On January 3, 2005, the Securities and Exchange Commission (the “SEC”) adopted Regulation SHO which regulates short selling. Regulation SHO was enacted to deter abusive “naked” short selling, which occurs where a person sells a security without owning or even having access to the security necessary to make delivery. This is to be distinguished from legal short selling, where the seller may not own the securities sold but does have access to or ability to borrow the securities and therefore make delivery. Although short selling can provide market liquidity and pricing efficiency, naked short selling may cause a number of negative market impacts, particularly when a large unfulfilled delivery obligation exists at the clearing agency where the trades are settled. In order to reduce the negative consequences of naked short selling, Regulation SHO:

1.   imposes new locate requirements on broker-dealers before selling and imposes delivery or close-out requirements on broker-dealers for securities in which a substantial number of instances of failure-to-deliver have occurred;

2.   adopts new order-marking requirements;

3.   creates a pilot program and temporarily suspends the operation of the “tick” test for certain securities;

4.   defers consideration of the uniform bid test of proposed Rule 201;

5.   defines ownership of certain securities for the purposes of determining delivery and close-our requirements; and

6.   eliminates the shelf offering exception to prohibit the use of offering shares to cover short sales effected prior to the pricing of a shelf offering.

Locate and Close-Out Requirement: Rule 203 of Regulation SHO requires all broker-dealers to “locate” securities available for borrowing before executing a short sale in any equity security. The rule prohibits a broker-dealer from executing a short sale for its own account or for the account of another person, unless the broker-dealer or person, as applicable, borrowed the security or entered into an arrangement to borrow the security or has “reasonable grounds” to believe that it could borrow the security so that it can be delivered on the date that delivery is due. The locate requirement must be made and documented in writing prior to making the trade, regardless of whether the short position could be closed out by purchasing securities that same day.

The SEC has provided three exceptions to the locate requirement. First, when a broker-dealer exerts a short sale for another broker-dealer, only the first broker-dealer must fulfill the locate requirement. Second, the locate requirement is extended to 35 days in circumstances where the broker-dealer effects the sale of a security that is not expected to be available on the delivery date, such as a security tendered for conversion or a resale of a restricted security pursuant to Rule 144 of the Securities Act of 1933. Third, market makers are exempt from the locate requirement where the short sale is effected in connection with bona fide market making activities. The SEC has commented that the following activities do not constitute bona fide market making:

1.   activity that is related to speculative selling strategies of the broker-dealer and is disproportionate to the broker-dealer’s usual market making patterns or practices;

2.   activity whereby the market maker posts continually at or near the best offer but does not also post at or near the best bid; or

3.   transactions whereby the market maker enters into an arrangement with another broker-dealer or customer to use the market maker’s exception to avoid compliance with the locate requirement.

Rule 203(a) sets out the delivery requirements for “long” sales. If a broker-dealer knows or ought reasonably to 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. The SEC has noted, however, that it may be unreasonable for a broker-dealer to treat the sale as “long” where the customer has repeatedly failed to deliver the security by the settlement date.

Rule 203 of Regulation SHO imposes requirements aimed at “threshold securities” where there is evidence of significant settlement failures. A threshold security means an equity security for which there is an aggregate fail-to-deliver position for five consecutive settlement days at a registered clearing agency of 10,000 shares or more per security, where the level of fails is equal to at least one half of one percent of the issuer’s total securities outstanding and the security is included on a list published by a self-regulatory organization (“SRO”) such as the NASD. For example, one-half of one percent (0.005) of 1,000,000 shares outstanding is 5,000 shares. The list of threshold securities will be published daily by the SRO on which the security is listed or bears surveillance responsibility.

Rule 203(b)(3) requires a market maker or broker-dealer, to close out any fail-to-deliver position in a threshold security that has remained open for 10 consecutive days after the settlement date (13 days in total) by purchasing securities of like kind and quantity. If the participant does not close out the position, Rule 203(b)(3)(iii) states that the market maker is prohibited from effecting further short sales in the threshold security until it borrows, or arranges to borrow, the security to close out the fail-to-deliver position.

Order Marking: Regulation SHO adopts marking requirements for all sell orders, requiring all equity securities to be marked as either “long”, “short” or “exempt short”. Exempt short refers to short sales permitted under an exemption.

Ownership: In order to determine when a security is owned for the purposes of the delivery and close-out rules of Regulation SHO, the SEC has defined ownership of unconditional sales contracts, securities underlying futures products and aggregation units.

Additionally, Rule 200 incorporates the short sale definition in Rule 3b-3 and includes the standard for determining whether the seller has a “net long position”, hence ownership, in a security. The seller of an equity security must aggregate all of its positions in the security across all accounts. The SEC, however, incorporated its no-action position into Rule 200(f) which allows registered broker-dealers to calculate their “net-long” or “net-short” positions within defined “aggregation” units instead of on a firm-wide basis, subject to certain requirements. The aggregation unit exception is not extended to non-broker dealers as such entities are not subject to regulatory oversight.

If you have any questions about Regulation SHO, contact any member of Clark Wilson LLP’s Corporate Finance/ Securities Law Group.