Short Sale

Short Sale Concept in Financial Law

A short sale is the sale of a security that the seller does not own and any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. In order to deliver the security to the purchaser, the short seller will borrow the security, usually from a broker-dealer or an institutional investor. Typically, the short seller later closes out the position by purchasing equivalent securities on the open market and returning the borrowed security to the lender. In general, short selling is used to profit from an expected downward price movement, to provide liquidity in response to unanticipated demand, or to hedge the risk of an economic long position in the same security or in a related security.

Short Sale Regulation in the United States

The U.S. Securities and Exchange Commission (SEC) has plenary authority under Section 10(a) of the Securities Exchange Act of 1934 to regulate short sales of securities registered on a national securities exchange, as necessary or appropriate in the public interest or for the protection of investors. Current regulatory requirements applicable to short sales of equity securities are generally found in Regulation SHO, which the Securities and Exchange Commission adopted to address its concerns regarding persistent fails to deliver and potentially abusive “naked” short selling. A “naked” short sale generally refers to selling short without having borrowed the securities to make delivery. All sellers of securities should promptly deliver, or arrange for delivery of, securities and all buyers of securities have a right to expect prompt delivery of securities purchased. The Commission was concerned about the negative effect that fails to deliver may have on the markets and shareholders. For example, large and persistent fails to deliver may deprive shareholders of the benefits of ownership, such as voting and lending, and sellers that fail to deliver securities on settlement date may attempt to use this additional freedom to engage in trading activities to improperly depress the price of a security.

Regulation SHO imposes four general requirements with respect to short sales of equity securities: a marking requirement, a short sale price test circuit breaker, a locate requirement, and a close-out requirement. Due to continued concerns about fails to deliver, and to promote market stability and preserve investor confidence, the Securities and Exchange Commission has amended Regulation SHO several times to eliminate certain exceptions, strengthen certain requirements and reintroduce a price test restriction.

As initially adopted, Regulation SHO included two major exceptions to the close-out requirement: the ‘‘grandfather’’ provision and the ‘‘options market maker’’ exception. Due to continued concerns about fails to deliver, and the fact that the Securities and Exchange Commission continued to observe certain securities with fail to deliver positions that were not being closed out under then existing requirements, in 2007 the Securities and Exchange Commission eliminated the ‘‘grandfather’’ provision and in 2008 the SEC eliminated the options market maker exception.

In 2008, the Securities and Exchange Commission adopted temporary Rule 204T, and in 2009 adopted final Rule 204, which strengthened further the close-out requirements of Regulation SHO by applying close-out requirements to fails to deliver resulting from sales of all equity securities and reducing the time-frame within which fails to deliver must be closed out.

The Securities and Exchange Commission adopted Rule 201 of Regulation SHO in 2010. Rule 201 restricts the price at which short sales may be effected when a stock has experienced significant downward price pressure. Rule 201 is designed to prevent short selling, including potentially manipulative or abusive short selling, from driving down further the price of a security that has already experienced a significant intra-day price decline, and to facilitate the ability of long sellers to sell first upon such a decline.

Regulation SHO’s four general requirements are summarized below:

• Rule 200 – Marking Requirements. Rule 200(g) requires that a broker-dealer must mark all sell orders of any equity security as “long,” “short” or “short exempt.” A sell order may only be marked “long” if the seller is “deemed to own” the security being sold and either: (i) the security to be delivered is in the physical possession or control of the broker or dealer; or (ii) it is reasonably expected that the security will be in the physical possession or control of the broker or dealer no later than the settlement of the transaction. The “short exempt” marking requirement applies only with respect to the short sale price test restriction.
• Rule 201 – Short Sale Price Test Circuit Breaker. Rule 201 generally requires trading centers to have policies and procedures in place to restrict short selling when a covered security has triggered a circuit breaker by experiencing a price decline of at least 10 percent in one day. Once the circuit breaker in Rule 201 has been triggered, the price test restriction will apply to short sale orders in that security for the remainder of the day and the following day, unless an exception applies.
• Rule 203(b)(1) and (2) – Locate Requirements. Rule 203(b)(1) generally prohibits a broker-dealer from accepting a short sale order in any equity security from another person, or effecting a short sale order in an equity security for the broker-dealer’s own account, unless the broker-dealer has: borrowed the security, entered into a bona-fide arrangement to borrow the security, or reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. Rule 203(b)(2) provides an exception to the locate requirement for short sales effected by a market maker in connection with bona-fide market making activities.
• Rule 204 – Close-out Requirements. Under Rule 204, participants of a registered clearing agency (as defined in section 3(a)(24) of the Exchange Act) must deliver securities to a registered clearing agency for clearance and settlement on a long or short sale transaction in any equity security by settlement date, or must close out a fail to deliver in any equity security for a long or short sale transaction in that equity security generally by the times described as follows: the participant must close out a fail to deliver for a short sale transaction by no later than the beginning of regular trading hours on the settlement day following the settlement date, referred to as T+4; if a participant has a fail to deliver that the participant can demonstrate on its books and records resulted from a long sale, or that is attributable to bona-fide market making activities, the participant must close out the fail to deliver by no later than the beginning of regular trading hours on the third consecutive settlement day following the settlement date, referred to as T+6. In addition, Rule 203(b)(3) of Regulation SHO requires that participants of a registered clearing agency must immediately purchase shares to close out fails to deliver in “threshold securities” if the fails to deliver persist for 13 consecutive settlement days. Threshold securities, as defined by Rule 203(c)(6), are generally equity securities with large and persistent fails to deliver.