Comments of Managed Funds Association on S7-23-03

Managed Funds Association

January 26, 2004

Via Electronic Mail: rule-comments@sec.gov

Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549

Attention: Jonathan G. Katz, Secretary

Re: Proposed Regulation SHO; File No. S7-23-03

Ladies and Gentlemen:

In response to the request of the Securities and Exchange Commission (the "Commission"), Managed Funds Association ("MFA")¹ offers the following comments on Securities Exchange Act Release No. 48709 (October 29, 2003) (the "Release"), "Proposed Rule: Short Sales" ("Regulation SHO"). In its comments below, MFA also addresses issues raised in Securities Exchange Act Release No. 48795 (November 17, 2003) (the "Married Put Release"). We hope our comments prove helpful to the Commission.

Introduction. MFA regards short selling as an essential method by which investors, including fiduciaries managing others' assets, can register their view that the current price of a security diverges from the value ascribed by the investor. It also is a means by which investors can invest in related or derivative instruments and then hedge the risk of such instruments by offsetting market exposure in the equity markets. The benefits of short selling to the broader market are well known.² When properly used, short selling provides liquidity to the market and participates importantly in price formation.

Overall, MFA supports the Commission's efforts to modernize short sale regulation in Regulation SHO. We recognize that in Regulation SHO, the Commission is looking to limit abuses while broadening the salutary uses of short selling. MFA recognizes that short selling also can be abused and can adversely affect the markets, but we believe that, with today's improved surveillance techniques, the risk of abuse can be adequately addressed without mechanical rules such as the current short sale rules and the proposed Regulation SHO.

In our view, the current short sale rules make no more sense as an economic matter than would a "long buying" rule, requiring long buyers to post a bid one cent below the best offer unless they were covering a short. We therefore applaud the Commission's willingness to suspend short sale regulation for large capitalization stocks. We believe the absence of apparent problems in the trading of Nasdaq securities on regional exchanges without short sale price regulation supports the notion that such regulation is not any more necessary than price regulation of long purchases. Accordingly, we encourage the Commission to adopt the proposed suspension and then move expeditiously toward the complete removal of short sale price regulation. We comment below on ways in which, in the interim, the proposed Regulation SHO can and should be improved before adoption.

The Bid Test. If a price test is to apply to short selling, we agree with the Commission's proposal for a uniform short sale rule across all equity markets, but we believe the bid test proposed in Rule 201(b) is not appropriate and would be dysfunctional. The proposed requirement for a one-cent pricing increment over the prevailing best bid should not apply in rising markets. It would impede trading and distort market pricing by preventing short sellers from hitting the best bid. If the proposal were adopted, short sellers would have to increase their offer prices by at least one cent above the current consolidated bid every time the consolidated bid moved up. In an upward moving market, the proposed one-cent increment might well make it difficult to get short sales executed. The Commission has not explained in the Release what economic benefits would be gained if a short seller were impeded from short selling in an upward moving market. The proposal would lessen the salutary benefits short selling has on an irrationally exuberant market and on securities the market has mispriced. Further, the Release offers no explanation for why a short seller should be prevented from selling at the same price as a long seller in a rising market.

The unequal and unfair burden of the proposed rule on market participants selling short in a rising market can be illustrated as follows: If the market were $X.12 bid and $X.15 asked, a long seller would be able to hit the $X.12 bid and sell shares at this price whereas a short seller would be prohibited from doing so even if the bid had been steadily increasing. This would decrease the liquidity available to the buyer at $X.12. If the buyer were unable to satisfy its demand from long sellers at $X.12, it would be forced to pay up by at least $.01 to lift the short seller's offer. If, on the other hand, the buyer did satisfy its demand from long sellers at $X.12, the short seller would have been unfairly excluded from participating in these sales and might miss the opportunity to sell shares into a strong market.³ There should be a strong presumption against any rule that prohibits a market transaction between a willing buyer and a willing seller. In the case of a rising market, no justification has been advanced that would overcome this presumption.

The proposed price-improvement rule could also divert trading volume into the derivatives markets, such as the single-stock futures market. While single-stock futures have not been a resounding success to date, the adoption of Regulation SHO in its current form would increase the attractiveness of the single-stock futures market and could well result in diverting order flow to that market. This regulation-induced distortion of market economics would not serve the public interest.

Accordingly, MFA respectfully recommends that the Commission consider adopting the alternative the Commission put forward in the Release, that is, "a bid test allowing short selling at a price equal to or above the consolidated best bid if the current best bid is above the previous bid (i.e., an upbid)."⁴ In this alternative, short selling would be restricted to a price at least one cent above the consolidated best bid (not equal to the best bid) only if the current best bid were below the previous bid (i.e., a downbid)."⁵ The alternative proposal, we believe, would adequately address the Commission's concern that short selling not be used to manipulate the market by artificially driving prices down. The application of the currently proposed bid test in an upward moving market would unfairly exclude short sellers from market transactions and would not seem to advance any legitimate regulatory objective.

After-Hours Trading and Trading in Foreign Markets. The proposed rule would prevent short selling at a price at or below the last published consolidated best bid after the consolidated best bid ceases to be calculated and disseminated and would apply to after-hours trading in all covered securities. To tie short selling in the after hours market to a stale price could well disadvantage investors and other market participants and does not serve any regulatory purpose. Currently, as the Commission knows, NASD Rule 3350 ceases to apply at 4:00 p.m., while a pilot program the Commission has approved for Nasdaq extends the operation of key trade- and price-reporting systems until 6:30 p.m. MFA is not aware of any evidence that the 4:00 p.m. cut-off for NASD Rule 3350 has led to any problems, nor does the Commission cite any in the Release. The stated objective of the price test is to prevent the manipulative use of short selling as "a tool for driving the market down" or "accelerating a declining market."⁶ Short selling that does not result in a "print" cannot communicate misleading information to the market and, therefore, is not likely to have manipulative effects. Accordingly, MFA recommends that when the consolidated tape stops, Regulation SHO should as well.

MFA also does not believe there is any sound justification for the regulation of trades that do not print in the United States but instead print in jurisdictions outside the United States. We are not aware of any data demonstrating that such trading is harmful to the markets or is manipulative. We respectfully suggest that Regulation SHO should not apply to trading that does not print in the United States because there is no significant risk of manipulative effect when trade prices are not published.

Aggregation Units. The test for aggregation of units stated in proposed Rule 200(e)(3) is difficult to apply in practice since it often is difficult to know whether trading objectives that involve, for example, short-term holding can be put in different aggregation units if they are similar in appearance but involve different, computer-driven trading algorithms, such as mean-reversion strategies, that are not designed by a single individual or a group working together. Requiring the aggregation of such trading programs for short sale purposes is not workable and is not required for investor protection.

We recommend, in addition, that the Commission consider expanding the availability of the exception to include the "buy side". The Commission's decision to allow registered broker-dealers to comply with Rule 10a-1 on the basis of aggregation units was motivated by the belief that such a regime would adequately serve the purposes of short sale regulation and would resolve three problems caused by applying the regulation across an entire firm: (i) the requirement adversely affects a market participant's ability to provide liquidity to the marketplace and to engage in other legitimate transactions; (ii) it is unnecessarily burdensome for firms that engage in many different activities to comply with the different calculations needed to be made pursuant to the applicable sections of Rule 10a-1; and (iii) permitting separate trading units to sell long up to the amounts of their own, independently established long positions is not the deliberate, manipulative market activity that the short-sale rule is intended to prohibit - accordingly, the cost of the rule, as applied across an entire firm, greatly outweighs any perceived benefit.⁷ The same rationale applies to investment firms on the "buy side" and the Commission should now expand the relief granted to broker-dealers to investment firms that are acting for their many investors. If the Commission is concerned about whether buy-side firms will in fact comply with the aggregation unit requirements, it can evaluate that compliance through its examination of the brokers for such entities.

Proposed Rule 201(d)(5). Proposed Rule 201(d)(5) retains the narrow exemption in (e)(7) for "bona fide arbitrage," that is, selling short contemporaneously with purchasing a security (the "Equity-linked Security"), whose value depends on or relates to the security sold short. The proposed rule further narrows the exemption by making it available only to those investors that convert their Equity-linked Security, instead of electing other investment alternatives. We believe that an arbitrage exception is necessary, that the current exception in paragraph (e)(7) of Rule 10a-1 is too narrow to accord with current market conditions and that the additional limitations the proposed exception in Rule 201(d)(5) would impose are unnecessary and inappropriate.

Equity-linked Securities such as convertible bonds play a large and vital role in the capital markets and are an instrument of choice for issuers that seek to raise capital at a lower cost than straight debt.⁸ The growth of Equity-linked Securities owes much to the proliferation of hedging technology and the ease with which investors can implement Equity-linked Securities hedging strategies. The value of Equity-linked Securities reflects a complex, dynamic relation between an issuer's credit quality and the prospective dynamics of the underlying equity. The efficiency of the Equity-linked Securities market depends critically on investors' willingness to commit capital whenever Equity-linked Securities prices deviate from their estimated values. These values normally presume an ability to offset the equity exposure of the Equity-linked Securities by selling the equity short and altering the hedge dynamically thereafter. Any impediment to the ability of investors to reduce the risk of holding an Equity-linked Security through hedging has an adverse economic impact on current and prospective issuers, diminishing the attractiveness of this important investment medium. By limiting its applicability in ways that have no market-based or other justification, the current exception in paragraph (e)(7) of Rule 10a-1 severely circumscribes the market participant's ability to reduce risk. Our recommendations are as follows:

First, the exception should be expanded to apply to exchangeable securities as well as to convertible securities.⁹ The market efficiencies gained by allowing short selling, already recognized by the Commission in respect of convertible securities, apply equally to exchangeable securities.
Second, the exception should be clarified to indicate that the market participant can hedge an Equity-linked Security by selling the underlying stock short without complying with the short-sale price test as long as the total amount of short sales does not exceed the amount of stock underlying the Equity-linked Security. For Equity-linked Securities to be attractive, investors should be unfettered in how much they hedge (up to the equivalent amount of shares), when they hedge, and the exception should apply wherever the arbitrage is designed to take advantage of mispricing (present or expected).¹⁰
Third, the proposed rule adds a further limitation not present in paragraph (e)(7) of Rule 10a-1, that to be eligible for the exemption the investor must thereafter exercise the embedded right and acquire the underlying securities. This restriction serves no beneficial regulatory purpose and significantly interferes with the investment decision of a holder of an Equity-linked Security. It should be deleted. A simple example of the drawback to this limitation is in the case of an Equity-linked Security that falls deep-out-of-the-money when the stock price falls sharply. An investor may never exercise the security, but that should not result in an ex post facto retraction of the exception that applied to an investment decision to sell short when the price of the security was higher. In any event, the manner of exit from the position, whether by exercise or sale of the Equity-linked Security or receipt of cash-equivalent value rather than the physical security underlying the Equity-linked Security, should not affect availability of the exception.
Fourth, the reference to a "special arbitrage account" in proposed Rule 201(d)(5) is archaic, serves no useful purpose and should be deleted.¹¹
Finally, we recommend that the requirement that the Equity-linked feature have been "originally attached to or represented by another security, or was issued to all holders of the securities" be deleted. While this language characterizes the classic convertible security or warrant issuance to all holders, it does not have any necessary bearing on whether the exception should apply in today's markets. Various options spreading strategies, involving standardized and customized options issued by entities other than the issuer of the underlying stock, should be allowable under this exception for the same reason as classic convertible arbitrage has been allowed: they tend to eliminate pricing distortions in the markets and improve the efficiency and reliability of the markets as a pricing mechanism without presenting any of the manipulative risks short sale price regulation was intended to address.

Merger Arbitrage. Proposed Rule 201(e)(7) would not except from the bid test short sales effected in connection with a merger where the right to acquire another security in a merger scenario arises only by terms of the merger agreement and not through a right vested in the security itself. As in other forms of arbitrage, merger arbitrage involves a hedge between what may be viewed as two markets, the current market price and the contingent parity value if the merger is consummated.¹² It is not clear what perceived risk the Commission seeks to prevent or control by submitting short sales in a merger scenario to the bid test. The relevant analysis is not whether a right in the shorted security has vested but whether the positions taken in hedging a merger arbitrage position are directionally biased. The positions taken by fund managers engaged in merger arbitrage are not based on anticipation of a decline in the stock, that is, they are not directionally biased, but are instead designed, as the Commission has noted, to capture a spread between the existing stock price and the contingent parity value.

MFA, therefore, respectfully recommends that the Commission include a merger arbitrage exception in proposed Rule 201(e)(7). We think the merger arbitrage exception should apply to any announced tender offer, merger or recapitalization that involves the issuance of one class of securities in respect of another class of securities. There is no reason to postpone availability of the exception to any point after public announcement, whereas trading before an announcement presumably is based on conjecture rather than the established fact of a pending deal.

Locate and Delivery Requirements. As currently drafted, the Commission's proposed locate and delivery requirements in proposed Rule 203 would appear to require that if an investor effects a short sale and there is a subsequent delivery failure, the investor would be penalized. While we understand the Commission's objective of protecting against collusive shorting, for example, through "daisy chain" trading, we do not believe that purpose is served by penalizing an investor who might not be at all responsible for his or her brokerage firm's failure to deliver. Also, we are concerned that the proposed locate and delivery requirements well exceed the actual requirements of delivery, particularly where an investor shorts and then covers the short, possibly several times during a single trading session, in the course of program trading or other strategies. Requiring more locates than are necessary will tend to dry up the pool of stock available for borrowing, particularly if short sellers have to ensure a borrow at the time of a locate (locating without more does not commit the source to a stock loan). The carrying costs of pre-borrowing, moreover, would likely exceed the benefit to investors in pursuing many commonly implemented trading strategies, particularly program trading. The increase in frictional costs would reduce the efficiency of the markets as a pricing mechanism and would diminish market efficiency and reduce investors' returns.

The Commission also should consider the unintended consequences of the proposed locate and deliver requirements. The proposed rules would encourage short sellers to borrow shares in advance at unprecedented levels. Also, the rules would encourage the development of manipulative "games" to squeeze the short sellers, particularly given the proposed requirement that delivery be made within five business days of trade date.¹³ Since a "locate" does not necessarily commit the holder of the located shares to lend them to the locating party, short sellers will locate shares that they then discover are not available for loan on the sale date and they will be forced to cover the trades, often at a loss. This has substantial manipulative potential. Securities lenders would be able to make shares available for locates on days when there is significant, negative, news activity but then decline to lend them to the street on the sale date. That, in turn, will force the broker-dealers to buy in the new shorts, driving the price up.

We respectfully recommend that that the Commission reconsider its approach to the locate and deliver issue. Given the risks that whatever changes the Commission imposes will lead to increased costs and other economic distortions, the Commission should not change the existing rules more than is absolutely necessary to address known abuses and should rely more on Commission and self-regulatory organization surveillance of market makers, prime brokers and others to detect and curtail abusive conduct.

Exclusion of Bonds. In the Release, the Commission asked whether short sale regulation should apply to bonds. Regulation SHO would not do so. MFA believes there is no reason to apply short sale regulation to bonds. Corporate bonds trade on the basis of a spread over a "benchmark" on-the-run Treasury. The spread is dependent on several factors, including the rating, if any, other characteristics affecting the issuer's creditworthiness and any special call features or other individual factors affecting the particular security. Previous trading in the particular security sometimes may be a factor, but we are not aware of any instances of short selling bonds for manipulative purposes. Short selling of bonds is more common today than it had been historically, but it is still much less common than short selling equity, in part because many bonds are relatively less readily available for borrowing.

The Married Put Release. In our view, the Married Put Release raises a number of questions that should be resolved through formal rulemaking. It is not clear, for example, what combinations of financial instruments, beyond married puts, would be subject to the six-factor test set forth in the Married Put Release. Statements in footnote 21 to the Married Put Release suggest that the same analysis might be applied to forward conversions and other strategies. The Married Put Release provides little guidance as to what steps can be taken to comply with the law.

In light of the foregoing, we recommend the Commission codify the Married Put Release and incorporate it into the new Regulation SHO with clearly articulated, objective tests. The Commission should delete any suggestion that other, unnamed and unspecified strategies may also receive the same treatment as married puts on the basis of a trader's subjective motivation. If the short sale rules are supposed to be mechanical, not requiring a subjective showing of scienter or manipulative intent, there should not be suggestions about unspecified strategies that will or could be deemed to cut against a long position. The Commission has been quite precise in the short tendering rule, Exchange Act Rule 14e-4, as to what does or does not count against a long position and should be equally precise in Regulation SHO. Subjective or imprecise tests should have no place with respect to guidance concerning Rule 3b-3.

* * *

MFA appreciates the opportunity to offer its comments to the Commission on Regulation SHO. If we may be of further service to the Commission or its staff in their evaluation of these matters, please let me know. I can be reached at 202.367.1140.

Respectfully submitted,

/s/ John G. Gaine

John G. Gaine
President

cc: The Hon. William H. Donaldson, Chairman
The Hon. Paul S. Atkins, Commissioner
The Hon. Cynthia A. Glassman, Commissioner
The Hon. Harvey J. Goldschmid, Commissioner
The Hon. Roel C. Campos, Commissioner
Annette L. Nazareth, Director,
Division of Market Regulation
Robert L. D. Colby, Deputy Director,
Division of Market Regulation
Larry E. Bergmann, Associate Director,
Division of Market Regulation
James A. Brigagliano, Assistant Director
Division of Market Regulation
Gregory J. Dumark, Special Counsel
Division of Market Regulation
Kevin J. Campion, Special Counsel
Division of Market Regulation
Lillian S. Hagen, Special Counsel
Division of Market Regulation
Elizabeth A. Sandoe, Special Counsel
Division of Market Regulation
Marla O. Chidsey, Special Counsel
Division of Market Regulation
Stephen L. Williams, Economist
Division of Market Regulation
Lawrence E. Harris, Chief Economist
Giovanni P. Prezioso, General Counsel

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¹ MFA, located in Washington, DC, is the only U.S.-based membership organization dedicated to serving the needs of professionals worldwide that specialize in the alternative investment industry - managed futures funds, hedge funds and funds of funds. MFA has approximately 700 members who manage a significant portion of the $700 billion invested in these alternative investment vehicles globally.
² See, e.g., Arturo Bris, William N. Goetzmann and Ning Zhu, "Efficiency and the Bear: Short Sales and Markets Around the World" (Yale School of Management, Jan. 2003), a study of forty-seven stock markets around the world, in which the authors found that markets with active short sellers reacted to information more quickly and set prices more accurately; and Owen A. Lamont, "Go Down Fighting: Short Sellers vs. Firms", available at http://www.som.yale.edu/faculty/oal4/research/go%20down%20fighting.pdf (concluding that constraints on short selling as a result of various actions taken by firms allow stocks to be overpriced and that firms taking anti-shorting actions have in the subsequent year abnormally low returns of about minus two percent per month).
³ Locking a short seller out of the market in this way could be particularly harmful to an investor attempting to establish a hedge against a long position that had already been acquired.
⁴ Release, in text following n.77.
⁵ Release in text at n.78.
⁶ Securities Exchange Act Release No. 42037 (October 20, 1999) at n.17.
⁷ See, Letter from Roger D. Blanc on behalf of 14 firms to Dr. Richard R. Lindsey, Director, Division of Market Regulation (November 23, 1998) at III. Discussion, and response by Dr. Lindsey of the same date, 1998 SEC No-Act. LEXIS 1038.
⁸ The notional value of convertible bonds issued in the United States over the 10-year period between 1994 and 2003 increased from $22.6 billion to $91.8 billion. (Data derived from financial sources that actively cover the convertible bond market.).
⁹ We use the term "convertible securities" to refer to securities that convert into equity securities of the same issuer and the term "exchangeable securities" to refer to securities that convert into securities of an issuer other than the issuer of the exchangeable security.
¹⁰ The proposed rule contains limitations on applicability such as "the short sale is in an amount equivalent to the number of the securities that he is entitled to acquire, the sale is effected to profit from a current price difference between the security sold short and the security he is entitled to acquire . . ." The rule, we believe, should instead say, "the short sale is in an amount not greater than the number of shares he is entitled to acquire, the sale is effected to profit from a current or reasonably expected price difference between the security sold short and the security he is entitled to acquire . . ." Those changes would resolve confusion about how the exception applies to dynamic hedging on a ratio basis (which we believe would not in any event involve more than the total number of shares receivable upon full exercise of the overlying position in Equity-linked Securities) and would clarify that the exception applies to current practices among market participants involving convertible and exchangeable securities, in which the expectation of profit is based on projected changes in the volatility of the embedded call option in the Equity-linked Security will translate into changes in the market price of the Equity linked security that will make the arbitrage profitable. Such practices of dynamic hedging and of performing convertible arbitrage on the basis of computer-driven options pricing models do involve a legitimate arbitrage strategy, although a more sophisticated one than the arbitrage practices that existed when paragraph (e)(7) of Rule 10a-1 was first written.
¹¹ This provision may well have been designed to dovetail with certain former provisions in the margin rules that were deleted long ago. For similar reasons, we suggest that proposed Rule 201(d)(7) be revised to (a) remove the reference to "special international arbitrage account" and (b) revert to the language in paragraph (e)(8) of Rule 10a-1, which requires only that the investor have reasonable grounds to believe that an offer enabling him or her to cover the short sale is available, rather than being required to make an offer simultaneously.
¹² See Securities Exchange Act Release No. 13355 (January 29, 1979) at n.55.
¹³ See Owen Lamont, op cit. In addition, we recommend that the Commission look further into instances in which issuers have attempted to organize "short squeezes" by withdrawing their certificates from DTCC and recommending to shareholders to transfer their stock from margin accounts into cash accounts, triggering the termination of stock loans. The academic literature tends to suggest that the stocks of issuers that punish the short sellers experience inferior returns over time, probably because the short sellers were correct in identifying the stocks as overvalued. Id.