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 A FOLEY & LARDNER LLP INFORMATION BULLETIN FOR CLIENTS AND FRIENDS
                                                                                                                                August 27, 2004


SEC Adopts Regulation SHO to Amend Short Sale Rules                                                                                            Brussels
                                                                                                                              Avenue de Cortenbergh, 118
Regulation SHO. On June 23, 2004, the Securities and Exchange Commission (“SEC”)                                                B-1000 Brussels, Belgium
                                                                                                                                      011-32.2-639-2710
adopted new Regulation SHO under the Securities Exchange Act of 1934 (the “Act”) and                                                           Chicago
amended several rules that relate to the short selling of securities.1 Regulation SHO is                                 321 North Clark Street, Suite 2800
                                                                                                                                   Chicago, IL 60610-4764
intended to curtail increased instances of abusive “naked” short selling, (i.e., selling short                                              (312) 832-4500

without borrowing the necessary securities to make delivery), particularly in thinly capitalized                                                 Detroit
                                                                                                                             150 W. Jefferson, Suite 1000
stocks that might be more prone to manipulation. Specifically, Regulation SHO requires short                                     Detroit, MI 48226-4443
                                                                                                                                          (313) 963-6200
sellers in all equity securities to locate those securities before selling, and also imposes
                                                                                                                                          Jacksonville
additional delivery requirements on broker-dealers for securities in which a substantial                                One Independent Drive, Suite 1300
                                                                                                                                  Jacksonville, FL 32202
number of failures to deliver have occurred. Regulation SHO also includes a temporary rule                                               (904) 359-2000
that establishes procedures by which the SEC may temporarily suspend the operation of the                                                 Los Angeles
current “tick” test and any short sale price test of any exchange or national securities                                2029 Century Park East, Suite 3500
                                                                                                                             Los Angeles, CA 90067-3021
association, for specified securities. As described in more detail below, pursuant to this                                                 (310) 277-2223

temporary rule, the SEC issued an order on July 28, 2004 that will suspend such price tests                                                    Madison
                                                                                                                                   150 East Gilman Street
for a group of close to a thousand securities.2                                                                                  Madison, WI 53703-1481
                                                                                                                                          (608) 257-5035

                                                                                                                                            Milwaukee
Short Selling. Though short selling can serve useful market purposes (e.g., market liquidity                           777 East Wisconsin Ave., Suite 3800
                                                                                                                               Milwaukee, WI 53202-5306
and pricing efficiency), abusive short selling may be used to illegally manipulate stock prices,                                           (414) 271-2400
especially in thinly-capitalized securities trading over-the-counter. Naked short selling                                                     New York
sometimes results in a “fail to deliver” by the seller to the buyer which, in turn, can have                                              90 Park Avenue
                                                                                                                                New York, NY 10016-1314
negative effects on the market, particularly when the fails to deliver persist for an extended                                             (212) 682-7474

period of time and result in a significantly large unfulfilled delivery obligation at the clearing                                              Orlando
                                                                                                                     111 North Orange Avenue, Suite 1800
agency where trades are settled. Unrestricted short selling can exacerbate a declining                                           Orlando, FL 32801-2386
                                                                                                                                          (407) 423-7656
market in a security by increasing pressure from the sell-side, eliminating bids, and causing a
                                                                                                                                          Sacramento
further reduction in the price of a security by creating an appearance that the security price is                                1215 K. Street, Suite 1920
                                                                                                                                   Sacramento, CA 95184
falling for fundamental reasons. Regulation SHO was adopted to protect issuers and                                                          (916) 443-8005
investors from these negative consequences of abusive short selling.                                                                         San Diego
                                                                                                                           402 West Broadway, Suite 2300
                                                                                                                              San Diego, CA 92101-3542
“Threshold Securities” and Close-Out Requirement. Rule 203 of Regulation SHO                                                              (619) 234-6655
                                                                                                                          11250 El Camino Real, Suite 200
imposes requirements targeted at securities where there is evidence of significant settlement                                       San Diego, CA 92130
                                                                                                                                          (858) 847-6700
failures (i.e., certain designated “threshold securities”). Rule 203 incorporates the NASD
                                                                                                                                       San Francisco
Rule 11830 definition of “threshold security” which defines this term to mean an equity                                     One Maritime Plaza, Sixth Floor
                                                                                                                            San Francisco, CA 94111-3409
security (1) for which there is an aggregate fail to deliver position for five consecutive                                                 (415) 434-4484
settlement days at a registered clearing agency of 10,000 shares or more per security; (2)                                              Silicon Valley
                                                                                                                              Building 3, Palo Alto Square
where the level of fails is equal to at least one half of one percent of the issuer's total shares                         3000 El Camino Real, Suite 100
outstanding; and (3) the security is included on a list published by an SRO.3                                                        Palo Alto, CA 94306
                                                                                                                                           (650) 856-3700

                                                                                                                                           Tallahassee
With limited exception, Rule 203 requires a participant of a registered clearing agency that                              106 East College Ave., Suite 900
                                                                                                                             Tallahassee, FL 32301-7732
has a fail to deliver position in threshold securities that persists for ten consecutive days after                                        (850) 222-6100

the normal settlement date (i.e., 13 consecutive settlement days), to take action to close out                                                   Tampa
                                                                                                                       100 North Tampa Street, Suite 2700
                                                                                                                                  Tampa, FL 33602-5810
                                                                                                                                          (813) 229-2300
          1
              The rules were proposed by the SEC on October 29, 2003 (See Release No. 34-48709). The adopted                                      Tokyo
                                                                                                                                           JT Building 15F
final rules (See Release No. 34-50103) and the proposed rules are available on the SEC’s website at:                           2-2-1 Toronomon Minato-ku
www.sec.gov.                                                                                                                       Tokyo, Japan 105-0001
                                                                                                                                       +81 (03) 5114-8320
          2
           The order (See Release No. 34-50104) is available on the SEC’s website at:                                              Washington, D.C.
                                                                                                                            3000 K Street, N.W., Suite 500
http://www.sec.gov/rules/other/34-50104.htm.                                                                                Washington, D.C. 20007-5101
                                                                                                                                           (202) 672-5300
          3
            For example, if an issuer had 1,000,000 shares outstanding, one-half of one percent (.005) would be                    West Palm Beach
5,000 shares. An aggregate fail to deliver position at a clearing agency of 10,000 shares or more would thus         777 South Flagler Dr., 901 West Tower
exceed the specified level of fails. If an issuer had 10,000,000 shares outstanding, one-half of one percent would       West Palm Beach, FL 33401-6195
                                                                                                                                             (561) 655-5050
be 50,000 shares. An aggregate fail to deliver position at a clearing agency of 50,000 shares or greater would
exceed the specified level of fails.                                                                                             www.foley.com
FOLEY & LARDNER LLP CLIENT ALERT                                                                                                    August 27, 2004




the extended fail to deliver position by purchasing securities of like kind and quality. Until the position is closed out, the
participant, and any broker-dealer for which it clears transactions, may not effect further short sales in the particular
threshold security without borrowing or entering into a bona fide arrangement to borrow the security. Rule 203 will
become effective 30 days after its publication in the Federal Register and has a compliance date of January 3, 2005, to
permit firms to make programming and procedural adjustments.

Uniform “Locate” Rule. Rule 203 of Regulation SHO enhances “locate” and delivery requirements by incorporating a
uniform locate rule applicable to short sales in all equity securities, wherever they are traded. Rule 203 prohibits a
broker-dealer from executing a short sale order for its own account or the account of another person, unless the broker-
dealer: (1) borrowed the security, or entered into an arrangement for the borrowing of the security, or (2) had
reasonable grounds to believe that it could borrow the security so that it would be capable of delivering the securities on
the date delivery is due. Though Rule 203 supersedes current comparable SRO rules4, it incorporates the requirement
that the “locate” be made and annotated in writing prior to effecting any short sale, regardless of whether the seller’s
short position may be closed out by purchasing securities the same day. Generally, the requirements of Rule 203
reflect current industry practice, but the SEC believes that adopting Rule 203 is desirable in order to establish a uniform
standard specifying the procedures for all markets.

Exceptions to Locate Requirement. Rule 203 of Regulation SHO includes a limited number of exceptions from its
locate requirement, including an exception for short sales by market makers (including specialist and option market
makers) in connection with bona-fide market making, even when effecting short sales in threshold securities.5 This
exception is based on the premise that a narrow exception for market makers and specialists engaged in bona fide
market making activities is necessary due to their potential need to facilitate customer orders in a fast moving market
without possible delays associated with complying with Rule 203. Further, the SEC reasoned that most specialists and
market makers seek a net “flat” position in a security at the end of each day and often “offset” short sales with
purchases such that they are not required to make delivery under the security settlement system. Market makers will
not be excepted from the requirements to close out fails to deliver in threshold securities that remain for thirteen
consecutive settlement days.

Regulation SHO does not incorporate an exception from the locate and delivery requirements of Rule 203 for short
sales that result in bona-fide fully hedged or arbitraged positions previously allowed under NASD Rule 3370.
Regulation SHO also does not include an exception from the locate requirements for transactions in exchange traded
funds.

Order-Marking Requirements. Rule 200(g) of Regulation SHO adopts new order-marking requirements. The new
marking requirements apply to all equity securities, not just exchange-listed securities and differentiate between “long,”
“short,” and “short exempt” orders for all exchange-listed and over-the-counter equity securities. The new marking
requirements will eliminate the prior discrepancy between how Rule 3b-3 under the Act defined a short sale and the
marking provisions previously found in Rule 10a-1. In addition, the new marking requirements should facilitate the
surveillance and monitoring of compliance with Rule 10a-1.

The former marking requirements contained in Rule 10a-1 provided that a broker-dealer could only mark an order to sell
a security “long” if the security is carried in the account for which the sale is to be effected, or the broker-dealer is
informed that the seller owns the security to be sold, and will deliver the security to the account for which the sale is
effected as soon as possible without undue inconvenience or expense.




          4
             NYSE Rule 440C.10 states that no NYSE member or member organization should “fail to deliver” against a short sale of a security on
a national securities exchange until a diligent effort has been made by such member or member organization to borrow the necessary securities
to make delivery. NASD Rule 3370 generally provides that no member, or person associated with a member, shall effect a short sale for a
customer or for its own account unless the member makes an “affirmative determination” that the member can borrow the securities or otherwise
provide for delivery of the securities by settlement date.
          5
            Other exceptions to the locate requirement are applicable to: (i) registered broker-dealers that receive short sale orders from other
registered broker-dealers and, (ii) under limited circumstances, to situations where a broker-dealer effects a sale on behalf of a customer that is
deemed to own the security, but will not be expected to have physical possession or control of the broker-dealer by the settlement date.


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FOLEY & LARDNER LLP CLIENT ALERT                                                                                                          August 27, 2004




Under Rule 200(g), an order can be marked “long” when the seller owns the security being sold and the security either
is in the physical possession or control of the broker-dealer, or it is reasonably expected that the security will be in the
physical possession or control of the broker or dealer no later than settlement. The SEC added the language
“reasonably expected” because it acknowledged that it may be difficult for a person to know with certainty at the time of
sale that a security will be in the possession or control of the broker-dealer prior to settlement. However, if a person
owns the security sold and does not reasonably believe that the security will be in the possession or control of the
broker-dealer prior to settlement, the sale should be marked “short.” The sale could be marked “short exempt” if the
seller is entitled to rely on an exception from the tick test of Rule 10a-1, or the price test of an exchange or national
securities association. Rule 200 will become effective 30 days after publication in the Federal Register.

Pilot Program and Temporary Suspension of “Tick” Test. Rule 202T of Regulation SHO establishes procedures to
allow the SEC to temporarily suspend the trading restrictions of the current “tick” test in Rule 10a-1 under the Act,6 and
any short sale price test of any exchange or national securities association, for specified liquid securities. Utilizing
these procedures, on July 28, 2004, the SEC issued an order that suspends on a pilot basis for a one-year period the
tick test provision of Rule 10a-1(a), and any short sale price test of any exchange or national securities association, for:
(1) short sales in approximately one-third of stocks in the Russell 3000 index; (2) short sales executed in any security
included in the Russell 1000 index after 4:15 p.m. Eastern and the open of the consolidated tape the following day, and
(3) short sales in any security not included in (1) and (2) between the close of the consolidated tape and the open of the
consolidated tape the following day. The pilot suspends only the operation of the tick test, while the other requirements
of Regulation SHO, including the order-marking, locate and close-out requirements, remain in effect.

The pilot will allow the SEC to review the effects of relatively unrestricted short selling on, among other things, market
volatility, price efficiency, and liquidity. The SEC anticipates that the data derived from the pilot will assist in its
consideration of alternatives for regulating short sales in actively-traded securities which may include actions such as:
(i) eliminating a SEC-mandated price test for an appropriate group of securities (which may be all securities), (ii)
adopting a uniform bid test, and any exceptions with the possibility of extending a uniform bid test to smaller securities
for which there currently is no price test, or (iii) leaving in place the current price tests.

The pilot will commence on January 3, 2005 to permit broker-dealers and self-regulatory organizations to make the
necessary programming adjustments.

Proposed Uniform Bid Test. In light of the substantial programming changes that could be incurred in going forward
with its previous proposal to replace the “tick” test of Rule 10a-1 with a new uniform bid test,7 the SEC deferred
consideration of this issue until after the conclusion of the pilot established by Rule 202T. Therefore, Rule 10a-1 and all
other SRO price tests are still effective in their current form for securities not included in the pilot.

Ownership. Unconditional Contracts to Purchase Securities. Rule 200(b) of Regulation SHO incorporates the current
definition of unconditional contract found in Rule 3b-3(b) without amending the rule to require the specification of a fixed
price and amount of securities to be purchased in order for a person to claim ownership of the securities underlying the
contract as the SEC had proposed. However, the SEC will continue to consider whether any future changes to the
unconditional contract provision are appropriate, and may revisit its decision upon termination of the pilot to be
implemented pursuant to Rule 202T.

Ownership of Securities Underlying Securities Futures Products. Rule 200(b) of Regulation SHO also includes
language consistent with existing SEC guidance concerning the manner in which Rule 3b-3 addresses instances where
a person owns a derivative instrument that entitles the person to acquire securities underlying the instrument (e.g.,
options, rights, warrants, convertibles, and security futures). Rule 200(b) provides that a person holding a long security
futures position is not considered to own the underlying security until the security future stops trading and the person

           6
            Rule 10a-1(a)(1) provides that, subject to certain exceptions, a listed security may be sold short: (a) at a price above the price at
which the immediately preceding sale was effected (plus tick), or (b) at the last sale price if it is higher than the last different price (zero-plus tick)
(commonly referred to as the “tick” test). In 1994, the SEC granted temporary approval to the NASD to apply its own short sale rule to Nasdaq
National Market System (NMS) securities. NASD Rule 3350 prohibits short sales by NASD members in Nasdaq NMS Securities at or below the
current best (inside) bid when that bid is lower than the previous best (inside) bid (commonly referred to as the “bid” test).
           7
               This rule change was proposed by the SEC on October 29, 2003. See supra note 1.


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FOLEY & LARDNER LLP CLIENT ALERT                                                                                                      August 27, 2004




has received notice that the position will be physically settled and is irrevocably bound to receive the underlying
security. The SEC has stated that the termination of trading is the moment at which an open position in a security
future, either a long or short position, can no longer be closed or liquidated either by buying or selling an opposite
position. At that point, the person obligated to deliver would be considered short, and a person entitled to acquire the
securities would be considered long.

Aggregation. Rule 200(f) of Regulation SHO incorporates aggregation unit netting because the SEC believes that
such netting allows aggregation units at multi-service broker-dealers to pursue different trading strategies, as well as
provide liquidity to the market, without the restrictions of firm-wide netting.8 Rule 200(f) permits trading unit aggregation
if a registered broker-dealer meets the following requirements: (1) the broker or dealer has a written plan of organization
that identifies each aggregation unit, specifies the trading objective of each, and supports its independent identity;
(independence of the units would be evidenced by factors such as: separate management structures, location, business
purpose, and profit and loss treatment), (2) each aggregation unit within the firm continuously determines, on a real-
time basis, its net position for every security that it trades, (3) all traders in an aggregation unit pursue only the trading
objectives or strategies of that aggregation unit; and (4) individual traders are assigned to only one aggregation unit at a
time.

Block Positioners and Liquidation of Index Arbitrage Positions. Rule 200(d) of Regulation SHO incorporates the
block positioner exception currently found in Rule 10a-1(e)(13) under the Act. A broker-dealer that engages in block-
positioning will continue to be able to disregard economically neutral bona-fide arbitrage, risk arbitrage, and bona-fide
hedge positions involving short stock components in determining its net position in the block-positioned security. Rule
200(e) of Regulation SHO provides a limited exception for unwinding index arbitrage positions by relaxing the
requirement that a person selling a security aggregate all of the person's positions in that security to determine whether
he or she has a net long position.

Long Sales. Subject to limited exception, Rule 203(a) of Regulation SHO requires that if a broker-dealer knows or
should know that a sale of an equity security is marked long, the broker-dealer must make delivery when due and
cannot use borrowed securities to do so. This delivery obligation does not apply in three circumstances: (1) the loan of
a security through the medium of a loan to another broker or dealer; (2) where the broker or dealer knows or has been
reasonably informed by the seller that the seller owns the security and will deliver it to the broker or dealer prior to the
scheduled settlement of the transaction and the seller fails to make such delivery; or (3) where an exchange or
securities association finds, prior to the loan or arrangement to loan any security for delivery, or failure to deliver, that
the sale resulted from a good-faith mistake, the broker-dealer exercised due diligence, and either that requiring a buy-in
would result in undue hardship or that the sale had been effected at a permissible price.

Rule 105 of Regulation M. The Regulation SHO adopting release also contained amendments to Rule 105 of
Regulation M (which relates to short selling prior to a public offering) that eliminate the shelf offering exception. The
amendment applies to short sales effected within five days prior to the pricing of a shelf offering. These short sales may
not be covered with offering securities purchased from an underwriter or other broker-dealer participating in the offering.
Additionally, the SEC enumerated a non-exhaustive list of transactions that would be considered sham transactions
designed to evade Rule 105 and advised that such transactions if used as part of a fraudulent or manipulative scheme,
may violate the federal anti-fraud and anti-manipulation securities laws. The Rule 105 amendments will be effective 30
days after publication in the Federal Register.

Conclusion. In adopting Regulation SHO, the SEC revised its regulatory framework regarding short selling primarily to
enhance the efficiency of the national clearance and settlement system and to protect investors and issuers from
abusive short selling tactics that are intended to manipulate the market. Regulation SHO also provides a
comprehensive structure designed to modernize short sale rules and establish a uniform regulatory standard.
Additionally, the SEC plans to use the information collected in connection with the pilot program to apply future
regulation to areas where regulation is most needed and away from areas where regulation is not necessary or practical
in light of actual market operation.


          8
           Rule 3b-3 requires a seller of an equity security subject to Rule 10a-1 to aggregate all of its positions in that security in order to
determine whether the seller has a “net long position” in the security.


                                                                          4
FOLEY & LARDNER LLP CLIENT ALERT                                                                                             August 27, 2004



If you have any questions concerning the matters discussed in this Foley & Lardner Client Alert, please call Amy N. Kroll at (202) 295-4157,
or Arden T. Phillips at (202) 295-4077 in our Washington, DC office, George T. Simon (312) 832-4554 or Craig Long (312) 832-4558 in our
Chicago, Illinois office, or contact your Foley & Lardner attorney. Foley & Lardner Client Alerts are intended to provide information (not
legal advice) about important new legislation or other legal developments. The great number of legal developments does not permit the
issuing of a Client Alert for each one, nor does it allow the issuing of a follow-up on all subsequent developments.




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