What Is Regulation SHO?
Regulation SHO established "locate" and "close-out" requirements aimed at curtailing naked short selling and other practices. Naked shorting takes place when investors sell short shares that they do not possess and have not confirmed their ability to possess.
- Regulation SHO is a 2005 SEC rule that regulates short selling.
- The regulation introduced the "locate" and "close-out" requirements aimed at curtailing naked short selling.
- In 2010, Regulation SHO was amended via changes to Rule 201, which stops short selling on a security when prices have decreased by 10% or more during the trading day, mandating that new bids be above the current price.
Understanding Regulation SHO
Short selling refers to an exchange of securities through a broker on margin. An investor borrows a stock, sells it, and then buys the stock back to return to the lender. Short sellers are betting the stock they sell will drop in price. Broker-dealers loan securities to clients for the purpose of short selling.
The SEC implemented Regulation SHO on January 3, 2005—the first significant update to short selling rules since they were first adopted in 1938. Regulation SHO's "locate" standard requires brokers to have a reasonable belief the equity to be shorted can be borrowed and delivered on a specific date before short selling can occur. The "close-out" standard represents the increased amount of delivery requirements imposed upon securities that have many extended delivery failures at a clearing agency.
Regulation SHO requires reporting when the following has occurred for five consecutive settlement days:
- The aggregate fails to deliver at a registered clearing agency of 10,000 shares or more per security.
- The number of fails is equal to at least one-half of one percent of the issue's total shares outstanding.
- The security is included on a list published by a self-regulatory organization (SRO).
History of Regulation SHO
Regulation SHO has been amended over the years. After initial adoption came two exceptions to the close-out requirement: the legacy provision and the options market maker exception. There were ongoing concerns, though, regarding instances where requirements were not being met for closing out securities that had failed to deliver positions. Those concerns eventually led to the elimination of both exceptions in 2008. The result of this change was the strengthening of the close-out requirements by applying them to failures to deliver as a result of a sales of all equity securities (as well as cutting down the time allowed for failures to deliver to be closed out).
Further changes to Regulation SHO came in 2010. One of the primary issues the SEC had originally sought to address was the use of short selling to artificially force down the price of a security. It specifically dealt with this problem via the modification of Rule 201, which limits the price that short sales can be affected during a period of significant downward price pressure on a stock.
Rule 201 is triggered in the midst of a substantial decrease in a stock's price during intraday trading—specifically when its shares fall at least 10% in one day. It mandates that short-sale orders must include a price above the current bid, a move that prevents sellers from accelerating the downward momentum of a security already in sharp decline.
As a part of Rule 201, trading centers are required to establish and enforce policies that prevent short sales at what would be deemed impermissible prices after a stock is dealt a 10% decrease in its price within the trading day. This would trigger a "circuit breaker" that would bring price test restrictions into effect on short sales on that day and into the next trading day.
Certain types of short sales can qualify for an exception to Regulation SHO. These orders are known as short exempt and are marked by brokers with the initials SSE. The primary exception is the use of non-standard pricing quotes for trade execution.