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Living without an Uptick Rule on Short Sales: A Pilot Program Set

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WASHINGTON (–The Securities and Exchange Commission changed its rules on short selling at its meeting June 23, adopting with some modifications Regulation SHO, as proposed last fall, which sets the stage for a pilot program that will eliminate the uptick rule for approximately 1,000 stocks.

The SEC hasn’t yet announced the specific stocks that will be involved in the pilot program. They will be drawn from the Russell 3000 index. The uptick rule will remain in place for all other stocks until the pilot program has concluded.

The new regulation also imposes rule 203, with its uniform locate and delivery provisions designed to address the problem of “naked” short selling. Prior to effecting short sales in any equity security, the SEC will require broker-dealers to locate securities available for borrowing, with limited exceptions, including an exception for short sales by registered market makers in connection with bona fide market making. Additional requirements apply to “threshold securities,” i.e. securities for which there is an aggregate fail-to-deliver position for five consecutive settlement days at a registered clearing agency of 10,000 shares or more that is equal to at least 0.5% of the issue’s total shares outstanding.

When a clearing agency participant has a fail-to-deliver position in threshold securities that persists for 10 consecutive days after settlement, the participant must take action to close out the position. Until it is closed out, neither that participant nor any broker-dealer for which it clears transactions may effect further short sales in that security with borrowing or entering into a bona fide arrangement to borrow that security.

Some of the comments the SEC received about Reg SHO expressed concern that such changes must be phased in, because immediate implementation could disrupt the smooth functioning of financial markets. The Securities Industry Association, for example, in its comment submitted Jan. 30, said that it thought some securities firms would not be able to bring themselves into compliance “without incurring considerable costs, especially for the reprogramming and testing of trading and other systems” which would “adversely affect the ability of such firms to provide liquidity and ultimately would be passed on to customers.”

The SEC acknowledged such concerns. The pilot program suspending the uptick rule won’t begin until Jan. 3, 2005. Also, brokers have until that same date to comply with the new locate-and-delivery rules.

Ann Vlcek, associate general counsel of the SIA, praised the SEC in a statement Wednesday. “We have maintained” she said, “that a pilot enables all market participants to evaluate the most appropriate short-selling program that protects investors’ interests and contributes to the markets’ important function of determining the value of securities.”

The uptick rule has long been controversial both in the United States and abroad. The SEC had been considering a new “uniform bid” rule that would replace the uptick rule as applied to all exchange-listed securities and Nasdaq National Market System securities. The uniform bid rule would have allowed short sales to be effected one cent above the consolidated best bid. It has now put that on hold until the conclusion of the pilot program.

Other SEC Decisions

On a related point, the SRC adopted amendments to rule 105 of Regulation M, removing the current shelf-offering exemption, and it issued interpretive guidance addressing sham transactions designed to evade the rule. Regulation M prohibits most short selling in the five days before the pricing of a security in an offering pursuant to a registration statement. There had been an exception in place to Reg M that allowed short sales during the five days following the announcement of a “shelf takedown” but before its pricing. That exception has now been abolished effective 30 days after publication of this amendment in the Federal Register.

In other business at the Wednesday meeting, the SEC amended its rules regarding mutual funds and other registered management investment companies. It determined that the shareholder reports of such funds must discuss, in reasonable detail, the material factors and the conclusions that formed the basis for advisory contracts into which the board has entered in the most recent fiscal half-year. This disclosure must include: the nature, extent and quality of the services to be provided by the investment adviser; the investment performance of the fund and the adviser; the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the fund; the extent to which economies of scale will be realized as the fund grows; and whether fee levels reflect those economies of scale for the benefit of fund investors.

The SEC also adopted a rule that independent directors must constitute at least 75% of a mutual fund’s board, except for boards with only three directors (which can have one management director). The chairman must be an independent director, and the independent directors must be authorized to hire their own staff.

Michael G. Oxley, chairman of the Financial Services Committee, U.S. House of Representatives, immediately praised the new rule regarding mutual fund governance. “Finally, mutual fund investors will have someone leading the board who is focused on earning returns for shareholders, rather than earning fees from shareholders,” he said in a statement.

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