SEC Enhances Regulation SHO to Curb Abusive Short Selling

October 21, 2008

The Securities and Exchange Commission (“SEC”) adopted temporary Rule 204T of Regulation SHO as an interim final temporary rule, and solicited comments on the rule1 on October 14, 2008. The effective date of Rule 204T was October 17, 2008 and the rule will remain in effect until July 31, 2009.

The SEC’s adoption of temporary Rule 204T is rooted in the prior month’s flurry of emergency orders from the SEC. On September 17, 2008, the SEC issued an emergency order adopting, among other things, a new, temporary rule imposing restrictions designed to curb “naked” short selling and the resulting delivery failures (the “Short Selling Emergency Order”).2

The Short Selling Emergency Order, which applies to all transactions in equity securities effected, cleared, or settled by or through U.S. broker-dealers or clearing agencies, took effect at 12:01 AM EDT on September 18, 2008 and, after an extension,3 expired at 11:59 PM EDT on Friday, October 17, 2008. The Short Selling Emergency Order strengthened delivery requirements on sales of all equity securities by adding an immediately effective provision to Regulation SHO, Rule 204T. That new temporary rule imposed a penalty on any clearing agency participant and any broker-dealer from which the participant received trades for clearance and settlement for having a failure to deliver position at a clearing agency in any equity security. The SEC’s October 14, 2008 action adopted, with some technical modifications, Rule 204T as it appeared in the Short Selling Emergency Order.

In general, a short sale is the sale of a security that the seller does not own or any sale that is con- summated by the delivery of a security borrowed by, or for the account of, the seller. In a short sale transaction, if the price of a stock decreases after the stock is sold, the short seller makes a profit equivalent to the difference between the sale price and the price at which the stock was bought back (a covering or close-out transaction) in the open market. A naked short sale occurs when a party sells a stock short but does not own for delivery or intend to deliver stock at settlement and does not enter into a corresponding transaction to borrow the stock for delivery, thereby resulting in a “fail to deliver.” Extensive naked short selling in a company’s stock or large numbers of fails to deliver on short sales are believed by some to be abusive and to create downward pressure on the price of the company’s stock. Rule 204T is intended to prevent naked short selling by enhancing the delivery requirements for such securities (i.e., to preclude short sales that are, in fact, naked).

Rule 204T Delivery and Close-Out Requirements

Temporary Rule 204T(a) mandates that a partici- pant, which includes broker-dealers, of a registered clearing agency (“Clearing Agency”) must deliver equity securities to the Clearing Agency on a long or short sale (each, a “Sale”) by settlement date. With respect to any Sale, if a Clearing Agency’s participant fails to deliver, the participant must, no later than the start of regular trading hours on the settlement day immediately following the Sale’s settlement date (the “Close-Out Date”), close out the fail to deliver position (either by borrowing or purchas- ing securities of like kind and quantity). Fails must be closed out before the participant or broker-dealer may accept another short sale in the same security without first borrowing or entering into an arrangement to borrow the security.

Regulation SHO already has a close-out requirement targeted at naked short selling. Specifically, Rule 203(b)(3) requires Clearing Agency participants to close out fails to deliver in securities that have substantial and regular fails to deliver (“threshold securities”) before the participant can effect any additional short sale in the threshold security without first borrowing the security. Temporary Rule 204T goes further because its close-out requirement applies to all Sales that result in a fail to deliver, rather than just transactions in threshold securities, and requires such fails to be closed out before trading begins on the next settlement day after the fail occurs. The current rule requires close-out if the fail persists for 13 days.

Temporary Rule 204T’s close-out requirements do not apply if a fail to deliver occurs for legitimate reasons (e.g., human or mechanical errors and/or processing delays resulting from securities that are not in book entry form). In particular, if a participant of a Clearing Agency has a fail to deliver in connection with a long sale, temporary Rule 204T(a)(1) exempts the fail from the temporary rule’s close-out requirement, provided the participant can demonstrate on its books and records that such a fail to deliver position resulted from a long sale (i.e., was not naked). In such instances, the participant has until the start of trading on the third consecutive settlement day following the Close-Out Date to close out the fail (either by borrowing or purchasing securities of like kind and quantity). However, if a seller misleads a purchaser or participant about his intention to deliver a security by settlement, the seller may be in violation of new Rule 10b- 21, an antifraud rule the SEC has adopted specifically to combat such conduct.4

The close-out requirements of temporary Rule 204T(a)(1) apply in the context of securities lending programs. If an investor that has loaned a security sells the security and issues a recall within two business days after the trade date, the investor is “deemed to own” the security for purposes of Rule 200(g)(1) of Regulation SHO, and such a sale is not treated as a short sale for purposes of temporary Rule 204T .

Sunset Provision

Rule 204T is a temporary rule and will expire on July 31, 2009. In the Adopting Release, the SEC stated that it expects the sunset provision “will enable the Commission to assess the operation of the temporary rule and intervening developments, including a restoration of stability to the financial markets, as well as public comments, and consider whether to continue the rule with or without modification or not at all.”


Clearly, the SEC believes that fails to deliver can be part of manipulative or naked short selling, which, in turn, can be used to drive down an issuer’s stock price and undermine the confidence of investors generally. To prevent or mitigate these effects, the SEC has adopted Rule 204T as an interim temporary rule that strengthens the delivery requirements for such securities.

Interestingly, on September 19, 2008, a SEC press release announced “a sweeping expansion of its ongoing investigation into possible market manipulation in the securities of certain financial institutions.”5 To the extent that resulting investigations produce evidence of market manipulation, the probability of Rule 204T becoming a permanent rule increases.


1) Amendments to Regulation SHO, SEC Rel. No. 34 58773 (Oct. 14, 2008) (the “Adopting Release”).
2) Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments, SEC Rel. No. 34-58572 (Sept. 17, 2008).
3) Order Extending Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments, SEC Rel. No. 34-58711 (Oct. 1, 2008).
4) See, Final Rule, “Naked” Short Selling Antifraud Rule, SEC Rel. No. 34-58774 (Oct. 14, 2008).
5) See, SEC Expands Sweeping Investigation of Market Manipulation. 

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