SERIES 7 | SERIES 65 | FINANCIAL REGULATION COURSES
FINRA Rule 4320 — Short Sale Delivery Requirements — extends the short sale close-out obligations of SEC Regulation SHO to equity securities of non-reporting issuers — companies not registered under Section 12 of the Securities Exchange Act of 1934 or not required to file reports under Section 15(d) — that would otherwise fall outside Regulation SHO's threshold security close-out framework, preventing the accumulation of persistent unclosed fail-to-deliver positions in the equity securities of smaller and less liquid companies that could facilitate abusive naked short selling and harm investors trading in those markets.
FINRA Rule 4320 was adopted from its predecessor NASD Rule 3210 and approved by the SEC in August 2010 — filling a specific regulatory gap identified in Regulation SHO's framework by extending parallel close-out requirements to non-reporting threshold securities while aligning its interpretive standards with those applied by the SEC to Regulation SHO's reporting threshold security provisions.
The rule operates alongside Regulation SHO — the SEC's primary regulatory framework for short selling — rather than replacing it, creating a comprehensive close-out requirement framework that covers both reporting issuers through Regulation SHO and non-reporting issuers through FINRA Rule 4320.
The Short Selling and Fail-to-Deliver Framework
Short selling — the practice of selling securities that the seller does not own, borrowing them from a broker-dealer or third party to deliver to the buyer, with the intention of purchasing them later at a lower price to close the position — is a legitimate investment strategy that provides market liquidity and enables price discovery. However short selling creates a delivery obligation — the short seller must deliver the sold securities to the buyer on the settlement date, which requires borrowing or otherwise obtaining the securities before the trade settles.
When a short seller fails to deliver the sold securities to the buyer on the settlement date — because the securities could not be located or borrowed in sufficient quantity — a fail-to-deliver position arises at the registered clearing agency processing the settlement. Fail-to-deliver positions represent unfulfilled delivery obligations and can create settlement system inefficiencies, potential market distortions, and investor harm if they persist without resolution.
Naked short selling — effecting a short sale without first locating or borrowing the securities to be delivered — creates fail-to-deliver positions intentionally rather than incidentally, and can be used to artificially suppress the price of the shorted security by creating selling pressure that is not backed by genuine borrowed shares. Persistent unclosed fail-to-deliver positions are a primary indicator of potential naked short selling activity.
Regulation SHO — The Primary Framework
SEC Regulation SHO — adopted in January 2005 and substantially strengthened by subsequent amendments — is the primary federal regulatory framework governing short selling and fail-to-deliver close-out requirements for reporting threshold securities.
The locate requirement of Regulation SHO Rule 203(b)(1) prohibits broker-dealers from accepting a short sale order or effecting a short sale for their own account unless they have first borrowed the security, entered into a bona-fide arrangement to borrow the security, or have reasonable grounds to believe the security can be borrowed so that it can be delivered on the settlement date. The locate requirement addresses the root cause of fails-to-deliver by ensuring that short sellers have arranged the borrowing necessary to fulfil the delivery obligation before the short sale is executed.
The close-out requirements of Regulation SHO Rule 204 require participants of registered clearing agencies to close out fail-to-deliver positions in threshold securities — securities with aggregate fails-to-deliver at a registered clearing agency at or above a specified threshold — by purchasing securities of like kind and quantity within thirteen consecutive settlement days of the fail arising. Until the position is closed out the participant and any broker-dealer for which it clears may not effect further short sales in the threshold security without first borrowing or arranging to borrow the security — the penalty box restriction that prevents continued short selling into an unresolved delivery failure.
Regulation SHO's close-out requirements apply only to the equity securities of reporting issuers — companies that file periodic reports with the SEC under the Securities Exchange Act of 1934. The equity securities of non-reporting issuers — small companies trading in the OTC markets that do not meet the reporting requirements of a registered issuer — were not covered by Regulation SHO's close-out framework, creating a regulatory gap that FINRA Rule 4320 fills.
Non-Reporting Threshold Securities — The Gap FINRA Rule 4320 Fills
FINRA Rule 4320 defines a non-reporting threshold security as an equity security of an issuer that is not registered under Section 12 of the Exchange Act and not required to file reports pursuant to Section 15(d) — and that has an aggregate fail-to-deliver position at a registered clearing agency of at least ten thousand shares and that is equal to at least one-half of one percent of the issue's total shares outstanding for five consecutive settlement days.
The threshold test for non-reporting threshold securities mirrors the structure of Regulation SHO's threshold security definition — establishing a minimum absolute size requirement of ten thousand shares and a relative size requirement of one-half of one percent of shares outstanding that must both be met for five consecutive settlement days before the security is designated as a non-reporting threshold security subject to Rule 4320's close-out obligations.
A security ceases to be a non-reporting threshold security when the aggregate fail-to-deliver position at the registered clearing agency does not meet or exceed either of the threshold tests for five consecutive settlement days — allowing the security to exit threshold status once the delivery failure problem has been sufficiently resolved.
The Close-Out Requirement
Rule 4320(b) establishes the close-out requirement applicable to participants of registered clearing agencies that have fail-to-deliver positions in non-reporting threshold securities.
If a participant of a registered clearing agency has a fail-to-deliver position at a registered clearing agency in a non-reporting threshold security for thirteen consecutive settlement days — or thirty-five consecutive settlement days if entitled to rely on the market maker exception — the participant and any broker-dealer for which it clears transactions may not accept a short sale order in the non-reporting threshold security from another person, or effect a short sale in the security for its own account, without first borrowing the security or entering into a bona-fide arrangement to borrow the security, until the participant closes out the fail-to-deliver position by purchasing securities of like kind and quantity and that purchase has cleared and settled.
The thirteen-day close-out period — consistent with Regulation SHO's timeline for reporting threshold securities — gives participants a reasonable opportunity to close out fail-to-deliver positions through normal market means before the penalty box restriction takes effect. The thirty-five day extended period for market makers recognises that registered market makers in equity securities have a legitimate function in providing continuous liquidity that may require short selling in excess of the immediate borrowing availability — the extended period gives market makers additional time to close out fail-to-deliver positions before facing the short-selling restriction.
The Penalty Box Restriction
The consequence of failing to close out a fail-to-deliver position within the required timeframe is the penalty box restriction — the prohibition on accepting short sale orders or effecting short sales in the security without first borrowing or arranging to borrow the security.
The penalty box restriction applies to the clearing agency participant and to every broker-dealer for which the participant clears transactions — ensuring that the restriction cannot be circumvented by routing short sale orders through different clearing arrangements. The comprehensive scope of the restriction prevents the participant from satisfying the close-out requirement while simultaneously continuing to accumulate new fail-to-deliver positions through continued naked short selling.
The penalty box restriction remains in effect until the fail-to-deliver position has been closed out through the purchase of securities of like kind and quantity and that purchase has cleared and settled at the registered clearing agency. The requirement that the closing purchase actually clear and settle — not merely be executed — prevents the use of uncompleted purchase transactions to temporarily satisfy the restriction without actually resolving the delivery failure.
Connection to Regulation SHO and the Broader Short Sale Framework
FINRA Rule 4320 is designed to operate consistently with Regulation SHO — FINRA applies all interpretive positions issued by the SEC and its staff regarding the parallel provisions of Regulation SHO to Rule 4320, ensuring that the regulatory standards for non-reporting securities are not materially different from those applicable to reporting securities under Regulation SHO.
The practical significance of this interpretive alignment is that broker-dealers do not need to maintain separate interpretive frameworks for their Regulation SHO and Rule 4320 compliance obligations — the same legal analysis that applies to their close-out decisions under Regulation SHO applies to their Rule 4320 decisions, with the only meaningful distinction being the category of issuer — reporting versus non-reporting — to which each rule applies.
The Short Selling entry of this dictionary addresses the broader framework of short selling regulation — including the locate requirement, the uptick rule, Regulation SHO's complete framework, and the investor protection purposes that short sale regulation serves. Rule 4320 is the FINRA-level extension of that framework to the segment of the equity markets — non-reporting issuers — that Regulation SHO alone does not reach.
Examination Relevance and Key Takeaways
FINRA Rule 4320 is tested on the Series 7 examination in the context of short sale regulation, fail-to-deliver close-out requirements, and the relationship between FINRA's rules and SEC Regulation SHO.
The key points to retain are these.
FINRA Rule 4320 — Short Sale Delivery Requirements — extends Regulation SHO's fail-to-deliver close-out requirements to equity securities of non-reporting issuers — companies not registered under Section 12 of the Exchange Act and not required to file Section 15(d) reports — filling the regulatory gap left by Regulation SHO's limitation to reporting threshold securities.
A non-reporting threshold security is an equity security of a non-reporting issuer with an aggregate fail-to-deliver position at a registered clearing agency of at least ten thousand shares and at least one-half of one percent of shares outstanding for five consecutive settlement days. Participants with fail-to-deliver positions in non-reporting threshold securities for thirteen consecutive settlement days — or thirty-five days for market makers — may not accept short sale orders or effect short sales in the security without first borrowing or arranging to borrow the security until the fail-to-deliver position is closed out through a purchase that has cleared and settled. This penalty box restriction applies to the participant and all broker-dealers for which it clears. FINRA applies all SEC interpretive positions regarding Regulation SHO to Rule 4320 — ensuring consistent regulatory standards across reporting and non-reporting securities in the short sale framework.
