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Sunday, 05/06/2001 11:59:40 AM

Sunday, May 06, 2001 11:59:40 AM

SEVU Short Sales: IM-3350. Short Sale Rule...

(a)

(1) In developing a Short Sale Rule for Nasdaq National Market securities, the Association adopted an exemption to the Rule for certain market making activity. This exemption was deemed an essential component of the Rule because bona fide market making activity is necessary and appropriate to maintain continuous, liquid markets in Nasdaq National Market securities. Rule 3350(c)(1) states that short selling prohibitions shall not apply to sales by qualified Nasdaq market makers in connection with bona fide market making activity and specifies that transactions unrelated to normal market making activity, such as index arbitrage and risk arbitrage that are independent from a member’s market making functions, will not be considered as bona fide market making. Thus two standards are to be applied: one must be a “qualified” Nasdaq market maker and one must engage in “bona fide” market making activity to take advantage of this exemption. With this interpretation, the Association wishes to clarify for members some of the factors that will be taken into consideration when reviewing market making activity that may not be deemed to be bona fide market making activity and therefore would not be exempted from the Rule’s application.

(2) First, as the Rule indicates, bona fide market making activity does not include activity that is unrelated to market making functions, such as index arbitrage and risk arbitrage that is independent from a member’s market making functions. While these types of arbitrage activity appear to be suitable for the firm’s overall hedging or risk management concerns, they do not warrant an exemption from the Rule. However, short sales of a security of a company involved in a merger or acquisition will be deemed bona fide market-making activity if made to hedge the purchase or prospective purchase (based on communicated indications of interest) of another security of a company involved in the merger or acquisition, which purchase was made, or is to be made, in the course of bona fide market making activity. The purchase of a security of a company involved in a merger or acquisition made to hedge a short sale of another security involved in the merger or acquisition, which sale was made in the course of bona fide market making activity, will not cause the sale to be deemed unrelated to normal market-making activity. Short sales made to hedge any such purchases or prospective purchases must be reasonably consistent with the exchange ratio (or exchange ratio formula) specified by the terms of the merger or acquisition.

(3) Similarly, bona fide market making would exclude activity that is related to speculative selling strategies of the member or investment decisions of the firm and is disproportionate to the usual market making patterns or practices of the member in that security. The Association does not anticipate that a firm could properly take advantage of its market maker exemption to effectuate such speculative or investment short selling decisions. Disproportionate short selling in a market making account to effectuate such strategies will be viewed by the Association as inappropriate activity that does not represent bona fide market making and would therefore be in violation of Rule 3350.

(b)

(1) Rule 3350 requires that no member shall effect a short sale for the account of a customer or for its own account in a Nasdaq National Market security at or below the current best (inside) bid when the current best (inside) bid as displayed by The Nasdaq Stock Market is below the preceding best (inside) bid in the security. The Association has determined that in order to effect a “legal” short sale when the current best bid is lower than the preceding best bid the short sale must be executed at a price of at least 1/16th point above the current inside bid when the current inside spread is 1/16th point or greater. The last sale report for such a trade would, therefore, be above the inside bid by at least 1/16th of a point. If the current spread is less than 1/16th of a point, however, the short sale must be executed at a price equal to or greater than the current inside offer price.

(2) Moreover, the Association believes that requiring short sales to be a minimum increment of 1/16th point above the bid when the current spread is 1/16th or greater and equal to or greater than the offer when the current spread is less than 1/16th ensures that transactions are not effected at prices inconsistent with the underlying purpose of the Rule. It would be inconsistent with Rule 3350 for a member or customer to cause the inside spread for an issue to narrow when the current best bid is lower than the preceding best bid (e.g., lowering its offer to create an inside spread less than 1/16th) for the purpose of facilitating the execution of a short sale at a price less than 1/16th above the inside bid.

(c)

(1) Rule 3350 prohibits a member from effecting a short sale for the account of a customer or for its own account directly or through the offices of a third party for the purpose of avoiding the application of the Short Sale Rule. Further, the Rule prohibits a member from knowingly, or with reason to know, effecting sales for the account of a customer or for its own account for the purpose of avoiding the Rule. With this interpretation, the Association wishes to clarify some of the circumstances under which a member would be deemed to be in violation of Rule 3350.

(2) For example, in instances where the current best bid is below the preceding best bid, if a market maker alone at the inside best bid were to lower its bid and then raise it to create an “up bid” for the purpose of facilitating a short sale, the Association would consider such activity to be a manipulative act and a violation of the Association’s Short Sale Rule. The Association also would consider it a manipulative act and a violation of the Rule if a market maker with a long stock position were to raise its bid above the inside bid and then lower it to create a “down bid” for the purpose of precluding market participants from selling short. In addition, if a market maker agrees to an arrangement proposed by a member or a customer whereby the market maker raises its bid in The Nasdaq Stock Market in order to effect a short sale for the other party and is protected against any loss on the trade or on any other executions effected at its new bid price, the market maker would be deemed to be in violation of Rule 3350. Similarly, a market maker would be deemed in violation of the Rule if it entered into an arrangement with a member or a customer whereby it used its exemption from the rule to sell short at the bid at successively lower prices, accumulating a short position, and subsequently offsetting those sales through a transaction at a prearranged price, for the purpose of avoiding compliance with the Rule, and with the understanding that the market maker would be guaranteed by the member or customer against losses on the trades.

(3) The Association believes that members’ activities to circumvent the Rule through indirect actions such as executions with other members or through facilitation of customer orders while being protected from loss are antithetical to the purposes of the Rule. Accordingly, the Association will consider any such activity as a violation of Rule 3350.

[Amended by SR-NASD-97-59 eff. Sept. 26, 1997.]

3370. Prompt Receipt and Delivery of Securities

(a) Purchases

No member or person associated with a member may accept a customer’s purchase order for any security unless it has first ascertained that the customer placing the order or its agent agrees to receive securities against payment in an amount equal to any execution, even though such an execution may represent the purchase of only a part of a larger order.

(b) Sales

(1) Long Sales

No member or persons associated with a member shall accept a long sale order from any customer in any security (except exempt securities other than municipals) unless:

(A) The member has possession of the security;

(B) The customer is long in his account with the member;

(C) The member or person associated with a member makes an affirmative determination that the customer owns the security and will deliver it in good deliverable form within three (3) business days of the execution of the order; or

(D) The security is on deposit in good deliverable form with a member of the Association, a member of a national securities exchange, a broker/dealer registered with the Commission, or any organization subject to state or federal banking regulations and that instructions have been forwarded to that depository to deliver the securities against payment.

(2) “Short Sales”

(A) Customer short sales

No member or person associated with a member shall accept a “short” sale order for any customer in any security unless the member or person associated with a member makes an affirmative determination that the member will receive delivery of the security from the customer or that the member can borrow the security on behalf of the customer for delivery by settlement date. This requirement shall not apply, however, to transactions in corporate debt securities.

(B) Proprietary short sales

No member shall effect a “short” sale for its own account in any security unless the member or person associated with a member makes an affirmative determination that the member can borrow the securities or otherwise provide for delivery of the securities by the settlement date. This requirement will not apply to transactions in corporate debt securities, to bona fide market making transactions by a member in securities in which it is registered as a Nasdaq market maker, to bona fide market maker transactions in non-Nasdaq securities in which the market maker publishes a two-sided quotation in an independent quotation medium, or to transactions which result in fully hedged or arbitraged positions.

(3) Public Offering

In the case of a public offering of securities, paragraph (b)(1) hereof shall not apply during the period from the commencement of the public offering until seven (7) business days following the date of settlement between the underwriter and issuer of the securities; provided, however, that the member believes in good faith that the customer has purchased the securities.

(4) “Affirmative Determination”

(A) To satisfy the requirements for an “affirmative determination” contained in paragraph (b)(1)(C) above for long sales, the member or person associated with a member must make a notation on the order ticket at the time the order is taken which reflects the conversation with the customer as to the present location of the securities in question, whether they are in good deliverable form and the customer’s ability to deliver them to the member within three (3) business days.

(B) To satisfy the requirement for an “affirmative determination” contained in paragraph (b)(2) above for customer and proprietary short sales, the member or person associated with a member must keep a written record which includes:

(i) if a customer assures delivery, the present location of the securities in question, whether they are in good deliverable form and the customer’s ability to deliver them to the member within three (3) business days; or

(ii) if the member or person associated with a member locates the stock, the identity of the individual and firm contacted who offered assurance that the shares would be delivered or that were available for borrowing by settlement date and the number of shares needed to cover the short sale.

(C) The manner by which a member or person associated with a member annotates compliance with the “affirmative determination” requirement contained in subsection (b)(2) above (e.g., marking the order ticket, recording inquiries in a log, etc.) is not specified by this Rule and, therefore, shall be decided by each member. Members may rely on “blanket” or standing assurances (i.e., “Easy to Borrow” lists) that securities will be available for borrowing on settlement date to satisfy their affirmative determination requirements under this Rule. For any short sales executed in Nasdaq National Market (NNM) or national securities exchange-listed (listed) securities, members also may rely on “Hard to Borrow” lists indicating NNM or listed securities that are difficult to borrow or unavailable for borrowing on settlement date to satisfy their affirmative determination requirements under this Rule, provided that: (i) any securities restricted pursuant to UPC 11830 must be included on such a list; and (ii) the creator of the list attests in writing on the document or otherwise that any NNM or listed securities not included on the list are easy to borrow or are available for borrowing. Members are permitted to use Easy to Borrow or Hard to Borrow lists provided: (i) the information used to generate the list is less than 24-hours old; and (ii) the member delivers the security on settlement date. Should a member relying on an Easy to Borrow or Hard to Borrow list fail to deliver the security on settlement date, the Association shall deem such conduct inconsistent with the terms of this Rule, absent mitigating circumstances adequately documented by the member.

(5) “Bona Fide Fully Hedged” and “Bona Fide Fully Arbitraged”

In determining the availability of the exemption provided in paragraph (b)(2)(B) above and in Rule 11830 from short sale requirements for “bona fide fully hedged” and “bona fide fully arbitraged” transactions, the following guidelines shall apply. These guidelines are for illustrative purposes and are not intended to limit the Association’s ability to determine the proper scope of the terms “bona fide fully hedged” or “bona fide fully arbitraged” pursuant to this provision, on a case-by-case basis.

(A) Bona Fide Fully Hedged

The following transactions shall be considered bona fide fully hedged:

(i) Short a security and long a convertible debenture, preferred or other security which has a conversion price at or in the money and is convertible within ninety days into the short security.

Example: Long ABCD Company 9% convertible subordinated debentures due 2003. Each debenture is convertible into common at $27.90 per share of common equal to 35.842 shares of common per 1M debenture.

· With the price of the ABCD at 8¾-9 or 8.75-9 and a short position of 100 shares of ABCD the short position would not be exempt.

· If the price of ABCD was $28 with a short position of 100 shares, 35 shares would be exempt and the remaining 65 shares would not be exempt.

(ii) Short a security and long a call which has a strike price at or in the money and which is exercisable within 90 calendar days into the underlying short security.

Example: Long 1 call of EFGH at a price of either 44 1/8 or $44.10 with a strike price of 40 expiring within 90 calendar days.

· With the circumstances as above 100 shares would be exempt.

· If the strike price was 50 a short position of 100 shares would not be exempt.

· With any strike price and the call expiring in more than 90 days any short of the common would not be exempt.

(iii) Short a security and long a position in warrants or rights which are exercisable within 90 days into the short security. To the extent that the long warrants or rights are “out of the money,” then the short position shall be exempt up to the market value of the long warrants or rights.

Example: Long 100 warrants of IJKL (IJKLW: 2¼-2¾ or 2.25-2.75). Each warrant is exercisable into 1 share of common at $2. (IJKL: 4-4 ½ or $4-4.50).

· With the circumstances as above a short position of 100 shares would be exempt.

· If the price of IJKL is $1.50 and the market value of long warrants is ¼ of a point, or $.25, a short position of 16 shares would be exempt.

(B) Bona Fide Fully Arbitraged

The following transactions shall be considered bona fide fully arbitraged:

(i) Long a security purchased in one market together with a short position from an offsetting sale of the same security in a different market at as nearly the same time as practicable for the purpose of taking advantage of a difference in price in the two markets.

Example: Purchase 100 shares of EFGH on the London Stock Exchange and simultaneously effecting a short sale of 100 shares of EFGH on Nasdaq.

· Under the above circumstances, the 100 shares short would be exempt.

(ii) Long a security which is without restriction other than the payment of money exchangeable or convertible within 90 calendar days of the purchase into a second security together with a short position from an off-setting sale of the second security at or about the same time for the purpose of taking advantage of a concurrent disparity in the prices of the securities.

Example: Long 100 shares of MNOP (MNOP: 51-51¼ or 51.00-51.25) which is being acquired by QRST Corp. (QRST: 52 1/8 -52 3/8 or 52.10-52.30) at the rate of 1.15 shares per MNOP share.

· If the exchange is to take place within 90 days then a short of 115 shares of QRST would be exempt from the mandatory buy-in. Also, if the exchange was to take place at a date later than 90, all short positions in the above example would be subject to the mandatory buy-in.

(C) The transaction date of the short sale shall govern when a fully hedged or fully arbitraged position exists.

[Adopted eff. Sept. 9, 1968; amended eff. Sept. 1, 1972, Nov. 15, 1973; Oct. 15, 1986; Aug. 3, 1987; July 5, 1990; July 14, 1993; amended by SR-NASD-94-32 eff. Jan. 9, 1995; amended by SR-NASD-95-02 eff. Jan. 9, 1995; amended by SR-NASD-94-56 eff. June 7, 1995; amended by SR-NASD-95-38, Sept. 18, 1995; amended by SR-NASD-95-62 eff. Feb. 20, 1996; amended by SR-NASD-95-39 eff. Oct. 10, 1996; amended by SR-NASD-00-46 eff. Aug. 28, 2000; amended by SR-NASD-99-37 eff. June 9, 2000.]

Selected Notices to Members: 86-69, 88-47, 90-51, 94-80, 95-36, 00-28.

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