C. REGULATION SHO
11. Rules 203, 204, and 204T of Reg. SHO deal with the requirement to close-out failures to deliver. Rule 204T became effective on September 18, 2008 and Rule 204 became effective on July 31, 2009. 17 C.F.R. § 242.204.
12. Rules 204 and 204T require participants of a registered clearing agency to deliver equity securities to a registered clearing agency when delivery is due; that is, by settlement date. Settlement date is generally three days after the trade date (“T+3”). optionsXpress is a participant of a registered clearing agency.
13. For short sales, if the participant does not deliver securities by T+3 and it has a failure-to-deliver position at the clearing agency, it must purchase or borrow securities of like kind and quantity to close out the failure-to-deliver position by no later than the beginning of regular trading hours on the settlement day following the settlement date (“T+4”).
14. A participant of a clearing agency does not fulfill its requirements under Rules 204 and 204T if it enters into an arrangement with another person to purchase or borrow securities as required, and the participant knows or has reason to know that the other person will not deliver securities in settlement of the purchase or borrow. 17 C.F.R. § 242.204(f); 73 FR 61706, 61714-61715 n.78 (Oct. 17, 2008).
15. Where a participant of a clearing agency subject to the close-out requirement purchases or borrows securities on the applicable close-out date and on that same date engages in sale transactions that can be used to re-establish or otherwise extend the participant’s fail position, and for which the participant is unable to demonstrate a legitimate economic purpose, the participant will not be deemed to have satisfied the close-out requirement. 74 Fed. Reg. 38266, 38272 n.82 (July 31, 2009).
16. To satisfy the close-out requirements under Rules 204 and 204T, a clearing broker must take affirmative action to close out the failure-to-deliver position by purchasing or borrowing securities. 73 Fed. Reg. at 61710-11.
17. In narrowly limited instances, Rules 204 and 204T provide credit for certain activity conducted by a broker-dealer prior to the occurrence of the fail. Under Rule 204’s pre-fail credit provision, a broker-dealer can meet its close-out obligation by purchasing or borrowing securities after the trade date but no later than the end of regular trading hours on the settlement date of the transaction if (1) the purchase or borrow is bona fide; (2) the purchase or borrow is of a quantity of securities sufficient to cover the entire amount of the broker-dealer’s failure to deliver; and (3) the broker-dealer can demonstrate that it has a net flat or net long position on its books and records on the day of the purchase or borrow. 17 C.F.R. § 242.204(e). Rule 204T contained a similar provision, however, the broker-dealer could not meet the requirements of the provision unless it purchased the shares. 17 C.F.R. § 242.204T(e).
18. Under Rule 10b-21 of the Exchange Act, it is a manipulative or deceptive device or contrivance for any person to submit an order to sell an equity security if such person deceives a broker or dealer, a participant of a registered clearing agency, or a purchaser about its intention or ability to deliver the security on or before the settlement date, and such person fails to deliver the security on or before settlement date.
19. Rule 10b-21 and Rules 204 and 204T were adopted, among other things, to address abusive “naked” short selling and failures to deliver. Abusive “naked” short selling generally refers to selling short without having stock available for delivery and failing to deliver stock within the standard three-day settlement cycle.
20. Sellers sometimes intentionally fail to deliver securities as part of a scheme to manipulate the price of a security, or possibly to avoid borrowing costs associated with short sales, especially when the costs of borrowing stock are high. Failures to deliver, however, can negatively affect purchasers of stock by depriving them of the benefits of ownership, such as voting and lending, and create a misleading impression of the market for an issuer’s stock.
