates for temporary Rule 

204T, which we incorporate by 

reference.160

We published a notice of our 

estimated time requirements for 

participants to comply with these 

collection of information provisions and 

requested comment on the collection of 

information requirements in connection 

with temporary Rule 204T. We 

submitted the collection of information 

to OMB for review and approval in 

accordance with 44 U.S.C. 3507(j) and 5 

CFR 1320.13. 

One commenter indicated that 

compliance with temporary Rule 204T 

resulted in an increase in man-hours to 

monitor multiple levels of data across 

various system platforms and business 


jlentini on DSKJ8SOYB1PROD with RULES2
38280 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

161See letter from SIFMA. The commenter noted 

that one firm indicated its operations personnel 

initially spent an extra 60 man-hours per day to 

comply with the rule, but acknowledged that time 

amount had tapered down through automation. The 

comment is addressed more directly in the costbenefit analysis in Section VII below. 

162See e.g., letters from CBOE; State Street. 

163Temporary Rule 204T will expire on July 31, 

2009. 

164See Memorandum from OEA Re: Impact of 

Recent SHO Rule Changes on Fails to Deliver, 

November 26, 2008 at http://www.sec.gov/ 

comments/s7-30-08/s73008-37.pdf; see also 

Memorandum from OEA Re: Impact of Recent SHO 

Rule Changes on Fails to Deliver, March 20, 2009 

at http://www.sec.gov/comments/s7-30-08/s73008- 

107.pdf; Memorandum from OEA Re: Impact of 

Recent SHO Rule Changes on Fails to Deliver, April 

16, 2009 at http://www.sec.gov/comments/s7-30-08/ 

s73008-121.pdf. 

165See e.g., letters from BATS; LEK; MFA; 

SIFMA; State Street. 

166See, e.g., letter from SIFMA. 

167See 17 CFR 242.203(b)(3). 

168See letters from BATS; ICI; SIFMA. 

169See letters from CBOE; SIFMA; State Street 

(noting some of the potential costs associated with 

units within a firm,161 and other 

commenters expressed general concerns 

with the administrative and operational 

burdens on clearing firms, customers, 

and their regulators.162 The 

Commission, however, did not receive 

any comments as to the burdens 

associated with the collection of 

information requirements in temporary 

Rule 204T. 

The information collected under Rule 

204 will continue to be retained and/or 

provided to other entities pursuant to 

the specific rule provisions and will be 

available to the Commission and SRO 

examiners upon request. The 

information collected will continue to 

aid the Commission and SROs in 

monitoring compliance with these 

requirements. In addition, the 

information collected will aid those 

subject to Rule 204 in complying with 

its requirements. 

An agency may not conduct or 

sponsor, and a person is not required to 

respond to, a collection of information 

unless it displays a currently valid OMB 

control number. The title for the 

collection of information is changed 

from ‘‘Temporary Rule 204T’’ to ‘‘Rule 

204’’ to indicate that the collection is no 

longer with regard to a temporary rule 

and the OMB control number for the 

collection of information is 3235–0647. 

VII. Cost-Benefit Analysis 

A. Summary 

The Commission is sensitive to the 

costs and benefits of its rules and we 

have considered such with respect to 

the adoption of Rule 204 of Regulation 

SHO. We are incorporating by reference 

the cost-benefit discussion in the Rule 

204T Adopting Release, except to the 

extent that we have made modifications 

or because we are addressing comments. 

In order to assist our evaluation, we 

solicited comment via questions as to 

the costs and benefits of temporary Rule 

204T, which is substantially similar to 

Rule 204. We address these comments 

as applied to permanent Rule 204 in 

detail below. In addition, we discuss in 

more detail below that we believe the 

benefits of adopting Rule 204 justify its 

costs. We also believe that the benefits 

of adopting Rule 204 justify forgoing 

benefits that might accrue if the 

Commission were to allow temporary 

Rule 204T to expire without a 

substantially similar replacement.163

As discussed above, preliminary 

results from OEA indicate that our 

actions to further reduce fails to deliver 

and, thereby, help address potentially 

abusive ‘‘naked’’ short selling are having 

their intended effect. For example, these 

preliminary results indicate a significant 

downward trend in the number of fails 

to deliver in all equity securities since, 

in addition to other measures, the 

adoption of temporary Rule 204T.164

Due to the positive impact that 

temporary Rule 204T, among other 

actions, is having on reducing fails to 

deliver and after considering the 

comments received, we believe adopting 

the provisions of that rule in a 

permanent rule, Rule 204 of Regulation 

SHO, with limited modifications to 

promote the rule’s workability and 

address commenters’ concerns, will 

further the goals outlined above and 

below. We believe these modifications 

will aid compliance with Rule 204. 

We believe that Rule 204 will help 

maintain the recent reduction in fails to 

deliver and address potentially abusive 

‘‘naked’’ short selling in all equity 

securities by requiring that, subject to 

certain limited exceptions, if a 

participant of a registered clearing 

agency has a fail to deliver position at 

a registered clearing agency it must 

immediately purchase or borrow 

securities to close out the fail to deliver 

position by no later than the beginning 

of regular trading hours on the 

settlement day following the day the 

participant incurs the fail to deliver 

position. We recognize that, like 

temporary Rule 204T, Rule 204 may 

impose increased purchasing and 

borrowing costs beyond those that 

would occur if the rule was not in place 

and that these costs may increase the 

costs of legitimate short selling. We 

believe, however, that continuing the 

requirements of temporary Rule 204T by 

adopting them in Rule 204 is necessary 

to maintain the reduction in fails to 

deliver and to continue to address 

potentially abusive ‘‘naked’’ short 

selling. We believe that continuing these 

benefits achieved under temporary Rule 

204T justifies the potential costs 

associated with making the 

requirements of that rule permanent. 

Further, we believe that the benefits 

of making the requirements of 

temporary Rule 204T permanent in Rule 

204 will justify forgoing any potential 

benefits that might accrue if the 

Commission were to allow temporary 

Rule 204T to expire. If the Commission 

were to allow temporary Rule 204T to 

expire without replacement, there might 

be potential benefits. For example, some 

commenters noted that they believe that 

there has been price disruption and 

market volatility resulting from 

temporary Rule 204T’s requirement that 

participants close out fails to deliver by 

no later than the beginning of regular 

trading hours on the applicable closeout date.165 Some commenters stated 

that temporary Rule 204T’s close-out 

requirements cause over-buying and 

over-borrowing at the market open by 

parties seeking to meet the close-out 

requirements and has unnecessarily 

interfered in transactions that would 

settle in the normal course.166

If we were to allow temporary Rule 

204T to expire without adopting a 

substantially similar rule, the 

marketplace would revert back to the 

close-out requirements of Rule 203(b)(3) 

of Regulation SHO that apply only to 

those securities with a large and 

persistent level of fails to deliver, i.e., 

threshold securities, and only to those 

fail to deliver positions that have 

persisted for thirteen consecutive 

settlement days.167 Thus, it is plausible 

that a return to this pre-temporary Rule 

204T close-out requirement might 

alleviate concerns expressed by 

commenters regarding potential overbuying, over-borrowing, volatility, and 

price disruption at the market open, be 

easier to comply with and, therefore, 

potentially reduce transaction costs to 

market participants. Further, according 

to some commenters, temporary Rule 

204T may provide disincentives to 

lenders of securities and, thus, may 

cause lower liquidity levels in the 

market place.168

In addition, if we were to allow 

temporary Rule 204T to expire without 

taking substantially similar action, 

participants might experience fewer 

costs in terms of monitoring systems 

platforms and notification obligations 

associated with complying with 

temporary Rule 204T169 and with Rule 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38281 

complying with temporary Rule 204T’s close-out 

requirements). 

170See, e.g., Rule 204T Adopting Release, 73 FR 

61711–61712. 

171See supra note 164. 

172See 2006 Regulation SHO Proposed 

Amendments, 71 FR 41712; 2007 Regulation SHO 

Final Amendments, 72 FR 45545; 2007 Regulation 

SHO Proposed Amendments, 72 FR 45558–45559; 

Anti-Fraud Rule Proposing Release, 73 FR 15378; 

Rule 204T Adopting Release, 73 FR 61709–61710 

(providing discussion of the impact of fails to 

deliver on the market); see also 2003 Regulation 

SHO Proposing Release, 68 FR 62975 (Nov. 6, 2003) 

(discussing the impact of ‘‘naked’’ short selling on 

the market). 

173See supra Section II. (discussing the potential 

negative impact of large and persistent fail to 

delivers). 

174See id. 

175See id. 

176See 204T Adopting Release, 73 FR 61709– 

61710. 

177See Rule 204(a). 

178See Rules 204(a)(1) and 204(a)(3). 

179See, e.g., letters from MFA; CBOE; SIFMA; 

BATS; RMA; State Street. 

204. For instance, the demonstration 

and notification requirements of 

temporary Rule 204T and Rule 204 and 

related compliance costs in terms of 

personnel, recordkeeping, systems, and 

surveillance mechanisms would not 

apply. However, as noted in the 

temporary Rule 204T Adopting Release, 

we believe any potential additional 

costs incurred in implementing the 

collection of information requirements 

under temporary Rule 204T would be 

minimal. We believe the same with 

respect to the costs associated with Rule 

204. In addition, we note that most of 

the infrastructure necessary to comply 

with Rule 204 should already be in 

place in order to meet the close-out 

requirements of Rule 203(b)(3) of 

Regulation SHO and, more recently, of 

temporary Rule 204T. 

For the reasons articulated above and 

below, in more detail, we believe that a 

reversion to the pre-temporary Rule 

204T close-out regime would result in a 

number of costs to the securities 

markets in the forms of an increase in 

the level of fails to deliver and a lack of 

incentive for sellers to promptly deliver 

securities by settlement date. Such 

results would undermine our goals of 

reducing fails to deliver and addressing 

potentially abusive ‘‘naked’’ short 

selling. 

As previously noted, and stated in the 

temporary Rule 204T Adopting Release, 

we are concerned that the close-out 

requirements of Regulation SHO do not 

adequately address our goals of 

reducing fails to deliver and addressing 

potentially abusive ‘‘naked’’ short 

selling.170 In part due to such concerns, 

we have taken measures to help further 

reduce fails to deliver in all equity 

securities. As discussed above, OEA’s 

findings regarding the impact of 

temporary Rule 204T, and other 

Commission actions, indicate a 

significant reduction in the number of 

fails to deliver.171 Thus, we believe it is 

necessary to adopt temporary Rule 

204T’s close-out requirements in a 

permanent rule, Rule 204, such that fails 

in all equity securities must be closed 

out within specific timeframes and, 

thereby, help maintain the recent 

reduction in fails to deliver and the 

benefits already achieved. 

B. Benefits 

By continuing to require that 

participants of a registered clearing 

agency immediately close-out a fail to 

deliver position on the applicable closeout date, Rule 204 will further our goals 

of reducing fails to deliver by 

maintaining the reductions in fails to 

deliver achieved by the adoption of 

temporary Rule 204T, as well as other 

actions taken by the Commission, and 

addressing potentially abusive ‘‘naked’’ 

short selling. This, in turn, will help to 

ensure that investors remain confident 

that trading can be conducted without 

the influence of illegal manipulation.172

The rule also furthers the goals of 

helping to maintain fair and orderly 

markets against the threat of sudden and 

excessive fluctuations of securities 

prices and substantial disruption in the 

functioning of the securities markets. 

The rule also promotes the prompt and 

accurate clearance and settlement of 

transactions in equity securities. 

In addition, by helping to further our 

goal of reducing fails to deliver by 

maintaining the reductions in fails to 

deliver achieved by the adoption of 

temporary Rule 204T, as well as other 

actions taken by the Commission, Rule 

204, like temporary Rule 204T, will help 

continue to address concerns that fails 

may create a misleading impression of 

the market for securities. Large and 

persistent fails to deliver may have a 

negative effect on shareholders, 

potentially depriving them of the 

benefits of ownership, such as voting 

and lending.173 Thus, by facilitating the 

prompt receipt of shares, Rule 204 will 

help enable investors to receive the 

benefits associated with share 

ownership. 

Persistent fails to deliver in a security 

may also be perceived by potential 

investors negatively and may affect their 

investment decisions.174 Thus, 

providing greater assurance that 

securities will be delivered might help 

alleviate investor apprehension about 

investing in certain securities and 

increase investor confidence in the 

settlement process.175

1. Close-Out Requirements 

By maintaining the close-out 

requirements of temporary Rule 204T 

we believe Rule 204 will continue to 

help restore, maintain, and enhance 

investor confidence in the securities 

markets. It will also help continue to 

limit the use of manipulative schemes 

involving ‘‘naked’’ short selling in all 

equity securities.176 Without the 

requirements of Rule 204, sellers that 

fail to deliver securities on settlement 

date may attempt to engage in trading 

activities that deliberately depress the 

price of a security. Rule 204’s close-out 

requirements will continue the 

limitations on a potential means of 

manipulation, thereby decreasing the 

possibility of artificial market influences 

and contributing to price efficiency. 

Rule 204’s close-out requirements are 

also expected to prevent large, 

widespread build-ups of fails over time. 

As in temporary Rule 204T(a), Rule 

204(a) provides that a participant of a 

registered clearing agency must deliver 

securities to a registered clearing agency 

for clearance and settlement on a long 

or short sale in any equity security by 

settlement date or, if a participant of a 

registered clearing agency has a fail to 

deliver position at a registered clearing 

agency in any equity security for a long 

or short sale transaction in that equity 

security, the participant shall, by no 

later than the beginning of regular 

trading hours on the settlement day 

following the settlement date, 

immediately close out the fail to deliver 

position by borrowing or purchasing 

securities of like kind and quantity.177

Similarly, consistent with temporary 

Rule 204T(a)(1) and (a)(3), the close-out 

requirements of Rule 204(a)(1) and (a)(3) 

for fails to deliver resulting from long 

sales and certain bona fide market 

making activity must be closed out by 

the beginning of regular trading hours 

on the close-out date for such fails to 

deliver (i.e., T+6).178

As discussed in Section III above, 

some commenters requested that we 

extend the close-out period for fails to 

deliver resulting from short sales, long 

sales, and bona fide market making 

activity from the beginning to the end of 

regular trading hours on the applicable 

close-out date. Commenters expressed 

concern that temporary Rule 204T’s 

requirement to close out fails to deliver 

by no later than the beginning of regular 

trading hours can create buying pressure 

at the open, that may temporarily distort 

the price of the security.179

Other commenters requested 

additional days within which to close 


jlentini on DSKJ8SOYB1PROD with RULES2
38282 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

180See, e.g., letters from EWT; Coalition of Private 

Investment Companies; SIFMA; MFA; State Street. 

181See, e.g., letters from CBOE; Options 

Exchanges. 

182See, e.g., letters from SIFMA; MFA; State 

Street; CBOE; Options Exchanges; Coalition of 

Private Investment Companies. 

183See, e.g., letter from SIFMA. 

184See letter from SIFMA; see also letters from 

RMA; ICI. 

185See letter from SIFMA; see also letter from 

RMA (recommending the extension of the close-out 

period for fails to deliver for all sales to settlement 

date plus three days (i.e., T+6) ‘‘to ensure that 

beneficial owners selling on-loan positions are not 

compromised by close-outs of long sales on T+4’’). 

186See letters from EWT; BATS; RMA; ICI; 

Wedbush. 

187See letters from EWT; BATS; RMA; ICI; RMA. 

188See supra note 16 (discussing the standard 

three-day settlement cycle). 

189See Rule 204T Adopting Release, 73 FR 

61712–61713. 

190See id. 

191See id. at n. 68. We note that OEA’s analysis 

examined the period from January to July 2008 and 

used the age of the fail to deliver position as 

reported by the NSCC. The NSCC data included 

only securities with at least 10,000 shares in fails 

to deliver. These numbers also included securities 

that were not subject to the close-out requirement 

in Rule 203(b)(3) of Regulation SHO, which applies 

only to ‘‘threshold securities’’ as defined in Rule 

203(c)(6) of Regulation SHO. 

192See, e.g., Anti-Fraud Rule Adopting Release, 

73 FR 61666. 

out fails to deliver in connection with 

short sales. For example, some 

commenters requested that the 

Commission extend the close-out period 

for fails to deliver resulting from short 

sales to three settlement days after the 

fail occurs, consistent with the close-out 

period for fails to deliver resulting from 

long sales and market making 

activity.180 Other commenters requested 

that the Commission extend the closeout requirement for fails to deliver 

resulting from all sales to five settlement 

days after the fail to deliver position 

occurs.181 These commenters stated that 

the additional time to close out fails to 

deliver would allow the majority of 

trades to clear and settle on their own 

within a few days following the regular 

settlement date (i.e., T+3).182

Some commenters expressed concerns 

about the effect of the close-out 

requirements of temporary Rule 204T on 

securities lending.183 One commenter 

also noted that in practice fails to 

deliver resulting from sales of securities 

on loan, which are considered ‘‘long’’ 

sales, are often closed out in accordance 

with the time-frames for fails to deliver 

resulting from short sales rather than 

long sales because temporary Rule 204T 

does not provide sufficient time to 

determine whether or not a fail to 

deliver position resulted from a long or 

short sale.184 According to this 

commenter, because some brokerdealers are purchasing securities by no 

later than the beginning of regular 

trading hours on the settlement date 

after the fail to deliver occurs, in 

accordance with the close-out 

requirements for short sales, such 

purchasing activity acts as a 

disincentive to lending and causes 

institutions to question their 

participation in lending programs.185

Other commenters stated that where 

the holder of a long position sells 

securities that have been financed 

through a securities loan, the close-out 

requirements of temporary Rule 204T 

may not provide sufficient time for the 

securities to be recalled and delivered in 

time for settlement of the sale 

transaction.186 These commenters 

stated, among other things, that 

temporary Rule 204T’s requirement that 

securities be delivered by no later than 

the beginning of regular trading hours 

does not allow for the completion of the 

securities lending cycle, which may not 

occur until the close of the DTC 

settlement window on the third 

settlement day after settlement date (i.e., 

T+6).187

Although we recognize commenters’ 

concerns regarding the potential market 

impact of the close-out requirements of 

temporary Rule 204T, particularly at the 

market open, we believe that these 

potential concerns are justified by the 

benefits of retaining in Rule 204 the 

strict close-out requirements of 

temporary Rule 204T. As discussed 

above, since the adoption of temporary 

Rule 204T, and other actions taken by 

the Commission aimed at reducing fails 

to deliver, there has been a significant 

reduction in fails to deliver. To 

maintain this reduction, we believe it is 

appropriate at this time to continue to 

require that participants close out fails 

to deliver by no later than the beginning 

of regular trading hours on the 

applicable close-out date. Thus, we are 

adopting as a permanent rule the 

requirement that fails to deliver 

resulting from short sales, long sales, 

and certain bona fide market making 

activity must be closed out by no later 

than the beginning of regular trading 

hours on the applicable close-out date. 

In addition, we believe that 

continuing to require that fails to deliver 

be closed out on the day immediately 

following the day on which the fail to 

deliver occurs is consistent with our 

goals of reducing fails to deliver by 

maintaining the reductions in fails to 

deliver achieved by the adoption of 

temporary Rule 204T, as well as other 

actions taken by the Commission, and 

addressing ‘‘naked’’ short selling and, in 

particular, potentially abusive ‘‘naked’’ 

short selling. Although extending the 

time-frames within which fails to 

deliver must be closed out may allow 

for ordinary course settlement, as 

several commenters contend, we believe 

that the close-out requirements of Rule 

204 are necessary to help encourage 

delivery by settlement date and achieve 

our goal of not allowing fails to deliver 

to persist.188

As we discussed in the Rule 204T 

Adopting Release, we believe that 

delivery on sales should be made by 

settlement date.189 In the Rule 204T 

Adopting Release, we noted that the 

vast majority of fails to deliver are 

closed out within five days after T+3.190

In addition, in that release we 

referenced a recent analysis by OEA that 

found that more than half of all fails to 

deliver and more than 70% of all fail to 

deliver positions are closed out within 

two settlement days after T+3.191 We 

also noted in that release, however, that 

although this information shows that 

delivery is being made, it demonstrates 

that often delivery is not being made 

until several days following the 

standard three-day settlement cycle. 

In addition, as discussed above, fails 

to deliver may be associated with a 

scheme to manipulate the price of a 

security. We are also concerned about 

the negative effect that fails to deliver 

and potentially abusive ‘‘naked’’ short 

selling may have on individual 

securities and the broader market, 

including on investor confidence.192

The close-out requirements of Rule 204 

help address these concerns by 

encouraging timely settlement and not 

allowing fails to deliver to persist. 

We understand, however, that fails to 

deliver may occur from long sales 

within the first two settlement days after 

settlement date for legitimate reasons. 

For example, human or mechanical 

errors or processing delays can result 

from transferring securities in custodial 

or other form rather than book-entry 

form, thereby causing a fail to deliver on 

a long sale. 

Thus, in Rule 204(a)(1), we are 

adopting, with certain limited 

modifications, the provisions of 

temporary Rule 204T(a)(1) relating to 

closing out fails to deliver resulting 

from long sales. Specifically, Rule 

204(a)(1) provides that if a participant of 

a registered clearing agency has a fail to 

deliver position at a registered clearing 

agency in any equity security and the 

participant can demonstrate on its books 

and records that such fail to deliver 

position resulted from a long sale, the 

participant shall by no later than the 

beginning of regular trading hours on 

the third consecutive settlement day 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38283 

193See Rule 204(a)(1). 194See e.g., letters from SIFMA; EWT; MFA; State 

Street; BATS; Wedbush. 195Although Rule 204(a)(1) permits borrowing to 

close out a fail to deliver position resulting from a 

long sale, broker-dealers must also comply with 

Rule 203(a) of Regulation SHO. Rule 203(a)(1) 

provides that, unless an exception applies, ‘‘[i]f a 

broker or dealer knows or has reasonable grounds 

to believe that the sale of an equity security was or 

will be effected pursuant to an order marked ‘long,’ 

such broker or dealer shall not lend or arrange for 

the loan of any security for delivery to the 

purchaser’s broker after the sale, or fail to deliver 

a security on the date delivery is due.’’ 17 CFR 

242.203(a). 

196See temporary Rule 204T(d); see also 17 CFR 

242.203(b)(3)(vi). Rule 203(b)(3)(vi) of Regulation 

SHO provides that ‘‘[i]f a participant of a registered 

clearing agency reasonably allocates a portion of a 

fail to deliver position to another registered broker 

or dealer for which it clears trades or for which it 

is responsible for settlement, based on such broker 

or dealer’s short position, then the provisions of 

this paragraph (b)(3) relating to such fail to deliver 

position shall apply to the portion of such 

registered broker or dealer that was allocated the 

fail to deliver position, and not to the participant.’’ 

197See Rule 204(d). 

following the settlement date 

immediately close out the fail to deliver 

position by purchasing or borrowing 

securities of like kind and quantity.193

In addition, consistent with 

temporary Rule 204T(a)(3), Rule 

204(a)(3) extends the close-out 

requirement for fails to deliver 

attributable to certain bona fide market 

making activities by requiring a 

participant to close out the fail to 

deliver position attributable to such 

activities by no later than the beginning 

of regular trading hours on the third 

settlement day after the settlement date. 

We believe this exception to Rule 

204(a)’s close-out requirement benefits 

clearing agency participants because the 

two additional days to close-out these 

fail to deliver positions may reduce 

close-out costs for such participants. 

Although we have determined at this 

time not to provide additional time 

within which fails to deliver must be 

closed out on the applicable close-out 

date, we are providing additional 

flexibility to the close-out requirements 

for fails to deliver resulting from long 

sales and certain bona fide market 

making activity by, in contrast to 

temporary Rule 204T(a)(1) and (a)(3), 

providing in Rule 204(a)(1) and (a)(3) 

the ability to borrow as well as purchase 

securities to close out a fail to deliver 

position. As some commenters noted, 

we believe that the ability to borrow a 

security to close-out a fail to deliver 

position may have less market impact 

than a purchase, while serving the 

objective of closing-out a fail 

position.194 In addition, we believe that 

the additional flexibility afforded by the 

ability to close out a fail to deliver 

position either through a purchase or a 

borrow, will allow participants to access 

additional liquidity sources, thereby 

potentially reducing close-out costs and 

helping to ensure that fails to deliver are 

closed out on the applicable close-out 

date.195

Temporary Rule 204T(d) provides that 

a participant may reasonably allocate its 

responsibility to close out a fail to 

deliver position to another broker-dealer 

from which the participant receives 

trades for clearance and settlement.196

Consistent with temporary Rule 

204T(d), Rule 204(d) provides for 

allocation of a fail to deliver position by 

a participant to a broker-dealer. 

Specifically, Rule 204(d) provides that if 

a participant of a registered clearing 

agency reasonably allocates a portion of 

a fail to deliver position to another 

registered broker-dealer for which it 

clears trades or from which it receives 

trades for settlement, based on such 

broker-dealer’s short position, the 

provisions of Rule 204(a) and (b) 

relating to such fail to deliver position 

shall apply to such registered brokerdealer that was allocated the fail to 

deliver position, and not to the 

participant.197 This allocation provision 

benefits participants because if a 

participant can identify the accounts of 

broker-dealers for which they clear or 

from which they receive trades for 

settlement, the participant can allocate 

the responsibility to close out the fail to 

deliver position to the particular brokerdealer account(s) whose trading 

activities caused the fail to deliver 

position, provided the allocation is 

reasonable. In this way, the allocated 

broker-dealer rather than the participant 

will incur any costs associated with 

Rule 204’s close-out requirement. 

In addition, consistent with 

temporary Rule 204T(d), Rule 204(d) 

imposes a notification requirement on a 

broker-dealer that has been allocated 

responsibility for complying with the 

rule’s requirements. Thus, under the 

rule’s allocation provision, if the brokerdealer does not comply with the 

provisions of Rule 204(a), it must 

immediately notify the participant that 

it has become subject to the borrowing 

requirements of Rule 204(b). This 

notification requirement is intended to 

let participants know when a brokerdealer from which the participant 

receives trades for clearance and 

settlement has become subject to the 

rule’s borrowing requirements. The 

notification requirement furthers the 

Commission’s goals of limiting fails to 

deliver and addressing abusive ‘‘naked’’ 

short selling by promoting the prompt 

and accurate clearance and settlement of 

transactions involving equity securities. 

The notification requirement will also 

help ensure that participants that 

receive trades for clearance and 

settlement from broker-dealers will be 

on notice that the broker-dealer is 

subject to the borrow requirements of 

Rule 204(b) until the fail to deliver 

position has been closed out. 

Under Rule 204(e), even if a 

participant of a registered clearing 

agency has not closed out a fail to 

deliver position at a registered clearing 

agency in accordance with Rule 204(a), 

or has not allocated a fail to deliver 

position to a broker-dealer in 

accordance with Rule 204(d), a brokerdealer shall not be subject to the 

requirements of Rule 204(a) or (b) if it 

purchases or borrows securities, and 

complies with the conditions set forth 

in Rule 204(e)(1) through (4), as 

described in detail in Section III.C. 

above. We note that, unlike temporary 

Rule 204T(e), Rule 204(e) permits a 

broker-dealer to use a borrow, as well as 

a purchase, to close out a position prior 

to the applicable close-out date. Rule 

204(e), similar to temporary Rule 

204T(e), encourages early close-outs of 

fail to deliver positions, by providing 

that a broker-dealer can satisfy the rule’s 

close-out requirements by purchasing 

securities prior to the applicable closeout date provided the broker-dealer 

complies with certain conditions. In 

addition, as noted above, Rule 204(e) 

provides more flexibility than 

temporary Rule 204T(e) by allowing a 

broker-dealer to close out a fail to 

deliver position prior to the applicable 

close-out date by borrowing, as well as 

purchasing securities. We believe this 

ability to borrow, as well as purchase, 

securities further encourages early 

close-outs of fail to deliver positions 

which serves the benefit of promoting 

our goal of maintaining the reductions 

in fails to deliver achieved by the 

adoption of temporary Rule 204T, as 

well as other actions taken by the 

Commission, by facilitating the ability 

to close-out fails faster. 

Further, Rule 204(e) is modified from 

temporary Rule 204T(e)(3)’s provision 

that the purchase must be of a quantity 

of securities sufficient to cover the 

entire amount of the broker-dealer’s 

open short position. The purpose of 

Rule 204(e) is to encourage brokerdealers to close out fail to deliver 

positions prior to the applicable closeout date (i.e., T+4 or T+6) by reducing 

the costs of the early close-out. 

Requiring a broker-dealer to close out its 

open fail to deliver position prior to the 

applicable close-out date is more closely 

tailored towards achieving that goal 

than requiring a broker-dealer to close 

out its open short position prior to the 


jlentini on DSKJ8SOYB1PROD with RULES2
38284 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

198See supra Section III.C. (explaining the 

conditions of Rule 204(e), as well as commenters’ 

concerns that by requiring broker-dealers to closeout their entire open short position temporary Rule 

204T(e) does not encourage early close-outs). 

199See 17 CFR 242.203(b)(2)(iii) (providing an 

exception from Regulation SHO’s ‘‘locate’’ 

requirement for short sales effected by a market 

maker in connection with bona fide market making 

activities in the securities for which the exception 

is claimed). 

200See Rule 204(b). The borrow requirements of 

Rule 204(b) are also consistent with the 

requirements of Rule 203(b)(3)(iv) of Regulation 

SHO for a participant that has not closed out a fail 

to deliver position in a threshold security that has 

persisted for thirteen consecutive settlement days. 

See 17 CFR 242.203(b)(3)(iv). Rule 203(b)(3)(iv) of 

Regulation SHO provides that ‘‘[i]f a participant of 

a registered clearing agency has a fail to deliver 

position at a registered clearing agency in a 

threshold security for thirteen consecutive 

settlement days, the participant and any broker or 

dealer for which it clears transactions, including 

any market maker that would otherwise be entitled 

to rely on the exception provided in paragraph 

(b)(2)(iii) of this section, many not accept a short 

sale order in the threshold security from another 

person, or effect a short sale in the threshold 

security for its own account, without borrowing the 

security or entering into a bona fide arrangement to 

borrow the security, until the participant closes out 

the fail to deliver position by purchasing securities 

of like kind and quantity.’’ 

201See letter from SIFMA. 

202See supra note 199. 

203See Rule 204(c). 

applicable close-out date. Thus, in 

response to commenters’ concerns, in 

Rule 204(e)(3) we have modified the 

requirement of temporary Rule 

204T(e)(3) to provide that a brokerdealer must purchase or borrow a 

quantity of securities sufficient to cover 

the entire amount of that broker-dealer’s 

fail to deliver position at a registered 

clearing agency in that security on the 

day of the purchase. Consequently, we 

believe our incorporation of the 

conditions of temporary Rule 204T(e), 

with the noted modifications, facilitates 

early close-outs of fail to deliver 

positions.198

2. Borrowing Requirements 

Under temporary Rule 204T(b), if a 

participant does not purchase or borrow 

shares, as applicable, to close out a fail 

to deliver position in accordance with 

temporary Rule 204T, the participant 

violates the close-out requirements of 

that rule. We are adopting in Rule 

204(b) the borrowing requirements of 

temporary Rule 204T(b), without 

modification. Accordingly, Rule 204(b) 

imposes on the participant and on all 

broker-dealers from which that 

participant receives trades for clearance 

and settlement (including introducing 

and executing brokers) a requirement to 

borrow or arrange to borrow securities 

prior to accepting or effecting further 

short sales in that security. We believe 

that this borrow requirement is 

beneficial in that it furthers our goals of 

reducing fails to deliver by helping to 

maintain the reductions in fails to 

deliver achieved by the adoption of 

temporary Rule 204T, as well as other 

actions taken by the Commission, and 

addressing potentially abusive ‘‘naked’’ 

short selling, by promoting the prompt 

and accurate clearance and settlement of 

securities transactions. 

Specifically, Rule 204(b) provides that 

the participant and any broker-dealer 

from which it receives trades for 

clearance and settlement, including any 

market maker that is otherwise entitled 

to rely on the exception provided in 

Rule 203(b)(2)(iii) of Regulation SHO,199

may not accept a short sale order in an 

equity security from another person, or 

effect a short sale order in such equity 

security for its own account, to the 

extent that the broker-dealer submits its 

short sales to that participant for 

clearance and settlement, without first 

borrowing the security, or entering into 

a bona-fide arrangement to borrow the 

security, until the participant closes out 

the fail to deliver position by 

purchasing securities of like kind and 

quantity and that purchase has cleared 

and settled at a registered clearing 

agency.200

Rule 204, like temporary Rule 204T, 

is aimed at reducing fails to deliver and 

addressing potentially abusive ‘‘naked’’ 

short selling. To that end, we believe it 

is appropriate to include in the rule 

borrowing requirements for brokerdealers, including participants, that sell 

short a security for which a fail to 

deliver position has not been closed out 

in accordance with the requirements of 

the rule. We believe that the borrowing 

requirements of Rule 204(b) will help 

further our goals of reducing fails to 

deliver by helping to maintain the 

reductions in fails to deliver achieved 

by the adoption of temporary Rule 204T, 

as well as other actions taken by the 

Commission, and addressing potentially 

abusive ‘‘naked’’ short selling by 

promoting the prompt and accurate 

clearance and settlement of securities 

transactions. In addition, we believe the 

rule’s requirement that participants and 

broker-dealers from which they receive 

trades for clearance and settlement 

borrow or arrange to borrow securities 

prior to accepting or effecting short sales 

in the security that has a fail to deliver 

position that has not been closed out 

will help continue to ensure that shares 

will be available for delivery on any 

additional short sales by settlement date 

and, thereby, help to avoid additional 

fails to deliver occurring in the security. 

We note that one commenter asked for 

clarification regarding whether a 

participant ceases to be subject to the 

borrow requirements of temporary Rule 

204T(b) if a participant no longer has a 

fail to deliver position at a registered 

clearing agency due to the participant 

borrowing the securities or the 

participant receiving securities from the 

seller (e.g., in connection with long 

sales).201 Temporary Rule 204T(b) 

imposes short sale borrowing 

requirements until the participant closes 

out the fail to deliver position by 

purchasing securities of like kind and 

quantity and that purchase has cleared 

and settled at a registered clearing 

agency. Thus, under temporary Rule 

204T, regardless of whether a 

participant borrows or receives delivery 

of securities, the requirements of 

temporary Rule 204T(b) continue to 

apply until the participant purchases 

securities to close out the fail to deliver 

position and that purchase has cleared 

and settled at a registered clearing 

agency. 

We have incorporated these same 

requirements into Rule 204(b) without 

modification. The provisions of Rule 

204(b) are intended to act as an 

additional incentive to broker-dealers to 

deliver securities by settlement date, 

and to close out fail to deliver positions 

in accordance with the requirements of 

Rule 204. We believe that the purchase 

requirement of Rule 204(b) is beneficial 

in that it will continue to further these 

goals. 

In connection with the borrowing 

requirements of Rule 204(b), we are 

incorporating into Rule 204(c) the 

notification requirement contained in 

temporary Rule 204T(c), without 

modification. In accordance with Rule 

204(c), participants must notify all 

broker-dealers from which they receive 

trades for clearance and settlement that 

a fail to deliver position has not been 

closed out in accordance with Rule 204. 

Specifically, Rule 204(c) provides that 

the participant must notify any brokerdealer from which it receives trades for 

clearance and settlement, including any 

market maker that is otherwise entitled 

to rely on the exception provided in 

Rule 203(b)(2)(iii) of Regulation SHO,202

(a) that the participant has a fail to 

deliver position in an equity security at 

a registered clearing agency that has not 

been closed out in accordance with the 

requirements of Rule 204, and (b) when 

the purchase that the participant has 

made to close out the fail to deliver 

position has cleared and settled at a 

registered clearing agency.203

We are including this notification 

requirement in Rule 204(c) so that all 

broker-dealers that submit trades for 

clearance and settlement to a participant 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38285 

204See Rule 204(d). 

205See Rule 204(b). 

206See temporary Rule 204T(b)(2). 

207See e.g., letter from SIFMA. 

208See Rule 204(a)(2). 

209See id. 

210See letter from SIFMA. 

211See Rule 204(b). 

that has a fail to deliver position in a 

security that has not been closed out in 

accordance with Rule 204 will be on 

notice that short sales in that security to 

be cleared or settled through that 

participant will be subject to the borrow 

requirements of Rule 204(b) until the 

fail to deliver position has been closed 

out. We believe this notification 

requirement will help serve the goal of 

addressing potentially abusive ‘‘naked’’ 

short selling in equity securities. 

As noted above, Rule 204(d) provides 

that a participant may reasonably 

allocate (e.g., the allocation must be 

timely) its responsibility to close out a 

fail to deliver position to another 

broker-dealer for which the participant 

clears or from which the participant 

receives trades for settlement. Thus, to 

the extent that the participant can 

identify the broker-dealer(s) that have 

contributed to the fail to deliver 

position, and the participant has 

reasonably allocated the close-out 

obligation to the broker-dealer(s), the 

requirement to borrow or arrange to 

borrow prior to effecting further short 

sales in that security will continue to 

apply to only those particular brokerdealer(s).204

Rule 204(b) includes an exception 

from the borrowing requirements for 

any broker-dealer that can demonstrate 

that it was not responsible for any part 

of the fail to deliver position of the 

participant. We have incorporated into 

Rule 204(b) the language of temporary 

Rule 204T(b)(1), without modification. 

Thus, Rule 204(b) provides that a 

broker-dealer shall not be subject to the 

requirements of paragraph (b) of Rule 

204 if the broker-dealer timely certifies 

to the participant that it has not 

incurred a fail to deliver position on 

settlement date for a long or short sale 

in an equity security for which the 

participant has a fail to deliver position 

at a registered clearing agency or that 

the broker-dealer is in compliance with 

the requirements of Rule 204(e).205 We 

have included this exception because 

we continue to believe that a brokerdealer should not be subject to the 

borrowing requirements of the rule if 

the broker-dealer can demonstrate that it 

did not incur a fail to deliver position 

in the security on settlement date, or if 

it has taken steps, in accordance with 

Rule 204(e), to close out the fail to 

deliver position. 

Temporary Rule 204T(b)(2) included 

an exception from the borrowing 

requirements of temporary Rule 204T(b) 

for market makers that can demonstrate 

that they do not have an open short 

position in the equity security at the 

time of any additional short sales.206 We 

do not believe that a similar exception 

is necessary under Rule 204(b) because, 

as with other broker-dealers, a market 

maker is excepted from the borrowing 

requirements of Rule 204(b) if it timely 

certifies to the participant that it has not 

incurred a fail to deliver position on 

settlement date for a long or short sale 

in an equity security for which the 

participant has a fail to deliver position 

at a registered clearing agency or that it 

is in compliance with the requirements 

of Rule 204(e). Because Rule 204(b) 

includes an exception applicable to all 

broker-dealers, including market 

makers, we do not think it is necessary 

to maintain a separate exception 

applicable only to market makers. 

3. Sales of Certain Deemed To Own 

Securities 

After considering the comments and 

to provide consistency between the 

delivery requirements of Rule 

203(b)(2)(ii) of Regulation SHO and the 

close-out requirements of Rule 204, we 

are adopting in Rule 204(a)(2) the 

requirements of temporary Rule 

204T(a)(2) with some limited 

modifications.207 Specifically, we are 

expanding the universe of securities to 

which Rule 204(a)(2) will apply. Rule 

204(a)(2) will apply to fails to deliver 

resulting from the sale of an equity 

security that a person is ‘‘deemed to 

own’’ pursuant to Rule 200 of 

Regulation SHO and that such person 

intends to deliver as soon as all 

restrictions on delivery have been 

removed.208 In addition, we are revising 

the close-out period within which a 

participant must close out fails to 

deliver resulting from sales of such 

securities to be consistent with the 

delivery period contained in Rule 

203(b)(2)(ii) of Regulation SHO. 

Thus, Rule 204(a)(2) provides that if 

a participant of a registered clearing 

agency has a fail to deliver position at 

a registered clearing agency in any 

equity security resulting from the sale of 

a security that a person is deemed to 

own pursuant to Rule 200 of Regulation 

SHO and that such person intends to 

deliver as soon as all restrictions on 

delivery have been removed, the 

participant shall, by no later than the 

beginning of regular trading hours on 

the thirty-fifth consecutive calendar day 

following the trade date for the 

transaction, immediately close out the 

fail to deliver position by purchasing 

securities of like kind and quantity.209

We believe that amending the close-out 

requirement to 35 consecutive calendar 

days from trade date for fails to deliver 

resulting from sales of such owned 

securities will better permit the orderly 

settlement of such sales without the risk 

of causing market disruption due to 

unnecessary purchasing activity 

(particularly if the purchases are for 

sizable quantities of stock). In addition, 

the amendment to the close-out period 

relieves an inconsistency between Rule 

203(b)(2)(ii) of Regulation SHO and 

temporary Rule 204T(a)(2), as noted by 

one commenter.210

Although this amendment will 

provide an extended period of time 

within which fails to deliver resulting 

from sales of certain ‘‘deemed to own’’ 

securities must be closed out, we 

believe that such additional time is 

warranted and does not undermine our 

goal of reducing fails to deliver because 

these are sales of owned securities that 

cannot be delivered by settlement date 

due solely to processing delays outside 

the seller’s or broker-dealer’s control. 

Moreover, delivery will be made on 

such sales as soon as all restrictions on 

delivery have been removed. In 

addition, if a fail to deliver position is 

not closed out in accordance with Rule 

204(a)(2), the borrowing requirements of 

Rule 204(b) will apply. Rule 204(b)’s 

borrowing requirements will help 

ensure that additional fails to deliver 

cannot occur until securities have been 

purchased to close out the fail to deliver 

position and such purchase has cleared 

and settled. 

Thus, if a participant does not close 

out a fail to deliver position at a 

registered clearing agency in accordance 

with Rule 204(a)(2), the rule prohibits 

the participant, and any broker-dealer 

from which it receives trades for 

clearance and settlement, including 

market makers, from accepting any short 

sale orders or effecting further short 

sales in the particular security without 

borrowing, or entering into a bona-fide 

arrangement to borrow, the security 

until the participant closes out the 

entire fail to deliver position by 

purchasing securities of like kind and 

quantity and that purchase has cleared 

and settled at a registered clearing 

agency.211

C. Costs 

We recognize that temporary Rule 

204T may have resulted in increased 

short selling costs for participants that 

may have impacted legitimate short 


jlentini on DSKJ8SOYB1PROD with RULES2
38286 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

212See, e.g., letter from CBOE (noting its belief 

that legitimate short selling activity has been 

damaged by temporary Rule 204T). 

213See letters from CBOE (stating that temporary 

Rule 204T has created undue burdens in trading 

and risk management, clearing, lending and buy-in 

operations and front-end trading, back-office and 

regulatory systems); SIFMA; State Street (noting the 

‘‘additional transactional, operational and market 

costs which the industry had to incur’’). 

214See supra notes 39–42 and accompanying text 

(discussing recent Commission actions in addition 

to the adoption of temporary Rule 204T). 

215See September Emergency Order, 73 FR 

54875. 

216See Adam C. Kolasinski, Adam V. Reed, and 

Jacob R. Thornock, Prohibitions versus Constraints: 

The 2008 Short Sales Regulations, March 2009 

working paper. 

217See e.g., letters from SIFMA; MFA; Wedbush; 

Lek Securities; State Street. 

218Letter from ICI; see also letter from CBOE. 

219See letters from ICI; BATS. 

220See Rule 204(a). 

221See Rules 204(a)(1) and 204(a)(3). 

222See, e.g., letters from MFA; CBOE; SIFMA; 

BATS; RMA; State Street. 

223See e.g., letters from EWT; Coalition of Private 

Investment Companies; SIFMA; MFA; State Street; 

CBOE; Options Exchanges. 

224See, e.g., letters from SIFMA; MFA; State 

Street; CBOE; Options Exchanges; Coalition of 

Private Investment Companies. 

225See, e.g., letter from SIFMA. 

226See letter from SIFMA; see also letters from 

RMA; ICI. 

227See letters from EWT; BATS; RMA; ICI; 

Wedbush; RMA. 

selling activities.212 To the extent that 

the requirements of temporary Rule 

204T have resulted in increased short 

selling costs, we do not believe that 

such costs will increase, and may in fact 

decrease, under Rule 204 because, as 

discussed below, among other things, 

we have provided additional flexibility 

to closing out fails to deliver under Rule 

204 as compared to Rule 204T. 

Some commenters stated that 

temporary Rule 204T has imposed 

burdens on market participants in 

several areas, including on firm 

operations personnel.213 Some industry 

participants have stated that lending 

rates increased significantly following 

the adoption of temporary Rule 204T 

and other recent Commission actions.214

We note, however, that the evidence 

that attempts to specify the cause of any 

such increase in lending rates is 

confounded by the unusual 

circumstances of the continued credit 

crisis. In addition, we note that a recent 

academic study that examined 

borrowing costs after the September 

Emergency Order 215 found no 

significant increase in average lending 

rates.216

As discussed in more detail below, 

some commenters also stated that the 

inflexibility of temporary Rule 204T’s 

requirement that participants purchase 

securities to close-out a fail to deliver 

position by no later than the beginning 

of regular trading hours on the 

applicable close-out date has led to 

increased market pressures and market 

volatility due to the need to execute 

potentially large purchases at the market 

open.217

To the extent that the requirements of 

Rule 204 result in increased costs to 

short selling in equity securities, it may 

lessen some of the benefits of legitimate 

short selling and, thereby, result in a 

reduction in short selling generally. 

Such a reduction may lead to a decrease 

in market efficiency 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. We also recognize that 

requiring that participants close out fails 

to deliver in equity securities in 

accordance with the rule may 

potentially impact the willingness of 

participants to provide liquidity. As one 

commenter stated, certain aspects of the 

close-out process ‘‘may have an 

unintended impact on the securities 

lending market and therefore the 

efficient functioning of the markets.’’ 218

As a result, securities lending could 

become more risky and costly and, in 

turn, impact market liquidity and price 

discovery benefits of short selling.219

Although we recognize that Rule 204 

may result in the continuation of some 

costs, as well as new costs, to certain 

participants, as discussed in detail 

below, we believe such costs will be 

limited and are justified by the fact that 

the rule will continue our efforts to 

achieve our goals of reducing fails to 

deliver by maintaining the reductions in 

fails to deliver achieved by the adoption 

of temporary Rule 204T, as well as other 

actions taken by the Commission, and 

addressing potentially abusive ‘‘naked’’ 

short selling and, thereby help restore, 

maintain, and enhance investor 

confidence in the markets. 

1. Close-Out Requirements 

Consistent with temporary Rule 

204T(a), Rule 204(a) provides that a 

participant of a registered clearing 

agency must deliver securities to a 

registered clearing agency for clearance 

and settlement on a long or short sale 

in any equity security by settlement 

date, or if a participant of a registered 

clearing agency has a fail to deliver 

position at a registered clearing agency 

in any equity security for a long or short 

sale transaction in that equity security, 

the participant shall, by no later than 

the beginning of regular trading hours 

on the settlement date, immediately 

close out the fail to deliver position by 

borrowing or purchasing securities of 

like kind and quantity.220 Similarly, 

consistent with temporary Rule 

204T(a)(1) and (a)(3), the close-out 

requirements of Rule 204(a)(1) and (a)(3) 

for fails to deliver resulting from long 

sales and certain bona fide market 

making activity must be closed out by 

the beginning of regular trading hours 

on the close-out date for such fails to 

deliver (i.e., T+6).221

As discussed in detail above in 

Section VII.B. in connection with the 

benefits of Rule 204, some commenters 

requested that we extend the close-out 

period for fails to deliver resulting from 

short sales, long sales, and bona fide 

market making activity from the 

beginning to the end of regular trading 

hours on the applicable close-out date 

due to concerns that temporary Rule 

204T’s requirement to close out fails to 

deliver by no later than the beginning of 

regular trading hours can create buying 

pressure at the open, that may 

temporarily distort the price of the 

security.222 Other commenters 

requested additional days within which 

to close out fails to deliver in 

connection with short sales.223

Commenters stated that the additional 

time to close out fails to deliver would 

allow the majority of trades to clear and 

settle on their own within a few days 

following the regular settlement date 

(i.e., T+3).224

Some commenters expressed concerns 

about the effect of the close-out 

requirements of temporary Rule 204T on 

securities lending.225 One commenter 

also noted that in practice fails to 

deliver resulting from sales of securities 

on loan, which are considered ‘‘long’’ 

sales, are often closed out in accordance 

with the time-frames for fails to deliver 

resulting from short sales rather than 

long sales because temporary Rule 204T 

does not provide sufficient time to 

determine whether or not a fail to 

deliver position resulted from a long or 

short sale, which acts as a disincentive 

to lending and causes institutions to 

question their participation in lending 

programs.226 Other commenters 

expressed concerns regarding the 

impact of temporary Rule 204T’s closeout requirements on the lending recall 

process.227

As discussed above, although we 

recognize commenters’ concerns 

regarding the potential market impact of 

the close-out requirements of temporary 

Rule 204T, such close-out requirements 

are furthering our goal of reducing fails 

to deliver, as evidenced in part by 

preliminary results from OEA regarding 

its impact on the number of fails to 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38287 

228See supra note 164. 

229See 17 CFR 242.203(b)(3). 

230See supra note 16. 

231Letter from SIFMA. 

232See supra note 35. 

233See id. 

234See id. 

235See 17 CFR 242.203(b)(3). 

236See, e.g., letter from SIFMA (indicating that 

their existing system for tracking and eliminating 

fails to deliver is based on the Regulation SHO 

framework). 

237See Rule 204T Adopting Release, 73 FR 61725. 

238See also supra Section VII.B.I. (discussing 

benefits of the close-out requirements despite 

commenters’ costs concerns). 

239See Rule 204(a)(1). 

deliver.228 To maintain this reduction, 

we believe it is appropriate at this time 

to adopt as a permanent rule the 

requirement that fails to deliver 

resulting from short sales, long sales, 

and certain bona fide market making 

activity must be closed out by no later 

than the beginning of regular trading 

hours on the applicable close-out date. 

In addition, as discussed above, we 

believe that continuing to require that 

fails to deliver be closed out on the day 

immediately following the day on 

which the fail to deliver occurs is 

consistent with our goal of reducing 

fails to deliver and addressing ‘‘naked’’ 

short selling and, in particular, 

potentially abusive ‘‘naked’’ short 

selling. Although extending the timeframes within which fails to deliver 

must be closed out may allow for 

ordinary course settlement, as several 

commenters contend, we believe that 

the close-out requirements of Rule 204 

are necessary to help encourage delivery 

by settlement date and achieve our goal 

of not allowing fails to deliver to persist. 

We recognize that Rule 204T’s closeout requirement resulted in costs for 

participants of a registered clearing 

agency in terms of systems and 

surveillance modifications and 

recordkeeping, as well as changes to 

processes and procedures. Because we 

have made limited modifications in 

Rule 204 to some of the requirements of 

temporary Rule 204T, compliance with 

Rule 204’s requirements may result in 

new costs for participants in terms of 

systems and surveillance modifications 

and recordkeeping, as well as changes to 

processes and procedures. 

We believe, however, that most of the 

infrastructure and personnel necessary 

to comply with Rule 204 is already in 

place to meet the requirements of Rule 

203(b)(3) of Regulation SHO 229 and 

temporary Rule 204T. As temporary 

Rule 204T has been in effect since 

September 2008, and Rule 204 

incorporates the substance of temporary 

Rule 204T with limited modifications, 

market participants should already have 

established systems and processes that 

should mitigate many of the costs to 

comply with Rule 204. Thus, we believe 

any additional costs incurred with 

respect to complying with Rule 204’s 

close-out requirements, over those 

incurred with respect to complying with 

temporary Rule 204T, will be minimal. 

In addition, we note that the close-out 

requirements of Rule 204 are consistent 

with current settlement practices and 

procedures and with the close-out 

requirements of temporary Rule 204T 

and Rule 203(b)(3) of Regulation SHO. 

For example, because most transactions 

settle by T+3, participants should 

already have had in place policies and 

procedures to help ensure that delivery 

is being made by settlement date prior 

to the implementation of the 

requirements of temporary Rule 

204T.230 Nevertheless, under Rule 204, 

as under temporary Rule 204T, we 

recognize that participants will continue 

to incur costs for each close-out and 

these costs could accumulate to 

significant amounts over time and 

across participants. For example, one 

commenter noted that ‘‘the close-out 

process is manual in nature and 

involves intensive monitoring of 

multiple levels of data across various 

system platforms and business units 

within the firm.’’ 231 We believe, 

however, that the experience 

participants have gained to date in 

complying with temporary Rule 204T is 

expected to reduce the costs to 

participants in complying with Rule 204 

from those incurred in connection with 

complying with Rule 204T. 

Moreover, similar to the existing 

close-out requirements of Rule 203(b)(3) 

of Regulation SHO and consistent with 

temporary Rule 204T, the requirements 

of Rule 204 are based on a participant’s 

fail to deliver position at a registered 

clearing agency. As noted above, the 

NSCC clears and settles the majority of 

equity securities trades conducted on 

the exchanges and in the over-thecounter markets.232 The NSCC clears 

and settles trades through the CNS 

system, which nets the securities 

delivery and payment obligations of all 

of its members.233 The NSCC notifies its 

members of their securities delivery and 

payment obligations daily.234 Because 

Rule 204 is based on a participant’s fail 

to deliver position at a registered 

clearing agency, it is consistent with 

current settlement practices and 

procedures and with the Regulation 

SHO framework regarding delivery of 

securities.235 As such, we anticipate that 

most participants will already have 

systems, processes and procedures in 

place in order to comply with Rule 

204’s close-out requirements and, 

therefore, that any additional 

implementation costs associated with 

the rule will be minimal. 

In addition, to comply with 

Regulation SHO’s close-out requirement 

when it became effective in January 

2005, participants needed to modify 

their recordkeeping systems and 

surveillance mechanisms.236

Participants also should have retained 

and trained the necessary personnel to 

ensure compliance with the Regulation 

SHO’s close-out requirements. As we 

noted in the Rule 204T Adopting 

Release, the infrastructure necessary to 

comply with the requirements of that 

rule should already be in place.237

Because Rule 204 incorporates the 

substance of temporary Rule 204T with 

limited modifications, we similarly 

believe that most of the infrastructure 

necessary to comply with Rule 204’s 

close-out requirements will already be 

in place. Thus, we believe minimal 

modifications will be necessary to 

comply with Rule 204. Accordingly, we 

believe that any changes to personnel, 

computer hardware and software, 

recordkeeping or surveillance costs will 

be minimal.238

We recognize that the requirements of 

Rule 204(a)(1) with respect to closing 

out fails to deliver resulting from long 

sales, may impose additional costs on 

participants. However, we believe that 

these costs are consistent with those 

currently borne by these entities in 

complying with temporary Rule 

204T(a)(1). Under Rule 204(a)(1), a 

participant of a registered clearing 

agency that has a fail to deliver position 

at a registered clearing agency in an 

equity security and can demonstrate on 

its books and records that the fail to 

deliver position resulted from a long 

sale will have until no later than the 

beginning of regular trading hours on 

the third consecutive settlement day 

following the settlement date to 

immediately close out the fail to deliver 

position by purchasing or borrowing 

securities of like kind and quantity.239

Thus, to qualify for this additional time 

to close out a fail to deliver position, the 

rule requires the participant to 

demonstrate on its books and records 

that the fail to deliver position resulted 

from a long sale. This demonstration 

requirement may result in participants 

continuing to incur costs related to 

personnel, recordkeeping, systems, and 

surveillance mechanisms. However, 

because most of these systems have 

been in place since September 2008 in 

order for broker-dealers to comply with 

the requirements of temporary Rule 


jlentini on DSKJ8SOYB1PROD with RULES2
38288 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

240 17 CFR 242.203(b)(3)(iv). 

241Letter from MFA. 

242See Rule 204(b). 

243See id. 

244See Rule 204T Adopting Release, 73 FR 

61726–61727. 

245See supra note 199. 

204T, we do not believe that the 

demonstration requirements of Rule 

204(a)(1) will result in significant 

additional cost. 

In addition, we recognize that the 

allocation notification requirement of 

Rule 204(d) may continue to impose 

costs on broker-dealers that have been 

allocated responsibility for the close-out 

requirement under the rule. As 

discussed above, consistent with 

temporary Rule 204T(d), Rule 204(d) 

requires a broker-dealer that has been 

allocated a portion of a fail to deliver 

position that has not complied with the 

close-out requirements under the rule to 

notify the participant that it has become 

subject to the borrowing requirements of 

Rule 204(b). This notification 

requirement may result in brokerdealers incurring costs related to 

personnel, recordkeeping, systems, and 

surveillance mechanisms. Again, as 

most of these mechanisms have been in 

place since the implementation of 

temporary Rule 204T, we believe any 

further implementation costs will be 

minimal, and the costs incurred with 

each notification will be similar to those 

incurred under temporary Rule 204T. 

We also recognize that like temporary 

Rule 204T, the requirements of Rule 

204(e) may continue to impose costs on 

broker-dealers. Rule 204(e) allows a 

broker-dealer to obtain credit if it 

purchases securities in accordance with 

the conditions specified in that 

provision of the rule. Rule 204(e) 

requires, among other things, that a 

broker-dealer demonstrate that it has a 

net long position or net flat position on 

its books and records on the settlement 

day for which the broker-dealer is 

claiming credit. This demonstration 

requirement may continue to result in 

participants incurring costs related to 

personnel, recordkeeping, systems, and 

surveillance mechanisms. However, we 

believe the costs associated with Rule 

204(e) will be minimal because the 

mechanisms necessary to comply with 

this requirement should already be in 

place. 

2. Borrowing Requirements 

Consistent with temporary Rule 204T, 

we believe that Rule 204’s borrowing 

requirements for fail to deliver positions 

that are not closed out in accordance 

with the rule will result in limited, if 

any, implementation costs—in terms of 

personnel, recordkeeping, systems and 

surveillance mechanisms—to 

participants of a registered clearing 

agency, and broker-dealers from which 

they receive trades for clearance and 

settlement. These entities have already 

had to comply with the borrowing 

requirements of Rule 203(b)(3)(iv) of 

Regulation SHO,240 since January 2005, 

and temporary Rule 204T since 

September 2008, as applicable, if a fail 

to deliver position has not been closed 

out in accordance with those rules’ 

mandatory close-out requirements. 

Accordingly, participants and brokerdealers are already required to have in 

place the personnel, recordkeeping, 

systems, and surveillance mechanisms 

necessary to comply with Rule 204(b)’s 

borrowing requirements. Nevertheless, 

we recognize that these borrowing 

requirements will impose costs on 

participants, broker-dealers, and 

investors, and these costs can 

accumulate to significant amounts if the 

borrowing requirement is triggered 

often. One commenter stated a concern 

that, ‘‘[R]equiring a borrow or 

arrangement to borrow securities prior 

to accepting or effectuating further short 

sales in a security that failed to deliver 

and has not been closed out, are overly 

restrictive.’’ 241 Because Rule 204 does 

not modify this requirement, we expect 

these costs to be similar to those under 

temporary Rule 204T. 

Consistent with temporary Rule 204T, 

however, Rule 204 is aimed at 

addressing potentially abusive ‘‘naked’’ 

short selling. To that end, we believe it 

is appropriate to continue to include in 

the rule borrowing requirements for 

participants and broker-dealers that sell 

short a security for which a fail to 

deliver position has not been closed out 

in accordance with the requirements of 

the rule. We believe that the borrowing 

requirements of Rule 204(b), like those 

already required by temporary Rule 

204T(b), will help further our goals of 

reducing fails to deliver by helping to 

maintain the reductions in fails to 

deliver achieved by the adoption of 

temporary Rule 204T, as well as other 

actions taken by the Commission, and 

addressing potentially abusive ‘‘naked’’ 

short selling by promoting the prompt 

and accurate clearance and settlement of 

securities transactions. By continuing to 

require that participants and brokerdealers from which they receive trades 

for clearance and settlement borrow or 

arrange to borrow securities prior to 

accepting or effecting additional short 

sales in the security that has a fail to 

deliver position that has not been closed 

out, the rule will continue to help 

ensure that shares will be available for 

delivery on the short sale by settlement 

date and, thereby, will continue to help 

avoid additional fails to deliver 

occurring in the security. 

Moreover, we believe any other costs 

incurred in connection with the 

borrowing requirements of Rule 204(b) 

will be limited because, consistent with 

temporary Rule 204T(b)(1), if a 

participant becomes subject to the 

borrowing requirements of Rule 204(b), 

a broker-dealer that clears through the 

participant will not also be subject to 

the borrowing requirements of Rule 

204(b) if that broker-dealer can 

demonstrate that it was not responsible 

for any part of the fail to deliver 

position of the participant or that it has 

complied with the requirement of Rule 

204(e).242

The certification requirement of Rule 

204(b) may impose some costs on a 

broker-dealer having to demonstrate that 

it was not responsible for any part of the 

fail to deliver position of the 

participant. As discussed above, Rule 

204(b) requires a broker-dealer to timely 

certify to the participant that it has not 

incurred a fail to deliver position on 

settlement date in an equity security for 

which the participant has a fail to 

deliver position at a registered clearing 

agency or the broker-dealer is in 

compliance with the requirements set 

forth in Rule 204(e).243 However, as we 

noted in the PRA section for temporary 

Rule 204T, the certification 

requirement’s impact on broker-dealers’ 

costs related to personnel, 

recordkeeping, systems, and 

surveillance mechanisms is expected to 

be limited.244 We expect that Rule 204’s 

impact on broker-dealers’ costs similarly 

will be limited because the 

requirements of Rule 204(b) are 

consistent with the requirements of 

temporary Rule 204T(b)(1). 

Consistent with existing requirements 

under temporary Rule 204T(c), the 

notification requirement of Rule 204(c) 

may continue to impose costs on 

participants of a registered clearing 

agency. Rule 204(c) requires a 

participant to notify any broker-dealer 

from which it receives trades for 

clearance and settlement, including any 

market maker that would otherwise be 

entitled to rely on the exception 

provided in Rule 203(b)(2)(iii) of 

Regulation SHO,245 (1) that the 

participant has a fail to deliver position 

in an equity security at a registered 

clearing agency that has not been closed 

out in accordance with the requirements 

of Rule 204(a), and (2) when the 

purchase that the participant has made 

to close out the fail to deliver position 

has cleared and settled at a registered 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38289 

246See Rule 204(c). 

247See Rule 204(a)(2). 

248See, e.g., letter from SIFMA. 

249 15 U.S.C. 78c(f). 

250 15 U.S.C. 78w(a)(2). 

251See, e.g., Fotak, Raman, and Yadav, 2009, 

Naked Short Selling: The Emperor’s New Clothes?, 

working paper, University of Oklahoma. 

252See supra note 164. 

253See Rule 204T Adopting Release, 73 FR 

61728–61729. 

254See supra Section III (discussing commenters’ 

concerns regarding the market impact of temporary 

Rule 204T). 

255See supra note 66. 

clearing agency.246 This notification 

requirement may result in participants 

incurring costs related to personnel, 

recordkeeping, systems, and 

surveillance mechanisms. We believe, 

however, that any additional costs 

under Rule 204 will be minimal because 

participants should already have in 

place mechanisms necessary to comply 

with this requirement pursuant to 

temporary Rule 204T. 

3. Sales of Certain Deemed To Own 

Securities 

We do not believe that the 

modification in Rule 204(a)(2) to apply 

the close-out requirement to fails to 

deliver resulting from the sale of any 

equity security that a person is ‘‘deemed 

to own’’ pursuant to Rule 200 of 

Regulation SHO, and that such person 

intends to deliver as soon as all 

restrictions on delivery have been 

removed, rather than just fails to deliver 

resulting from sales of Rule 144 

Securities as in temporary Rule 

204T(a)(2), will impose any significant 

additional cost on participants.247 In 

fact, this modification is responsive to 

issues raised by commenters and should 

decrease costs from those of temporary 

Rule 204T by providing additional time 

to close out fails to deliver in additional 

‘‘deemed to own’’ securities.248

Participants may incur some costs to 

implement changes to their current 

systems to comply with the limited 

modifications in Rule 204(a)(2) as 

compared with temporary Rule 

204T(a)(2). Specifically, participants 

will have to ensure that their systems 

apply the close-out requirements to all 

‘‘deemed to own’’ securities, rather than 

just equity securities sold pursuant to 

Rule 144 of the Securities Act, as well 

as monitor for compliance with the 35 

calendar day close-out period. However, 

we believe the costs for such 

adjustments will be minimal. 

VIII. Consideration of Burden on 

Competition and Promotion of 

Efficiency, Competition, and Capital 

Formation 

Section 3(f) of the Exchange Act 

requires the Commission, whenever it 

engages in rulemaking and is required to 

consider or determine if an action is 

necessary or appropriate in the public 

interest, to consider whether the action 

would promote efficiency, competition, 

and capital formation.249 In addition, 

Section 23(a)(2) of the Exchange Act 

requires the Commission, when 

adopting rules under the Exchange Act, 

to consider the impact such rules would 

have on competition.250 Exchange Act 

Section 23(a)(2) prohibits the 

Commission from adopting any rule that 

would impose a burden on competition 

not necessary or appropriate in 

furtherance of the purposes of the 

Exchange Act. 

We believe Rule 204 will not 

materially affect the promotion of the 

efficiency of the capital markets. Rule 

204 makes some modifications relative 

to temporary Rule 204T and we believe 

that Rule 204 will help limit disruptions 

due to potentially abusive ‘‘naked’’ 

short selling, but several commenters 

argue that temporary Rule 204T created 

disruptions at the open and empirical 

evidence suggests that fails to deliver, 

on average, are unrelated to stock 

prices.251

As discussed in the Rule 204T 

Adopting Release, we believe that Rule 

204 will help further our goals of 

reducing fails to deliver by maintaining 

the reductions in fails to deliver 

achieved by the adoption of temporary 

Rule 204T, as well as other actions 

taken by the Commission, and 

addressing potentially abusive ‘‘naked’’ 

short selling without unduly burdening 

legitimate short selling activity. Rule 

204 is intended to maintain the 

significant reductions in the number of 

fails to deliver in all equity securities 

since, among other actions, the adoption 

of temporary Rule 204T252 by requiring 

that participants of a registered clearing 

agency that have a fail to deliver 

position, immediately close out the fail 

to deliver position by borrowing or 

purchasing securities of like kind and 

quantity by no later than the beginning 

of regular trading hours on the 

applicable close-out date. A participant 

that does not comply with Rule 204’s 

close-out requirements, and any brokerdealer from which it receives trades for 

clearance and settlement, will not be 

able to short sell the security either for 

itself or for the account of another, 

unless it has borrowed the security, or 

entered into a bona fide arrangement to 

borrow the security, until the fail to 

deliver position is closed out. 

The rule is designed to help ensure 

that buyers of equity securities receive 

delivery of their shares, thereby helping 

to discourage persistent fails to deliver, 

which may have a negative effect on the 

securities markets and investors and 

also may be used to facilitate 

manipulative trading strategies. By 

requiring that participants of a 

registered clearing agency borrow or 

purchase securities to close out a fail to 

deliver position by no later than the 

beginning of regular trading hours on 

the applicable close-out date, Rule 204 

will promote the prompt clearance and 

settlement of securities transactions. By 

doing so, the rule will help further our 

goals of reducing fails to deliver by 

maintaining the reductions in fails to 

deliver achieved by the adoption of 

temporary Rule 204T, as well as other 

actions taken by the Commission, and 

addressing potentially abusive ‘‘naked’’ 

short selling and, thereby, will help 

ensure that investors remain confident 

that trading can be conducted without 

the illegal influence of manipulation. A 

loss of confidence in the market for 

these securities can lead to panic 

selling, which may be further 

exacerbated by potentially abusive 

‘‘naked’’ short selling. 

We sought comment regarding 

whether the rule may adversely impact 

liquidity, disrupt markets, or 

unnecessarily increase risks or costs to 

participants of a registered clearing 

agency. We are incorporating by 

reference the discussion in the Rule 

204T Adopting Release regarding the 

burden on competition and promotion 

of efficiency, competition, and capital 

formation,253 except to the extent that 

we have made modifications or because 

we are addressing comments. 

Several commenters suggested that 

temporary Rule 204T has had a negative 

impact, particularly at the market 

open.254 Although we recognize 

commenters’ concerns regarding the 

potential market impact of the close-out 

requirements of temporary Rule 204T, 

we believe that these potential concerns 

are justified by the benefits of retaining 

the strict close-out requirements of 

temporary Rule 204T. In addition, we 

note that the close-out provisions of 

Rule 204 provide additional flexibility 

in 204(a)(1) and (a)(3) by allowing a 

participant to close out a fail to deliver 

position resulting from a long sale or 

certain bona fide market making activity 

by borrowing as well as purchasing 

securities. In addition, as discussed 

above, in contrast to temporary Rule 

204T, participants may satisfy the closeout requirement to purchase securities 

of like kind and quantity with a VWAP 

order.255 This increased flexibility in 


jlentini on DSKJ8SOYB1PROD with RULES2
38290 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

256See, e.g., 2008 Regulation SHO Final 

Amendments, 73 FR 61690. 257See supra note 28 (discussing comments in 

response to the Rule 204T Adopting Release 

expressing concern about the impact of potential 

‘‘naked’’ short selling on capital formation, claiming 

that ‘‘naked’’ short selling causes a drop in an 

issuer’s stock price and may limit the issuer’s 

ability to access the capital markets). In connection 

with prior proposed amendments to Regulation 

SHO aimed at reducing fails to deliver and 

addressing potentially abusive ‘‘naked’’ short 

selling, such as the 2007 Regulation SHO Proposed 

Amendments, we sought comment on whether such 

proposed amendments would promote capital 

formation, including whether the proposed 

increased short sale restrictions would affect 

investors’ decisions to invest in certain equity 

securities. In response, commenters expressed 

concern about the potential impact of ‘‘naked’’ short 

selling on capital formation claiming that ‘‘naked’’ 

short selling causes a drop in an issuer’s stock price 

that may limit the issuer’s ability to access the 

capital markets. See, e.g., letters from Medis; 

NCANS. 

258See supra note 164. 

259Although the requirements of the Regulatory 

Flexibility Act are not applicable to rules adopted 

under the Administrative Procedure Act’s ‘‘good 

cause’’ exception, see 5 U.S.C. 601(2) (defining 

‘‘rule’’ and notice requirements under the 

Administrative Procedures Act), we nevertheless 

prepared an FRFA. 

260See Rule 204T Adopting Release, 73 FR 61712. 

261 17 CFR 240.0–10(c)(1). 

262These numbers are based on OEA’s review of 

2008 FOCUS Report filings reflecting registered 

broker-dealers. This number does not include 

broker-dealers that are delinquent on FOCUS 

Report filings. 

Rule 204, as compared with temporary 

Rule 204T, is expected to reduce the 

possibility of the increased volatility 

and market disruptions potentially 

caused by temporary Rule 204T by 

potentially providing additional sources 

of liquidity from which to obtain shares 

to close out fail to deliver positions. 

We believe that the rule will promote 

capital formation. Issuers and investors 

have repeatedly expressed concerns 

about fails to deliver in connection with 

potentially manipulative ‘‘naked’’ short 

selling.256 The perception that 

potentially abusive ‘‘naked’’ short 

selling is occurring in securities could 

undermine the confidence of investors. 

These investors, in turn, may be 

reluctant to commit capital to an issuer 

they believe to be subject to such 

manipulative conduct.257 To the extent 

that ‘‘naked’’ short selling and fails to 

deliver result in an unwarranted decline 

in investor confidence about a security, 

the rule will improve investor 

confidence about the security. As 

previously noted, preliminary results 

from OEA indicate that the 

Commission’s various recent actions 

with respect to further reducing fails to 

deliver, including the adoption of 

temporary Rule 204T, have contributed 

to a significant reduction in the number 

of fails to deliver.258 In addition, the 

rule may lead to a greater certainty in 

the settlement of these securities which 

is expected to strengthen investor 

confidence in the settlement process. 

Therefore, we believe maintaining the 

substance of temporary Rule 204T in 

permanent Rule 204 will help achieve 

the Commission’s goals of preventing 

substantial disruption in the securities 

markets, reducing fails to deliver by 

maintaining the reductions in fails to 

deliver achieved by the adoption of 

temporary Rule 204T, as well as other 

actions taken by the Commission, and 

helping to prevent potentially abusive 

‘‘naked’’ short-selling. 

We also believe that the rule will not 

impose any burden on competition not 

necessary or appropriate in furtherance 

of the purposes of the Exchange Act. By 

requiring that participants of a 

registered clearing agency borrow or 

purchase securities to close out a fail to 

deliver position by no later than the 

beginning of regular trading hours on 

the applicable close-out date, we believe 

the rule will promote competition by 

requiring similarly situated participants 

of a registered clearing agency, 

including broker-dealers from which 

they receive trades for clearance and 

settlement, to close out fail to deliver 

positions in any equity securities within 

similar time-frames. Moreover, the 

requirements of the rule will help to 

further reduce any possibility that 

potentially abusive ‘‘naked’’ short 

selling may contribute to the disruption 

of markets in equity securities and, 

therefore, will help ensure that all 

investors remain confident that trading 

in these securities can be conducted 

without the influence of illegal 

manipulation. We also believe that the 

rule will promote competition by 

protecting and enhancing the operation, 

integrity, and stability of the markets. At 

the same time, the rule will help to 

maintain fair and orderly markets 

without unduly restricting legitimate 

short selling. 

IX. Final Regulatory Flexibility 

Analysis 

The Final Regulatory Flexibility 

Analysis (‘‘FRFA’’) has been prepared in 

accordance with 5 U.S.C. 604. This 

FRFA relates to the adoption of Rule 

204 to Regulation SHO.259

A. Need for and Objectives of the Rule 

Sections I through VI of this release 

describe the reasons for and objectives 

of Rule 204. As previously stated in the 

temporary Rule 204T Adopting 

Release,260 we are concerned that the 

close-out requirements of Regulation 

SHO have not gone far enough in 

reducing fails to deliver and addressing 

potentially abusive ‘‘naked’’ short 

selling. Thus, we are incorporating the 

requirements of temporary Rule 204T 

with limited modification into Rule 204 

to help maintain the recent reductions 

in fails to deliver resulting from the 

implementation of temporary Rule 204T 

and other Commission actions. We 

believe the adoption of Rule 204 is 

appropriate to continue our goals of 

reducing fails to deliver by maintaining 

the reductions in fails to deliver 

achieved by the adoption of temporary 

Rule 204T, as well as other actions 

taken by the Commission, addressing 

potentially abusive ‘‘naked’’ short 

selling, and providing an incentive for 

sellers to promptly deliver securities by 

settlement date. 

B. Small Entities Affected by the Rule 

The entities covered by the rule will 

include small entities that are 

participants of a registered clearing 

agency and small broker-dealers from 

which participants receive trades for 

clearance and settlement. In addition, 

the entities covered by the rule will 

include small entities that are market 

participants that effect sales subject to 

the requirements of Regulation SHO. 

Although it is impossible to quantify 

every type of small entity covered by the 

rule, Paragraph (c)(1) of Rule 0–10 

under the Exchange Act 261 states that 

the term ‘‘small business’’ or ‘‘small 

organization,’’ when referring to a 

broker-dealer, means a broker or dealer 

that had total capital (net worth plus 

subordinated liabilities) of less than 

$500,000 on the date in the prior fiscal 

year as of which its audited financial 

statements were prepared pursuant to 

§ 240.17a–5(d); and is not affiliated with 

any person (other than a natural person) 

that is not a small business or small 

organization. We estimate that as of 

2008 there were approximately 915 

broker-dealers that qualified as small 

entities as defined above.262

As noted above, the entities covered 

by the rule will include small entities 

that are participants of a registered 

clearing agency. As of May 30, 2009, 

approximately 89% of participants of 

the NSCC, the primary registered 

clearing agency responsible for clearing 

U.S. transactions, were registered as 

broker-dealers. Participants not 

registered as broker-dealers include 

such entities as banks, U.S.-registered 

exchanges, and clearing agencies. 

Although these entities are participants 

of a registered clearing agency, generally 

these entities do not engage in the types 

of activities that would implicate the 

close-out requirements of Regulation 

SHO. 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38291 

263See 13 CFR 121.201. 

264 17 CFR 240.0–10(e). 

265 17 CFR 240.0–10(d). 266See 5 U.S.C. 603(c). 

The Federal securities laws do not 

define what is a ‘‘small business’’ or 

‘‘small organization’’ when referring to 

a bank. The Small Business 

Administration regulations define 

‘‘small entities’’ to include banks and 

savings associations with total assets of 

$175 million or less.263 As of May 30, 

2009, no bank that was a participant of 

the NSCC was a ‘‘small entity’’ because 

none met that criteria. 

Paragraph (e) of Rule 0–10 under the 

Exchange Act 264 states that the term 

‘‘small business’’ or ‘‘small 

organization,’’ when referring to an 

exchange, means any exchange that: (1) 

Has been exempted from the reporting 

requirements of Rule 601 under the 

Exchange Act; and (2) is not affiliated 

with any person (other than a natural 

person) that is not a small business or 

small organization, as defined by Rule 

0–10. No U.S. registered exchange is a 

small entity because none meets these 

criteria. 

Paragraph (d) of Rule 0–10 under the 

Exchange Act 265 states that the term 

‘‘small business’’ or ‘‘small 

organization,’’ when referring to a 

clearing agency, means a clearing 

agency that: (1) Compared, cleared and 

settled less than $500 million in 

securities transactions during the 

preceding fiscal year (or in the time that 

it has been in business, if shorter); (2) 

had less than $200 million in funds and 

securities in its custody or control at all 

times during the preceding fiscal year 

(or in the time that it has been in 

business, if shorter); and (3) is not 

affiliated with any person (other than a 

natural person) that is not a small 

business or small organization as 

defined by Rule 0–10. No clearing 

agency that is subject to the 

requirements of Regulation SHO is a 

small entity because none meets these 

criteria. 

C. Projected Reporting, Recordkeeping 

and Other Compliance Requirements 

The rule may impose some new or 

additional reporting, recordkeeping, or 

compliance costs on small entities that 

are participants of a clearing agency 

registered with the Commission and 

small broker-dealers from which the 

participant receives trades for clearance 

and settlement. We do not believe, at 

this time, that any specialized 

professional skills will be necessary to 

comply with the rule. 

D. Agency Action To Minimize Effect on 

Small Entities 

As required by the Regulatory 

Flexibility Act, we have considered 

alternatives that would accomplish our 

stated objectives, while minimizing any 

significant adverse impact on small 

entities. Rule 204 is not expected to 

adversely affect small entities because it 

imposes minimal reporting, record 

keeping, or compliance requirements, 

many of which were previously 

required of small entities pursuant to 

the implementation of Regulation SHO 

and, more recently, temporary Rule 

204T. Moreover, it is not appropriate to 

develop separate requirements for small 

entities because we believe that to 

accomplish the Commission’s stated 

goals, all broker-dealers, regardless of 

size, should be subject to the same 

enhanced delivery requirements 

imposed by the rule. 

E. Duplicative, Overlapping, or 

Conflicting Federal Rules 

The Commission believes that there 

are no rules that duplicate, overlap, or 

conflict with Rule 204. The Commission 

has designed the rule so that it is 

consistent with the close-out 

requirements of Rule 203(b)(3) of 

Regulation SHO. In addition, with 

limited modifications to address 

commenters’ concerns, Rule 204 

incorporates the substance and 

maintains most of the components of 

temporary Rule 204T of Regulation SHO 

and will become effective on July 31, 

2009, the expiration date for temporary 

Rule 204T. 

F. Significant Alternatives 

The Regulatory Flexibility Act directs 

us to consider significant alternatives 

that would accomplish our stated 

objective, while minimizing any 

significant adverse impact on small 

entities.266 In connection with the rule, 

we considered the following 

alternatives: (1) Establishing different 

compliance or reporting standards or 

timetable that take into account the 

resources available to small entities; (2) 

clarifying, consolidating, or simplifying 

compliance requirements under the rule 

for small entities; (3) using performance 

rather than design standards; and (4) 

exempting small entities from coverage 

of the rule, or any part of the rule. 

The rule furthers the Commission’s 

stated goal of helping to eliminate the 

possibility that potentially abusive 

‘‘naked’’ short selling may contribute to 

disruption in the securities markets and, 

therefore, to help ensure that investors 

remain confident that trading in equity 

securities can be conducted without the 

illegal influence of manipulation. The 

rule also furthers the goals of helping to 

maintain fair and orderly markets 

against the threat of sudden and 

excessive fluctuations of securities 

prices generally. 

The rule should not adversely affect 

small entities because the rule will 

impose only minimal compliance 

requirements, many of which were 

previously required of small entities 

pursuant to the implementation of 

Regulation SHO and, more recently, 

temporary Rule 204T. Moreover, it is 

not appropriate to develop different 

compliance requirements for small 

entities with respect to the rule because 

we believe all entities, including small 

entities, should be subject to the 

requirements of the rule. We believe 

that imposing different compliance 

requirements, and possibly a different 

timetable for implementing compliance 

requirements, for small entities would 

undermine the Commission’s goals of 

reducing fails to deliver by maintaining 

the reductions in fails to deliver 

achieved by the adoption of temporary 

Rule 204T, as well as other actions 

taken by the Commission, and 

addressing potentially abusive ‘‘naked’’ 

short selling. We have concluded 

similarly that it is not consistent with 

the goal of the rule to further clarify, 

consolidate or simplify the rule for 

small entities. The Commission also 

believes that it is inconsistent with the 

purposes of the Exchange Act to exempt 

small entities from having to comply 

with the rule. 

X. Statutory Authority 

Pursuant to the Exchange Act and, 

particularly, Sections 2, 9(h), 10, 11A, 

15, 17, 17A, and 23(a) thereof, 15 U.S.C. 

78b, 78i(h), 78j, 78k–1, 78o, 78q, 78q– 

1, and 78w(a), the Commission is 

amending Regulation SHO to adopt Rule 

204. 

XI. Text of Amendments 

List of Subjects 

17 CFR Part 200 

Administrative practice and 

procedure, Authority delegations 

(Government agencies). 

17 CFR Part 242 

Brokers, Fraud, Reporting and 

recordkeeping requirements, Securities. 

■ For the reasons set out in the 

preamble, Title 17, Chapter II of the 

Code of Federal Regulations is amended 

as follows: 


jlentini on DSKJ8SOYB1PROD with RULES2
38292 Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 

PART 200—ORGANIZATION; 

CONDUCT AND ETHICS; AND 

INFORMATION AND REQUESTS 

■ 1. The authority citation for Part 200, 

Subpart A, continues to read in part as 

follows: 

Authority: 15 U.S.C. 77o, 77s, 77sss, 78d, 

78d–1, 78d–2, 78w, 78ll(d), 78mm, 80a–37, 

80b–11, and 7202, unless otherwise noted. 

* * * * * 

■ 2. Section 200.30–3 is amended by 

adding paragraph (a)(11) to read as 

follows: 

§ 200.30–3 Delegation of authority to 

Director of Division of Trading and Markets. 

* * * * * 

(a) * * * 

(11) Upon written application or upon 

its own motion, either unconditionally 

or on specified terms and conditions, to 

grant or deny by order an exemption 

from the requirements of Regulation 

SHO (§ 242.200 of this chapter) under 

the Act pursuant to Section 36 of the 

Act (15 U.S.C. 78mm). 

* * * * * 

PART 242—REGULATIONS M, SHO, 

ATS, AC, AND NMS AND CUSTOMER 

MARGIN REQUIREMENTS FOR 

SECURITY FUTURES 

■ 3. The authority citation for part 242 

continues to read as follows: 

Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 

78b, 78c, 78g(c)(2), 78i(a), 78j, 78k–1(c), 781, 

78m, 78n, 78o(b), 78o(c), 78o(g), 78q(a), 

78q(b), 78q(h), 78w(a), 78dd–1, 78mm, 80a– 

23, 80a–29, and 80a–37. 

■ 4. Section 242.204 is added to read as 

follows: 

§ 242.204 Close-out requirement. 

(a) A participant of a registered 

clearing agency must deliver securities 

to a registered clearing agency for 

clearance and settlement on a long or 

short sale in any equity security by 

settlement date, or if a participant of a 

registered clearing agency has a fail to 

deliver position at a registered clearing 

agency in any equity security for a long 

or short sale transaction in that equity 

security, the participant shall, by no 

later than the beginning of regular 

trading hours on the settlement day 

following the settlement date, 

immediately close out its fail to deliver 

position by borrowing or purchasing 

securities of like kind and quantity; 

Provided, however: 

(1) If a participant of a registered 

clearing agency has a fail to deliver 

position at a registered clearing agency 

in any equity security and the 

participant can demonstrate on its books 

and records that such fail to deliver 

position resulted from a long sale, the 

participant shall by no later than the 

beginning of regular trading hours on 

the third consecutive settlement day 

following the settlement date, 

immediately close out the fail to deliver 

position by purchasing or borrowing 

securities of like kind and quantity; 

(2) If a participant of a registered 

clearing agency has a fail to deliver 

position at a registered clearing agency 

in any equity security resulting from a 

sale of a security that a person is 

deemed to own pursuant to § 242.200 

and that such person intends to deliver 

as soon as all restrictions on delivery 

have been removed, the participant 

shall, by no later than the begining of 

regular trading hours on the thirty-fifth 

consecutive calendar day following the 

trade date for the transaction, 

immediately close out the fail to deliver 

position by purchasing securities of like 

kind and quantity; or 

(3) If a participant of a registered 

clearing agency has a fail to deliver 

position at a registered clearing agency 

in any equity security that is attributable 

to bona fide market making activities by 

a registered market maker, options 

market maker, or other market maker 

obligated to quote in the over-thecounter market, the participant shall by 

no later than the beginning of regular 

trading hours on the third consecutive 

settlement day following the settlement 

date, immediately close out the fail to 

deliver position by purchasing or 

borrowing securities of like kind and 

quantity. 

(b) If a participant of a registered 

clearing agency has a fail to deliver 

position in any equity security at a 

registered clearing agency and does not 

close out such fail to deliver position in 

accordance with the requirements of 

paragraph (a) of this section, the 

participant and any broker or dealer 

from which it receives trades for 

clearance and settlement, including any 

market maker that would otherwise be 

entitled to rely on the exception 

provided in § 242.203(b)(2)(iii), may not 

accept a short sale order in the equity 

security from another person, or effect a 

short sale in the equity security for its 

own account, to the extent that the 

broker or dealer submits its short sales 

to that participant for clearance and 

settlement, without first borrowing the 

security, or entering into a bona fide 

arrangement to borrow the security, 

until the participant closes out the fail 

to deliver position by purchasing 

securities of like kind and quantity and 

that purchase has cleared and settled at 

a registered clearing agency; Provided, 

however: A broker or dealer shall not be 

subject to the requirements of this 

paragraph if the broker or dealer timely 

certifies to the participant of a registered 

clearing agency that it has not incurred 

a fail to deliver position on settlement 

date for a long or short sale in an equity 

security for which the participant has a 

fail to deliver position at a registered 

clearing agency or that the broker or 

dealer is in compliance with paragraph 

(e) of this section. 

(c) The participant must notify any 

broker or dealer from which it receives 

trades for clearance and settlement, 

including any market maker that would 

otherwise be entitled to rely on the 

exception provided in 

§ 242.203(b)(2)(iii): 

(1) That the participant has a fail to 

deliver position in an equity security at 

a registered clearing agency that has not 

been closed out in accordance with the 

requirements of paragraph (a) of this 

section; and 

(2) When the purchase that the 

participant has made to close out the 

fail to deliver position has cleared and 

settled at a registered clearing agency. 

(d) If a participant of a registered 

clearing agency reasonably allocates a 

portion of a fail to deliver position to 

another registered broker or dealer for 

which it clears trades or from which it 

receives trades for settlement, based on 

such broker’s or dealer’s short position, 

the provisions of paragraphs (a) and (b) 

of this section relating to such fail to 

deliver position shall apply to such 

registered broker or dealer that was 

allocated the fail to deliver position, and 

not to the participant. A broker or dealer 

that has been allocated a portion of a fail 

to deliver position that does not comply 

with the provisions of paragraph (a) of 

this section must immediately notify the 

participant that it has become subject to 

the requirements of paragraph (b) of this 

section. 

(e) Even if a participant of a registered 

clearing agency has not closed out a fail 

to deliver position at a registered 

clearing agency in accordance with 

paragraph (a) of this section, or has not 

allocated a fail to deliver position to a 

broker or dealer in accordance with 

paragraph (d) of this section, a broker or 

dealer shall not be subject to the 

requirements of paragraph (a) or (b) of 

this section if the broker or dealer 

purchases or borrows the securities, and 

if: 

(1) The purchase or borrow is bona 

fide; 

(2) The purchase or borrow is 

executed after trade date but by no later 

than the end of regular trading hours on 

settlement date for the transaction; 

(3) The purchase or borrow is of a 

quantity of securities sufficient to cover 

the entire amount of that broker’s or 


jlentini on DSKJ8SOYB1PROD with RULES2
Federal Register / Vol. 74, No. 146 / Friday, July 31, 2009 / Rules and Regulations 38293 

dealer’s fail to deliver position at a 

registered clearing agency in that 

security; and 

(4) The broker or dealer can 

demonstrate that it has a net flat or net 

long position on its books and records 

on the day of the purchase or borrow. 

(f) A participant of a registered 

clearing agency shall not be deemed to 

have fulfilled the requirements of this 

section where the participant enters into 

an arrangement with another person to 

purchase or borrow securities as 

required by this section, and the 

participant knows or has reason to know 

that the other person will not deliver 

securities in settlement of the purchase 

or borrow. 

(g) Definitions. (1) For purposes of 

this section, the term settlement date 

shall mean the business day on which 

delivery of a security and payment of 

money is to be made through the 

facilities of a registered clearing agency 

in connection with the sale of a security. 

(2) For purposes of this section, the 

term regular trading hours has the same 

meaning as in Rule 600(b)(64) of 

Regulation NMS (17 CFR 

242.600(b)(64)). 

Dated: July 27, 2009. 

By the Commission. 

Elizabeth M. Murphy, 

Secretary. 

[FR Doc. E9–18185 Filed 7–30–09; 8:45 am] 

BILLING CODE 8010–01–P 


jlentini on DSKJ8SOYB1PROD with RULES2