Regulators Provide "Tips" for Broker-Dealers on Avoiding Failures to Deliver Securities

Last updated on 11/25/08

The Staff of the SEC's Division of Trading and Markets and the Office of Compliance Inspections and Examinations, along with FINRA and NYSER, are providing the following information to assist broker-dealer firms in preventing failures to deliver securities. Firms conducting short sales are encouraged to consider practices to prevent delivery failures, including, for example:

Borrowing. Borrowing and obtaining control of the securities before settlement, rather than entering into an agreement to borrow such securities. One firm, for example, has indicated that it has made a practice of borrowing or maintaining adequate inventory to allow it to deliver securities by settlement date and thereby prevent a fail to deliver in that security.

Arrangement to borrow. Entering into a bona fide agreement to borrow securities, especially in transactions in hard-to-borrow securities, in order to ensure that the firm will be able to settle the transaction on T + 3. This practice provides assurance that the shares will be available upon settlement and that the trade will not fail.

Earmarking. If the firm enters into an arrangement to pre-borrow shares without obtaining control, determining that the source of shares for the pre-borrow will be available on T + 3. Shares may be specifically earmarked for each arrangement to borrow.

Maintaining an inventory. Maintaining adequate inventory of securities in which the firm frequently executes short sales sufficient to cover anticipated short sales and to cover any pre-borrows granted by the firm. Reducing the shares available from inventory in order to ensure that adequate shares are available to deliver by settlement date.

In addition, firms are reminded of their obligations under Regulation SHO, as amended by Rule 204T, regarding documentation and monitoring of sources of shares.

Documenting the source of shares.  In instances where a customer relies on a broker-dealer other than the executing broker-dealer to settle a transaction, the broker-dealer that settles the customer's transaction must document the source of the customer's locate or pre-borrow. Additionally, the executing broker-dealer must have adequate controls in place to ensure that locates or pre-borrow arrangements provided by the customer are valid. In addition, executing broker-dealers are reminded that when a customer provides assurance that it has access to shares to settle their transaction, the executing broker-dealer is required to document the source of the customer's locate or pre-borrow.

Monitoring locates. Regulation SHO, as amended by Rule 204T, requires firms to actively monitor the performance of locates or pre-borrows, including locates or pre-borrows provided by customers, to assess future reliability.

Direct market access/sponsored access. Firms should consider whether their policies and procedures regarding short sales entered via direct market access or sponsored participant arrangements are in compliance with Regulation SHO, as amended by Rule 204T. For example, firms must, at a minimum, document the source of located or pre-borrowed shares when a short sale transaction is entered via a direct market access and/or other sponsored access arrangements.

Finally, firms should work with institutional clients to encourage the development of efficient systems for confirmation and affirmation of trades, to assure timely delivery of DVP trades.

Firms are reminded that they must maintain adequate surveillances and written supervisory procedures to detect manipulative short selling activity and activity that is violative of the Commission's rules.

These "tips" are intended to assist broker-dealer firms in establishing policies and procedures and controls to avoid failures to deliver. Regulators will also monitor for compliance with the SEC's rules to protect investors against naked short selling abuses.  

Below are links to the Recent Short Selling Rule Updates:

Elimination of the options market maker exception to Regulation SHO’s close-out requirement: http://edocket.access.gpo.gov/2008/pdf/E8-24742.pdf

Amendment to Regulation SHO by adopting an interim final temporary rule, Rule 204T, which strengthens Regulation SHO’s delivery requirements: http://edocket.access.gpo.gov/2008/pdf/E8-24785.pdf. (Rule 204T is effective October 17, 2008 — July 31, 2009).

Rule 10b-21, an antifraud rule that addresses fails to deliver securities that have been associated with ‘‘naked’’ short selling by targeting short sellers, including broker-dealers acting for their own accounts, who deceive specified persons about their intention or ability to deliver securities in time for settlement (including persons that deceive their broker-dealer about their locate source or ownership of shares) and that fail to deliver securities by settlement date: http://edocket.access.gpo.gov/2008/pdf/E8-24714.pdf

Interim final temporary rule, Rule 10a—3T and Temporary Form SH (Form SH) requiring short sale disclosure by certain institutional investment managers (Rule 10a—3T and Temporary Form SH (Form SH) are effective October 15, 2008 — August 1, 2009): http://edocket.access.gpo.gov/2008/pdf/E8-24895.pdf.