Regulation SHO: Short-Sale Compliance

A short sale is a sale of stock the seller does not own; the seller borrows the stock to deliver it and hopes to buy it back later at a lower price. Reg SHO is the SEC's framework for preventing fails to deliver and abusive short selling that can manipulate price or undermine settlement.

The supervisor's duty under Reg SHO is to ensure:

• Every order is correctly marked
• Every short has a documented locate
• Every fail is closed out on time
• The alternative uptick rule is enforced when triggered

Definition and Order Marking

A "short sale" under Reg SHO is any sale of a security that the seller:

• Does not own, OR
• Owns but consummates by delivering a borrowed security

Every sell order must be marked at the time of entry:

Net positions are determined firm-wide by default, or by unit when the firm elects and meets the independent-aggregation conditions. That election does not remove the other ownership and delivery conditions for long marking.

Exam Tip: Gotchas

• Independent unit netting requires qualification. Merely naming two desks does not authorize separate netting. The written-plan, sale-time netting, independent-strategy, and single-unit trader conditions must be met.
• A "short exempt" mark is NOT the same as "exempt from Reg SHO." Short exempt means the sale is short under Reg SHO but qualifies for an exception to the alternative uptick price test. The locate and close-out obligations still apply.

The Locate Requirement

Before a broker-dealer accepts a short-sale order in any equity security, the firm must locate the security to be borrowed. The firm must have one of:

• Borrowed the security
• Entered into a bona fide arrangement to borrow the security
• Reasonable grounds to believe the security can be borrowed and delivered by the settlement date

The locate must be documented before order acceptance. A firm cannot accept the short, then look for a locate, then back-fill paperwork.

Bona Fide Market-Maker Exception

A registered market maker engaged in bona fide market-making activities is exempt from the locate requirement. The exception exists because a market maker often shorts as part of providing liquidity; requiring a locate before every market-maker short would impede the function.

Think of it this way: The locate requirement is the broker-dealer's promise that the firm has a path to borrow the stock at settlement. The promise must be in place at order entry; it cannot be retroactive. The market-maker exception trades a locate-by-locate check for an overall presumption that bona fide market making does not contribute to fails.

Exam Tip: Gotchas

• Locate must be in place BEFORE order entry, not before settlement. A firm that accepts a short and then runs the locate has violated the locate requirement even if the locate succeeds before settlement.
• The market-maker locate exception applies only to BONA FIDE market making. A firm that uses its market-maker hat to bypass the locate on directional proprietary trades has lost the exception. The exception protects liquidity provision, not directional positions.
• The locate must be documented. Verbal assurance from the stock-loan desk is not sufficient; the firm must record who provided the locate, when, and what shares were located.

The Close-Out Requirement

If a short sale results in a fail to deliver (the seller's broker cannot deliver the shares to the buyer's broker by settlement), the clearing-agency participant must close out the fail by purchasing or borrowing securities of like kind and quantity.

The close-out timing depends on the type of fail:

These clocks begin at settlement, not trade date. Under ordinary T+1 settlement, the first deadline generally corresponds to T+2 and the third-day deadline to T+4. Special ownership or delivery circumstances can have separate provisions.

After a missed close-out, the restriction reaches the participant and brokers submitting shorts to it for clearing, subject to allocation and exceptions. Covered short orders require a borrow or bona fide arrangement to borrow until the close-out purchase clears and settles. There is no additional undefined clean period, and the restriction is not automatically market-wide.

Threshold Securities

A threshold security is an equity security of a qualifying registered or reporting issuer with aggregate clearing-agency fails of at least 10,000 shares and 0.5% of shares outstanding for five consecutive settlement days, included on the applicable self-regulatory organization's list. Threshold status and the duration of a participant's fail have separate roles; listing alone is not a universal immediate pre-borrow trigger.

Exam Tip: Gotchas

• Close-out deadlines run from settlement date. Ordinary short fails use the next settlement day; documented long and bona fide market-making fails use the third, at regular-trading open.
• A missed close-out creates a scoped pre-borrow requirement. Check the participant, submitting brokers, allocations, and exceptions. The covering purchase must clear and settle before this restriction ends.
• Bona fide market making gets an extended close-out window, not an exemption. The fail still must be closed out; the deadline is just later.

The Alternative Uptick Rule (Circuit Breaker)

The "alternative uptick rule" is a short-sale price test that triggers only when a covered security has experienced a sharp intraday decline:

• Trigger: the security drops 10% or more from the prior day's closing price (intraday decline)
• Effect: short sales may not execute or display at a price at or below the current National Best Bid (NBB)
• Remains in effect for the rest of the trigger day plus the following trading day

While the test is active, nonexempt short sales must execute above the current national best bid. An execution can occur between the bid and offer; taking the offer or waiting for a last-sale uptick is not required. Bona fide market making alone does not supply a price-test exception.

The exam tests "short exempt" markings here: a sale that is short under Reg SHO but qualifies for an exception to the alternative uptick rule (e.g., a market-maker short that provides liquidity at the NBB) is marked short exempt so the price-test does not apply.

Exam Tip: Gotchas

• The alternative uptick rule triggers at a 10% intraday decline, not at any decline. Smaller declines do not engage the circuit breaker.
• The trigger lasts for the rest of that day PLUS the next trading day. A late-day trigger does not reset at the close; it persists into the following session.
• The price test uses the current best bid. Nonexempt short sales must execute above it. A locate exception is not automatically a price-test exception.

Putting Locate and Close-Out Together

Reg SHO operates in a sequence:

Think of it this way: The exam loves to walk through a fact pattern and ask which requirement was violated at each step. Locate fails happen at order entry; price-test fails happen during the day on a trigger; close-out fails happen at clearing. The supervisor must catch breakdowns at each stage.

Exam Tip: Gotchas

• Locate is BEFORE order entry; close-out is AFTER settlement-date fail. The exam will describe a sequence and ask which requirement applies at each step. Locate failures happen at trade entry; close-out failures happen at clearing.
• Ordinary locate evidence differs from the missed-close-out requirement. That requirement calls for borrowing or a bona fide arrangement to borrow, not merely reasonable grounds to believe shares will be available.

What Should You Check on Exam Day?

• Do you know a locate must be documented before order entry, not before settlement, and who is exempt under the market-maker exception?
• Can you calculate the next- and third-settlement-day close-out deadlines from settlement date?
• Do you know the threshold security definition: fails of 5 or more consecutive days totaling 10,000 shares and 0.5% of shares outstanding?
• Can you state when the alternative uptick rule triggers, a 10% intraday decline, and how long it remains in effect?