Securities Lending

Short selling requires borrowed shares, which brings us to securities lending: the mechanism that makes short selling possible and the enforcement framework for when borrowed shares are not returned on time.

How Does Securities Lending Work?

• A securities lender (typically a custodian or institutional investor) lends shares to a borrower (typically a broker-dealer or hedge fund) for a fee
• The borrower posts collateral (usually cash or other securities) equal to or exceeding the value of the borrowed shares
• Securities lending facilitates short selling, settlement, and market making

What Are Hard-to-Borrow Securities?

• Securities with limited availability for borrowing due to high demand, low float, or heavy short interest
• Broker-dealers maintain easy-to-borrow and hard-to-borrow lists
• For any short sale, the firm must still satisfy the Regulation SHO locate requirement before accepting the order: borrow the security, arrange to borrow it, or have reasonable grounds to believe it can be borrowed and delivered by settlement
• A hard-to-borrow label does not by itself create a separate universal pre-borrow rule; pre-borrow is only required once a security is in the penalty box (see below)
• Borrowing fees for hard-to-borrow securities are significantly higher than for easy-to-borrow securities

Exam Tip: Gotchas

• A "hard-to-borrow" label alone does not require a pre-borrow. The standard locate still applies unless the security has entered the penalty box for an uncured fail to deliver.

What Is a Fail to Deliver (FTD)?

• A fail to deliver occurs when the selling party does not deliver securities to the buying party by the settlement date
• FTDs can result from:
  • Naked short selling
  • Operational errors
  • Inability to locate shares

When Must a Fail-to-Deliver Position Be Closed Out?

If a participant has a fail-to-deliver position, it must close out the position by purchasing or borrowing securities of like kind and quantity:

Standard, long-sale, and bona fide market-maker fails may be closed out by purchasing or borrowing like securities; a restricted-delivery fail must be closed out by purchasing like securities (borrowing does not satisfy it).

Exam Tip: Gotchas

• Short sale fails-to-deliver (FTDs) must be closed out by T+2; long sale FTDs get until T+4. The shorter deadline for short sales reflects the higher regulatory concern around failures from short selling.
• A restricted-delivery fail can only be closed out by a purchase, not a borrow, and gets the longest window (35 calendar days).

What Is the Penalty Box?

• If a participant fails to close out a fail to deliver (FTD) by the required date, a stricter restriction kicks in
• The participant and any broker-dealer for which it clears may not accept a short sale order in that security without first borrowing or arranging to borrow the security
• This means a simple "locate" is no longer sufficient; the firm must actually pre-borrow
• The restriction remains until the FTD is closed out

Think of it this way: The penalty box works like a probation system. Once a firm fails to clean up its fail to deliver on time, the rules get stricter: a simple "locate" (knowing where shares are available) is no longer enough. The firm must actually borrow or arrange to borrow the shares before accepting any new short sale orders in that security.

Exam Tip: Gotchas

• The penalty box applies to the clearing participant AND every broker-dealer that clears through it. A single firm's failure can restrict short selling for all its correspondent firms in that security.
• A "locate" is NOT sufficient once in the penalty box. The firm must actually borrow or pre-borrow the shares.

What Counts as an Invalid "Sham" Close-Out?

• A purchase or borrow does not qualify as a close-out if the participant knows or has reason to know the securities will not actually be delivered
• Prevents "sham" close-outs designed to reset the clock on fail-to-deliver (FTD) obligations
• Example: Buying shares from someone you know also can't deliver them is not a valid close-out

Exam Tip: Gotchas

• A purchase or borrow is not a valid close-out if the participant knows the securities will not actually be delivered. This prevents firms from doing "sham" transactions just to reset the clock on their fail-to-deliver (FTD) obligations.

What Is a Non-Reporting Threshold Security?

• A non-reporting threshold security is an unregistered equity security whose issuer is not required to file Exchange Act reports and that appears on FINRA's threshold list
• A security reaches threshold status when, for five consecutive settlement days, aggregate fails to deliver are at least 10,000 shares and worth at least $50,000 each day; it leaves the list after failing either test for five consecutive settlement days
• A clearing-agency participant with a fail lasting 13 consecutive settlement days must immediately buy like securities to close it out; the period extends to 35 consecutive settlement days when the fail involves a qualifying sale of restricted securities under the resale-registration-exemption rule for restricted and control securities
• Until that purchase clears and settles, the participant and every broker-dealer for which it clears may not accept or effect a short sale in that security without first borrowing it or entering a bona fide borrowing arrangement
• A knowing sham purchase that will not settle does not satisfy this close-out requirement

Exam Tip: Gotchas

• This mandatory 13-day close-out is separate from Regulation SHO's T+2/T+4 deadlines. It applies specifically to non-reporting threshold securities and extends to 35 days when the fail involves a qualifying restricted-securities sale under the resale-exemption rule.

What Should You Check on Exam Day?

• Do not assume a hard-to-borrow label alone requires pre-borrowing; the standard locate still applies unless the security is in the penalty box.
• Match close-out deadlines to fail type: T+2 for short sale fails, T+4 for long sale or bona fide market-maker fails, 35 calendar days (purchase only) for restricted-delivery fails.
• Remember the penalty box restricts every broker-dealer that clears through the participant, not just the participant itself.
• Reject any close-out purchase or borrow the firm knows will not actually settle.
• Distinguish Regulation SHO's general close-out deadlines from the 13-day (or 35-day, restricted-securities sale) mandatory buy-in for non-reporting threshold securities.