Regulation SHO Explained: Short Sale Rules and Key Requirements

Regulation SHO Explained: Short Sale Rules and Key Requirements

What is Regulation SHO?

Regulation SHO is a set of Securities and Exchange Commission (SEC) rules, adopted in 2005, that govern short selling in U.S. equity markets. Its main goals are to curb naked short selling (selling shares that have not been located or borrowed) and to reduce persistent failures to deliver shares.

Key takeaways

• Requires brokers to “locate” shares they can borrow before effecting a short sale.
• Imposes “close-out” obligations for securities with extended delivery failures.
• Triggers reporting and mandatory close-outs when persistent fails meet specific thresholds.
• Rule 201 (the alternative uptick rule), added later, restricts short-sale pricing when a stock falls sharply intraday.
• Certain short sales can be marked “short exempt” (SSE) when they meet narrow exceptions.

How short selling works (brief)

A short sale involves borrowing a security (via a broker), selling it on the market, and later buying it back to return to the lender. Short sellers profit if the stock price falls; they lose if it rises. Broker-dealers typically facilitate short sales by lending securities to clients.

Core requirements of Regulation SHO

Locate requirement

Brokers must have a reasonable belief that the stock to be sold short can be borrowed and delivered on the settlement date before permitting the short sale. This “locate” obligation is intended to prevent naked shorting.

Close-out requirement

When particular securities experience repeated delivery failures, broker-dealers and clearing entities face accelerated delivery demands to eliminate those fails. The rule targets persistent failures to deliver that can distort markets.

Thresholds that trigger close-out actions and reporting

Regulation SHO requires reporting and close-out procedures when all three of the following apply for five consecutive settlement days:
* Aggregate fails to deliver at a registered clearing agency of 10,000 shares or more for the security.
* Those fails equal at least 0.5% (one-half of one percent) of the security’s outstanding shares.
* The security appears on a list published by a self-regulatory organization (SRO).

Evolution and notable amendments

• 2005: Regulation SHO enacted as the first major short-sale update since 1938.
• 2008: Two earlier exceptions to the close-out requirement (legacy provision and options market-maker exception) were eliminated, strengthening close-out obligations.
• 2010: Rule 201 (the alternative uptick rule) was adopted to limit short selling during sharp intraday price declines.

Rule 201 (alternative uptick rule) — how it works

Rule 201 is triggered when a stock’s price falls 10% or more from the prior day’s close during intraday trading. Once triggered:
* A “price test” (a circuit-breaker-like restriction) applies to that security for the remainder of the day and the following trading day.
* Short-sale orders must be executed at a price above the current best bid (i.e., not at or below the bid), preventing short sellers from accelerating a rapid decline.

Trading venues must implement policies to enforce these price-test restrictions automatically when the trigger condition occurs.

Exceptions: short-exempt markings (SSE)

Certain orders can be designated “short exempt” and are marked SSE by brokers. These are limited exceptions—often tied to specific nonstandard pricing quotes or narrowly defined market-making or settlement transactions—and allow short selling without satisfying the locate/price-test conditions. The scope of exempt transactions is narrow and specifically defined by rules and market practices.

Enforcement and reporting

Regulation SHO relies on self-regulatory organizations, clearing agencies, and broker-dealers to identify fails, publish lists of impacted securities, and carry out mandated close-outs. The SEC monitors compliance and may take enforcement action where the rules are violated.

Practical implications for investors

• Retail investors: Regulation SHO reduces the likelihood of manipulation via naked shorting and helps ensure short sellers can deliver shares they sell.
• Short sellers: Must rely on brokers to meet locate requirements and be prepared for price-test restrictions if a stock drops sharply.
• Brokers and market makers: Must maintain procedures for locates, close-outs, and implementing Rule 201 price-test restrictions; certain narrowly defined transactions may be eligible for short-exempt treatment but require proper marking.

Conclusion

Regulation SHO modernized short-sale oversight by requiring pre-borrow locates, addressing persistent delivery failures through close-outs, and adding a price-test mechanism (Rule 201) to limit short selling during large intraday declines. These measures aim to promote market integrity, reduce abusive naked short selling, and limit the potential for short sellers to exacerbate sharp price drops.