Regulation SHO

Regulation SHO
Name	Regulation SHO
Issued by	Securities and Exchange Commission
Effective	2005
Related legislation	Securities Exchange Act of 1934, Sarbanes–Oxley Act
Subject	Short selling, market structure, clearance and settlement

Regulation SHO Regulation SHO is a set of rules promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934 to govern short selling practices, locate requirements, and broker-dealer close-out procedures. It was adopted amid market concerns after episodes such as the Enron scandal and controversies involving Bear Stearns and Long-Term Capital Management, aiming to enhance market integrity and reduce failure-to-deliver positions. The regulation interfaces with self-regulatory organization standards, national market system operation, and trade reporting mechanisms.

Background and Purpose

Regulation SHO was proposed and adopted by the Securities and Exchange Commission in response to post-2000s market events and legislative changes including the Sarbanes–Oxley Act. It sought to address persistent delivery failures noted by the Public Company Accounting Oversight Board and concerns raised by market participants such as investment banks and prime brokers. The rule intended to clarify obligations under the Exchange Act and align with initiatives by The Depository Trust Company and major securities exchange operators like NASDAQ and the New York Stock Exchange.

Key Provisions

Regulation SHO introduced several core elements: a "locate" requirement obligating broker-dealers to have a reasonable belief that a security can be borrowed prior to effecting a short sale, an affirmative "close-out" requirement to eliminate persistent fail-to-deliver positions, and restrictions on short selling in threshold securities identified by clearing statistics. The rule defined procedures for broker-dealer recordkeeping, marked short sale transactions consistent with order handling rules, and set out exceptions for bona fide market-making activities involving specialists and designated market makers. It also established reporting and monitoring responsibilities coordinated with self-regulatory organizations such as the Financial Industry Regulatory Authority and Options Clearing Corporation.

Impact on Short Selling and Market Practice

Implementation of the rule influenced trading strategies at hedge funds, proprietary trading firms, and institutional investors by increasing borrowing transparency and operational costs associated with locating shares. Market microstructure participants including market makers, electronic communication networks, and dark pools adjusted order-routing systems to comply with locate and marking requirements. Academics from institutions like Columbia University, Harvard University, and University of Chicago studied Regulation SHO's effects on liquidity, volatility, and price discovery, comparing outcomes with earlier regimes influenced by cases such as Knight Capital Group and Société Générale trading incidents.

Enforcement and Compliance

Enforcement actions under the rule have been pursued by the Securities and Exchange Commission and Financial Industry Regulatory Authority against broker-dealers and trading firms for failures to locate, improper marking, or inadequate close-outs, with coordination involving Department of Justice inquiries in some high-profile investigations. Compliance programs incorporated supervision by chief compliance officers within firms, surveillance by exchange regulatory staffs at the New York Stock Exchange and NASDAQ OMX Group, and remediation measures including buy-ins facilitated by The Depository Trust Company. Public enforcement matters have named entities such as major broker-dealers and investment banks, reflecting the intersection of Regulation SHO with broader securities litigation and administrative proceedings.

Criticisms and Legal Challenges

Critics argued that certain provisions created operational burdens for small broker-dealers and could impair market liquidity, with academic commentators at Stanford University and London School of Economics questioning whether the locate requirement effectively reduced abusive shorting or merely pushed activity into less regulated venues. Market participants pressed challenges in administrative proceedings and litigation invoking principles under the Administrative Procedure Act and precedent from cases such as SEC v. Chenery Corporation. Others highlighted gaps evident during crisis episodes like 2008 financial crisis and emergency actions involving short-sale bans instituted by regulatory bodies in European Union member states and Japan.

Revisions and Regulatory Developments

Since adoption, the Securities and Exchange Commission has amended aspects of the rule, adjusted threshold lists, and issued guidance responding to market events and technological changes such as high-frequency trading by firms like Getco and Virtu Financial. Interplay with rulemaking by self-regulatory organizations, updates to trade reporting standards, and international coordination with authorities like the Financial Conduct Authority and European Securities and Markets Authority have shaped ongoing refinements. Subsequent policy debates have considered additional measures inspired by reforms after the 2010 Flash Crash and legislative proposals debated in the United States Congress.

Category:United States securities regulation Category:Securities and Exchange Commission rules