May 25, 2001
This is in response to the letter from Firm A, dated April 6, 2001, in which Firm A requests interpretive guidance on the application of NASD Rule 3370 to a proposed arrangement with Firm A's customers who execute short sales. By way of background, your letter states that Firm A has been in the process of developing a new service to offer to customers of its current Prime Brokerage business. Firm A would offer equity execution services in the U.S. markets through a distribution agent, such as an executing broker, and Firm A would act as an intermediary between its clients and an executing broker. Firm A is an introducing broker and would act only as a fully disclosed agent to its customers and would not take on principal positions or engage in market making activity.
According to your letter, Firm A has been in contact with NASD District Office regarding this proposed activity and is awaiting written approval to conduct this proposed business under the terms of its current Membership Agreement. In addition, Firm A has been in contact with Yvonne Huber, Associate Director of NASD's Market Regulation Department, regarding the handling of customer short sale orders. Given the nature of the inquiry, Ms. Huber suggested that Firm A seek written interpretive guidance on whether the two scenarios described below would comply with the affirmative determination requirements under Rule 3370.
Firm A proposes to provide its clients with a daily "Easy to Borrow" list, as described in NASD Notice to Member 00-28 (May 2000). Firm A will provide, on a daily basis, standing assurances that specific securities contained on the "Easy to Borrow" list will be available for borrowing on settlement date to satisfy Firm A's affirmative determination requirements. To ensure compliance with the affirmative determination requirement, Firm A has contemplated two alternatives with regard to Rule 3370. In the long term, Firm A intends to establish a technological "firewall" that will prevent customers from placing short sale orders for securities that do not appear on the distributed "Easy to Borrow" list ("Scenario 1"). However, prior to the creation of such an electronic blocking mechanism, Firm A will perform an end of the day or next day review of all executed short sale orders and confirm whether all the securities for all such orders are on the "Easy to Borrow" list. Should any short sale transaction occur for securities not on the "Easy To Borrow" list, Firm A will ensure the availability of such securities by settlement date through its securities lending desk on the next trade date (T+1).("Scenario 2")
Rule 3370(b)(2) states that no member or person associated with a member shall accept a short sale order for a customer unless the member or person associated with a member makes an affirmative determination that the member 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. Rule 3370(b)(4)(C) permits members to rely on "blanket" or standing assurances (i.e., "Easy to Borrow" lists) that securities will be available for borrowing on settlement date to satisfy their affirmative determination requirements under this Rule.
With respect to the first scenario whereby the firm will establish firewalls that prevent the execution of short sales in securities not on the "Easy to Borrow" list, the staff believes that such safeguards are consistent with the intent of Rule 3370(b). However, members are required to annotate compliance with the "affirmative determination" requirement contained in Rule 3370(b)(2) (e.g., marking the order ticket, recording inquiries in a log, etc.). Your letter does not indicate the manner in which your firm intends to comply with the annotation requirements, and thus we cannot provide you guidance concerning that requirement.
With respect to the second scenario whereby the firm will conduct a review after the short sale order has been executed to ensure that the security is on the "Easy to Borrow" list, the staff does not believe that such an arrangement would comply with Rule 3370(b). Although, on the following trade date, Firm A will ensure the availability of such securities by settlement date, the affirmative determination requirements must be fulfilled by the member or person associated with the member prior to accepting the short sale order. An affirmative determination conducted after the order has been accepted would not comply with Rule 3370(b).
Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the Board of Directors of NASD Regulation, Inc. This letter responds only to the issues you have raised based on the facts as you have described them, and does not address any other rule or interpretation of the NASD, or all the possible regulatory and legal issues involved.
Stephanie M. Dumont