Living with Reg SHO

Brokers need to stay on top of the new rules governing short sales

Over much of the past two decades, brokers handling short sales could be playing with fire. The explosion of technology and markets made it difficult to observe the rule of only executing trades on the “uptick,” that is, the sale would occur at a price that was higher than the last time the stock traded down in price. While the stock price could be coming off an increase in one marketplace, the stock might be trading down in another. That meant it was difficult to pinpoint with any certainty what trade in which marketplace made the short sale possible.

Another problem for brokers was having to worry about the short sale being covered by shares that could be easily borrowed. As the army of hedge funds grew dramatically and aggressive shorting became commonplace, the markets suffered an epidemic of “naked” shorts, as uncovered transactions are called.

Last year, though, the SEC took some giant strides in addressing both problems with the passage of Regulation SHO. The new regulation opened up the possibility of completing a short sale without worrying if it complied with the uptick or bid test, and put into affect rules requiring greater effort on the part of brokers and other participants in the securities industry to ensure that short sales were covered.

Brokers appear to be better off for the changes. If they follow the rules they can be more confident that their short sales will be made correctly. Still, brokers are responsible for the details. Whereas, in the past, they could just make an informal effort to cover a short, now, as Jerry O'Connell, a principal in Jeremiah Associates, notes, there is a formal procedure. They also have to stay on top of the rules because they are evolving. If they don't comply with the regulation they could face some stiff penalties, including fines and censure.

The “Uptick” Rule

The “uptick” rule is a work in progress. The SEC is experimenting with the number of stocks and the times they can be shorted under the new regulation. It wants to see how the rule works first before deciding if, when and how every stock can be shorted, regardless of direction all the time.

What the SEC did was put into place a one-year pilot program, which ends next month. (The stocks that can be shorted without concern for direction differences during the course of 24 hours.) During the day, the pilot stocks include 1,000 stocks from the Russell 3000 Index. They're all listed on the NYSE, NASDAQ and, in some cases, the American Stock Exchange. From the time the market closes until 8 p.m., the pilot stocks are all the stocks in the Russell 1000 Index. After 8 p.m. and until the markets open the next day, any stock can be shorted-up, down or sideways. (When a stock is not being tested it is bound by the “Uptick” and “Best bid” rules).

Covering the “Naked” Shorts

Making sure short sales are covered is all about brokers covering every base — and keeping a record of it — before executing the trade. The first and simplest thing a broker has to do is consult his or her firm's “easy to borrow” and “hard to borrow” lists.

The former is readily available to a broker, either on paper or online, and contains the names of lending institutions that his or her firm does business with regularly. Brokers need to check that the list is current because the contents change daily. If the stock a client wants to short is on it, they can proceed with their firm's normal procedures.

If not, they have to check with their back office. They are the keepers of the “hard to borrow” list. If the back office can assure the broker that they can round up the shares, only then can the broker go ahead with the short sale.

There is one other list brokers should know about. It's the Threshold Securities list that is put out daily by the NASDAQ and the NYSE. Stocks on this list have egregious problems with uncovered shorts and are essentially off limits to brokers. A broker can see it online, but the back office is going to check it routinely. When the broker calls about a stock and its on the threshold list, the back office will tell the broker they won't be able to round up the shares he needs.

One last source for the broker is the client. The broker is on delicate ground here. He may complete the short on word of the client that he will be able to borrow the shares as long as the client has never failed to put up the borrowed stock before, says Anand Ramtahal, vice president of member firm regulation at the NYSE Regulation.

It also helps if the client presents a convincing case that he or she can come up with the shares to cover the short. A client who has a personal or business relationship with owners of the shares or someone who has access to them is also an acceptable risk.

However, brokers have to tell their client, diplomatically, that they can't do the short sale until the stock can be secured if the client is the source of the borrowed stock and he's failed to deliver in the past.

Aside from any regulatory penalties, there are simple financial consequences for failing to deliver on the borrowed shares. Should 14 days pass and the stock hasn't turned up, the broker must close out the position. Any profits go to the firm. Any losses go to client. Neither outcome is likely to be good for the broker/client relationships.

Under the new rule, a firm must have a formal procedure for recording the facts of how it went about tracking down the borrowed stock. Some broker/dealers have developed software to record the facts behind “the locate,” as the search is called, while others may write down what they do. In other words, the regulators want to see a paper trail of what happened, which is good for both brokers and clients. At least then, if things go wrong, everyone knows why.

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