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

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. 2). 3). It  is unclear whether the number of threshold securities and their FTD  would have increased further in the absence of Regulation SHO. 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. 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. 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. Others, however, did not follow these  practices. As a result, under Regulation SHO, FTD resulting from  naked short sales could persist for many days. 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. CBOE staff also have developed surveillance to  help detect noncompliance with the close-out requirements of Regulation  SHO. In Part Because SEC Has Not Finalized Guidance, the Industry Has Experienced Some Challenges in Complying with the Locate Requirement

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. 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. 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. 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. 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. Recommendations for Executive Action

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. Key contributors to this report are listed in appendix V.

Appendix I: Scope and Methodology

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).
Why GAO Did This Study

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.

What GAO Found

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.