Short Sale Regulations

Everything else in this unit runs off one definition and one ownership test. The definition decides whether a sale is short at all. The ownership test decides how much of a sale is long. Get either wrong and the order is marked wrong, and every duty downstream keys off that mark.

What Makes a Sale a Short Sale?

Regulation SHO's definition and order marking rule gives the term two branches, and either one on its own is enough.

• The seller does not own it. Any sale of a security which the seller does not own.
• The delivery came from a borrow. Any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller.

The second branch does not ask about ownership at the moment of the sale. It looks at how the sale was settled, so stock delivered out of a borrow by or for the seller makes the sale a short sale.

Exam Tip: Gotchas

• The two branches are joined by "or", not by "and". A sale satisfies the definition on the borrow branch alone, whatever the seller's claim to shares looked like when the order was entered.

When Is a Seller Deemed to Own the Security?

The rule's deemed-ownership paragraph lists six routes.

Three of the six take two acts, not one. Owning a convertible security, an option, or rights and warrants is not ownership of the underlying stock until the holder has also tendered or exercised.

The security futures route takes two further facts on top of holding the contract: the notice that the position will be physically settled, and the irrevocable obligation to receive the underlying security. The locate and borrow rule gives security future the meaning the Securities Exchange Act gives that term; the definition rule itself defines no such term.

Exam Tip: Gotchas

• An unconditional purchase contract is ownership before the shares arrive. The rule's own words are "but has not yet received it", so a buyer waiting on delivery is already deemed to own the stock.
• Holding a convertible security is not owning the underlying. The conversion, option and rights routes each need a second act, the tender or the exercise, before the holder is deemed to own what is being sold.
• The purchase contract must be unconditional and binding on both parties. A one-sided commitment, or one that still depends on a condition, does not reach this route.

How Does the Net Long Position Limit Ownership?

A person is deemed to own securities only to the extent that he has a net long position in them.

That cap sits on top of the six routes rather than beside them. A trader long 1,000 shares and short 800 shares of one issue is deemed to own 200 shares, so a sale of 500 shares is long as to 200 shares and short as to the remaining 300.

Exam Tip: Gotchas

• Net long is a ceiling, not a seventh route to ownership. A seller must first be deemed an owner under one of the rule's routes, and the net long position then decides how many shares that ownership actually covers. Two broker-dealer deemings, for block positioners and index arbitrage, apply even when the firm is not net long.

When Is a Broker-Dealer Deemed to Own Stock It Is Not Net Long?

Two paragraphs deem a broker or dealer to own a security even if it is not net long. Each states a closed set of conditions, and every condition in the set must hold.

The block positioner paragraph has two conditions.

• The broker or dealer acquired that security while acting in the capacity of a block positioner; and
• If and to the extent that the broker or dealer's short position in the security is the subject of offsetting positions created in the course of bona fide arbitrage, risk arbitrage, or bona fide hedge activities.

The index arbitrage paragraph has three conditions.

• The broker-dealer is unwinding index arbitrage position involving a long basket of stock and one or more short index futures traded on a board of trade or one or more standardized options contracts as the options disclosure delivery rule defines them; and
• If and to the extent that the short position is the subject of offsetting positions created and maintained in the course of bona-fide arbitrage, risk arbitrage, or bona fide hedge activities; and
• The sale does not occur during a period commencing at the time that the NYSE Composite Index has declined by two percent or more from its closing value on the previous day and terminating upon the end of the trading day.

That third condition carries its own arithmetic. The two percent shall be calculated at the beginning of each calendar quarter, and shall be two percent, rounded down to the nearest 10 points, of the average closing value of the NYSE Composite Index for the last month of the previous quarter.

Standardized options are options contracts trading on a national securities exchange, an automated quotation system of a registered securities association, or a foreign securities exchange, which relate to options classes the terms of which are limited to specific expiration dates and exercise prices, or such other securities as the Commission may, by order, designate.

Exam Tip: Gotchas

• The two arbitrage paragraphs are not worded alike. The block positioner route needs offsetting positions created in the course of the named activities. The index arbitrage route needs them created and maintained.
• The index arbitrage route shuts off during a market decline. The closed window opens when the NYSE Composite Index has declined by two percent or more from the previous day's closing value, and it runs to the end of that trading day.
• The two percent figure is fixed once a quarter, not measured fresh each day. It is set at the beginning of each calendar quarter, rounded down to the nearest 10 points of the index's average closing value for the last month of the previous quarter.
• Both paragraphs are conjunctive. Meeting one condition and not the others leaves the firm outside the deeming provision entirely.

How Does a Firm Determine Its Net Position?

To determine its net position, a broker or dealer shall aggregate all of its positions in a security, unless it qualifies for independent trading unit aggregation. Where it does qualify, each independent trading unit aggregates all of its own positions in a security to determine its net position.

Independent trading unit aggregation is available only if all four of the following hold.

• The broker or dealer has a written plan of organization that identifies each aggregation unit, specifies its trading objectives, and supports its independent identity.
• Each aggregation unit within the firm determines, at the time of each sale, its net position for every security that it trades.
• All traders in an aggregation unit pursue only the particular trading objectives or strategies of that aggregation unit, and do not coordinate that strategy with any other aggregation unit.
• Individual traders are assigned to only one aggregation unit at any time.

Exam Tip: Gotchas

• Firm-wide aggregation is the default. Unit-level aggregation is the exception, and a firm has it only while all four conditions are satisfied.
• The written plan carries three separate jobs. It must identify each unit, specify that unit's trading objectives, and support the unit's independent identity, so a plan that merely lists desk names is short of the condition.
• Net position is determined at the time of each sale. A unit that reconciles its position once at the end of the day has not met the second condition.

What Should You Check on Exam Day?

• Read both branches of the definition. Stock delivered out of a borrow by or for the seller makes the sale short even where the seller had a claim to shares.
• On a deemed-ownership question, name the route first, then ask whether its second act, the tender or the exercise, has happened.
• Apply the net long cap after the ownership route, and split the sale into its long portion and its short portion.
• Count the conditions on a broker-dealer arbitrage route: two for the block positioner, three for index arbitrage.
• Confirm the firm actually qualifies for unit-level aggregation before treating one desk's position as the firm's net position.