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FINRA Manual - Notices - 1988 - 88-62 SEC Adopts Rule 10b-21 Prohibiting Shorting into Secondaries
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In response to the NASD's request, the Securities and Exchange Commission (SEC) has adopted Rule 10b-21 to prohibit persons from purchasing securities out of a public offering to cover short sales executed after the registration statement is filed. The rule will be effective 30 days after publication in the Federal Register.
In 1974, the SEC first proposed for comment Rule 10b-21 to regulate the practice of short selling into secondary public offerings.1 Different versions of the proposal were published in 1975 and, again, in 1976.2 Since the SEC's first publication for comment of Rule 10b-21, the NASD has consistently maintained the position that the SEC should adopt a rule to regulate the practice of short selling into secondary public distributions.
The NASD's concerns have focused on the practice of short selling prior to a secondary distribution of securities in order to lower the price of the security before the offering date and thereby reduce the offering price. The short sellers then can cover their short transactions by purchasing securities in the distribution at the reduced price.
The NASD has argued that such short sellers are not subject to the usual market risk attendant on the covering transaction as the downward pressure of the short selling all but ensures that the transactions will be covered out of the offering at a lower price.
As a result of the continuing concern expressed by the NASD's Corporate Financing Committee and Corporate Advisory Board, the NASD's Board of Governors submitted a petition for rulemaking (Petition) to the SEC on June 11, 1986. The Petition urged the SEC to adopt a modified version of Rule 10b-21 and included proposed language for the rule.
In the Petition, the NASD argued that short selling into secondary distributions adversely affects issuers by depriving them of offering proceeds that would have been realized had the market not been subject to excessive short selling. Unlike the SEC's prior published versions of proposed Rule 10b-21, the NASD proposed that the rule apply only to short sale transactions entered into between the filing of the registration statement and commencement of the offering. Further, the NASD proposed that restrictions on covering transactions be limited to transactions with an underwriter or a member of the selling group where the short seller is bearing no market risk.
In response to the NASD's Petition, the SEC published two alternative versions of Rule 10b-21 for comment in Securities Exchange Act Release No. 24485 (May 20, 1987). The NASD submitted three comment letters in response to the SEC's proposal. In support of its position, the NASD comment letters included a study of price movements immediately prior to and subsequent to secondary offerings and provided information with respect to investigations of three secondary offer ings where it was determined that manipulative short selling had occurred.3
DESCRIPTION OF RULE 10b-21
On August 25, 1988, the Securities and Exchange Commission approved the adoption of Rule 10b-21 on a temporary basis, but did not attach an expiration date.4 The Commission requested, however, that the NASD monitor the application of the rule to ensure its effectiveness during the first 18 months of its operation. The rule is to take effect 30 days after publication in the Federal Register.5
A copy of the SEC release announcing adoption of Rule 10b-21 is attached.
As adopted, Rule 10b-21 applies to all NASDAQ and exchange-listed securities that are underwritten on a "firm-commitment" basis. However, the rule includes an exemption for "shelf registrations, pursuant to SEC Rule 415. Rule 10b-21 applies only to short sale transactions between the time that a registration statement is filed with the SEC and the time that sales may be made pursuant to the registration statement.
The rule prohibits any person who effects, during the restricted period, one or more short sales of equity securities of the same class as securities offered pursuant to a registration statement filed with the SEC from covering such short sales with offered securities purchased from an underwriter or broker or dealer participating in the offering.
The version of the rule published for comment by the SEC included language that prohibited covering a short position "indirectly" with securities purchased from distribution participants. A number of commenters questioned whether this language imposed an insurmountable compliance burden on market makers to trace the source of securities used to cover a short sale transacted during the prohibited time period if the securities were purchased from the open market at the time of or immediately subsequent to the offering. Therefore, such commenters argued, the rule should include an exemption for market makers.
To avoid ambiguity as to the application of the rule, the SEC has deleted the phrase "directly or indirectly" from the rule. The adopting release states that the SEC determined not to adopt an exemption for market makers as a result of concerns about the enforcement of Rule 10b-21 with respect to market makers that engage in the manipulative activity the rule is intended to address. Moreover, it is clarified that covering purchases effected by prearrangement or other understanding through other purchasers in the primary offering are proscribed through the operation of Section 20(b) of the Securities Exchange Act of 1934, which prohibits a person from doing indirectly any act that is prohibited directly by the Exchange Act or any rule thereunder.
Questions concerning this notice can be directed to Suzanne E. Rothwell, Associate General Counsel, NASD Office of the General Counsel, at (202)728-8247 or to Laura R. Singer, Counsel to Market Surveillance, at (202)728-6982.
1 Securities Exchange Act Release No. 10626A (February 12,1974).
2 Securities Exchange Act Release No. 11328 (April 2, 1975) and Securities Exchange Act Release No. 13092 (September 21, 1976).
3 The NASD's letters of comment are available for public inspection and copying at the SEC's Public Reference Room (See File No. S7-18-87) and from the NASD's Office of the General Counsel.
4 Securities Exchange Act Release No. 26028 (August 25, 1988).
5 Securities Exchange Act Release No. 26028 (August 25, 1988) was published in the Federal Register on August 31, 1988 and will be effective on September 30, 1988. See, 53 FR 33455 (August 31, 1988).
[Release No. 33-6798; 34-26028; File No. S7-18-87]
Short Sales in Connection with a Public Offeing
SUMMARY: The Commission today announced the adoption, on a temporary basis, of Rule 10b-21(T) under the Securities Exchange Act of 1934, pertaining to certain short sales in connection with a public offering of securities. Rule 10b-21(T) prohibits a person who effects short sales of an equity security during the period beginning at the time that a registration statement or Form 1-A relating to the same class of equity securities is filed and ending at the time that sales may be made in the offering, from covering such short sales with offered securities purchased from an underwriter or other broker or dealer participating in the offering of such securities.
EFFECTIVE DATE: (Thirty days after publication in the Federal Register).
FOR FURTHER INFORMATION CONTACT: Nancy J. Burke or Ivette Lopez at (202) 272-2848, Office of Trading Practices, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.
The Commission has adopted, on a temporary basis, Rule 10b-21(T) ("Rule") under the Securities Exchange Act of 1934 ("Exchange Act"),1 which is designed to prevent manipulative short selling of securities in anticipation of a public offering of the same securities. The Commission proposed the Rule for public comment2 in response to a petition ("NASD Petition") for rulemaking filed by the National Association of Securities Dealers, Inc. ("NASD"). 3 The Rule prohibits a person who effects one or more short sales of equity securities of the same class as securities distributed for cash pursuant to a registration statement filed under the Securities Act of 1933 ("Securities Act") 4 or pursuant to a notification on Form 1-A5 under the Securities Act, from covering such short sale or sales with offered securities purchased from an underwriter or broker or dealer participating in such public offering, if such short sale or sales took place during the period beginning at the time that the registration statement or Form 1-A is filed and the time that sales are permitted to be made pursuant to the registration statement or Form 1-A6. After considering the public comments received on the Proposing Release, the Commission has adopted the Rule substantially as proposed.
The NASD Petition was based on concerns relating to short selling prior to a public offering.7 Such short sales may result in a decrease in the price of the security and consequently a lower offering price. The short sellers are then able to cover their sales and realize a profit by purchasing securities in the offering at the reduced price. Because of the availability of securities at a fixed price from the public offering, the risks entailed in covering those short sales are reduced substantially. The NASD indicated that this practice deprives the issuer of offering proceeds that otherwise would have been realized.
The Commission suggested in the Proposing Release that certain drafting changes could improve the NASD proposal ("Alternative A"). Accordingly, an alternative formulation ("Alternative B") was presented that: (1) reflected the scope of the Commission's authority to promulgate the Rule by substituting the phrase "it shall be unlawful" for the proposed reference solely to Section 10(b) of the Exchange Act; 8 (2) deleted paragraph (b) of Alternative A since it was virtually identical to the definition of "short sale" contained in Rule 3b-3 under the Exchange Act; 9 (3) inserted the term "offered securities" since the Commission understood the NASD Petition to be addressed only to covering purchases involving the securities that are offered pursuant to a registration statement or Form 1-A;10 and (4) substituted the term "offering" for "distribution" since the latter term has a specific definition in Rule 10b-6 under the Exchange Act.11
A. The Need for the Rule
The Commission received thirty-six comment letters submitted by thirty-two commentators.12 The majority of the commentators supported the adoption of the Rule. 13 Commentators favoring adoption stated that short selling in anticipation of a public offering can and does have the effect of driving down the price of the securities to be distributed. These commentators also indicated that, unlike the traditional short sale, persons selling short in anticipation of a public offering are not subject to the usual market risk accompanying the covering transaction, but are assured of covering with offered securities purchased in the public offering at a fixed, and generally lower, price. Only three commentators opposed adoption of the Rule, stating that manipulative short selling practices already are proscribed by existing laws, and that the Rule would have an adverse impact on normal market operations and result in unnecessary compliance burdens.
Nine commentators responded to the Commission's request for comment regarding the extent of pre-offering short selling activity and the impact of such sales on the costs to issuers of completing an offering. Seven of these commentators described first-hand experiences with the adverse effects of short selling activity, which caused them to cancel proposed offerings, or to complete offerings even though they were deprived of proceeds that would have been realized had the market not been subject to such activity. They noted that the market price of the security to be offered had declined significantly just prior to the public offer ing, allegedly as a result of short selling, and caused them to forfeit substantial proceeds that they otherwise would have received.
The NASD submitted information relating to investigations of three separate public offerings, and stated that, based on these investigations and others involving similar circumstances, it believed that the practice of short selling before a public offering with the intention of covering with shares purchased in the public offering is not uncommon. The investigations revealed substantial short selling activity by certain firms after the filing of the registration statement and a decline in the price of the stock prior to the effective date of the registration statement.14 In each investigation, the short sellers covered their short positions immediately after the offering at a profit with shares purchased from entities that had obtained them in the public offering. The NASD stated that the timing and prices involved in these transactions may indicate prearrangement.15
The NASD also pointed to problems it faces in pursuing enforcement actions in such cases. The NASD does not have jurisdiction over certain non-broker-dealer entities from whom its members may routinely acquire offered securities to cover short positions established prior to an offering. Thus, the NASD may have difficulty obtaining information from those entities necessary to develop cases against such members. In addition, the NASD indicated that, since this abuse has not been specifically prohibited by a Commission rule, it must bring such cases under general anti-manipulation provisions of the federal securities laws which entail the difficult step of proving specific intent to depress the market price of the issuer's stock.
B. Decision to Adopt Rule 10b-21(T)
In light of the comments discussed above, the Commission believes that there is sufficient reason to adopt the Rule on a temporary basis,16 and has determined to adopt Alternative B with slight modifications. The Rule will help deter a practice that the Commission views as manipulative and destructive of issuers' capital raising activities.17 The Commission believes that the Rule will serve an important purpose by avoiding the difficult proof problems involved in demonstrating manipulative purpose.18
Short selling involves sales of stock that the seller does not own. These sales are made with the expectation that the market price of the stock will be lower at the time of the covering transactions. This selling entails the risk that the security's price might increase or the security's supply might be limited. The Commission believes that legitimate short selling activity contributes to the efficient pricing of securities. The activity prohibited by the Rule differs, however, from short selling as usually practiced because a short seller who covers from an offering has access to a pool of securities obtainable from identifiable sources at prices based upon market values that can be adversely affected by the short seller's activity. No such pool of securities or pricing relationships are, however, available for short selling activity as usually practiced. The market risk facing short sellers who cover their positions from the offering can therefore be less than the market risk that generally faces short sellers. This lower degree of risk can, in turn, provide the incentive for manipulative short selling. Because it results in a level of short selling activity greater than that which would otherwise occur in the secondary market for the issuer's shares, that manipulative short selling can cause an artificial price decline around the time of the offering.
The Rule will not adversely affect legitimate market activity. It does not proscribe short selling, nor does it prevent covering transactions made in the open market. Moreover, the Rule does not prevent using securities acquired in a public offering to cover short sales effected prior to the time that the registration statement was filed, or short sales effected after the time that sales may be made in the offering.19 The Rule is narrowly drawn to impede the particularly abusive conduct of short selling in anticipation of a public offering and covering with offered securities. As a result, all short sellers will be exposed to the risks inherent in short selling, namely, that the necessary securities may not be readily available, or that if available, they may be priced higher than the public offering price.
C. Time Period Covered by the Rule
As proposed, the Rule would have applied to short sales effected during the period "between the filing date of the registration statement or Form 1-A and the date that sales may be made pursuant to the registration statement or Form 1-A." The Commission believes that this period is overly broad in that it captures short sales made (1) on the date of filing, but prior to the time of filing, and (2) on the date of effectiveness, but after the time of effectiveness. Short sales made at those times, however, do not implicate the abuses to which the Rule is addressed. Accordingly, the period specified in the Rule has been refined to begin at the time that the registration statement or Form 1-A is filed with the Commission and end at the time that sales may be made pursuant to the registration statement or Form 1-A.20
D. Indirect Covering Purchases
The Rule as proposed would have prohibited a short seller from "directly or indirectly" covering short sales with securities purchased in the public offering, if the short sales took place between the filing date of the registration statement or Form 1-A and the time that sales may be made. Several commentators objected to the term "indirectly," particularly as it would apply in the context of market making activities, and suggested that the Commission include an exemption for market makers from the Rule's restrictions.21
Specifically, one commentator stated that the word "indirectly" was undefined and ambiguous, leaving open to question exactly what types of transactions were prohibited by the Rule. Several commentators suggested that the term "indirectly" could be read to require a market maker who had established a short position in the normal course of business to ascertain whether the shares purchased in the market following an offering had been issued in that offering. This was described as an insurmountable compliance burden that might severely restrict the legitimate activities of market makers during the period from the filing date of the registration statement and its effectiveness. Commentators remarked that, because no market maker would want to assume such a burden, trading would be disrupted, thereby adversely affecting the liquidity of the market and the stability of security prices. Such result, it was argued, would not be in the public interest.
The NASD, in its letter dated June 8,1988, however, urged the Commission not to remove market makers from the Rule's coverage, although it acknowledged that prior proposals of the Rule did provide for an exemption for bona fide market makers. According to the NASD, the term "indirectly" was intended to cover the situation where a short seller interjects an intermediary for the purpose of covering a short sale with securities purchased in a public offering. In the NASD's opinion, normal market making purchases would not constitute the type of conduct meant to be covered by the term "indirectly." Consequently, it believed that no special compliance procedure to determine the source of the securities purchased would be required. Any exemption for market makers, stated the NASD, would shield market makers engaged in manipulative short selling and would hinder successful enforcement of the Rule.
The Commission agrees with the NASD that a market maker exemption may allow certain persons who engage in manipulative pre-offering short selling to continue that activity free of the Rule's restrictions. Nonetheless, the Commission recognizes the adverse effects that the reading of the proposed Rule suggested by some commentators might have on market makers and securities markets, and has modified the Rule to address those concerns. The "indirectly" language of the proposed Rule was intended to address circumstances where a person covers his short sale by an arrangement or understanding to obtain offered securities from another person who acquires the securities in the primary offering. However, that language could have been interpreted broadly to bring within the Rule transactions in which a person acquired in the marketplace offered securities from persons who had purchased in the offering, but where there was no arrangement or understanding as described above. In order to avoid this ambiguity and possible uncertainty on the part of market participants, the phrase "directly or indirectly" has been deleted from the Rule.
The Rule as adopted prohibits purchases of offered securities to cover short sales made during the specified period, as originally intended. The Rule proscribes such covering purchases effected directly from an underwriter, broker, or dealer participating in the offering. Moreover, such covering purchases effected by prearrangement or other understanding through other purchasers in the primary offering are proscribed through the operation of Section 20(b) of the Exchange Act,22 which prohibits a person from doing indirectly any act that he is prohibited from doing directly by the Exchange Act or any rule thereunder. Thus, the "prearrangement" of the sort that the NASD believes may have been present in the cases it investigated23 would be prohibited by Rule 10b-21(T) through the operation of Section 20(b).24
The Commission requested commentators to address various other issues related to the Rule including the specified time period of the Rule, and application of the Rule to exchange-traded securities and to shelf offerings conducted pursuant to Rule 415 under the Securities Act.25
Two commentators expressed concern about the time period specified in the Proposing Release, i.e., from the filing date of a registration statement or Form 1-A until the time that sales may be made. They noted that a significant period of time could occur between those two events and suggested the period begin on the later of a specified number of days prior to the date sales may be made or the date of filing of the registration statement or Form 1-A. The Commission recognizes that, where, for example, extended review of a registration statement is involved, a substantial period of time could elapse before the public offering commences. Nevertheless, use of a lesser time period would create compliance problems because short sellers would not necessarily be aware of the effective date planned for an offering. Accordingly, the Commission is adopting the Rule with the time period essentially as proposed.26
There was little comment on the propriety of applying the Rule to exchange-traded securities. Two commentators noted that the "tick test" of Rule 10a-127 may not be a proper deterrent to short selling prior to an offering of exchange-listed securities and that the Rule should apply to such securities. One commentator pointed out that, in light of the differences between the over-the-counter and exchange markets, the Rule should apply to over-the-counter securities only. The NASD specifically declined to comment on the issue. The Commission believes that the potential for manipulative short selling based on the ability to cover in the offering exists both on an exchange and in the over-the-counter market. Accordingly, the Rule as adopted applies to both over-the-counter and exchange-listed securities.28
Several commentators stated that the Rule should not apply to shelf offerings conducted pursuant to Rule 415 under the Securities Act. The Commission agrees that such offerings are not normally conducive to the abuse at which the Rule is directed. Accordingly, the Commission has decided to except Rule 415 offerings from the coverage of the Rule. The Commission has also determined to limit the applicability of the Rule to firm commitment offerings, as these offerings present a greater potential for manipulative short selling.29
This Final Regulatory Flexibility Analysis, which relates to Rule 10b-21(T), has been prepared in accordance with 5 U.S.C. 604. The corresponding Initial Regulatory Flexibility Analysis ("IRFA") is contained in the Proposing Release.30 No comments on the IRFA were received.
A. The Need for and Objectives of the Rule
Rule 10b-21(T) prohibits a person who effects short sales of an equity security during the period beginning at the time that a registration statement or Form 1-A relating to the same class of equity securities is filed and ending at the time that sales may be made pursuant to such registration statement or Form 1-A, from covering such short sales with securities purchased from an underwriter or broker or dealer participating in the public offering of such equity securities. The Rule excludes offerings conducted pursuant to Rule 415 under the Securities Act and offerings conducted otherwise than on a firm commitment basis. The Rule is designed to prevent manipulative short selling by market participants in anticipation of underwritten public offerings.
Manipulative opportunities exist in such offerings because outstanding securities can be sold short prior to the commencement of a public offering of such securities with the motive that such selling activity will lower the price of the offered security and enable the short seller to cover at a depressed price. The ability to purchase shares in the public offering substantially reduces the risks entailed in such short selling. Because the shares in a public offering are generally priced at or slightly below the price of securities of the same class and series in the existing trading market as of a given date shortly before the public offering commences, the issuer and underwriting group may be forced to offer the security at a lower price if the market price decreases during the registration process, especially in the period immediately before the offering price is fixed. As a result, the issuer may realize lower than expected proceeds while the short sellers may cover their short sales with lower priced securities purchased in the public offering.
The Rule addresses the concerns created by the type of short selling activity described above without affecting open market activities. It is designed to deter a practice that does not involve legitimate short selling activity. The Rule only prohibits covering short sales with offered securities purchased from an underwriter or broker or dealer participating in a public offering of such securities. Short sellers will still be able to cover their short sales with purchases outside the public offering. Such purchases would expose short sellers to the risks inherent in short selling, namely, that the necessary securities may not be available in the amount required, or that if available, the securities may be priced higher than the public offering price.
B. Issues Raised by Public Comment
No comments were received on the IRFA. Several commentators remarked, however, that the Rule would impose difficult compliance burdens on market makers as it applied to their purchases to cover short positions established in the course of normal market making activities. The Commission does not intend that market makers establish specific procedures to ensure that shares purchased in normal market making transactions did not originate from a public offering. The Rule is designed to address those situations in which a per son covers his short sale by an arrangement or understanding to obtain offered securities from another person who acquired the securities in the primary offering.
The Regulatory Flexibility Act directs the Commission to consider significant alternatives to the Rule consistent with the stated objectives of the applicable statutes and designed to minimize any significant economic impact of the Rule on small entities. The Rule has the potential to affect small businesses that engage in short sales prior to a distribution, small businesses with an existing market for their stock that anticipate a public offering of stock, and small broker-dealers that participate in the offering of securities.
The Rule prohibits the covering of a short sale from a broker or dealer participating in a public offering of the security sold short. The Commission has previously proposed three different versions of the Rule, none of which were adopted. In the Commission's opinion, the Rule adopted today is the least intrusive to deal with the practice of manipulative short selling prior to a public offering. Indeed, small issuers with an existing market in their stock may benefit from the Rule since it should remove an incentive to engage in short selling of the issuer's stock before a public offering. The Commission continues to believe that any adverse economic impact on small entities will be outweighed by the primary objective of the Rule, which is to prevent manipulative short selling of an issuer's securities by market participants in anticipation of an underwritten public offering.
The Commission indicated in the Proposing Release that the cost associated with the Rule would be a reduction in the ability of market participants to sell short in advance of offerings that they believed to be overpriced, resulting in an increased incidence of such offerings. The NASD questioned the assumption underlying this statement, namely, that there is a correct price for securities distributed in a public offering, and stated that the criteria to be used in determining when an offering is overpriced are not well defined. The NASD pointed out that the Rule is intended to ensure that a short seller will not use the distribution process to eliminate the market risk associated with short sale transactions. Another commentator pointed out that the Rule does not prohibit short selling, but merely restricts covering transactions in the context of a registered offering and for a limited and well-defined period. A third commentator acknowledged that short selling could benefit the public by allowing a security to be purchased at a more attractive price, but also was of the opinion that to allow the short seller to cover through the public offering represented an unfair advantage and could result in manipulative conduct.
Although the Commission recognizes that the Rule will diminish a short seller's ability to effect a covering transaction by restricting the source of securities from which he may cover, it believes the Rule will not prevent the beneficial effects of short selling from reaching the market. If legitimate market forces would have driven down the price of a security before a public offering in the past, those same forces are free to operate in the same manner today.
The Commission believes that the cost of restricting a short seller's ability to cover is balanced by the benefits derived from preventing manipulative short selling activity before a public offering. Several commentators described instances of such selling resulting in the withdrawal of proposed public offerings or in lower proceeds than anticipated. In the case of a withdrawn public offering, an issuer faces out-of-pocket expenses that have been incurred by the time the offering is filed. When an issuer completes a public offering despite lower proceeds, it may have been forced to do so because of an urgent need for the funds or the higher cost of alternative financing. The Rule adopted today will allow an issuer to proceed with a proposed offering without facing the situations described above. The Commission believes that the resulting benefit to issuers outweighs the limited cost imposed on short sellers.
Section 23(a)(2) of the Exchange Act31 requires the Commission, in adopting rules under the Exchange Act, to consider the anti-competitive effects of such rules, if any, and to balance any impact against the regulatory benefits gained in terms of furthering the purposes of the Exchange Act. The Commission has considered Rule 10b-21(T) in light of the standards cited in Section 23(a)(2) and believes for the reasons stated in this release that adoption of Rule 10b-21(T) will not impose any burden on competition not necessary or appropriate in furtherance of the Exchange Act.
Broker-dealers, Reporting and recordkeeping requirements, Securities, Issuers, Fraud.
Statutory Authority and Text of Rule
The Commission hereby amends Part 240 of Chapter II of Title 17 of the Code of Federal Regulations as follows:
1.	The authority citation for Part 240 is amended by adding the following citation.
Authority: Sec. 23, 48 Stat. 901, as amended, 15 U.S.C. 78w, * * * §240.10b-21(T) also issued under Sees. 2, 3, 9(a)(6), 10(a), 10(b), 15(c), 23(a), and 30(a), 15 U.S.C. 78b, 78c, 78i(a)(6), 78j(a), 78j(b), 78o(c), 78w(a), and 78dd(a).
2.	By adding new text of §240.10b-21(T) to read as follows:§240.10b-21(T). Short Selling in connection with a public offering.
(a)	It shall be unlawful for any person who effects one or more short sales of equity securities of the same class as securities offered for cash pursuant to a registration statement filed under the Securities Act of 1933 ("Securities Act") or pursuant to a notification on Form 1-A under the Securities Act ("offered securities") to cover such short sale or sales with offered securities purchased from an underwriter or broker or dealer participating in the offering, if such short sale or sales took place during the period beginning at the time that the registration statement or Form 1-A is filed and ending at the time that sales may be made pursuant to the registration statement or Form 1-A.
(b)	This rule shall not apply to offerings filed under Rule 415 under the Securities Act (17 CFR 230.415) or to offerings that will not be conducted on a firm commitment basis.
(c)	This rule shall not prohibit any transac tion or transactions if the Commission, upon writ ten request or upon its own motion exempts such transaction or transactions either unconditionally or on specified terms and conditions.
Date: August 25,1988
1 15U.S.C.78a etseq.
2 Securities Exchange Act Release No. 24485 (May 20, 1987), 52 FR 19885 ("Proposing Release").
3 The NASD Petition was filed with the Com mission on June 12, 1986 pursuant to 553(e) of the Administrative Procedure Act, 5 U.S.C. §553(e), and Rule 4(a) of the Commission's Rules of Prac tice, 17 CFR 201.4(a), and is publicly available in File No. S7-18-87 in the Commission's Public Reference Room.
4 15 U.S.C. 77a et seq.
5 17 CFR 239.90. Form 1-A is used in con nection with offerings made pursuant to Regula tion A under the Securities Act. 17 CFR 230.251- 230.264.
6 The Commission previously proposed three different versions of the Rule, none of which has been adopted. See Securities Exchange Act Release No. 10636 (February 11, 1974), 39 FR 7806; Securities Exchange Act Release No. 11328 (April 2, 1975), 40 FR 16090; and Securities Exchange Act Release No. 13092 (December 21, 1976), 41 FR 56542; File No. S7-510. For further discussion of these proposals, see Proposing Release, 52 FR at 19886. In light of today's adoption of the Rule as proposed in 1987, the Commission is withdrawing all three prior proposals.
7 The NASD's study, "Short-Sale Regulation of NASDAQ Securities" (November 2, 1986), headed by former Commissioner Irving M. Pollack, endorsed the NASD Petition and the proposed Rule.
8 The Commission observed that the notational convention of using "10b-" to designate a rule is not a reflection of the scope of the rule's statutory authority. See Proposing Release, 52 FR at 19987 n.19.
9 17 CFR 240.3b-3.
10 The NASD urged the Commission to regulate only those covering purchases made out of the public offering to avoid affecting the operation of the market for the securities already outstanding. The Commission agrees that covering short sales in the open market exposes the short seller to the risk that securities to cover the short sale will not be readily available in the amount required, or will be priced higher than the public offering price, and that such purchases should not be restricted by the Rule.
11 See 17 CFR 240.10b-6(c)(5).
12 The letters of comment, as well as a summary of the comment letters prepared by the staff, are available for public inspection and copying at the Commission's Public Reference Room. See File No. S7-18-87.
13 The six commentators who discussed the alternative proposed formulations, including the NASD, endorsed Alternative B.
14 The Commission had requested that commentators provide statistical analysis demonstrating the extent to which short selling prior to public offerings results in a decrease in the market price of the security to be offered. In response, the NASD conducted a study ("NASD Study") that analyzed the price movements of 194 NASDAQ issues (i.e., securities quoted in the National Association of Securities Dealers Automated Quotation System) and 158 exchange-listed issues immediate ly prior to and subsequent to non-initial public of ferings of common stock conducted from May 1, 1986 to May 31, 1987 and priced at $5 or more.The NASD Study also examined equity audit trail data for NASDAQ/NMS securities (i.e., NASDAQ securities designated as national market system securities under Rule HAa2-l under the Exchange Act, 17 CFR 240.11Aa2-l), and National Securities Clearing Corporation (NSCC) clearing short position data for many of the 194 NASDAQ securities included in the price performance analysis.The NASD Study concluded that its findings provide evidence of unusual short selling, as well as the possible effect of Rule 10b-6 under the Ex change Act, 17 CFR 240.10b-6, on the market price of securities subject to non-initial public offerings. Rule 10b-6 precludes persons participating in a distribution from bidding for or purchasing the security to be distributed, absent an exception to or exemption from the rule. The NASD further concluded that the price data reviewed are consistent with the widely held view that a pattern exists of short selling prior to a non-initial public offering, with covering transactions made from offered securities.The NASD Study, along with two other studies it references, Barclay and Litzenberger, "Announcement Effects of New Equity Issues and the Use of Intraday Price Data," and Barclay, "Common Stock Returns Preceding Seasoned New Equity Offerings on the New York Stock Exchange," are attached as exhibits to the NASD's comment letter dated November 2,1987, included in File No. S7-18-87.
15 Any prearrangement between short sellers and those purchasing from underwriters or broker-dealers participating in the offering would be an "indirect" covering transaction with offered securities and would violate the Rule. See Section II.D. infra.
16 The Commission is adopting the Rule on a temporary basis to give it the opportunity to analyze, at a later date, whether the Rule is achieving its intended purpose. In this regard, the Commission's staff will request the NASD and the exchanges to furnish statistical information for non-initial public offerings conducted after adoption of the Rule for an eighteen-month period. The staff will then review this data and report to the Commission, within twenty-four months of adoption, whether the pricing impact the NASD believes is indicative of short selling persists and whether any new pricing impacts are observed. At that time, the Commission may revisit Rule 10b-21(T), including whether the Rule should continue to apply to exchange-traded securities.
18 The Commission has on other occasions recognized the need to protect the market for of-fered securities from the manipulative influences of certain market participants by adopting such rules as Rules 10b-6 and 10b-7 under the Exchange Act, 17 CFR 240.10b-6 and 240.10b-7. These rules limit bids and purchases, including stabilizing transactions, by persons participating in a distribution of securities to prevent their artificially conditioning the market to facilitate the distribution.A few commentators, including the NASD in its comment letter dated November 2, 1987, sug gested that Rule 10b-6, which requires distribution participants to cease market making in the security to be distributed two or nine business days prior to the offering's commencement, may also play a role in a decline of the security's price immediately preceding the offering. The NASD, in its comment letter dated June 2, 1988, stated that its investigation of a corporation that experienced a lower stock price prior to an offering demonstrated that such decline is not necessarily due to the withdrawal of market makers for Rule 10b-6 purposes, but may be due to short selling. The Commission believes that adoption of Rule 10b-21(T) will prevent price declines due to abusive short selling activity related to the ability to cover from the offering, independent of price effects, if any, that may result as a consequence of Rule 10b-6.
19 See Section II.C. infra for a discussion of the time period covered by the Rule.
20 In most registered offerings, the time that sales may be made occurs on the date of effectiveness of the pricing amendment to the registration statement. However, for offerings conducted pursuant to Rule 430A under the Securities Act, 17 CFR 230.430A, the time that sales may first be made is on the date of pricing, which may be later than the effective date.Where a short position is held immediately prior to the time of filing, and one or more subsequent short sales and covering transactions occur, it will not always be evident whether the short sales associated with a current short position were effected before the time of filing or subsequently. Under these circumstances, it is intended that holders of short positions prior to the time of filing may cover, with offered shares purchased from a broker or dealer participating in an offering, the lesser of the short position that existed immediately prior to the filing time or the smallest short position held subsequent to that time. Cf. Letter regarding Bernard H. Raouls, Jr., [1985-1986 Transfer Binder] Fed.Sec.L.Rep. (CCH) |78,144, at 76,637 (June 7, 1985).
21 Previous versions of the Rule included an exemption for bonafide market makers, exchange specialists, odd-lot dealers, and bonafide ar bitrageurs. See note 6 supra.
22 15 U.S.C. 78t(b). Section 20(b) provides: It shall be unlawful for any person, directly or indirectly, to do any act or thing which it would be unlawful for such person to do under the provisions of this title or any rule or regulation thereunder through or by means of any other person.Although Section 20 is entitled "Liabilities of Controlling Persons," paragraph (b) is not limited to situations involving persons in control relationships.
23 See note 15 supra.
24 Trading volume in a security subject to an offering may be greater than usual on the offering's effective date, indicating that a significant number of shares sold in the public offering have entered the secondary market. Customers of the distribution participants may have purchased in the offering and have decided to sell shortly thereafter. Moreover, certain distribution participants may resume market making as soon as the distribution is completed. However, a person with a short position is not required by the Rule to inquire whether any covering purchases he makes in the secondary market (e.g., from a market maker who had participated in the distribution) include shares that had been acquired in the offering.
25 17 CFR 230.415.
26 See Section II.C. supra.
27 17CFR240.10a-l.
28 See note 16 supra.
29 One commentator suggested adding to theRule a prohibition on covering purchases made from an issuer to prevent manipulative short selling in connection with rights offerings. The Commission is not aware of this type of abuse occurring in rights offerings and is therefore not adopting the suggested change. The Commission will, however, continue to review whether the Rule should be extended to rights offerings, self offerings, and best efforts offerings.
30 52 FR at 19888.
31 15 U.S.C. 78w(a)(2).