SEC Adopts New Circuit Breaker Price Test for Short Sales

At an open meeting on February 24, 2010, the Securities and Exchange Commission (the “Commission”), with Commissioners Casey and Paredes dissenting, voted to adopt a new “circuit breaker” restriction on short sales in stocks that experience a price decline of 10% or more from the prior day’s close. Once the circuit breaker is triggered for a stock, short selling in that stock will only be allowed at prices above the current national best bid (“NBB”) for the remainder of the trading day and the next trading day, subject to certain exemptions. Notably, the Commission did not adopt an exemption for bona fide market making activity. Market participants will be required to comply with the new rule approximately eight months following its publication in the Federal Register.

Circuit Breaker

Unlike the permanent, market-wide restrictions under former Exchange Act Rule 10a-1 and some of the alternative proposals described by the Commission in its April 2009 and August 2009 proposing releases, the new rule will not impose short sale restrictions with respect to a particular stock unless the price of that stock has dropped by 10% or more from the prior day’s close. According to Chairman Schapiro, the rule is intended to address concerns that excessive downward price pressures on individual stocks, accompanied by the fear of unconstrained short selling, can destabilize markets and undermine investor confidence.

The new rule will apply to all “NMS stock,” which generally includes all U.S.-listed equity securities, whether traded on an exchange or over-the-counter. In response to concerns that an across-the-board 10% threshold would disproportionately affect lower-priced stocks or lower capitalization companies, Jamie Brigagliano, Deputy Director of the Division of Trading and Markets, explained that the Commission staff decided against recommending a circuit breaker trigger with multiple tiers because of the operational challenges and costs that such an approach would likely involve.

Whether a stock has declined 10% or more will be measured relative to the previous day’s closing price at the primary listing venue for the particular stock, and that venue will be required to notify the securities information processor for that stock if a circuit breaker has been triggered. Because price declines will be measured from the previous day’s close, overnight news, overseas trading activities and other market events that often give rise to volatility could trigger short sale restrictions at market open.

Once the circuit breaker is triggered for a stock, short sale restrictions for that stock will be in place for the remainder of the trading day and for the duration of the next trading day. This is longer than the period specified in the proposing releases, which proposed applying restrictions only for the remainder of the trading day.

Price Test

Once the circuit breaker is triggered for a stock, the new rule will require all “trading centers” to establish, maintain and enforce policies and procedures reasonably designed to prevent the execution or display of any short sale order in that stock at a price that is at or below the current NBB. The Commission staff noted that although this rule will restrict more short selling activity than a rule that would permit short sales on up-bids, they believed that this approach will be easier to implement because it will not require the sequence of bids to be tracked.

The obligation of “trading centers” to implement reasonably designed policies and procedures is patterned after the approach taken by Regulation NMS with respect to the prevention of transactions that “trade-through” protected bids and offers. “Trading centers” include any national securities exchange, alternative trading system, market-maker, or any other broker or dealer that executes orders internally by trading as principal or crossing orders as agent.

Exemptions

Trading centers will be permitted to execute or display any short sale order marked “short exempt” without regard to whether the order is at a price above the current NBB, even after a circuit breaker has been triggered. Short exempt orders will include orders (i) at a price above the current NBB at the time the order is submitted to the trading center; (ii) where the seller owns the stock being sold and intends to deliver the stock as soon as all restrictions on delivery have been removed; (iii) in connection with certain odd-lot transactions; (iv) associated with certain domestic and international arbitrage transactions; (v) in connection with certain over-allotments and lay-off sales; (vi) as part of certain riskless principal transactions; and (vii) executed on a volume-weighted average price (VWAP) basis. The Commission also adopted amendments to Rule 200(g)(2) of Regulation SHO to reinstitute the requirement that a broker-dealer mark a short sale order “short exempt” if the seller is relying on an exemption from the short sale price test.

Although the exemptions for arbitrage transactions adopted by the Commission were not discussed in detail during the open meeting, the proposing releases included detailed arbitrage exemptions. The domestic arbitrage exemption contained in the proposing releases would apply to arbitrage undertaken to profit from a current difference in price between a convertible security and the underlying common stock. The proposing releases’ international arbitrage exemption, in turn, would apply to arbitrage undertaken to profit from a price difference between a stock on a foreign securities market and a stock on a U.S. market, provided that the short seller has an offer to buy on a foreign market that allows the seller to immediately cover the short sale at the time it was made. For purposes of this international arbitrage exemption, a depository receipt (e.g., an ADR) of a stock would be deemed to be the same as the stock it represents.

The Commission did not adopt certain exemptions that were widely recommended by commenters. Most notably, the Commission did not adopt an exemption for bona fide market making activity. This is in contrast to the “locate” and close-out requirements of Regulation SHO (Rules 203 and 204) and the terms of a number of emergency actions taken by the Commission in 2008, under which there is or was special treatment for short sales by market makers engaged in bona fide market making activity. Commenters have emphasized that, absent a market making exemption, restrictions on short sales would likely have a detrimental impact on liquidity, particularly for options markets.

The Commission also did not adopt exemptions for short sales of exchange-traded funds (ETFs) and other index-linked products or hedges relating to such products, which may similarly lead to substantial disruptions in liquidity for these products.

The Commission staff indicated that the new rule contains procedures for exemptive relief to be granted, either in response to a request or on the Commission’s own initiative, for discrete market activities where the exemption would not undermine the intent of the rule. Market participants should consider what relief, if any, to seek prior to the compliance date of the rule.

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The summary above is based on remarks at the open meeting; the Commission’s full release, including the text of the amendments, is not yet available. The webcast of the open meeting may be found here.

If you have any questions about these developments, please feel free to contact any of your regular contacts at the firm or any of our partners and counsel listed on our website under Capital Markets or Banking and Financial Institutions.