SEC Changes Short-Selling Rules

June 2007

Short selling is the practice of borrowing stock (usually from a broker-dealer or institutional investor), then selling it in anticipation that the stock price will go down. Because the short-seller has borrowed the stock, he benefits when the stock price declines, allowing the stock to be subsequently purchased (and the borrowed security returned) at a lower price. Like a normal transaction, the short-seller’s profit is the spread between the higher price of the sale, and the lower price when the security is purchased – it simply happens in the reverse order with a short-sale.

The Securities and Exchange Commission (SEC) voted last week to end short selling restrictions that have existed since 1938. Investors seeking to sell a security that they do not own will no longer be prevented from doing so because the share price is dropping. Under the “tic-test,” short sellers previously needed to wait to sell until the price increased in the most recent transaction.

An experiment in lifting the tic-test for certain securities showed there was little reason for continuing the tic-test.

The SEC also modified Regulation SHO. The SEC adopted Regulation SHO in 2004, with a January 2005 compliance date. The change affects “naked shorting,” which is an attempt to perform a short sale without having first borrowed the stock.

A naked short-seller fails to make delivery within the standard three-day settlement period. To address problems associated with failures to deliver, Regulation SHO states that a broker-dealer can accept a short sale order only if he has reasonable grounds to believe that the security can be borrowed by the time the sold security must be delivered (three days). Reasonableness is determined based on the facts and circumstances of the particular transaction.

Despite the requirement that there be a reasonable expectation that the security can be borrowed, sold securities are sometimes not delivered. Usually this occurs because of human/clerical errors, but naked short selling has also been connected to “pump and dump” stock manipulation. If this happens a lot for a specific security, then a threshold for regulation is triggered and the naked short position must be closed. Specifically, a threshold security is one in which there is an aggregate failure to deliver a borrowed security for five consecutive settlement days of at least 10,000 shares that is equal to at least 0.5% of the issue's total shares outstanding. Where a fail-to-deliver position in threshold securities persists for 13 consecutive settlement days, the position must be closed. However, this rule has not previously applied to positions established prior to the stock becoming a threshold stock.

Under the modifications to Regulation SHO, grandfathered naked short positions (i.e., those which began before a security became classified as “threshold”) also must be closed once a security becomes a threshold stock.

Defenders of naked shorting claim that this provides a legitimate market force against overhyped or fraudulent micro-cap stocks. Regardless of this defense, naked short selling will be further reduced.


Fulcrum Inquiry appraises companies, stocks, and intangible business assets. Because of this expertise, we regularly assist with litigation involving alleged stock fraud and manipulation.