Document ID: SEC-2006-1610-0001
Agency: sec
Document Type: Proposed Rule
Title: Amendments to Regulation SHO and Rule 10a-1
Posted Date: 2006-12-13T05:00Z

[Federal Register: December 13, 2006 (Volume 71, Number 239)]
[Proposed Rules]               
[Page 75067-75082]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr13de06-28]                         

[[Page 75067]]

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

Part V

Securities and Exchange Commission

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

17 CFR Part 240 and 242

Amendments to Regulation SHO and Rule 10a-1; Proposed Rule

[[Page 75068]]

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

SECURITIES AND EXCHANGE COMMISSION

17 CFR PARTS 240 and 242

[Release No. 34-54891; File No. S7-21-06]
RIN 3235-AJ76

 
Amendments to Regulation SHO and Rule 10a-1

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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

SUMMARY: The Securities and Exchange Commission (``Commission'' or 
``SEC'') is proposing to amend the short sale price test under the 
Securities Exchange Act of 1934 (``Exchange Act''). The proposed 
amendments are intended to provide a more consistent regulatory 
environment for short selling by removing restrictions on the execution 
prices of short sales (``price tests'' or ``price test restrictions''), 
as well as prohibiting any self-regulatory organization (``SRO'') from 
having a price test. In addition, the Commission is proposing to amend 
Regulation SHO to remove the requirement that a broker-dealer mark a 
sell order of an equity security as ``short exempt,'' if the seller is 
relying on an exception from a price test.

DATES: Comments should be received on or before February 12, 2007.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml.
); or     Send an e-mail to rule-comments@sec.gov. Please include 

File Number S7-21-06 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov
). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number S7-21-06. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments 

are also available for public inspection and copying in the 
Commission's Public Reference Room, 100 F Street, NE., Washington, DC 
20549. All comments received will be posted without change; we do not 
edit personal identifying information from submissions. You should 
submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Acting Associate 
Director, Josephine J. Tao, Branch Chief, Lillian Hagen, Special 
Counsel, Victoria L. Crane, Special Counsel, Office of Trading 
Practices and Processing, Division of Market Regulation, at (202) 551-
5720, at the Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-6628.

SUPPLEMENTARY INFORMATION: The Commission is requesting public comment 
on the removal of Rule 10a-1 [17 CFR 240.10a-1] and proposed amendments 
to Rules 200 and 201 of Regulation SHO [17 CFR 242.200 and 242.201] 
under the Exchange Act.

I. Introduction

    Section 10(a) of the Exchange Act \1\ gives the Commission plenary 
authority over short sales \2\ of securities registered on a national 
securities exchange as necessary or appropriate in the public interest 
or for the protection of investors. The Commission originally adopted 
Rule 10a-1 in 1938 to restrict short selling in a declining market.\3\
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78j(a).
    \2\ Rule 200(a) of Regulation SHO defines a ``short sale'' as 
``any sale of a security which the seller does not own or any sale 
which is consummated by the delivery of a security borrowed by, or 
for the account of, the seller.'' 17 CFR 242.200(a).
    \3\ See Exchange Act Release No. 1548 (January 24, 1938), 3 FR 
213 (January 26, 1938).
---------------------------------------------------------------------------

    The core provisions of Rule 10a-1 have remained virtually unchanged 
since its adoption almost 70 years ago. As discussed in more detail 
below, however, over the years, in response to changes in the 
securities markets, including changes in trading strategies and systems 
used in the marketplace, the Commission has added exceptions to Rule 
10a-1 and granted numerous written requests for relief from the rule's 
restrictions. In addition, under current price test regulation, 
different price tests apply to securities trading in different markets. 
We also note that current price test restrictions apply generally only 
to large or more actively-traded securities. We believe that the 
increased demand for exemptions from the restrictions of Rule 10a-1, 
and the disparate application of current price test regulation, limit 
the reach of current price test restrictions, potentially create an 
unlevel playing field among market participants, and allow for 
regulatory arbitrage.
    In 2004, we adopted Rule 202T of Regulation SHO,\4\ which 
established procedures for the Commission to temporarily suspend price 
tests so that the Commission could study the effectiveness of these 
tests.\5\ Pursuant to the process established in Rule 202T of 
Regulation SHO, we issued an order (``First Pilot Order'') creating a 
one year pilot (``Pilot'') temporarily suspending the provisions of 
Rule 10a-1(a) and any price test of any exchange or national securities 
association for short sales of certain securities.\6\
---------------------------------------------------------------------------

    \4\ 17 CFR 242.202T.
    \5\ See id.; see also Exchange Act Release No. 50103 (July 28, 
2004), 69 FR 48008, 48012-48013 (August 6, 2004) (``Regulation SHO 
Adopting Release'').
    \6\ Exchange Act Release No. 50104 (July 28, 2004), 69 FR 48032 
(August 6, 2004). Specifically, the First Pilot Order suspended 
price tests for: (1) Short sales in the securities identified in 
Appendix A to the First Pilot Order; (2) short sales in the 
securities included in the Russell 1000 index effected between 4:15 
p.m. EST and the open of the effective transaction reporting plan of 
the Consolidated Tape Association (``consolidated tape'') on the 
following day; and (3) short sales in any security not included in 
paragraphs (1) and (2) effected in the period between the close of 
the consolidated tape and the open of the consolidated tape on the 
following day. In addition, the First Pilot Order provided that the 
Pilot would commence on January 3, 2005 and terminate on December 
31, 2005, and that the Commission might issue further orders 
affecting the operation of the First Pilot Order. 69 FR at 48033. On 
November 29, 2004, we issued an order resetting the Pilot to 
commence on May 2, 2005 and end on April 28, 2006 to give market 
participants additional time to make systems changes necessary to 
comply with the Pilot. Exchange Act Release No. 50747 (November 29, 
2004), 69 FR 70480 (December 6, 2004). On April 20, 2006, we issued 
an order (``Third Pilot Order'') extending the termination date of 
the Pilot to August 6, 2007, the date on which temporary Rule 202T 
of Regulation SHO expires. Exchange Act Release No. 53684 (April 20, 
2006), 71 FR 24765 (April 26, 2006). The purpose of the Third Pilot 
Order is to maintain the status quo with regard to price tests for 
Pilot securities while the staff completes its analysis of the Pilot 
data and the Commission conducts any additional short sale 
rulemaking.
---------------------------------------------------------------------------

    The Pilot was designed to assist the Commission in assessing 
whether changes to current short sale regulation are necessary in light 
of current market practices and the purposes underlying short sale 
regulation.\7\ The Commission stated in the Regulation SHO Adopting 
Release that conducting a pilot pursuant to Rule 202T would ``allow us 
to obtain data on the impact of short selling in the absence of a price 
test to assist in determining, among other things, the extent to which 
a price test is necessary to further the objectives of short sale 
regulation, to study the effects of relatively unrestricted short 
selling on market volatility, price efficiency, and liquidity, and to 
obtain empirical data to

[[Page 75069]]

help assess whether a price test should be removed, in part or in 
whole, for some or all securities, or if retained, should be applied to 
additional securities.'' \8\ As noted in the Regulation SHO Adopting 
Release, the empirical data from the Pilot was to be obtained and 
analyzed ``as part of [the Commission's] assessment as to whether the 
price test should be removed or modified, in part or whole, for 
actively-traded securities or other securities.'' \9\
---------------------------------------------------------------------------

    \7\ 69 FR at 48032.
    \8\ Regulation SHO Adopting Release at 48009.
    \9\ Regulation SHO Adopting Release at 48013. In the Regulation 
SHO Adopting Release we noted that ``the purpose of the [P]ilot is 
to assist the Commission in considering alternatives, such as: (1) 
Eliminating a Commission-mandated price test for an appropriate 
group of securities, which may be all securities; (2) adopting a 
uniform bid test, and any exceptions, with the possibility of 
extending a uniform bid test to securities for which there is 
currently no price test; or (3) leaving in place the current price 
tests.'' Regulation SHO Adopting Release at 48010.
---------------------------------------------------------------------------

    Thus, the Commission's Office of Economic Analysis (``OEA'') 
gathered the data made public during the Pilot, analyzed this data and 
provided the Commission with a draft summary report on the Pilot.\10\ 
The OEA Staff's Draft Summary Pilot Report examined several aspects of 
market quality including the overall effect of price tests on short 
selling, liquidity, volatility and price efficiency. The Pilot data was 
also designed to allow the Commission and members of the public to 
examine whether the effects of price tests are similar across 
stocks.\11\
---------------------------------------------------------------------------

    \10\ See Office of Economic Analysis U.S. Securities and 
Exchange Commission, Economic Analysis of the Short Sale Price 
Restrictions Under the Regulation SHO Pilot (September 14, 2006) 
(the ``OEA Staff's Draft Summary Pilot Report''), available at 
http://www.sec.gov/[fxsp0]about/economic/[fxsp0]shopilot091506/

draft--reg--[fxsp0]sho--pilot--[fxsp0]report.pdf.
    \11\ In the Regulation SHO Adopting Release, the Commission 
stated its expectation that data on trading during the Pilot would 
be made available to the public to encourage independent researchers 
to study the Pilot. See Regulation SHO Adopting Release at 48009, 
n.9. Accordingly, nine SROs began publicly releasing transactional 
short selling data on January 3, 2005. The nine SROs were the AMEX, 
ARCA, BSE, CHX, NASD, Nasdaq, National Stock Exchange, NYSE and 
Phlx. The SROs agreed to collect and make publicly available trading 
data on each executed short sale involving equity securities 
reported by the SRO to a securities information processor. The SROs 
published the information on a monthly basis on their Internet Web 
sites.
---------------------------------------------------------------------------

    In addition, the Commission encouraged outside researchers to 
examine the Pilot. In response to this request, the Commission has 
received three completed studies (the ``Academic Studies'') from 
outside researchers that specifically examine the Pilot data.\12\ The 
Commission also held a public roundtable (the ``Regulation SHO 
Roundtable'') that focused on the empirical evidence learned from the 
Pilot data (the OEA Staff's Draft Summary Pilot Report, Academic 
Studies, and Regulation SHO Roundtable are referred to collectively 
herein as, the ``Pilot Results'').\13\ The Pilot Results contained a 
variety of observations, which we considered in determining whether or 
not to propose removal of current price test restrictions. Generally, 
the Pilot Results urged removal of current price test restrictions. In 
addition, the empirical evidence did not support extending a price test 
to either small or thinly-traded securities.\14\
---------------------------------------------------------------------------

    \12\ See Karl Diether, Kuan Hui Lee and Ingrid M. Werner, It's 
SHO Time! Short-Sale Price-Tests and Market Quality, June 20, 2006 
(``Diether, Lee and Werner''); Gordon J. Alexander and Mark A. 
Peterson, (How) Do Price Tests Affect Short Selling? May 23, 2006 
(``Alexander and Peterson''); J. Julie Wu, Uptick Rule, short 
selling and price efficiency, August 14, 2006 (``Wu'').
    \13\ A transcript from the roundtable (``the Roundtable 
Transcript'') is available at http://www.sec.gov/[fxsp0]about/

economic/[fxsp0]shopilottrans091506.pdf.
    \14\ The Pilot Results are discussed in more detail in Section 
II.D below.
---------------------------------------------------------------------------

    Based on our review of the Pilot Results and of the status of 
current price test restrictions, we are proposing to remove the tick 
test of Rule 10a-1 and add Rule 201 of Regulation SHO to provide that 
no price test, including any price test of any SRO, shall apply to 
short sales in any security. Rule 201 would also prohibit any SRO from 
having a price test. In addition, because we are proposing to remove 
all current price test restrictions, and prohibit any price test by any 
SRO, we are proposing to amend Rule 200(g) of Regulation SHO to remove 
the requirement that a broker-dealer mark a sell order of an equity 
security as ``short exempt'' if the seller is relying on an exception 
from the price test of Rule 10a-1, or any price test of any exchange or 
national securities association.\15\
---------------------------------------------------------------------------

    \15\ This proposal affects price tests and related marking 
requirements only. It does not relate to other provisions of 
Regulation SHO. We note, however, that in a separate proposal we 
recently proposed amendments to provisions of Regulation SHO that 
would eliminate the ``grandfather'' provision and limit the options 
market maker exception. See Exchange Act Release No. 54154 (July 14, 
2006), 71 FR 41710 (July 21, 2006) (``Regulation SHO Amendments 
Proposing Release''). This proposal does not alter the proposed 
amendments in the Regulation SHO Amendments Proposing Release.
---------------------------------------------------------------------------

    We note that today's markets are characterized by high levels of 
transparency and regulatory surveillance. These characteristics greatly 
reduce the risk of abusive or manipulative short selling going 
undetected if we were to remove price test restrictions, and permit 
regulators to monitor the types of activities that Rule 10a-1 and other 
price tests are designed to prevent. The general anti-fraud and anti-
manipulation provisions of the federal securities laws would also 
continue to prohibit activity that improperly influences the price of a 
security.\16\
---------------------------------------------------------------------------

    \16\ See, e.g., Securities Act of 1933 Section 17(a), Exchange 
Act Sections 9(a), 10(b), and 15(c) and Rule 10b-5 thereunder. See 
also Regulation M, Rule 105.
---------------------------------------------------------------------------

II. Background

A. Short Selling and Its Market Uses and Effects

    A short sale is the sale of a security which the seller does not 
own or any sale which is consummated by the delivery of a security 
borrowed by, or for the account of, the seller.\17\ In order to deliver 
the security to the purchaser, the short seller borrows the security, 
typically from a broker-dealer or an institutional investor. The short 
seller later closes out the position by purchasing equivalent 
securities on the open market, or by using an equivalent security it 
already owned, and returning the security to the lender. A short seller 
hopes to profit from the transaction by selling short at a higher price 
than the price at which it repurchases the securities to return to the 
lender. In general, short selling is used to profit from an expected 
downward price movement, to provide liquidity in response to 
unanticipated demand, or to hedge the risk of a long position in the 
same security or in a related security.
---------------------------------------------------------------------------

    \17\ 17 CFR 242.200(a).
---------------------------------------------------------------------------

    Short selling provides the market with at least two important 
benefits: market liquidity and pricing efficiency.\18\ Market liquidity 
may be provided through short selling by market professionals, such as 
market makers (including specialists) and block positioners, to offset 
temporary imbalances in the buying and selling interest for securities. 
These short sales make stock available to purchasers and reduce the 
risk that the price paid by purchasers is artificially high because of 
a temporary contraction of selling interest. Short sellers covering 
their sales also may add to the buying interest of stock available to 
sellers.
---------------------------------------------------------------------------

    \18\ See Owen A Lamont and Richard H Thaler, Can the Market Add 
and Subtract? Mispricing in Tech Stocks Carve-outs, Journal of 
Political Economy, May 2001.
---------------------------------------------------------------------------

    In addition, short selling contributes to the pricing efficiency of 
the equities markets. Efficient markets require that prices fully 
reflect all buy and sell interest. Short sales reflect the view that 
the security is overvalued and the price of the security will fall, 
just as long purchases reflect the view that the security is 
undervalued and the price

[[Page 75070]]

will rise. Both the long purchaser and the short seller hope to profit, 
or hedge against loss, by buying low and selling high, though the 
strategies differ in the sequence of transactions. Market participants 
who believe a stock is overvalued may engage in short sales in an 
attempt to profit from a perceived divergence of prices from true 
economic values. Such short sellers add to stock pricing efficiency 
because their transactions inform the market of their evaluation of 
future stock price performance. This evaluation is reflected in the 
resulting market price of the security.\19\
---------------------------------------------------------------------------

    \19\ Arbitrageurs also contribute to pricing efficiency by 
utilizing short sales to profit from price disparities between a 
stock and a derivative security, such as a convertible security or 
an option on that stock. For example, an arbitrageur may purchase a 
convertible security and sell the underlying stock short to profit 
from a current price differential between two economically similar 
positions.
---------------------------------------------------------------------------

    Although short selling serves useful market purposes, it also may 
be used to illegally manipulate stock prices.\20\ One example is the 
``bear raid'' where an equity security is actively sold short to drive 
down prices in the hope of convincing less informed investors of a 
negative material perception of the stock, triggering sell orders. 
Falling prices could also trigger margin calls and possibly forced 
liquidations of the security, depressing the price further.\21\ This 
unrestricted short selling could exacerbate a declining market in a 
security by eliminating bids, and causing a further reduction in the 
price of a security by creating an appearance that the security's price 
is falling for fundamental reasons.
---------------------------------------------------------------------------

    \20\  See, e.g., S.E.C. v. Gardiner, 48 S.E.C. Docket 811, No. 
91 Civ. 2091 (S.D.N.Y. March 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 (2nd 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).
    \21\ At that time, many people blamed ``bear raids'' for the 
1929 stock market crash and the market's prolonged inability to 
recover from the crash. See 7 Louis Loss and Joel Seligman, 
Securities Regulation 3203-04, n.213 (3d ed. 2006).
---------------------------------------------------------------------------

B. Current Short Sale Regulation

    One way short sales are regulated in the United States is through 
price tests, which regulate the execution prices of short sales. 
Current short sale regulation applies different price tests to 
securities trading in different types of markets. Section 10(a) of the 
Exchange Act gives the Commission plenary authority to regulate short 
sales of securities registered on a national securities exchange, as 
necessary or appropriate in the public interest for the protection of 
investors.\22\ After conducting an inquiry into the effects of 
concentrated short selling during the market break of 1937, the 
Commission adopted the price test contained in Rule 10a-1 in 1938 to 
restrict short selling in a declining market.\23\ The core provisions 
of the rule are largely the same today as when they were adopted.
---------------------------------------------------------------------------

    \22\ See 15 U.S.C. 78j(a).
    \23\ See supra n.3.
---------------------------------------------------------------------------

    Paragraph (a) of Rule 10a-1 covers short sales in securities 
registered on, or admitted to unlisted trading privileges (``UTP'') on, 
a national securities exchange (``listed securities''), if trades of 
the security are reported pursuant to an ``effective transaction 
reporting plan'' and information regarding such trades is made 
available in accordance with such plan on a real-time basis to vendors 
of market transaction information.\24\
---------------------------------------------------------------------------

    \24\ Rule 10a-1 uses the term ``effective transaction reporting 
plan'' as defined in Rule 600 of Regulation NMS (17 CFR 242.600) 
under the Exchange Act. See 17 CFR 240.10a-1(a)(1)(i).
---------------------------------------------------------------------------

    Rule 10a-1(a)(1) provides that, subject to certain exceptions, a 
listed security may be sold short (A) at a price above the price at 
which the immediately preceding sale was effected (plus tick), or (B) 
at the last sale price if it is higher than the last different price 
(zero-plus tick).\25\ Short sales are not permitted on minus ticks or 
zero-minus ticks, subject to narrow exceptions. The operation of these 
provisions is commonly described as the ``tick test.'' The following 
transactions illustrate the operation of the tick test:
---------------------------------------------------------------------------

    \25\ The last sale price is the price reported pursuant to an 
effective transaction reporting plan, i.e., the consolidated tape, 
or to the last sale price reported in a particular marketplace. 
Under Rule 10a-1, the Commission gives market centers the choice of 
measuring the tick of the last trade based on executions solely on 
their own exchange rather than those reported to the consolidated 
tape. See 17 CFR 240.10a-1(a)(2).
[GRAPHIC] [TIFF OMITTED] TP13DE06.000

    The first execution at 47.04 is a plus tick since it is higher than 
the previous last trade price of 47.00. The next transaction at 47.04 
is a zero-plus tick since there is no change in trade price but the 
last change was a plus tick. Short sales could be executed at 47.04 or 
above. The final two transactions at 47.00 are minus and zero-minus 
transactions, respectively. Subsequently, short sales would have to be 
effected at the next higher increment above 47.00 in order to comply 
with Rule 10a-1.
    In adopting the tick test, the Commission sought to achieve three 
objectives: (i) Allowing relatively unrestricted short selling in an 
advancing market; (ii) preventing short selling at successively lower 
prices, thus eliminating short selling as a tool for driving the market 
down; and (iii) preventing short sellers from accelerating a declining 
market by exhausting all remaining bids at one price level, causing 
successively lower prices to be established by long sellers.\26\
---------------------------------------------------------------------------

    \26\ See Exchange Act Release No. 13091 (December 21, 1976), 41 
FR 56530 (December 28, 1976).
---------------------------------------------------------------------------

    Rule 10a-1 applies only to listed securities and, therefore, 
securities quoted on the over-the-counter bulletin board (``OTCBB'') 
and pink sheets are not subject to Rule 10a-1. In addition, prior to 
January 13, 2006, before The NASDAQ Stock Market LLC (``Nasdaq'') began 
operations as a national securities exchange, Nasdaq securities were 
not subject to Rule 10a-1.
    In 1994, the Commission granted temporary approval to the National 
Association of Securities Dealers, Inc. (``NASD'') to apply its own 
short sale rule, NASD Rule 3350 (``former NASD Rule 3350'' or ``former 
NASD Rule 3350's bid test''), to Nasdaq Global

[[Page 75071]]

Market securities \27\ on a pilot basis.\28\ Under former NASD Rule 
3350, Nasdaq Global Market securities traded over-the-counter (``OTC'') 
and reported to an NASD facility were subject to former NASD Rule 
3350's bid test.\29\ In addition, Nasdaq Global Market securities 
traded on, or reported to, Nasdaq were subject to former NASD Rule 
3350's bid test.
---------------------------------------------------------------------------

    \27\ Nasdaq Global Market securities were formerly known as 
Nasdaq National Market securities. In connection with Nasdaq 
commencing operations as a national securities exchange, the Nasdaq 
National Market was renamed the Nasdaq Global Market and Nasdaq 
National Market securities were renamed Nasdaq Global Market 
securities. See NASD Rule 4200(a)(6) (providing that the Nasdaq 
Global Market is the successor to the Nasdaq National Market); see 
also Exchange Act Release No. 54071 (June 29, 2006), 71 FR 38922 
(July 10, 2006). In this release, references to Nasdaq Global Market 
securities includes Nasdaq National Market securities, as 
applicable.
    \28\ See Exchange Act Release No. 34277 (June 29, 1994), 59 FR 
34885 (July 7, 1994). The NASD's short sale rule was originally 
approved on an eighteen-month pilot basis. The NASD proposed, and 
the Commission approved, extensions of former NASD Rule 3350 several 
times. See, e.g., Exchange Act Release No. 53093 (January 10, 2006), 
71 FR 2966 (January 18, 2006).
    \29\ Former NASD Rule 3350's bid test provided that short sales 
in Nasdaq Global Market securities must not be effected at or below 
the current national best (inside) bid when the current national 
best (inside) bid is below the preceding national best (inside) bid.
---------------------------------------------------------------------------

    Former NASD Rule 3350 was, by its terms, inapplicable to Nasdaq 
Capital Market securities.\30\ In addition, short sales in Nasdaq 
Global Market securities effected on any national securities exchange 
that traded Nasdaq Global Market securities on a UTP basis were not 
subject to former NASD Rule 3350.
---------------------------------------------------------------------------

    \30\ Nasdaq Capital Market securities were formerly known as 
Nasdaq SmallCap securities. See Exchange Act Release No. 34-52489 
(September 21, 2005), 70 FR 56948 (September 29, 2005).
---------------------------------------------------------------------------

    On January 13, 2006, the Commission approved Nasdaq's application 
to become a national securities exchange.\31\ Once Nasdaq's exchange 
application became effective, Rule 10a-1 would have applied to all 
Nasdaq securities wherever traded. In Nasdaq's exchange application, 
however, Nasdaq requested an exemption from Rule 10a-1 and proposed to 
adopt a short sale rule, Nasdaq Rule 3350 (``Nasdaq Rule 3350'' or 
``Nasdaq's bid test''), similar to former NASD Rule 3350, so that it 
could continue to regulate short sales in Nasdaq Global Market 
securities under a bid test.\32\ Nasdaq also requested to exempt Nasdaq 
Capital Market securities from Rule 10a-1's tick test.\33\ In granting 
Nasdaq's requested exemptions, the Commission noted that it believed 
that it is important to maintain the status quo of short sale 
regulation during the Pilot in order to promote efficient regulation 
and to avoid unnecessarily burdening markets with the imposition of 
costs associated with implementing a price test that may be 
temporary.\34\ Nasdaq Rule 3350 prohibits short sales in Nasdaq Global 
Market securities at or below the current best (inside) bid displayed 
in the National Market System when the current best (inside) bid is 
below the preceding best (inside) bid in the security.\35\
---------------------------------------------------------------------------

    \31\ See SEC Order in the Matter of the Application of The 
Nasdaq Stock Market LLC for registration as a National Securities 
Exchange, Exchange Act Release No. 53128 (January 13, 2006), 71 FR 
3550 (January 23, 2006).
    \32\ Nasdaq Rule 3350 contains provisions similar to former NASD 
Rule 3350 regarding short sales in Nasdaq Global Market securities 
executed on, or reported to, Nasdaq. See Nasdaq Rule 3350. See also 
71 FR at 3561.
    \33\ See id.
    \34\ See 71 FR at 3562.
    \35\ See Nasdaq Rule 3350.
---------------------------------------------------------------------------

    Similarly, to maintain the status quo for Nasdaq Global Market 
securities traded OTC and reported to a NASD facility during the Pilot, 
we granted an exemption to the NASD to permit Nasdaq Global Market 
securities traded OTC and reported to a NASD facility to continue to be 
subject to a bid test similar to that contained in former NASD Rule 
3350 rather than Rule 10a-1's tick test, and Nasdaq Capital Market 
securities traded OTC and reported to a NASD facility to continue to 
not be subject to any price test.\36\ Thus, with respect to trades in 
Nasdaq Global Market securities reported to the NASD's Alternative 
Display Facility (``ADF'') \37\ or the Trading Reporting Facility 
(``TRF''),\38\ NASD Rule 5100 prohibits short sales at or below the 
current national best (inside) bid when the current national best 
(inside) bid is below the previous best (inside) bid in the 
security.\39\
---------------------------------------------------------------------------

    \36\ See letter from James A. Brigagliano, Acting Associate 
Director, Division of Market Regulation to Marc Menchel, Executive 
Vice President and General Counsel, NASD, Inc. (June 26, 2006) 
(providing exemptive relief to allow (i) Nasdaq Global Market 
securities traded OTC and reported to a NASD facility to be subject 
to NASD Rule 5100 (``NASD Rule 5100'' or ``NASD's bid test'') rather 
than Rule 10a-1, and (ii) Nasdaq Capital Market securities traded 
OTC and reported to a NASD facility to not be subject to either Rule 
10a-1 or NASD Rule 5100).
    \37\ The ADF is a facility operated by NASD on a pilot basis for 
members that choose to quote or effect trades in Nasdaq securities 
otherwise than on an exchange. The ADF collects and disseminates 
quotations and trade reports, and compares trades. See NASD Rule 
4100A.
    \38\ The TRF permits NASD members that internalize customer 
orders through the Nasdaq Stock Market facility of the NASD to 
continue to internalize such orders pursuant to NASD rules and to 
report trades to the TRF of the NASD. The TRF uses Nasdaq's 
technology, i.e., ACT, to accept OTC trade reports from NASD members 
in Nasdaq securities. See Exchange Act Release No. 54085 (June 30, 
2006), 71 FR 38910 (July 10, 2006).
    \39\ See NASD Rule 5100.
---------------------------------------------------------------------------

    For these same reasons, we also granted an exemption for exchanges 
trading Nasdaq Global Market and Nasdaq Capital Market securities on a 
UTP basis to continue to do so without being subject to any price test 
until completion of the Pilot.\40\
---------------------------------------------------------------------------

    \40\ See letter from James A. Brigagliano, Acting Associate 
Director, Division of Market Regulation to David C. Whitcomb, Jr., 
Senior Vice President and Chief Regulatory Officer, the Chicago 
Stock Exchange, Inc. (July 20, 2006) (providing an exemption from 
any price test for exchanges trading Nasdaq securities on a UTP 
basis. Exchanges may, however, adopt a bid test to apply to trading 
in Nasdaq securities).
---------------------------------------------------------------------------

    In summary, under the current market structure, Nasdaq Global 
Market securities traded on Nasdaq or the OTC market and reported to a 
NASD facility are subject to Nasdaq's or NASD's bid tests.\41\ Other 
listed securities traded on an exchange, or otherwise, are subject to 
Rule 10a-1's tick test. Nasdaq securities traded on exchanges other 
than Nasdaq are not subject to any price test. In addition, many 
thinly-traded securities, such as Nasdaq Capital Market securities, and 
securities quoted on the OTCBB and pink sheets, are not subject to any 
price test wherever traded.
---------------------------------------------------------------------------

    \41\ Recently, the Commission approved proposed rule changes by 
Nasdaq and the NASD to exempt securities comprising the Nasdaq-100 
Index from Nasdaq Rule 3350 and NASD Rule 5100, respectively. See 
Exchange Act Release No. 54435 (September 13, 2006), 71 FR 55042 
(September 20, 2006); Exchange Act Release No. 54558 (October 2, 
2006), 71 FR 59573 (October 10, 2006).
---------------------------------------------------------------------------

C. Current Price Test Exemptions

    As noted above, the core provisions of Rule 10a-1 have remained 
essentially unchanged since the rule was adopted in 1938. Over the 
years, however, in response to changes in trading strategies and 
systems used in the marketplace, the Commission has added exceptions to 
Rule 10a-1 \42\ and granted numerous written requests for relief from 
the rule's restrictions. These requests for exemptive relief have 
increased dramatically in recent years in response to significant 
developments in the securities markets, such as

[[Page 75072]]

decimalization and the spread of fully automated markets. Among others, 
the Commission has granted exemptions from Rule 10a-1: (i) For 
transactions in exchange traded funds (``ETFs''); \43\ (ii) to permit 
registered market makers and exchange specialists publishing two-sided 
quotes in a security to sell short to facilitate customer market and 
marketable limit orders at the consolidated best offer, regardless of 
the last trade price; \44\ (iii) for certain transactions executed on a 
volume-weighted average price (``VWAP'') basis; \45\ (iv) to electronic 
trading systems that match and execute trades at independently derived 
prices during random times within specific time intervals; \46\ and (v) 
to allow broker-dealers to fill customer orders, without the 
restrictions of the tick test, if: (a) A broker-dealer receives a sell 
order from a customer who is net ``long'' the securities being sold, 
and the broker-dealer then seeks to execute that order, either in whole 
or in part, by selling the security as riskless principal, even if the 
broker-dealer has an overall net ``short'' position in such security; 
or (b) a broker-dealer receives a buy order from a customer, and the 
broker-dealer then seeks to execute that order, either in whole or in 
part, by purchasing the security as riskless principal, and then 
selling the security to the customer, even if the broker-dealer has an 
overall net ``short'' position in such security.\47\ We have granted 
these exemptions because we believe that the types of trading 
activities described in each of the exemptive request letters do not 
appear to involve the types of abuses that Rule 10a-1 was designed to 
address.\48\ We believe, however, that by granting these exemptions we 
limit the reach of the price test restrictions contained in Rule 10a-1 
and potentially create an unlevel playing field among market 
participants. Moreover, the fact that an increasing number of market 
participants have requested these exemptions indicates to us that the 
current rule may no longer be suited to the wide variety of trading 
strategies and systems currently used in the marketplace.
---------------------------------------------------------------------------

    \42\ Paragraph (e) of Rule 10a-1 contains the exceptions to the 
rule. The exceptions to the tick test are designed to permit certain 
types of trading activities that are intended to benefit the markets 
or that are believed to carry little risk of the kind of 
manipulative or destabilizing trading that Rule 10a-1 was designed 
to address. See Exchange Act Release No. 48709 (October 28, 2003), 
68 FR 62972 (November 6, 2003); 17 CFR 240.10a-1(e). In addition, in 
considering whether to propose removing the price tests of any 
exchange or national securities association for all securities, the 
Commission reviewed the exceptions to the NASD's and Nasdaq's bid 
tests, such as the bona-fide market maker exception contained in 
each of those rules. See NASD Rule 5100(c); Nasdaq Rule 3350(c).
    \43\ See, e.g., letter from Racquel L. Russell, Esq., Branch 
Chief, Office of Trading Practices and Processing, Division of 
Market Regulation to George T. Simon, Esq., Foley & Lardner LLP 
(June 21, 2006); letter from James A. Brigagliano, Assistant 
Director, Division of Market Regulation, to Claire P. McGrath, Vice 
President and Special Counsel, AMEX (August 17, 2001). In granting 
such exemptions, the Commission noted that its decision was 
generally based on the fact that the market value of ETF shares 
would rise and fall based on changes in the net asset value of the 
component stocks in the particular index, and supply and demand. 
Each of the approvals for relief is conditioned on the ETF meeting 
certain enumerated conditions, either specific to certain products 
or included as part of a broader ``class exemption.''
    \44\ See letter from James A. Brigagliano, Assistant Director, 
Division of Market Regulation to Bernard L. Madoff, Chairman, 
Bernard L. Madoff Investment Securities LLC (February 9, 2001). This 
relief is strictly limited to the facilitation of customer market 
and marketable limit orders and is not available as a means of 
soliciting customer orders.
    \45\ See, e.g., letter from Larry E. Bergmann, Senior Associate 
Director, Division of Market Regulation to Soo Yim, Wilmer, Cutler & 
Pickering (December 7, 2000); letter from James A. Brigagliano, 
Assistant Director to Andre E. Owens, Esq., Schiff Hardin & Waite 
(March 30, 2001); letter from James A. Brigagliano, Assistant 
Director, Division of Market Regulation to Sam Scott Miller, Esq., 
Orrick, Herrington & Sutcliffe LLP (May 11, 2001); letter from James 
A. Brigagliano, Assistant Director, Division of Market Regulation to 
William W. Uchimoto, Esq., Vie Institutional Services (February 12, 
2003); letter from James A. Brigagliano, Assistant Director, 
Division of Market Regulation to Amy N. Kroll, Esq., Foley & Lardner 
(March 16, 2004). Among other things, the relief is limited to VWAP 
transactions that are arranged or ``matched'' before the market 
opens at 9:30 a.m. but are not assigned a price until after the 
close of trading when the VWAP value is calculated. The Commission 
granted the exemptions based, in part, on the fact that these VWAP 
short sale transactions appear to pose little risk of facilitating 
the type of market effects that Rule 10a-1 was designed to prevent. 
In particular, the pre-opening VWAP short sale transactions do not 
participate in, or affect, the determination of the VWAP for a 
particular security. Moreover, the Commission stated that all trades 
used to calculate the day's VWAP would continue to be subject to 
Rule 10a-1.
    \46\ See, e.g., letter from James A. Brigagliano, Acting 
Associate Director, Division of Market Regulation, to Alan J. Reed, 
Jr., First Vice President and Director of Compliance, Instinet 
Group, LLC. (June 15, 2006) (granting Instinet modified exemptive 
relief from Rule 10a-1 for certain transactions executed through 
Instinet's Intraday Crossing System). These systems have requested 
relief from Rule 10a-1 because matches could potentially occur at a 
price below the last reported sale price. Due to the passive nature 
of pricing and the lack of price discovery, trades executed through 
the passive systems generally do not appear to involve the types of 
abuses that Rule 10a-1 was designed to prevent.
    \47\ See Letter from James A. Brigagliano, Assistant Director, 
Division of Market Regulation to Ira Hammerman, Senior Vice 
President and General Counsel, Securities Industry Association (July 
18, 2005).
    \48\ We note, however, that each exemption from Rule 10a-1 was 
granted subject to conditions for relief designed to ensure that the 
trading activities contemplated by the requests for relief do not 
implicate the types of trading activity that Rule 10a-1 was designed 
to prevent.
---------------------------------------------------------------------------

D. Pilot Results

    The Pilot commenced on May 2, 2005 and is scheduled to terminate no 
later than August 6, 2007.\49\ The purpose of the Pilot was to allow 
the Commission to study the effectiveness of current price test 
restrictions and, in particular, to assist the Commission in 
determining whether current price test restrictions should be removed 
or modified, in part or whole, for some or all securities.\50\ 
Consistent with this purpose, the Commission has been able to collect 
empirical evidence on the effects of relatively unrestricted short 
selling on market volatility, price efficiency (including 
manipulation), and liquidity from the OEA Staff's Draft Summary Pilot 
Report and the Academic Studies. The Commission has also collected 
information on whether unrestricted short selling affects actively-
traded securities differently than thinly-traded securities (according 
to turnover) or affects large securities differently than small 
securities (according to market capitalization). In addition, the 
Commission has collected empirical evidence on the effect of price test 
restrictions on the level of short selling and options trading, the 
balance of trade, and the effect of disparate price test restrictions 
on different market centers trading the same securities. Finally, the 
Commission has collected information on whether the impact of Rule 10a-
1 is different than the impact of former NASD Rule 3350 on short 
selling activity.
---------------------------------------------------------------------------

    \49\ See supra n.6 and supporting text.
    \50\ See Regulation SHO Adopting Release at 48012-48013.
---------------------------------------------------------------------------

 i. OEA Staff's Draft Summary Pilot Report
    OEA analyzed the effects of the Pilot on the securities included in 
the Pilot by comparing short selling activity, volatility, price 
efficiency, and liquidity in those securities to a control group of 
securities.\51\ In particular, OEA estimated how these securities 
changed from the four months prior to the Pilot to the first six months 
of the Pilot and compared the Pilot securities' changes to the control 
group securities' changes.\52\ OEA's analysis was conducted separately 
for listed securities and Nasdaq Global Market securities. OEA's main 
empirical results are discussed below.
---------------------------------------------------------------------------

    \51\ OEA selected the securities to be included in the Pilot by 
sorting the 2004 Russell 3000, first by listing market and then by 
average daily dollar volume from June 2003 through May 2004, and 
then within each listing market, selecting every third company 
starting with the second. Because the selection process relied on 
average daily dollar volume, companies that had their Initial Public 
Offering (``IPO'') in May or June 2004, just prior to the Russell 
reconstitution, were not included. The securities in the control 
group came from the remainder of the 2004 Russell 3000 not included 
in the Pilot (excluding the IPOs in May or June 2004 and any 
securities added to the Russell 3000 after June 2004). See OEA 
Staff's Draft Summary Pilot Report at 22 (discussing the selection 
of securities included in the Pilot and the control group).
    \52\ Table 2 of the OEA Staff's Draft Summary Pilot Report shows 
that the Pilot stocks were statistically similar to the control 
group securities during the four months prior to the Pilot. See id. 
at 61.
---------------------------------------------------------------------------

    Because price test restrictions are meant to keep short sales from 
creating

[[Page 75073]]

excessive downward price pressure,\53\ OEA studied whether price test 
restrictions dampen volatility. In particular, OEA studied whether 
price test restrictions dampen short-term intraday volatility 
associated with temporary order imbalances or daily volatility 
associated with price changes. OEA found that price test restrictions 
did not have a significant impact on daily volatility for either listed 
or Nasdaq Global Market securities, while price test restrictions 
appear to dampen intraday volatility, particularly in listed 
securities.\54\
---------------------------------------------------------------------------

    \53\ See, e.g., supra n.3 and supporting text (providing that a 
primary reason that the Commission adopted Rule 10a-1 in 1938 was to 
restrict short selling in a declining market).
    \54\ See infra n.61-63 and supporting text.
---------------------------------------------------------------------------

    OEA analyzed the Pilot data to determine what impact, if any, price 
test restrictions have on price efficiency. OEA found that the Pilot 
data provided limited evidence that price test restrictions distort a 
security's price.\55\ In addition, the Pilot data did not provide any 
indication that there is an association between manipulative short 
selling, such as ``bear raids,'' and price test restrictions on short 
selling.\56\
---------------------------------------------------------------------------

    \55\ On the day the Pilot went into effect, listed Pilot 
securities underperformed listed control group securities by 
approximately 24 basis points. The Pilot and control group 
securities, however, had similar returns over the first six months 
of the Pilot. See OEA Staff's Draft Summary Pilot Report at 8.
    \56\ See id. at 48, 56.
---------------------------------------------------------------------------

    Price test restrictions could inhibit the free movement of a 
security's price, and thereby, make markets less liquid. Price test 
restrictions could also induce more liquidity by forcing short sellers 
to engage in more passive trading strategies. To test these potential 
effects, OEA analyzed whether price test restrictions have an impact on 
liquidity by comparing quoted and effective spreads and quoted bid and 
ask depth for those securities contained in the Pilot and the control 
group. OEA found that price test restrictions resulted in an increase 
in quote depths. Liquidity levels, however, were unaffected by the 
removal of price test restrictions.\57\
---------------------------------------------------------------------------

    \57\ This conclusion is based on the result that changes in 
effective spreads were not economically significant (less than a 
basis point) and that the changes in the bid and ask depth appear 
not to affect the transaction costs paid by investors. Arguably, the 
changes in bid and ask depth appeared to affect the intraday 
volatility. However, OEA concludes that overall, the Pilot data does 
not suggest a deleterious impact on market quality or liquidity. See 
id. at 42, 56.
---------------------------------------------------------------------------

    An important element of the Pilot was to determine whether price 
test restrictions affect securities of varying size and trading volume 
differently. For the most part, OEA found that current price test 
restrictions affect securities to the same extent regardless of size or 
trading volume.\58\ For example, OEA found that regardless of a 
security's size or trading volume, price test restrictions discouraged 
short selling.\59\ In addition, OEA found that price test restrictions 
did not distort a security's price or affect its liquidity in a way 
that was related to the size of, or trading volume in, the 
security.\60\ OEA did find, however, that a security's size or volume 
mattered with respect to routing decisions and volatility. For example, 
OEA found that for Nasdaq Global Market securities, in the absence of a 
price test, there was a more significant increase in Nasdaq's market 
share of short sales than in smaller Nasdaq Global Market 
securities.\61\ Similarly, OEA found that price test restrictions 
dampen both transitory and permanent price volatility in smaller 
securities while amplifying it in larger securities.\62\ With respect 
to intraday volatility, OEA found that there was an increase in 
volatility in smaller securities and a decline in volatility in larger 
securities in the absence of price tests. This evidence was much weaker 
for Nasdaq Global Market securities than listed securities.\63\
---------------------------------------------------------------------------

    \58\ See id. at Section IV.E.
    \59\ See id. at 52.
    \60\ See id. at 52-53. The report finds that former NASD Rule 
3350 seems to generate statistically lower effective spreads for 
large or more active Nasdaq Global Market securities. However, the 
difference does not appear to be economically meaningful.
    \61\ See id. at 52.
    \62\ See id. at 53.
    \63\ See id. at 43, 53.
---------------------------------------------------------------------------

    When reviewing the results of the Pilot, OEA analyzed whether price 
test restrictions represent an economically meaningful constraint on 
short selling and, thereby, may induce some traders to avoid short 
selling or reduce the size of their short positions. OEA found that for 
both listed and Nasdaq Global Market securities, price test 
restrictions reduce the volume of executed short sales relative to 
total volume, indicating that price test restrictions act as a 
constraint on short selling.\64\ In neither market, however, did OEA 
find a significant difference in short interest positions.\65\
---------------------------------------------------------------------------

    \64\ See id. at 35.
    \65\ See id.
---------------------------------------------------------------------------

    Because not all market centers that trade Nasdaq Global Market 
securities apply price test restrictions, OEA analyzed whether removing 
price test restrictions affects where short sales in Nasdaq Global 
Market securities are executed. OEA found that Nasdaq's share of short 
selling volume is negatively impacted by price test restrictions, 
suggesting that some short sellers route orders to avoid the 
application of a price test.\66\
---------------------------------------------------------------------------

    \66\ See id. at 36.
---------------------------------------------------------------------------

    In addition, OEA tested whether broker-dealers use the options 
markets to avoid application of a price test. OEA found no evidence, 
however, that price test restrictions on equity securities have any 
impact on options trading.\67\
---------------------------------------------------------------------------

    \67\ See id. at 37.
---------------------------------------------------------------------------

    OEA found that price test restrictions affect the ability of short 
sellers to demand liquidity by getting prompt execution of market 
orders. For listed Pilot securities, OEA found that the application of 
the tick test of Rule 10a-1 resulted in significantly fewer than 50% of 
transactions occurring on minus ticks or zero-minus ticks. In the 
absence of a tick test, OEA found that tick-to-tick changes in price 
were more balanced.\68\ For Nasdaq Global Market securities, OEA found 
that the percentage of time the market was in a down bid state declined 
when the bid test was removed, suggesting that down bids occur more 
regularly when the bid test applies.\69\ This result suggests that 
short selling under former NASD Rule 3350 might shorten the duration of 
upbids, reflecting the restriction that short sales can only hit 
upbids. Removing former NASD Rule 3350 resulted in longer lasting 
upbids.
---------------------------------------------------------------------------

    \68\ See id. at 39.
    \69\ See id.
---------------------------------------------------------------------------

    In summary, OEA found little empirical justification for 
maintaining price test restrictions, especially for large securities. 
Despite changes in the displayed liquidity, all securities in the study 
had about the same realized liquidity and pricing efficiency whether or 
not price test restrictions apply. When OEA examined the differences 
between large and small securities, the most interesting pattern showed 
that price test restrictions actually amplify volatility in large 
securities while dampening it in small securities. While the majority 
of results do not suggest that removing price test restrictions would 
harm small securities, this volatility result is a potential 
concern.\70\
---------------------------------------------------------------------------

    \70\ But, c.f., n.80 and supporting text (noting that one 
Academic Study did not document that volatility was affected by the 
size of the security).
---------------------------------------------------------------------------

ii. Academic Studies and Regulation SHO Roundtable
    To better inform the Commission regarding the effects of the Pilot 
and, in turn, of price test restrictions, we encouraged researchers to 
provide the Commission with their own empirical analyses of the Pilot. 
In response to this request, the Commission received the

[[Page 75074]]

Academic Studies.\71\ In addition, the Commission held the Regulation 
SHO Roundtable that focused on the empirical evidence learned from the 
Pilot.\72\ The Academic Studies and Regulation SHO Roundtable contained 
a variety of observations, which we considered in determining whether 
or not to propose removal of price test restrictions.
---------------------------------------------------------------------------

    \71\ See supra n.12. The Commission notes that although these 
Academic Studies examined the Pilot data, the Academic Studies vary 
with respect to the time periods and the composition of the sample 
securities examined and the methodologies used. Thus, the Commission 
realizes that differences in findings among the Academic Studies may 
be due, in part, to the different approaches used for each of the 
Academic Studies.
    \72\ See supra n.13 (providing a url link to the transcript of 
the Regulation SHO Roundtable).
---------------------------------------------------------------------------

    Generally, the Academic Studies and Regulation SHO Roundtable 
panelists, who were all economists, urged removal of short sale price 
test restrictions; although they also noted some market quality 
benefits of these restrictions. The results of the Academic Studies on 
volatility and price efficiency were largely consistent with the 
results in the OEA Staff's Draft Summary Pilot Report. However, the 
conclusions regarding liquidity differed. For example, some of the 
Academic Studies found that price test restrictions result in narrower 
spreads than if these restrictions did not apply.\73\ Similarly, some 
Academic Studies found that bid and ask depths are greater when short 
sale price test restrictions apply.\74\ Thus, according to some of the 
Academic Studies the Commission received, the Pilot results indicate 
that removal of price test restrictions may result in a decrease in 
liquidity.\75\ Several panelists at the Regulation SHO Roundtable 
questioned whether this result, that is, the decrease in liquidity 
after the removal of price test restrictions, is economically 
meaningful.\76\
---------------------------------------------------------------------------

    \73\ See, e.g., Wu at 5, 18. As an explanation for this finding, 
Wu notes that price test restrictions require short sellers to act 
as liquidity suppliers because price test restrictions might require 
short sellers to place more limit orders on the ask side. Wu notes 
that in the absence of price test restrictions, short sellers demand 
liquidity by being able to place market orders without restrictions. 
See id.; see also, Alexander and Peterson at 19; Diether, Lee and 
Werner at 19-23. Although Diether, Lee and Werner find that spreads 
widen when price test restrictions do not apply for NYSE-listed 
securities, this study also states that they do not interpret wider 
spreads as evidence that price tests are effective. See id. at 6, 
31.
    \74\ See, e.g., Alexander and Peterson at 19-20 (finding smaller 
bid and ask depths for NYSE-listed securities included in the 
Pilot). Alexander and Peterson suggest that bid depth declines 
because short sale market orders can execute immediately, and when 
they do, depth at the bid is reduced. As an explanation for the 
decline in ask depth, Alexander and Peterson suggest that in the 
absence of short sale price test restrictions, market orders no 
longer turn into limit orders and, therefore, contribute to the ask 
depth. See id.; see also Diether, Lee and Werner at 20. Diether, Lee 
and Werner note that the suspension of price tests result in wider 
spreads because price tests ``* * * distort how people trade. 
Specifically, NYSE short sale orders are treated as liquidity 
supplying orders so as to comply with the Uptick Rule. As a result, 
short sellers forgo the option-value of their order flow. Moreover, 
their opportunities to trade in a timely manner are curtailed. The 
fact that short-sellers are unable to use marketable orders 
increases the costs of trading for buyers relying on passive pricing 
strategies (limit orders). In addition, short-sellers effectively 
``penny'' long-sellers using limit orders. Thus, the regulation 
causes redistribution of welfare away from short-sellers and passive 
buyers and (long) sellers in favor of active buyers.'' Id. at 31.
    \75\ See, e.g., Alexander and Peterson at 2, 20 (providing that 
the studies' results appear to indicate a decrease in liquidity 
associated with the removal of price tests). Alexander and Peterson 
note, however, that ``while it is tempting to conclude that price 
tests improve liquidity, it is more appropriate to view them as 
distorting liquidity.'' Id. at 27.
    \76\ See Roundtable Transcript at 50, 93, 99, 114, 151.
---------------------------------------------------------------------------

    In addition, we note that only one Academic Study examined whether 
Rule 10a-1 has a different impact on small securities than on large 
securities and found that the significance of the impact of the removal 
of Rule 10a-1 at times depended on the size (that is, market 
capitalization) of the securities examined.\77\ While the results of 
this Academic Study suggest that Rule 10a-1 can have a larger impact on 
small securities, the specific results are not consistent with the 
results described in the OEA Staff's Draft Summary Pilot Report 
described above. For example, although OEA found the effect of Rule 
10a-1 on short selling volume did not depend on size, this Academic 
Study found that removal of Rule 10a-1 resulted in a significant 
increase in short selling volume only in smaller securities.\78\ 
Similarly, with respect to the widening of spreads following the 
removal of Rule 10a-1, this Academic Study found that the widening of 
spreads was more pronounced for smaller rather than larger securities, 
while OEA documents no relationship between size and spreads in the OEA 
Staff's Draft Summary Pilot Report.\79\ Finally, unlike the OEA Staff's 
Draft Summary Pilot Report, this Academic Study did not document that 
volatility was affected by the size of the security.\80\ Overall, when 
considering the results in this Academic Study and the OEA Staff's 
Draft Summary Pilot Report, the evidence regarding the application of 
price test restrictions to small securities is inconsistent. While 
there is some evidence supporting the application of price test 
restrictions to smaller securities, the evidence is not strong enough 
to warrant its continuation in any subset of securities or the 
expansion of price test restrictions to securities currently not 
covered by any price test restrictions.
---------------------------------------------------------------------------

    \77\ See Wu.
    \78\ See id. at 4, 14 (finding that the increase in short 
selling volume occurred only in smaller NYSE-listed securities. Wu 
found that larger NYSE-listed securities did not experience a 
significant change in short selling volume).
    \79\ See id. at 5, 19 (finding that smaller NYSE-listed 
securities experience the most pronounced widening of spreads, while 
larger NYSE-listed securities saw no changes in spreads. Wu noted 
that an explanation for this result might be that small securities 
are harder to sell short and are more sensitive to liquidity 
shocks).
    \80\ See id. at 16, 20.
---------------------------------------------------------------------------

    Consistent with the results in the OEA Staff's Draft Summary Pilot 
Report, we note that some Academic Studies found that the significance 
of the impact of the removal of price test restrictions at times 
depended on which price test restrictions applied.\81\ In particular, 
the magnitude of the changes from removing Rule 10a-1 are larger than 
the changes from removing former NASD Rule 3350, suggesting that Rule 
10a-1 is more restrictive.
---------------------------------------------------------------------------

    \81\ See e.g., Alexander and Peterson at 3 (stating that 
Nasdaq's bid test seems to be relatively inconsequential); see also, 
Diether, Lee and Werner at 30 (stating that this Academic Study's 
results show that the ``NYSE Uptick Rule has a very different effect 
on the trading strategies of short-sellers compared to the Nasdaq 
bid-price rule'').
---------------------------------------------------------------------------

    Two of the Academic Studies commented on whether the original 
rationale for adopting Rule 10a-1 in 1938 still applies in today's 
market. For example, one Academic Study noted that it found ``little 
evidence to support the argument that price tests are needed to prevent 
short sellers from driving prices down from either shorting 
`successively lower prices' or `exhausting all remaining bids at one 
price level, causing successively lower prices.' '' \82\ Another 
Academic Study noted that there is no empirical support for the 
rationale underlying the adoption of the tick test that unfettered 
short selling would produce significant volatility.\83\ In addition, 
nine of the twelve panelists in the Regulation SHO Roundtable 
explicitly supported removing price test restrictions,\84\ though a few 
of the nine noted a lack of evidence for removing price test 
restrictions from small securities.\85\ The Commission considered these 
opinions in deciding whether to propose

[[Page 75075]]

removing price test restrictions for all securities.
---------------------------------------------------------------------------

    \82\ See Alexander and Peterson at 18.
    \83\ See Diether, Lee and Werner at 23.
    \84\ Prof. Werner, Prof. Irvine, Prof. Alexander, Prof. Harris, 
Prof. Kyle, Prof. Lamont, Prof. Lehmann, Dr. Lindsey and Dr. 
Sofianos. See Roundtable Transcript at 48, 49, 72, 97, 100, 104, 
111, 113, 119. The remaining panelists did not explicitly state an 
opinion regarding removing price test restrictions.
    \85\ Dr. Sofianos and Dr. Lindsey. See Roundtable Transcript at 
117, 119, 123.
---------------------------------------------------------------------------

III. Discussion of Proposed Amendments

A. Removal of Price Test Restrictions

    We are proposing to remove the tick test of Rule 10a-1 \86\ and add 
Rule 201 of Regulation SHO \87\ to provide that no price test, 
including any price test of any SRO, shall apply to short sales in any 
security. In addition, we are proposing to prohibit any SRO from having 
a price test.
---------------------------------------------------------------------------

    \86\ 17 CFR 240.10a-1.
    \87\ Id. at 242.201.
---------------------------------------------------------------------------

    Price test restrictions have applied to short sales for almost 70 
years. Current short sale regulation is disparate, however, with 
different price tests applying depending on the type of security being 
sold and where the short sale order is executed. Rule 10a-1's tick test 
applies only to short sale transactions in securities listed on a 
national securities exchange, other than Nasdaq securities, whether the 
transaction is effected on an exchange or otherwise. The NASD's bid 
test applies only to short sale transactions in Nasdaq Global Market 
securities reported to a NASD facility. Nasdaq's bid test applies only 
to trades in Nasdaq Global Market securities on Nasdaq. In addition, no 
price test applies to short sales of Nasdaq securities executed on 
other exchanges trading Nasdaq securities. This disparate regulation 
has the potential for confusion and compliance difficulties. In 
addition, we are concerned that this current market structure could 
competitively disadvantage investors because short sale orders obtain 
different treatment depending on where the orders are executed.
    We also note that small or more thinly-traded securities, such as 
Nasdaq Capital Market securities and those quoted on the OTCBB and pink 
sheets continue to be unrestricted by any price test, while large or 
more actively-traded securities remain subject to a price test. 
Continuing to impose a price test on only larger securities or those 
that are more actively-traded would be anomalous, given the greater 
difficulty of manipulating the price of a security as market 
capitalization and trading volume increase.\88\
---------------------------------------------------------------------------

    \88\ See Exchange Act Release No. 42037 (October 20, 1999), 64 
FR 57996 (October 28, 1999) (noting that some of the Commission's 
anti-manipulation rules assume that highly liquid securities are 
less susceptible to manipulation and abuse than other securities).
---------------------------------------------------------------------------

    Moreover, we believe that the increasing number of requests for 
relief from the provisions of Rule 10a-1 that the Commission has 
granted in recent years for a wide range of short selling activities 
have limited the applicability of the rule's price restrictions, 
potentially created an unlevel playing field among market participants 
and has indicated to us that current price test restrictions have not 
kept pace with the wide variety of trading strategies and systems 
currently used in the marketplace. Rule 10a-1 was adopted in 1938 and 
its restrictions on short selling have remained essentially unchanged 
since that time. Thus, we believe that this is an appropriate time to 
propose amendments that would provide for a more consistent and simpler 
approach to short sale regulation.\89\
---------------------------------------------------------------------------

    \89\ We note that in 2003, in the Regulation SHO proposing 
release, we proposed a price test that, if adopted, would have 
required that all short sales in covered securities be effected at a 
price at least one cent above the consolidated best bid at the time 
of execution. Additionally, the Commission sought comment on an 
alternative price test that would allow short selling at a price 
equal to or above the consolidated best bid if the current best bid 
was above the previous bid (i.e. an upbid). Under this alternative, 
short selling would be restricted to a price at least one cent above 
the consolidated best bid if the current best bid was below the 
previous bid (i.e. a downbid). See Exchange Act Release No. 48709 
(October 28, 2003), 68 FR 62972 (November 6, 2003) (the ``Regulation 
SHO Proposing Release''). Based on the comments received to that 
proposal, however, the Commission determined to defer consideration 
of the proposed uniform bid test until after completion of the 
Pilot. See Regulation SHO Adopting Release at 48010. Although a 
uniform bid test similar to that proposed in the Regulation SHO 
Proposing Release would also result in consistent price test 
regulation, based on our review of the applicability of current 
price test restrictions, in particular, the need for such price test 
restrictions in light of today's market structure and the Pilot 
Results, we do not believe that any price test restrictions are 
currently necessary.
---------------------------------------------------------------------------

    In addition, based on the Pilot Results, we believe that removal of 
current price test restrictions would not have a significant impact on 
market quality. The Pilot Results found little evidence suggesting that 
the removal of the price test restrictions would harm market 
volatility, price efficiency, or liquidity. In fact, the empirical 
results indicate that the observed effect of a price test may have a 
larger negative than positive impact on markets. For example, the OEA 
Staff's Draft Summary Pilot Report suggests that price test 
restrictions result in decreased short selling volume.\90\ Short 
selling provides the marketplace with important benefits such as 
liquidity and price efficiency. The OEA Staff's Draft Summary Pilot 
Report indicates that price test restrictions may limit these benefits. 
In addition, the OEA Staff's Draft Summary Pilot Report suggests that 
price test restrictions result in market participants routing orders to 
avoid application of price test restrictions,\91\ resulting in a loss 
of trading volume for market centers that have a price test. Other 
market centers may use the absence of a price test to their advantage 
to attract order flow away from market centers that have a price test. 
Thus, current price test regulation may competitively disadvantage 
certain investors because their short sale orders may or may not be 
subject to price test restrictions depending on which market center the 
order is executed.
---------------------------------------------------------------------------

    \90\ See OEA Staff's Draft Summary Pilot Report at 35.
    \91\ See id. at 36.
---------------------------------------------------------------------------

    As noted above, a primary reason that the Commission adopted Rule 
10a-1 in 1938 was to restrict short selling in a declining market.\92\ 
Although there is concern regarding the possibility of manipulation 
using short sales, we note that the OEA Staff's Draft Summary Pilot 
Report did not evidence an increase in manipulative short selling 
during the time period studied.\93\ In addition, we believe that the 
high levels of transparency and sophisticated surveillance for 
securities traded on exchanges and other regulated markets would allow 
manipulative or abusive short selling activity to be detected and 
pursued in the absence of price test restrictions. Moreover, the 
general anti-fraud and anti-manipulation provisions of the federal 
securities laws would continue to prohibit trading activity designed to 
improperly influence the price of a security.\94\
---------------------------------------------------------------------------

    \92\ See supra n.3.
    \93\ See OEA Staff's Draft Summary Pilot Report at 47-51 
(discussing the Pilot data in connection with ``bear raids''). We 
note that the OEA Staff's Draft Summary Pilot Report did not 
evaluate the impact of short selling activity in connection with 
extraordinary events, such as initial or secondary public offerings, 
mergers and acquisitions or private placements.
    \94\ See supra n.16.
---------------------------------------------------------------------------

    In addition, after a review of the Pilot Results, we believe that 
the empirical analyses not only provide support for removing price test 
restrictions for either large or actively-traded securities, but also 
do not provide strong support for extending a price test to either 
small or thinly-traded securities. For example, the OEA Staff's Draft 
Summary Pilot Report discusses whether the removal of price test 
restrictions affects thinly- and actively-traded securities (according 
to turnover) differently.\95\ Generally, the results indicate that 
neither Rule 10a-1 nor former NASD Rule 3350 affects thinly-traded 
stocks differently than actively-traded stocks.
---------------------------------------------------------------------------

    \95\ See OEA Staff's Draft Summary Pilot Report Section VI.E. at 
51-54 and Wu at 4-5, 19-20.
---------------------------------------------------------------------------

    The OEA Staff's Draft Summary Pilot Report and one Academic Study 
also discuss whether the removal of price

[[Page 75076]]

test restrictions affect small and large stocks differently (according 
to market capitalization). These studies provide inconsistent results 
regarding whether Rule 10a-1 has a larger impact on the liquidity and 
volatility of smaller rather than larger securities. In addition, 
several Regulation SHO Roundtable panelists asserted that price test 
restrictions are unnecessary in smaller stocks because these stocks are 
harder to borrow and, therefore, are less likely to be sold short.\96\
---------------------------------------------------------------------------

    \96\ See Roundtable Transcript at 122-130.
---------------------------------------------------------------------------

    Overall, because the results suggest that price test restrictions 
affect thinly-traded securities no differently than actively-traded 
securities and the results are inconsistent regarding the effects of 
price test restrictions on large and small stocks, we believe the 
current evidence is not strong enough to warrant a proposal to continue 
imposing price test restrictions on only a subset of either small or 
thinly-traded securities, or to extend price test restrictions to 
securities currently not subject to any price test restrictions. We 
request comment, however, regarding whether or not price test 
restrictions should apply to securities not currently covered by any 
price test restrictions.
    We also note that current price test restrictions impose costs on 
market participants in terms of time and technology. For example, to 
comply with the tick test of Rule 10a-1, short sellers may incur 
additional transactional costs as they await a proper tick for 
execution. Moreover, in some cases, the tick test of Rule 10a-1 can 
create potential conflicts with best execution responsibilities 
(although the Commission has provided relief to minimize these 
instances).\97\
---------------------------------------------------------------------------

    \97\ For example, as previously described by the Commission, 
``in order to resolve a potential conflict between the tick test and 
the quote rule, the Commission adopted (e)(5)(ii) to permit market 
makers to execute transactions at their offer following a trade-
through, and (e)(11) to permit non-market makers to effect a short 
sale at a price equal to the price associated with their most 
recently communicated offer up to the size of that offer so long as 
the offer was at a price, when communicated, that was permissible 
under Rule 10a-1. The (e)(11) exception was added in response to 
several comments that, in addition to orders for their own account, 
specialists and other floor members also often represent as part of 
their displayed quotations orders of other market participants 
(e.g., public agency orders or proprietary orders of non-market 
makers) that also might be ineligible for execution under Rule 10a-1 
following a trade-through in another market.'' Exchange Act Release 
No. 48709 (October 28, 2003), 68 FR 62972, 62986 (November 6, 2003).
---------------------------------------------------------------------------

    In addition, we are aware that in a decimals environment, with 
penny or even sub-penny price points and narrow spreads, a short seller 
can await or create an uptick with minimal burden. On the other hand, 
in a decimals environment, the tick test of Rule 10a-1 may be triggered 
by a change in price that reflects an extremely small decrease in the 
price of the security. We do not believe that a price change as small 
as one penny per share results in the type of market impact that Rule 
10a-1 was designed to prevent. Rather, we believe that current price 
test restrictions may have become unduly burdensome and are possibly 
ill-suited to present and future markets.
    Thus, for all these reasons, we believe that this is an appropriate 
time to modernize and simplify price test regulation by proposing to 
remove Rule 10a-1's tick test and add Rule 201(a) of Regulation SHO to 
provide that no price test, including any price test of any SRO, shall 
apply to short sales in any securities.
    In addition, we are proposing to add Rule 201(b) of Regulation SHO 
that would provide that no SRO shall have a price test. A primary goal 
of the proposed amendments is to achieve greater regulatory consistency 
and simplification. To date, we have permitted SROs to adopt their own 
price tests. As noted above, this has resulted in a regulatory 
environment that applies different tests to securities trading in 
different markets, and even to the same security trading in different 
markets. We believe that by proposing to require that no SRO shall have 
its own price test, the goals of regulatory simplification and 
consistency would be better met.
    We are aware, however, that some SROs may want to maintain or adopt 
a new price test. For example, we are aware that previously, SROs have 
adopted price tests to attract issuers concerned about the potential 
effects of short selling on the issuer's stock price. Thus, we solicit 
comment regarding whether we should allow SROs to have their own price 
tests.
    Regardless of whether or not we adopt the proposed amendments, 
however, the Commission and the SROs will continue to monitor for, and 
pursue, abusive trading activities. In addition, as already noted, the 
general anti-fraud and anti-manipulation provisions of the federal 
securities laws will continue to prohibit trading activity that 
improperly influences the price of a security.\98\
---------------------------------------------------------------------------

    \98\ In addition, as noted previously, this proposal would not 
amend any short selling regulations other than those related to 
price tests. See supra n.15.
---------------------------------------------------------------------------

Request for Comment
    The Commission seeks comment generally on all aspects of the 
proposed amendments to Rule 10a-1 and Regulation SHO. In addition, we 
seek comment on the following:
     The proposed amendments state that no ``short sale price 
test'' shall apply to short sales in any security. Should we define the 
term ``short sale price test'' for purposes of these amendments?
     Some SROs have adopted price tests to attract issuers 
concerned about the potential effects of short selling on the issuer's 
stock price. The proposed amendments would prohibit any SRO from having 
its own price test. If the Commission removes Rule 10a-1, should the 
Commission continue to allow the SROs to adopt their own price tests? 
Should the Commission require uniformity with respect to any SRO price 
tests? Should any such SRO price tests be limited to certain 
securities? What would be the costs and benefits of allowing the SROs 
to adopt their own price tests?
     We request comment from issuers regarding their views of 
the impact of the proposed amendments on their securities. Are issuers 
concerned that unrestricted short selling could result in undue 
downward price pressure on their company's stock? Are issuers concerned 
that the proposed amendments could result in manipulative short selling 
of their company's stock? Alternatively, would these concerns be 
mitigated because the general anti-fraud and anti-manipulation 
provisions of the federal securities laws would continue to prohibit 
trading activity designed to improperly influence the price of a 
security? Please submit any available empirical evidence of 
manipulation of pilot stocks.
     To what extent does the tick test of Rule 10a-1 impose 
market costs on traders desiring to sell short? For example, if the 
removal of price test restrictions were to result in wider spreads, 
could this result in higher transaction costs for all traders? What 
would be the impact on investors? Would the removal of the price test 
restrictions result in shifting higher trading costs from short sellers 
to other traders? To what extent would such costs justify any benefits 
of removing price test restrictions?
     Would the removal of price tests benefit the markets by 
allowing investors to more freely short sell potentially over-valued 
securities so that the security's price more accurately reflects its 
fundamental value? Would the removal of price tests lead to benefits 
such as a reduction in costs associated with systems and surveillance 
costs? What would be the costs to the markets of removing price

[[Page 75077]]

tests? Please provide any quantified evidence available.
     To what extent does the tick test of Rule 10a-1 affect the 
ability to sell short in a decimals environment? Please explain any 
difficulties of complying with the tick test or any other price test in 
a decimals environment. In light of all the exemptions from, and 
exceptions to, Rule 10a-1, how significant a test is it? On what types 
of trading activities does Rule 10a-1 have a significant or meaningful 
impact? Similarly, in light of the exceptions to NASD Rule 5100 and 
Nasdaq Rule 3350, how significant are these tests? On what types of 
trading activities do NASD Rule 5100 and Nasdaq Rule 3350 have a 
significant or meaningful impact? Please explain.
     To what extent, if any, is retention of price test 
restrictions valuable for investor confidence to commit capital to the 
markets?
     Is the tick test in Rule 10a-1 appropriate for some 
securities but not all securities? If the Commission were to maintain a 
price test for some securities, which types of securities should be 
subject to a price test?
     We note that in 2003, in the Regulation SHO Proposing 
Release, we proposed adopting a price test using the consolidated best 
bid as a reference point for permissible short sales.\99 \ Should the 
Commission adopt a new price test, such as a uniform bid test, that 
would replace all current price tests, including those of any exchange 
or national securities association? If so, should the new price test 
apply to all securities, including those not currently subject to a 
price test? What should be the requirements of any new price test?
---------------------------------------------------------------------------

    \99\ See supra n.89.
---------------------------------------------------------------------------

     If the Commission were to maintain the tick test contained 
in Rule 10a-1, should the Commission amend the tick test to apply to 
all markets or securities equally?
     If the Commission were to maintain the tick test contained 
in Rule 10a-1, which, if any, of the exceptions contained in paragraph 
(e) of Rule 10a-1 should the Commission retain? Please explain. Should 
the Commission include exceptions not currently in Rule 10a-1? What 
should those exceptions address?
     If the Commission were to retain the tick test contained 
in Rule 10a-1, should the Commission codify all the exemptions the 
Commission has previously granted from this rule? If not all the 
exemptions, which exemptions should the Commission codify?
     NASD Rule 5100 and Nasdaq Rule 3350 contain exceptions for 
bona-fide market making. If the Commission were to retain the tick test 
contained in Rule 10a-1 or adopt a new price test, should such price 
test include an exception for bona-fide market making? If the 
Commission were to continue to allow for a market maker exception in 
NASD Rule 5100 or Nasdaq Rule 3350 or adopt a price test that contains 
a market maker exception, should the Commission limit the applicability 
of the exception? How should it be limited? What would be the purpose 
of such limitations?
     We request specific comment regarding the importance of 
retaining a market maker exception, for example, with respect to 
liquidity, price efficiency, market depth, speed of execution and 
flexibility for capital commitment.
     Should the Commission retain a price test for times during 
which there are unusual market declines? If so, please discuss what 
type of price test should be retained and under what types of 
circumstances such a price test should be applied?
     To what extent, if at all, would removal of price test 
restrictions impact the ability of short sellers to be liquidity 
providers versus liquidity demanders?
     If the Commission were to maintain the current tick test 
of Rule 10a-1 or adopt a new price test, should the price test apply 
only during regular market hours or should the price test apply 
regardless of when trades occur? What are the benefits and costs of 
applying price tests in the after-hours market?
     To what extent does real-time access to information 
regarding issuers, their respective industries and other influences on 
a security's price reduce the ability to manipulate prices in declining 
markets through short selling?
     To what extent is a price test an impediment to trading in 
a down market? Is it preferable to allow unimpeded short selling in a 
down market? Are there circumstances where such trading should not be 
permitted?
     Would removal of all price test restrictions result in the 
markets being truly representative of what is a fair price for an 
individual security?
     Are there any technical or operational challenges that 
would arise in complying with the proposal if the Commission were to 
adopt the proposal?
     How much would the proposed amendments affect specific 
compliance costs or other costs for small, medium and large entities 
(brokers, dealers, and SROs)?
     Would the proposed amendments create additional costs for, 
or otherwise impact, short sellers, issuers, investors, or others?
     Should we provide a compliance date, separate from an 
effective date, if the Commission were to adopt the proposed 
amendments? If yes, please explain why a compliance date would be 
appropriate and give suggestions as to how long a compliance period 
would be needed.
     Nine reporting markets have been making public information 
on short selling transactions.\100\ This information was vital to the 
study of the Pilot. Would it be in the public interest to request that 
the markets continue to release this information? In particular, would 
it improve transparency of short selling? Would it help the Commission 
and the markets monitor for potential abuses if the Commission were to 
approve the removal of price tests? How costly would continuing to 
produce the data be? Are there any less costly alternatives to the 
current information being released by the markets?
---------------------------------------------------------------------------

    \100\ See supra n.11.
---------------------------------------------------------------------------

     If the Commission were to adopt the proposed amendments, 
the Commission and the SROs would continue to monitor for manipulative 
activity. Should the Commission ask the SROs to submit periodic reports 
regarding the effects of the removal of price tests at regular 
intervals, for example, on a semi-annual or annual basis? What would be 
the costs associated with such reporting?
     Is the data from the Pilot sufficient for the purposes for 
which the Commission is using it? Is the data reliable? Are there any 
limitations in the Pilot Results that call the results and conclusions 
into question?
     The Pilot created a temporary rule amendment that affected 
a subset of securities trading in the market. To what extent would a 
permanent rule amendment applied to all stocks affect the market 
differently than the Pilot?

B. Removal of ``Short Exempt'' Marking Requirement

    We are proposing to amend Rule 200(g) of Regulation SHO \101\ to 
remove the requirement that a broker-dealer mark a sell order of an 
equity security as ``short exempt'' if the seller is relying on an 
exception from the tick test of Rule 10a-1, or any price test of any 
exchange or national securities association.
---------------------------------------------------------------------------

    \101\ 17 CFR 242.200(g).
---------------------------------------------------------------------------

    Rule 200(g) of Regulation SHO provides that a broker-dealer must 
mark all sell orders of any security as ``long,'' ``short,'' or ``short 
exempt.'' \102\ Further, Rule 200(g)(2) of Regulation SHO provides that 
a short sale order must be

[[Page 75078]]

marked ``short exempt'' if the seller is ``relying on an exception from 
the tick test of 17 CFR 240.10a-1, or any short sale price test of any 
exchange or national securities association.'' \103\ The ``short 
exempt'' marking requirement provides a record that short sellers are 
availing themselves of the various exceptions to, or exemptions from, 
the application of the restrictions of Rule 10a-1 or of any price test 
of any exchange or national securities association. However, if the 
Commission were to adopt the proposals to remove all price test 
restrictions, as well as prohibit any price test by any SRO, the 
``short exempt'' marking requirement would no longer be applicable. 
Thus, we are proposing to remove this marking requirement. Broker-
dealers would, however, continue to be required to mark sell orders as 
either ``long'' or ``short'' in compliance with Rule 200(g).\104\
---------------------------------------------------------------------------

    \102\ See id.
    \103\ See id. at 242.200(g)(2).
    \104\ See id. at 242.200(g).
---------------------------------------------------------------------------

Request for Comment
     If the Commission were to adopt the proposal to remove the 
``short exempt'' marking requirement of Rule 200(g) of Regulation SHO, 
would it be sufficient to require broker-dealers to mark all sell 
orders of any equity security as either ``long'' or ``short''? Under 
what circumstances, if any, would broker-dealers need to mark sell 
orders other than as ``short'' or ``long''?
     To facilitate the application of Rule 10a-1, NASD Rule 
5100, and Nasdaq Rule 3350, market makers and specialists receive 
information allowing them to distinguish short sales from other sales. 
In other words, the information on whether an order is marked ``long,'' 
``short,'' or ``short exempt'' is made transparent to market makers and 
specialists but not to other market participants or the public. In the 
absence of price test restrictions, would the marking of sell orders 
need to be transparent to market makers and specialists? Would there be 
any systems or market quality costs/benefits associated with not 
revealing this information to specialists and market makers?
     Would there be any costs or burdens associated with 
removing the ``short exempt'' marking requirement of Rule 200(g) of 
Regulation SHO? If so, please explain.

IV. General Request for Comment

    The Commission seeks comment generally on all aspects of the 
proposed amendments to Rule 10a-1 and Regulation SHO. Commenters are 
requested to provide empirical data to support their views and 
arguments related to the proposals herein. In addition to the questions 
posed above, commenters are welcome to offer their views on any other 
matter raised by the proposed amendments to Rule 10a-1 and Regulation 
SHO. With respect to any comments, we note that they are of the 
greatest assistance to our rulemaking initiative if accompanied by 
supporting data and analysis of the issues addressed in those comments 
and by alternatives to our proposals where appropriate.

V. Paperwork Reduction Act

    The proposed amendments to Regulation SHO would impose a 
``collection of information'' within the meaning of the Paperwork 
Reduction Act of 1995;\105\ however, the collection of information is 
covered by the approved collection for Exchange Act Rule 19b-4.\106\ 
Proposed Rule 201(a) of Regulation SHO provides that no price test, 
including any price test of any SRO, shall apply to short sales in any 
security. In addition, proposed Rule 201(b) of Regulation SHO would 
prohibit any SRO from having a price test. Thus, to the extent that any 
SRO currently has a price test, that SRO would be required to amend its 
rules to comply with these proposed amendments to Regulation SHO. Any 
such amendments would need to be filed with the Commission as proposed 
rule changes, pursuant to Section 19(b) of the Exchange Act \107\ and 
Rule 19b-4 thereunder. This collection of information, however, would 
be collected pursuant to Exchange Act Rule 19b-4 and, therefore, would 
not be a new collection of information for purposes of the proposed 
amendments.
---------------------------------------------------------------------------

    \105\ 44 U.S.C. 3501 et seq.
    \106\ 17 CFR 240.19b-4.
    \107\ 15 U.S.C. 78s(b).
---------------------------------------------------------------------------

VI. Consideration of Costs and Benefits of Proposed Amendments to Rule 
10a-1 and Regulation SHO

    The Commission is considering the costs and benefits of the 
proposed amendments to Rule 10a-1 and Regulation SHO. The Commission is 
sensitive to these costs and benefits, and encourages commenters to 
discuss any additional costs or benefits beyond those discussed here. 
In particular, the Commission requests comment from all market 
participants regarding the costs and benefits of unrestricted short 
selling activity. The Commission also requests comment regarding the 
costs associated with complying with the proposed amendments, if the 
Commission were to adopt the proposed amendments. Specifically, we seek 
comment regarding any costs relating to the removal of price test 
restrictions adopted by the SROs. In addition, the Commission requests 
comment on the potential costs for any modification to both computer 
systems and surveillance mechanisms and for information gathering, 
management, and recordkeeping systems or procedures, as well as any 
potential benefits resulting from the proposals for registrants, 
issuers, investors, brokers or dealers, other securities industry 
professionals, regulators, and other market participants. Commenters 
should provide analysis and data to support their views on the costs 
and benefits associated with the proposed amendments to Rule 10a-1 and 
Regulation SHO.

A. Removal of Price Test Restrictions

1. Benefits
    The proposed amendments would remove the tick test of Rule 10a-1 
and provide that no SRO shall have a price test. We believe that this 
is an appropriate time to propose removing existing price test 
restrictions because the current regulation is disparate, potentially 
creates an unlevel playing, allows for regulatory arbitrage and has not 
kept pace with the types of trading systems and strategies currently 
used in the marketplace. In addition, today's markets are characterized 
by high levels of transparency and regulatory surveillance. These 
characteristics greatly reduce the risk of undetected manipulation and 
permit regulators to monitor for the types of activities that Rule 10a-
1 and other price tests are designed to prevent.
    The Commission believes that removal of all price test restrictions 
would benefit market participants by providing market participants with 
the ability to execute short sales in all securities in all market 
centers without regard to price test restrictions. In addition, market 
centers would be competing for executions on a level playing field 
because they would not be affected by the existence or non-existence of 
price test restrictions.
    The Commission believes that removing price test restrictions would 
be preferable to applying different tests in different markets, which 
can require market participants to apply different rules to different 
securities depending on which market the trade is executed. Thus, the 
proposed amendments would reduce confusion and compliance difficulties 
for market participants.

[[Page 75079]]

    We also believe that the proposed amendments would benefit 
exchanges and other market centers because market participants would no 
longer be able to select a market on which to execute a short sale 
based on the applicability of price test restrictions. The proposed 
amendments would remove a competitive disadvantage purportedly 
experienced by some market centers because market participants would no 
longer route orders to avoid application of a market center's price 
test. Nor would market centers that do not have a price test be able to 
use that factor to attract order flow away from market centers that 
have a price test.
    In addition, the proposed amendments would result in benefits 
associated with systems and surveillance mechanisms because these 
systems and mechanisms would no longer need to be programmed to account 
for price test restrictions based on last sale and last bid 
information. We also note that in the absence of price test 
restrictions, new staff (compliance personnel, broker-dealers, etc.) 
would no longer need to be trained regarding rules relating to price 
tests. Over the long run, we believe this would likely lead to 
decreased training and compliance costs for market participants.
    We are aware that the degree of restrictiveness of a price test may 
affect how well a security's price represents a company's true 
financial value. We seek comment regarding whether the absence of price 
test restrictions would result in prices that are a better reflection 
of a company's true financial value.
    In addition, we seek estimates and views regarding the benefits to 
particular types of market participants as well as any other benefits 
that may result from the adoption of the proposed amendments. Please 
provide any specific data.
    We also believe that the proposed amendments would lead to a 
reduction in costs because market participants and their lawyers, both 
in-house and outside counsel, would no longer need to make either 
informal (phone calls) or formal (letters) requests for exemptions from 
Rule 10a-1. We request empirical data to quantify this benefit.
    We anticipate that broker-dealers, including specialists and market 
makers in listed securities, could provide greater liquidity in the 
marketplace because the absence of price test restrictions would make 
it easier for market participants to fill orders. In addition, an 
increase in trading volume resulting from the removal of price test 
restrictions could result in increased price efficiency because prices 
may more fully reflect both buy and sell interest.
    We solicit comment on any additional benefits that could be 
realized if the Commission were to adopt the proposed amendments, 
including both short-term and long-term benefits. We solicit comment 
regarding other benefits to market efficiency, pricing efficiency, 
market stability, market integrity, and investor protection.
2. Costs
    In order to comply with the Pilot when it became effective on May 
2, 2005, market participants needed to modify their systems and 
surveillance mechanisms to exempt those securities included in the 
Pilot from all price test restrictions. The Pilot exempts a select 
group of securities from price test restrictions during regular trading 
hours. Between the close of the consolidated tape and the open of the 
consolidated tape on the following day, however, all equity securities 
are exempted from price test restrictions. Thus, we believe that the 
infrastructure necessary to comply with the proposed amendments should, 
for the most part, already be in place. Any additional changes to the 
infrastructure should be minimal. In addition, because the proposed 
amendments would remove all price test restrictions, rather than for 
example, imposing a modified price test, we believe that further 
changes to systems and surveillance mechanisms or procedures should be 
relatively minor. Nor do we believe that market participants would need 
to incur costs to purchase new systems, or increase staffing based 
solely on the implementation of the proposed amendments.
    In addition, the proposed amendments would remove a restriction on 
trading activity with which market participants must currently monitor 
for compliance. Thus, we do not believe that the proposed amendments 
would impose additional compliance costs. Moreover, we believe that any 
costs incurred to modify, establish or implement existing or new 
supervisory and compliance procedures due to the proposed amendments 
would be minimal because market participants should currently have in 
place supervisory or compliance procedures to monitor for trading 
activity that current price test restrictions are designed to prevent.
    We seek comment as to how the proposed amendments would affect 
costs for market participants. We believe that market participants, 
including broker-dealers and SROs, would incur costs related to systems 
changes to computer hardware and software, reprogramming costs, or 
surveillance costs that could be necessary to comply with this proposed 
rule. We believe that these costs would be on a one-time basis. We 
solicit comment on these costs as well as whether these costs would be 
incurred on a one-time or ongoing basis.
    We also note that if the Commission were to adopt the proposed 
amendments, all SROs that have adopted price test restrictions would 
have to remove such price tests. As discussed above, the NASD and 
Nasdaq have their own bid tests that, under the proposed amendments, 
would no longer be applicable. In addition, some exchanges have adopted 
short sale rules in conformity with the provisions of the tick test of 
Rule 10a-1, which also would no longer be applicable if the Commission 
were to adopt the proposed amendments. We believe the SROs could incur 
costs associated with the processes to remove such rules, including 
filing rule changes with the Commission, as well as reprogramming 
systems designed to enforce these rules. We request comment regarding 
these costs, including costs relating to preparing and filing any 
necessary rule changes with the Commission.
    Based on the Pilot Results, we believe that removing the tick test 
of Rule 10a-1 and providing that no price test, including any price 
test of any SRO, shall apply to short sales in any security, has the 
potential to increase transaction costs, decrease quoted depth and 
increase intraday price volatility, particularly in small stocks. The 
Pilot Results suggest, however, that these changes are small in 
magnitude and would not significantly increase costs or reduce 
liquidity.
    We seek comment regarding the following specific costs:
     What are the economic costs of removing the tick test of 
Rule 10a-1 and any price test of any SRO for all securities? How would 
this affect the liquidity and transaction costs of equity securities? 
How would this affect the quoted depth and the price volatility of 
equity securities? Would the effects be more severe for liquid or 
illiquid securities? Would the effects be more severe for small or 
large securities?
     Are there any other costs associated with the proposal?
     How much would the removal of price test restrictions 
affect the compliance costs for small, medium, and large market 
participants (e.g., personnel or system changes)? We seek comment on 
the costs of compliance that could arise as a result of these proposed 
amendments. For instance, to

[[Page 75080]]

comply with the proposed amendments, would market participants be 
required to:
     Purchase new systems or implement changes to existing 
systems? Would changes to existing systems be significant? What would 
be the costs associated with acquiring new systems or making changes to 
existing systems? How much time would be required to fully implement 
any new or changed systems?
     Increase staffing and associated overhead costs? Would 
market participants have to hire more staff? How many, and at what 
experience and salary level? Could existing staff be retrained? What 
would be the costs associated with hiring new staff or retraining 
existing staff? If retraining were required, what other costs could be 
incurred, e.g., would retrained staff be unable to perform existing 
duties in order to comply with the proposed amendments? Would other 
resources need to be re-dedicated to comply with the proposed 
amendments?
     Implement, enhance or modify surveillance systems and 
procedures? Please describe what would be needed, and what costs would 
be incurred.
     Establish and implement new supervisory or compliance 
procedures, or modify existing procedures? What would be the costs 
associated with such changes? Would new compliance or supervisory 
personnel be needed? What would be the costs of obtaining such staff?
     Are there any other costs that may be incurred to comply 
with the proposed amendments?

B. Removal of ``Short Exempt'' Marking Requirement

1. Benefits
    The proposed amendment would remove the ``short exempt'' marking 
requirement of Rule 200(g) of Regulation SHO.\108\ Rule 200(g)(2) of 
Regulation SHO provides that a short sale order must be marked ``short 
exempt'' if the seller is ``relying on an exception from the tick test 
of 17 CFR 240.10a-1, or any short sale price test of any exchange or 
national securities association.'' \109\ Thus, if the Commission were 
to adopt the proposed amendments that would remove all price test 
restrictions, as well as prohibit any SRO from having a price test, the 
``short exempt'' marking requirement would no longer be applicable.
---------------------------------------------------------------------------

    \108\ 17 CFR 242.200(g).
    \109\ See id. at 242.200(g)(2).
---------------------------------------------------------------------------

2. Costs
    Some market participants, including broker-dealers and SROs, may 
have to reprogram systems and update supervisory procedures due to the 
removal of the ``short exempt'' marking requirement. Sales of 
securities previously marked ``short exempt,'' however, would continue 
to be marked either ``long'' or ``short.'' Thus, we believe that such 
costs would be minor. We seek comment, however, on these and any 
additional costs that could be incurred, as well as specific data to 
support such costs.

VII. 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 whenever it 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.\110\ In addition, Section 23(a)(2) 
of the Exchange Act requires the Commission, when making rules under 
the Exchange Act, to consider the impact such rules would have on 
competition.\111\ 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.
---------------------------------------------------------------------------

    \110\ 15 U.S.C. 78c(f).
    \111\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    The proposed amendments would remove the price test restrictions of 
Rule 10a-1 \112\ and provide that no price test, including any price 
test of any SRO, shall apply to short sales in any security. The 
proposed amendments would also prohibit any SRO from having a price 
test. In addition, the proposed amendments would remove the ``short 
exempt'' marking requirement of Rule 200(g) of Regulation SHO because 
this marking requirement applies only if the seller is relying on an 
exception from the tick test of Rule 10a-1 or any short sale price test 
of any exchange or national securities association.
---------------------------------------------------------------------------

    \112\ 17 CFR 242.10a-1.
---------------------------------------------------------------------------

    Current short sale regulation is disparate. For example, Rule 10a-1 
applies only to short sale transactions in listed securities. The 
NASD's and Nasdaq's bid tests apply only to Nasdaq Global Market 
securities. No price tests apply to short sales in Nasdaq Capital 
Market securities or securities quoted on the OTCBB or pink sheets. In 
addition, no price test applies to short sales of Nasdaq Global Market 
securities executed on exchanges trading Nasdaq securities on a UTP 
basis, unless the market on which the securities are being traded has 
adopted its own price test. Moreover, the current exceptions to, and 
exemptions from, the price tests for a wide range of short selling 
activities, have limited the applicability of the restrictions 
contained in these rules. The end result is inconsistent short sale 
regulation of securities, depending on the market where the securities 
are trading, and the type of short selling activity. Thus, the proposed 
amendments are intended to promote regulatory simplification and 
uniformity by no longer applying any price test restrictions on short 
selling.
    We believe that the proposed amendments would not harm efficiency 
because the empirical evidence from the Pilot Results shows that the 
Pilot did not adversely impact price efficiency. Further, market 
participants would no longer have to apply different price tests to 
securities trading in different markets. We seek comment on whether the 
proposed amendments promote price efficiency, including whether the 
proposals might impact the potential for manipulative short selling.
    In addition, we believe that the proposed amendments would not have 
an adverse impact on capital formation because the empirical evidence 
from the Pilot Results shows that the price tests have very little 
impact on overall market quality and, particularly in large securities, 
may be harmful to overall market quality. We solicit comment on whether 
the proposed amendments would promote capital formation, including to 
what extent the proposed removal of price test restrictions would 
affect investors' decisions to sell short certain equity securities.
    We believe that the proposed amendments would promote competition 
among exchanges and other market centers because market participants 
would no longer be able to select a market on which to execute a short 
sale based on the applicability of price test restrictions. The 
proposed amendments would remove a purported competitive disadvantage 
experienced by some market centers because market participants would no 
longer route orders to avoid application of a market center's price 
test. Nor would market centers that do not have a price test be able to 
use that factor to attract order flow away from market centers that 
have a price test. Moreover, the proposed amendments would level the 
playing field for all market participants by requiring that no price 
test shall apply

[[Page 75081]]

to any short sale in any security in any market.
    We solicit comment on whether the proposed amendments would promote 
competition, including whether market participants' decisions regarding 
on which market to execute a short sale would be affected by the 
removal of all price test restrictions.
    We request comment on whether the proposed amendments would be 
expected to promote efficiency, competition, and capital formation.

VIII. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \113\ we must advise the Office of 
Management and Budget as to whether the proposed regulation constitutes 
a ``major'' rule. Under SBREFA, a rule is considered ``major'' where, 
if adopted, it results or is likely to result in:
---------------------------------------------------------------------------

    \113\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996) (codified 
in various sections of 5 U.S.C., 15 U.S.C. and as a note to 5 U.S.C. 
601).
---------------------------------------------------------------------------

     An annual effect on the economy of $100 million or more 
(either in the form of an increase or a decrease);
     A major increase in costs or prices for consumers or 
individual industries; or
     Significant adverse effect on competition, investment or 
innovation.
    If a rule is ``major,'' its effectiveness will generally be delayed 
for 60 days pending Congressional review. We request comment on the 
potential impact of the proposed amendments on the economy on an annual 
basis. Commenters are requested to provide empirical data and other 
factual support for their view to the extent possible.

IX. Initial Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis (IRFA), in accordance with the provisions of the Regulatory 
Flexibility Act (RFA),\114\ regarding the proposed amendments to Rule 
10a-1 and Regulation SHO, Rules 200 and 201, under the Exchange Act.
---------------------------------------------------------------------------

    \114\ 5 U.S.C. 603.
---------------------------------------------------------------------------

A. Reasons for the Proposed Action

    Based on the Pilot Results as well as our review of the status of 
short sale regulation in the context of the current application of Rule 
10a-1 and other price tests, including the exceptions to the current 
rules and grants of relief from Rule 10a-1 by the Commission for a wide 
range of short selling activities, we are proposing to remove the tick 
test of Rule 10a-1 and to amend Regulation SHO to provide that no price 
test, as well as any price test by any SRO, shall apply to short 
selling in any security. In addition, the proposed amendments would 
prohibit any SRO from having a price test. These amendments are 
designed to modernize and simplify short sale regulation in light of 
current short selling systems and strategies used in the marketplace, 
while providing greater regulatory consistency to short selling. We are 
also proposing to remove the ``short exempt'' marking requirement of 
Regulation SHO because this requirement only applies if a seller is 
relying on an exception to a price test.

B. Objectives

    The proposed amendments are designed to provide consistent 
regulation for short selling in all securities regardless of when or 
where such trades occur by removing all price test restrictions. In 
addition, the proposed amendments are intended to provide greater 
flexibility in effecting short sales because market participants would 
no longer be constrained by price test restrictions. Moreover, in light 
of the number of exemptions the Commission has granted under Rule 10a-1 
for a wide range of short selling activities, the proposed amendments 
are designed to accommodate trading strategies and systems currently 
utilized in the marketplace that conflict with current price test 
restrictions. The proposed amendment to the ``short exempt'' marking 
requirement of Rule 200(g) of Regulation SHO \115\ is necessary because 
this requirement only applies if a seller is relying on an exception to 
a price test.
---------------------------------------------------------------------------

    \115\ 17 CFR 242.200(g).
---------------------------------------------------------------------------

C. Legal Basis

    Pursuant to the Exchange Act and, particularly, Sections 2, 3(b), 
6, 9(h), 10, 11A, 15, 15A, 17, 19, 23(a) thereof, 15 U.S.C. 78b, 78c, 
78f, 78i, 78j, 78k-1, 78o, 78o-3, 78q, 78s, 78w(a), the Commission is 
proposing to remove Rule 10a-1, Sec.  240.10a-1 and to amend Regulation 
SHO, Sec. Sec.  242.200 and 242.201.

D. Small Entities Subject to the Rule

    The entities covered by the proposed rule would include small 
broker-dealers, small businesses, and any investor who effects a short 
sale that qualifies as a small entity. Although it is impossible to 
quantify every type of small entity that may be able to effect a short 
sale in a security, Paragraph (c)(1) of Rule 0-10 under the Exchange 
Act \116\ 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 Sec.  
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. As 
of 2005, the Commission estimates that there were approximately 910 
broker-dealers that qualified as small entities as defined above.\117\
---------------------------------------------------------------------------

    \116\ 17 CFR 240.0-10(c)(1).
    \117\ These numbers are based on OEA's review of 2005 FOCUS 
Report filings reflecting registered broker-dealers. This number 
does not include broker-dealers that are delinquent on FOCUS Report 
filings.
---------------------------------------------------------------------------

    Paragraph (e) of Rule 0-10 under the Exchange Act \118\ 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 11Aa3-1 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 
national securities exchanges are small entities because none meets 
these criteria. There is one national securities association (NASD) 
that would be subject to these proposed amendments. NASD is not a small 
entity as defined by 13 CFR 121.201.
---------------------------------------------------------------------------

    \118\ 17 CFR 240.0-10(e).
---------------------------------------------------------------------------

    Any business, however, regardless of industry, could be subject to 
the proposed amendments if it effects a short sale. The Commission 
believes that, except for the broker-dealers discussed above, an 
estimate of the number of small entities that fall under the proposed 
rule is not feasible.

E. Reporting, Recordkeeping, and other Compliance Requirements

    The proposed amendments may impose some new or additional 
reporting, recordkeeping, or compliance costs on any affected party, 
including broker-dealers, that are small entities.
    In order to comply with the Pilot when it became effective on May 
2, 2005, small entities needed to modify their systems and surveillance 
mechanisms to exempt those securities included in the Pilot from 
current price test restrictions. Thus, the systems and surveillance 
mechanisms required to comply with the proposed amendments should 
already be in place. We believe that any necessary additional systems 
and surveillance changes would be small because, due to the Pilot, 
systems are currently programmed to exempt

[[Page 75082]]

many securities from price test restrictions prior to the close of the 
consolidated tape and exempt all securities from price test 
restrictions between the close of the consolidated tape and the open of 
the consolidated tape on the following day.
    We believe that any reprogramming costs or updating of surveillance 
mechanisms associated with the removal of the ``short exempt'' marking 
requirement should be minimal because sales of securities would 
continue to be required to be marked either ``long'' or ``short.'' The 
proposed amendments, if adopted, would merely remove an alternative 
marking requirement.
    We solicit comment on what new recordkeeping, reporting or 
compliance requirements may arise as a result of these proposed 
amendments.

F. Duplicative, Overlapping or Conflicting Federal Rules

    The Commission believes that there are no federal rules that 
duplicate, overlap or conflict with the proposed amendments.

G. Significant Alternatives

    The RFA directs the Commission to consider significant alternatives 
that will accomplish the stated objective, while minimizing any 
significant adverse impact on small entities. Pursuant to Section 3(a) 
of the RFA,\119\ the Commission must consider the following types of 
alternatives: (a) The establishment of differing compliance or 
reporting requirements or timetables that take into account the 
resources available to small entities; (b) the clarification, 
consolidation, or simplification of compliance and reporting 
requirements under the rule for small entities; (c) the use of 
performance rather than design standards; and (d) an exemption from 
coverage of the rule, or any part thereof, for small entities.
---------------------------------------------------------------------------

    \119\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    The proposed amendments are intended to modernize and simplify 
price test regulation by removing restrictions on the execution prices 
of short sales contained in current price tests, such as Rule 10a-1. As 
such, we believe that imposing different compliance requirements, and 
possibly a different timetable for implementing compliance 
requirements, for small entities would undermine the goal of this 
proposal. In addition, we have concluded similarly that it would be 
inconsistent with this goal of the proposed amendments to further 
clarify, consolidate or simplify the proposed amendments for small 
entities. Finally, the proposed amendments would impose performance 
standards rather than design standards.

H. Request for Comments

    The Commission encourages the submission of written comments with 
respect to any aspect of the IRFA. In particular, the Commission seeks 
comment on (i) the number of small entities that will be affected by 
the proposed amendments; and (ii) the existence or nature of the 
potential impact of the proposed amendments on small entities. Those 
comments should specify costs of compliance with the proposed 
amendments, and suggest alternatives that would accomplish the 
objective of the proposed amendments.

X. Statutory Authority

    Pursuant to the Exchange Act and, particularly, Sections 2, 3(b), 
6, 9(h), 10, 11A, 15, 15A, 17, 17A, 23(a) thereof, 15 U.S.C. 78b, 78c, 
78f, 78i, 78j, 78k-1, 78o, 78o-3, 78q, 78q-1, 78w(a), the Commission is 
proposing to remove Rule 10a-1, Sec.  240.10a-1 and to amend Regulation 
SHO, Sec. Sec.  242.200 and 201.

Text of the Proposed Amendments to Rule 10a-1 and Regulation SHO

List of Subjects in 17 CFR Parts 240 and 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 proposed to be amended as follows.

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    1. The general authority citation for part 240 is revised to read 
as follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 
78w, 78x, 78ll, 78mm, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 
80b-11, and 7201 et. seq.; and 18 U.S.C. 1350, unless otherwise 
noted.
* * * * *

Sec.  240.10a-1  [Removed and reserved]

    2. Section 240.10a-1 is removed and reserved.

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 242.200 is amended by revising the introductory text of 
paragraph (g) to read as follows and by removing and reserving 
paragraph (g)(2):

Sec.  242.200  Definition of ``short sale'' and marking requirements.

    (g) A broker or dealer must mark all sell orders of any equity 
security as ``long'' or ``short.''
* * * * *
    5. Section 242.201 is added to read as follows:

Sec.  242.201  Price test.

    (a) No short sale price test, including any short sale price test 
of any self-regulatory organization, shall apply to short sales in any 
security.
    (b) No self-regulatory organization shall have any rule that is not 
in conformity with, or conflicts with, paragraph (a) of this section.

    Dated: December 7, 2006.
    By the Commission.
Nancy M. Morris,
Secretary.
[FR Doc. E6-21156 Filed 12-12-06; 8:45 am]

BILLING CODE 8011-01-P