Division of Market Regulation:
Responses to Frequently Asked Questions Concerning Regulation SHO

Responses to these frequently asked questions were prepared by and represent the views of the staff of the Division of Market Regulation (“Staff”). They are not rules, regulations, or statements of the Securities and Exchange Commission (“Commission”). Further, the Commission has neither approved nor disapproved these interpretive answers.

For Further Information Contact: Any of the following attorneys in the Office of Trading Practices, Division of Market Regulation, Securities and Exchange Commission, 100 F Street, N. E., Washington, D.C. 20549-1001, at (202) 551-5720: James Brigagliano, Assistant Director, Josephine Tao, Branch Chief, Joan Collopy, Lillian Hagen, Elizabeth Sandoe, and Victoria Crane, Special Counsels.

I. Introduction

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, typically from a broker-dealer or an institutional investor. The short seller later closes out the position by purchasing equivalent securities on the open market, or by using an equivalent security it already owned, 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 a long position in the same security or in a related security.

Regulation SHO became effective on September 7, 2004. (Securities Exchange Act Release No. 50103 (July 28, 2004), 69 FR 48008 (August 6, 2004) (“Adopting Release”)). The commencement date to comply with the provisions of Regulation SHO is January 3, 2005. Pursuant to the terms of Regulation SHO, the Commission approved an order establishing a one-year pilot program (“Pilot”) suspending the provisions of Rule 10a-1(a) under the Securities Exchange Act of 1934 (“Exchange Act”) and any short sale price test of any exchange or national securities association (“SRO”) for short sales of certain securities for certain time periods. (See Securities Exchange Act Release No. 50104 (July 28, 2004), 69 FR 48032 (August 6, 2004) (“Pilot Order”)). The Adopting Release and the Pilot Order may also be found on the Commission’s Internet web site (http://www.sec.gov/spotlight/shortsales.htm). (See also http://www.sec.gov/rules/final/34-50103.htm for the Adopting Release, and http://www.sec.gov/rules/other/34-50104.htm for the Pilot Order). On November 29, 2004, the Commission approved an order resetting the Pilot to commence on May 2, 2005 and end on April 28, 2006. (See Securities Exchange Act Release No. 50747 (November 29, 2004), 69 FR 70480 (December 6, 2004) (“Second Pilot Order”)). The Second Pilot Order may be also be found on the Commission’s Internet web site (http://www.sec.gov/spotlight/shortsales.htm). (See also http://www.sec.gov/rules/other/34-50747.htm). Although the Second Pilot Order resets the start date and end date for the Pilot, the other terms of the Pilot Order remain unchanged, and the compliance date for all other provisions of Regulation SHO remains January 3, 2005. The Commission from time to time may approve further orders affecting the Pilot.

Regulation SHO provides a new regulatory framework governing short selling of securities. Regulation SHO is designed, in part, to fulfill several objectives, including (1) establish uniform locate and delivery requirements in order to address problems associated with failures to deliver, including potentially abusive “naked” short selling (i.e., selling short without having borrowed the securities to make delivery); (2) create uniform marking requirements for sales of all equity securities; and (3) establish a procedure to temporarily suspend Commission and SRO short sale price tests in order to evaluate the overall effectiveness and necessity of such restrictions. Moreover, the rules are consistent with the objective of simplifying and modernizing short sale regulation, providing controls where they are most needed, and temporarily removing restrictions where they may be unnecessary.

Specifically, Regulation SHO replaces Commission Rules 3b-3, 10a-1(d), 10a-1(e)(13) and 10a-2 with the following provisions:

• Rule 200 – Definitions and Marking Requirements. Rule 200 incorporates and amends Rules 3b-3, 10a-1(d) and 10a-1(e)(13). It defines ownership for short sale purposes, and clarifies the requirement to determine a short seller’s net aggregate position. It also incorporates requirements to mark sales in all equity securities “long,” “short,” or “short exempt.”
   
• Rule 202T – Pilot Program. Rule 202T is a temporary rule that creates a procedure by which the Commission issued the Pilot Order to establish the Pilot. It also creates a procedure by which the Commission may issue additional orders relating to the Pilot. This rule is scheduled to expire on August 6, 2007.
   
• Rule 203 – Locate and Delivery Requirements. Rule 203 incorporates Rule 10a-2 and existing SRO rules into a uniform Commission rule. It requires broker-dealers, prior to effecting short sales in all equity securities, to locate securities available for borrowing in order to be able to deliver securities on the settlement date of the transaction. It also imposes additional requirements on broker-dealers for securities in which a substantial amount of failures to deliver have occurred.

The Commission decided to defer consideration of proposed Rule 201, which would have replaced the current “tick” test of Rule 10a-1(a) with a new uniform bid test restricting short sales to a price above the consolidated best bid, subject to certain exceptions. (See Securities Exchange Act Release No. 48709 (October 28, 2003), 68 FR 62972 (November 6, 2003) (“Proposing Release”), which may also be found on the Commission’s Internet web site at http://www.sec.gov/rules/proposed/34-48709.htm). The Commission will reconsider any further action on these proposals after the completion of the Pilot.

Regulation SHO sets forth the requirements for conducting short sale transactions in equity securities. Other rules and regulations may apply also to short sales; for example, the margin requirements of Regulation T. Market participants conducting short sale transactions are responsible for complying with Regulation SHO as well as any other rules and regulations that may apply to their short sale transactions.

The following questions and answers regarding Regulation SHO have been compiled by the Staff to assist in the understanding and application of this regulation and the Pilot. These questions and answers are intended to provide general guidance. Facts and circumstances of a particular transaction may differ, and the Staff notes that even slight variations may require different responses. The Commission is not bound by the statements and may interpret Regulation SHO in any manner that it deems necessary or appropriate in the public interest or for the protection of investors.

The Staff may update these questions and answers periodically. In each update, the questions added after publication of the last version will be marked with “NEW!”

II. Responses to Frequently Asked Questions

1. General

Question 1.1: When should market participants comply with Regulation SHO?

Answer: Regulation SHO became effective on September 7, 2004. However, market participants are required to begin complying with Regulation SHO on January 3, 2005. Regulation SHO has a long compliance period to permit broker-dealers and SROs to make necessary systems changes and other order processing adjustments.

On November 29, 2004, the Commission approved an order resetting the Pilot to commence on May 2, 2005 and end on April 28, 2006. Although the Second Pilot Order resets the start date and end date for the Pilot, the other terms of the Pilot Order remain unchanged. Furthermore, the compliance date for all other provisions of Regulation SHO remains January 3, 2005.

Question 1.2: When does Regulation SHO supplant existing SRO Rules?

Answer: Regulation SHO supplants any conflicting SRO short sale rule. For example, SROs that have their own rules regarding locate and delivery have filed and are filing proposed rule changes with the Commission that will suspend such rules.

However, Regulation SHO does not conflict with SRO rules that have a purpose other than short sales. For example, NYSE Rule 80A is not directed at short sales, as such, but rather has a different purpose (i.e., reducing market volatility). For this reason, Regulation SHO does not supplant NYSE Rule 80A.

Question 1.3: How does Regulation SHO apply to overseas transactions?

Answer: Footnote 54 of the Adopting Release states that any broker-dealer using the United States jurisdictional means to effect short sales in securities traded in the United States are subject to Regulation SHO, regardless of whether the broker-dealer is registered with the Commission or relying on an exemption from registration. The Proposing Release explains that short sale regulation applies to trades in reported securities when the trades are agreed to in the United States, even if the trades are booked overseas. (68 FR at 62997 and 62998). Whether a short sale is executed or agreed to in the United States will depend on the particular facts and circumstances of the transaction. The Proposing Release provides some examples of when we would consider a short sale to have been agreed to in the United States. (68 FR at 62997 and 62998). For further information about how the provisions of Regulation SHO may apply to overseas transactions, please refer to Question 4.6.

Question 1.4: Does Regulation SHO apply to bonds?

Answer: Regulation SHO applies to short sales of equity securities. The term “equity security” is defined in Section 3(a)(11) of the Exchange Act and Rule 3a11-1 thereunder (17 CFR 240.3a11-1). A security convertible into an equity security is an equity security. Therefore, short sales of bonds that are convertible into equity would be subject to Regulation SHO. The Staff will consider on a case-by-case basis securities, including structured products, to which the “equity” status may not be clear.

Answer: Syndicate activity is not expressly addressed in Regulation SHO. However, the Staff will not recommend enforcement action for violation of Rule 203(b)(1) of Regulation SHO (locate requirement) with regard to any sale by an underwriter, or any member of a syndicate or group participating in the distribution of a security, in connection with an over-allotment of securities, or any lay-off sale by such a person in connection with a distribution of securities through rights or a standby underwriting commitment.

In addition, the Staff will not recommend enforcement action for violation of Rule 203(b)(3) of Regulation SHO (close-out and pre-borrow requirements) with respect to a net syndicate short position created in connection with a distribution of a security that is part of a fail to deliver position at a registered clearing agency in a threshold security that has persisted for 13 consecutive settlement days, if action is taken to close out the net syndicate short position no later than the 30th day after commencement of sales in the distribution.

2. Order Marking Requirements – Rule 200(g)

Question 2.1: Should a broker or dealer mark a short sale order “short exempt” if the order involves an OTCBB stock?

Answer: Rule 200(g)(2) provides that a short sale shall be marked “short exempt” if the seller is relying on an exception from the tick test of Rule 10a-1 or any short sale price test of any SRO. Securities traded on the over-the-counter bulletin board (“OTCBB”) are not subject to any short sale price tests and are therefore do not rely on an exception from such price tests. As such, they need not be marked “short exempt.” Short sales in such securities may continue to be marked “short.”

Question 2.2: May market participants presume that an “S” designation on an order indicates that an order is “sell long” and an “SS” designation on an order indicates that an order is “sell short?” Do these designations satisfy the new marking requirements under Regulation SHO?

Answer: Under Rule 200(g), brokers and dealers must mark all sell orders of any equity security as “long,” “short,” or “short exempt.” The primary objective is to make sure that orders are marked and executed properly and that accurate data on those orders is available for the pilot study and for surveillance and compliance purposes. For this reason, the Staff strongly suggests that firms use the designations specified in Rule 200(g) of Regulation SHO. The firms, however, may use other designations to identify long, short and short exempt trades, and to process the orders properly. The designations should follow a clear and consistent methodology for marking orders, and clear and accurate records must be maintained to demonstrate compliance.

Question 2.3: May a seller mark an order “long” if the seller owns the security pursuant to Rule 200(b) but is not “net long” in the security?

Answer: Rule 200(c) provides that a person shall be deemed to “own” securities only to the extent that the person has a “net long” position in such securities. Therefore, a seller must be net long in a security in order to mark “long” an order for that security. Rule 200(c) does not change the “net long” requirement of former Rule 3b-3.

3. Trade Execution

Question 3.1: How should brokers and dealers process orders when the normal closing time for a regular trading day has changed (e.g., early closing of markets for holidays)?

Answer: Footnote 17 of the Pilot Order explains that 4:15 pm was designated as the end of regular trading activity for Regulation SHO because regular trading hours normally end at 4:00 pm, and an extra 15 minutes was added because trade reporting can be delayed and continue past 4:00 pm. For days when regular trading hours end earlier than 4:00 pm, the time designated as the end of regular trading for the purposes of Regulation SHO should be the time the trading hours end on those days plus 15 minutes.

4. Locate and Delivery Requirement – Rules 203(b)(1) and (2)

Question 4.1: How should broker-dealers determine “reasonableness” to satisfy the locate requirement of Regulation SHO?

Answer: Rule 203(b)(1)(ii) permits a broker or dealer to accept a short sale order in an equity security if the broker-dealer has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the settlement date. “Reasonableness” is determined based on the facts and circumstances of the particular transaction. What is reasonable in one context may not be reasonable in another context. The Commission provided some examples of reasonableness in the Adopting Release. (69 FR at 48014 and Footnotes 58, 61 and 62).

Question 4.2: How may broker-dealers use Easy to Borrow lists?

Answer: The Adopting Release states that Easy to Borrow lists generally may be used to establish a reasonable basis for a locate. (69 FR at 48104). Easy to Borrow lists are prepared by a firm to indicate that firm’s ability to supply the identified securities. Therefore, for example, introducing firms may rely on Easy to Borrow lists of the clearing firms through which they clear and settle transactions unless circumstances indicate that it would not be reasonable to rely on such lists. For example, if the securities on the Easy to Borrow list have experienced delivery failures, it would not be reasonable to rely on the list. Furthermore, if the Easy to Borrow list is prepared by a clearing firm through which the introducing firm does not clear or settle transactions, or otherwise does not maintain a relationship in which the clearing firm agrees to make securities on its Easy to Borrow lists available to the introducing firm, then it would not be reasonable to rely on the list.

Question 4.3: May an executing broker rely on customer representations that a short sale is supported by a locate from the stock loan department of the executing broker, then execute the order, and then confirm the locate later in the same day or the next morning?

Answer: The executing broker has the responsibility to perform the locate prior to effecting a short sale, and must have a reasonable basis to believe that the security can be delivered on the settlement date. Footnote 58 of the Adopting Release explains that a broker-dealer may obtain an assurance from a customer that the customer can obtain securities from another identified source in time to settle the trade. The executing broker may rely on a customer’s representation that an order to sell short a security is supported by a locate obtained by the customer from the stock loan department of the executing broker, or any other identified entity that is authorized to loan stock, as long as reliance on such representation is reasonable. However, where a broker-dealer knows or has reason to know that a customer’s prior assurances resulted in failures to deliver, assurances from such customer would not provide the reasonable grounds required for a locate.

Rule 203(b)(1) requires that the executing broker document the locate. Documentation should include the source of the securities cited by the customer. Documentation should also include support for the reasonable grounds to rely on customer assurances. For example, an executing broker may provide information showing that previous borrowings arranged by the customer resulted in timely deliveries of securities to settle the customer’s transactions.

After the executing broker executes a short sale, the executing broker may take steps to confirm the locate information provided by the customer. Confirmation of the locate after the execution of a short sale may provide information on whether the locate based on customer representations was reasonable. However, confirmation after the fact is not a substitute for a locate that is required to be performed before a short sale may be executed.

(NEW! 11/04/05)

Question 4.3(B): How does a customer's history with respect to timely delivery of securities in settling short sale transactions affect a broker-dealer's "reasonable grounds" obligation under Rule 203(b)(1)?

Answer: Rule 203 requires that the executing broker has the responsibility to perform the locate prior to effecting a short sale, and must have a reasonable basis to believe that the security can be delivered on the settlement date. Reasonableness is based on the facts and circumstances of a particular transaction. In some instances, it may be reasonable for an executing broker to rely on assurances from a customer that the customer can obtain the securities from an identified source in time to settle the trade. If the executing broker knows or has reason to know that a customer's prior assurances resulted in failures to deliver, however, reliance on further assurances from that customer would not be reasonable.

Rule 203(b)(1) requires that the locate be made and documented prior to effecting any short sale, including the broker-dealer's reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. Information important to assessing the broker-dealer's "reasonable grounds" includes information about whether securities were delivered on a timely basis for settlement in situations where the broker-dealer relied on representations from the customer to support its locate. Accordingly, the executing broker-dealer must consider information, either from its own records or from the records of its clearing firm, about settlement of the customer's trades. It would not be reasonable for an executing broker to assert that it did not know or have reason to know whether a customer's prior short sale trades resulted in delivery failures if the executing broker made no reasonable effort to obtain such information. See Footnote 58 of the Adopting Release.

If the executing broker discovered that the customer's prior assurances resulted in a single failure to deliver, the executing broker should consider the relevant facts and circumstances to determine whether it would be reasonable to rely on the customer's assurances for other transactions. For example, it may be reasonable for an executing broker to rely on the customer's assurances if the circumstances of the fail in a prior transaction were unusual, or if previous locates relying on the customer's assurances resulted in timely deliveries of securities to settle the customer's transactions and the fail in the prior transaction was an anomaly.

(NEW! 10/10/06)

Question 4.3(C): May firms rely on pre-existing agreements, such as standing instruction letters or blanket assurances, with customers when complying with the locate requirements of Rule 203(b)(1) of Regulation SHO?

Answer: Rule 203(b)(1) of Regulation SHO provides that a "broker or dealer may not accept a short sale order in an equity security from another person, or effect a short sale in an equity security for its own account, unless the broker or dealer has: (i) Borrowed the security, or entered into a bona-fide arrangement to borrow the security; or (ii) Reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due; and (iii) Documented compliance with this paragraph (b)(1)." Thus, the broker-dealer has the responsibility to perform the locate prior to effecting each short sale.

To comply with the rule, the broker-dealer must perform the locate prior to, and on the same day that, the broker-dealer effects each short sale. For example, the broker-dealer must perform a new locate when a Good Till Cancel ("GTC") short sale order requiring a locate cannot be effected on the same day that the locate was performed. Moreover, the broker-dealer may not rely on a pre-existing agreement with another source in lieu of this trade-by-trade determination.

In addition, the rule requires that broker-dealers document, at a minimum, the identity of the source, as well as the fact that the locate was performed prior to, and on the same day that, the broker-dealer effected the short sale. The rule also requires documentation of the number of shares located. We understand, however, that documenting the specific number of shares located may be problematic for systems reasons. In such circumstances, the broker-dealer must be able to demonstrate, upon request of SRO or Commission staff, that the locate: (1) was performed prior to, and on the same day that, the broker-dealer effected the short sale; (2) the short sale did not exceed the number of shares located, and (3) that there were reasonable grounds to rely on the locate.

Footnote 58 of the Adopting Release provides that a broker-dealer may obtain an assurance from a customer that such party can obtain securities from another identified source in time to settle the trade. As discussed in more detail in Question 4.3(B), that customer assurance may in some circumstances provide the "reasonable grounds" required by Rule 203(b)(1)(ii). Where the broker-dealer is relying on a customer assurance, the broker-dealer must demonstrate, upon request of SRO or Commission staff, that it confirmed that the customer performed the locate prior to, and on the same day that, the broker-dealer effected the short sale. The broker-dealer may not rely on a pre-existing agreement, such as a standing instruction letter or blanket assurance, with a customer when complying with the locate requirements of the rule, but must obtain the customer's individual assurance prior to, and for, each short sale.

Question 4.4: May an executing broker-dealer re-apply a locate for intra-day buy-to-cover trades?

Answer: A locate for a security may be re-applied for an intra-day buy-to-cover trade in the following scenario:

Prior to a customer’s short sale of 100 shares of XYZ stock, the executing broker-dealer obtains an appropriate locate for the securities. The short sale is then executed. Subsequently that day, the broker-dealer purchases 100 shares of XYZ stock for the customer, and the customer’s net trading position is flat. If the customer wants to then sell short another 100 shares of XYZ stock in the same trading day, the executing broker-dealer may apply the original locate to that sale, provided that such subsequent short sale is for an amount of securities that is no greater than the amount of securities obtained in the original locate, and provided further that the source of the located shares indicates that the original locate is good for the entire trading day.

For a "hard to borrow" security or a threshold security, a broker-dealer may not re-apply a locate for intra-day buy-to cover trades. Without obtaining locates prior to each short sale in such securities in the scenario described above, it is unlikely that the broker-dealer executing such trades would have reasonable grounds to believe that such securities can be borrowed so that they can be delivered on the date that delivery is due on each trade. A broker-dealer, however, may have reasonable grounds to believe that securities will be available when delivery is due on such short sales if the broker-dealer pre-borrows the securities.

Question 4.5: Does the locate requirement apply to convertible securities?

Answer: The locate requirement applies to all equity securities. The term “equity security” is defined in Section 3(a)(11) of the Exchange Act and Rule 3a11-1 thereunder (17 CFR 240.3a11-1). A security convertible into an equity security is an equity security; therefore, such convertibles would be subject to the locate requirement. The Staff will consider on a case-by-case basis securities, including structured products, to which the “equity” status may not be clear.

A convertible security that is subject to the locate requirement may qualify for an exception. Rule 203(b)(2)(ii) provides an exception from the uniform locate requirement for situations in which a broker-dealer effects a sale on behalf of a customer that is deemed to “own” the security although, through no fault of the customer or the broker-dealer, it is not reasonably expected that the security will be in the physical possession or control of the broker-dealer by the settlement date. The Adopting Release states that such circumstances could include the situation where a convertible security, option, or warrant has been tendered for conversion or exchange, but the underlying security is not reasonably expected to be received by the settlement date. (69 FR at 48015). In such situation, delivery should be made on the sale as soon as all restrictions on delivery have been removed, and in any event within 35 days after trade date. If delivery is not made within 35 days after the trade date, the broker-dealer that sold on behalf of the person must either borrow securities or close out the open position by purchasing securities of like kind and quantity.

Question 4.6: May a U.S. broker-dealer that executes orders on behalf of a foreign broker-dealer rely on a locate by such foreign broker-dealer in the same way that the U.S. broker-dealer may rely on a locate by a U.S. broker-dealer or customer?

Answer: Rule 203(b)(1)(ii) permits a broker or dealer to accept a short sale order in an equity security if the broker-dealer has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the settlement date. The U.S. broker-dealer may rely on a locate of a foreign broker-dealer in the same way that the U.S. broker-dealer may rely on a locate of a U.S. broker-dealer or customer: the facts and circumstances must provide a basis for a reasonable belief that the security will be available for delivery on the settlement date.

Moreover, the locate information must be documented. Consistent with Footnote 58 of the Adopting Release, the documentation should include the source of the securities given by the foreign broker-dealer as the basis for the locate and support for the reasonableness of the reliance on the foreign broker-dealer. For further information about how the provisions of Regulation SHO may apply to overseas transactions, please refer to Question 1.3.

Question 4.7: Market makers, as defined in Section 3(a)(38) of the Exchange Act, include block positioners. Regulation SHO provides an exception to the locate requirement for market makers. Are all block positioners excepted from the locate requirement?

Answer: Rule 203(b)(2)(iii) provides an exception from the locate requirement for short sales effected by market makers, but only in connection with bona-fide market making activities. Rule 203(c)(1) provides that the term “market maker” has the same meaning as in Section 3(a)(38) of the Exchange Act, which defines “market maker” as “any specialist permitted to act as a dealer, any dealer acting in the capacity of a block positioner, and any dealer that, with respect to a security, holds itself out (by entering quotations in an inter-dealer communications system or otherwise) as being willing to buy and sell such security for its own account on a regular or continuous basis.”

The term “block positioner” is not defined in Regulation SHO or the Exchange Act. However, for purposes of Regulation SHO, the Staff interprets this term to have the same meaning as in Rule 3b-8(c) of the Exchange Act (17 CFR 240.3b-8(c)), which defines a “qualified block positioner” as a dealer that: (1) is a broker or dealer registered pursuant to Section 15 of the Exchange Act; (2) is subject to and in compliance with Rule 15c3-1 of the Exchange Act (17 CFR 240.15c3-1); (3) has and maintains minimum net capital, as defined in Rule 15c3-1, of $1,000,000; and (4) except when such activity is unlawful, meets all of the following conditions: (i) engages in the activity of purchasing long or selling short, from time to time, from or to a customer (other than a partner or a joint venture or other entity in which a partner, the dealer, or a person associated with such dealer, as defined in Section 3(a)(18) of the Exchange Act, participates) a block of stock with a current market value of $200,000 or more in a single transaction, or in several transactions at approximately the same time, from a single source to facilitate a sale or purchase by such customer, (ii) has determined in the exercise of reasonable diligence that the block could not be sold to or purchased from others on equivalent or better terms, and (iii) sells the shares comprising the block as rapidly as possible commensurate with the circumstances.

Therefore, block positioners may rely on the exception to the locate requirement in connection with bona-fide block positioning activities.

Question 4.8: What constitutes “bona-fide market making activities?”

Answer: The term “bona-fide market making” refers to bona-fide activities described in Section 3(a)(38) of the Exchange Act. Whether activity is “bona-fide” will depend on the facts and circumstances of the particular activity. However, the Adopting Release sets forth examples of activities that would not be considered to be “bona-fide market making activities.” (69 FR at 48015).

Question 4.9: How does the locate requirement apply to short sales of securities in a Rule 144 transaction?

Answer: Rule 203(b)(2)(ii) provides an exception from the uniform locate requirement for situations in which a broker-dealer effects a sale on behalf of a customer that is deemed to “own” the security although, through no fault of the customer or the broker-dealer, it is not reasonably expected that the security will be in the physical possession or control of the broker-dealer by the settlement date. Footnote 71 of the Adopting Release states that one such situation is where a customer owns stock that was formerly restricted, but presently may be sold pursuant to the provisions of Rule 144 under the Securities Act of 1933 (17 CFR 230.144). Rule 144 securities may not be capable of being delivered on settlement date due to processing to remove the restricted legend. In such situation, delivery should be made on the sale as soon as all restrictions on delivery have been removed, and in any event within 35 days after trade date. If delivery is not made within 35 days after the trade date, the broker-dealer that sold on behalf of the person must either borrow securities or close out the open position by purchasing securities of like kind and quantity.

(NEW - 07/06/07)

Question 4.10: A broker-dealer wishes to execute customer orders internally at a price that would trade through one or more protected quotations on other trading centers, but pursuant to Regulation NMS, is able to do so only if it simultaneously routes one or more ISOs to execute against the full displayed size of each of such better-priced quotations.  Where the ISO is a short sale ISO, is the broker-dealer required to obtain a "locate" (i.e., have reasonable grounds to believe that the securities to be sold short are available for borrowing), as required by Rule 203(b)(1) of Regulation SHO?

Answer:  In certain circumstances, a broker-dealer facilitating a customer order may be required under Regulation NMS to effect a ISO, while the broker-dealer is short the stock. Rule 203(b) of Regulation SHO provides that a broker or dealer may not accept a short sale order in an equity security from another person, or effect a short sale in an equity security for its own account, unless the broker or dealer has borrowed the security or entered into a bona-fide arrangement to borrow the security, or has reasonable grounds to believe the security can be borrowed so that it can be delivered on the date delivery is due. Regulation SHO includes an exception from the locate requirement, in Rule 203(b)(3)(iii), for short sales effected by market makers in connection with bona-fide market making activities. 

The Staff has previously indicated that because market makers, as defined in Section 3(a)(38) of the Exchange Act, include block positioners, the exception from the locate requirement also applies to short sales effected by block positioners in connection with bona fide block positioning activities. See Regulation SHO FAQ 4.7. The block positioner exception allows block positioners to facilitate customer orders in a fast moving market without possible delays associated with complying with the locate requirement.

A broker-dealer that submits a short sale ISO as a result of facilitating a customer order in the following circumstances would not be required to comply with the locate requirement in connection with the ISO, even if the customer order being facilitated was not necessarily of block size and the broker-dealer was not necessarily acting in the capacity of a block positioner or market maker:

• a broker-dealer that sells to facilitate a customer purchase at a price that would trade through one or more protected quotations on other trading centers and submits a principal sell short ISO to execute against the full displayed size of each such better-priced quotation pursuant to Rule 611;
   
• a broker-dealer that agrees to purchase from a customer at a price that would trade through one or more protected quotations on other trading centers and submits a principal sell short ISO to execute against the full displayed size of each such better-priced quotation pursuant to Rule 611.

In addition, a broker-dealer that agrees to facilitate two customers in an agency cross transaction at a price that would trade through one or more protected quotations on other trading centers may agree with the customers that the broker will send principal sell short ISOs to execute against the full displayed size of each such better-priced quotation pursuant to Rule 611. A short sale ISO submitted in such circumstances solely to comply with Rule 611 is also excepted from the locate requirement.

In all of the examples described above, the locate exception is limited to the short sale ISO only. There is no exemption from the locate requirement for any short sale executed to facilitate the customer order. For example, if the broker-dealer is routing a short sale ISO for its principal account but owes any executions it receives to customer orders, and the customer orders are short sales, the locate exception does not apply to the customer short sale. The broker-dealer must continue to comply with the locate requirements of Rule 203(b)(1) with regard to that order.

This interpretive guidance is strictly limited to a broker-dealer's submission of a short sale ISO under the facts presented above, and any other short sales by the broker-dealer or customer would be required to comply with the Regulation SHO locate requirement, unless the broker-dealer or customer is otherwise entitled to rely on another exception in Rule 203(b)(2) of Regulation SHO.  In the event that the broker-dealer's short sale ISO in a "threshold security" resulted in a fail-to-deliver position at a registered clearing agency, such fail position would be subject to the close-out requirement of Rule 203(b)(3) of Regulation SHO.

5. Close-Out and Pre-Borrow Requirements – Rule 203(b)(3)

Question 5.1: Does the close-out requirement apply to open fail positions in securities that exist prior to January 3, 2005?

Answer: The Adopting Release states that the requirement to close out fail to deliver positions in threshold securities that remain for 13 consecutive settlement days does not apply to any positions that were established prior to the security becoming a threshold security. (69 FR at 48018, and Rule 203(b)(3)(i)). On January 3, 2005, no securities will have been identified as threshold securities. Therefore, open fail positions in securities that exist prior to January 3, 2005 will not be required to be closed out under Regulation SHO. However, this does not affect the obligation of sellers of securities to deliver those securities to buyers under existing delivery and settlement guidelines.

As explained in Question 6.1, on January 3, 2005, the SROs will begin the calculations necessary to determine whether securities qualify as threshold securities. January 10, 2005 is the first day on which SROs will publish threshold lists. Until a security appears on a threshold list for 13 consecutive settlement days and an open fail position for such security exists for those days, Regulation SHO does not require a broker or dealer to close out the open fail position. Therefore, the first day on which a close-out action would be required is January 28, 2005.

Question 5.2: Must an open fail position be closed out if a security is not a threshold security on the trade date but later appears on a threshold list? Must an open fail position be closed out if a security is a threshold security on the trade date but later does not appear on a threshold list?

Answer: The close-out and pre-borrow requirements of Regulation SHO are based on settlement days, not trade days. Under Regulation SHO, it is irrelevant whether a security is a threshold security on the date that it is sold short. The close-out and pre-borrow requirements apply if a security is a threshold security for 13 consecutive settlement days and a participant in a registered clearing agency has open delivery failures in that security on each of those days.

For example, if a participant sells short a security that is not a threshold security on the date of sale, the close-out and pre-borrow requirements would not apply to a fail to deliver position on the participant’s net short settlement obligation unless the security later becomes a threshold security and it maintains that status for 13 consecutive settlement days and the participant has delivery failures for all of those days. On the other hand, a participant must close out a fail to deliver position in a threshold security that has persisted for 13 consecutive settlement days irrespective of the dates of the participant’s trades in that security. If the security ceases to be a threshold security prior to the 13^th consecutive settlement day that a participant has a fail position in the security, there would be no obligation under Regulation SHO to close out the fail position.

Question 5.3: Does the close-out requirement apply to delivery failures that do not occur at a registered clearing agency?

Answer: We interpret the close-out requirement to apply only to fail to deliver positions at a registered clearing agency. Our interpretation is based on our understanding that transactions conducted outside the Continuous Net Settlement System (“CNS”) operated by the National Securities Clearing Corporation (“NSCC”) are rare. If this historical pattern changes and a significant level of fails are not included in CNS, we will reconsider this position.

Question 5.4: When entering into an arrangement to pre-borrow a threshold security, must a firm clean up the entire amount of the fail before accepting additional orders to sell short such threshold security? Or, may the firm effect short sale orders up to the amount of shares of the threshold security that is pre-borrowed?

Answer: Under Rule 203(b)(3), when a participant of a registered clearing agency has a net settlement failure in a threshold security for 13 consecutive settlement days, two consequences follow: (1) the participant must immediately take steps to close out the fail to deliver position; and (2) until the fail to deliver position is closed out, the participant and any broker or dealer for which it clears transactions must borrow the security that is the subject of the fail, or enter into a bona-fide arrangement to borrow such security before the participant or such broker or dealer may effect any subsequent short sales in such security. This pre-borrow requirement remains in place until the participant closes out the entire fail to deliver position. Therefore, a participant that has a close-out obligation for a threshold security may effect short sale orders for such threshold security up to the amount pre-borrowed.

Rule 203(b)(3)(iv) permits the participant to reasonably allocate a portion of a fail to deliver position to another registered broker or dealer for which it clears trades or for which it is responsible for settlement, based on such broker’s or dealer’s short position. If the participant has reasonably allocated the fail to deliver position, the provisions of Rule 203(b)(3) relating to such fail to deliver position shall apply to the portion of such registered broker or dealer that was allocated the fail to deliver position, and not to the participant.

Question 5.5: When must the close-out be initiated?

Answer: Rule 203(b)(3) provides that participant of a registered clearing agency that has a net settlement failure in a threshold security for 13 consecutive settlement days must immediately take steps to close out the fail to deliver position. The close-out process must be initiated no later than the beginning of trading on the trading day following the 13^th consecutive settlement day with a net short settlement obligation.

Question 5.6: If a threshold security also qualifies as an “owned” security within the meaning of Rule 203(b)(2)(ii), when should the firm close out the short position: after the 13^th consecutive settlement day; or the day that is 35 days after the trade date?

Answer: The close-out requirement that applies to threshold securities in Rule 203(b)(3)(iii) is based on net short positions, not trade dates. If a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency in a threshold security for 13 consecutive settlement days, the participant must take action to close out the fail to deliver position after the 13^th consecutive settlement day (see Question 5.5), and, until the close-out obligation is satisfied, the participant must pre-borrow securities prior to effecting any subsequent short sales in such threshold security (see Question 5.4).

The close-out requirement that applies to “owned” securities in Rule 203(b)(2)(ii), however, is a sale-based provision that does not apply directly to net short positions and is not limited to sales of threshold securities. It provides an exception from the locate requirement for a short sale of an “owned” security, provided that the broker or dealer has been reasonably informed that the person intends to deliver such security as soon as all restrictions on delivery have been removed. If the person has not delivered such security within 35 days after the date of sale, the broker or dealer that effected the sale must borrow securities or close out the short position by purchasing securities of like kind and quantity.

These close-out requirements operate independently and concurrently. Therefore, if an “owned” security is a threshold security, the security must be delivered within 35 days of the trade date, and a fail to deliver position in that security must be closed out after 13 consecutive settlement days of delivery failures.

(NEW! 05/24/05)

Question 5.7: If a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency in a threshold security for 13 consecutive settlement days and immediately thereafter purchases securities of like kind and quantity to close out the fail to deliver position as required under Rule 203(b)(3), will the participant be deemed to have satisfied the close-out obligation on the day the purchase is executed, or on the day the purchase settles?

Answer: Rule 203(b)(3) provides that a participant of a registered clearing agency that has a fail to deliver position in a threshold security for 13 consecutive settlement days must immediately thereafter close out the fail to deliver position by purchasing securities of like kind and quantity. Until the close-out obligation is satisfied, a participant must pre-borrow securities to effect any new short sales in such threshold securities.

The Staff interprets the phrase "purchasing securities of like kind and quantity" in Rule 203(b)(3) to mean that a participant satisfies the obligation to close out an open fail to deliver position in a threshold security that has persisted for 13 consecutive settlement days when such participant executes a purchase of securities, and where:

• the purchase is a bona fide transaction;
   
• the purchase is executed on settlement day 11, 12 or 13;
   
• the purchase is submitted to a registered clearing agency for settlement;
   
• the purchase is of a quantity of securities sufficient to close out the entire amount of the open fail position that has persisted for 11, 12 or 13 consecutive settlement days, as applicable; and
   
• the net purchases of the threshold security effected by the participant on that day, as reflected in such participant's books and records, are at least equal to the amount of such participant's open fail to deliver position in such threshold security on that day.
   

Purchases to close out fail to deliver positions in threshold securities must be bona-fide purchases. Rule 203(b)(3)(v) provides that where a participant enters into an arrangement with another person to purchase securities to close out an open fail to deliver position in a threshold security, and the participant knows or has reason to know that the other person will not deliver securities in settlement of the purchase, the participant will not be deemed to have fulfilled the close-out requirements of Rule 203(b)(3).

The Staff's interpretation that a participant satisfies the close-out obligation on the day when such participant executes a purchase of securities applies only to fail positions that are or are projected to be subject to the close-out requirements of Rule 203(b)(3); i.e., to purchases made on settlement day 11, 12, or 13. Therefore, this interpretation does not apply to purchases made on settlement day 10 or earlier, because there is no present or projected close-out requirement and such purchases would settle on or before 13 consecutive settlement days has elapsed.

(NEW! 03/17/06)

Question 5.8: If a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency in a threshold security at the end of each day for 13 consecutive settlement days, but during the 13-day period the participant experiences a reduction in its end of day fail to deliver position at NSCC, how should the participant apply that reduction to its open fail position(s)?

Answer: Rule 203(b)(3) of Regulation SHO requires a participant to close out a fail to deliver position in a threshold security that has persisted for 13 consecutive settlement days by purchasing securities of like kind and quantity. A participant's close-out requirement is determined by the change in the participant's end-of-day net fail to deliver position, in excess of any grandfathered amount, as recorded at NSCC that has remained open for 13 consecutive settlement days. In determining its close-out requirement, the participant must look to its total fails position at NSCC and not to fails positions at the customer account level.

If, prior to the 13th consecutive settlement day, the participant reduces its open fail to deliver position and such reduction is reflected in the participant's end-of-day net fail to deliver position at NSCC, the participant may first apply the reduction to the most recent increase in its fail to deliver position reflected at NSCC and then to any increase in its fails position that existed at NSCC on the day preceding that day and so forth until the entire amount of the reduction has been applied. If the participant wishes to apply any reduction reflected in its end-of-day net fail to deliver position at NSCC, the participant must do so in accordance with the methodology described in this Question 5.8.

Example

In this example, the participant has a fail to deliver position at NSCC of 5,000 shares in threshold security X that is subject to both increases and decreases during the 13 consecutive settlement day period. Assume, in this example, that there is no grandfathered amount.

In the above example, the participant has three separate increases in its fail to deliver position at NSCC that persist for 13 consecutive settlement days and must be closed out by the participant at the end of the 13th settlement day following the day of the increase, or on the morning of the 14th settlement day following the day of the increase, by purchasing shares of like kind and quantity.

The participant has an initial increase in its fail to deliver position of 5,000 shares that persists for 13 consecutive settlement days and must be closed out at the end of the 13th settlement day following the day of the increase, or on the morning of the 14th settlement day following the day of the increase.

In addition, the participant's fail to deliver position increases by 500 shares to 5,500 and then again by 400 shares to 5,900 shares on settlement days 3 and 7, respectively. On settlement day 8, however, the participant's end of day fail to deliver position reflects a 600 shares reduction from the prior day. This 600 shares reduction is applied first to the 400 shares increase on settlement day 7 and the excess amount of 200 shares is then applied to the 500 shares increase on settlement day 3. As a result of the 600 shares reduction at NSCC, the 400 shares increase in the participant's position that occurred on day 7 is reduced to 0 and the 500 shares increase in the participant's position that occurred on day 3 is reduced to 300. There are no further reductions in the participant's end-of-day net fail to deliver position. Thus, the 300 shares increase must be closed out at the end of the 13th settlement day following the day of the increase to 500 shares, or on the morning of the 14th settlement day following the day of the increase to 500 shares.

On settlement day 11, the participant's fail to deliver position is 10,000 shares, an increase of 4,700 shares from the prior settlement day. The participant's position then decreases by 5,000 shares on settlement day 16 as a result of the purchase to close out the 5,000 share open fail position that occurred on day 1 and that has persisted for 13 consecutive settlement days. On settlement day 18, the participant's fail to deliver position decreases to 4,700 shares, a 300 shares reduction from the prior settlement day, as a result of the purchase to close out the 300 shares open fail to deliver position that has persisted for 13 consecutive settlement days. On settlement day 26, the participant's fail to deliver position decreases to 0 shares, a 4,700 shares reduction from the prior settlement day, as a result of the purchase to close out the 4,700 shares increase in the participant's fail to deliver position that occurred on settlement day 11 and that has persisted for 13 consecutive settlement days.

Although there are reductions in the participant's fail to deliver position at NSCC on settlement days 16, 18 and 26, these reductions are as a result of the participant fulfilling its close out requirement of 5,000, 300 and 4,700 shares, respectively, at the end of the 13th settlement day and, therefore, are not allocated to prior increases in the participant's fail to deliver position.

To the extent that a reduction in a participant's fail to deliver position at NSCC is equal to, and results from, a prior close out requirement, the participant may not allocate the reduction to prior increases in its fail to deliver position because the participant has already received credit for such reduction due to the reduction being applied to the amount of the participant's close out requirement. If, however, the reduction in the participant's fail to deliver position at NSCC is greater than the amount of the participant's close out requirement, the participant may allocate any amount in excess of the close out requirement in accordance with this Question 5.8.

6. Threshold Securities – Rule 203(c)(6)

Question 6.1: Who is responsible for providing lists of threshold securities? When will the threshold lists be provided?

Answer: The SROs will disseminate threshold lists that will contain securities that are listed on their market systems and that exceed the specified fail level for at least five consecutive settlement days. A threshold security is expected to appear on one list. If a threshold security is listed on more than one market system, we understand that the SROs have agreed that the security will appear only on the threshold list of the SRO that maintains the primary listing.

On January 3, 2005, the SROs will begin the calculations necessary to determine whether securities may qualify as threshold securities. This process is described in greater detail in Question 6.2. On January 10, 2005, the SROs should disseminate the first threshold lists. SROs are expected to disseminate their threshold lists before the commencement of each trading day. We understand that the SROs have agreed to make all their lists publicly available at or before midnight each trading day. Therefore, these threshold lists will be in effect for the open of trading immediately following the posting of the threshold lists. We further understand that SROs will make threshold data available on their web sites in a downloadable, uniform, pipe-delimited ASCII format.

Question 6.2: How will SROs determine which securities should be included on a threshold list?

Answer: Any equity security of an issuer that is registered under Section 12 or that is required to file reports pursuant to Section 15(d) of the Exchange Act could qualify as a threshold security. Therefore, threshold securities may include those equity securities that trade on the OTCBB or on the pink sheets, as well as those that trade on the exchanges or Nasdaq.

At the conclusion of each settlement day, NSCC will provide the SROs with data on securities that have aggregate fails to deliver at NSCC of 10,000 shares or more. For the securities for which it is the primary market, each SRO will use this data to calculate whether the level of fails is equal to at least 0.5% of the issuer’s total shares outstanding of the security. If, for five consecutive settlement days, such security satisfies these criteria, then such security will be a threshold security. Each SRO should include such security on its daily threshold list until the security no longer qualifies as a threshold security.

(NEW! 05/06/05)

7. Clearance and Settlement

Question 7.1: Do naked short sale transactions create "counterfeit shares?"

Answer: Some believe that naked short sale transactions cause the number of shares trading to exceed the number of shares outstanding, which in turn allows broker-dealers to trade shares that don't exist. Others believe that the U.S. clearance and settlement system, and specifically the National Securities Clearing Corporation's ("NSCC") Continuous Net Settlement System ("CNS"), produces "phantom" or "counterfeit" securities by accounting for fails to deliver.

Naked short selling has no effect on an issuer's total shares outstanding. There is significant confusion relating to the fact that the aggregate number of positions reflected in customer accounts at broker-dealers may in fact be greater than the number of securities issued and outstanding. This is due in part to the fact that securities intermediaries, such as broker-dealers and banks, credit customer accounts prior to delivery of the securities. For most securities trading in the U.S. market, delivery subsequently occurs as expected. However, fails to deliver can occur for a variety of legitimate reasons, and flexibility is necessary in order to ensure an orderly market and to facilitate liquidity. Regulation SHO is intended to address the limited situations where fails are a potential problem (for example, fails in securities on a threshold list).

Similarly, CNS has no effect on an issuer's total shares outstanding. With regards to the contention that the U.S. clearance and settlement system, and specifically NSCC's CNS system, creates counterfeit shares, this is not the case. CNS is essentially an accounting system that indicates delivery and receive obligations among its members (i.e., broker-dealers and banks). These obligations do not reflect ownership positions until such time as delivery of shares are actually made. Ownership positions are reflected on the records of The Depository Trust Company ("DTC").

Question 7.2: Does NSCC's stock borrow program ("SBP") create "counterfeit shares"?

Answer: The SBP was implemented in the late 1970s to allow NSCC to satisfy its members' priority needs for stocks that they do not receive because of fails. It is governed by NSCC rules approved by the Commission. Under the SBP, NSCC uses shares voluntarily made available to the SBP by some of its members to complete deliveries to members that did not receive their securities on settlement day. The SBP moves securities that are actually on deposit at DTC from the lending member to the NSCC member who did not receive securities. NSCC then records the lender's right to receive the same amount of shares that it loaned just as if the lender had purchased securities but not received them (i.e., the member lending the securities replaces the member receiving the loaned securities in the CNS system). The lending and delivery of shares through the SBP, however, does not relieve the member that has failed to deliver from its obligation to deliver securities.

The shares loaned by NSCC members for use in the SBP must be on deposit at DTC and are debited from members' accounts when the securities are used to make delivery. Once a member's shares are used for delivery to another member, the lending member no longer has the right to sell or relend those shares until such time as the shares are returned to its DTC account. Accordingly, NSCC's SBP does not create "counterfeit shares." In fact, the program facilitates the delivery of securities to buyers while maintaining the obligation of the sellers to deliver securities to NSCC. This outcome is consistent with the NSCC's obligation to facilitate the prompt and accurate clearance and settlement of securities transactions and in general to protect investors and the public interest.

Question 7.3: Should NSCC buy-in all fails to deliver in CNS?

Answer: A "fail to deliver" in NSCC's CNS occurs when an NSCC member (e.g., a broker-dealer or a bank) fails to deliver securities on settlement date. There are many reasons why NSCC members do not or cannot deliver securities to NSCC on the settlement date. Many times the member will experience a problem that is either unanticipated or is out of its control, such as (1) delays in customer delivery of shares to the broker-dealer; (2) an inability to borrow shares in time for settlement; (3) delays in obtaining transfer of title; (4) an inability to obtain transfer of title; and (5) deliberate failure to produce stock at settlement which may result in a broker-dealer not receiving shares it had purchased to fulfill its deliver obligations. In addition, market makers may maintain temporary short positions in CNS until such time as there is sufficient trading to flatten out their position.

NSCC does not have the authority to execute buy-ins on behalf of its members. Moreover, forcing close-outs of all fails can increase risk in clearing and settling transactions as well as potentially interfering with the trading and pricing of securities.

http://www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm