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Regulating Short Sales in the 21st Century

Houman B. Shadab

Associate Professor of Law

New York Law School

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Reading Questions What is a short sale and why are they undertaken? What is the difference between a “covered” and a “naked” short

sale? What regulations of general application apply to short sales? What price test applied to short sales before Regulation SHO

was adopted? What emergency actions did the SEC and other regulators take

with respect to short sales in 2008? How has Regulation SHO been amended since its adoption in

2004? What price test currently applies to short sales? What “locate” and “close out” rules currently attempt to prevent

fails to deliver and abusive naked short sales? What are the exceptions to the close out requirements? How are approaches taken by non-U.S. regulators to short

sales different than that taken by the SEC?

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Short Sales

“Long” sales contrasted Purpose of “short” sales Goals of short sale regulation

Prevent fraud and enforce antifraud regimePrevent insider tradingPrevent artificial depression of stock pricesPrevent manipulative price declines and

exacerbating price declines

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U.S. Short Sale Regulation Background

Regulation pursuant to 1934 Securities and Exchange Act

Rule 10a-1 price test (“tick test”) Erosion of Rule 10a-1

Governmental studies Market developments

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Tick Test Elimination

Regulation SHO initially suspended Rule 10a-1 tick test in 2004 and eliminated tick test entirely in 2007.

Regulation SHO imposed new “locate” and “close out” rules to prevent abuse naked short sales.

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“Covered” Versus “Naked” Short Sales “Covered” short sale “Naked” short sale

Failure to borrowFailure to deliverThree-day settlement date (T+3)

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2008 Temporary Emergency Actions In response to concerns about abusive naked short

sales during the market volatility of 2008, the SEC undertook several temporary emergency actions, including: Strict T+3 close-out requirements Prohibition of short sales in nearly 800 financial company

stocks Institutional investor disclosure of certain short sale

positions confidentially to the SEC Non-U.S. regulators undertook similar temporary

actions in 2008.

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Current Short Sale Regulation: Antifraud Regime Exchange Act Rule 10b-5 and other rules. Prohibits misrepresentations in connection with

short sales. Prohibits insider trading with short sales. Prohibits the use of short sales to implement a

scheme of market manipulation such as through abusive naked short selling that drives down market prices.

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Current Short Sale Regulation: Price Test Regulation SHO amended in February 2010. Combines a “circuit breaker” approach with an

“alternative uptick” rule. Rule: if the price of an exchange-listed equity security

declines by 10 percent or more in one day, absent an exception Rule 201 prohibits a national securities exchange, alternative trading system, or other “trading center” from effecting a short sale unless the price is above the current national best bid.

Exceptions and marking trades “short exempt.”

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Current Short Sale Regulation: Locate and Close Out Requirements Rule 203 “locate” requirement. Rule 10b-21 antifraud rule specifically targeting abusive

naked short sellers. Rule 204 “close out” requirement (2009).

Generally requires a clearing broker with a failure to deliver position to purchase or borrow the security and close out the position by the beginning of the settlement day after the trade’s settlement date.

Exceptions Pre-borrow requirement Pre-close out credit Clearing broker may allocate fail to broker-dealer

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Conclusion SEC short sale regulation remained static for its first

70 years but will likely change more frequently in the future.

Changes will come in response to: Rapid developments in market microstructure Differences of opinion among SEC Commissioners Academic and other commentator scrutiny Periods of extended share price volatility or stability

Market participants should not the expect the current approach to short sale regulation to remain the same.