What Is Regulation SHO?
Let me explain Regulation SHO directly to you: it's a set of rules from the Securities and Exchange Commission (SEC) that I know was implemented in 2005 to regulate short sale practices. This regulation established 'locate' and 'close-out' requirements specifically aimed at curtailing naked short selling and similar practices. Naked shorting happens when investors sell short shares they don't possess and haven't confirmed they can possess.
Key Takeaways
Here's what you need to grasp about Regulation SHO: it's that 2005 SEC rule that directly regulates short selling. The regulation brought in the 'locate' and 'close-out' requirements to cut down on naked short selling. Then, in 2010, it was amended through changes to Rule 201, which halts short selling on a security when its price drops by 10% or more during the trading day, requiring new bids to be above the current price.
Understanding Regulation SHO
Short selling, as you might know, involves exchanging securities through a broker on margin. You borrow a stock, sell it, and then buy it back to return to the lender. Short sellers bet that the stock they sell will drop in price, and broker-dealers loan those securities to clients for this purpose.
The SEC implemented Regulation SHO on January 3, 2005—it was the first significant update to short selling rules since their adoption in 1938. The 'locate' standard requires brokers to have a reasonable belief that the equity to be shorted can be borrowed and delivered on a specific date before any short selling occurs. The 'close-out' standard increases delivery requirements for securities with many extended delivery failures at a clearing agency.
Regulation SHO also requires reporting when, for five consecutive settlement days, the aggregate fails to deliver at a registered clearing agency reach 10,000 shares or more per security, or when the number of fails equals at least one-half of one percent of the issue's total shares outstanding, or if the security is on a list published by a self-regulatory organization (SRO).
History of Regulation SHO
Regulation SHO has seen amendments over the years. After its initial adoption, there were two exceptions to the close-out requirement: the legacy provision and the options market maker exception. But ongoing concerns about requirements not being met for closing out failed delivery positions led to the elimination of both exceptions in 2008. This change strengthened the close-out requirements by applying them to failures to deliver from sales of all equity securities, and it reduced the time allowed for closing out those failures.
Further changes came in 2010. One key issue the SEC aimed to address was the use of short selling to artificially drive down a security's price. They handled this through modifications to Rule 201, which limits the prices at which short sales can occur during periods of significant downward price pressure on a stock.
Important Details on Rule 201
Rule 201 is commonly known as the alternative uptick rule. It gets triggered during a substantial intraday decrease in a stock's price—specifically when shares fall at least 10% in one day. At that point, it mandates that short-sale orders must include a price above the current bid, preventing sellers from worsening the downward momentum of a security already in sharp decline.
As part of Rule 201, trading centers must establish and enforce policies to prevent short sales at impermissible prices after a stock experiences a 10% price decrease within the trading day. This activates a 'circuit breaker' that imposes price test restrictions on short sales for that day and the next trading day.
Special Considerations
Certain types of short sales can qualify for an exception to Regulation SHO. These are known as short exempt orders, marked by brokers with the initials SSE. The primary exception involves the use of non-standard pricing quotes for trade execution.
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