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. 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. 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.