Short Sale Exemptions

The short exempt mark is what buys an order out of the price test. Neither route is a standing permission: both are written as things a firm may do following any determination and notification by the listing market, which means both are dormant until a covered security has actually triggered the circuit breaker.

When May a Submitting Firm Mark an Above-the-Bid Order Short Exempt?

Following any determination and notification by the listing market, a broker or dealer submitting a short sale order of the covered security in question to a trading center may mark the order "short exempt" if it identifies the order as being at a price above the current national best bid at the time of submission.

The permission carries a proviso with two parts, and both bind the firm that uses it.

• It must establish, maintain, and enforce written policies and procedures reasonably designed to prevent incorrect identification of orders for the purposes of that paragraph.
• It shall regularly surveil to ascertain the effectiveness of those policies and procedures, and shall take prompt action to remedy deficiencies in them.

Note where the price is measured. This route tests the order at the time of submission, while the price test's own permission for a displayed order tests it at the time of initial display. Two different moments, in two neighbouring paragraphs.

Exam Tip: Gotchas

• This route belongs to the firm submitting the order, not to the venue. A trading center's own duty is to have procedures that permit certain executions; this paragraph is about the submitting broker-dealer identifying the order it submits.
• The two price moments are not the same. The short exempt identification is made at the time of submission; the trading center's permission for a displayed order looks at the time of initial display.
• The procedures and the surveillance are both conditions. A firm using this route without written procedures reasonably designed to prevent incorrect identification has not satisfied the paragraph.

Which Seven Situations Support a Short Exempt Mark?

Following any determination and notification by the listing market, a broker or dealer may mark a short sale order of a covered security "short exempt" if the broker or dealer has a reasonable basis to believe that one of seven things is true.

The over-allotment and lay-off entries are two branches of a single numbered exception, which is why the list is seven and not eight.

The deemed-owner entry is the one most often stated too broadly. It is not a bare ownership exception: the intent-to-deliver proviso is part of it, and without that intent the exception does not apply.

Exam Tip: Gotchas

• The deemed-owner exception carries an intent-to-deliver proviso. The person must intend to deliver the security as soon as all restrictions on delivery have been removed, so ownership alone does not reach this exception.
• The odd-lot exception belongs to a market maker and has a size limit. It covers offsetting customer odd-lot orders or liquidating an odd-lot position that changes the firm's position by no more than a unit of trading.
• The international arbitrage exception needs a live offer on the foreign side. The seller must have an offer to buy on a foreign market allowing immediate cover at the time the short sale was made.
• The standard throughout is a reasonable basis to believe. The firm does not have to prove the exception; it must have a reasonable basis to believe the situation applies.

What Must a Riskless Principal Firm Have in Place?

The riskless principal exception adds a requirement on top of the situation itself. For that exception, a broker or dealer must have written policies and procedures in place to assure that, at a minimum, three things hold.

• The customer order was received prior to the offsetting transaction.
• The offsetting transaction is allocated to a riskless principal or customer account within 60 seconds of execution.
• The broker or dealer has supervisory systems in place to produce records that enable it to accurately and readily reconstruct, in a time-sequenced manner, all orders on which it relies pursuant to this exception.

The phrase at a minimum floors that list rather than closing it. Three items are the least the procedures must assure, not the most.

Exam Tip: Gotchas

• The allocation clock is 60 seconds from execution. The offsetting transaction must reach a riskless principal or customer account inside that window.
• "At a minimum" opens the list upward. An answer describing these three as the complete set of what the procedures must assure misreads the floor as a ceiling.
• The order of events is part of the test. The customer order has to have been received before the offsetting transaction, so a firm that trades first and matches later fails the first condition.

What Conditions Does a Volume Weighted Average Price Sale Carry?

The last of the seven situations is a sale at the volume weighted average price (VWAP), and five criteria attach to it.

• The calculation. The VWAP for the covered security is calculated in three steps, set out below.
• The modifier. The transactions are reported using a special VWAP trade modifier.
• The security. The VWAP matched security either qualifies as an "actively-traded security" under Regulation M's distribution participant rule and its issuer and selling security holder rule, or the proposed short sale transaction is conducted as part of a basket transaction of twenty or more securities in which the subject security does not comprise more than 5% of the value of the basket traded.
• The purpose. The transaction is not effected for the purpose of creating actual, or apparent, active trading in or otherwise affecting the price of any security.
• The principal cap. A broker or dealer may act as principal on the contra-side to fill customer short sale orders only if its position in the covered security does not exceed 10% of that security's relevant average daily trading volume.

That position is measured as committed by the broker or dealer during the pre-opening period of a trading day, and aggregated across all of its customers who propose to sell short the same security on a VWAP basis.

The calculation itself is stated in three steps.

• Calculate the values for every regular way trade reported in the consolidated system for the security during the regular trading session, by multiplying each such price by the total number of shares traded at that price.
• Compile an aggregate sum of all values.
• Divide the aggregate sum by the total number of reported shares for that day in the security.

The actively-traded security test is Regulation M's, and Regulation M is covered in the unit on IPOs, secondary offerings and safe harbor. Regulation M's own short sale rule, which forbids a purchase in the offering by someone who shorted during the restricted period rather than the short sale itself, is covered there as well.

Exam Tip: Gotchas

• The security test is a choice of two, not a single standard. An actively-traded security qualifies, and so does a subject security that is no more than 5% of the value of a basket of twenty or more securities.
• The 10% cap is measured on a pre-opening commitment, aggregated across customers. It is not a per-customer limit, and it is measured against the covered security's relevant average daily trading volume.
• The special trade modifier is a condition of the exception. A VWAP sale reported without it has not met the second criterion, whatever the pricing was.

Who Can Grant an Exemption From These Rules?

Three of the four Regulation SHO rules in this unit carry their own exemptive authority, and each is worded almost identically. Upon written application or upon its own motion, the Commission may grant an exemption from that rule's provisions, either unconditionally or on specified terms and conditions, to any transaction or class of transactions, any security or class of securities, or any person or class of persons.

Exam Tip: Gotchas

• The exemptive authority is the Commission's alone. The rules give it to the SEC on written application or on its own motion, and give no equivalent power to an exchange, an association or a trading center.

What Should You Check on Exam Day?

• Confirm the listing market's determination and notification has already happened. Neither short exempt route opens before it.
• On the above-the-bid route, measure the price at the time of submission, and require the written procedures and the surveillance.
• On the deemed-owner exception, require the intent to deliver as soon as all restrictions on delivery have been removed.
• On the riskless principal exception, check the customer order came first and the allocation ran inside 60 seconds.
• On a VWAP sale, test the special trade modifier, the actively-traded or basket limb, and the 10% pre-opening principal cap.