An investor holds 400 shares of a stock in an account at another broker-dealer and sells 400 shares of it through a second firm. On settlement date the second firm delivers 400 shares borrowed for the investor's account. Under Regulation SHO Rule 200, was that sale a short sale?

No, because the investor held an equal number of shares when the order was entered, which is what the definition turns on

Yes, because a sale consummated by the delivery of borrowed securities is a short sale whatever shares the seller holds elsewhere

No, because delivery was made on the settlement date, the definition reaching only sales that fail to deliver to the buyer

Yes, but only because the borrowed shares came from a third party; a borrow from the executing firm's own inventory would leave it long

At 10:00 a seller who owns none of a stock sells 300 shares of it. At 14:00 the same day the seller buys 300 shares of the same stock. What was the character of the 10:00 sale?

A long sale, because the purchase and the sale offset within the same session and leave no position open

A long sale, because the shares needed for delivery were acquired well before the settlement date arrived

A short sale, because the seller did not own the security at the time the sale was made

Neither, because the two transactions net to no position and the character of the sale is fixed only at settlement

An investor has purchased 1,000 shares of a stock and, in a separate transaction, has sold 500 shares of the same stock short. For how many shares is that investor deemed to own the security under Rule 200(b)?

Five hundred, deemed ownership extending only to the net long position, the excess of purchases over short sales

One thousand, deemed ownership following only the shares the investor has actually purchased in the security

One thousand five hundred, each of the two transactions adding to the quantity in which the investor has an interest

None, because an outstanding short sale in a security removes the deemed ownership that purchases in it would otherwise give

A customer with a net long position in a stock instructs a sale of it. The certificates are with the transfer agent and the firm knows they cannot reach its possession or control until after the settlement date. How must the order be marked under Rule 200(g)?

Long, because the net long position is the condition Rule 200(g) imposes and the customer plainly has one in the security

Short, because a long marking needs both the net long position and delivery from the firm's possession or control by settlement

Long, provided the firm records that the certificates are in transit and delivers them to the buyer as soon as they arrive

Short exempt, because the delay arises within the transfer process and is outside the control of both the customer and the firm

A member firm correctly marks a customer's equity sell order long. Which of Regulation SHO's requirements does that marking leave the order outside?

The Rule 201 price restriction, the locate requirement continuing to apply because delivery is still owed on the settlement date

The locate requirement, the Rule 201 price restriction continuing to apply while a circuit breaker is in force in the security

Both the locate requirement and the Rule 201 price restriction, neither reaching a sale delivered from the seller's own holdings

Neither, both applying to every equity sell order, with the marking serving only the surveillance of short selling activity

An equity sell order is marked short exempt. What does that marking do for the order, and what has to be true for it to be used?

It frees the order from the locate requirement and from the Rule 201 price restriction, and is available to any seller registered as a market maker in the security

It frees the order from the locate requirement, the seller remaining obliged to deliver the security on settlement date whatever the source of the shares

It records that the seller's ownership of the security is unresolved, so that the marking may be corrected to long or to short before the trade settles

It lets the order execute despite the Rule 201 price restriction, provided it meets one of the exceptions that rule specifies, such as a riskless principal sale

A firm's systems assign the long, short or short exempt designation to equity sell orders in an end-of-day process, after the trades have been executed and reported. Why does that fail Rule 200?

The designation has to be applied on the settlement date, when it is finally known whether the securities were delivered from the seller's own holdings

The designation may be assigned at any time before the trade is reported to the tape, provided the firm can reconstruct the order's status from its own records

The designation has to be applied before the order is routed away, orders a firm executes against its own inventory falling outside the marking requirement

Under Rule 10a-1 as it stood before 2007, a stock's last reported sale on the exchange is $20.00 and the sale before that was $20.05. A short sale order is entered at $20.00. Could it execute?

Yes, a short sale at the price of the last reported sale satisfying the rule whichever way the preceding price change had run

No, a sale at the last reported price where the previous change was downward being a zero minus tick, which the rule prohibited

No, the rule prohibiting any short sale below the highest price at which the security had traded during that trading session

Yes, provided no other short sale had already executed at that price in the session, the rule testing successive short sales

While Rule 10a-1 was in force, a dealer effects two short sales over the counter on the same day: one in a stock listed on the New York Stock Exchange, the other in a stock not listed on any exchange and traded only over the counter. Which of them was subject to the rule's price test?

Only the sale in the stock traded solely over the counter, a listed stock traded away from its exchange being left to that exchange's own rules

Both of them, the price test reaching a short sale in any equity security on whatever venue the order was executed

Only the sale in the listed stock, the price test reaching short sales in exchange-listed securities whether or not effected on an exchange

Neither of them, the price test having reached only short sales effected on the floor of a national securities exchange, never trades away from it

Before eliminating the price test, the SEC ran a pilot programme under Regulation SHO Rule 202T that removed it from a designated subset of securities. What did the pilot's evidence and the SEC's conclusion from it rest on?

Market makers had borne most of the cost of the price test, so the SEC confined it to orders entered by sellers other than registered market makers

Price tests had reduced volatility in the pilot securities, so the SEC kept the test for those securities and removed it from the rest of the market for equities

The pilot securities proved more volatile than the rest, which the SEC attributed to the friction the test still imposed on the orders it continued to reach

Price tests did not meaningfully reduce short selling pressure or volatility, and in a market where prices adjust instantly the test's friction could impair legitimate short selling

A stock has fallen ten percent from the prior day's closing price and the Rule 201 circuit breaker is in force in it. Its national best bid is $18.40 and its national best offer is $18.45. At what price may a short sale in it be executed?

Above $18.40, the restriction keeping a short seller from hitting the prevailing bid for as long as it is in force

At $18.40, the restriction barring only short sales priced below the prevailing bid for as long as it is in force

Above $18.45, the restriction requiring a short seller to price above the prevailing offer for as long as it is in force

At any price above the last reported sale in the security, the restriction reinstating a tick test for the rest of the session

A stock triggers the Rule 201 circuit breaker in the morning by falling ten percent from the prior day's closing price, then recovers during the afternoon to within a few cents of that close. What happens to the price restriction?

It lifts as soon as the price climbs back above the level at which the circuit breaker was triggered that morning

It runs on for the rest of that session and the whole of the next one, the trigger once pulled not being reset by a recovery

It runs to the end of that session only, the following session starting free of it because the decline did not persist

It runs on until the security trades at or above the prior day's closing price, the recovery then restoring ordinary short sale pricing for the remainder of that session

The Rule 201 circuit breaker has been triggered in an equity security. Does the price restriction reach the listed options and the futures whose prices move in response to that security's price?

Yes for the futures, which call for delivery of the security, but not for the options, which the holder may let lapse

Yes, any instrument whose price responds to the restricted security comes within it for as long as it is in force

No, it reaches NMS stocks, leaving options, futures and other derivatives on the security outside it

No, and it likewise leaves the security itself untouched on any venue other than the exchange on which it is listed

A firm executes two short sales for different customers. For the first it has entered a bona fide arrangement to borrow the shares; for the second it has neither borrowed nor arranged to borrow and has no grounds for believing the shares can be borrowed. How does Regulation SHO classify the two sales?

Both are naked short sales until the shares have actually been borrowed, an arrangement to borrow leaving the delivery obligation unsecured

Both are covered short sales, the classification turning on whether the shares are in fact delivered to the buyer on the settlement date

The first is covered and the second becomes naked only if the shares are not delivered, an arrangement to borrow being one route among several

The first is a covered short sale and the second a naked one, the classification turning on whether the locate was satisfied before execution

One fail to deliver arises because shares that were located before execution became unavailable before settlement; another arises because the seller never arranged to borrow at all. What does Regulation SHO's close-out regime require of each?

Prompt resolution of both, the close-out requirements reaching each of these two fails, the difference between them going to culpability

Prompt resolution of the deliberate fail, a fail arising from an operational failure being left to resolve in the clearing process

Prompt resolution of both, but only once the SEC has determined which of the two categories the fail belongs in and notified the firm

Prompt resolution of the operational fail alone, the deliberate fail being left to enforcement because a close-out would reward it

Naked short selling undertaken deliberately is treated as a manipulation device rather than as a processing lapse. What is the mechanism by which it is said to act on the price?

It raises the fees the lending market charges on the security, which deters other investors from continuing to hold it

It creates phantom supply, shares sold into the market that the seller had not made available to borrow or to deliver

It leaves the buyer who is not delivered to having to sell other holdings in order to fund the position it has taken on

It leaves the buyer without the voting rights in the security, which reduces what other investors will pay to hold it

Two funds each sold a stock short ahead of the pricing of a follow-on offering in it — one six business days before the pricing, the other two business days before. Whose short sale fell inside Rule 105's restricted period?

The fund that sold six business days before the pricing, the restricted period being measured back from the filing of the offering rather than from its pricing

Both of them, the restricted period opening with the public announcement of the offering and closing when the offering is priced

The fund that sold two business days before the pricing, the restricted period running the five business days that end with the pricing

Neither of them, the restricted period beginning with the pricing of the offering and running for the five business days that follow it

An investor sells a stock short during Rule 105's restricted period. Which act does the rule prohibit?

Buying the offered securities, but only where they are allocated by the same participating underwriter through which the short sale ran

Making the short sale, a purchase of the offered securities being the evidence by which the prohibited sale is identified afterwards

Both the short sale and the purchase of the offered securities, the rule treating the two legs as a single prohibited course of conduct

Whose interests does Rule 105's restricted-period prohibition protect, and against what?

The issuer and the other offering participants, against the spread between the market price and the discounted offering price being taken out of the offering

The underwriters, against the risk that shares bought in the offering are resold into the market before the offering has been fully distributed

The short sellers in the security, against an issuer timing a discounted offering so as to force them to buy at an inflated market price

The retail purchasers in the offering, against an allocation that gives institutional buyers the shares at a lower price than they are charged

An analyst concludes that a security is overvalued but holds none of it and is unable to sell it short. What does that do to the force with which the negative view reaches the market price?

It leaves it unchanged, since a refusal to buy withdraws demand and so acts on the price in the same way as a sale of the security would

It weakens it, the only action available being to decline to own the security, which does not press on the price as a purchase presses the other way

It strengthens it, the absence of a short position making the published view more credible to the investors who do hold the security

It leaves it unchanged, because the price is set only by the holders of the security, whose own valuations the analyst's view never enters

An investor holding a portfolio of bank stocks establishes a short position in a financial sector index. What has that short position done to the portfolio's risk?

It replaces the portfolio's risk with the index's, so that the position now returns what the financial sector index returns

It removes the portfolio's risk entirely, the holdings and the index being exposed to the same sector and so moving together

It offsets the part of the risk the index shares with the portfolio, leaving the risk specific to the individual holdings in place

It transfers the risk specific to the individual holdings onto the index's other constituents, leaving the sector-wide risk of the bank holdings where it was before the hedge

Section 10(a) of the Securities Exchange Act of 1934 empowers the SEC to prescribe rules defining and preventing short sales that are manipulative or deceptive. What does the form of that grant show about how the statute treats short selling?

It is a power to approve the short selling rules the exchanges write, the statute leaving the substance of those rules to each market

It is a power to prohibit the practice, exercised so far by rules that permit a short sale only where an express exemption applies

It is a power confined to cases where a manipulation has been established, rulemaking about short selling resting with the exchanges

It is a power to regulate the practice, not to prohibit it, short selling being taken to serve legitimate functions in the market

Violations of Regulation M Rule 105, the rule addressing short selling ahead of a public offering, have been a consistent priority of the SEC's Division of Enforcement. What have those enforcement actions produced, and against whom?

Cancellation of the offerings concerned and bars from future underwritings, against the underwriters that had managed those offerings

Suspension of trading in the offered security and fines, against the issuers that priced their offerings at a discount to the market

Restitution to the retail buyers in the offering and suspensions, against the registered representatives who entered the short sales

A firm's order system marks every equity sell order long unless a trader changes the marking, and over several weeks many short sales pass through it marked long. Apart from the marking breach itself, what has the defect undermined?

The clearing agency's netting of the trades, which processes long and short sales in separate streams and settles each of those streams on its own cycle

Regulators' monitoring of short selling activity, including their ability to identify potential manipulation and abusive naked short selling in the security

The customers' tax reporting, in which the marking given to each sale fixes whether the gain on it is reported as a short-term or as a long-term gain

The settlement date of the trades, short-marked sales settling on a longer cycle that gives the firm the time it needs to complete the borrow of the shares

Rule 10a-1, the original uptick rule, was for decades the SEC's primary price-based restriction on short selling. What was its price test designed to stop short sellers from doing?

Selling shares they had neither borrowed nor arranged to borrow, which left their buyers undelivered on the settlement date

Building positions so large that the shares available to borrow ran out and other sellers could no longer go short at all

Driving a declining price lower still by selling short in rapid succession at each new low that the security reached

Selling short into a rising price at each new high, then buying the shares back as soon as the advance had begun to stall

A stock listed on an exchange closed yesterday at $40.00 and is trading on that exchange today about three percent lower. Its last reported sale was at $38.80, and a short sale order is entered at $38.75. How would the original uptick rule, Rule 10a-1, have treated the order, and how does Rule 201 treat it?

Rule 10a-1 would have allowed it, testing only sales at the last reported price; Rule 201 leaves it unrestricted, no ten percent decline having triggered it

Rule 10a-1 would have barred it as a sale below the last reported price; Rule 201 bars it as well, testing every short sale against the last reported price

Rule 10a-1 would have allowed it, testing only sales at the last reported price; Rule 201 bars it, applying on any day the stock trades below its prior close

Rule 10a-1 would have barred it as a sale below the last reported price; Rule 201 leaves it unrestricted, no ten percent decline having triggered it

Before executing a customer's short sale, a firm has neither borrowed the shares nor entered an arrangement to borrow them, but it has reasonable grounds to believe they can be borrowed for delivery on settlement date. Under Regulation SHO, is the sale covered or naked?

Covered, reasonable grounds to believe the shares can be borrowed for delivery being one of the ways the locate requirement is satisfied

Naked, because the shares had not actually been borrowed, nor an arrangement to borrow them entered, before the sale was executed

Naked, reasonable grounds counting toward the locate only where the firm has also posted collateral with a lender for the shares before execution

Covered, but on condition that the firm is registered as a market maker in the security, which lets reasonable grounds stand in for a borrow

Two funds each sell a stock short and hold the position for a year, and in both cases the price falls as the fund expected. The first stock is widely available and actively lent; the second is in heavy demand from borrowers because short interest in it is elevated. How does the cost of borrowing bear on the two results?

Equally on both, the cost of borrowing being fixed by the margin requirement on each position rather than by the demand from borrowers to borrow that stock

Lightly on the first, where it is a small friction against the profit; heavily on the second, where it can be large enough to strain the position even with the thesis right

Heavily on the first, more lenders competing to lend a widely held stock and so bidding its fee up; lightly on the second, where the lendable shares are scarce

Not at all on either, the cost of borrowing falling due only on a position that is closed out at a loss, which neither of these two positions turned out to be

A firm arranged to borrow shares for a customer's short sale before executing it, but the shares became unavailable before settlement date and the sale failed to deliver. What does Regulation SHO require, and of whom?

Nothing further, the borrow having been arranged before execution, the fail being left to resolve in the ordinary clearing process

Close-out of the fail-to-deliver position by the lender, the shares having become unavailable on the lender's side of the arrangement

Close-out of the fail-to-deliver position, an obligation that falls on the clearing participant through which the sale cleared

Close-out of the fail-to-deliver position by the National Securities Clearing Corporation, the level at which the fail is recorded

Investors hedge long positions with short positions in related securities, and arbitrageurs hold long and short positions in related securities against each other. What does that use of short selling contribute to the market as a whole?

It supplies the borrowable shares that other short sellers need, which brings down the cost of borrowing across the market

It takes the hedged securities out of the price discovery process, which keeps their prices steady during periods of stress

It adds selling pressure to each related security, which holds their prices below the level their fundamentals would support

It keeps related securities priced in appropriate relationships to one another, which adds to the efficiency of the market

Title: Short Sale — Regulation SHO Marking Rules Explained

Short Sale

A short sale is the sale of a security that the seller does not own, or any sale that is consummated by the delivery of a security borrowed by or for the account of the seller — the foundational statutory definition established in Regulation SHO Rule 200 under the Securities Exchange Act of 1934, which consolidated and replaced the prior definition in former Exchange Act Rule 3b-3. Every short sale involves two distinct elements that define it — the seller's lack of ownership of the securities at the time of sale, and the obligation to borrow securities to make delivery to the buyer on settlement date. The short sale is the transaction that establishes a short position, and understanding its regulatory definition, its marking requirements, its economic function, its historical regulatory evolution, and the specific rules governing when and how short sales may be executed is foundational knowledge for every securities professional and is among the most heavily tested topics on the Series 7 examination.

The Regulatory Definition — Rule 200 and the Ownership Determination

Regulation SHO Rule 200 — adopted by the SEC effective January 3, 2005 as part of the comprehensive Regulation SHO framework codified at 17 CFR Part 242 — defines a short sale and establishes the ownership determination that governs whether a sale order must be marked long or short. Understanding how Rule 200 defines ownership is essential for correctly marking orders and for understanding when the locate requirement of Rule 203 applies.

Under Rule 200(b), a person is deemed to own a security only to the extent that they have a net long position in the security — meaning they have purchased more shares than they have sold short in that security, creating a positive net balance. A seller who has purchased one thousand shares and sold five hundred short in a different transaction has a net long position of five hundred shares and is deemed to own five hundred shares for purposes of Rule 200's ownership determination.

Under Rule 200(g), a sale order may be marked long only if the seller is deemed to own the security being sold — having a net long position — and either the security is in the physical possession or control of the broker-dealer or it is reasonably expected that the security will be in the possession or control of the broker-dealer no later than the settlement of the transaction. If either condition is not met — the seller does not have a net long position, or the securities cannot be delivered by settlement — the sale must be marked short.

This marking requirement is the operational foundation of the short sale regulatory framework — accurate marking enables FINRA and the SEC to monitor short selling activity, identify potential manipulation or abusive naked short selling, and enforce the locate and close-out requirements that depend on whether a sale is long or short.

The Three Order Markings — Long, Short, and Short Exempt

Regulation SHO Rule 200 requires that every sell order in an equity security be marked as one of three designations — long, short, or short exempt — at the time the order is entered into the broker-dealer's order management system.

A long marking indicates that the seller owns the security and that it will be delivered from the seller's own holdings by the settlement date. Long-marked orders are not subject to the locate requirement or the alternative uptick rule restriction.

A short marking indicates that the seller does not own the security or cannot deliver from owned shares by settlement — the sale must be consummated through borrowed shares. Short-marked orders are subject to the locate requirement of Rule 203(b)(1) — the broker-dealer must have borrowed the security, entered a bona fide arrangement to borrow it, or have reasonable grounds to believe it can be borrowed for delivery before accepting or executing the short sale order.

A short exempt marking indicates that the sale qualifies for an exemption from the alternative uptick rule price restriction of Rule 201 — which restricts short sales in securities that have declined ten percent or more from the prior day's closing price. A short exempt marking allows the order to execute even if it would otherwise be restricted by Rule 201's circuit breaker, provided the order meets one of the exceptions that rule specifies — an order priced above the current national best bid at the time it is submitted, or a sale the broker-dealer reasonably believes falls within one of the rule's enumerated cases, among them a market maker's sale to offset customer odd-lot orders, convertible-security and cross-border arbitrage, an underwriter's over-allotment or lay-off sale, a riskless principal sale, a sale at the volume-weighted average price, and certain other specified circumstances. Rule 201 contains no general exception for bona fide market making, and its arbitrage exceptions do not extend to risk-arbitrage in connection with mergers and acquisitions.

The Historical Context — Section 10(a) and the Original Uptick Rule

The short sale has been subject to federal regulation since the Securities Exchange Act of 1934 — Section 10(a) of the Exchange Act grants the SEC authority to regulate short sales by prescribing rules and regulations to define and prevent short sales that are manipulative or deceptive or that might operate as a device for fraud or deceit.

Under this authority, the SEC adopted Rule 10a-1 in 1938 — the original uptick rule — which prohibited the execution of short sales on a national securities exchange at a price below the last reported sale price — called a minus tick — or at the same price as the last reported sale if the last change in price was downward — called a zero minus tick. The uptick rule required that short sales be executed only at a price equal to or above the last reported sale price — the plus tick condition — or at the same price as the last reported sale when the immediately preceding price change was upward — the zero plus tick condition.

The uptick rule served for sixty-nine years as the primary price-based restriction on short selling — the SEC's mechanism for preventing short sellers from accelerating a declining market by pile-driving prices lower through rapid successive short sales at each new low. In the form it took before its elimination, it applied to short sales in exchange-listed securities wherever the sale was effected — on an exchange or over the counter — but not to securities traded only over the counter, creating an asymmetric regulatory framework as the OTC market grew.

The SEC eliminated Rule 10a-1 in 2007 following a pilot programme — Regulation SHO Rule 202T — that tested the removal of price tests from a designated subset of securities — every third stock, ranked by average daily dollar volume within each listing market, among the stocks of the Russell 3000 index. The pilot programme's evidence suggested that price tests did not meaningfully reduce short selling pressure or volatility in the pilot securities, and the SEC concluded that the uptick rule was unnecessary in a modern electronic market where prices adjusted instantly and the uptick rule's friction could actually impair legitimate short selling that serves price discovery functions.

The 2008 financial crisis — during which dramatic declines in financial sector stocks generated intense political and regulatory pressure to restrict short selling — demonstrated that the removal of the uptick rule had occurred at exactly the wrong moment from a political perspective. The SEC responded first with emergency orders in 2008 temporarily banning short sales in financial sector stocks — an emergency restriction that most academic research subsequently concluded had limited effectiveness in stabilising prices and may have impaired market quality — and then with the adoption of the alternative uptick rule in 2010.

The Alternative Uptick Rule — Rule 201

Regulation SHO Rule 201 — adopted February 26, 2010 and effective May 10, 2010 — is the circuit-breaker-based price restriction that replaced the abolished uptick rule. Unlike the original uptick rule — which applied to every short sale on a tick-by-tick basis — Rule 201 applies only when a security's price has declined by ten percent or more from the prior day's closing price during the current trading session.

When the ten percent decline circuit breaker is triggered for a specific security, the SEC requires that for the remainder of that trading day and the following full trading day, short sales in that security may only be executed at a price above the current national best bid. This restriction prevents short sellers from hitting the bid — selling at the prevailing bid price — during a period of severe price decline, requiring them instead to place orders above the current best bid to sell short. The restriction is intended to give long sellers priority to exit the market ahead of short sellers during periods of severe stress, preventing short selling from accelerating a panic-driven decline.

The ten percent trigger is calculated from the prior day's official closing price as reported in the consolidated tape. A security whose official close was fifty dollars experiences a Rule 201 trigger at forty-five dollars — when the intraday price first touches a ten percent decline from the prior close. Once triggered, the restriction applies automatically for the remainder of that trading session and all of the following trading session — the restriction does not reset intraday if the stock recovers above the ten percent threshold after the trigger has been pulled.

The alternative uptick rule applies to all NMS stocks — all equity securities traded on national securities exchanges — but does not apply to options, futures, or other derivatives whose prices move in response to the underlying equity's price movement. Its exceptions, under which an order may be marked short exempt, are specific and narrow: in adopting the rule the SEC declined to provide a general exception for bona fide market making, so market makers that sell short to provide liquidity while the restriction is in force must price those sales above the current national best bid unless an enumerated exception, such as offsetting customer odd-lot orders, applies.

Covered Versus Naked Short Sales — The Critical Distinction

A covered short sale is one in which the seller has satisfied the locate requirement — the seller has borrowed the securities, entered a bona fide arrangement to borrow, or has reasonable grounds to believe they can borrow for delivery on the settlement date. Covered short sales are the standard form of legitimate short selling — they satisfy Regulation SHO's locate requirement and therefore qualify for the safe harbour from manipulation concerns that compliance with Regulation SHO provides.

A naked short sale is a short sale executed without satisfying the locate requirement — the seller sells shares they have not borrowed and have no arrangement to borrow, creating an obligation to deliver securities on settlement date that they cannot fulfill. Naked short selling produces fail-to-deliver positions at the NSCC clearing level — the sold shares are not delivered to the buyer on settlement date because the seller never arranged for borrowable supply.

Naked short selling is prohibited by Regulation SHO Rule 203(b)(1)'s locate requirement — any short sale executed without a prior locate is a violation. The SEC has acknowledged that some forms of apparent naked short selling arise from legitimate operational failures — securities that were located but became unavailable between the locate and the settlement date — and that these unintentional fails are treated differently from intentional naked short selling that is designed to manipulate prices through the creation of phantom supply. The Regulation SHO close-out requirements of Rule 204 address both categories by requiring prompt resolution of fail-to-deliver positions regardless of their cause.

Short Sales in Connection with Public Offerings — Regulation M Rule 105

Short selling conducted in connection with a public securities offering is subject to additional restrictions beyond the general Regulation SHO framework — specifically Regulation M Rule 105, which prohibits purchasing securities in a public offering from an underwriter or broker-dealer participating in the offering if the purchaser sold short the same security during the restricted period that begins five business days before the pricing of the offering and ends with the pricing.

The Rule 105 restriction is designed to prevent a specific form of manipulation in which an investor sells a security short before a discounted public offering — establishing a short position at prevailing market prices — and then covers that short position by purchasing the newly issued shares at the discounted offering price, profiting from the spread between the market price and the offering price at the expense of the issuer and the other offering participants. Violations of Rule 105 have been a consistent enforcement priority for the SEC's Division of Enforcement — the SEC has brought numerous Rule 105 enforcement actions resulting in disgorgement of profits and civil penalties against hedge funds and other sophisticated investors who engaged in this prohibited pattern.

Short Sales and the Securities Lending Market

Every covered short sale requires a borrowing arrangement — short sellers obtain the securities they sell short through the securities lending market, as discussed in the Securities Lending entry of this dictionary. The cost of the borrowing arrangement — expressed as a lending fee for non-cash collateralised loans or as a reduction in the rebate paid on cash collateral — is an ongoing cost that the short seller incurs throughout the life of the short position and that directly reduces the net profit from a successful short trade.

For general collateral securities — widely available, actively borrowed equity securities — borrowing costs are minimal and represent a small friction cost relative to the potential profit from the short trade. For special collateral securities — securities in high demand for borrowing because of elevated short interest — borrowing costs can be substantial, sometimes reaching double-digit annualised rates that make the economics of holding a short position challenging even when the fundamental bearish thesis is correct. The availability and cost of borrowing is therefore a practical constraint on short selling that the theoretical framework of Regulation SHO's locate requirement reflects — a locate that becomes unavailable before settlement creates a fail-to-deliver that Rule 204 requires the clearing participant to close out.

The Economic Functions of Short Selling

The short sale serves three distinct economic functions in well-functioning securities markets — functions that are important to understand both for examination purposes and for the investment analysis and communication obligations of registered representatives. Price discovery is the most fundamental economic function of short selling — short sellers who identify overvalued securities and sell them short incorporate their negative information into market prices more rapidly than would occur if only long investors could act on their information.

A market without short selling would systematically overvalue securities because pessimistic investors could only avoid owning overvalued stocks rather than actively selling them — they could not express their negative view with the same force as optimistic investors who can purchase. The Securities Exchange Act's grant of authority in Section 10(a) to regulate rather than prohibit short selling reflects Congress's recognition that short selling serves legitimate price discovery functions that benefit market efficiency.

Market making and liquidity provision require short selling as an operational necessity — a market maker who receives a customer buy order in a security where they have no long inventory must sell short to fill the order and then work to acquire the security in the market to cover the resulting short position. Without the ability to short, market makers could only fill customer buy orders by first purchasing the security — an impossible requirement in a fast-moving market where the customer's order must be filled immediately. The bona fide market making exception from Regulation SHO's locate requirement reflects this operational reality.

Hedging allows investors to manage risk by establishing short positions that offset the risk of long positions in related securities — a long position in a portfolio of bank stocks can be partially hedged with short positions in the financial sector index, a long convertible bond position can be delta-hedged with short equity positions, and arbitrage positions in merger targets can be hedged with short positions in the acquirer. These hedging and arbitrage applications of short selling contribute to market efficiency by keeping related securities priced in appropriate relationships to each other.

Examination Relevance and Key Takeaways

The short sale is tested on the Series 7 examination in the context of the Regulation SHO regulatory framework, the marking requirements, the locate requirement, the alternative uptick rule, naked short selling, and the economic functions of short selling in securities markets.

The key points to retain are these.

A short sale is the sale of a security the seller does not own, or any sale consummated by delivery of borrowed securities — the statutory definition under Regulation SHO Rule 200, which replaced former Exchange Act Rule 3b-3 effective January 3, 2005. Regulation SHO — codified at 17 CFR Part 242, Rules 200 through 204 — is the comprehensive short sale regulatory framework enacted under Securities Exchange Act Section 10(a)'s authority to regulate manipulative or deceptive short selling practices.

Rule 200 requires every equity sell order to be marked long, short, or short exempt at the time of order entry. Long marking requires that the seller has a net long position and that the security will be delivered by settlement. Short marking triggers the locate requirement. Short exempt marking indicates the order qualifies for an exemption from the Rule 201 alternative uptick rule price restriction. Rule 201 — the alternative uptick rule adopted February 26, 2010 — restricts short sales in a security whose price has declined ten percent or more from the prior day's closing price during the current session, requiring that all short sales for the remainder of that session and the following full session execute only at prices above the current national best bid.

Rule 203(b)(1) — the locate requirement — prohibits broker-dealers from accepting or effecting short sale orders unless the security has been borrowed, a bona fide arrangement to borrow has been entered, or reasonable grounds exist to believe it can be borrowed for delivery on the settlement date — documented in writing before execution. The bona fide market making exception under Rule 203(b)(2) exempts genuine market making activities from the locate requirement.

Covered short sales satisfy the locate requirement. Naked short sales are executed without any borrowing arrangement and produce fail-to-deliver positions that Rule 204 requires to be closed out by the beginning of regular trading hours on the settlement day following the settlement date. Regulation M Rule 105 prohibits purchasing shares in a public offering from a participating underwriter if the purchaser sold the same security short during the five-business-day restricted period before the offering pricing.

The three economic functions of short selling are price discovery, market making and liquidity provision, and hedging and arbitrage — all of which contribute to market efficiency and are recognised by the legislative framework of Securities Exchange Act Section 10(a) which grants authority to regulate rather than prohibit short selling.