Notice To Members 86-69

Amendments to NASD Rules on Short Sales Become Effective October 15, 1986

Published Date:

TO: All NASD Members and Other Interested Persons

EXECUTIVE SUMMARY

The Securities and Exchange Commission recently approved amendments to the Board of Governors' Interpretation on Prompt Receipt and Delivery of Securities and Article III, Section 21 of the NASD Rules of Fair Practice (SEC Release No. 34-23572). The amendments, which will become effective on October 15, 1986, provide for additional regulation of short selling in the over-the-counter market. The text of the amendments is attached.

ACCEPTING ORDERS

The amendments to the Board of Governors' Interpretation on Prompt Receipt and Delivery of Securities (Interpretation) create separate procedures for the acceptance of "long" and "short" customer sale orders and establish new requirements for accepting "short" sale orders from customers.

Perhaps the most significant change relates to the acceptance of "short" sale orders from customers as provided in new section (b)(2) of the Interpretation. Section (b)(2) prohibits a member from accepting a "short" sale order from a customer unless the member makes an affirmative determination that it 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.

In adopting this new provision for "short" sales, the Board of Governors stated that the requirement to make an "affirmative determination" does not permit members to make assumptions with respect to a customer's ability to deliver securities in a "short" sale situation. A member must specifically ask the customer whether the securities will be delivered by settlement so that the member may determine whether it must borrow the securities on behalf of the customer for delivery by settlement. The Board chose not to establish a single method for members to demonstrate their compliance with the new requirements, but found it appropriate that the rule allow members the flexibility to design their own procedures.

Another amendment to the Interpretation involves a change in the criteria for accepting "long" sale orders from customers. Previously, section (b)(l) of the Interpretation prohibited a member from accepting a "long" sale order from a customer unless:

(A) The member had possession of the security;
(B) The customer was long in his account with the member;
(C) The member received reasonable assurance that the customer would deliver the security to the member within five business days; or
(D) The security was on deposit with a registered broker-dealer or an organization subject to state or federal banking regulations and the customer forwarded instructions to deliver the security to the member against payment.

Under the amended Interpretation, the requirements in subsections (b)(l) (A), (B) and (D) are unchanged. The requirement in subsection (C), that a member receive reasonable assurance that the customer will deliver the security within five business days, has been amended. Subsection (C) now requires members to make an "affirmative determination" that the customer owns the security to be sold and will deliver it within five business days. Guidance as to what is necessary to make an "affirmative determination" in the case of a "long" sale is provided in section (b)(4). That section requires members to make a notation on the order ticket at the time of the conversation with the customer reflecting the location of the securities and the ability of the customer to deliver them in good form within five business days.

MARKING OF ORDER TICKETS

The amendment to Article III, Section 21 of the NASD Rules of Fair Practice requires that each order ticket for a sale by a customer be marked "long" or "short." An order may be marked "long" only if:

(1) The customer's account is "long" the security; or
(2) The member is informed that the customer owns the security and will deliver it as soon as possible without undue inconvenience or expense.

If neither of these conditions can be satisfied, the order must be marked as a "short" sale.

It may be useful to point out that the five-business-day requirement for the delivery of securities in connection with a "long" sale under the Interpretation is not inconsistent with Article III, Section 21(b), which permits an order ticket to be marked "long" if the customer owns the security and will deliver it as soon as possible without undue inconvenience or expense.

The purpose of the requirement under the Interpretation to make an "affirmative determination" that securities sold "long" will be delivered within five business days is to prevent the build-up of fails between members by eliminating, insofar as possible, situations in which members enter into transactions that they are unable to consummate. The requirement to mark customer order tickets "long" or "short" under Article III, Section 21(b) serves an entirely different purpose. The marking of order tickets is a surveillance mechanism that enables member firms and regulatory bodies to monitor compliance with the Interpretation and other applicable requirements. As a result, the circumstances under which an order ticket may be marked "long" are purposely broad.

Therefore, upon determining that a customer owns a security and will deliver it within five business days, a member may accept the customer's order as a "long" sale under the Interpretation and mark the ticket "long." In the event that the customer subsequently becomes unable to deliver within five days, but represents that he will deliver as soon as possible, the member may continue to treat the order as a "long" sale without any further notation. Article III, Section 21(b) permits an order to be marked "long" if the customer owns the security and will deliver it as soon as possible without undue inconvenience or expense.

Pursuant to Article II, Section l(f) of the NASD Rules of Fair Practice, the term "customer" does not include a broker or dealer. Therefore, the requirements of the Interpretation on Prompt Receipt and Delivery of Securities for accepting orders and the requirements of Article III, Section 21(b) for marking order tickets do not apply to orders placed with one broker-dealer by another broker-dealer. Nor do the requirements apply to orders received by persons engaged in market making or similar trading activities for a member if such requirements have already been satisfied by other persons associated with the member.

Questions regarding this notice may be directed to Mary S. Head, NASD Office of General Counsel, at (202) 728-8284.

Sincerely,

Frank J.
Executive Vice President
Legal and Compliance

Attachment

AMENDMENTS TO NASD RULES ON SHORT SALES*

Effective October 15, 1986

Amendment to the Board of Governors' Interpretation on Prompt Receipt and Delivery of Securities

It shall be deemed a violation of Article III, Section 1 of the Rules of Fair Practice of the Association for a member to violate the provisions of the following interpretation hereof:

(a) Purchases: No 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 person associated with a member shall accept [execute] a long sale [sell] order [for] from any customer in any security unless:
(A) The member has possession of the security;
(B) The customer is long in his account with the member;
(C) The member makes an affirmative determination [Reasonable assurance is received by the member, or person associated with a member, from the customer] that the customer owns the security and will deliver [be delivered to] it in good deliverable form within five (5) 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 Securities and Exchange 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
No member or person associated with a member shall accept a "short" sale order [for] from any customer in any security unless the member makes an affirmative determination that it will receive delivery of the security from the customer or that it can borrow the security on behalf of the customer for delivery by settlement date.
(3) Public Offering
In the case of a public offering of securities, paragraph 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 the issuer of the securities; provided, however, that the member believes in good faith that the customer has purchased the securities.
(4) "Affirmative Determination"
To satisfy the requirements for an "affirmative determination" ["reasonable assurance"] contained in subsection [subparagraphl (l)(C)[(c)] above, the member or person associated with a member must make a notation on the order ticket at the time he takes the order which reflects his conversation with the customer as to the present location of the securities in question, whether they are in good deliverable form and his ability to deliver them to the member within five (5) business days.

Amendment to Article III, Section 21 of the NASD Rules of Fair Practice

Marking of Customer Order Tickets

(b) A person associated with a member shall indicate on the memorandum for each customer order for the sale of any security whether the order is "long" or "short." An order shall be marked "long" only if (1) the customer's account is "long" the security involved or (2) the member is informed that the customer owns the security and will deliver it as soon as possible without undue inconvenience or expense.

* New language is underlined; deleted language is bracketed.