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Deciphering Dodd-Frank: The SEC’s Renewed Focus on Short Selling

October 16, 2014
Following the recent financial crisis, Congress enacted the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, the country’s most sweeping financial reform since the Great Depression. While the law’s scope is extremely broad, one niche area in particular concerns a fundamental market vulnerability that stems from a widespread trading practice: short selling.

By Ryan Streit, Penn Law ’16

Specifically, Dodd-Frank amended Section 10 of the Securities and Exchange Act of 1934 (Exchange Act) to strengthen the Securities and Exchange Commission’s (SEC) ability to pursue those who engage in abusive “naked short sales”. A naked short sale occurs when an investor sells a security he or she does not own and has not yet borrowed.[1]  Although this practice is not per se illegal, an investor can unlawfully abuse it by using such sales to artificially inflate the supply of the security’s shares, thus causing its price to decline. The investor then purchases the security at the suppressed price and pockets the difference between the initial selling price and later buying price. While the law provides a much needed foundation for addressing potential market vulnerabilities, there remains confusion regarding what the SEC had done previously regarding naked short sales, or what Dodd-Frank has really tried to accomplish in this area.

The U.S. Securities and Exchange Commission Headquarters - from Wikimedia Commons.The SEC originally adopted Regulation SHO (Reg SHO), codified at 17 C.F.R. §§ 242.203 and 242.204, in 2004 to prevent abusive naked short sales. Under Reg SHO, a broker need not own nor borrow a security prior to lending it for use in a short sale. However, the regulation did institute two borrowing requirements for naked short sales: (1) a broker must have “reasonable grounds” for believing it will be able to borrow the shorted security prior to the delivery date, and; (2) a broker must document those grounds.[2]

To satisfy these requirements, a broker can rely on “easy-to-borrow” lists published by the broker-dealers themselves, as long as they are less than 24 hours old.[3] If multiple failures to deliver occur for a security on an easy-to-borrow list, however, it may no longer be presumed reasonable for a broker to rely on that list, regardless of its age.[4] A broker may also provide documentation showing that previous borrowings by the client resulted in on-time deliveries, or it may reasonably rely on a client’s assurance that a “locate” can be obtained from another source in time to deliver.[5] Where a broker knows or has reason to know that a client has a history of delivery failures, though, reliance on such assurances would not be considered reasonable.[6] Further, the fact that a security is not on a “hard-to-borrow” list does not by itself establish reasonable grounds under Reg SHO.[7] Consequently, Reg SHO established that a broker must demonstrate both that it has relied on up-to-date lists and that the security is readily available.

Next, a standard “T+3” settlement rule applies to almost all securities transactions, meaning that a broker must deliver the traded security by the third business day following the trade date. 17 C.F.R. § 240.15c6–1(a) (2014). The main exceptions to this requirement are transactions involving government securities and stock options, which must be closed out the business day after the trade date. Id. Reg SHO contains a close-out requirement which kicks in when a failure to deliver reaches “T+13”, or 10 days after the initial settlement date, and which applies only to “threshold securities.” 17 C.F.R. § 242.203(b)(3) (2008). Threshold securities are any equity security for which there is failure to deliver of at least five consecutive settlement days of a proportion of the security’s total outstanding shares significant enough to impact the broader market for that security. 17 C.F.R. § 242.203(c)(6) (2008). Reg SHO then provides that if a broker has an open failure of 13 days or more, that broker is barred from engaging in or facilitating any short sales of that threshold security until it actually borrows or arranges to borrow the security prior to the new transaction.[8]

Wall Street & Broadway - public domain image.As originally adopted, Reg SHO provided “grandfather” and “options market-maker” exceptions to this close-out requirement. The former exempted transactions in threshold securities that were entered into prior to the enactment of Reg SHO, while the latter exempted brokers who engaged in bona fide market-making activity by using short sales to hedge options positions established before a stock became a threshold security.[9] Both exceptions were eliminated, however, in Reg SHO’s final 2008 amendments.[10]

Overall, Reg SHO provides that naked short sales are permissible so long as the broker does not abuse them by artificially suppressing the price of the shorted security with no intention of actually delivering by the settlement date. Dodd-Frank then simply gave the SEC more bite in its efforts to enforce Reg SHO, creating a cause of action under the Exchange Act and reining in the latitude brokers have so far enjoyed in engaging in trading practices that have the potential to manipulate the market. Abusive naked short sales take advantage of an otherwise legitimate means for brokers to facilitate greater trading volume, and in turn, create more efficient markets. By rooting out such a manipulative practice, Reg SHO and Dodd-Frank will thus continue to aid the SEC in its mission to protect America’s investors.


The United States Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its current or former employees. This article was not prepared by the author in connection with his/her employment by the Commission. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.

[1] See “Naked” Short Selling Antifraud Rule,Exchange Act Release No. 34-58774, 94 SEC Docket 1095 (Oct. 14, 2008), available at http://www.sec.gov/rules/final/2008/34-58774.pdf

[2] Rule 203(b)(1)(ii)-(iii), supra note 1.

[3] Perrie Weiner & Edward Totino, New SEC Rules Change Regulation of Short Sales, Mondaq (Aug. 9, 2004), available at http://www.mondaq.com/unitedstates/x/28029/New+SEC+Rules+Change+Regulation+Of+Short+Sales

[4] Id.

[5] Short Sales, 69 Fed. Reg. 48,014, n.58 (Aug. 6, 2004).

[6] Id.

[7] Id. at 48,014.

[8] Rule 203(b)(3), supra note 2.

[9] See Amendments to Regulation SHO, Exchange Act Release No. 34-58775 (Oct. 14, 2008), available at https://www.sec.gov/rules/final/2008/34-58775.pdf

[10] Id.


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