• <div class="header-image" style="background-image: url(/live/image/gid/4/2897_V6N9_Header.rev.1540219621.jpg);">​</div><div class="header-background-color"/>

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.

 

Student Blog Disclaimer
  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Penn Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

 

PENN WHARTON PPI
RESOURCE SPOTLIGHT:

  • <h3>Federal Reserve Economic Data (FRED®)</h3><p><strong><img width="180" height="79" alt="" src="/live/image/gid/4/width/180/height/79/481_fred-logo.rev.1407788243.jpg" class="lw_image lw_image481 lw_align_right" data-max-w="222" data-max-h="97"/>An online database consisting of more than 72,000 economic data time series from 54 national, international, public, and private sources.</strong> FRED®, created and maintained by Research Department at the Federal Reserve Bank of St. Louis, goes far beyond simply providing data: It combines data with a powerful mix of tools that help the user understand, interact with, display, and disseminate the data.</p><p> Quick link to data page: <a href="http://research.stlouisfed.org/fred2/tags/series" target="_blank">http://research.stlouisfed.org/fred2/tags/series</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>National Bureau of Economic Research (Public Use Data Archive)</h3><p><img width="180" height="43" alt="" src="/live/image/gid/4/width/180/height/43/478_nber.rev.1407530465.jpg" class="lw_image lw_image478 lw_align_right" data-max-w="329" data-max-h="79"/>Founded in 1920, the <strong>National Bureau of Economic Research</strong> is a private, nonprofit, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works. The NBER is committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.</p><p> Quick Link to <strong>Public Use Data Archive</strong>: <a href="http://www.nber.org/data/" target="_blank">http://www.nber.org/data/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>Congressional Budget Office</h3><p><img width="180" height="180" alt="" src="/live/image/gid/4/width/180/height/180/380_cbo-logo.rev.1406822035.jpg" class="lw_image lw_image380 lw_align_right" data-max-w="180" data-max-h="180"/>Since its founding in 1974, the Congressional Budget Office (CBO) has produced independent analyses of budgetary and economic issues to support the Congressional budget process.</p><p> The agency is strictly nonpartisan and conducts objective, impartial analysis, which is evident in each of the dozens of reports and hundreds of cost estimates that its economists and policy analysts produce each year. CBO does not make policy recommendations, and each report and cost estimate discloses the agency’s assumptions and methodologies. <strong>CBO provides budgetary and economic information in a variety of ways and at various points in the legislative process.</strong> Products include baseline budget projections and economic forecasts, analysis of the President’s budget, cost estimates, analysis of federal mandates, working papers, and more.</p><p> Quick link to Products page: <a href="http://www.cbo.gov/about/our-products" target="_blank">http://www.cbo.gov/about/our-products</a></p><p> Quick link to Topics: <a href="http://www.cbo.gov/topics" target="_blank">http://www.cbo.gov/topics</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>USDA Nutrition Assistance Data</h3><p><img width="180" height="124" alt="" src="/live/image/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg" class="lw_image lw_image485 lw_align_right" srcset="/live/image/scale/2x/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg 2x, /live/image/scale/3x/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg 3x" data-max-w="1233" data-max-h="850"/>Data and research regarding the following <strong>USDA Nutrition Assistance</strong> programs are available through this site:</p><ul><li>Supplemental Nutrition Assistance Program (SNAP) </li><li>Food Distribution Programs </li><li>School Meals </li><li>Women, Infants and Children </li></ul><p> Quick link: <a href="http://www.fns.usda.gov/data-and-statistics" target="_blank">http://www.fns.usda.gov/data-and-statistics</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>MapStats</h3><p> A feature of FedStats, MapStats allows users to search for <strong>state, county, city, congressional district, or Federal judicial district data</strong> (demographic, economic, and geographic).</p><p> Quick link: <a href="http://www.fedstats.gov/mapstats/" target="_blank">http://www.fedstats.gov/mapstats/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>Federal Aviation Administration: Accident & Incident Data</h3><p><img width="100" height="100" alt="" src="/live/image/gid/4/width/100/height/100/80_faa-logo.rev.1402681347.jpg" class="lw_image lw_image80 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/100/height/100/80_faa-logo.rev.1402681347.jpg 2x, /live/image/scale/3x/gid/4/width/100/height/100/80_faa-logo.rev.1402681347.jpg 3x" data-max-w="550" data-max-h="550"/>The NTSB issues an accident report following each investigation. These reports are available online for reports issued since 1996, with older reports coming online soon. The reports listing is sortable by the event date, report date, city, and state.</p><p> Quick link: <a href="http://www.faa.gov/data_research/accident_incident/" target="_blank">http://www.faa.gov/data_research/accident_incident/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>National Center for Education Statistics</h3><p><strong><img width="400" height="80" alt="" src="/live/image/gid/4/width/400/height/80/479_nces.rev.1407787656.jpg" class="lw_image lw_image479 lw_align_right" data-max-w="400" data-max-h="80"/>The National Center for Education Statistics (NCES) is the primary federal entity for collecting and analyzing data related to education in the U.S. and other nations.</strong> NCES is located within the U.S. Department of Education and the Institute of Education Sciences. NCES has an extensive Statistical Standards Program that consults and advises on methodological and statistical aspects involved in the design, collection, and analysis of data collections in the Center. To learn more about the NCES, <a href="http://nces.ed.gov/about/" target="_blank">click here</a>.</p><p> Quick link to NCES Data Tools: <a href="http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4" target="_blank">http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4</a></p><p> Quick link to Quick Tables and Figures: <a href="http://nces.ed.gov/quicktables/" target="_blank">http://nces.ed.gov/quicktables/</a></p><p> Quick link to NCES Fast Facts (Note: The primary purpose of the Fast Facts website is to provide users with concise information on a range of educational issues, from early childhood to adult learning.): <a href="http://nces.ed.gov/fastfacts/" target="_blank">http://nces.ed.gov/fastfacts/#</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>NOAA National Climatic Data Center</h3><p><img width="200" height="198" alt="" src="/live/image/gid/4/width/200/height/198/483_noaa_logo.rev.1407788692.jpg" class="lw_image lw_image483 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/200/height/198/483_noaa_logo.rev.1407788692.jpg 2x, /live/image/scale/3x/gid/4/width/200/height/198/483_noaa_logo.rev.1407788692.jpg 3x" data-max-w="954" data-max-h="945"/>NOAA’s National Climatic Data Center (NCDC) is responsible for preserving, monitoring, assessing, and providing public access to the Nation’s treasure of <strong>climate and historical weather data and information</strong>.</p><p> Quick link to home page: <a href="http://www.ncdc.noaa.gov/" target="_blank">http://www.ncdc.noaa.gov/</a></p><p> Quick link to NCDC’s climate and weather datasets, products, and various web pages and resources: <a href="http://www.ncdc.noaa.gov/data-access/quick-links" target="_blank">http://www.ncdc.noaa.gov/data-access/quick-links</a></p><p> Quick link to Text & Map Search: <a href="http://www.ncdc.noaa.gov/cdo-web/" target="_blank">http://www.ncdc.noaa.gov/cdo-web/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>Internal Revenue Service: Tax Statistics</h3><p><img width="155" height="200" alt="" src="/live/image/gid/4/width/155/height/200/486_irs_logo.rev.1407789424.jpg" class="lw_image lw_image486 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/155/height/200/486_irs_logo.rev.1407789424.jpg 2x" data-max-w="463" data-max-h="596"/>Find statistics on business tax, individual tax, charitable and exempt organizations, IRS operations and budget, and income (SOI), as well as statistics by form, products, publications, papers, and other IRS data.</p><p> Quick link to <strong>Tax Statistics, where you will find a wide range of tables, articles, and data</strong> that describe and measure elements of the U.S. tax system: <a href="http://www.irs.gov/uac/Tax-Stats-2" target="_blank">http://www.irs.gov/uac/Tax-Stats-2</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>HUD State of the Cities Data Systems</h3><p><strong><img width="200" height="200" alt="" src="/live/image/gid/4/width/200/height/200/482_hud_logo.rev.1407788472.jpg" class="lw_image lw_image482 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/200/height/200/482_hud_logo.rev.1407788472.jpg 2x, /live/image/scale/3x/gid/4/width/200/height/200/482_hud_logo.rev.1407788472.jpg 3x" data-max-w="612" data-max-h="613"/>The SOCDS provides data for individual Metropolitan Areas, Central Cities, and Suburbs.</strong> It is a portal for non-national data made available through a number of outside institutions (e.g. Census, BLS, FBI and others).</p><p> Quick link: <a href="http://www.huduser.org/portal/datasets/socds.html" target="_blank">http://www.huduser.org/portal/datasets/socds.html</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>The World Bank Data (U.S.)</h3><p><img width="130" height="118" alt="" src="/live/image/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg" class="lw_image lw_image484 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg 2x, /live/image/scale/3x/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg 3x" data-max-w="1406" data-max-h="1275"/>The <strong>World Bank</strong> provides World Development Indicators, Surveys, and data on Finances and Climate Change.</p><p> Quick link: <a href="http://data.worldbank.org/country/united-states" target="_blank">http://data.worldbank.org/country/united-states</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>The Penn World Table</h3><p> The Penn World Table provides purchasing power parity and national income accounts converted to international prices for 189 countries/territories for some or all of the years 1950-2010.</p><p><a href="https://pwt.sas.upenn.edu/php_site/pwt71/pwt71_form.php" target="_blank">Quick link.</a> </p><p>See all <a href="/data-resources/">data and resources</a> »</p>