SEC REGULATIONS:
www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm. Locate and Delivery Requirement – Rules 203(b)(1) and (2)
Question 4.1: How should broker-dealers determine “reasonableness” to satisfy the locate requirement of Regulation SHO?
Answer: Rule 203(b)(1)(ii) permits a broker or dealer to accept a short sale order in an equity security if the broker-dealer has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the settlement date. “Reasonableness” is determined based on the facts and circumstances of the particular transaction. What is reasonable in one context may not be reasonable in another context. The Commission provided some examples of reasonableness in the Adopting Release. (69 FR at 48014 and Footnotes 58, 61 and 62).
Question 4.2: How may broker-dealers use Easy to Borrow lists?
Answer: The Adopting Release states that Easy to Borrow lists generally may be used to establish a reasonable basis for a locate. (69 FR at 48104). Easy to Borrow lists are prepared by a firm to indicate that firm’s ability to supply the identified securities. Therefore, for example, introducing firms may rely on Easy to Borrow lists of the clearing firms through which they clear and settle transactions unless circumstances indicate that it would not be reasonable to rely on such lists. For example, if the securities on the Easy to Borrow list have experienced delivery failures, it would not be reasonable to rely on the list. Furthermore, if the Easy to Borrow list is prepared by a clearing firm through which the introducing firm does not clear or settle transactions, or otherwise does not maintain a relationship in which the clearing firm agrees to make securities on its Easy to Borrow lists available to the introducing firm, then it would not be reasonable to rely on the list.
Question 4.3: May an executing broker rely on customer representations that a short sale is supported by a locate from the stock loan department of the executing broker, then execute the order, and then confirm the locate later in the same day or the next morning?
Answer: The executing broker has the responsibility to perform the locate prior to effecting a short sale, and must have a reasonable basis to believe that the security can be delivered on the settlement date. Footnote 58 of the Adopting Release explains that a broker-dealer may obtain an assurance from a customer that the customer can obtain securities from another identified source in time to settle the trade. The executing broker may rely on a customer’s representation that an order to sell short a security is supported by a locate obtained by the customer from the stock loan department of the executing broker, or any other identified entity that is authorized to loan stock, as long as reliance on such representation is reasonable. However, where a broker-dealer knows or has reason to know that a customer’s prior assurances resulted in failures to deliver, assurances from such customer would not provide the reasonable grounds required for a locate.
Rule 203(b)(1) requires that the executing broker document the locate. Documentation should include the source of the securities cited by the customer. Documentation should also include support for the reasonable grounds to rely on customer assurances. For example, an executing broker may provide information showing that previous borrowings arranged by the customer resulted in timely deliveries of securities to settle the customer’s transactions.
After the executing broker executes a short sale, the executing broker may take steps to confirm the locate information provided by the customer. Confirmation of the locate after the execution of a short sale may provide information on whether the locate based on customer representations was reasonable. However, confirmation after the fact is not a substitute for a locate that is required to be performed before a short sale may be executed.
(NEW! 11/04/05)
Question 4.3(B): How does a customer's history with respect to timely delivery of securities in settling short sale transactions affect a broker-dealer's "reasonable grounds" obligation under Rule 203(b)(1)?
Answer: Rule 203 requires that the executing broker has the responsibility to perform the locate prior to effecting a short sale, and must have a reasonable basis to believe that the security can be delivered on the settlement date. Reasonableness is based on the facts and circumstances of a particular transaction. In some instances, it may be reasonable for an executing broker to rely on assurances from a customer that the customer can obtain the securities from an identified source in time to settle the trade. If the executing broker knows or has reason to know that a customer's prior assurances resulted in failures to deliver, however, reliance on further assurances from that customer would not be reasonable.
Rule 203(b)(1) requires that the locate be made and documented prior to effecting any short sale, including the broker-dealer's reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. Information important to assessing the broker-dealer's "reasonable grounds" includes information about whether securities were delivered on a timely basis for settlement in situations where the broker-dealer relied on representations from the customer to support its locate. Accordingly, the executing broker-dealer must consider information, either from its own records or from the records of its clearing firm, about settlement of the customer's trades. It would not be reasonable for an executing broker to assert that it did not know or have reason to know whether a customer's prior short sale trades resulted in delivery failures if the executing broker made no reasonable effort to obtain such information. See Footnote 58 of the Adopting Release.
If the executing broker discovered that the customer's prior assurances resulted in a single failure to deliver, the executing broker should consider the relevant facts and circumstances to determine whether it would be reasonable to rely on the customer's assurances for other transactions. For example, it may be reasonable for an executing broker to rely on the customer's assurances if the circumstances of the fail in a prior transaction were unusual, or if previous locates relying on the customer's assurances resulted in timely deliveries of securities to settle the customer's transactions and the fail in the prior transaction was an anomaly.
(NEW! 10/10/06)
Question 4.3(C): May firms rely on pre-existing agreements, such as standing instruction letters or blanket assurances, with customers when complying with the locate requirements of Rule 203(b)(1) of Regulation SHO?
Answer: Rule 203(b)(1) of Regulation SHO provides that a "broker or dealer may not accept a short sale order in an equity security from another person, or effect a short sale in an equity security for its own account, unless the broker or dealer has: (i) Borrowed the security, or entered into a bona-fide arrangement to borrow the security; or (ii) Reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due; and (iii) Documented compliance with this paragraph (b)(1)." Thus, the broker-dealer has the responsibility to perform the locate prior to effecting each short sale.
To comply with the rule, the broker-dealer must perform the locate prior to, and on the same day that, the broker-dealer effects each short sale. For example, the broker-dealer must perform a new locate when a Good Till Cancel ("GTC") short sale order requiring a locate cannot be effected on the same day that the locate was performed. Moreover, the broker-dealer may not rely on a pre-existing agreement with another source in lieu of this trade-by-trade determination.
In addition, the rule requires that broker-dealers document, at a minimum, the identity of the source, as well as the fact that the locate was performed prior to, and on the same day that, the broker-dealer effected the short sale. The rule also requires documentation of the number of shares located. We understand, however, that documenting the specific number of shares located may be problematic for systems reasons. In such circumstances, the broker-dealer must be able to demonstrate, upon request of SRO or Commission staff, that the locate: (1) was performed prior to, and on the same day that, the broker-dealer effected the short sale; (2) the short sale did not exceed the number of shares located, and (3) that there were reasonable grounds to rely on the locate.
Footnote 58 of the Adopting Release provides that a broker-dealer may obtain an assurance from a customer that such party can obtain securities from another identified source in time to settle the trade. As discussed in more detail in Question 4.3(B), that customer assurance may in some circumstances provide the "reasonable grounds" required by Rule 203(b)(1)(ii). Where the broker-dealer is relying on a customer assurance, the broker-dealer must demonstrate, upon request of SRO or Commission staff, that it confirmed that the customer performed the locate prior to, and on the same day that, the broker-dealer effected the short sale. The broker-dealer may not rely on a pre-existing agreement, such as a standing instruction letter or blanket assurance, with a customer when complying with the locate requirements of the rule, but must obtain the customer's individual assurance prior to, and for, each short sale.
Question 4.4: May an executing broker-dealer re-apply a locate for intra-day buy-to-cover trades?
Answer: A locate for a security may be re-applied for an intra-day buy-to-cover trade in the following scenario:
Prior to a customer’s short sale of 100 shares of XYZ stock, the executing broker-dealer obtains an appropriate locate for the securities. The short sale is then executed. Subsequently that day, the broker-dealer purchases 100 shares of XYZ stock for the customer, and the customer’s net trading position is flat. If the customer wants to then sell short another 100 shares of XYZ stock in the same trading day, the executing broker-dealer may apply the original locate to that sale, provided that such subsequent short sale is for an amount of securities that is no greater than the amount of securities obtained in the original locate, and provided further that the source of the located shares indicates that the original locate is good for the entire trading day.
For a "hard to borrow" security or a threshold security, a broker-dealer may not re-apply a locate for intra-day buy-to cover trades. Without obtaining locates prior to each short sale in such securities in the scenario described above, it is unlikely that the broker-dealer executing such trades would have reasonable grounds to believe that such securities can be borrowed so that they can be delivered on the date that delivery is due on each trade. A broker-dealer, however, may have reasonable grounds to believe that securities will be available when delivery is due on such short sales if the broker-dealer pre-borrows the securities.
Question 4.7: Market makers, as defined in Section 3(a)(38) of the Exchange Act, include block positioners. Regulation SHO provides an exception to the locate requirement for market makers. Are all block positioners excepted from the locate requirement?
Answer: Rule 203(b)(2)(iii) provides an exception from the locate requirement for short sales effected by market makers, but only in connection with bona-fide market making activities. Rule 203(c)(1) provides that the term “market maker” has the same meaning as in Section 3(a)(38) of the Exchange Act, which defines “market maker” as “any specialist permitted to act as a dealer, any dealer acting in the capacity of a block positioner, and any dealer that, with respect to a security, holds itself out (by entering quotations in an inter-dealer communications system or otherwise) as being willing to buy and sell such security for its own account on a regular or continuous basis.”
The term “block positioner” is not defined in Regulation SHO or the Exchange Act. However, for purposes of Regulation SHO, the Staff interprets this term to have the same meaning as in Rule 3b-8(c) of the Exchange Act (17 CFR 240.3b-8(c)), which defines a “qualified block positioner” as a dealer that: (1) is a broker or dealer registered pursuant to Section 15 of the Exchange Act; (2) is subject to and in compliance with Rule 15c3-1 of the Exchange Act (17 CFR 240.15c3-1); (3) has and maintains minimum net capital, as defined in Rule 15c3-1, of $1,000,000; and (4) except when such activity is unlawful, meets all of the following conditions: (i) engages in the activity of purchasing long or selling short, from time to time, from or to a customer (other than a partner or a joint venture or other entity in which a partner, the dealer, or a person associated with such dealer, as defined in Section 3(a)(18) of the Exchange Act, participates) a block of stock with a current market value of $200,000 or more in a single transaction, or in several transactions at approximately the same time, from a single source to facilitate a sale or purchase by such customer, (ii) has determined in the exercise of reasonable diligence that the block could not be sold to or purchased from others on equivalent or better terms, and (iii) sells the shares comprising the block as rapidly as possible commensurate with the circumstances.
Therefore, block positioners may rely on the exception to the locate requirement in connection with bona-fide block positioning activities.
Question 4.8: What constitutes “bona-fide market making activities?”
Answer: The term “bona-fide market making” refers to bona-fide activities described in Section 3(a)(38) of the Exchange Act. Whether activity is “bona-fide” will depend on the facts and circumstances of the particular activity. However, the Adopting Release sets forth examples of activities that would not be considered to be “bona-fide market making activities.” (69 FR at 48015).
Question 5.3: Does the close-out requirement apply to delivery failures that do not occur at a registered clearing agency?
Answer: We interpret the close-out requirement to apply only to fail to deliver positions at a registered clearing agency. Our interpretation is based on our understanding that transactions conducted outside the Continuous Net Settlement System (“CNS”) operated by the National Securities Clearing Corporation (“NSCC”) are rare. If this historical pattern changes and a significant level of fails are not included in CNS, we will reconsider this position.
Question 5.4: When entering into an arrangement to pre-borrow a threshold security, must a firm clean up the entire amount of the fail before accepting additional orders to sell short such threshold security? Or, may the firm effect short sale orders up to the amount of shares of the threshold security that is pre-borrowed?
Answer: Under Rule 203(b)(3), when a participant of a registered clearing agency has a net settlement failure in a threshold security for 13 consecutive settlement days, two consequences follow: (1) the participant must immediately take steps to close out the fail to deliver position; and (2) until the fail to deliver position is closed out, the participant and any broker or dealer for which it clears transactions must borrow the security that is the subject of the fail, or enter into a bona-fide arrangement to borrow such security before the participant or such broker or dealer may effect any subsequent short sales in such security. This pre-borrow requirement remains in place until the participant closes out the entire fail to deliver position. Therefore, a participant that has a close-out obligation for a threshold security may effect short sale orders for such threshold security up to the amount pre-borrowed.
Rule 203(b)(3)(iv) permits the participant to reasonably allocate a portion of a fail to deliver position to another registered broker or dealer for which it clears trades or for which it is responsible for settlement, based on such broker’s or dealer’s short position. If the participant has reasonably allocated the fail to deliver position, the provisions of Rule 203(b)(3) relating to such fail to deliver position shall apply to the portion of such registered broker or dealer that was allocated the fail to deliver position, and not to the participant.
Question 5.5: When must the close-out be initiated?
Answer: Rule 203(b)(3) provides that participant of a registered clearing agency that has a net settlement failure in a threshold security for 13 consecutive settlement days must immediately take steps to close out the fail to deliver position. The close-out process must be initiated no later than the beginning of trading on the trading day following the 13th consecutive settlement day with a net short settlement obligation.
Question 5.6: If a threshold security also qualifies as an “owned” security within the meaning of Rule 203(b)(2)(ii), when should the firm close out the short position: after the 13th consecutive settlement day; or the day that is 35 days after the trade date?
Answer: The close-out requirement that applies to threshold securities in Rule 203(b)(3)(iii) is based on net short positions, not trade dates. If a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency in a threshold security for 13 consecutive settlement days, the participant must take action to close out the fail to deliver position after the 13th consecutive settlement day (see Question 5.5), and, until the close-out obligation is satisfied, the participant must pre-borrow securities prior to effecting any subsequent short sales in such threshold security (see Question 5.4).
The close-out requirement that applies to “owned” securities in Rule 203(b)(2)(ii), however, is a sale-based provision that does not apply directly to net short positions and is not limited to sales of threshold securities. It provides an exception from the locate requirement for a short sale of an “owned” security, provided that the broker or dealer has been reasonably informed that the person intends to deliver such security as soon as all restrictions on delivery have been removed. If the person has not delivered such security within 35 days after the date of sale, the broker or dealer that effected the sale must borrow securities or close out the short position by purchasing securities of like kind and quantity.
These close-out requirements operate independently and concurrently. Therefore, if an “owned” security is a threshold security, the security must be delivered within 35 days of the trade date, and a fail to deliver position in that security must be closed out after 13 consecutive settlement days of delivery failures.
(NEW! 05/24/05)
Question 5.7: If a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency in a threshold security for 13 consecutive settlement days and immediately thereafter purchases securities of like kind and quantity to close out the fail to deliver position as required under Rule 203(b)(3), will the participant be deemed to have satisfied the close-out obligation on the day the purchase is executed, or on the day the purchase settles?
Answer: Rule 203(b)(3) provides that a participant of a registered clearing agency that has a fail to deliver position in a threshold security for 13 consecutive settlement days must immediately thereafter close out the fail to deliver position by purchasing securities of like kind and quantity. Until the close-out obligation is satisfied, a participant must pre-borrow securities to effect any new short sales in such threshold securities.
The Staff interprets the phrase "purchasing securities of like kind and quantity" in Rule 203(b)(3) to mean that a participant satisfies the obligation to close out an open fail to deliver position in a threshold security that has persisted for 13 consecutive settlement days when such participant executes a purchase of securities, and where:
the purchase is a bona fide transaction;
the purchase is executed on settlement day 11, 12 or 13;
the purchase is submitted to a registered clearing agency for settlement;
the purchase is of a quantity of securities sufficient to close out the entire amount of the open fail position that has persisted for 11, 12 or 13 consecutive settlement days, as applicable; and
the net purchases of the threshold security effected by the participant on that day, as reflected in such participant's books and records, are at least equal to the amount of such participant's open fail to deliver position in such threshold security on that day.
Purchases to close out fail to deliver positions in threshold securities must be bona-fide purchases. Rule 203(b)(3)(v) provides that where a participant enters into an arrangement with another person to purchase securities to close out an open fail to deliver position in a threshold security, and the participant knows or has reason to know that the other person will not deliver securities in settlement of the purchase, the participant will not be deemed to have fulfilled the close-out requirements of Rule 203(b)(3).
The Staff's interpretation that a participant satisfies the close-out obligation on the day when such participant executes a purchase of securities applies only to fail positions that are or are projected to be subject to the close-out requirements of Rule 203(b)(3); i.e., to purchases made on settlement day 11, 12, or 13. Therefore, this interpretation does not apply to purchases made on settlement day 10 or earlier, because there is no present or projected close-out requirement and such purchases would settle on or before 13 consecutive settlement days has elapsed.
(NEW! 03/17/06)
Question 5.8: If a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency in a threshold security at the end of each day for 13 consecutive settlement days, but during the 13-day period the participant experiences a reduction in its end of day fail to deliver position at NSCC, how should the participant apply that reduction to its open fail position(s)?
Answer: Rule 203(b)(3) of Regulation SHO requires a participant to close out a fail to deliver position in a threshold security that has persisted for 13 consecutive settlement days by purchasing securities of like kind and quantity. A participant's close-out requirement is determined by the change in the participant's end-of-day net fail to deliver position, in excess of any grandfathered amount, as recorded at NSCC that has remained open for 13 consecutive settlement days. In determining its close-out requirement, the participant must look to its total fails position at NSCC and not to fails positions at the customer account level.
If, prior to the 13th consecutive settlement day, the participant reduces its open fail to deliver position and such reduction is reflected in the participant's end-of-day net fail to deliver position at NSCC, the participant may first apply the reduction to the most recent increase in its fail to deliver position reflected at NSCC and then to any increase in its fails position that existed at NSCC on the day preceding that day and so forth until the entire amount of the reduction has been applied. If the participant wishes to apply any reduction reflected in its end-of-day net fail to deliver position at NSCC, the participant must do so in accordance with the methodology described in this Question 5.8.
Example
In this example, the participant has a fail to deliver position at NSCC of 5,000 shares in threshold security X that is subject to both increases and decreases during the 13 consecutive settlement day period. Assume, in this example, that there is no grandfathered amount.
Settlement Day Participant's End-of-Day Fail to Deliver Position Increase/(Reduction) in Fail to Deliver Position from Previous Settlement Day Participant's Close-out Requirement
1 5,000 5,000 0
2 5,000 0 0
3 5,500 500 0
4 5,500 0 0
5 5,500 0 0
6 5,500 0 0
7 5,900 400 0
8 5,300 (600) 0
9 5,300 0 0
10 5,300 0 0
11 10,000 4,700 0
12 10,000 0 0
13 10,000 0 5,000
14 10,000 0 0
15 10,000 0 300
16 5,000 (5,000) 0
17 5,000 0 0
18 4,700 (300) 0
19 4,700 0 0
20 4,700 0 0
21 4,700 0 0
22 4,700 0 0
23 4,700 0 4,700
24 4,700 0 0
25 4,700 0 0
26 0 (4,700) 0
In the above example, the participant has three separate increases in its fail to deliver position at NSCC that persist for 13 consecutive settlement days and must be closed out by the participant at the end of the 13th settlement day following the day of the increase, or on the morning of the 14th settlement day following the day of the increase, by purchasing shares of like kind and quantity.
The participant has an initial increase in its fail to deliver position of 5,000 shares that persists for 13 consecutive settlement days and must be closed out at the end of the 13th settlement day following the day of the increase, or on the morning of the 14th settlement day following the day of the increase.
In addition, the participant's fail to deliver position increases by 500 shares to 5,500 and then again by 400 shares to 5,900 shares on settlement days 3 and 7, respectively. On settlement day 8, however, the participant's end of day fail to deliver position reflects a 600 shares reduction from the prior day. This 600 shares reduction is applied first to the 400 shares increase on settlement day 7 and the excess amount of 200 shares is then applied to the 500 shares increase on settlement day 3. As a result of the 600 shares reduction at NSCC, the 400 shares increase in the participant's position that occurred on day 7 is reduced to 0 and the 500 shares increase in the participant's position that occurred on day 3 is reduced to 300. There are no further reductions in the participant's end-of-day net fail to deliver position. Thus, the 300 shares increase must be closed out at the end of the 13th settlement day following the day of the increase to 500 shares, or on the morning of the 14th settlement day following the day of the increase to 500 shares.
On settlement day 11, the participant's fail to deliver position is 10,000 shares, an increase of 4,700 shares from the prior settlement day. The participant's position then decreases by 5,000 shares on settlement day 16 as a result of the purchase to close out the 5,000 share open fail position that occurred on day 1 and that has persisted for 13 consecutive settlement days. On settlement day 18, the participant's fail to deliver position decreases to 4,700 shares, a 300 shares reduction from the prior settlement day, as a result of the purchase to close out the 300 shares open fail to deliver position that has persisted for 13 consecutive settlement days. On settlement day 26, the participant's fail to deliver position decreases to 0 shares, a 4,700 shares reduction from the prior settlement day, as a result of the purchase to close out the 4,700 shares increase in the participant's fail to deliver position that occurred on settlement day 11 and that has persisted for 13 consecutive settlement days.
Although there are reductions in the participant's fail to deliver position at NSCC on settlement days 16, 18 and 26, these reductions are as a result of the participant fulfilling its close out requirement of 5,000, 300 and 4,700 shares, respectively, at the end of the 13th settlement day and, therefore, are not allocated to prior increases in the participant's fail to deliver position.
To the extent that a reduction in a participant's fail to deliver position at NSCC is equal to, and results from, a prior close out requirement, the participant may not allocate the reduction to prior increases in its fail to deliver position because the participant has already received credit for such reduction due to the reduction being applied to the amount of the participant's close out requirement. If, however, the reduction in the participant's fail to deliver position at NSCC is greater than the amount of the participant's close out requirement, the participant may allocate any amount in excess of the close out requirement in accordance with this Question 5.8.
