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:

The "net long" determination is made at the aggregation unit level, not firm-wide. This is why aggregation units (covered in the previous section) matter so much for short-sale compliance.

Exam Tip: Gotchas

• The long/short determination is at the aggregation unit level, not firm-wide. A firm with one long desk and one short desk in the same security can mark each desk's sales independently based on that desk's net position, not the firm's consolidated position.
• 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:

If the participant fails to close out, the participant and any broker that accepts a short order from a customer in that security becomes subject to a pre-borrow requirement until the fail is closed and additional days have passed without further fails. A pre-borrow requires actual borrowing (not just a locate) before the short can be entered.

Threshold Securities

A "threshold security" is a security with fail-to-deliver positions of 5+ consecutive settlement days at a clearing agency, totaling at least 10,000 shares AND at least 0.5% of the issuer's total shares outstanding. Threshold securities are published by the exchanges and trigger heightened pre-borrow obligations under Reg SHO.

Exam Tip: Gotchas

• Short fails close out by start of trading on T+1; long fails close out by start of trading on T+3. The shorter window for shorts reflects the SEC's view that fails from short selling are more concerning than fails from long sales.
• A failure to close out triggers pre-borrow obligations on EVERY subsequent short order in that security. The penalty is not just the missed close-out; it is the ongoing pre-borrow regime until the fail is cured plus a clean period.
• 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 trigger is in effect, a short sale must be priced above the NBB (not at or below). This forces short sellers to lift the offer or wait for an uptick, slowing the decline.

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 alternative uptick rule prohibits short sales AT OR BELOW the NBB; sales above the NBB are permitted. The price test forces shorts to take the offer or wait for an uptick.

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.
• A locate is not a borrow. A locate is reasonable grounds to believe shares can be borrowed; an actual borrow is the contractual loan. Pre-borrow obligations require an actual borrow, not just a locate.