Close-Out Requirements for Fails to Deliver

The threshold-security close-out runs off a security's fail history. This one runs off a single transaction in any equity security, whether or not it is a national market system (NMS) stock, and it needs no threshold label, no self-regulatory organization list and no five-day fail history. It starts the very next settlement day, and it is the close-out a trading desk meets most often.

What Must a Participant Deliver, and by When?

A participant of a registered clearing agency must deliver securities to a registered clearing agency for clearance and settlement on a long or short sale in any equity security by settlement date.

Where the participant instead has a fail to deliver position at a registered clearing agency in any equity security for a long or short sale transaction in that security, the deadline moves.

It shall, by no later than the beginning of regular trading hours on the settlement day following the settlement date, immediately close out its fail to deliver position by borrowing or purchasing securities of like kind and quantity.

Two definitions fix the clock. Settlement date is the business day on which delivery of a security and payment of money is to be made through the facilities of a registered clearing agency in connection with the sale of a security.

Regular trading hours takes the meaning the Regulation NMS definitions give it: the time between 9:30 a.m. and 4 p.m. Eastern Time, or such other time as is set forth in the procedures established under the order execution disclosure rule.

Exam Tip: Gotchas

• The baseline close-out accepts a borrow. This deadline is met by borrowing or purchasing securities of like kind and quantity, which separates it from the threshold-security close-out that requires a purchase.
• The duty attaches to a long sale as well as a short sale. The delivery obligation is stated for a long or short sale in any equity security, so an answer limiting this rule to short selling is too narrow.
• The deadline is a time of day, not a day. It falls at the beginning of regular trading hours on the settlement day following the settlement date.

Which Fails Carry a Later Deadline?

Three provisos push the deadline out, and they do not all take the same clock or the same remedy.

The deemed-owner proviso is the odd one on three counts. It counts calendar days rather than settlement days, it counts from the trade date rather than the settlement date, and its remedy is purchasing alone.

Exam Tip: Gotchas

• Only one proviso runs on calendar days from trade date. The deemed-owner branch counts thirty-five consecutive calendar days following the trade date, while the other two count settlement days from the settlement date.
• Only one proviso drops the borrow option. The deemed-owner branch must be closed out by purchasing, so a borrow that satisfies the long-sale branch does not satisfy this one.
• The long-sale proviso needs a demonstration on books and records. A participant asserting a long-sale cause without records that show it stays on the next-settlement-day deadline.
• The market making proviso names three kinds of market maker. It reaches a registered market maker, an options market maker, and any other market maker obligated to quote in the over-the-counter market.

What Happens if the Participant Does Not Close Out?

A participant that has a fail to deliver position and does not close it out as the rule requires triggers a pre-borrow bar.

The bar reaches the participant and any broker or dealer from which it receives trades for clearance and settlement, including any market maker that would otherwise be entitled to rely on the bona-fide market making exception to the locate requirement.

Those firms may not accept a short sale order in the equity security from another person, or effect a short sale in the equity security for its own account, without first borrowing the security, or entering into a bona fide arrangement to borrow the security.

The bar carries its own scope clause. It applies to the extent that the broker or dealer submits its short sales to that participant for clearance and settlement, so a firm that clears its short sales elsewhere is not caught through that other channel.

The bar lifts only when the participant closes out the fail to deliver position by purchasing securities of like kind and quantity and that purchase has cleared and settled at a registered clearing agency.

One escape sits inside the paragraph. A broker or dealer is not subject to the bar if it timely certifies to the participant either of two things.

• That it has not incurred a fail to deliver position on settlement date for a long or short sale in an equity security for which the participant has a fail to deliver position at a registered clearing agency.
• That it is in compliance with the rule's own bona fide purchase or borrow paragraph, set out under How Can a Firm Stay Outside These Duties? below.

Exam Tip: Gotchas

• The bar lifts on a settled purchase, never on a borrow. The participant's close-out may be a borrow, but the pre-borrow bar on everyone else lifts only when a closing purchase has cleared and settled.
• The certification has to be timely and it has two branches. Certifying that the firm has not incurred a fail on settlement date in the equity security in which the participant has its fail is one route; certifying compliance with the bona fide purchase or borrow paragraph is the other.
• The bar reaches a market maker relying on bona-fide market making. That locate exception buys nothing once the participant's fail goes unclosed.

Who Must the Participant Notify, and When Does the Duty Move?

The participant must notify any broker or dealer from which it receives trades for clearance and settlement, including any market maker that would otherwise be entitled to rely on the bona-fide market making exception, of two things.

• That the participant has a fail to deliver position in an equity security at a registered clearing agency that has not been closed out as the rule requires.
• When the purchase the participant made to close out that fail has cleared and settled at a registered clearing agency.

An allocation moves the duty. Where a participant reasonably allocates a portion of a fail to deliver position to another registered broker or dealer for which it clears trades or from which it receives trades for settlement, based on such broker's or dealer's short position, the close-out duty and the pre-borrow bar for that fail apply to that allocated firm and not to the participant.

An allocated firm that does not comply with the close-out paragraph must immediately notify the participant that it has become subject to the pre-borrow bar.

Exam Tip: Gotchas

• Both notices matter, not just the first. The participant owes one notice while the fail is open and not closed out, and another when the purchase it made to close out the fail has cleared and settled at a registered clearing agency. That second notice is how those firms learn the bar has ended; what ends the bar is the closing purchase clearing and settling.
• The allocation description is not the one the threshold-security rule uses. Here the relationship is a firm for which the participant clears trades or from which it receives trades for settlement, which is worded differently from the threshold-security close-out.
• An allocated firm that misses the deadline owes an immediate notice. It must tell the participant that it has become subject to the pre-borrow bar, rather than waiting to be asked.

How Can a Firm Stay Outside These Duties?

The rule provides one route out that works even if the participant has not closed out the fail or has not allocated it.

A broker or dealer is not subject to the close-out paragraph or the pre-borrow bar if it purchases or borrows the securities and all four of the following hold.

• The purchase or borrow is bona fide.
• The purchase or borrow is executed after trade date but by no later than the end of regular trading hours on settlement date for the transaction.
• The purchase or borrow is of a quantity of securities sufficient to cover the entire amount of that firm's fail to deliver position at a registered clearing agency in that security.
• The firm can demonstrate that it has a net flat or net long position on its books and records on the day of the purchase or borrow.

A participant cannot buy its way out with a counterparty that will not perform. A participant is not deemed to have fulfilled the rule where it enters into an arrangement with another person to purchase or borrow securities as required, and it knows or has reason to know that the other person will not deliver securities in settlement of the purchase or borrow.

The buy-in and sell-out procedures a member uses against another member on a fail are a separate scheme, covered in the unit on clearance and settlement.

Exam Tip: Gotchas

• The bona fide purchase or borrow window closes on settlement date. It must be executed after trade date and by no later than the end of regular trading hours on settlement date, which is earlier than the close-out deadline itself.
• A partial cover fails the test. The quantity must be sufficient to cover the entire fail to deliver position in that security, so covering most of it leaves the firm inside both duties.
• The sham-arrangement clause reaches borrows as well as purchases. This rule's version names a purchase or borrow, which is wider than the threshold-security rule's purchase-only version.

What Should You Check on Exam Day?

• Confirm the duty-bearer is the participant of a registered clearing agency, and that the security is any equity security, threshold label or not.
• Take the baseline deadline as the beginning of regular trading hours on the settlement day following settlement date, closeable by borrowing or purchasing.
• On a proviso, ask whether the clock counts settlement days from settlement date or calendar days from trade date, and whether borrowing is still allowed.
• On a pre-borrow question, require a closing purchase that has cleared and settled, and check for a timely certification.
• On the bona fide purchase or borrow escape, test all four conditions, including net flat or net long on the day of the purchase or borrow.