SEC Grants COVID-19-Related Exemptions from Short Sale Rules

August 31, 2020
by Larry E. Bergmann

In response to a request from the Securities Industry and Financial Markets Association (“SIFMA”), on August 25, 2020, the Securities and Exchange Commission (“SEC”) granted conditional and temporary exemptions from the “locate” and “close-out” requirements of Rule 203(b)(2)(ii) and Rule 204(a) and (b), respectively, of Regulation SHO.1   SIFMA’s request relates to intermittent suspensions of physical delivery securities processing services at the Depository Trust Company (“DTC”) that are resulting from the effects of COVID-19.  SIFMA stated that, as a result of such processing interruptions, there are likely to be delays in settlement of sales of equity securities that the seller was “deemed to own” and for which settlement is dependent on the delivery of physical certificates (referred to as “owned physical securities”).2

Rule 203(b)(2): “locates”

A person is “deemed to own” a security if one of the provisions of Rule 200(b) of Regulation SHO applies.  Typical examples include: the person has title to the security; or has exercised a convertible security for the underlying equity security.3   In some situations, the seller of the equity security or its broker-dealer may not be able to obtain the security in time for settlement of the sale transaction through no fault of the seller or the broker-dealer.  In that case, the sale transaction must be marked “short.”4   As a consequence of the “short” marking, the seller’s broker-dealer must obtain a “locate” for the quantity sold, unless an exception is available.5   The focus in the Order is on the exception in Rule 203(b)(2)(ii) which provides that the broker-dealer need not obtain a locate if the seller is deemed to own the security and intends to deliver the security as soon as all restrictions on delivery have been removed.  However, if the seller has not delivered the security within 35 days after the trade date, the broker-dealer must borrow securities or close out the short position by purchasing securities of like kind and quantity.

The SEC is of the view that requiring compliance with the 35-day requirement in circumstances when COVID-19-related processing interruptions at DTC prevent the seller from delivering the securities within that timeframe “may cause undue burdens on various market participants, particularly in the context of physical securities for which lending markets are small or nonexistent.”  Accordingly, the temporary exemption from the “locate” requirement in Rule 203(b) and the 35-day delivery requirement in Rule 203(b)(2)(ii) with respect to a short sale of an owned physical security applies where the broker-dealer:

  1. Determines that the sale is a sale of an owned physical security that the seller is “deemed to own;”
  2. Maintains contemporaneous records reflecting reliance on the Order; and
  3. Provides notice on its website of its reliance on the Order.6

Rule 204: “closeouts”

Rule 204 requires a participant of a registered clearing agency to “close out” a failure to deliver in an equity security within the timeframes specified in Rule 204(a).  An exception from that requirement is provided in Rule 204(a)(2) where the failure to deliver relates to a sale of a security that the seller was “deemed to own” and intends to deliver as soon as all restrictions on delivery have been removed.  In that case, if the fail to deliver position relating to the sale persists for 35 calendar days after the trade date (“T+35”), the participant must close out the position immediately by purchasing securities of like kind and quantity.

 Moreover, if a participant does not close out a fail to deliver position as required by Rule 204(a) (including failing to satisfy the T+35 provision), the participant becomes subject to the “penalty box” provision of Rule 204(b).  In that situation, the participant may not effect a short sale in the subject security without first borrowing, or arranging to borrow, the security until the participant closes out the fail to deliver position by purchasing securities of like kind and quantity and the purchase has cleared and settled at a registered clearing agency.

Similar to the “locate” context, SIFMA stated that “due to the inaccessibility of the physical certificates resulting from DTC’s intermittent suspension of physical securities processing, there may be instances in which sales of owned physical securities may result in a [fail to deliver] position that persists beyond the T+35 close-out timeframe.”  On that basis, the SEC granted relief from Rule 204(a) and (b) with respect to a fail to deliver position resulting from the sale of an owned physical security where the participant:

  1. Determines and documents that the fail to deliver position resulted from a sale of an owned physical security that a person is “deemed to own;”
  2. Checks DTCC systems on a daily basis to determine when the owned physical security is available for settlement;
  3. Delivers the owned physical security as soon as possible and, in any event, delivers the security or closes out the fil to deliver position by purchasing or borrowing securities of like kind and quantity no later than the beginning of regular trading hours on the fourth settlement day following the date on which the participant determines that the owned physical security is available for settlement;
  4. Reflects in its books and records that it made delivery of the owned physical securities within the time periods required by the Order;
  5. Maintains contemporaneous records reflecting reliance on the Order; and
  6. Provides notice on its website until it ceases to rely on the Order.7

The Order expires on December 31, 2020, unless extended and “applies only in the context of suspensions of physical securities processing resulting directly from ongoing concerns related to COVID-19."8


1  Release 34-89659 (August 25, 2020) (“Order”), https://www.sec.gov/rules/exorders/2020/34-89659.pdf.  The Order was issued by the Division of Trading and Markets pursuant to delegated authority.  All rule references herein are to Regulation SHO.
2  The SEC analogized the present impact on securities market participants to the processing delays that resulted from Hurricane Sandy in 2012 and noted that similar relief was granted then. See Release 34-68419 (December 12, 2012),  https://www.sec.gov/rules/exorders/2012/34-68419.pdf.
3  Rule 200(b)(1) and (3), respectively.
4  See Rule 200(g)(1)(ii).
5  Rule 203(b)(2). A “locate” means that the broker-dealer has reasonable, documented, grounds to believe that the security can be borrowed so that it can be delivered on the date that delivery is due.
6  This is an unusual requirement that was not included in the analogous Hurricane Sandy relief.  See n.2 above.
7  The conditions largely track the Hurricane Sandy relief, with the exception of Condition 6.
8  Order n.17.