Locates and Borrows

The locate is the gate a short sale passes through before it is accepted. The locate and borrow rule also sets a separate duty on the long side, aimed at firms that lend out or fail to deliver stock behind an order marked long.

What Must a Firm Do Before Accepting or Effecting a Short Sale?

A broker or dealer may not accept a short sale order in an equity security from another person, or effect a short sale in an equity security for its own account, unless the broker or dealer has one of two sourcing positions plus a record.

• Route one, the borrow. It has borrowed the security, or entered into a bona-fide arrangement to borrow the security.
• Route two, the belief. It has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due.
• The record, on either route. It has documented compliance with the paragraph.

The two sourcing routes are alternatives. The documentation requirement is not: it is joined to the pair with "and", so a firm relying on the reasonable-grounds route owes exactly the same record as a firm that has actually borrowed the stock.

Note the reach of the paragraph. It covers any equity security, and it bites at two moments: when the firm accepts an order from someone else, and when the firm effects a short sale for its own account.

Exam Tip: Gotchas

• Route two is a belief about availability, not a completed borrow. Reasonable grounds to believe the stock can be borrowed for delivery on the due date satisfies the rule, so an answer requiring an executed borrow on every short sale overstates it.
• Documentation is owed on both routes. The record is a separate clause joined with "and", not a substitute for sourcing and not something only the belief route triggers.

Which Four Situations Excuse the Locate?

The rule states four exceptions. Three of them carry a limit inside the exception itself; the fourth, transactions in security futures, carries none.

The deemed-owner exception carries a clock inside it. If the person has not delivered the security within 35 days after the trade date, the broker-dealer that effected the sale must borrow securities or close out the short position by purchasing securities of like kind and quantity.

The market maker exception is security-specific on its face. It reaches bona-fide market making in the security for which the exception is claimed, so making a market in one name does not excuse a locate in another.

Market maker here takes the statutory definition of a market maker, which reaches any specialist permitted to act as a dealer, any dealer acting in the capacity of block positioner, and any dealer who, with respect to a security, holds himself out (by entering quotations in an inter-dealer communications system or otherwise) as being willing to buy and sell such security for his own account on a regular or continuous basis.

Exam Tip: Gotchas

• The first exception reverses where the firm took the duty on by contract. A firm that contractually undertook responsibility for the other firm's locate compliance cannot then rely on the other firm having done it.
• The deemed-owner exception carries a 35-day backstop. If the person has not delivered within 35 days after the trade date, the firm that effected the sale must borrow or close out by purchasing, and the remedy is stated in the alternative rather than as purchase only.
• Bona-fide market making is claimed name by name. The exception's own words tie it to the security for which it is claimed, so a firm quoting an active book elsewhere gets nothing here.
• The market maker definition is broader than a quoting desk. It reaches a specialist permitted to act as a dealer and a dealer acting as a block positioner, not only a dealer holding itself out on a regular or continuous basis.

What Does the Rule Forbid on a Sale Marked Long?

The long-sale paragraph binds a broker or dealer that knows or has reasonable grounds to believe that the sale of an equity security was or will be effected pursuant to an order marked "long." Such a firm is subject to two prohibitions.

• It shall not lend or arrange for the loan of any security for delivery to the purchaser's broker after the sale.
• It shall not fail to deliver a security on the date delivery is due.

The trigger is knowledge or reasonable grounds for belief about the mark, not certainty. A firm with reasonable grounds to believe the order is marked long that lends stock to cover the delivery has the problem the paragraph is aimed at, unless one of the paragraph's exceptions applies.

When Does the Long-Sale Prohibition Not Apply?

Three exceptions turn it off.

• A loan through another firm. The loan of any security by a broker or dealer through the medium of a loan to another broker or dealer.
• A seller known to own the stock who then failed to deliver. Where the firm knows, or has been reasonably informed by the seller, that the seller owns the security, and that the seller would deliver the security to the broker or dealer prior to the scheduled settlement of the transaction, but the seller failed to do so.
• A pre-loan finding by an exchange or association. Where, prior to any loan or arrangement to loan any security for delivery, or failure to deliver, a national securities exchange (for a sale effected on it) or a national securities association (for a sale not effected on an exchange) makes three findings.

Those three findings are cumulative.

• That such sale resulted from a mistake made in good faith.
• That due diligence was used to ascertain that the circumstances specified in the order marking paragraph existed.
• Either that the condition of the market at the time the mistake was discovered was such that undue hardship would result from covering the transaction by a "purchase for cash," or that the mistake was made by the seller's broker and the sale was at a permissible price under any applicable short sale price test.

Exam Tip: Gotchas

• The exchange or association finding must come first. The rule requires the finding prior to any loan, arrangement to loan, or failure to deliver, so a firm cannot lend the stock and then seek a ruling that cures it.
• The third finding is itself a choice of two. Undue hardship measured at the time the mistake was discovered is one branch; a mistake by the seller's broker on a sale at a permissible price is the other.
• The second exception turns on the firm's knowledge, however it arose. The firm must know, or have been reasonably informed by the seller, that the seller owns the security and would deliver it to the firm prior to the scheduled settlement of the transaction, but the seller failed to do so.

What Should You Check on Exam Day?

• Confirm the firm has one of the two sourcing routes and the documentation. The record is not optional on either route.
• On a market making claim, check the exception is claimed in the same security in which the firm is making a bona-fide market.
• On a deemed-owner locate exception, count 35 days from the trade date, and if the person has not delivered by then, require a borrow or a closing purchase.
• On a first-exception question, look for a contract in which the relying firm took on the other firm's locate compliance.
• On a long-sale question, ask whether the exchange or association made all three findings before any loan, arrangement to loan or failure to deliver occurred.