SEC Issues Important New Reg SHO FAQs Concerning "Long" and "Short" Order Marking and Locates for Foreign Broker-Dealers

Advisory | August 31, 2009

On August 28, the staff of the Securities Exchange Commission’s Division of Trading and Markets (“Staff”) issued three new frequently asked questions (“FAQs”) relative to Regulation SHO. New Questions 2.4 and 2.5 provide guidance on the proper order marking of sales as either “long” or “short.” New Question 4.6 provides guidance on locates for orders involving a foreign broker-dealer.

New FAQ 2.4—Splitting Orders to Accommodate Order Marking

In new FAQ 2.4, the Staff addresses the order marking requirements for situations in which a seller has a net long position for only a portion of a sell order. For example, if a seller wishes to sell 600 shares but has an inventory of only 500 shares, the FAQ requires the broker-dealer to split the order into two sell orders: one for 500 shares marked “long” and one for 100 shares marked “short.”

The Staff noted that Rule 200(g) of Regulation SHO under the Securities Exchange Act of 1934 (“Exchange Act”) requires a broker-dealer to mark “long” only those sale orders where the broker-dealer is deemed to own the security being sold. Further, Rule 17a-3 under the Exchange Act requires a broker-dealer to make and keep records of each order showing the terms and conditions of the order. The Staff has interpreted both Rule 200(g) and Rule 17a-3 to require a broker-dealer to split the original order into two orders to comply with these requirements.

New FAQ 2.5—Including Pending Orders in Calculating Long and Short Positions

In new FAQ 2.5, the Staff provides guidance on order marking when a broker-dealer has entered sell orders that have not yet been executed. The Staff states that where a seller is net long 1,000 shares and simultaneously enters multiple orders to sell 1,000 shares, only one such order will constitute a long sale. Accordingly, the additional sell orders must be marked “short.”

The Staff’s rationale for this interpretation is based on the premise that the broker-dealer may no longer reasonably expect that delivery can be made by settlement date on additional orders to sell the same shares. Rule 200(g)(1) of Regulation SHO states that for an order to sell to be marked “long,” the security to be delivered must be “in the physical possession or control of the broker or dealer” or the broker-dealer must have “reasonably expected that the security will be in the physical possession or control of the broker or dealer no later than the settlement of the transaction.”

The FAQ is silent on whether simultaneously entering multiple buy orders should also be counted toward the broker-dealer’s overall long or short position for purposes of order marking. It would seem that if the broker-dealer has a reasonable expectation that, because of multiple buy orders, the security will be in the physical possession or control of the broker or dealer no later than the settlement of the transaction, the pending buy orders also should be included in calculating long and short positions. To count only pending sell orders and not pending buy orders would have the effect of artificially increasing the number of sell short orders for a broker-dealer. However, the Staff has not addressed this issue in the FAQ.

New FAQ 4.6—Locates for Foreign Broker-Dealers

New FAQ 4.6 clarifies that U.S. broker-dealers may only rely on the “broker to broker” exception for U.S. registered broker-dealers. Rule 203(b)(1)(ii) of Regulation SHO provides that a broker-dealer may accept a short sale order if the broker-dealer has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. Rule 203(b)(2)(i) provides an exception to this “locate” requirement when the short sale order is received from a “registered broker or dealer.” According to the Staff, this “broker to broker” exception applies only to transactions between broker-dealers registered in the United States under Section 15(a) of the Exchange Act.

Click here to view the FAQs.

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