SEC Issues Guidance Regarding SEC's Previous Emergency Order Regarding "Naked" Short Selling.Development Of Note The SEC's Division of Trading and Markets has issued guidance in the form of Frequently Asked Questions ("FAQs") that we referenced in the client alert we issued earlier this evening. These FAQs deal with the close-out provisions of temporary Rule 204T of Reg SHO, which was adopted by the SEC in an emergency order on September 17, 2008. Because we feel that these FAQs are critical to our trading clients' ability to ensure their compliance with new Rule 204T with respect to trading this morning, we are issuing this summary analysis of the provisions of the FAQs that we feel are most important. Pre-Fail Credit Can Be Used To Avoid The 204T "Penalty Box" For Short Sales The FAQs provide that any broker-dealer, including broker-dealers that are not clearing brokers, can receive Pre-Fail Credit for purpose of closing out a fail to deliver position for a prior short sale by purchasing securities of like kind and in the same amount as the prior short sale at any time from trade date ("T") until the end of regular trading hours on T+3. Thus, a broker-dealer can close out a fail on a short sale and receive Pre-Fail Credit by purchasing securities on T, T+1, T+2, or T+3. However, in order to rely upon Pre-Fail Credit for a close-out purchase, the broker-dealer must be either net long or net flat at the end of the trading day In Business, the trading day is the time span that a particular stock exchange is open. For example, the New York Stock Exchange is, as of 2006, open from 09:30AM to 4:00PM. Trading days never take place on weekends. "on the settlement day for which the broker is claiming Pre-Fail Credit." While this condition is not completely clear, we believe that the best interpretation of this condition is that a broker-dealer that wishes to claim Pre-Fail Credit for a close-out purchase must end up net long or net flat on the trading day on which the close-out purchase was effected. By effecting a close-out purchase that permits it to rely upon Pre-Fail Credit, a broker-dealer can avoid the Rule 204T "penalty box" provision, which would otherwise require the broker-dealer and all of its customers to refrain from short selling Short Selling The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short. the security that was the subject of the short sale fail other than on a pre-borrow basis. In other words Adv. 1. in other words - otherwise stated; "in other words, we are broke" put differently , a clearing broker and its introducing brokers will not be required, nor will their customers be required, to pre-borrow for short sales if the clearing broker or introducing broker can rely on Pre-Fail Credit to stay out of the Rule 204T penalty box. What This Means For Brokers and Their Customers: Importantly, the ability to rely on Pre-Fail Credit provides brokers and their customers with the more flexibility to determine for themselves when they will make close-out purchases, since neither brokers nor their customers will be forced to wait until the morning of T+4 to make close-out purchases. Prior to the issuance of the FAQs, it was thought by some that it was necessary to wait until the morning of T+4 to effect a borrow or a close-out purchase. Now it is clear that close-out purchases on T, T+1, T+2 or T+3 will suffice. This should significantly reduce the number and frequency of involuntary buy-ins of customers by broker-dealers that have experienced a fail to deliver on short sales of a particular equity security. Allocation Of Close-Out Responsibility A clearing broker that has a fail position in a security that was caused by an introducing broker (including a market maker) that clears through the clearing broker is now permitted under the FAQs to allocate the responsibility for closing out that fail to the introducing broker who caused the fail. If an introducing broker is so allocated a fail, it must either (i) close-out the fail using Pre-Fail Credit or (ii) borrow or arrange to borrow securities prior to effecting any subsequent short sales in the security, until it has closed out the fail and the close-out transaction has settled. Market Makers The FAQs set forth two separate relief provisions for registered equities market makers, registered options market makers and other market makers obligated ob·li·gate tr.v. ob·li·gat·ed, ob·li·gat·ing, ob·li·gates 1. To bind, compel, or constrain by a social, legal, or moral tie. See Synonyms at force. 2. To cause to be grateful or indebted; oblige. to quote in the OTC market Noun 1. OTC market - a stock exchange where securities transactions are made via telephone and computer rather than on the floor of an exchange over-the-counter market (collectively "Market Makers") that are engaged in bona fide [Latin, In good faith.] Honest; genuine; actual; authentic; acting without the intention of defrauding. A bona fide purchaser is one who purchases property for a valuable consideration that is inducement for entering into a contract and without suspicion of being market making activity. First, the FAQs extend the existing close-out requirements of Rule 204T by three additional days for fails attributable to short sales by Market Makers. Thus, where a clearing broker previously was required to close-out a fail on a short by T+4, the clearing broker now under the guidance set forth in the FAQs can close out a Market Maker's fails on short sales by effecting a close-out transaction on any date before T+6. Second, the FAQs now exclude Market Makers from the pre-borrow requirements of Rule 204T(b). This means that a Market Maker with a fail position in a security at a clearing broker is not subject to the pre-borrow requirement of the Rule 204T penalty box and can effect short sales in the security without pre-borrowing, provided that the Market Maker can demonstrate it does not have any open fails to deliver in the security at the time of its subsequent short sales in that security. However, a Market Maker is still required to close out its fail positions in that security. The FAQs also impose an additional requirement on Market Makers with respect to any fail to deliver position in a security at a clearing agency that is attributable to the Market Maker, which requires a Market Maker to attest in writing to the market on which it is registered that the fail to deliver position at issue was established solely in connection with the Market Maker's bona fide market making activity. The Market Maker must also attest to the steps it has taken to deliver securities to the clearing agency. A link to the FAQs is provided here: http://www.sec.gov/divisions/marketreg/204tfaq.htm Goodwin Procter Goodwin Procter LLP is a law firm based in the United States, with a team of 750 attorneys serving clients through offices in Boston, Los Angeles, New York City, San Diego, San Francisco, Washington, D.C. and Palo Alto. 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