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The SEC is temporarily exempting the securities industry from complying with certain requirements related to the sale and delivery of physical securities under short sale rules in Regulation SHO because of ongoing concerns related to COVID-19, a highly contagious respiratory disease caused by a novel coronavirus.

In order to contain the virus, many states have ordered lockdowns, leading many businesses and organizations to either suspend some operations or have employees work from home in the spring. Since then the restrictions have been eased.

Reg SHO established “locate” and “close-out” standards that are largely intended to prevent stock traders from engaging in naked short selling. Naked shorting is when a stock is traded without first borrowing the security or before making sure that the security can be borrowed.

The commission is providing certain exemptive relief from the locate and close-out requirements in Release No. 34-89659, Order Granting Exemptions from Certain Rules Related to the Sale and Delivery of Physical Securities under Regulation SHO Related to COVID-19, issued on Aug. 25, 2020.

The exemptive order expires on Dec. 31, 2020.

In explaining the exemption, the SEC said that the clearinghouse, Depository Trust & Clearing Corporation (DTCC), has intermittently suspended physical securities processing services by its subsidiary, Depository Trust Company (DTC), because of COVID-19 related safety and health concerns.

The DTCC has resumed limited services for new physical securities transactions, but the SEC said that there are likely to be delays in settlement for the sales of stocks that the seller is “deemed to own” under Rule 200(b) of Reg SHO, and for which settlement depends on the delivery of physical certificates. This may result in extended failures to deliver.

Rule 200(g) requires brokers to mark all sell orders as “long,” “short,” or “short exempt.”

A broker can mark long only if the seller is “deemed to own” the security being sold. And the broker must physically possess or control the security to be delivered, or it is reasonably expected that the security will be physically possessed or controlled by the broker no later than the settlement of the transaction. Because of the intermittent inaccessibility of physical certificates at DTC, sell orders for owned physical securities may not quality for long order.

Rule 203(b) states that a broker may not short unless the broker has borrowed the security or has an arrangement to borrow the security, or the broker has reasonable grounds to believe that the security can be borrowed and be delivered on the date delivery is due.

The SEC provided an exception to the “locate” requirement for sales of securities that the person is deemed to own provided that the seller intends to deliver the securities as soon as all restrictions on delivery have been removed. And this is provided that if the seller has not delivered such securities within 35 days after the trade date, the broker-dealer must borrow securities or close out the short position by purchasing securities of like kind and quantity.

But the Securities Industry and Financial Markets Association (SIFMA) has told the SEC staff that fail to deliver positions resulting directly from DTC’s intermittent suspension may persists longer than the 35-day delivery requirement.

“We believe that requiring compliance with the Rule 203(b) ‘locate’ requirement or the delivery requirement under Rule 203(b)(2(ii) in spite of the anticipated delivery delays as a result of DTC’s intermittent suspension of physical securities processing due to ongoing concerns related to COVID-19 may cause undue burdens on various market participants, particularly in the context of physical securities for which lending markets are small or non-existent,” the SEC said in Release No. 34-89659. “As a result, we believe that the temporary relief from the Rule 203(b) “locate” requirement of Regulation SHO for owned physical securities provided by this Exemptive Order is appropriate in the public interest and consistent with the protection of investors.”

The order, however, lays out certain conditions that the brokerage industry must meet to get the exemption.

For more information on this topic, or to learn how Baker Tilly SEC accounting specialists can help, contact our team.

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