Capital Markets

SEC Releases Reg. SHO Amendments

In the ongoing fight against naked short-selling, the regulator proposes tightening loophole, once again.
Marie LeoneJuly 13, 2006

To stamp out the abusive practice of naked short selling, the Securities and Exchange Commission approved proposed amendments to Regulation SHO late Wednesday.

The amendments are intended to reduce the number of persistent “fails to deliver” created by traders who sell stock short without borrowing the stock first to cover the position. The amendments, if passed in their current form, will rewrite two of Reg SHO’s delivery requirements. In particular, the new regulations would eliminate the grandfather provision and narrow the options market maker exception. Reg SHO governs short-selling practices.

Naked short-selling occurs when brokers fail to deliver securities to the buyer within the typical three-day period after “selling” shares, sending IOUs through a stock clearinghouse. The increase in selling volume, unhindered by shares available to borrow, can send the stock price into a tailspin. The practice is usually considered illegal, but a loophole exists in federal securities law that gives market makers that sell short “thinly traded, illiquid stock” extra time to obtain the securities for delivery, according to the SEC.

In January 2005, the SEC enacted Reg SHO to tighten the loophole. For one thing, the rule required exchanges to provide a list of stocks that have been shorted and not delivered to a buyer for five consecutive trading days. After 13 trading days, the broker or dealer must settle the trade by buying securities “of like kind and quantity.”

The SEC claims that Reg SHO has “achieved substantial results in reducing fails to deliver,” but the commission admits that problems still persist. Many corporate executives whose companies have been the target of short-selling debacles agree that Reg SHO has not been effective, and will likely welcome the revisions.

The SEC is seeking public comment on the proposed amendments within 60 days.

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