What Are Short Sale Failures to Deliver?
In recent weeks, it has been claimed that microcap issuers are the target of rumor mongering by stock bashers working in collusion with market makers and notorious short sellers. It is sometimes difficult to differentiate between legitimate short selling and unlawful manipulative short selling, and to determine whether a stock’s price has declined as the result of dilution or short sales, particularly in the penny markets. Regulation SHO addressed failures-to-deliver in short sales by imposing obligations on broker-dealers and attaching liability for non-compliance.
Rule 10b-21 of the Securities and Exchange Act of 1934 (the “Exchange Act”) provides liability for the short seller who fails to deliver under certain circumstances.
Market Manipulation l Section 10(b) and 10(b)5
Section 10(b) of the Exchange Act prohibits the use of “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of a security. Manipulative conduct is defined as the performance of intentional or willful acts designed to deceive or defraud investors. Manipulative conduct could be engaged in to distort the truth about a stock’s price, value or demand. Examples include dissemination of false or misleading information about a public company, wash sales, matched orders, or rigged prices to increase or decrease a stock’s price or volume. Buys or sales made to create trading activity, prevent price declines or price increases for the purpose of causing others to purchase or sell a security distorts the true activities of buyers and sellers of securities in the public markets.
Market Manipulation l Liability of Short Sellers l Failures to Deliver
A short sale is considered a sale of securities for the purposes of the federal securities laws, including the antifraud provisions of Section 10(b) and Rule 10b-5 of the Exchange Act. Thus a short seller must consider whether he possesses material, nonpublic information about the issuer before effecting a short sale.
Rule 10b-21 of the Exchange Act is the naked short selling antifraud rule. Rule 10b-21 assigns liability to the short seller for certain failures to deliver. Rule 10b-21 provides that a person who submits a sell order for an equity security violates the antifraud provisions of the Exchange Act if he knowingly or recklessly deceives a broker-dealer about his intention or ability to deliver the shorted security on or before the settlement date (T+3 Settlement), AND fails to deliver the security on or before the settlement date (T+3 Settlement).
Rule 10b-21 stipulates that short sellers who make misrepresentations about their intent and ability to deliver equity securities in compliance with the T+3 Settlement requirements violate the securities laws if they fail to deliver a shorted security as represented. By adopting the rule, the SEC has clearly determined that a short seller can be held liable for undermining the ability of its broker-dealer to comply with Regulation SHO.
Compliance with Regulation SHO
Rule 200(g) of Regulation SHO requires that broker-dealers mark all sell orders as “long,” “short,” or “short-exempt.”
Orders can be short-exempt if the stock is at a price above the current national best bid at the time of the order and submission, and falls within an exception under Rule 201.
Orders can be marked as long if the seller owns the security to be sold for purposes of Rule 200, and the broker-dealer has, or reasonably expects to have physical possession or control of the security before settlement. Unless both of these conditions are met, the broker-dealer must mark the order as short or short-exempt.
Share-Borrowing (Locate Obligation)
Rule 203(b)(1) of Regulation SHO requires a broker-dealer to identify, or locate, borrowable securities before executing a trade when an order has been marked as short. The broker-dealer must either borrow or arrange to borrow the security in time for delivery at settlement or have reasonable grounds to believe that the security can, if necessary, be borrowed for delivery at settlement. In its release explaining the adoption of Regulation SHO, the SEC indicated that the broker-dealer can rely on its customer’s representations in determining that shares are available for borrowing.
The Alternative Uptick Rule l Circuit Breaker
Rule 201 is known as the “Alternative Uptick Rule” and it applies only when a stock has had a price decline of at least 10% in one day, an event that triggers a “circuit breaker.” Rule 201 prevents short sellers from further driving down a stock’s price when it has experienced a 10% decrease from the prior days trading price. It applies to orders for the security for the remainder of the day the decrease occurred as well as the following session. Originally, Regulation SHO applied only to “covered securities,” which are equity securities that are listed on a national securities exchange. In 2006, the omission of stocks trading over-the-counter was rectified by FINRA Rule 3210, which was superseded in 2010 by Rule 4320.
Short Selling l Manipulative Conduct by Market Makers l Specific Examples
Courts have held that short selling in legitimate transactions to real buyers does not artificially affect prices and therefore cannot be manipulative trading. There must be deceptive or manipulative conduct by the short seller, such as the release of false or fraudulent information concerning the issuer, or the creation of a false impression of the supply and demand for trading activity.
In SEC v. Badian, the SEC charged that the defendants had engaged in short selling to manipulate the price of Sedona Corporation’s securities, so that their dilution funder client would receive a larger number of shares when it exercised conversion rights under a debenture it held. The conversion price of the debenture was based upon the market price of Sedona’s shares, so if the price declined the client would receive more shares. Short sales were conducted in the client’s account and covered with shares issued upon conversion of the debenture. The debenture agreement prohibited the investor from short selling Sedona’s shares. In order to conceal the short sales, the defendants engaged in wash trading and matched orders, and fraudulently marked the short sale orders as long on the broker’s records. The court held that the covenant against short sales in the debenture had been disclosed to investors, and the sellers had created the false appearance of massive selling by individual investors to conceal their activities. They were found to have engaged in manipulative trading.
For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected] or visit www.securitieslawyer101.com. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
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Brenda Hamilton, Securities Attorney
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