Close-Out Requirements for Threshold Securities

This close-out sits on the clearing side rather than the trading side. Its duty-bearer is a participant of a registered clearing agency, and the security has to have earned the threshold label first.

What Makes a Security a Threshold Security?

The term reaches any equity security of an issuer that is registered under the Securities Exchange Act's registration provision, or for which the issuer is required to file reports under that Act, and then adds two tests plus a proviso.

• The fail test. There is an aggregate fail to deliver position for five consecutive settlement days at a registered clearing agency of 10,000 shares or more, and that position is equal to at least 0.5% of the issue's total shares outstanding.
• The list test. The security is included on a list disseminated to its members by a self-regulatory organization.
• The exit proviso. A security shall cease to be a threshold security if the aggregate fail to deliver position at a registered clearing agency does not exceed the level specified in the fail test for five consecutive settlement days.

Both tests inside the fail limb are conjunctive. A fail of 10,000 shares that is under half a percent of shares outstanding does not qualify, and neither does a fail that clears the percentage but falls short of the share count.

Three supporting definitions carry the rest of the rule.

Exam Tip: Gotchas

• A threshold security needs a share count and a percentage. The fail must be 10,000 shares or more and at least 0.5% of total shares outstanding, so satisfying one test alone leaves the security outside the definition.
• The exit test is worded from the other side. A security stops being a threshold security once the fail position does not exceed the qualifying level for five consecutive settlement days, which is not the same as the position reaching zero.
• Settlement days are not calendar days. A settlement day is a business day on which deliveries and payments may be made through a registered clearing agency's facilities.
• Being on the list is part of the definition. Inclusion on a self-regulatory organization's disseminated list is a separate limb joined with "and", not a consequence of hitting the fail test.

Who Must Close Out, and When?

If a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency in a threshold security for thirteen consecutive settlement days, the participant shall immediately thereafter close out the fail to deliver position by purchasing securities of like kind and quantity.

The duty-bearer is the participant. It is not the broker-dealer that sold the stock short, unless that firm is itself the participant or the participant has reasonably allocated a portion of the fail to it, based on its short position.

The remedy is stated as one thing only. This close-out runs by purchasing securities of like kind and quantity, and borrowing does not discharge it.

Exam Tip: Gotchas

• Borrowing does not satisfy this close-out. The obligation is to close out by purchasing securities of like kind and quantity, so an answer offering a borrow as an alternative here reads across from a different rule.
• The clock counts consecutive settlement days. Thirteen consecutive settlement days is the trigger, and a day on which the position clears breaks the run.

Which Fails Carry a Thirty-Five Day Close-Out Instead?

One proviso replaces the thirteen-day deadline with a thirty-five day one.

It ends in the same remedy as the main rule: purchasing securities of like kind and quantity.

Exam Tip: Gotchas

• The longer clock changes the count, not the remedy. The restricted-securities proviso counts thirty-five consecutive settlement days of the fail itself and then requires an immediate close-out.

What Happens to New Short Sales While the Fail Stays Open?

Two provisos turn the open fail into a pre-borrow requirement, and they run off different clocks.

At thirteen consecutive settlement days, the bar reaches the participant and any broker or dealer for which it clears transactions, 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 threshold security from another person, or effect a short sale in the threshold security for its own account, without borrowing the security or entering into a bona-fide arrangement to borrow the security.

That bar lasts until the participant closes out the fail to deliver position by purchasing securities of like kind and quantity.

At 35 consecutive settlement days, the same bar attaches to a participant entitled to rely on the thirty-five day proviso above, and it lifts on the same closing purchase.

As the rulebook prints it, that bar reaches the participant and any broker or dealer for which it clears transactions, including any market maker, that would otherwise be entitled to rely on the exception provided in the deemed-owner locate exception.

Exam Tip: Gotchas

• The thirteen-day bar withdraws the market maker's locate exception. A market maker relying on bona-fide market making must borrow, or enter into a bona-fide arrangement to borrow, before selling short in that threshold security once its clearing participant's fail reaches thirteen consecutive settlement days, whatever the market maker's own conduct was.
• The two bars name different locate exceptions. The thirteen-day bar names the bona-fide market making exception; the thirty-five day bar, as printed, names the deemed-owner exception instead.
• The bar lifts on a purchase, not on the passage of time. Both provisos end the restriction only when the participant closes out by purchasing securities of like kind and quantity.

When Does the Duty Move, and When Is It Not Fulfilled?

Two final provisos deal with who owes the close-out and what does not count as performing it.

• Allocation. 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 for which it is responsible for settlement, based on such broker's or dealer's short position, the close-out provisions relating to that fail apply to the portion allocated to that firm, and not to the participant.
• Sham arrangements. A participant shall not be deemed to have fulfilled the close-out requirement where it enters into an arrangement with another person to purchase securities as required, and the participant knows or has reason to know that the other person will not deliver securities in settlement of the purchase.

The allocation must be reasonable and it must be based on the other firm's short position. An allocation made on some other basis does not move the duty. Whatever the participant did not allocate stays with the participant.

Exam Tip: Gotchas

• Allocation moves the duty only as to the portion allocated. The close-out provisions relating to that fail apply to the portion allocated to the other firm and not to the participant, so the participant still owes the close-out on whatever it did not allocate.
• A purchase arrangement with a counterparty who will not deliver is worthless. Knowledge, or reason to know, that the other person will not deliver leaves the participant treated as not having closed out at all.

What Should You Check on Exam Day?

• Test both fail limbs before calling a security a threshold security: 10,000 shares or more and at least 0.5% of shares outstanding, for five consecutive settlement days.
• Confirm the security is also on a self-regulatory organization's disseminated list.
• Put the close-out duty on the participant of a registered clearing agency, and require a purchase rather than a borrow.
• Count thirteen consecutive settlement days for the general close-out, and check whether the restricted-securities thirty-five day proviso applies instead.
• On a pre-borrow question, ask which locate exception the proviso names and whether the participant's closing purchase has happened.