Introduction
On November 28, 2005, the Securities and Exchange Commission approved amendments (the “Amendments”) to Exchange Rules 282 (“Mandatory Buy-In”), 284 (“Procedure for Closing Defaulted Contract”), 289 (“Must Receive Delivery”) and 290 (“Defaulting Party May Deliver After Notice of Intention to Close”) (collectively, the “Buy-In Rules”) to both standardize and streamline buy-in rules and procedures.1
The Amendments, which are effective immediately, permit buyer-initiated buy-ins; reduce the waiting period to initiate a buy-in from thirty days to three days; and otherwise provide consistency with industry buy-in rules and procedures.2
Background
The Exchange Buy-In Rules apply to transactions in Exchange-listed securities that are not subject to the rules of a Qualified Clearing Agency such as the National Securities Clearing Corporation (“NSCC”),3 including the Continuous Net Settlement (“CNS”)4 transactions that settle through them. Under the pre-amendment Buy-In Rules, the defaulting (selling) member organization had no incentive to clean up fails on a timely basis. Further, “buyer” member organizations did not have the ability to initiate action when a customer’s trade had not settled and the customer’s securities were not available because a buy-in had not been executed by the defaulting member organization in a timely manner. This contributed to aged fails and capital charge implications for possession and control under Rule 15c3-35 under the Securities Exchange Act of 1934 (the “Exchange Act”)6 as well as client service issues related to delivery.
Industry Recommendations
To address these concerns, Exchange staff met with the Securities Industry Association (“SIA”) Securities Operations Division Buy-In Committee (the “Committee”) and other self-regulatory organizations (“SROs”) to identify and harmonize various buy-in rules and procedures regarding the close-out process related to street-side contracts. The Committee, in conjunction with the Depository Trust & Clearing Corporation (“DTCC”), has contributed to the implementation of several enhancements to the buy-in process, such as changes to the electronic reporting process within the DTCC Participant Exchange Service Main Menu (“PEXM”) function.7
One recommendation to emerge from the meetings was to eliminate the “Notice” procedures (described below) and to move toward a more permissive process that would allow buy-side member organizations to initiate and execute buy-ins on a more timely basis.
Specifically, it was recommended that Rule 282 be amended to remove hard-copy notice requirements to otherwise better coordinate the Buy-In Rules with industry practice at DTCC, NASD, NSCC and CNS where many buy-in notices are issued; for example, non-member firms are permitted to close-out NYSE trades by executing them in their own order room. Further, it was recommended that Rules 284, 289 and 290 be amended in light of the proposed changes to Rule 282. Accordingly, the following amendments have been adopted.
The Amendments
Rule 282 (“Mandatory Buy-In”)
Prior to the Amendments, Rule 282 prescribed a process in which the initiating member organization was required to wait until “the fourth business day prior to the thirty-first calendar day after the due date of the contract” before taking steps to close-out a contract that had not been completed by the defaulting seller (i.e., a “mandatory buy-in”). A mandatory buy-in required that a “Buy-In Notice” be delivered, in triplicate, by the initiating member organization (the buyer) to the member organization in default (the seller). The member organization receiving the Buy-in Notice would then indicate its position – whether it could deliver or not. If the Buy-in Notice was not returned when due, or was returned with an indication that the contract is known but that delivery cannot be made, then a “Buy-in Order” in duplicate would be sent to the member organization in default (the seller) for execution.
The amendments to Rule 282 (see Exhibit A) permit the initiating (buying) member organization failing to receive the securities to execute the buy-in. Further, the waiting period to initiate a buy-in has been reduced to three business days after settlement date. By shifting responsibility to the buy-side of the transaction and reducing the time frames, the buy-in process should work more efficiently.
The requirement for duplicate and triplicate paper notices has been eliminated and electronic notices (including notices from a computerized network facility or the electronic functionality of a Qualified Clearing Agency, such as DTCC and NSCC) are now permitted to be delivered by the initiating member organization at or before 12:00 noon ET at least two business days before the proposed execution of a buy-in. The Amendments also delete Rule 282’s time deadlines for delivering notices, securities, and executions and substitute those generally used by the industry.
Regulation SHO
Of relevant note is that in early 2005 the SEC implemented Regulation SHO (“Regulation of Short Sales”),8 which shares a similar purpose with the amended Buy-In Rules – specifically, the reduction or elimination of “fails to deliver.” Rule 203 under Regulation SHO imposes locate and borrowing/delivery requirements on broker-dealers that sell equity securities. Further, like Exchange Rule 282, Rule 203 imposes delivery obligations on broker-dealers with the objective of reducing fails to deliver.
Contemporaneous with the implementation of Regulation SHO, the SEC issued an Order Suspending the Operation of Short Sale Price Provisions for Designated Securities and Time Periods 9 which established a Regulation SHO Pilot Program. The Order prohibits any SRO from having a rule that is not in conformity with, or that conflicts with, the provisions of Rule 10a-1(a) under the Exchange Act, or with any short sale price test of any exchange with respect to the Pilot Program.10
In addition, Regulation SHO requires, prior to effecting short sales in any equity security, that broker-dealers “locate” securities available for borrowing and to close-out “fail to deliver” positions in “threshold securities”11 which are open for a certain period of time. In light of these changes, Rule 282 has been amended to harmonize its requirements with those of Regulation SHO in order to more effectively accomplish the Regulation SHO objective of reducing failures to deliver.
Specifically, amendments to Rule 282’s Supplementary Material are intended to ensure that members and member organizations comply with the closeout requirements of Regulation SHO, as well as with its marking, locate, and delivery requirements. Members and member organizations are required to have policies and procedures in place to comply with these rules, including closeout procedures.
Rule 284 (“Procedure for Closing Defaulted Contract”)
Prior to the Amendments, Exchange Rule 284 set forth a permissive procedure by which an initiating member organization (buyer) could close-out a contract that had not been completed by the defaulting member organization (seller), but that was not required to be closed-out. Rule 284 also required that a Buy-in Notice be delivered to the defaulting member organization within 45 minutes after delivery time, then delivered to the member organization in default between 2:15 and 2:30 p.m. for execution after 2:35 p.m.
The Amendments rescind Rule 284 and incorporate the permissive buy-in procedures of Rule 284 into Rule 282, subject to Rule 282’s revised time frames.
Rules 289 (“Must Receive Delivery”) and 290 (“Defaulting Party May Deliver After Notice of Intention to Close”)
Rule 289 had required an initiating member organization to accept physical delivery of some or all of the securities that are the subject of a buy-in, thereby halting the buy-in execution for those securities if they are delivered prior to the buy-in. Rule 290 permitted a defaulting member organization to deliver securities subject to a notice of buy-in until 2:30 p.m. on the day of the execution of the buy-in.
Amendments to Rules 289 and 290 revise and clarify the requirements and timeframes within which a defaulting member organization may deliver against a “buy-in” notice. Of particular note is the extension of the delivery requirement deadline from 2:30 p.m. to 3:00 p.m. ET. Finally, the amendments make technical changes to Rules 282, 289 and 290 to accord with industry practice.
Conclusion
The Exchange believes the amendments to its Buy-In Rules will expedite the clearance and settlement of transactions by member organizations and the industry as a whole by creating incentives for member organizations to clean-up fails and to deliver on a more timely basis.
Questions regarding this Info Memo may be directed to Anand Ramtahal at (212) 656-5741 or Bernadette Chichetti at (212) 656-6934.
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