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Broker-dealers are ultimately responsible for ensuring that short sales, including "naked" short sales, are covered (settled) through the delivery of securities. While the initial obligation falls on the seller to deliver the shares, regulations place specific requirements and liabilities on broker-dealers to prevent and resolve failures to deliver.
Here are the key points regarding broker-dealer responsibility:
"Locate" Requirement: Under the SEC's Regulation SHO, before executing a short sale, an executing or order-entry broker-dealer is generally required to have reasonable grounds to believe that the security can be borrowed and delivered by the settlement date. This "locate" rule aims to prevent most naked short sales from occurring in the first place.
Fails-to-Deliver (FTDs) and Close-out Requirements: If a short sale results in an FTD (the shares are not delivered by the standard two-day settlement date, T+2), the broker-dealer is subject to specific close-out requirements, especially if the stock is a "threshold security" (a security with a large, persistent FTD position).
Mandatory Buy-ins: For threshold securities, if an FTD position persists for 13 consecutive settlement days, the broker (or its clearinghouse participant) must close out the position by purchasing securities of like kind and quantity in the open market. After this period, the broker-dealer cannot accept further short sale orders in that security without pre-borrowing the shares, until the FTD is resolved.
Anti-Fraud Liability: The SEC also adopted Rule 10b-21, an anti-fraud rule, which clarifies the liability of sellers (including broker-dealers trading for their own accounts) who deceive others about their ability or intention to deliver securities by the settlement date and subsequently fail to deliver.
Reliance on Customer Assurances: While a broker-dealer may rely on a customer's assurance that they have a valid share locate, they must have a reasonable belief in that assurance. If a customer misrepresents their ability to deliver shares, the customer is liable, but the broker-dealer still faces regulatory scrutiny and potential liability if they did not have reasonable grounds for belief.
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