Regulation sho

What Is Regulation SHO?

Regulation SHO is a comprehensive set of rules implemented by the Securities and Exchange Commission (SEC) to regulate short selling in equity securities. As a cornerstone of securities regulation, its primary purpose is to prevent abusive short selling practices, such as "naked" short selling, and to address persistent failures to deliver (FTDs) that can undermine market integrity. Regulation SHO imposes requirements on broker-dealers regarding the "locate" of securities before a short sale and establishes "close-out" procedures for unresolved delivery failures.

History and Origin

Regulation SHO was adopted by the SEC on July 28, 2004, with compliance beginning on January 3, 2005. This marked the first significant update to short sale regulations since they were initially adopted in 1938, in response to concerns about market developments and potentially abusive "naked" short selling⁴⁸, ⁴⁹. Before Regulation SHO, various self-regulatory organizations (SROs) had their own "locate" rules, which Regulation SHO superseded with a uniform standard⁴⁵, ⁴⁶, ⁴⁷.

The rule was a direct response to issues arising from the move to electronic clearing and settlement systems, which critics argued facilitated the practice of selling shares without actually borrowing them, known as naked short selling⁴⁴. While short selling is a legitimate trading strategy, the practice of failing to deliver shares at settlement raised concerns about potential market manipulation and artificial price pressure on stocks⁴², ⁴³.

Following its initial adoption, Regulation SHO underwent several amendments to strengthen its requirements. For instance, in 2007, the SEC eliminated the "grandfather" provision and the "options market maker" exception, which had allowed some failures to deliver to remain open indefinitely⁴⁰, ⁴¹. Further amendments in 2008 and 2009 strengthened the close-out requirements, applying them to failures to deliver from sales of all equity securities and reducing the timeframe for closing out such failures³⁸, ³⁹. In 2010, the SEC introduced Rule 201, often referred to as the "alternative uptick rule" or "short sale circuit breaker," which restricts short selling when a stock experiences a significant intra-day price decline³⁵, ³⁶, ³⁷.

A notable moment in the history of short selling regulation, which underscored the concerns Regulation SHO aimed to address, was the temporary ban on short selling of financial stocks by the SEC in September 2008, amidst the global financial crisis. This emergency action, which covered shares of more than 700 financial companies, aimed to restore stability and confidence in the markets by curbing what the SEC termed "abusive naked short selling"³⁴. The Reuters news agency reported on this ban, highlighting the regulatory response to extreme market conditions.³³

Key Takeaways

• Regulation SHO is a set of rules from the SEC designed to regulate short selling and prevent abusive practices.³²
• It introduced the "locate" requirement, mandating that broker-dealers must have reasonable grounds to believe a security can be borrowed before a short sale is executed.²⁹, ³⁰, ³¹
• Regulation SHO also includes "close-out" requirements, compelling broker-dealers to resolve persistent failures to deliver shares.²⁸
• The regulation aims to curtail "naked" short selling, where shares are sold short without being borrowed or located, which can lead to artificial selling pressure.
• Rule 201 of Regulation SHO, added in 2010, implements a "short sale circuit breaker" that restricts short selling if a stock's price falls by 10% or more in a trading day.²⁶, ²⁷

Formula and Calculation

Regulation SHO does not involve a specific financial formula or calculation in the traditional sense, as it is primarily a regulatory framework governing conduct rather than a quantitative measure. Its requirements focus on operational procedures, such as the "locate" of shares and the timely "close-out" of failed deliveries. Therefore, a formula and calculation section is not applicable to Regulation SHO.

Interpreting Regulation SHO

Interpreting Regulation SHO involves understanding its core objectives and the mechanisms it employs to achieve them within the broader context of financial markets. The regulation is fundamentally about ensuring orderly and transparent trading by addressing potential abuses associated with short selling.

The "locate" requirement means that before a short sale order is accepted or executed, a broker-dealer must have a verifiable source from which the shares can be borrowed and delivered by the settlement date (typically two business days after the trade date)²³, ²⁴, ²⁵. This provision is crucial in preventing "naked" short selling, where a seller sells shares they do not own and have not arranged to borrow, potentially leading to a failure to deliver.

The "close-out" requirement mandates that if a broker-dealer experiences an FTD in an equity security, they must take action to close out that position by borrowing or purchasing the securities. For short sale transactions, FTDs must generally be closed out by the beginning of regular trading hours on the settlement day following the settlement date²². For certain threshold securities—those with significant and persistent failures to deliver—stricter close-out rules apply, often requiring resolution within a specific number of settlement days. Co²¹mpliance with these rules indicates a firm's adherence to fair trading practices and contributes to the stability of the clearing and settlement process.

Hypothetical Example

Imagine an investor, Sarah, believes that shares of TechCo XYZ, currently trading at $100, are overvalued and will decline. She decides to execute a short sale.

1. The "Locate" Requirement: Before Sarah's broker-dealer can execute her short sale order, they must fulfill the Regulation SHO "locate" requirement. This means they need to confirm they have reasonable grounds to believe that 100 shares of TechCo XYZ can be borrowed and delivered by the settlement date (typically T+2). The broker-dealer checks their inventory, or contacts other lenders, to ensure the shares are available for borrowing.
2. Execution: Once the locate is confirmed, Sarah's broker-dealer executes the short sale, selling 100 shares of TechCo XYZ at $100 per share, resulting in $10,000 in proceeds (minus commissions). These proceeds are typically held in a margin account.
3. Delivery and Borrowing: On the settlement date, the broker-dealer borrows 100 shares of TechCo XYZ to deliver to the buyer. Sarah now has a short position.
4. Market Movement: A week later, TechCo XYZ's stock price falls to $80 per share.
5. Closing the Position: Sarah decides to close her position. She buys 100 shares of TechCo XYZ in the open market for $80 per share, costing her $8,000. These shares are then returned to the lender, fulfilling her obligation.
6. Profit/Loss: Sarah's profit, before commissions, is $10,000 (sale price) - $8,000 (buyback price) = $2,000.

In this example, Regulation SHO's locate requirement ensures that the shares are available for delivery, preventing a potential failure to deliver and promoting an orderly transaction.

Practical Applications

Regulation SHO plays a critical role in maintaining the fairness and integrity of securities trading. Its practical applications are evident across several areas:

• Preventing Abusive Naked Short Selling: The "locate" requirement directly targets naked short selling, where sellers do not possess or arrange to borrow shares before selling them. This practice can create an artificial supply of shares, potentially leading to significant and persistent failures to deliver (FTDs) and downward pressure on a stock's price, which could be a form of market manipulation.
• ²⁰ Enhancing Market Stability: By requiring a pre-borrow or reasonable belief of borrowability, Regulation SHO aims to reduce instances of FTDs, which can disrupt the settlement process and erode investor confidence.
• ¹⁹ Promoting Transparency: The regulation includes marking requirements, where all sell orders must be marked "long," "short," or "short exempt." This helps regulators and exchanges monitor short selling activity.
• ¹⁷, ¹⁸ Regulating Market Makers: While bona fide market makers have certain exemptions from the locate rule to provide liquidity, they are still subject to Regulation SHO's close-out requirements. FINRA provides guidance on what constitutes bona fide market making activities to prevent misuse of these exemptions.
• ¹⁵, ¹⁶ Addressing Price Pressure: Rule 201, the "circuit breaker," is designed to prevent excessive price declines fueled by short selling, allowing long sellers to execute trades more readily when a stock has experienced significant downward movement.

#¹³, ¹⁴# Limitations and Criticisms

Despite its intentions, Regulation SHO has faced various criticisms and perceived limitations. One primary concern revolves around its effectiveness in completely eradicating abusive naked short selling. Critics argue that loopholes and challenges in enforcement may still allow for the practice to occur, leading to ongoing failures to deliver.

S¹¹, ¹²ome commentators contend that the regulation's exemptions, particularly for market makers, can be exploited. While market makers are crucial for providing liquidity, the ability to sell short without immediately locating shares can, in some views, contribute to unchecked naked shorting if not rigorously supervised. Th⁹, ¹⁰e complexity of the rules and the sheer volume of trades can make detection and enforcement challenging for regulators.

A⁸nother criticism levied against Regulation SHO is that while it addresses FTDs, the penalties for non-compliance are sometimes seen as insufficient to deter persistent violations. Th⁷ere have been historical instances where companies, such as Overstock.com, alleged that extensive naked short selling created artificial downward pressure on their stock prices, leading to legal disputes and highlighting the contentious nature of the issue. These events underscore the ongoing debate about the efficacy of Regulation SHO in fully preventing manipulative practices and protecting companies from aggressive short attacks.

Regulation SHO vs. Naked Short Selling

Regulation SHO is often discussed in direct relation to naked short selling, but it is crucial to understand that Regulation SHO is the regulatory framework designed to address and curtail the practice of naked short selling, rather than being the practice itself.

• Regulation SHO: This is a set of rules established by the SEC that governs short sale practices. Its primary components, the "locate" and "close-out" requirements, are specifically intended to prevent failures to deliver and, consequently, abusive naked short selling. It mandates that a broker-dealer must have a reasonable belief that shares can be borrowed before a short sale is executed and imposes obligations to resolve any resulting failures to deliver shares within specific timeframes.
• Naked Short Selling: This refers to the practice of selling shares short without first borrowing them or having arranged to borrow them. In a legitimate short sale, the seller borrows shares (or ensures they can be borrowed) to deliver to the buyer by the settlement date. Naked short selling, in contrast, involves a sale where the seller does not possess the shares and has not confirmed their ability to possess them for delivery. This can lead to a "failure to deliver" if the shares cannot be acquired in time, potentially creating an artificial supply of stock and exerting undue downward pressure on a security's price. While some forms of naked short selling are permissible for market makers to facilitate liquidity, abusive or intentional naked short selling without the intent or ability to deliver is illegal under Regulation SHO.

In essence, Regulation SHO serves as the regulatory fence built to contain and control the activity of naked short selling within the boundaries of fair and orderly markets.

FAQs

What are the main requirements of Regulation SHO?

The main requirements of Regulation SHO include the "locate" rule, which demands that broker-dealers have reasonable grounds to believe a security can be borrowed before a short sale; the "close-out" rule, which requires firms to address and resolve failures to deliver within specified timeframes; and marking requirements, where all sell orders must be designated as "long," "short," or "short exempt."

##⁵, ⁶# Does Regulation SHO prohibit all naked short selling?
Regulation SHO aims to prevent abusive naked short selling. While it does not prohibit all instances of selling short without an immediate physical borrow (particularly for bona fide market makers who provide liquidity), it establishes strict requirements like the "locate" and "close-out" rules to ensure that shares are ultimately delivered and to prevent intentional failures to deliver that could manipulate stock prices.

##⁴# What happens if a broker-dealer fails to comply with Regulation SHO?
If a broker-dealer fails to comply with Regulation SHO's requirements, particularly the "close-out" rule for failures to deliver, they may face sanctions from the Securities and Exchange Commission (SEC) or self-regulatory organizations like FINRA. Non-compliant firms may also be subject to trading restrictions, such as being prohibited from effecting new short sales in the affected security until the failure to deliver is resolved by borrowing or purchasing shares.

##², ³# What are "threshold securities" under Regulation SHO?
Threshold securities are equity securities that have a substantial number of persistent failures to deliver at a registered clearing agency. Specifically, a security is considered a threshold security if there are aggregate fails to deliver of 10,000 shares or more, and the number of fails equals at least one-half of one percent of the issue's total shares outstanding, for five consecutive settlement days. These securities are subject to more stringent close-out requirements under Regulation SHO.¹