4.

6

unwinding, it was not intended to cover any situation
where an avoidable delay in reversing one side
results in "legging-out" of the position.

The No-Action Position provides relief from the
aggregation requirements of Rule 3b-3 only with
respect to securities positions that are the subject
of bona fide arbitrage, risk arbitrage, or bona fide
hedge positions. Cf. Securities Exchange Act Release
No. 15533 (January 29, 1979), 44 FR 6081.
Accordingly, where the seller seeks to unwind an
index arbitrage position and has one or more short
positions in the component securities of the index
that are not the subject of bona fide arbitrage, risk
arbitrage, or bona fide hedge positions, the seller
must aggregate those short positions with the index
arbitrage positions that it seeks to unwind. For
purposes of this paragraph only, fully-hedged index
arbitrage positions may be considered as "bona fide
arbitrage" for aggregation purposes. Aggregation
must be based on securities positions in all
proprietary accounts as determined at least once each
trading day.

Moreover, when selling securities from a proprietary
account in a transaction not involving the unwinding
of an index arbitrage position, the 1986 Letter does
not provide any relief from the requirement to

7

aggregate short positions established in index

arbitrage transactions with such proprietary stock positions.

The Commission believes that publication of the Division's views in this release will assist market participants in understanding the limited scope of the no-action position. It also is important to note that the staff no-action position as expressed in the 1986 Letter and in this interpretive release is strictly limited to the application of Rule 10a-1 to sales in the course of liquidating the index arbitrage positions described above, and continues to be subject to modification or revocation if at any time the Commission or the Division determines that such action is necessary or appropriate in furtherance of the purposes of the Exchange Act.

By the Commission.

Dated: April 23, 1990

Jonathan G. Katz,
Secretary

The Commerce, Consumer, and Monetary Affairs Subcommittee,
as you are aware, is assigned oversight responsibility under the
rules of the House of Representatives for the activities of the
Securities and Exchange Commission and for securities market
regulation generally. It is in connection with this
responsibility that the subcommittee has recently initiated a
general inquiry into the nature and consequences of short selling
in the equity markets and has written to the SEC requesting
responses to a number of fundamental questions relating to short
selling. A copy of that inquiry letter, which has previously
been shared with your staff, is attached for your information.

I am writing to you at this time specifically to suggest the
need for the NASD to give increased attention, in its regulation
of short sales, to the substantial disparities between
broker/dealer firms on the one hand and public customers on the
other hand in the terms on which they are permitted to engage in
short selling. There appears to be a pattern, in the present
NASD rules, of exempting broker/dealers who trade for their own
proprietary accounts from certain important standards that the
investing public must adhere to.

Let me clarify at the outset that I am not speaking of dealer positions in securities that result from market making. am addressing instead the proprietary investment activities of broker/dealer firms for purposes other than making a market.

I

3

Interpretation on Prompt Receipt and Delivery that the NASD is seeking to reduce or discourage naked shorting?

Mandatory Buy-in Requirement

The reason I am asking about the NASD policy toward naked shorting is that it is generally acknowledged that a requirement to ascertain the availability of shares to borrow, prior to accepting a short sale order, does not ensure that the broker or the short selling customer will in fact borrow and deliver the necessary shares before settlement. Shares believed in good faith to be available for borrowing may ultimately be unavailable. Consequently, even if it is amended as proposed, and even if it were to be extended to the proprietary investment activities of market makers as I suggested above, the Interpretation on Prompt Receipt and Delivery cannot prevent the development of naked short positions of substantial magnitude.

I recognize also that it may be exceedingly difficult in practice to distinguish appropriately, by regulation, between proprietary investment positions and legitimate market making activities by market makers, and so it may not be feasible to make even the Interpretation on Prompt Receipt and Delivery applicable to a broad class of short sale transactions.

The only way to effectively eliminate naked short selling in cases where shares may not be available for borrowing, or where for other reasons it is more convenient for the selling broker not to deliver borrowed shares, is to mandate timely completion of the short trades through some form of mandatory buy-in for the benefit of the purchaser. If the NASD's purpose in proposing an amendment to the Interpretation on Prompt Receipt and Delivery has been to effectively reduce or eliminate naked short selling, then it stands to reason that the NASD should, in order to accomplish its purpose, also take the related step of implementing a mandatory buy-in requirement to assure the timely completion of short-sale trades.

It is significant, I believe, that this idea of a mandatory buy-in requirement has already been proposed twice to the NASD by its own consultants. Irving Pollack recommended such a requirement in his 1986 study for the NASD entitled "Short-Sale Regulation of NASDAQ Securities" (recommendation 4 on page 69). A similar recommendation has also been made more recently in the July 1988 report of the NASD's Special Committee of the Regulatory Review Task Force on the Quality of Markets.

In view of the close connection between this proposal and the proposed amendment to the Interpretation on Prompt Receipt and Delivery of Securities, I would therefore urge the NASD to give serious and simultaneous consideration to the recommendation