Regulation SHO

Regulation SHO is an SEC rule that regulates short selling. It requires brokers to have a reasonable belief that shares can be borrowed before allowing a customer to short a stock, and imposes penalties (buyins) if the short seller fails to deliver shares within a specified time. Reg SHO was meant to prevent “naked short selling” — selling shares that do not exist.

The locate rule and borrowing

Short selling requires borrowing shares — you borrow 100 shares from a lender (typically another investor’s broker), sell them, and later buy them back to return. The challenge is that brokers did not always ensure shares were actually available to borrow before allowing the short sale.

Regulation SHO’s key requirement is the “locate rule”: before allowing a customer to short a stock, the broker must have “a reasonable belief” that the shares can be located and borrowed. This requirement is meant to prevent naked short selling — selling shares without any intention or ability to deliver.

In practice, the locate rule has been criticized as weak. Brokers have extensive share-lending arrangements and can usually believe shares can be borrowed, even if they cannot immediately locate specific shares. The rule is subjective — “reasonable belief” is not defined clearly.

Failed deliveries and buy-ins

When a short seller sells shares, they must deliver within three business days (the standard settlement window). If they fail to deliver — if the shares do not arrive in the buyer’s account — the Short Sale Rule (Rule 10a-1 under Reg SHO) imposes a “buy-in”: the buyer’s broker will forcibly buy shares in the market to cover the failed delivery and charge the cost to the short seller.

For threshold securities (stocks with excessive failed deliveries), the rule is stricter. The short seller must cover within 10 business days; if not, the buy-in is mandatory.

Naked short selling concerns

Naked short selling occurs when a short seller sells shares without borrowing (or even intending to borrow). This can happen when:

• A broker and customer agree to a short sale without verifying share availability
• A trader sells shares that do not exist (a failed delivery that is not covered)
• A market maker engages in “abusive naked shorting” to manipulate a stock down

Naked short selling is technically illegal under Reg SHO, but enforcement is difficult. A short seller who fails to deliver can always blame a borrowing failure, and distinguishing a good-faith failure from naked shorting is hard.

The 2008 crisis and emergency measures

During the 2008 financial crisis, the SEC temporarily prohibited naked short selling (with exceptions for market makers). The SEC was concerned that coordinated short selling was driving stocks down artificially. The emergency rule was lifted after the crisis, but naked short selling remains a flash point in enforcement.

Criticisms and enforcement gaps

Short-sale advocates argue Reg SHO is too permissive — naked short selling still happens, and brokers do not enforce locate rules strictly enough. Short-sale opponents argue the rule is too strict — it limits short selling, which is a valuable price-discovery mechanism.

The SEC has brought enforcement actions against firms for Reg SHO violations, but the cases are relatively rare given the volume of short selling. Some economists argue the rule needs teeth — for example, meaningful financial penalties for violations — to deter naked short selling.

See also