Regulation SHO (for SHOrt selling), Securities Exchange Act Release No. 34-50103 (July 28, 2004) of the Securities and Exchange Commission, updates and modifies rules pertaining to transactions involving short selling. by replacing and amending Rules 3b-3, 10a-1, and 10a-2 of the Securities Exchange Act of 1934. The regulation is comprised of SEC Rules 200, 202T, and 203 and is the first update of short selling restrictions since 1938.

Regulation SHO was proposed by the SEC on October 28, 2003 and became effective September 7, 2004 (except Part 241 which became effective August 6, 2004 and §242.202T effective from September 7, 2004 to September 7, 2007). Compliance with the regulation began on January 3, 2005. Complaince with the §242.202T became effective on September 7, 2007.

The rule's stated intent was to curb the incidence of delivery failures in the U.S. equities markets. Delivery failures result when a selling broker fails to deliver shares of stock it sold. Due to the manner in which trades are processed, share delivery is left for 3 days following the day the transaction is booked and the stock paid for. Some view this latency and resultant failure to delivers as a mechanism for market manipulation via boundless sales transactions with no accompanying deliveries, although regulators are quick to point out that delivery failures can occur for innocent reasons.

One of the principal objectives of Regulation SHO is to discourage abuses in naked short selling of equities by broker-dealers by establishing uniform "locate" and "close-out" requirements:

Locate Requirement - Broker-dealers must attempt to "locate" and document securities available for borrowing prior to effecting a short sale.

Close-Out Requirement - For certain "threshold securities" broker-dealers who are participants of a registered clearing agency are required to perform "close-outs" of failure-to-deliver positions that have persisted for 13 consecutive days by purchasing securities of like kind and quality.

Reg SHO provides market makers the ability to fail to deliver shares they sold, in order to provide liquidity to the markets. This is an example of legal failing to deliver.

Controversy

The SEC has taken the position that Reg SHO would result in an improvement in the overall number of failed deliveries (FTDs). It is difficult to know whether there has been genuine improvement, as the SEC doesn't release data on total FTDs. Freedom of Information Act (FOIA) requests have shown increases in delivery failures in some high profile companies, as well as in total exchange figures for the NYSE, so there is contention as to whether the regulation has had any meaningful positive impact.

Critics of Reg SHO have cited the inclusion of a "Grandfather" exemption that forgave all prior incidences of failing to deliver prior to an equity going onto the Reg SHO Threshold List. The Threshold List is a list of companies whose stock has more than 10,000 shares of delivery failures, and greater than 0.5% of the company's outstanding shares failed to deliver. The grandfather exemption was not submitted for public comment, and has been challenged by some as outside of the authority of the SEC to implement.

Critics have also pointed out that there are 88 uses of the word "exemption" [1] in the original regulation, creating a set of loopholes so broad as to minimize any effectiveness the rule might have had.

Both critics and proponents agree that there are no penalties articulated for failing to deliver, thus the rule lacks essential disincentives for violations.

Recent developments

The SEC has publicized the success of Reg SHO, and has made numerous public statements as to the efficacy of the rule in reducing the number of delivery failures in the U.S. equities markets. Critics contend that Freedom Of Information Act (FOIA) [2] data contradict these claims, and in fact shows an increase in delivery failures during the reported period on the OTCBB.

The SEC has recently requested public commentary [3] on several amendments to Reg SHO [4], which include eliminating the grandfather exemption, limiting the market maker exemption, and providing remedial reporting of aggregate levels of failures.

Critics argue that these proposals don't go far enough, and cite the lack of improvement (per the NYSE and OTCBB FOIA delivery failure data) over the rule's 18 month life as proof of its inefficiency.

See also

• U.S. Securities and Exchange Commission
• Key Points About Regulation SHO
• The Securities and Exchange Commission website
• SecuritiesLinks - Links related to Securities Exchange Act of 1934