Misconceptions

A Short Selling FAQ by the SEC also cites common misconceptions about the practice, such as the belief that naked short sale transactions cause the number of shares trading to exceed the number of shares outstanding. Another source of confusion is that the U.S. clearance and settlement system, and specifically the Continuous Net System (CNS) produces “phantom” or “counterfeit” securities by accounting for fails to deliver. The SEC states that naked short selling has no effect on an issuer’s total shares outstanding and that NSCC’s CNS system does not create counterfeit shares. “Fails-todeliver can occur for a number of reasons on both long and short sales,” the SEC said. “Therefore, fails-to-deliver are not necessarily the result of short selling, and are not evidence of abusive short selling or ‘naked’ short selling.”(59)

Regulation SHO includes a number of requirements “designed to target problematic failures to deliver.”(60) The regulation requires that, before effecting a short sale in any equity security, a broker-dealer must either have borrowed or arranged to borrow the security or have “reasonable grounds to believe” that the security being shorted can be borrowed so that it can be delivered on the date delivery is due (the “locate requirement”).(61)

Regulation SHO includes the following exceptions from the requirement that a broker or dealer borrow or arrange to either borrow or locate an equity security before effecting a short sale:

Broker or dealer accepting a short sale order from another registered broker-dealer or dealer that is required to comply with such requirements (unless the broker or dealer relying on the exception contractually undertook the responsibility to comply).
Short sales effected by a market maker(62) in connection with bona-fide market making activities in the security for which the exception is claimed.(63)
Any sale of a security that a person is “deemed to own” under Rule 200 of Regulation SHO,(64) 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.(65)
Transactions in security futures.

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Misconceptions

59. SEC, Frequently Requested FOIA Document, op. cit., footnote 56.

60. Ibid.

61. See Rule 203(b) of Regulation SHO. 17 CFR 6242.203(b).

62. A “market maker” is a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers.

63. “Broker-dealers engaged in bona-fide market making are excepted from having to borrow or arrange to borrow shares due to their potential need to facilitate customer orders associated with complying with Regulation SHO in fast-moving markets without possible delays associated with complying with Regulations SHO.” SEC, Key Points, op cit.

64. Rule 200 of Regulation SHO, 17 CFR 242.200, specifies which securities a person is “deemed to own.” Securities sold pursuant to Rule 144 of the Securities Act of 1933 are formerly restricted securities that a seller is “deemed to own,” as defined by Rule 200(a) of Regulation SHO.

65. If the person has not delivered such a security within 35 days after the trade date, the broker-dealer that effected the sale must borrow securities or close out the short position by purchasing securities of like kind and quality.