The Basics

What is a Threshold Security?

Threshold securities are equity securities that have an aggregate fail to deliver position for:

- Five consecutive settlement days at a registered clearing agency (e.g., National Securities Clearing Corporation (NSCC));

- Totaling 10,000 shares or more; and

- Equal to at least 0.5% of the issuer's total shares outstanding.

Threshold securities only include issuers registered or required to file reports with the Commission ("reporting companies"). Therefore, securities of issuers that are not registered or required to file reports with the Commission, which includes the majority of issuers on the Pink Sheets,18 cannot be threshold securities. This is because the SROs need to look to the total outstanding shares of the issuer in order to calculate whether or not the securities meet the definition of a "threshold security." For non-reporting companies, reliable information on total outstanding shares is difficult to determine.

"Naked" Short Sales

In a "naked" short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period. As a result, the seller fails to deliver securities to the buyer when delivery is due (known as a "failure to deliver" or "fail").

Failures to deliver may result from either a short or a long sale. There may be legitimate reasons for a failure to deliver. For example, human or mechanical errors or processing delays can result from transferring securities in physical certificate rather than book-entry form, thus causing a failure to deliver on a long sale within the normal three-day settlement period. A fail may also result from naked short selling. For example, market makers who sell short thinly traded, illiquid stock in response to customer demand may encounter difficulty in obtaining securities when the time for delivery arrives.

Naked short selling is not necessarily a violation of the federal securities laws or the Commission's rules. Indeed, in certain circumstances, naked short selling contributes to market liquidity. For example, broker-dealers that make a market in a security generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers. Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market. This may occur, for example, if there is a sudden surge in buying interest in that security, or if few investors are selling the security at that time. Because it may take a market maker considerable time to purchase or arrange to borrow the security, a market maker engaged in bona fide market making, particularly in a fast-moving market, may need to sell the security short without having arranged to borrow shares. This is especially true for market makers in thinly traded, illiquid stocks such as securities quoted on the OTC Bulletin Board,5 as there may be few shares available to purchase or borrow at a given time.

Regulation SHO

Compliance with Regulation SHO began on January 3, 2005. Regulation SHO was adopted to update short sale regulation in light of numerous market developments since short sale regulation was first adopted in 1938. Some of the goals of Regulation SHO include:

Establishing uniform "locate" and "close-out" requirements in order to address problems associated with failures to deliver, including potentially abusive "naked" short selling.
Locate Requirement: Regulation SHO requires a broker-dealer to have reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due before effecting a short sale order in any equity security.6 This "locate" must be made and documented prior to effecting the short sale.
"Close-out" Requirement: Regulation SHO imposes additional delivery requirements on broker-dealers for securities in which there are a relatively substantial number of extended delivery failures at a registered clearing agency7 ("threshold securities"). For instance, with limited exception, Regulation SHO requires brokers and dealers that are participants of a registered clearing agency8 to take action to "close-out" failure-to-deliver positions ("open fails") in threshold securities that have persisted for 13 consecutive settlement days.9 Closing out requires the broker or dealer to purchase securities of like kind and quantity. Until the position is closed out, the broker or dealer and any broker or dealer for which it clears transactions (for example, an introducing broker)10 may not effect further short sales in that threshold security without borrowing or entering into a bona fide agreement to borrow the security (known as the "pre-borrowing" requirement).
Temporarily suspending Commission and SRO11 short sale price tests12 in a group of securities to evaluate the overall effectiveness and necessity of such restrictions. The Commission will study the impact of relaxing the price tests for a period of one year.13
Creating uniform order marking requirements for sales of all equity securities. This means that orders you place with your broker-dealer must be marked "long," "short," or "short exempt."