SEC Regulation SHO

Regulation SHO serves as the main set of rules governing short selling Short selling Short selling is an investment strategy where a hedge fund borrows securities and sells them with the expectation of repurchasing them at a lower price in the future, profiting from price declines while incurring the obligation to return the borrowed securities. activities in the United States. Short selling Short selling Short selling is an investment strategy where a hedge fund borrows securities and sells them with the expectation of repurchasing them at a lower price in the future, profiting from price declines while incurring the obligation to return the borrowed securities. involves borrowing shares and selling them immediately, with the hope of buying them back later at a lower price to return to the lender.

The regulation's central requirement is straightforward: broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. must confirm they have either borrowed securities or have a reasonable way to borrow them before they accept a short sale order from their customers. This prevents "naked" short selling, where shares are sold without any plan for delivery.

Two additional SEC rules work alongside Regulation SHO to address short selling misconduct. Exchange Act Rule 10b-21SEC rule that creates liability for individuals and entities who deceive others about short sales, targeting those who misrepresent their ability to deliver shares by settlement date and then fail to deliver. targets short sellers who lie about their ability to deliver securities and then fail to deliver them by the settlement date. Rule 105 of Regulation M SEC Regulation M Regulation M is an SEC regulation that prohibits issuers, selling shareholders, and other distribution participants from artificially influencing a security's price during a public offering, affecting hedge funds participating in secondary offerings or SPAC transactions. separately restricts short selling by people who are participating in secondary stock offerings.

Regulation SHO establishes four main requirements that govern short sale transactions:

First, Exchange Act Rule 200 requires that all sale orders be properly marked to identify whether the seller is long or short the stock. Second, Exchange Act Rule 203 establishes the "locate requirement," meaning sellers must arrange to borrow shares before selling them short. Third, Exchange Act Rule 201 creates a price-based restriction that kicks in when a stock price falls sharply during the day. Fourth, Exchange Act Rule 204 sets deadlines for closing out positions when securities fail to be delivered.

These requirements technically apply only to broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account., not to investment advisers directly. However, the practical effect extends to hedge funds and their advisers because brokerage agreements typically require the customer—whether a fund or its adviser—to ensure all orders are properly marked as either "long" or "short" sales in compliance with the rules.

Exchange Act Rule 200(g) requires broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. to mark every sale order as "long," "short," or "short exempt." An order can only be marked "long" when the seller actually owns the security and has a net long position in that security.

When determining whether a seller has a net long position, all positions in that security must be counted together. For example, suppose a hedge fund uses multiple prime brokersA financial institution that provides comprehensive services to hedge funds including trade execution, custody, securities lending, margin financing, and capital introduction. and holds 10,000 shares long at one prime broker while holding 10,000 shares short at another prime broker. For order marking purposes, the fund's net position in that security would be zero—neither long nor short—so any additional sale would need to be marked "short."

This aggregation requirement prevents funds from incorrectly marking sales as "long" when they actually have offsetting short positions elsewhere.

Exchange Act Rule 203(b)(1) prohibits broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. from accepting short sale orders in stock unless they have either borrowed the securities, arranged to borrow them, or have reasonable grounds to believe the securities will be available for borrowing by the settlement date.

Broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. typically satisfy this requirement through one of two methods. Either they agree to lend shares directly to the customer to facilitate delivery at settlement, or they rely on the "reasonable grounds" standard by confirming that securities can likely be obtained for settlement from other sources.

The settlement date is typically two business days after the trade date (known as "T+2"), which gives the short seller time to actually borrow and deliver the shares to the buyer.

The "reasonable grounds" standard is typically satisfied when a fund or adviser identifies a third-party source that has indicated securities are available to be borrowed for settlement. These third-party sources might include clearing brokersFinancial institutions that facilitate the clearing and settlement of securities transactions and are required to deliver securities to registered clearing agencies by settlement date., custodians, or other market participants—but notably, not the fund's own prime broker.

However, when short sales placed using such third-party "away locates" result in repeated failures to deliver the shares, broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. may determine that the fund's track record undermines the reliability of future assurances from that customer. The SEC has made clear that a customer's promises about locate availability cannot satisfy the reasonable grounds requirement if that same customer's previous locates have resulted in delivery failures.

This creates a practical feedback loop where funds that repeatedly fail to deliver may find it harder to get their short sale orders accepted.

Exchange Act Rule 201 establishes a trading restriction that activates when a security experiences a significant price decline during the day. Specifically, the circuit breaker triggers when a stock falls at least 10% from the previous day's closing price.

This circuit breaker applies to all stocks listed on national securities exchanges, regardless of where the actual trading takes place. Once triggered, the restriction remains in effect for the rest of that trading day and continues through the entire following trading day.

During this period, short sales at or below the current national best bid price are prohibited across all trading centers. However, certain narrow exemptions apply for specific types of transactions.

Exchange Act Rule 204 requires clearing brokersFinancial institutions that facilitate the clearing and settlement of securities transactions and are required to deliver securities to registered clearing agencies by settlement date., including prime brokers, to deliver securities to registered clearing agenciesOrganizations that clear and settle securities transactions by matching trades, maintaining records, and ensuring delivery of securities between trading counterparties. by the settlement date. When they fail to do so, they must close out any resulting failure-to-deliver positions within specified timeframes.

Although these requirements do not directly apply to investment advisers or the funds they manage, advisers face practical consequences when funds experience delivery failures. If a fund cannot deliver shares and its prime broker becomes obligated to close out the position, the prime broker typically purchases securities in the market to cover the failure. The prime broker then charges the fund for any losses incurred, including market impactThe effect on securities prices caused by large transactions, typically resulting in less favorable execution prices. costs and trading expenses.

This creates a strong incentive for funds to ensure they can actually deliver the securities they have sold short.

While the main requirements of Regulation SHO do not directly apply to investment advisers, Exchange Act Rule 10b-21SEC rule that creates liability for individuals and entities who deceive others about short sales, targeting those who misrepresent their ability to deliver shares by settlement date and then fail to deliver. creates potential liability for individuals and entities that deceive others about short sales. This rule targets those who submit orders to sell stock while misleading broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account., clearing agencies, or purchasers about their intention or ability to deliver the shares by the settlement date, and then fail to deliver as promised.

Investment advisers can face SEC enforcement action under Exchange Act Rule 10b-21SEC rule that creates liability for individuals and entities who deceive others about short sales, targeting those who misrepresent their ability to deliver shares by settlement date and then fail to deliver. if they misrepresent that they have secured a locate or that they have a net long position in shares being sold, followed by subsequent delivery failures. This represents one of the primary ways the SEC can take enforcement action against advisers for problematic conduct in short selling activities, even though the advisers are not directly subject to most of Regulation SHO's requirements.