Regulation SHO: Recent Actions Appear to Have Initially Reduced Failures to Deliver, but More Industry Guidance Is Needed
Published: 2009-05-12T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Securities and Exchange Commission (SEC) adopted Regulation SHO to, among other things, curb the potential for manipulative naked short selling in equity securities. Selling a security short without borrowing the securities needed to settle the trade within the standard 3-day period, can result in failures to deliver (FTD), and can be used to manipulate (drive down) the price of a security. To further address this concern, SEC recently issued an order amending Regulation SHO. This report (1) provides an overview of Regulation SHO and related SEC actions, (2) discusses regulators' and market participants' views on the effectiveness of the rule, and (3) analyzes regulators' efforts to enforce the rule. To address these objectives, GAO reviewed SEC rules and draft industry guidance, analyzed FTD data, reviewed SEC and self-regulatory organization (SRO) examinations, and interviewed SEC and SRO officials and market participants.
section_title: What GAO Found
paragraphs: To address FTD and curb the potential for manipulative naked short selling in equity securities, Regulation SHO required broker-dealers to (1) locate securities available for borrowing before effecting short sales in that security and (2) close out FTD lasting ten consecutive settlement days in securities for which a substantial number of FTD accumulated (threshold securities). SEC imposed the close-out requirement only on threshold securities because it believed high levels of FTD could indicate potential manipulative naked short selling. Increasing market volatility led SEC to issue a September 2008 emergency order requiring broker-dealers to close out FTD resulting from short sales in any security the day after the settlement date. SEC extended thisrequirement until July 2009 in an interim final temporary rule. GAO found that the number of threshold securities declined after the implementation of the stricter close-out requirement, but it is not clear whether this trend can be sustained. Some market participants believe that the stricter close-out requirement does not prevent manipulative trading from occurring within the 3-day settlement period. They recommend that SEC address potential abuse by requiring all short sellers to borrow securities before a short sale. As the Commission considers whether to finalize the temporary rule, SEC staff said that they are continuing to evaluate the appropriateness of a preborrow requirement for addressing FTD and market manipulation related to naked short selling. However, SEC staff said that the costs of a preborrow requirement might outweigh the benefits because FTD represent 0.01 percent of the dollar value of trades, and that a small group of securities (small market capitalization, thinly traded, or illiquid) are likely to be the target of any manipulative scheme. SEC and SRO examiners have found that some broker-dealers do not monitor whether the source a broker-dealer uses to locate available securities is reasonable (i.e., does not result in FTD). The broker-dealers may not have done so because firms do not expect that the source from which it obtained the locate will be used to obtain shares for settlement. In some cases, the executing broker-dealer may lack information needed to establish whether the locates were reasonable. SEC staff worked with the industry to draft guidance in 2007 to clarify communication responsibilities in such instances, but SEC has not finalized it. As a result, some firms may continue to be noncompliant with the locate requirement. Furthermore, SEC sometimes did not provide interpretive guidance for questions on the implementation of Regulation SHO and temporary rule-related requirements, or did so after lengthy delays. SEC does not have formal processes for determining which requests for guidance merit a formal response, nor does it have a process by which implementation issues that arise from temporary rules can be readily addressed. Without timely and clear guidance to the industry, SEC cannot ensure the consistent implementation of its rules or help address the unintended consequences of operational issues that occur while awaiting rule expiry or finalization.

section_title: Letter
paragraphs: When investors agree to trade an equity security, the buyer promises to  deliver cash to the seller, and the seller promises to deliver the security to  the buyer. The process by which the seller receives payment and the buyer  receives the security is known as clearance and settlement. Trade  clearance and settlement in the United States operates on a standard 3-day  settlement cycle. Trades are executed on trade date (T) and settled 3 days  later (T+3). According to the Depository Trust and Clearing Corporation  (DTCC), the holding company whose subsidiaries are responsible for  clearing and settling broker-to-broker equity securities trades in the United  States, 99.9 percent of daily transactions, by dollar volume, clear and settle  within the standard 3-day settlement period. In the remaining transactions  (0.01 percent) the seller did not deliver the securities on time, resulting in  failures to deliver (FTD). According to the Securities and Exchange  Commission (SEC), FTD can be caused by mechanical error or processing   delays, which are typically resolved in a few days. However, FTD also can  result from naked short selling. While not defined in the federal securities  laws or rules, according to SEC, naked short selling generally refers to  selling short without having borrowed the securities to make delivery,  potentially resulting in FTD. When FTD persist for days or months, they  can reach a level that may affect the market for that security. They also  may be indicative of an illegal trading strategy known as manipulative  naked short selling, in which short sellers attempt to profit by using naked  short selling to flood the market with sales of a security with the intent of  lowering its price. For several years, and more recently in the financial  crisis, investors, publicly traded companies, and others have expressed  concerns about the level of FTD in specific securities and the potential for  manipulative naked short selling.
SEC has taken several actions in recent years intended to address FTD and  the potential for manipulative naked short selling. In August 2004, SEC  adopted Regulation SHO, which was intended to address large and  persistent FTD and curb the potential for manipulative naked short  selling. Among other things, the regulation imposed (1) uniform  requirements on broker-dealers to locate a source of securities available  for borrowing prior to effecting a short sale in any equity security  (generally referred to as performing a locate) and (2) delivery  requirements on broker-dealers for equity securities in which a substantial  amount of FTD had occurred, which the regulation designated as  threshold securities. Regulation SHO required broker-dealers that have  FTD in these securities lasting for 10 consecutive days to “close out” the  FTD by the beginning of regular trading hours the next morning (T+14) by  purchasing securities of like kind and quantity in the market, with some  exceptions. As we discuss in this report, in 2008, SEC took further  actions, which consisted of two emergency orders and an interim final  temporary rule (temporary rule), to address the potential for manipulative  naked short selling because of concerns about increasing market volatility.
This report addresses your interest in the implementation and  enforcement of Regulation SHO and subsequent regulatory actions and  their effectiveness in curbing FTD and the potential for manipulative  naked short selling. Specifically, this report   1.  provides an overview of the actions SEC has taken to address potential  manipulative naked short selling and FTD, including Regulation SHO  and the recent emergency orders, and the factors SEC considered in  taking them; 2.  discusses the potential impact of Regulation SHO on FTD in threshold  and nonthreshold securities using trend analysis; 3.  discusses regulatory, industry, and other market participants’ views on  the effectiveness of Regulation SHO and the recent emergency orders  in curbing the potential for manipulative naked short selling; 4.  analyzes SEC and self-regulatory organization (SRO) efforts to enforce  industry compliance with Regulation SHO and detect manipulative  naked short selling; and 5.  discusses industry experience with the implementation of the new and  enhanced delivery requirements.
To address the first objective, we reviewed the regulatory actions SEC has  taken to address naked short selling and FTD, including Regulation SHO,  amendments to the regulation, the recent emergency orders, and the  temporary rule relating to the delivery of equity securities. We also  conducted interviews with staff from SEC’s Division of Trading and  Markets (Trading and Markets) to obtain information on the factors SEC  considered in taking these actions. To address the second objective, we  analyzed publicly available FTD data produced by the National Securities  Clearing Corporation (NSCC), a clearing agency subsidiary of DTCC and  the daily threshold lists published by the SROs. We analyzed these data to  identify FTD trends in the threshold securities and across the market. We  determined these data were reliable for our purposes. To make this  determination, we reviewed a 2005 Office of Compliance and Inspections  and Examinations (OCIE) examination that, in part, assessed NSCC’s  processes for generating reports that are used to provide daily FTD data to  SEC and the equities SROs. We also employed our own data reliability  tests. For example, we reviewed the data for missing values and outliers as  well as the accuracy of pricing information. In addition, we reviewed  analyses of these data that SEC’s Office of Economic Analysis (OEA)  conducted. To address the third objective, we reviewed and analyzed the  requirements of Regulation SHO, the relevant recent emergency orders,  and the temporary rule and an OEA study. We also conducted interviews  with staffs from Trading and Markets, OCIE, OEA, SEC’s Division of  Enforcement (Enforcement), and the Financial Industry Regulatory  Authority, Inc. (FINRA); broker-dealers and two trade associations  representing broker-dealers; an issuer, and a trade association  representing issuers; securities lenders, and a trade association  representing securities lenders; securities lending consultants; an investor;  legal and subject area experts; and other market observers.
To address the fourth objective, we reviewed a 2005 joint sweep  examination that OCIE and the SROs conducted. In a sweep examination,  OCIE probes specific activities of a sample of broker-dealers to identify  emerging compliance problems in order that they may be remedied before  becoming too severe or systemic. We reviewed a sample of subsequent  OCIE and FINRA examinations, a 2006 sweep examination that the  Chicago Board Options Exchange (CBOE) conducted of its option market  making members, and FINRA examination guidance, and we interviewed  OCIE, FINRA, and CBOE staffs. We obtained data from FINRA and CBOE  on the numbers of Regulation SHO-related examinations conducted since  the regulation became effective and the number of examinations that  resulted in Regulation SHO deficiencies. To address the fifth objective, we  obtained and summarized comment letters submitted to SEC on the  temporary rule. We interviewed broker-dealers, a trade association  representing broker-dealers, and staffs from Trading and Markets and an  SRO.
We conducted this performance audit from March 2008 through May 2009  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives. Appendix I provides a more  detailed description of our scope and methodology.
subsections: section_title: Background
paragraphs: According to SEC, short selling provides the market with at least two  important benefits: market liquidity and pricing efficiency. For example,  market professionals, such as market makers (including specialists) may  provide liquidity by naked short selling to offset temporary imbalances in  the buying and selling interest for securities. Market makers generally  stand ready to buy and sell the security on a regular and continuous basis  at a publicly quoted price, even when there are no other buyers or sellers.
Thus, market makers must sell a security to a buyer even when there are  temporary shortages of sellers of that security available in the market. For  the purposes of this report, we refer to both market makers and specialists  as market makers. Efficient markets require that prices fully reflect all buy  and sell interest. Market participants that believe a security is overvalued  may engage in short sales to profit from a perceived divergence of prices  from economic values. According to SEC, such short sellers contribute to  pricing efficiency because their transactions inform the market of their  evaluation of the future price performance of the security. This evaluation  is reflected in the resulting market price of the security.
Naked short selling may have negative effects on the market, particularly  when it results in FTD and those FTD persist for an extended period and  represent a significantly large unfulfilled delivery obligation at the clearing  agency. Specifically, SEC stated that short sellers that fail to deliver  securities on the trade settlement date may face fewer restrictions than if  they were required to deliver the securities in a reasonable period. For  example, SEC said that short sellers may sometimes intentionally fail to  deliver securities to avoid borrowing costs, especially when the costs of  borrowing security are high. Furthermore, SEC stated that such sellers  could attempt to use this additional freedom to engage in trading activities  that deliberately and improperly depress the price of a security. For  example, SEC said that short sellers sometimes may intentionally fail to  deliver securities in an attempt to manipulatively naked short sell a  security. Issuers and investors have raised concerns to SEC in recent years  about manipulative naked short selling, particularly in thinly capitalized  securities that trade over the counter (OTC). To the extent that large and  persistent FTD might indicate manipulative naked short selling, SEC  stated that such FTD may undermine the confidence of investors. In turn,  investors may be reluctant to commit capital to an issuer that they believe  to be subject to such manipulative conduct.
Due to the volume and value of trading in today’s markets, NSCC nets  trades and payments among its participants using its Continuous Net  Settlement System (CNS System). This is a book-entry accounting system  in which each participant’s daily purchases and sales of securities, based  on trade date, are automatically netted into one long position (right to  receive) or one short position (obligation to deliver) for each securities  issue purchased or sold. The participant’s corresponding payment  obligations are similarly netted into one obligation to pay money or into  one obligation to receive money. If a member is unable to fulfill its  delivery obligation on settlement date, FTD occurs and the CNS System  maintains the net short position for that participant until the obligation is  fulfilled. As we have previously discussed, while naked short selling may  result in FTD, there are other legitimate reasons why FTD may occur. FTD  may result from either a long sale or a short sale, and, according to SEC  and FINRA, may result from mechanical error or processing delays. For  example, processing delays can result from transferring securities in  physical certificate, rather than in book-entry form.
SEC oversees broker-dealers primarily through OCIE and Trading and  Markets and in conjunction with FINRA and other SROs. FINRA is an SRO  with statutory responsibilities to regulate its broker-dealer members. As  part of its responsibilities, FINRA conducts examinations of its members  to ensure compliance with SRO rules and federal securities laws. OCIE  evaluates the quality of FINRA examinations by conducting oversight  examinations of broker-dealers recently examined by FINRA as well as  through inspections of SROs that review all aspects of the SRO’s  compliance, examination, and enforcement programs. OCIE also directly  assesses broker-dealer compliance with federal securities laws through  “special” and “cause” examinations. Special examinations include sweep  examinations. OCIE conducts cause examinations when it has reason to  believe something is wrong at a particular broker-dealer. Additionally,  OCIE conducts examinations of clearing agencies, which are the SROs  that clear and settle most securities trades in the United States. Trading  and Markets administers and executes the agency’s programs relating to  the structure and operations of the securities markets. SEC also has  delegated authority to Trading and Markets to administer the securities  laws affecting broker-dealers and engage in related oversight activities,  such as SRO rule filings. Where appropriate, SEC’s Enforcement and the  SROs’ enforcement divisions are responsible for investigating and  disciplining broker-dealers regarding violations of securities laws or  regulations.
section_title: SEC Initially Focused on Large and Persistent FTD in Certain Securities, but Growing Concerns about Investor Confidence Led SEC to Address FTD across the Market
paragraphs: When it initially promulgated Regulation SHO, SEC sought to curb the  potential for manipulative naked short selling by imposing (1) uniform  requirements on broker-dealers to locate a source of securities available  for borrowing and (2) additional delivery requirements on broker-dealers  for securities in which a substantial amount of FTD occurred. However,  growing concerns about volatile markets and declining investor  confidence prompted SEC to take emergency actions in the summer and  fall of 2008 to address all FTD in all equity securities by issuing both  permanent and temporary amendments to Regulation SHO.
subsections: section_title: To Address Manipulative Naked Short Selling, SEC Initially Targeted Regulation SHO to Large and Persistent FTD in Certain Equity Securities, with Some Exceptions
paragraphs: The locate and delivery requirements in Regulation SHO, which required  compliance beginning in January 2005, prohibited a broker-dealer from  accepting a short sale order in any equity security from another person, or  effecting a short sale order in any equity security for its own proprietary  accounts, unless it first located securities available for borrowing. To  satisfy this requirement, the broker-dealer must either borrow the security,  enter into an arrangement to borrow the security, or have reasonable  grounds to believe the security can be borrowed so that it can be delivered  on the settlement date. Executing broker-dealers must obtain and  document their source of borrowable stock (a locate) prior to effecting the  short sale.
Broker-dealers can demonstrate that they have reasonable grounds to  believe a security can be borrowed in time for settlement by directly  contacting a source for that security. Industry officials told us that a  potential source for securities might include the securities lending desk of  their own firm or that of another broker-dealer or the lending agents for  large institutional investors, such as mutual funds, pension funds, or  insurance companies. Regulation SHO also allows broker-dealers to rely  on industry-generated lists of securities that are considered widely  available, instead of contacting the source for those securities directly.  These lists generally are known as “easy-to-borrow” lists. Regulation SHO  also allows broker-dealers to rely on assurances from a customer that the  customer can obtain securities from a third party in time to settle the trade  (customer-provided locate). Broker-dealers must document compliance  with the locate requirement.
Regulation SHO included three exceptions to the locate requirement. First,  it excepted market makers from having to obtain a locate when they effect  short sales in connection with bona fide market making activities. SEC  stated that this exception was necessary because market makers may need  to facilitate customer orders in a fast-moving market without possible  delays associated with complying with the locate requirement. According  to SEC, market makers are unlikely to cause high levels of FTD, because  most of them seek a net “flat” position in a security at the end of each  day—offsetting short sales of a security with purchases of that security so  that they do not have to deliver securities under the CNS System. Second,  Regulation SHO allows an exception to the locate requirement when a  broker-dealer receives a short sale order from another broker-dealer  (introducing broker-dealer). In these cases, the introducing broker-dealer  is required to comply with the locate requirement, unless the executing  broker-dealer has entered into a contractual agreement to obtain locates  on behalf of the introducing broker-dealer. Third, Regulation SHO  provides an exception to the locate requirement in those cases where a  broker-dealer effects a sale on behalf of a customer that owns a particular  security, but through no fault of the customer or broker-dealer, the broker- dealer does not expect that the security will be delivered by the settlement  date. An example of this exception would be sales of restricted  securities—securities acquired in unregistered, private sales from the  issuers through private placement offerings. The sale of such securities  often involves processing delays that prevent the customer from obtaining  and delivering the securities on time. Since Regulation SHO requires  broker-dealers to mark sales as short if the customer does not have  possession of the securities at the time of the sale, broker dealers often  must mark the sale of restricted securities as short sales, even though the  customer owns the securities.
As we have previously discussed, Regulation SHO requires clearing  broker-dealers that have FTD in threshold securities persisting for 10 days  after the normal settlement date (T+13) to close out their FTD by  purchasing securities of like kind and quantity by the beginning of regular  trading hours the next day (T+14). For example, if a clearing broker- dealer has 100 FTD in threshold security XYZ for 13 consecutive days, the  participant is required to purchase 100 shares of XYZ by the next day to  close out these FTD. Clearing broker-dealers that do not close out their  FTD threshold securities by the morning of T+14 are required to  preborrow, or arrange to borrow, securities of XYZ before effecting  additional short sales for themselves or for any of their customers, until  the FTD are closed out. In adopting these close-out requirements, SEC  stated that it believed it was addressing those circumstances that warrant  action to address the potential negative effects of large and persistent  FTD. By narrowly targeting threshold securities, SEC stated that it would  not burden the vast majority of securities without similar concerns for  settlement. At the time SEC adopted the rule, OEA had calculated that  approximately 4 percent of all reporting securities would qualify as  threshold securities.
As adopted, Regulation SHO included three exceptions to the close-out  requirement. First, the close-out requirement did not apply to any FTD that  were established prior to the security becoming a threshold security.
SEC included this exception, termed the grandfather exception, because it  was concerned about creating volatility through short squeezes if la rge  preexisting FTD had to be closed out quickly after a security became a   Second, SEC allowed a limited exception for FTD  threshold security. resulting from short sales effected by options market markers to establish  or maintain a hedge on options created before the underlying security  became a threshold security, as long as the short sales were effected as  part of bona fide market making. SEC created this exception to address  concerns expressed by market participants that the close-out requirement  would affect the liquidity and pricing of options. These market participants  had argued that without the ability to hedge their options through short  sales, options market makers would cease options trading in securities  considered hard to borrow, and thus, prone to FTD—in other words— securities most likely to enter the threshold list. Finally, SEC excepted  FTD resulting from sales of customer-owned securities that the broker- dealer did not reasonably expect would be in its possession by the  settlement date, such as the restricted securities that we previously  discussed. Broker-dealers have 35 days to close out FTD resulting from the  sale of these securities.
section_title: After Considering Data Showing the Continued Persistence of FTD in Some Securities, SEC Amended Regulation SHO in August 2007 to Eliminate a Grandfathering Exception
paragraphs: After considering data showing that substantial and persistent FTD in a  small number of threshold securities were not being closed out due to  reliance on the grandfather exception, SEC amended Regulation SHO in  August 2007 to eliminate it. At the time it adopted Regulation SHO, the  Commission stated that it would monitor its operation to determine  whether grandfathered FTD were being cleared under the existing close- out requirement, or whether any further regulatory action was warranted.  We reviewed data that SEC used in its deliberations to eliminate the  grandfather exception. For example, we found that OEA had estimated  that from January 7, 2005, through December 31, 2005, the average daily  percentage of grandfathered FTD to total FTD for securities on the  threshold list was about 48 percent. Furthermore, in 2005, OCIE  conducted several examinations for Regulation SHO compliance that  found that some broker-dealers were still carrying a significant amount of  FTD in securities that they were not closing out because they were relying  on the grandfather provision.
In the 2007 rule amendment, SEC reiterated its concerns regarding the  impact that large and persistent FTD can have on the market for a  security. SEC also said that some issuers believed that they had suffered  unwarranted reputational damage because of investors’ negative  perceptions about large and persistent FTD in their securities. According  to one issuer’s comment letter, its investors attributed the issuer’s frequent  reappearances on the threshold list to manipulative short selling and  frequently demanded that the issuer take action to address this issue. SEC  stated that any unwarranted reputational damage caused by large and  persistent FTD might have an adverse impact on the security’s price. We  discuss the number of securities that reappeared on the threshold list  during the period of our review in greater detail later in this report.
section_title: In Response to Increasing Market Volatility, SEC Issued an Emergency Order in July 2008 to Temporarily Restrict Naked Short Selling in the Securities of 19 Firms
paragraphs: Increasing market volatility in the securities of financial institutions of  significance prompted SEC to issue an emergency order on July 15, 2008,  that temporarily restricted short sales in the publicly traded securities of  19 large financial firms, unless the seller had borrowed, or arranged to  borrow, the security prior to effecting the short sale. The order also  prohibited any FTD in these securities by requiring that the short seller  deliver the security on the settlement date. The order was effective from  July 21, 2008, to August 12, 2008. SEC amended the order on July 18, 2008,  to except market makers engaged in bona fide market making from the  preborrow requirement.
SEC issued the order because it was concerned that rumors about  financial institutions of significance in the United States may have fueled  market volatility in the securities of some of these institutions. Trading  and Markets staff said that SEC’s decision to issue the order was  precipitated by the rapid decline and subsequent collapse in the price of  the securities of the investment firm Bear Stearns. This event raised  concerns at SEC about a type of market manipulation called short and  distort (i.e., an individual short sells a particular security and then  attempts to drive down its price by spreading false rumors about the  company). Although a trader could engage in a short-and-distort scheme  without naked short selling, SEC stated it was concerned that naked short  selling could accelerate a price decline in the event of a false rumor.
SEC chose the 19 financial firms because it believed that they were  particularly susceptible to short-and-distort schemes. Trading and Markets  staff said that they did not see evidence of naked short selling or increased  FTD in these securities prior to the issuance of the emergency order.  Instead, they said that the emergency order was an attempt by the  Commission to reassure the investing public that SEC would not allow  naked short selling to occur.
section_title: Sudden and Unexplained Declines in the Prices of Equity Securities Led SEC to Issue Additional Emergency Orders in September 2008 That Address FTD across the Market
paragraphs: Citing concerns about sudden and unexplained declines in the prices of  equity securities generally, SEC, in consultation with the Federal Reserve  and the Treasury Department, issued an emergency order on September  17, 2008. This order (1) temporarily enhanced delivery requirements on  the sale of all equity securities, (2) implemented an antifraud rule targeted  to short sellers that lie about or misrepresent their intention to deliver  securities in time for settlement, and (3) eliminated the options market  maker exception to Regulation SHO’s close-out requirement.
First, SEC added a temporary amendment to Regulation SHO through the  September order to enhance delivery requirements on sales of all equity  securities. The temporary rule requires clearing broker-dealers to deliver  securities resulting from any short sale by the settlement date (T+3), or, if  they have FTD on the settlement date, to take action to purchase or  borrow securities to close out the FTD by no later than the beginning of  regular trading hours on T+4. Participants that do not close out their FTD  on the morning of T+4 are required to borrow, or arrange to borrow,  securities before effecting additional short sales. Clearing broker-dealers  that can show that the FTD resulted from a long sale, or a short sale by a  market maker engaged in bona fide market making, have until the  beginning of trading hours on T+6 to close out the FTD by purchasing  securities of like kind and quantity. Upon expiration of the emergency  order, SEC adopted these requirements as an interim final temporary rule,  with a request for comments, which is set to expire on July 31, 2009.
In issuing the temporary rule, SEC stated it was concerned that the current  locate and close-out requirements in Regulation SHO had not gone far  enough to reduce FTD and address potential manipulative naked short  selling, especially in light of the ongoing instability and lack of investor  confidence in the financial markets. SEC also noted that because  Regulation SHO’s close-out requirement applied only to threshold  securities, FTD in nonthreshold securities never had to be closed out. In  addition, SEC noted that the current delivery requirement for threshold  securities under Regulation SHO and the lack of any delivery requirement  for nonthreshold securities enabled FTD to persist for many days beyond  the settlement date. SEC stated that the temporary rule was needed to  require earlier close outs of FTD so that more sales would settle by  settlement date. SEC acknowledged that the temporary rule’s delivery  requirements may require the close out of some FTD that occur because of  ordinary settlement delays and would ordinarily clear up within a few  days, but SEC believes that these requirements were necessary to help  ensure that all trades in all equity securities settled by settlement date and  that FTD would be closed out promptly after being incurred.
The September order also made effective SEC’s proposed “naked” short  selling antifraud rule. The rule is intended to clearly affirm the liability of  individuals who deceive specified individuals about their intention or  ability to deliver securities in time for settlement, including individuals  who deceive their broker-dealer about their locate source or ownership of  shares and fail to deliver securities by settlement date. Enforcement staff  said that a rule highlighting the illegality of these activities would focus the  attention of market participants on such activities. This rule does not  provide SEC with any additional enforcement powers. Following the  expiration of the order, SEC made the amendment permanent.
Third, the September order made effective a proposed rule amendment to  eliminate the options market maker exception from Regulation SHO’s  delivery requirement. SEC had proposed to eliminate this exception in  August 2007, based in part on data it had obtained from SROs showing that  substantial levels of FTD continued to persist in some threshold securities  as a result of this exception. Following the expiration of the order, SEC  made the amendment permanent.
SEC issued a second emergency order on September 18, 2008, also in  consultation with Federal Reserve and Treasury Department officials, that  temporarily restricted all short sales in the publicly traded securities of  about 800 financial institutions (short sale ban). In the order, SEC noted  its continued concerns regarding recent market conditions, and noted that  short selling in the securities of a wider range of financial institutions than  those subject to the July emergency order may be causing sudden and  excessive fluctuations of the prices of such securities that could threaten  fair and orderly markets. The order expired on October 8, 2008.
section_title: The 2008 Emergency Orders Appear to Have Reduced Threshold Securities and FTD from Record Highs, but the Sustainability of This Trend Is Unclear
paragraphs: We reviewed trends in threshold securities and their FTD from January  2005 through December 2008 (the review period). These measures showed  initial declines soon after the implementation of Regulation SHO, but  subsequently increased during 2007, concurrent with increasing  turbulence in the markets brought on by the financial crisis. We observed  significant declines in threshold securities and their FTD after SEC  implemented the July and September 2008 emergency orders, but the  sustainability of this trend is unclear.
subsections: section_title: Threshold Securities Initially Declined after Implementation of Regulation SHO, but They Increased Significantly in 2007 and 2008 as the Financial Crisis Worsened
paragraphs: We reviewed trends in threshold securities and their FTD between January  2005 and December 2008. Although definitive conclusions cannot be  drawn from simple trend analysis, we had difficulty discerning an  intermediate impact of Regulation SHO on these measures. Figure 1 shows  the average number of securities on the threshold list, by month, over the  review period. Although subject to volatility from month to month, the  average monthly number of threshold securities declined from 423 to 231,  or by about 45 percent from January 2005 through August 2006. This  decline was most pronounced in the first 6 months after the regulation  became effective, and particularly in the first month, when the number of  securities declined from 529 on January 10, 2005 (the date the SROs  published the first threshold list), to 414 by January 31, 2005. After July  2006, however, the average monthly number of threshold securities per  month began to trend upward, reaching a record high of 582 for the review  period in July 2008. This upward trend corresponds to several indicators  of the severity of the current financial crisis, including several  bankruptcies involving mortgage lenders starting in December 2006;  announcements by the ratings agencies of downgrades and reviews for  potential downgrade of mortgage-related assets starting in June 2007; and  negative announcements by Bear Stearns beginning in June 2007 and its  subsequent merger to avoid collapse in March of 2008, among others.  Caution should be used in interpreting the trends in threshold FTD,  especially since we do not have an appropriate measure of FTD prior to  Regulation SHO.
Average outstanding FTD per month in these securities also declined from  218.5 million to 104.2 million, or 52 percent, between January 2005 and  August 2006 (fig. 2). However, there was greater volatility from month to  month in this figure, and the direction and magnitude of the change are  highly sensitive to the start and end points selected. After July 2006,  outstanding FTD increased considerably. As we discuss in the text that  follows, an increase in threshold security FTD does not necessarily imply  ineffectiveness since it is difficult to determine what would have happened  ppened  in the absence of Regulation SHO.  in the absence of Regulation SHO.
We also generated the total number of new FTD, per month, in threshold  securities over the review period (fig. 3). New FTD are the number of FTD  that occur each day. Total new FTD from January 2005 through August  2006 declined by about 43 percent, from 264.3 million to 151.7 million,  again subject to considerable volatility. For example, when we measured  the difference in new FTD from January 2005 through June 2006, we found  that new FTD increased 103 percent, to 535.3 million. This was largely due  to a significant increase in new FTD in June 2006. This measure also  began to increase in 2007.
The initial decline in threshold securities, particularly in the first few  months of 2005, may indicate that Regulation SHO had some impact on  reducing the number of threshold securities soon after the regulation  became effective. However, other market factors also may have  contributed to this initial decline. We found that the overall level of FTD  across the market appeared to have been declining since at least April  2004 (the earliest date we could obtain FTD data), almost 8 months before  the effective date of Regulation SHO’s locate and delivery requirements,  and continued after the adoption and implementation of Regulation SHO.  Regulation SHO may have accelerated this trend for the threshold  securities, and it is possible that a portion of this decline can be attributed  to an early impact of Regulation SHO through an announcement effect.
The subsequent increase in threshold securities, outstanding FTD, and  new FTD culminated in record highs for the review period in July 2008. It  is unclear whether the number of threshold securities and their FTD  would have increased further in the absence of Regulation SHO. We note  that Regulation SHO did not intend to prohibit FTD in threshold securities.  Rather, it was intended to address FTD once they had accumulated to a  substantial level and persisted for 13 consecutive days. Moreover, SEC  also intended for the locate requirement to limit naked short selling by  better ensuring that broker-dealers that effect short sales have a source of  securities they can borrow in time for settlement. If Regulation SHO acted  to curb FTD resulting from short sales, we would generally expect to see  declines in new FTD. Our data, however, indicate overall increases in new  FTD during 2007 and up until July 2008, subject to considerable volatility.
As we have previously discussed, SEC eliminated the grandfather  exception in August 2007 after data showed that persistent FTD in some  threshold securities were due to reliance on this exception. Our data show  that despite the elimination of this exception, threshold securities and  their FTD levels continued to increase. OEA examined FTD before and  after the elimination of the grandfather exception in the threshold  securities to determine the impact of its removal. According to OEA, FTD  shifted from nonoptionable to optionable securities after the elimination  of the grandfather exception. OEA staff said that one explanation of these  results could be short sellers that previously failed to deliver in the equity  market moved to the options market, where option market makers still  had an exception to the close-out requirement, to establish a synthetic  short position. In proposing to eliminate the options market maker  exception, SEC analyzed 2006 data and found that some threshold  securities were persisting on the threshold list due to option market  makers claiming an exception to the close-out requirement. However,  CBOE examiners said that by the time SEC eliminated the options market  maker exception, it was their understanding that option market makers  may have modified their hedging strategies and stopped relying on the  exception. They explained that, since SEC began seeking comments on  eliminating the exception in July 2006, options market makers had  anticipated that SEC would eventually eliminate the exception.
OEA staff said that changes in FTD may be influenced also by factors  other than Regulation SHO, such as changes in the mix of securities being  traded. For example, they noted that the mix of securities with FTD tilted  toward higher-priced stocks after the elimination of the grandfather  exception (higher-priced stocks also tend to be optionable stocks),  reflecting the financial sector and other industries undergoing turbulence  at that time. OEA and Trading and Markets staffs said that changes in  market conditions, including overall increases in trading volume, volatility,  and short interest, were also likely factors contributing to the increase in  FTD. According to these staff, increases in trading volume and volatility  are likely to correlate with increases in FTD because the higher the  volume of trades, the more likely errors and other processing delays will  occur. To the extent that FTD are due to errors or other processing  delays, we would expect to see an increase in FTD proportional to an  increase in trading volume. In figure 4, we show that the upward trend in  FTD for NYSE, NASDAQ, and Amex threshold securities persisted even  when expressed as a percentage of market volume. Thus, increased  trading volume may not entirely explain the increase in FTD for threshold  securities.
Figure 5 compares trends in volatility, market performance, and short  interest with the trends in FTD outstanding across NYSE, NASDAQ, and  Amex securities over the review period. The first graphic in figure 5 shows  market volatility, as measured by changes in the CBOE Volatility Index  (VIX), beginning to trend upward by January 2007. We measured market  performance using the S&P 500 Total Return Index (second graphic), and  we use short interest—the total number of shares of a security that have  been sold short, but not yet covered or closed out—as a proxy for the  volume of short selling occurring in the market (third graphic). We  expected declining market performance during 2007 and 2008 to correlate  with an increase in short interest as market sentiment declined. The third  graphic shows that after January 2007, short interest highly correlated  with FTD, suggesting that increased short selling activity partially explains  the rise in FTD. In particular, the July 2008 high in FTD correlated closely  with the peak in short interest over the review period.
The strong correlation between short interest and FTD suggests that the  effectiveness of the locate requirement during this period of market  turbulence may have been limited. OEA staff told us that a significant  increase in short selling may result in increased FTD as the current  processes for locating and obtaining securities may be temporarily  overwhelmed. Furthermore, they said that as short interest increases,  more securities— particularly those that are less liquid—face a binding  borrowing constraint. As a result, borrowing becomes more difficult for  more securities, potentially resulting in more FTD. Other factors may  also have contributed to the increased number of threshold securities and  FTD observed during this period. For example, OEA staff noted the  increasing presence of ETFs on the threshold list during this period. We  discuss ETFs in greater detail later in this report. Furthermore, industry  officials with whom we spoke also said that several threshold securitieshad ceased trading or were trading at very low prices, making it difficult  to  resolve any FTD in those securities.
After reaching a high on July 17, 2008, the number of threshold securities  and their FTD began to decline. OEA staff pointed to the corresponding  decline in short interest as one potential factor. While the SEC’s  emergency order restricting naked short selling in the securities of 19 large  financial firms was issued about the same time (July 15, 2008), OEA staff  said that they do not know to what extent the order was responsible for  the subsequent decline in threshold securities and their FTD. Only 1 of the  19 firms that were subject to the order was on the threshold list before the  order went into effect, and the other securities had low FTD levels.  However, these staff said that market uncertainty about whether SEC  would take additional emergency actions may have affected the amount of  short selling in which the market engaged.
OEA staff said that the September emergency orders—which eliminated  the options market makers exception, imposed stricter close-out  requirements on FTD in all equity securities, and temporarily banned short  selling in the securities of financial firms—had a significant impact on the  number of threshold securities and their FTD levels. Our data show that  the number of threshold securities continued to decline after the  September 2008 emergency orders became effective. Although the  elimination of the options market maker exception and the provisions of  the temporary rule were not fully in effect until mid-November when  compliance grace periods expired, the average number of threshold  securities declined to 72 in November—the lowest number during our  review period since the effective date of Regulation SHO. The number of  threshold securities temporarily increased to 123 by December 31, 2008,  but subsequently declined. By May 5, 2009, there were 68 securities on the  threshold list.
Similarly, outstanding FTD and total new FTD in threshold securities also  continued to decline after the September 2008 emergency order, although  these declines had slowed by the end of 2008, when the level of  outstanding FTD had declined to slightly below their January 2005 level.  Total new FTD also declined, but by the end of 2008 were still above their  January 2005 level. One explanation for continued outstanding FTD may  be that the enhanced delivery requirements of the temporary rule apply  only to FTD from trades that occurred after the September emergency  order became effective on September 18, 2008. Preexisting FTD in any  equity security do not have be closed out, unless the security enters the  threshold list. In that case, the close out provision for threshold securities  applies, and the clearing broker-dealer has 13 consecutive days to close  out the FTD. As a result, outstanding FTD may be due to new securities  entering the threshold list. We discuss characteristics of the remaining  threshold securities later in this section of our report. Furthermore, while  the temporary rule imposes close-out requirements on FTD in all equity  securities, it does not prohibit them from occurring. Levels of new FTD  can continue to fluctuate, although the overall decline since the September  2008 emergency order suggests that the close-out requirements of the  temporary rule have curbed the number of threshold securities and new  FTD in these securities.
section_title: Similar to Threshold Securities, FTD across the Market Showed a Noticeable Decline after the 2008 Emergency Orders
paragraphs: Figure 6 shows the number of equity securities across the market with  outstanding FTD and those with new FTD over the review period. As with  the threshold securities, the number of these securities began to decline  after the July order, concurrent with the decline in short interest, and  continued to decline after the implementation of the September  emergency order. As we have previously discussed, the close-out  requirements of the temporary rule applied to FTD resulting from trades in  any equity security, not just threshold securities. Most notably, we found  that the gap between securities with outstanding FTD and those with new  FTD narrowed considerably by December 2008, again suggesting that the  close-out requirements were resulting in more prompt close outs. The  overall decline in securities with new FTD also suggests the new  requirements may be having the effect of curbing new FTD.
Figure 7 shows the monthly average outstanding FTD for all securities,  and indicates a similar declining trend in threshold securities after July  2008. By the end of 2008, outstanding FTD did not appear to have declined  below the earlier low point (late-2005). As we have previously discussed,  FTD existing prior to the effective date of the September emergency order  do not have to be closed out, unless the security enters the threshold list.  In addition, although the temporary rule appeared to have curbed the  number of securities with new FTD by the end of 2008, it does not prohibit  new FTD. The potential exists that market events, such as increased  trading volume or short interest, could again lead to increased FTD. It  remains to be seen whether the stricter close-out requirements are having  the effect of encouraging improvements in locating and delivery processes  that would help mitigate increases in new FTD under such circumstances.
section_title: Although the Majority of Threshold Securities Graduated from the List in a Timely Manner, Some Securities Persisted for Extended Periods
paragraphs: Our review of FTD data showed that the majority of threshold securities  “graduated” from the threshold list in a timely manner over the review  period, although most returned to the threshold list at least once.  Furthermore, until the September emergency order became effective,  some threshold securities persisted on the list for extended periods. A  majority of the threshold securities (83 percent) graduated from the list  within 22 days, the earliest we expected given the implementation of the  close-out requirement, and many graduated sooner—25 percent within   6 days. The timely graduation of threshold securities, in most instances,  indicates that the regulation worked as intended to reduce FTD to below  the threshold level once securities appeared on the threshold list.  However, in many instances, this effect was not permanent, as FTD in  these securities eventually increased again. From January 10, 2005, the day  the first threshold list was published, until December 31, 2008, about  21,400 securities graduated from the threshold list. Of these securities,  about 17,000, or 80 percent, returned to the threshold list at least once, and  about 1,200, or 6 percent, returned to the list more than 10 times.
In addition to showing the average monthly number of threshold securities  over the review period, figure 8 includes data on the number of days these  securities persisted on the threshold list. We found that the average daily  number of securities per month that were on the threshold list for 22 days  or less ranged from 50 percent (October 2008) to 91 percent (December  2008). However, some securities persisted for considerably longer periods.  Figure 8 also indicates the number of securities that persisted on the list  for more than 22, 30, 60, and 90 days, respectively, during the review  period.
Securities legitimately could have persisted on the threshold list during the  review period for several reasons:    FTD in these securities could have been exempt from the close-out  requirement under the former grandfather and option market maker  exceptions, at least until these exceptions were eliminated. FTD in these  securities also could have fallen under the third exception from the  Regulation SHO delivery requirement if they resulted from long sales of  formerly restricted securities. As we have previously discussed, Regulation  SHO allows owners of formerly restricted securities 35 days to complete  processing of these securities and deliver them to their clearing broker- dealer.
Clearing broker-dealers may have closed out their FTD in compliance with  Regulation SHO, but as old FTD were cleared up, new ones were created  that kept the security on the threshold list.
Clearing broker-dealers may have been unable to close out their FTD after  13 consecutive settlement days, because, for example, of a lack of liquidity  in a specific security. In that case, until the relevant clearing broker-dealer  was able to obtain securities and close out its FTD, it would be required to  preborrow, or arrange to preborrow, securities before effecting additional  short sales.
Examination and enforcement staff at FINRA and SEC told us that until  they conduct an examination or inquiry into persistent FTD in a threshold  security, they do not know whether they were legitimate (e.g., based on an  exception) or whether the firm violated Regulation SHO’s delivery  requirements in those securities.
We reviewed securities that persisted for more than 90 days over the  review period and found they comprised about 300 unique securities.  Table 1 shows the number of securities that persisted on the threshold list  for more than 90 days, by the number of days. The table reflects a total of  365 because some securities appeared on the list more than once. We  found 1 security that persisted on the threshold list for more than 700  consecutive days. For those securities that returned to the threshold list  more than once, we found that the total number of days they could persist  on the list could be greater. For example, 1 security that returned to the  threshold list 5 times persisted for a total of 862 days.
The September emergency order appeared to significantly reduce the  ability of securities to persist for extended periods. From May 2005, the  first month that a security could be on the threshold list for more than 90  days, through September 2008, the average daily number of securities  persisting for more than 90 days ranged from a low of 12 per month (April  2007) to a high of 63 per month (August 2008). Our data showed that the  number of such securities did not begin to decline significantly from their  record high until after the September order became effective. By the end  of 2008, no securities on the threshold list had persisted for more than 90  days.
section_title: ETFs Accounted for Half of the Remaining Threshold Securities at the End of 2008
paragraphs: The percentage of ETFs on the threshold list increased over the review  period (fig. 9) as the number of these products trading in the financial  markets also grew. By December 2008, about 50 percent of the securities  remaining on the threshold list were ETFs. Trading and Markets and OEA  staffs said that, at this time, they do not believe ETFs are persistently  failing due to manipulation, and noted that ETFs are characteristically less  prone to manipulation than common stock since the ETF price is based  generally on large baskets of underlying securities.
Instead, Trading and Markets, OEA, and FINRA staffs believe that  structural characteristics associated with ETFs make them more likely to  experience FTD. This is primarily because ETFs can only be created and  redeemed in large blocks of shares (e.g., 50,000) called creation units.  For example, OEA staff said that, given the costs associated with creating  and redeeming units, broker-dealers may have little incentive to create  additional units until the number of FTD is at least as great as the creation  unit size. As a result, ETFs are more prone to inclusion on the threshold  list than other securities. OEA staff said that because many ETFs have a  low number of total shares outstanding, FTD in ETFs can easily trigger the  10,000 share FTD and 0.5 percent of total shares outstanding criterion for  becoming a threshold security. In addition, the creation unit size may far  exceed the 10,000 share FTD trigger level for becoming a threshold  security. FINRA staff told us that when newly listed ETFs begin trading,  there is uncertainty in the marketplace regarding the level of demand. If  demand for the specific ETF exceeds contemporaneous sell-side supply,  FINRA staff said that market makers will short sell the ETF pursuant to  existing exemptions, causing FTD. However, these staff said that the  resulting FTD are typically short term and resolved through the issuance  of additional creation units.
Trading and Markets and OEA staffs said that they are continuing to  review ETFs to further understand the reasons for FTD in the products,  and to monitor any potential changes to ETF products for manipulation or  other concerns.
section_title: Some Commenters Contend a Preborrow Requirement Is Needed to Address FTD and Market Manipulation, While SEC Is Still Considering Whether It Would Be Appropriate
paragraphs: Some market participants and others (commenters) expressed concern  that under the current locate requirement, broker-dealers with available  shares may provide more locates than they have shares available.  Furthermore, they said that the current close-out requirements do not  address manipulation that can occur within the 3-day settlement period.  To mitigate this potential, these commenters advocate requiring short  sellers to first borrow securities before effecting their short sales. Trading  and Markets and FINRA staffs agreed that market manipulation within the  T+3 settlement period is possible. Meanwhile, Trading and Markets staff  said that they are still considering whether a preborrow requirement is an  appropriate regulatory response.
subsections: section_title: Some Commenters Believe That the Current Locate and Close-out Requirements Are Not Sufficient to Prevent FTD and Market Manipulation
paragraphs: Some commenters believe that the current locate requirement is not  sufficient to curb FTD resulting from short sales or prevent manipulative  trading. As we have previously discussed, Regulation SHO allows broker- dealers to rely on industry easy-to-borrow lists, instead of directly  contacting the source of the securities. According to OCIE and FINRA  staffs and industry officials, the industry generally relies on these lists, to  satisfy the locate requirement when effecting short-sales in securities  considered widely available. For securities that are not on an easy-to- borrow list, the customer or the broker-dealer typically calls the securities  lending department of the broker-dealer to determine the availability of  the securities for borrowing. However, Regulation SHO does not require  the entity on which a broker-dealer relied as a source of available  securities to have the securities available on settlement date. Some  commenters have expressed concern that unless SEC requires broker- dealers to borrow securities prior to effecting short sales, or at least  requires sources of securities to set aside securities as they are providing  locates, broker-dealers could provide more locates than they could fill,  which could lead to FTD if they are not able to obtain sufficient shares for  delivery from another source on settlement day. One securities lending  consultant with whom we spoke said that the process of providing locates  for hard-to-borrow stocks generally is informal, with locates at times  provided verbally. This consultant said that such informal conversations  can result in the securities not being available on settlement day if the  parties misunderstand the type and amount of securities available.  Another consultant in financial services said that because broker-dealers  could rely on telephone calls, they may not actually check whether the  source was valid.
Although the temporary rule requires most FTD resulting from short sales  to be closed out on T+4, several commenters expressed concern that  market manipulation could occur within the T+4 time frame. These  commenters said that under the current locate and close-out requirements,  a trader could still naked short sell a security and cover the sales with  purchase orders prior to settlement day. Because the trader does not have  to incur the cost of borrowing shares, these commenters said that the  trader could naked short sell without limit—thus, flooding the market with  sell orders to potentially depress the price of the security and realize  greater profits. To mitigate this type of market manipulation, the  commenters recommended that SEC require broker-dealers to preborrow  securities prior to effecting a short sale on behalf of a customer, which  they said would eliminate the potential for manipulative short selling  within the 3-day settlement period and more generally provide greater  assurance that short sales do not result in FTD.
section_title: Although Regulatory Staff Said That Overlocating Is Unlikely, Inconsistent Industry Practices in Managing Easy-to-Borrow Lists Could Raise Concerns
paragraphs: Trading and Markets staff said that they have not conducted any empirical  studies to assess the effectiveness of the locate requirement for reducing  FTD. However, they and industry officials said that overlocating is unlikely  to occur because only an estimated 5 percent to 10 percent of locates  result in the actual borrowing and delivery of shares. For example, many  customers choose not to proceed with the short sale order after obtaining  or requesting a locate. Industry officials noted that there is a key  difference between a locate, which occurs prior to the short sale being  effected, and a borrow, which occurs at settlement. Because broker- dealers settle transactions in each security on a net basis, these officials  and the regulators said that the actual settlement obligation is often less  than the number of shares sold short, making borrowing unnecessary or  necessary only in limited quantities.
Industry officials told us that as a result of the standardization of the  locate requirement under Regulation SHO, they have developed policies  and procedures that help them to better manage their securities lending  operations. More specifically, these officials said that the locate  requirement, and the new T+4 close-out requirement for FTD resulting  from short sales, has resulted in increased and improved communication  with customers prior to effecting a short sale. For example, some industry  officials said that as a result of the locate requirement of Regulation SHO,  they are denying customers’ requests to effect short sales in hard-to- borrow securities because a source of available and sufficient securities  cannot be located. They said that the customer has a vested interest in  making sure that the broker-dealer can deliver the securities in time for  settlement. If securities cannot be borrowed and delivered in time for  settlement, the broker-dealer will be required to close out the FTD under  the temporary rule, thus increasing the chance that the customer may be  bought-in at a loss or will be required to close out its short position earlier  than desired. Industry officials said that, consequently, when customers  call the securities lending department to obtain a locate for hard-to- borrow securities, the customer and staff from the securities lending  department are more likely to discuss the availability of the security, the  cost to borrow it, and the length of time it can be borrowed. Furthermore,  industry officials said that broker-dealers also are motivated to manage  their inventory effectively to avoid FTD, which otherwise trigger the close- out obligations of the temporary rule.
To better understand industry practices regarding locates, we reviewed  several broker-dealer examinations conducted by OCIE that focused on  Regulation SHO compliance. We found that four of the five broker-dealers  that were examined either generated their own easy-to-borrow lists or  used the easy-to-borrow lists of other broker-dealers with which they had  stock borrow arrangements, to determine whether a security was widely  available for borrowing prior to effecting a short sale. We found that  some of these firms decremented their easy-to-borrow lists as they  provided locates, or practiced some other form of inventory management  to help ensure that they did not provide locates for more securities than  they could fill at settlement date. Others, however, did not follow these  practices. We note that without such practices in place, it is unclear how  these firms could ensure that they are not providing locates in excess of  their available supply of securities and thereby limiting the potential for  FTD. As we have previously discussed, Regulation SHO does not require  firms to decrement their easy-to-borrow lists as they provide locates to  their customers or traders, nor does it include definitive criteria regarding  what constitutes an easy-to-borrow security other than a reasonableness  requirement. Without such criteria, it is unclear how SEC could ensure  that firms prepare these lists in a consistent manner and contain an  appropriate range of securities that are available for borrowing.
section_title: Regulators and Industry Officials Said That the Current Locate and Close- out Requirements Make Manipulative Naked Short Selling More Difficult
paragraphs: Although short sellers and broker-dealers could still potentially collude to  effect a manipulative short selling scheme, Trading and Markets and  FINRA staffs said that under the current locate and close-out  requirements, it is less likely traders would effect short sales resulting in  persistent FTD. FINRA staff said that this is because the locate and close- out requirements mandate the broker-dealer to settle the trade or to  resolve the FTD created when the trade was not settled on time.  Customers, on the other hand, do not have any role in the settlement of  trades. For example, these staffs said that it would not be very likely that a  retail customer, who generally relies on the same broker-dealer to obtain a  locate, execute, and settle a trade, could implement a manipulative naked  short selling scheme. To do so, FINRA staff said that the broker-dealer  would in all likelihood have to collude with the customer and agree to  allow a short sale to be effected without a locate being obtained, fail to  deliver securities, and keep the FTD open while the customer attempted to  fraudulently drive down the price of the security.
Industry officials told us that the customers who are allowed to provide  their own locates to executing brokers and arrange for securities to be  delivered to the clearing broker-dealer for settlement generally are  institutional investors, such as hedge funds. They said that institutional  investors may choose to execute and settle the trade with one broker- dealer, or they may choose to execute the trade with one broker-dealer  and settle it with another broker-dealer (a prime brokerage arrangement),  where the clearing broker-dealer is called a prime broker. When a  customer uses a prime broker to clear and settle his trades, the executing  broker remains responsible for obtaining a locate, marking the trade long  or short, and executing the trade. The prime broker is responsible for  delivering securities in time for settlement, whether or not it relies on the  customer’s source of securities. Therefore, according to FINRA and  industry officials, manipulative naked short selling is likely to occur only  to the extent that the prime broker agrees to fail to deliver securities on  time and keep FTD open. According to industry officials, prime brokers  will only look to the customer’s source of a locate for delivery if the prime  broker cannot otherwise obtain the necessary shares for delivery.
Both Trading and Markets and FINRA staffs said that the preborrow  penalty specified in Regulation SHO and the temporary rule provides the  clearing broker-dealer with a strong financial incentive to close out FTD as  required by the rules. However, before SEC issued the temporary rule in  September 2008, Regulation SHO’s close-out requirement applied only to  threshold securities (and only after the FTD had been open for 13  consecutive days). Furthermore, FTD in nonthreshold securities never had  to be closed out. As a result, under Regulation SHO, FTD resulting from  naked short sales could persist for many days. Under the temporary rule,  subject to certain exceptions, if a clearing firm is unable to close out FTD  resulting from a short sale on the morning of T+4 in any security, or, for  FTD resulting from long sales or bona fide market making on T+6, the  clearing firm cannot execute additional short sales in that security for any  of its customers or its proprietary account, unless it first preborrows (or  arranges to borrow) the security. The temporary rule allows the clearing  firm to avoid the preborrow penalty to the extent that it can identify any  introducing broker-dealer(s) that have contributed to the FTD, by  allocating the close-out and preborrow obligations to those broker-dealers.  Industry officials and FINRA staff told us that clearing broker-dealers  generally do not allocate FTD in this manner. Instead, they told us that  clearing broker-dealers may choose to finance the costs of closing out  FTD, or preborrow the securities if they cannot, and allocate those costs  among their customers. Several clearing broker-dealers told us that they  allocate these costs to their customers with open short positions.
Hedge fund officials with whom we spoke said that FTD create friction  with prime brokers because the hedge funds rely on the prime brokers to  obtain and deliver shares on time. They said that resolving FTD is costly  and time-consuming because traders must spend time with the hedge  fund’s operations group to reconcile the trade. To the extent that the  prime broker cannot identify the customer responsible for the FTD, hedge  fund officials said that at times they have been allocated the costs of  closing out FTD for which they believe they were not responsible. These  officials said that if a hedge fund identifies settlement failures at a  particular prime broker, it typically will reduce its activity at that prime  broker or stop using it altogether.
section_title: Regulators Acknowledge the Potential for Intrasettlement Manipulation, and Are Continuing to Assess Whether a Preborrow Requirement Would Be Appropriate
paragraphs: Trading and Markets and FINRA staffs acknowledged the potential for  market manipulation within the T+4 time frame. FINRA officials explained  that a fraudulent short selling scheme could occur even in situations  where market participants or customers are fully compliant with the  locate rule and no FTD develop on settlement day. In such intraday  manipulations, the customer or market participant, after having made a  valid locate, engages in a pattern of short selling activity during a  concentrated period of time, with the specific intent of driving down the  price of a stock for a specific period. The customer or market participant  then purchases shares after the price decline occurs to cover its short  position for a profit. Because the purchase and sale activity nets out to  zero, no FTD develop on settlement day as a result of this activity.
Trading and Markets and FINRA staffs said that those securities that are  most vulnerable to such short selling abuse would be thinly traded, highly  illiquid, and have a relatively low number of total shares outstanding. They  said that securities that have many total shares outstanding and are very  liquid are more difficult to manipulate, because the trader would have to  effect very large and numerous short sale orders to create downward  pressure on the price. FINRA staff said that a marketwide preborrow  requirement would likely increase the overall costs of short selling,  including the costs to effect an intraday market manipulation, but it would  not necessarily eliminate this type of misconduct.
Trading and Markets staff also told us that the costs of a marketwide  preborrow requirement to address FTD, manipulative naked short selling,  or market manipulation occurring within the T+4 time frame might  outweigh any potential benefits, especially considering that the vast  majority of trades settle on time. After the July emergency order, OEA  staff conducted an analysis of the impact of the order to understand the  potential economic trade-offs of a preborrow requirement. To address  these questions, OEA examined how various measures hypothesized to be  affected by the order evolved over time for the securities of the 19  financial firms subject to the order. OEA then compared the experience  of these securities with that of two control samples that were not subject  to the order: one control sample consisted of other financial securities,  and the other sample consisted of large nonfinancial securities. OEA’s  results suggested that imposing a preborrow requirement may have had  the intended effect of reducing FTD, but also may have resulted in  significant costs to short sellers.
First, OEA found that short selling declined more for the securities in the  July emergency order than for securities in the two control groups—by  almost 9 percent of volume. Second, OEA’s analysis showed large, but  temporary, initial increases in securities lending rates, as measured by  rebate rates, followed by rates still higher than before the order. The  rebate rate reflects the portion of interest the lender earns on the  borrower’s collateral that the lender agrees to pay the borrower. The  lower the rebate rate, the higher the securities lending rate. OEA found  that rebate rates for these securities over the review period declined by  1.56 percent, from 1.8 percent to 0.24 percent. However, OEA found that  the rebate rates dropped significantly in the first day of the July order, on  average below negative 1 percent. Rates recovered to above zero before  the end of the order, but were still well below their preorder levels by the  end of the review period.
OEA also found that significant reductions in FTD were associated with  the emergency order—the level of FTD in the securities of the 19 firms  declined from 2.8 million to 1.0 million during the order, or about 64  percent. New FTD in these securities declined by about 78 percent, from  an average of 1.8 million shares per day to 0.4 million shares per day.
OEA concluded that the order appeared to have been effective at reducing  and preventing FTD, but it noted that the success came with significant  trade-offs, most notably a large increase in lending fees and a large decline  in short sales. OEA also noted that the securities included in the order had  relatively large market capitalization, traded in a liquid market, and tended  to be easy to borrow. Consequently, OEA cautioned that the results may  not be fully indicative of how a preborrow requirement might affect  markets if applied on a broader scale. Specifically, OEA said that similar  requirements imposed on smaller, more illiquid, or hard-to-borrow  securities might cause a significantly larger disruption to short selling and  to liquidity.
Trading and Markets staff said that they had received feedback from the  industry on the impact of the temporary preborrow requirement. The  industry commented that the order had a number of unintended  consequences, including forcing shares to be borrowed even when they  are not needed for delivery, thereby decreasing the liquidity of the  securities lending market and resulting in the supply of borrowable shares  being allocated to large broker-dealers, leaving smaller broker-dealers in  certain situations with less ability to borrow shares to effect short sales.  Furthermore, the industry commented that the order impacted the  efficient use of capital because firms were forced to commit their own  capital to preborrow securities. More specifically, according to an industry  trade association, several of its broker-dealer members reported a  reduction in the loan liquidity in some of the securities of the 19 firms,  ranging from an estimated 10 percent to 85 percent, depending on the  security. Instead of borrowing securities on a net basis when they were  required for the settlement date, the preborrow requirement caused  broker-dealers to borrow gross volumes of securities when the securities  were located, resulting in significant overborrowing. According to the  industry trade association, some firms reported additional balance sheet  costs related to financing preborrows, which affected such firms’ efficient  use of capital. The size of such increases to balance sheet costs varied,  with high-end costs of close to $2 billion per day to preborrow securities.  These firms reported that increases to balance sheet costs were lower for  firms that were arranging to borrow (i.e., hold) rather than to actually  preborrow securities prior to effecting the short sales.
As the Commission considers whether to finalize the temporary rule,  Trading and Markets staff said that they are continuing to evaluate the  appropriateness of a preborrow requirement for addressing FTD and  market manipulation related to naked short selling. Separately, SEC is  currently considering other measures that are intended to address abusive  short selling concerns. In April 2009, SEC voted to propose two  approaches to restrictions on short selling. One approach would apply on  a marketwide and permanent basis (short sale price restrictions), while  the other approach would apply only to a particular security during severe  market declines in that security (circuit breaker restrictions). SEC is  currently seeking public comments on these two approaches.
section_title: Regulators Have Categorized Noncompliance with Regulation SHO as Nonsystemic, but the Regulation Presents Some Compliance Challenges
paragraphs: After SEC implemented Regulation SHO, SEC and the SROs took steps to  enforce its requirements—first by conducting a joint sweep examination,  and later by conducting routine and other compliance examinations and  regular surveillances of FTD data. While these examinations have found a  significant number of firms with Regulation SHO compliance deficiencies,  OCIE and SRO staffs told us these deficiencies generally were not  indicative of systemic problems or attempts to manipulate a security.  However, broker-dealers are facing challenges in complying with  Regulation SHO’s requirement to determine whether the locates they  obtain prior to effecting a short sale are reasonable sources for securities  needed at settlement.
subsections: section_title: Although SEC and the SROs Found Noncompliance with Regulation SHO, They Characterized It as Technical and Brought Few Enforcement Actions
paragraphs: SEC and SRO examinations have found that most Regulation SHO  deficiencies by broker-dealers and options market makers appear to be  nonsystemic deficiencies. As of April 1, 2009, two SROs have brought  several compliance actions. Within months of Regulation SHO’s  compliance date and in coordination with Trading and Markets, OCIE,  NYSE, and the former NASD conducted a coordinated sweep examination  of 19 clearing broker-dealers that execute and clear short-sale  transactions. The 19 firms were selected from NASD- and NYSE- generated lists of firms that had aged FTD in threshold securities. The  purpose of the sweep examination was to determine whether firms were  in compliance with Regulation SHO’s locate, close-out, or order-marking  requirements, along with other Regulation SHO requirements. Examiners  also reviewed the adequacy of the firms’ written supervisory procedures  for ensuring compliance with these requirements. These joint sweep  examinations found deficiencies with Regulation SHO requirements at all  19 broker-dealers.
OCIE and SRO examiners told us that they generally did not find evidence  that these deficiencies were part of a deliberate problem or part of  attempts to manipulate a security. For example, deficiencies related to the  close-out requirement generally involved limited instances with a majority  of the firms having failed to deliver in only one or two securities. As a  result of the sweep examination, NYSE brought formal enforcement  actions against four of its members. According to examiners who had  participated in the examinations of these firms, NYSE brought these  enforcement actions because it believed that the firms had been given  adequate time before Regulation SHO went into effect to develop  processes and procedures for compliance with the requirements. OCIE  also found that the most serious finding was that most of the firms did not  have adequate written supervisory procedures to ensure compliance with  Regulation SHO.
Although OCIE does not conduct routine examinations of SRO member  firms for Regulation SHO compliance, OCIE officials stated that between  January 2005 and October 2008, OCIE conducted approximately 90 cause  or broker-dealer oversight examinations that included a review of the  firm’s compliance with Regulation SHO. Of these examinations, 41 had  Regulation SHO-related findings. We reviewed 12 of the 41 examinations  with Regulation SHO findings and found that the findings reported were  similar to those of the 2005 sweep examination. For example, examiners  generally found deficiencies in marking trades or performing an  appropriate locate prior to effecting a short sale in some firms. To assist  OCIE in their examinations, we found that OEA conducted multiple  analyses using NSCC-provided FTD and threshold list data to analyze data  on particular firms. Most recently, as part of a sweep examination, OCIE  stated that it has initiated 4 examinations to assess compliance with the  October 2008 rule changes. To date, SEC has not charged violations of  Regulation SHO in any enforcement actions. However, according to SEC  Enforcement staff, Regulation SHO is largely enforced by the SROs  because of the regulation’s focus on broker-dealer operations.
After the initial 2005 sweep examinations were completed, the SROs  continued to monitor the industry for compliance with Regulation SHO  through routine examinations and electronic surveillance. FINRA  continued to monitor firms for Regulation SHO compliance by  incorporating an assessment of Regulation SHO compliance into three of  its routine examination programs: the Risk Oversight and Operational  Regulation Program, which focuses on clearing firms; the Sales Practice  Examination Program, which focuses on introducing firms; and the  Trading and Market Surveillance Program, which complements existing  automated surveillance.
We reviewed the examination modules for each of the three FINRA  programs. To assess compliance with the locate and order-marking  requirements, the modules direct examiners to use various methods to  select samples of trades for review. For the selected sample, examiners  are directed to review a firm’s supporting documentation—such as locate  logs, trade blotters, position records, and FTD ledgers. Similarly, to  assess whether a clearing broker-dealer appropriately closed out FTD in  threshold securities, examiners are directed to select and analyze a sample  of FTD from the firm’s FTD ledgers. We found that FINRA had taken steps  to update the examination modules to reflect the stricter close-out  requirements of the temporary rule.
According to FINRA data, between January 1, 2005, and December 31,  2008, FINRA conducted 1,124 routine examinations of its members  through the 3 programs. Of these examinations, 302 contained Regulation  SHO deficiencies. FINRA staff stated that they have not detected any  particular trends or patterns in the types of violations that would indicate  systemic abuse, and do not consider the deficiencies found in these  examinations to be egregious. For example, staff found in 1 examination  that locates were not performed for 4 trades out of a sample of 60 trades.  In another example, examiners sampled 10 short sale transactions and  found 1 instance where the amount sold short exceeded the amount  located by 1,000 shares.
In addition to its examination programs, FINRA also uses automated  surveillance to identify firms with close-out obligations for all threshold  securities within a specified period. Specifically, we found that FINRA  runs quarterly reports using FTD data obtained from NSCC to identify all  threshold securities for that quarter and those clearing firms with potential  close-out obligations in those securities—that is, aged FTD in threshold  securities. FINRA staff then contact these firms to determine why the  potential close-out obligation has not been met, and to determine whether  there are any violations of Regulation SHO or whether the aged FTD were  due to legal exceptions. Since the adoption of the temporary rule, FINRA  staff stated that FINRA has updated its surveillances to monitor for FTD in  all securities, and that it runs the surveillance on a bimonthly basis. FINRA  then selects firms identified by this surveillance to contact to determine  why the potential close-out obligation has not been met and to determine  whether there are any violations of Regulation SHO.
CBOE also monitors its membership for compliance with Regulation SHO  through its member firm examinations and surveillances. Between January  1, 2005, and December 31, 2008, CBOE conducted 326 examinations that  included a review of Regulation SHO requirements. Of these examinations,  152 contained some level of apparent Regulation SHO violations (i.e., 140  marking violations, 65 locate violations, and 26 close-out violations). Due  to their nature, the majority of these violations were resolved through  nonformal disciplinary action. CBOE also participated in a 2006 sweep  examination that focused on the options market maker exception to the  close-out requirement for aged FTD in threshold securities that were open  for 13 consecutive days. CBOE staff also have developed surveillance to  help detect noncompliance with the close-out requirements of Regulation  SHO.
Moreover, beginning in early 2005, SRO staff identified multiple traders  that appeared to be using an illegal trading strategy to inappropriately  avoid the close-out requirement of Regulation SHO. These traders were  identified through SRO surveillance and complaints that the SRO received.  As a result of FINRA’s surveillances and investigations, which were  conducted on behalf of the American Stock Exchange (Amex), the  exchange brought two formal disciplinary actions for violations of  Regulation SHO against two options traders. Amex alleged that the  options traders improperly used the market maker exception to engage in  naked short selling without first obtaining a locate, and circumvented the  delivery obligation through various trading schemes. CBOE has also  initiated 26 investigations against member firms for similar apparent  activity. As of February 19, 2009, 7 cases have been presented to the  CBOE’s Business Conduct Committee. CBOE and FINRA staffs stated that  since the above Amex actions regarding two traders became public, this  type of activity appears to have ceased.
section_title: In Part Because SEC Has Not Finalized Guidance, the Industry Has Experienced Some Challenges in Complying with the Locate Requirement
paragraphs: Regulation SHO requires broker-dealers to demonstrate that the sources  on which they rely for locates are reasonable—that is, the broker-dealer  does not have reason to believe that the source will be unable to deliver  shares in time for settlement. Firms are also required to have procedures  or systems in place to determine whether it is reasonable to rely on  customer assurances or an easy-to-borrow list. However, in both the initial  sweep examinations and subsequent oversight and sweep examinations,  OCIE has found that some firms do not have procedures or systems in  place to monitor whether the locate source was reasonable. According to  OCIE examinations, some broker-dealers are not monitoring to determine  whether locates are resulting in FTD because firms do not expect that the  source from which the firm obtained the locate will be the source from  which the firm will obtain shares for settlement. As a result, it may be  difficult for broker-dealers and regulators to determine whether a locate  source is reasonable because the source that provided the locate for past  trades may or may not have been the source from which the clearing  broker-dealer attempted to obtain shares for settlement.
According to SEC and SRO staffs and industry officials the source used to  borrow shares and make delivery can differ from the locate source for  several reasons. The clearing broker-dealer may simply decide to use a  source other than the source used to obtain the locate. For example, a  broker-dealer may decide to use shares from its own inventory instead of  going to the source of its locate, or the locate source provided by the  customer. In addition, the netting process of the clearance and settlement  system may result in a broker-dealer not being required to deliver any  shares or only a portion of the total sold short, thus eliminating the need to  borrow securities or reducing the amount required and potentially  eliminating the need to borrow from the source used to obtain a locate for  a specific trade. The source used to borrow shares also may be different  than the locate source because securities that are available on trade date  may not be available on the settlement date from that locate source, when  borrowing is effected to settle the short sale. Conversely, a source that  may not be able to provide a locate on trade date may have the securities  available to be loaned on the settlement date.
We also found that executing broker-dealers may not always have the  information necessary to make a determination that the locate source  provided by the customer is reasonable. According to FINRA staff and  industry officials, this is most common in prime brokerage transactions  where the customer delivers the securities to the prime broker rather than  to the executing broker for settlement of sell orders. As we have  previously discussed, Regulation SHO requires the executing broker- dealer to locate shares available for borrowing prior to effecting a short  sale. An executing broker may fulfill this requirement by relying on a  customer’s representation that it has obtained the locate from another  source. However, because Regulation SHO does not obligate the clearing  firm—in this case, the prime broker—to provide trade settlement  information to the executing broker, the executing broker may not know  if, at settlement, the prime broker was unable to borrow shares to delivery,  and thus may not have the information necessary to determine whether it  can rely on that customer’s locates for future short sale transactions.
Industry, Trading and Markets, and FINRA staffs said that this information  gap in Regulation SHO could be addressed by clarifying the  responsibilities of the prime broker and executing broker to ensure  compliance with Regulation SHO. In March 2007, Trading and Markets and  industry representatives helped provide this clarification by drafting  revisions to the Prime Broker Letter issued by SEC staff in 1994.  According to the industry officials working with Trading and Markets,  these revisions are intended to enhance communications between the  prime broker and executing broker and to help ensure that the customer is  providing accurate information to the executing broker. Furthermore,  these revisions would provide the executing broker with the information  necessary to make a determination of whether a customer’s assurance is  reasonable.
As of April 2, 2009, Trading and Markets has not yet finalized the revised  Prime Broker Letter to make it effective. Trading and Markets staff said  that because SEC still is evaluating comments on the temporary rule and it  remains subject to modification, they cannot sign the letter. According to  these staff, the draft letter reflects Regulation SHO as adopted, and  officials need to review the letter to determine whether any adjustments  are necessary to reflect the provisions of the temporary rule, if it is  adopted as final. The letter was revised in March 2007, prior to the  issuance of the temporary rule in September 2008, and the information gap  has existed since Regulation SHO became effective in January 2005.
Without access to the information from prime brokers that would allow  them to establish whether customer-provided locates are resulting in FTD,  executing broker-dealers may not be able to achieve compliance with  Regulation SHO. In addition, this information gap may create the  perception that prime brokerage customers—typically, hedge funds or  large investors—are allowed to circumvent Regulation SHO and naked  short sell. SEC has said on several occasions that the perception that FTD  may be indicative of manipulative naked short selling can damage investor  confidence and the stability of the market. By completing its review and  finalizing the revised 1994 Prime Broker Letter, SEC can ensure that this  information gap is closed, and that the parties responsible for executing  and clearing and settling trades (1) establish the communication processes  necessary to comply with Regulation SHO and (2) make the appropriate  determinations about customer-provided locates.
section_title: Regulators Use Complaint Information, Surveillance, and Examinations to Identify Potential Manipulative Short Selling, but It Is Difficult to Prove Manipulation
paragraphs: Regulation SHO compliance violations do not necessarily indicate that  manipulative naked short selling has occurred. If examiners identify  indications of potential manipulative trading, OCIE or FINRA can pursue  further investigation or refer the case to their respective Enforcement  divisions for further investigation. For example, we reviewed one OCIE  examination where possible Regulation SHO violations led to such a  referral. As we have previously discussed, regulators have found  Regulation SHO deficiencies to be nonsystemic and not indicative of abuse  or attempts to manipulate individual securities. SRO staff stated that  Regulation SHO is effective from an examination and enforcement  perspective because it specifically identifies the parties responsible for  obtaining a locate or closing out FTD and identifies when each of these  responsibilities is to be completed. Furthermore, because Regulation SHO  was designed to curb manipulation facilitated by naked short selling and  address large and persistent FTD by imposing operational requirements on  regulated entities, the SROs are able to bring regulatory actions against  their members for Regulation SHO violations.
SEC and the SROs rely on complaints, tips, and electronic market  surveillance, among other things, to identify suspicious trading activity,  including potential instances of manipulative naked short selling.  Enforcement staff stated that while it is not difficult to determine whether  there are FTD in a security, they have found through their experiences and  discussions with the SROs that FTD are not a proxy for manipulative  conduct and do not provide regulators with much information regarding  possible manipulation. For example, a FTD could occur, but that  information alone does not tell a regulator whether there was intent to fail  to deliver or whether an appropriate locate was conducted. Also, as we  have previously discussed, FTD may result from long or short sales. To  determine if a trader was successful in manipulating the market through  naked short selling, regulators must unwind FTD and trading activity,  which requires considerable analysis of trading data and other supporting  documentation, such as e-mails, and reliance on large amounts of  circumstantial evidence. Furthermore, according to Enforcement and  FINRA staffs, manipulation investigations, including manipulative naked  short selling, are complex matters and the standard of proof, especially  proving intent, to prevail in an enforcement action is high. Enforcement  stated that quantifying the amount of manipulative activity, including  manipulative naked short selling, that occurs in the market is difficult.
According to FINRA, most market manipulation is identified through  activities of the market surveillance divisions at the SROs that review  market activity for aberrant price and volume movement in the security  that can suggest manipulation. The SROs have established electronic  surveillance systems that generate an alert if a security’s price or volume  of shares traded, among other things, moves outside of set parameters.  These price and volume movements can indicate a number of illegal  trading practices, including manipulative naked short selling. A significant  factor in determining whether an aberrant movement was a case of  potential manipulative naked short selling is if a FTD appears at NSCC 3  days after the aberrant movements. SRO staff review thousands of alerts  annually to identify those that are most likely to involve fraud or warrant  further investigation on the basis of a variety of factors, such as profit  potential and news related to the security. In the course of a full  investigation, the SROs gather information from their member broker- dealers, including the names of individuals and organizations that were  active in trading during the time in question. When an SRO finds evidence  of illegal trading involving its members, it can conduct disciplinary  hearings and impose penalties ranging from disciplinary letters to fines to  expulsion from trading and SRO membership. Because the SROs do not  have jurisdiction over entities and individuals that are not part of their  membership, they refer suspicious trading on the part of nonmembers,  including customers, directly to SEC Enforcement.
section_title: SEC Is Considering Finalizing the Temporary Rule by July 2009, but Implementation Issues and Inconsistent and Untimely Provision of Guidance Concern the Industry
paragraphs: Industry officials said that the stricter close-out requirements imposed  through the September emergency order and the temporary rule have  resulted in several unintended negative consequences on security prices  and securities lending. Trading and Markets staff said they are reviewing  these concerns to determine whether any changes to the requirements are  warranted before the Commission considers finalizing the rule by July  2009. The industry also has experienced operational issues in  implementing Regulation SHO and the temporary rule, but Trading and  Markets responsiveness to industry requests for guidance on these issues  has been mixed.
subsections: section_title: Although Generally Supportive of SEC’s Efforts to Prevent Abusive Naked Short Selling, Industry Officials Said That New Close-out Requirements Have Raised Operational Issues
paragraphs: According to several comment letters submitted to SEC on the temporary  rule, the industry generally supported the fundamental tenets of the  temporary rule, including a compressed mandatory close-out obligation  for all equity securities. However, industry commenters cited several  negative consequences that resulted from the temporary rule, noting that it  potentially contributed to market volatility and price spikes at market  open and to instability in the securities lending market. Industry  commenters said that the requirement that broker-dealers close out FTD  by the opening of trading on T+4 (for short sales) or T+6 (for long sales or  bona fide market maker sales) inadvertently contributes to increased  market volatility and price spikes at market open. For example, a large  industry group’s comment letter referenced 40 instances in which these  close-out requirements potentially created significant but temporary  upward pressure on the price of certain hard-to-borrow optionable  securities at the opening of trading. According to this letter, the price of  these securities opened trading at least 15 percent above the previous  night’s closing price, but prices receded back to approximately the  previous night’s closing price within 30 minutes.
Industry officials also said that the new close-out requirements are having  a negative impact on the efficient operation of the securities lending  market, leading potentially to reduced inventory of shares available for  borrowing, increased borrowing costs, and reduced liquidity. According to  an industry group comment letter, when a security that is out on loan is  sold, the lending agent will first attempt to reallocate the loan by  identifying other customers with shares available for lending. If that effort  is not successful, the lending agent must recall the loaned shares from the  borrower. The comment letter continues by explaining that the recall is  typically done through a written notice and takes place 1 or 2 days after  the trade, with the majority of the notices issued 2 days after the trade.  The borrower then has 3 full days to return the securities—in effect, until  the end of T+5. According to the comment letter, when the lending agent  receives the shares late on T+5, it returns the shares to the lender or its  agent, which must then deliver the shares for settlement. In many cases,  the ultimate delivery of shares will not be processed until the morning of  T+6. Under the temporary rule, FTD resulting from long sales—which  include the sale of securities out on loan—are required to close out by the  opening of trading on T+6. According to some comment letters and  industry officials, this requirement leaves little or no time for securities  lenders to deliver recalled shares in time to avoid being bought in at the  opening of trading on T+6. Furthermore, two large industry trade groups  commented that most current broker-dealer and clearing firm systems are  unable to differentiate between FTD that resulted from long sales versus  FTD that resulted from short sales, with one stating that any  differentiation requires extensive manual processing that typically cannot  be completed by the opening of trading on T+4. As a result, some industry  comment letters and officials stated that some broker-dealers are closing  out all FTD on T+4, regardless of whether they are the result of a long or  short sale, which further increases securities lenders’ risk of being bought- in and causes some lenders to exit or reduce their participation in the  market.
To resolve these concerns, several industry officials recommended that  SEC require broker-dealers to close out all FTD, regardless of whether  they result from long or short sales, by the close of trading on T+6. These  commenters said that doing so would allow for those FTD that occur for  processing reasons to be cleared up without the need to borrow and  deliver or buy-in FTD. Furthermore, they said closing out all FTD by the  close of trading on T+6 also would eliminate the need for broker-dealers to  engage in complex; time-consuming; and, at times, imperfect processes in  an effort to determine whether a FTD was due to a long or short sale,  because all FTD would be treated the same. Several industry officials with  whom we spoke also stated that it may not be possible to build systems  capable of differentiating between FTD that resulted from long sales  versus FTD that resulted from short sales prior to the opening of trading  on T+4. However, because they are unsure about what the requirements  will be after the rule is finalized, industry officials told us they are not yet  attempting to build these systems.
Some industry commenters also recommended that SEC change the close- out requirement to allow clearing broker-dealers to close out their FTD  throughout trading on the required close-out day, instead of only in the  morning at market open. According to one industry comment letter from a  large industry trade group, as a practical matter, transactions effected at  market open to close out FTD are no different than those effected later in  the trading session because both types are part of the same clearance and  settlement cycle. As such, the group said that this change would allow  clearing broker-dealers to close out FTD as currently intended by the  temporary rule, but eliminate the volatility and price spikes associated  with all FTD being required to close out prior to or at the opening of  trading.
Although SEC and FINRA acknowledge that the industry may be required  to make system changes to comply with the requirements of the temporary  rule, they believe the industry is capable of accomplishing these system  changes necessary for compliance. According to OCIE staff, during a  recent sweep examination of prime brokers they found that one broker  had already developed the capability of tracking its FTD back to the trade  that caused the FTD and then identifying whether that trade was marked  long or short. Examiners conducting these sweep examinations also stated  that the prime brokers they reviewed are able to identify the customers  that are failing to deliver to the prime brokers, and that determining  whether a trade was marked as long or short would most likely not require  much additional effort. However, they did note that each firm probably  will have a different infrastructure with which to work so each firm’s  implementation of the requirements may be unique. Trading and Markets  staff also said that while they are considering all of the comment letters  and proposed amendments to the rule, any change to extend the current  T+4 buy-in date for FTD resulting from short sales expands the time frame  in which manipulative naked short selling could occur, potentially  undermining the Commission’s policy objective of curbing this type of  abuse.
section_title: Trading and Markets Responses to Industry Requests for Guidance Were Sometimes Inconsistent during Regulation SHO and the Emergency Orders or Were Not Timely
paragraphs: SROs and industry officials noted that SEC staff were responsive to some  requests for implementation guidance regarding Regulation SHO and the  recent emergency orders; however, in some instances where complex  issues have arisen or the application of the rules to a particular scenario  was unclear, industry officials and staff from one SRO with whom we  spoke said that other requests went unanswered or experienced lengthy  delays. Staff from one SRO said that Trading and Markets has issued  numerous guidance and interpretive products and continuously updated  these products. Trading and Markets can provide interpretive guidance to  the SROs and industry through a number of publications, such as  exemptive orders, no-action letters, compliance guides, staff legal  bulletins, and answers to frequently asked questions. However, Trading  and Markets staff do not have a formal (i.e., written) process to determine  when requests from industry and SROs merit a formal response. Instead,  staff have discretion to determine when SRO and industry request merit  such a response. Staff from another SRO noted that SEC worked with  them to approve an appropriate methodology to use to assess Regulation  SHO exemption determinations. SRO staff told us that because the SROs  do not have the authority to independently issue interpretative guidance  on SEC rules, they must obtain this guidance from SEC for their own and  members’ consideration when necessary. The SRO staff cited an occasion  when they attempted to put guidance in a compliance circular that used  SRO interpretations to answer specific questions it or its membership had  regarding Regulation SHO. This SRO was delayed in providing the  guidance to its members because of the time that passed before SEC  provided feedback on whether the SRO’s interpretations were correct. In  this example, the SRO submitted a list of technical operational questions,  ranging from basic questions about the close-out requirement to  hypothetical situations that were described to elicit the meaning of certain  phrases to Trading and Markets. Although communication took place  between the SRO and SEC, an extended period of time passed between the  initial document being submitted to Trading and Markets and the SRO  providing answers to its members. The SRO also stated that in some  instances in which it had asked for guidance, Trading and Markets told the  SRO that the regulation was clear and no additional guidance was  necessary.
Industry officials with whom we spoke also stated that the SEC staff’s  responses to their requests for implementation guidance, particularly for  recent emergency orders, have been inconsistent. Several market  participants said that because Regulation SHO was enacted after a lengthy  comment period and firms were given many months to put systems and  policies and procedures in place, many of the potential implementation  issues were discovered and resolved prior to the regulation being  enforced. However, the July and September emergency orders and the  temporary rule were made effective the day they were issued, or soon  thereafter, with little or no advanced warning. According to some industry  officials, these orders required system changes, some on a global basis,  and numerous implementation issues arose. Industry officials said that, in  some cases, they were able to work quickly with Trading and Markets to  resolve these issues. For example, 3 days after the July emergency order  restricting short selling securities of certain financial firms, SEC amended  the order to exempt bona fide market making from the requirement.  Nevertheless, industry officials stated that, in other situations, SEC was  not responsive to their requests for guidance. For example, industry  officials stated that due to the rushed nature of the September emergency  order and the temporary rule, there was a lot of uncertainty and confusion  related to the scope and application of the new requirements. Although  some issues were addressed promptly, other industry requests for  clarification or additional guidance remained unresolved.
Trading and Markets staff stated that they did not believe issuing formal  guidance was appropriate for some of the requests for interpretive  guidance on Regulation SHO, because they felt the regulation was clear or  that the request was more for a change of rule that would require going  back to the Commission than an interpretation. Trading and Markets staff  also told us that they did not want to provide answers to some of the  requests that asked for guidance in specific circumstances, because they  felt such requests were attempts to find loopholes in Regulation SHO,  rather than attempts at compliance. These staff stated that because the  temporary rule is set to expire on July 31, 2009, they are focused on  reviewing and analyzing the written comments received to provide a  recommendation to the Commission about the final form of the rule. They  also said that providing the industry with guidance on a rule the  Commission is still attempting to finalize would be difficult, and that the  staff do not have a process by which implementation issues that arise from  temporary rules can be readily addressed. Furthermore, responding to  some of the implementation issues could have potentially required  changes to the temporary rule, something that Trading and Markets is not  authorized to do.
By the time that the Commission takes final action on the temporary rule,  it will have been in effect for 10 months, during which time the industry  may have been inconsistently implementing its requirements. Trading and  Markets’ varied and, at times, untimely responsiveness to industry and  SRO requests for interpretive guidance on Regulation SHO and the  emergency orders conflict with the goals articulated in SEC’s current  Strategic Plan. The plan states that SEC should write regulations that are  clearly written, flexible, and relevant and do not impose unnecessary  financial or reporting burdens. One potential measure for monitoring  progress the plan outlines is the length of time to respond to no-action  letters, exemptive applications, and interpretive requests. The Strategic  Plan also states that as part of its efforts to ensure compliance with  federal securities laws, SEC should work to enhance its interpretive  guidance process to meet the needs of the staff, the public, and other  external stakeholders. Without timely and clear interpretive guidance from  SEC, SROs may be unable to effectively enforce SEC rules and regulations,  and SEC cannot ensure the consistent implementation of the rules and  regulations.
section_title: Conclusions
paragraphs: FTD may undermine the confidence of investors, making them reluctant to  commit capital to an issuer that they believe to be subject to such  manipulative conduct. While our review of FTD data showed that the  majority of securities graduated from the threshold list in a timely manner,  we also found that about 80 percent of threshold securities returned to the  list, and some securities persisted for considerable periods of time. We  recognize that there are legitimate reasons why a security could persist on  the threshold list, but the cause for extended FTD in any individual  security only can be assessed through regulatory scrutiny and generally is  not apparent to the investing public, which may have concerns that  securities on the threshold list are the target of manipulative naked short  selling.
With the requirements of the temporary rule, SEC has made progress in  facilitating the goal that all sellers of securities should promptly deliver, or  arrange for delivery of, securities to the respective buyer, and that all  buyers of securities have a right to expect prompt delivery of securities  purchased. Of the threshold securities remaining in December 2008, about   50 percent were ETFs. SEC and SRO staffs have begun assessing the  reasons for FTD in these securities, and they believe structural  characteristics in the creation and redemption of these securities are a  critical factor. While these staff said their assessments do not currently  lead them to believe that these securities are vulnerable to manipulative  naked short selling, continued scrutiny of these products should help SEC  confirm this assessment and determine whether Commission action is  needed to address the causes for FTD in these products.
Although Trading and Markets staff are continuing to study the effects of  the temporary rule, they and FINRA staff believe that the locate and close- out requirements of Regulation SHO, and particularly the enhanced close- out requirements of the temporary rule, have made it less likely for traders  to effect short sales that result in persistent FTD. While we agree that the  close-out requirements of the temporary rule likely have reduced the  opportunity to create persistent FTD and, thus, the incentive to engage in  manipulative naked short selling, some potential for this illegal conduct  still may exist. In response to an alternate suggestion to implement a  marketwide preborrow requirement, Trading and Markets and FINRA  staffs said such a requirement might be costly to the industry because FTD  represent a very small percentage of the dollar value of trades and only a  small group of securities would likely be the target of any manipulative  scheme. However, Enforcement and FINRA staffs said that market  manipulation is difficult to detect and successfully prosecute, and the  potential damage to an individual company could be severe. For these  reasons, an important element of continued evaluation of the effects of the  temporary rule will be a careful evaluation of whether the T+4 close-out  requirement is sufficient to protect the most vulnerable firms from market  manipulation.
Another potentially important aspect of any SEC determination regarding  whether to continue to rely on the current locate and close-out  requirements for mitigating manipulative short selling will be an  evaluation of the effectiveness of the current locate requirement in  reducing FTD and the potential for market manipulation, with a particular  focus on the reliability of easy-to-borrow lists—that is, these lists must  represent securities that are available for borrowing. Regulation SHO  lacks specific criteria regarding what constitutes an easy-to-borrow  security, but SEC found that a few firms have not followed industry best  practices, which call for decrementing their inventory as locates are  provided. We note that unless firms follow such best practices, it is not  clear how they can ensure that they are providing locates only on their  available supply of securities and limiting the potential for FTD. However,  because following industry practice is voluntary, the magnitude of firms  overlocating or including securities that are not easy to borrow on the list  is currently unclear.
Our review also found that the industry currently faces challenges in  complying with Regulation SHO’s requirement to assess whether locates  provided by customers are reasonable and not resulting in FTD,  particularly in the context of prime brokerage. Regulation SHO currently  does not provide executing brokers with access to information from prime  brokers that would allow them to establish whether customer-provided  locates are resulting in FTD. Although SEC worked with the industry to  revise the 1994 Prime Broker Letter in 2007, it has not completed its  review of the letter, citing its need to wait until the Commission  determines whether to finalize the temporary rule. By finalizing the revised  Prime Broker Letter, SEC would provide the means by which executing  brokers could evaluate customer-provided locates to determine whether  they are reasonable and thus comply with the locate requirement.  Moreover, finalized guidance would help alleviate investor concerns that  such conduct could occur.
In implementing the new close-out requirements though emergency order  and extending them through a temporary rule, SEC imposed requirements  on the industry without first providing for the usual comment period. In  their comment letters, market participants generally supported the  fundamental tenets of the temporary rule, including a compressed  maximum close-out obligation for all equity securities; however, they also  have identified several operational issues and negative consequences  caused by the implementation of the temporary rule. According to Trading  and Markets staff, they had been unable to respond to some of these issues  raised by the industry because the requirements were issued as a  temporary rule and certain changes would require a rule change approved  by the Commission. Furthermore, Trading and Markets staff said that it  would be difficult to provide guidance to the industry about other issues  until the Commission determines whether to finalize the temporary rule,  which potentially will not occur until July 2009. We recognize that Trading  and Markets staff currently may have limited ability to resolve issues  arising from the implementation of a temporary rule without obtaining  input or authorization from the Commission. Without a formal process in  place that would give Trading and Markets staff a basis upon which to  address implementation issues that arise in connection with interim final  temporary rules in a timely manner, staff are unable to respond adequately  to concerns of industry participants affected by the rule. Moreover, while  providing formal responses to all requests for interpretive guidance may  not be appropriate, establishing a formal process would provide a basis for  consistently addressing matters relating to compliance with SEC  regulations. Doing so also would help prevent negative impacts from  temporary rules in the periods before expiry or finalizations. Furthermore,  providing timely answers to SRO and industry requests is important for SROs and industry to help ensure consistent implementation of SEC rules  and regulations.
section_title: Recommendations for Executive Action
paragraphs: To address the current information gap in Regulation SHO for prime  brokerage arrangements and mitigate the impact of any unintended  consequences caused by SEC rules, as well as ensure consistent  implementation of SEC rules by the industry, we recommend that the  Chairman of the Securities and Exchange Commission take the following  two steps:  finalize, in an expedited manner upon finalization of the temporary rule,  the revised 1994 Prime Broker Letter and   develop a process that allows Commission staff to raise and resolve  implementation issues that arise from SEC regulations, including interim  final temporary rules, in a timely manner.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of the report to the Chairman of the Securities and  Exchange Commission for her review and comment. We also provided  relevant portions of the report to FINRA and CBOE for their review and  comment. We received technical comments from SEC, FINRA, and CBOE,  that were incorporated, where appropriate. SEC provided written  comments that we reprinted in appendix IV.
In its written comments, SEC stated that regarding our first  recommendation, it will consider the need to clarify the communications  between prime broker-dealers and executing broker-dealers that would  facilitate Regulation SHO compliance in connection with its consideration  of further action on the temporary rule. We encourage SEC to take the  steps necessary to clarify this communication. In doing so, SEC would  provide the means by which executing brokers could evaluate customer- provided locates to determine whether they are reasonable and facilitate  compliance with the locate requirement. Moreover, finalized guidance  would help alleviate investor concerns that such relationships could be  exploited to engage in manipulative naked short selling. Regarding our  second recommendation, SEC noted that it regularly provides guidance to  the industry and outlines that routine rulemaking provides a time for  comments prior to the adoption of the final rule. It also noted that, unlike  routine rulemaking, when SEC promulgates a rule or regulation as an  interim final temporary rule, the rule is adopted and in effect during the  comment period. SEC stated that it is committed to engaging in a  deliberative process to develop meaningful regulation of short selling and  providing interpretive guidance to the industry to facilitate  implementation, as appropriate. SEC also stated that it will evaluate  whether there are additional steps that it can take, consistent with the  Administrative Procedure Act, to address implementation issues raised by  industry. Again, we encourage SEC to take the steps necessary to  determine what additional steps can be taken to address implementation  issues raised by the industry and SROs, especially regarding interim  temporary final rules, which can be in effect for significant periods of time.  While providing formal responses to all requests for interpretive guidance  may not be appropriate, establishing a formal internal process consistent  with the Administrative Procedure Act to facilitate providing timely  answers to SRO and industry requests would help ensure effective  administration of SEC rules and regulations. Furthermore, a formal  process would help reduce the chances of negative consequences of  temporary rules occurring during the periods before expiry or  finalizations.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution until 30 days from the report date.  At that time, we will send copies to interested congressional committees,  the Chairman of the Securities and Exchange Commission, and other  interested parties. The report also will be available at no charge on the  GAO Web site at http://www.gao.gov.
If you or your staffs have any questions about this report, please contact  me at (202) 512-8678 or williamso@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs can be found on the last  page of this report. Key contributors to this report are listed in appendix V.
section_title: Appendix I: Scope and Methodology
paragraphs: To provide an overview of the actions that the Securities and Exchange  Commission (SEC) has taken to address manipulative naked short selling  and failures to deliver (FTD), including Regulation SHO and the recent  emergency orders—and the factors SEC considered in taking these  actions, we reviewed Regulation SHO; the recent July and September 2008  emergency orders, including associated amendments; and the interim final  temporary rule (temporary rule) and interviewed staff from SEC’s Division  of Trading and Markets (Trading and Markets). We also obtained copies of  related rules issued by the former NASD.
To discuss the potential impact of Regulation SHO on FTD in threshold  and nonthreshold securities using trend analysis, we obtained (through  SEC) FTD data that the National Securities Clearing Corporation (NSCC)  generated from April 1, 2004, to December 31, 2008. We chose to obtain  data going back to April 1, 2004, because we wanted to identify any trends  in FTD prior to the effective date of Regulation SHO in January 2005, and  because April 1, 2004, was the earliest date SEC began receiving FTD data  from NSCC. We also obtained the daily lists of threshold securities  published by the equities self-regulatory organizations (SRO) from   January 10, 2005 (the date the first threshold list was published), through  December 31, 2008.
From these data, we generated a number of graphics to illustrate trends in  threshold securities, including the number of threshold securities and the  level of outstanding and new FTD in these securities, both across the  market and by individual markets. We generated other descriptive  statistics from the data on threshold securities, such as the number of  securities that had persisted for more than 90 days on the threshold list  over this period. In addition, we generated graphics illustrating trends in  FTD in all equity securities across the market and, by individual market,  from April 1, 2004, through December 31, 2008. In performing our analyses,  we conducted a data reliability assessment of the NSCC data. To do so, we  reviewed a 2005 SEC Office of Compliance Inspections and Examinations  (OCIE) examination that, in part, assessed NSCC’s processes for  generating reports that are used to provide daily FTD data to SEC and the  equities SROs. We also employed our own data reliability tests by taking a  random sampling of trading dates and verifying that the listing of threshold  securities provided to us by SEC matched those published by the New  York Stock Exchange (NYSE), NASDAQ, and the American Stock  Exchange (Amex). In addition, we reviewed these data for missing values  and outliers as well as for the accuracy of pricing information. We  determined that these data were reliable for our purposes. As part of our  work, we also obtained and reviewed multiple studies of the same data  conducted by SEC’s Office of Economic Analysis (OEA).
We also compared total new FTD in threshold securities listed on the  NYSE, NASDAQ, and Amex with consolidated trading volume on those  exchanges. We obtained consolidated trading volume data for all three  exchanges from the Financial Industry Regulatory Authority (FINRA). In  addition, we compared trends in FTD in these markets with trends in  volatility, as measured by the Chicago Board Options Exchange (CBOE)  Volatility Index (VIX); market performance, as measured by the S&P 500  Total Return Index; and short interest. We obtained the VIX from Yahoo!  Finance, the S&P 500 Total Return Index from Global Insight, and short  interest from the midmonth short interest press releases from the three  major exchanges. We did not conduct an assessment of the reliability of  these measures. However, these sources are widely used in both finance  and economics and are considered credible for the purposes in which we  used them. In addition, these measures are used solely for descriptive  purposes and not for the purpose of making recommendations or drawing  conclusions about causality. We also identified the percentage of  threshold securities in our review period that were exchange-traded funds  (ETF). To identify these securities, we downloaded lists of ETFs from four  separate sources—including Morningstar, Yahoo! Finance, MSN Money,  and Bloomberg—and compared these lists to identify any differences. We  found that differences between the sources amounted to less than 3  percent of ETFs appearing on each respective list. To have the most  comprehensive list, we included ETFs that appear on at least three of  these four sources. We have determined that these data were reliable for  our purpose, which was to provide descriptive information.
To discuss regulatory, industry, and other market participant views on the  effectiveness of Regulation SHO and the recent emergency orders in  curbing the potential for manipulative naked short selling, we reviewed  and analyzed the requirements of Regulation SHO, the recent emergency  orders, the temporary rule, and comment letters submitted to SEC. We  also reviewed the results from an OEA study on the impact of the  temporary preborrow requirement on the market in the July emergency  order. While we found the results were based on a reasonable  methodology, we note that is difficult to draw strong conclusions given a  number of limitations, including the temporary nature of the emergency  order. We also reviewed two private sector studies to better understand  market trends during and after the implementation of the July emergency  order. We did not evaluate or validate their findings because these private  sector studies were reviewed primarily to provide additional descriptive  information beyond the OEA study, and because neither conducted a  rigorous causal investigation. In general, the inclusion of the OEA and  private sector studies is purely for research purposes and does not imply  that we deem them definitive. Furthermore, we obtained and reviewed  comment letters submitted to SEC about Regulation SHO, the emergency  orders, and the temporary rule. Finally, we conducted interviews with  staffs from OEA, Trading and Markets, OCIE, SEC’s Division of  Enforcement, and FINRA; broker-dealers and two trade associations  representing broker-dealers; securities lenders and a trade association  representing securities lenders, securities lending consultants; an issuer  and a trade association representing issuers; an investor; legal and subject  area experts; and other market observers.
To analyze SEC and SRO efforts to enforce industry compliance with  Regulation SHO and to detect manipulative naked short selling, we  reviewed a 2005 joint sweep examination that OCIE, NYSE, and the former  NASD conducted. We obtained data from FINRA and CBOE on the  number of Regulation SHO-related examinations that they conducted  during calendar years 2005 through 2008, and the number of these  examinations that resulted in Regulation SHO deficiencies. We conducted  a data reliability assessment of the FINRA and CBOE data and determined  they were reliable for our purpose. We also reviewed FINRA data on the  periodic surveillance sweeps of FTD data that the authority conducted  during this period to monitor its members for potential Regulation SHO  violations. We obtained data from OCIE on the oversight and cause  examinations conducted from January 1, 2005, through September 30,  2008, that reviewed for Regulation SHO compliance. We conducted a data  reliability assessment of these data and determined they were reliable for  our purpose. From these data, we selected and reviewed 12 OCIE broker- dealer oversight or cause examination reports and 11 FINRA examination  reports that resulted in findings of Regulation SHO deficiencies. We also  reviewed a 2006 sweep examination conducted by CBOE of its options  market makers, FINRA examination guidance, and the revised 1994 Prime  Broker Letter. We conducted interviews with staffs from OCIE,  Enforcement, FINRA, CBOE, and NYSE, and with broker-dealers and a  trade association representing broker-dealers.
To discuss industry experience regarding the implementation of the new  and enhanced close-out requirements, we reviewed industry comment  letters submitted to SEC, documentation related to SRO requests to SEC  for guidance, and the 2004-2009 Strategic Plan. We also interviewed  broker-dealers and a trade association representing broker-dealers;  securities lenders and a trade association representing securities lenders;  securities lending consultants; and staff from Trading and Markets and an  SRO.
We conducted this performance audit from March 2008 through May 2009  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix II: Clearing Agencies Settle Equity Securities Trades through a 3-Day Settlement Cycle and Continuous Net Settlement
paragraphs: According to the Depository Trust and Clearing Corporation (DTCC), most  broker-to-broker equities securities trades in the United States are cleared  and settled through its clearing agency subsidiaries, NSCC and the  Depository Trust Company (DTC). As a clearing corporation, NSCC  provides clearing and settlement, risk management, central counterparty  services, and guarantee of trade completion in the event of a participant’s  default. As the central security depository and custodian in the United  States, DTC acts as a custodian for the majority of securities issues and  transfers ownership, in book-entry form, during settlement.
Due to the volume and value of trading in today’s markets, NSCC nets  trades and payments among its participants, using its Continuous Net  Settlement System (CNS System). The CNS System is a book-entry  accounting system in which each NSCC participant’s daily purchases and  sales of securities, based on trade date, are automatically netted into one  long position (right to receive) or one short position (obligation to deliver)  for each securities issue purchased or sold. The participant’s  corresponding payment obligations are similarly netted into one obligation  to pay or one obligation to receive money. For each participant with a  short position on settlement date, NSCC instructs the securities depository  designated by the participant—typically, DTC—to deliver securities from  the participant’s account at the depository to NSCC’s account. NSCC then  instructs the depository to deliver those securities from NSCC’s account to  participants with net long positions in the security. NSCC provides  participants with multiple daily reports that detail their net long and short  positions in each security. One example of such a report is the CNS  Accounting Summary, which provides NSCC participants with its prior  day’s positions, settling trades during the day, closing positions, and the  market value of its positions. Any unfulfilled net long or short position in a  settlement cycle is carried forward to succeeding settlement cycles.
Figures 10 and 11 illustrate the CNS process. Figure 10 illustrates a series  of transactions between multiple brokers and the resulting CNS position.
Figure 11 illustrates the transactions that occur on settlement day and the  resulting CNS positions. This example assumes that the brokers shown in  the graphic executed no other trades in the XYZ Company’s security.
If a participant fails to deliver the total number of securities that it owes  NSCC on a particular settlement date, NSCC may be unable to meet its  delivery obligations, resulting in a failures to receive (FTR) for  participants who have net long positions. NSCC uses the automated Stock  Borrow Program (SBP) to borrow shares to meet as many of its delivery  obligations as possible. This program allows participants to instruct NSCC  on the specific securities from their DTC account that are available for  borrowing to cover NSCC’s CNS delivery shortfalls. Any shares that NSCC  borrows are debited from the lending participant’s DTC account; delivered  to NSCC; and, subsequently, delivered to a NSCC participant with a net  long position. NSCC creates a right to receive (net long) position for the  lender in the CNS System to show that it is owed securities. Until the  securities are returned, the lending participant no longer has ownership  rights in them and, therefore, cannot relend them. Additionally, any  delivery made using the SBP does not relieve the participant that fails to  deliver from its delivery obligation to NSCC.
Participants with a FTR position not filled through the SBP have three  options for receiving the securities they are owed. First, the participant  can choose to wait for the CNS System to allocate the securities that it is  owed through the normal course of business. Second, the participant can  request that NSCC give its FTR priority in the CNS System. This allows the  participant’s FTR position to be filled with any securities NSCC receives  after all buy-in requests are fulfilled, but before CNS begins allocating  received shares to other participants with net long positions in the  security. Third, the participant can initiate a buy-in. This process requires  the participant to file paperwork with NSCC directing the corporation to  request a net short participant to deliver securities to NSCC and for NSCC  to deliver those securities to the net long participant. If the position  remains unfilled, NSCC instructs the member to buy-in the unfilled  position. NSCC has no authority under SEC rules to force a buy-in. DTCC  officials explained to us that approximately 6,000 notices of intention to  buy-in are filed each day, with approximately 20 notices resulting in  execution. According to these officials, relatively few such notices are  executed because FTD are generally resolved in the normal course of  business.
Trade clearance and settlement in the United States operate on a standard  3-day settlement cycle. On trade date (T), trade details are transmitted to  NSCC for processing. According to DTCC, an estimated 99.9 percent of  equity transactions are transmitted to the clearing agency as “locked-in,”  meaning that the security exchange has already compared the buyer’s  account with the seller’s account of the trade details (e.g., share quantity,  price, and security) and has determined that they match. On the first day  following the trade date (T+1), NSCC assumes the role of central  counterparty by taking on the buyer’s credit risk and the seller’s delivery  risk. On the second day (T+2), NSCC provides summaries of all compared  trades to its participant broker-dealers, including information on the net  positions of each security due or owed for settlement. On the third day  (T+3), securities are delivered and payments of money are made to the  respective parties through NSCC and DTC. Figure 12 summarizes the  clearance and settlement process for equity securities trades in the United  States.
section_title: Appendix III: Additional Trend Data on FTD in Threshold Securities, and All Equity Securities
paragraphs: SEC has taken several actions in recent years that were intended to  address FTD and manipulative naked short selling. In August 2004, SEC  adopted Regulation SHO, which was intended to address large and  persistent FTD and curb the potential for manipulative naked short  selling. Among other things, Regulation SHO imposed delivery  requirements on broker-dealers for equity securities in which a substantial  amount of FTD had occurred, which the regulation designated as  “threshold securities.” Regulation SHO required broker-dealers that have  FTD in these securities lasting for 10 consecutive days to “close out” the  FTD by purchasing securities of like kind and quantity in the market by the  beginning of regular trading hours, the next morning (T+14), with some  exceptions. In July 2008, SEC issued an emergency order (July emergency  order) to temporarily restrict naked short selling and FTD in the publicly  traded securities of 19 large financial firms, with limited exceptions. In  September 2008, SEC took more comprehensive action to curb the  potential for manipulative naked short selling when it issued another  emergency order (September emergency order) that temporarily enhanced  close-out requirements on the sale of all equity securities. The September  emergency order required broker-dealers to deliver securities resulting  from short sales in any equity security (not just threshold securities) by  the settlement date (T+3), or, if they have FTD on the settlement date, to  take action to purchase or borrow securities to close out the FTD by the  beginning of regular trading hours the next morning (T+4), with limited  exceptions. Broker dealers that can show that the FTD resulted from a  long sale were allowed until the beginning of regular trading hours on T+6  to close out the FTD. Upon expiration of the emergency order, SEC  extended this temporary requirement until July 31, 2009, as part of the  interim final temporary rule (temporary rule).
Figures 13 through 24 illustrate the trends in threshold securities and their  FTD between the effective date of Regulation SHO in January 2005  through December 2008, by the market on which these securities were  trading. These markets include the New York Stock Exchange (NYSE),  NASDAQ, and the American Stock Exchange (Amex). We have also  generated trends for threshold securities trading on NYSE Arca, the Over- The-Counter Bulletin Board (OTCBB), and Pink Quote under the “Other  Securities” category. We also generated trends in FTD in all securities  (both threshold and nonthreshold), by market, over the review period   market, over the review period  (figs. 25 through 36).  (figs. 25 through 36).
section_title: Appendix IV: Comments from the Securities and Exchange Commission
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Karen Tremba (Assistant  Director), Lawrance Evans, Stefanie Jonkman, Matthew Keeler, Marc  Molino, Carl Ramirez, Barbara Roesmann, Jeremy Schwartz, and Paul  Thompson made key contributions to this report.