Regulation SHO: Locate, Close-Out, and Threshold Rules

Regulation SHO is the Securities and Exchange Commission’s unified rulebook for short selling in U.S. equity markets, in effect since January 3, 2005.¹ It replaced a patchwork of older rules with standardized requirements to locate shares before selling them short, to mark every sell order accurately, to close out failed deliveries on a tight clock, and to restrict short sales in stocks that have already fallen sharply. The framework is aimed at abusive naked short selling, where sellers dump shares they never intend to deliver. Since 2005 the SEC has amended it several times, adding a price-test circuit breaker in 2010 and compressing every close-out deadline after U.S. markets moved to next-day (T+1) settlement in May 2024.

Locate Before You Sell Short

Rule 203(b)(1) is the front line. Before a broker-dealer accepts or executes a short sale order, it must have already borrowed the security, entered into a binding arrangement to borrow it, or formed reasonable grounds to believe it can be borrowed in time for settlement. The determination has to be documented in writing.² The idea is straightforward: every short sale should have a realistic path to delivering real shares on settlement day.

Most broker-dealers rely on an “Easy to Borrow” list — a regularly updated inventory of securities with enough lending supply that the locate can be presumed without a share-by-share inquiry. If a stock appears on a reasonably current list, that satisfies the obligation. For anything not on the list, the firm must contact a lending source and record where the shares are coming from.

Registered market makers get an exemption from the locate step when they are engaged in genuine market making, because forcing a locate on every quote would slow the liquidity they exist to provide.² The SEC has brought enforcement cases against firms that claimed market-maker status to skip locates while actually running directional short strategies.

How Sell Orders Must Be Marked

Every sell order for an equity security carries one of three labels: long, short, or short exempt. The marking is how the SEC tracks whether firms are actually following the locate and price-test rules. Under Rule 200(g), an order can be marked “long” only if the seller owns the security and the firm reasonably expects to have it in hand by settlement. Otherwise the order goes out as “short.”³

“Owning” a security is defined more carefully than most sellers assume. You own it if you hold title, hold an unconditional purchase contract that has not yet settled, have tendered a convertible security for conversion, have exercised an option or warrant to acquire it, or hold a physically settled futures contract with notice of settlement. Even then, ownership counts only to the extent of your net long position. If you own 500 shares and are already short 300, you are treated as owning 200.³

The “short exempt” label is reserved for trades allowed to bypass the price-test circuit breaker discussed next. It covers market makers offsetting odd-lot customer orders, certain arbitrage transactions, riskless principal trades, and qualifying volume-weighted-average-price sales, among others.⁴ Mismarking an order — sloppily or deliberately — is a serious compliance failure, because it hides whether the substantive trading rules are actually being followed.

The 10 Percent Circuit Breaker

Rule 201, added in 2010, keeps short sellers from piling onto a stock already in free fall. When a stock’s intraday price drops 10 percent or more from the prior day’s closing price, a restriction kicks in for the rest of that trading day and the entire next trading day. During that window, short sales in that security can only execute at a price above the current national best bid.⁵ The listing exchange watches the price in real time and broadcasts a notification the moment the threshold is crossed.⁴

Requiring shorts to sell above the best bid — rather than hitting the bid — prevents short flow from accelerating a decline during stress. The rule covers every equity security listed on a national exchange, whether the trade prints on an exchange or over the counter. Every trading center has to maintain written policies and procedures designed to prevent the execution or display of a prohibited short sale while the restriction is active.⁴

Some transactions still get through if properly marked “short exempt.” A broker-dealer can execute a short sale during the restriction when the price is above the national best bid at the time the order is submitted. Other exemptions cover situations where downward pressure is not the concern: arbitrage between markets, underwriter over-allotments in a securities offering, and riskless principal transactions filling a customer’s existing buy order.⁴ In each case, the firm must have a reasonable basis for concluding the trade qualifies and must maintain written policies backing that determination.

Close-Out Deadlines Under T+1 Settlement

When a short sale results in a failure to deliver on settlement day, Rule 204 forces the clearing firm to fix it quickly. The firm must purchase or borrow shares to close out the position no later than the beginning of regular trading hours on the settlement day after the settlement date.⁶ Under the T+1 cycle that took effect in May 2024, that means a short-sale fail on a standard trade has to be closed by the open of business on T+2. The old T+3 close-out window is gone.

Two situations get more time:

Long-sale fails and market-making fails. If the firm can show the failure came from a long sale (the seller owned the shares but hit a mechanical delivery snag) or from genuine market-making activity, the close-out deadline shifts to the beginning of regular trading hours on the third consecutive settlement day after the settlement date, or roughly T+4 under T+1 settlement.⁶
Restricted securities. If the seller owns the shares but they carry delivery restrictions, such as Rule 144 shares still inside their holding period, the deadline is the beginning of regular trading hours on the 35th calendar day after the trade date.⁶

The Pre-Borrow Penalty Box

A clearing firm that misses the close-out deadline lands in what the industry calls the penalty box. Formally, the SEC calls it a pre-borrow requirement. The firm, and every broker-dealer that clears through it, is barred from executing any further short sales in that security unless it has first borrowed the shares or entered into a binding arrangement to borrow them.¹ The ordinary “reasonable grounds to believe” flexibility of the locate rule is gone; the shares must be in hand or under a locked-in borrow.

The restriction lifts only after the firm purchases shares to close out the fail and that purchase clears and settles. For a stock with thin borrow supply, that can drag on for days, and the prohibition cascades to every introducing broker that clears through the penalized firm. One firm’s failure can freeze short selling in that security across multiple broker-dealers, which is precisely why firms treat close-out deadlines seriously.

Threshold Securities

The SEC uses a formal designation, threshold security, to flag stocks with persistent delivery problems. A security lands on the threshold list when it has an aggregate fail-to-deliver position at a registered clearing agency for five consecutive settlement days that totals at least 10,000 shares and at least 0.5 percent of the issuer’s shares outstanding.¹ Clearing agencies publish updated threshold lists daily, and broker-dealers are expected to monitor them.

Under Rule 203(b)(3), if a fail-to-deliver position in a threshold security persists for 13 consecutive settlement days, the clearing participant must immediately close out the position by purchasing shares. Borrowing alone will not satisfy the requirement at that stage.⁷ Once mandatory close-out is triggered, the clearing participant and any broker-dealer routing through it are barred from accepting new short-sale orders in that security without a pre-borrow. A security comes off the list once its aggregate fail-to-deliver position stays below the threshold criteria for five consecutive settlement days.

The SEC has drawn a clear line between abusive naked short selling and legitimate market making. Large-scale naked shorting floods the market with shares that do not exist, creating artificial selling pressure unrelated to the company’s fundamentals. A market maker briefly selling short to absorb a burst of buy orders and prevent an unjustified spike is doing something different, and the rules treat it that way.¹

Institutional Short Position Reporting Under Rule 13f-2

Rule 13f-2, adopted in 2023, adds a transparency layer the original Regulation SHO framework did not have. Institutional investment managers with large short positions must file Form SHO with the SEC within 14 calendar days after the end of each calendar month. The SEC plans to aggregate the data and publish it on EDGAR, showing overall short-selling activity without exposing any individual manager’s positions.⁸

Reporting thresholds depend on the type of security:

For Exchange Act-registered securities, a manager must report if its monthly average gross short position has a dollar value of $10 million or more, or represents 2.5 percent or more of the issuer’s shares outstanding.⁸
For non-registered securities, a manager must report if its gross short position reaches $500,000 or more in dollar value at the close of any settlement date during the month.⁸

There is an important caveat. Although Rule 13f-2 technically took effect on January 2, 2024, the SEC has granted temporary exemptive relief from compliance running through January 2, 2028.⁹ No institutional manager is required to file Form SHO right now. The first mandatory filings will cover the January 2028 reporting period and are due by mid-February 2028. Once reporting begins, the SEC plans to publish aggregated data — total short positions and daily net activity across all reporting managers — within one month after each reporting period, with a rolling 12-month history available on EDGAR.¹⁰

1
U.S. Securities and Exchange Commission. Key Points About Regulation SHO
2
eCFR. 17 CFR 242.203 – Borrowing and Delivery Requirements
3
eCFR. 17 CFR Part 242 – Regulation SHO – Regulation of Short Sales
4
eCFR. 17 CFR 242.201 – Circuit Breaker
5
U.S. Securities and Exchange Commission. SEC Adopts Rule to Restrict Short Selling
6
eCFR. 17 CFR 242.204 – Close-Out Requirement
7
eCFR. 17 CFR 242.203 – Borrowing and Delivery Requirements
8
eCFR. 17 CFR 240.13f-2 – Reporting by Institutional Investment Managers Regarding Gross Short Position and Activity Information
9
U.S. Securities and Exchange Commission. Order Granting Temporary Exemptive Relief From Exchange Act Rule 13f-2 and Form SHO
10
Federal Register. Short Position and Short Activity Reporting by Institutional Investment Managers