A New Rule Regarding Naked Short Selling And A Warning to Outside Directors
The SEC issued a rule yesterday regarding naked short selling as part of its efforts to quell the current market turmoil. In addition, the Commission filed a settled option backdating action that should serve as a warning to all outside directors.
The market crisis
The SEC expanded its rule regarding naked short selling. Under a new rule, which will become effective on Thursday, September 18, 2008, the Commission imposed a hard T+ 3 close out requirement on all short sales. Under this rule, any short seller and their broker-dealer will be required to deliver the securities by the close of business on the settlement date, which is three days after the transaction. The new rule incorporates sanctions for those who fail to deliver the securities.
The rule also eliminates the options market maker exception for the close-out requirement of Rule 203(b)(3) in Regulation SHO. Accordingly, market makers will be required to comply with the hard close requirements like all other market participants.
The new rule effectively extends the provisions of the emergency action taken back in July and discussed here, which only applied to a Freddie Mac, Fanny Mae and a handful of other companies. By expanding the emergency rule to all market participants, the Commission leveled the playing field, giving all issuers protection from naked short selling. At the same time, the rule will make it harder for options market-makers to hedge trades when they sell put contracts. The Commission is also requesting comments on the new rule.
The Commission also adopted Rule 10b-21 regarding fraudulent short selling transactions. The rule focuses on short sellers deceiving their broker dealer regarding the ability to cover.
While the new rule on short selling is clearly intended to help stabilize the markets, the need as well as its immediate impact is at best unclear. Naked short selling has not played a role in the demise of the two GSEs or Lehman, all of whom were protected by the earlier emergency rule. Perhaps the real impact of the new rule will be to remind market participants that as a “cop on the street” the SEC is closely monitoring the markets for those who might try to manipulate shares trading in these clearly volatile markets.
Option backdating and outside directors
Outside directors got a wake-up call and a reminder of their independent watchdog role yesterday when the SEC filed a settled enforcement action based on option backdating at Mercury Interactive, SEC v. Kohavi, Case No. 08-43-48 (N.D. Cal. Sept. 17, 2008). Named as defendants in the action are three former outside directors of the company, Igal Kohavi, Yair Shamr and Giora Yaron. The SEC’s complaint essentially claims that the directors were asleep at the switch, rubber stamping whatever management approved.
The complaint alleges that from 1997 through 2002 directors approved 21 separate backdated option grants and that they were reckless in not knowing that the grants violated company policy. A table in the complaint lists each of the backdated grants approved by the three outside directors. Another section of the complaint tiled “Kohavi, Shamir and Yaron Approved Options Notwithstanding Numerous Indications of Backdating” details what it claims are a series of “red flags” that were ignored by the three directors. Several of those red flags were approving grants with an “as of” date which preceded the time the three directors executed the approval papers. In two instances however, the three directors executed approvals that were backdated for employees and, a short time later, again executed a consent for backdated options for the same employees, but with different “as of dates” to take advantage of a share price drop.
To settle the action, each defendant consented to the entry of a permanent injunction prohibiting future violations of the antifraud, proxy and reporting provisions of the federal securities laws. In addition, each defendant consented to an order requiring that they pay a civil penalty of $100,000. The Commission previously settled its action based on backdated options against the company as discussed here. SEC v. Mercury Interactive, LLC, Case No. 07-2822 (N.D. Cal May 31, 2007).