Borrowing and Delivery Requirements — The Locate Requirement Under Regulation SHO
SEC Rule 203 of Regulation SHO, codified at 17 C.F.R. § 242.203 under the Securities Exchange Act of 1934, establishes the borrowing and delivery requirements applicable to broker-dealers in connection with short sales and long sales of equity securities. The rule comprises two distinct regulatory frameworks: Rule 203(a), which addresses long sales and prohibits broker-dealers from lending securities to cover another party's sale where that sale is marked long, and Rule 203(b), which establishes the locate requirement — the rule's most commercially significant provision — prohibiting broker-dealers from accepting or effecting short sale orders unless the broker-dealer has first located a source of borrowable shares or has reasonable grounds to believe the security can be borrowed and delivered on the settlement date. The locate requirement is the primary regulatory mechanism through which Regulation SHO addresses naked short selling — the practice of selling securities short without locating a borrowable supply of those securities, which can produce persistent settlement failures that distort market pricing and harm the buyers who do not receive the securities they have purchased. Rule 203 also establishes the threshold security concept and a mandatory close-out mechanism for fail-to-deliver positions in those securities, providing a targeted enforcement mechanism for securities experiencing the most severe settlement failure patterns.
Overview and Regulatory Purpose
Naked short selling — effecting a short sale without first locating a borrowable supply of the security — poses market integrity risks that ordinary short selling does not. A short seller who has located and borrowed shares must ultimately purchase those shares in the market to return them to the lender, creating a natural demand that partially offsets the selling pressure the short sale exerts on the security's price. A naked short seller who never locates or borrows shares may never be forced to close the short position through a market purchase — producing a persistent fail-to-deliver position that represents a synthetic increase in the supply of the security, potentially driving the price below the level that genuine market supply and demand would produce.
The harm from naked short selling falls primarily on the buyers in the transactions that generate the fail-to-deliver positions. A buyer who purchases shares and is not delivered those shares on settlement date has extended unsecured credit to the failing broker-dealer — credit that was never agreed to and that exposes the buyer to the counterparty risk of the failing firm. The cascade of fail-to-deliver positions that persistent naked short selling can generate also impairs the settlement system's integrity, diverting clearing agency resources to managing unclosed failures rather than processing legitimate transactions.
Rule 203(b)'s locate requirement directly addresses this harm by imposing a pre-trade affirmative obligation — the broker-dealer must locate a source of borrowable shares before effecting any short sale, ensuring that every short sale has at minimum a credible pathway to delivery on settlement date. The locate requirement does not guarantee delivery — the located shares may fail to materialise for operational reasons — but it substantially reduces the incidence of naked short selling by requiring affirmative pre-trade compliance documentation.
Statutory Authority and Rulemaking History
Rule 203 derives its statutory authority from Sections 10(a), 10(b), and 23(a) of the Securities Exchange Act of 1934, which authorise the Commission to regulate short sales, prevent manipulative and deceptive practices, and prescribe rules and regulations necessary or appropriate to carry out the Act's provisions. Rule 203 was adopted as part of the original Regulation SHO rulemaking, Securities Exchange Act Release No. 34-50103, published at 69 FR 48029, August 6, 2004, effective January 3, 2005. The rule was amended in August 2007 — 72 FR 45557 — to address specific technical issues in the locate requirement's application, and most recently in October 2008 — 73 FR 61706 — to address the treatment of certain categories of fail-to-deliver position. No amendments have been made to Rule 203's operative text since October 2008, and no pending rulemaking proposes changes to the rule through June 2026.
Key Provisions and Operative Requirements
Rule 203(a) addresses long sales. If a broker-dealer knows or has reasonable grounds to believe that the sale of an equity security was or will be effected pursuant to an order marked long, the broker-dealer shall not lend or arrange for the loan of any security for delivery to the purchaser's broker after the sale, or fail to deliver a security on the date delivery is due. This provision — which incorporated the former Rule 10a-2 — prevents broker-dealers from using securities lending to facilitate the delivery of shares for long sales that the seller does not actually hold, maintaining the integrity of the long sale classification by ensuring that long-marked orders are settled by actual delivery of owned securities rather than through borrowing activity that would be appropriate only for short sales.
Rule 203(b)(1) — the locate requirement — establishes the core short sale obligation. A broker-dealer may not accept a short sale order in an equity security from another person, or effect a short sale in an equity security for its own account, unless the broker-dealer has satisfied three conditions. First, the broker-dealer must have borrowed the security or entered into a bona fide arrangement to borrow the security, or must have reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. Second, the broker-dealer must have documented compliance with this requirement.
The reasonable grounds standard for the locate requirement is a principles-based determination that requires the broker-dealer to affirmatively assess the availability of borrowable shares based on credible, current market information. The Commission has confirmed through guidance that a broker-dealer may satisfy the reasonable grounds standard through several means: actual borrowing of the specific shares to be sold short; a written confirmation from a securities lender that the specific shares are available for borrowing; reliance on a firm's proprietary locate system that tracks available securities lending inventory; or reliance on an Easy to Borrow list — a list of securities that a broker-dealer or its clearing firm has determined, based on recent market data, are readily available for borrowing and unlikely to result in a fail to deliver. A broker-dealer may not satisfy the reasonable grounds standard merely by confirming that a security is not on a Hard to Borrow list — the absence of difficulty borrowing is insufficient without an affirmative basis for believing the security is available.
The documentation requirement of Rule 203(b)(1)(iii) is independently significant. The broker-dealer must document its compliance with the locate requirement before effecting the short sale — a contemporaneous record that demonstrates the locate was completed prior to the transaction rather than reconstructed after the fact. This documentation obligation creates an auditable compliance trail that enables Commission and FINRA examination staff to assess the adequacy of a broker-dealer's locate procedures and identify patterns of short selling activity that occurred without proper locates.
Rule 203(b)(2) provides three exceptions from the locate requirement. The first exception covers short sales effected by a registered options market maker, a person associated with a registered options market maker, a specialist registered in equity securities on a national securities exchange, and other registered market makers — where the short sale is effected in connection with bona fide market making activities in the security for which the exception is claimed. The bona fide market making exception is the most significant and commercially important of the three, acknowledging that market makers must be able to sell short to provide immediate liquidity to buyers without the delay that a pre-trade locate process would impose. The bona fide market making exception does not apply to positions established or maintained by a market maker that are not the result of genuine market making activity — a market maker that uses the exception to establish speculative short positions or directional trading positions unrelated to liquidity provision has violated Rule 203.
The second exception covers short sales of securities that are part of a distribution where the broker-dealer is participating as an underwriter or broker-dealer in connection with an overallotment — the creation of a short position in the context of a securities offering to facilitate syndicate covering activities permitted under Rule 104 of Regulation M. The third exception covers transactions effected pursuant to Rule 10b-18 of the Exchange Act in connection with repurchase programmes by issuers.
Rule 203(b)(3) establishes the threshold security close-out mechanism — a targeted mandatory purchase requirement for securities experiencing the most severe persistent settlement failures. A threshold security is defined in Rule 203(c)(6) as any equity security registered under Section 12 or required to file Section 15(d) reports where, for five consecutive settlement days, there are fail-to-deliver positions at a registered clearing agency of 10,000 shares or more that are equal to at least one-half of one percent of the issuer's total shares outstanding, and that are not otherwise exempt from Regulation SHO's requirements. Threshold securities are identified and published daily by the SRO bearing primary surveillance responsibility for the security, providing market participants with a readily accessible list of securities experiencing significant settlement failure levels.
Where a registered clearing agency participant has a fail-to-deliver position in a threshold security for thirteen consecutive settlement days, the participant must immediately close out that position by purchasing securities of like kind and quantity. This mandatory purchase requirement — the Rule 203 close-out mechanism — was the primary close-out mechanism for short sale-related failures before the adoption of Rule 204 in 2009. Rule 204 subsequently replaced Rule 203(b)(3) as the primary close-out mechanism for most short sale-related failures, establishing a more rapid T+2 close-out requirement applicable to all fail-to-deliver positions. Rule 203(b)(3)'s thirteen-day threshold security close-out remains operative alongside Rule 204 as a supplementary mechanism specifically targeting threshold security failures, though in practice Rule 204's faster close-out requirement triggers before the thirteen-day Rule 203 threshold for most positions.
Scope of Application
Rule 203 applies to all broker-dealers transacting in equity securities — whether effecting short sales for their own account or accepting short sale orders from customers. The locate requirement applies regardless of the trading venue — national securities exchanges, alternative trading systems, OTC markets, and any other facility through which short sales may be effected. The threshold security close-out requirement of Rule 203(b)(3) applies to participants of registered clearing agencies — primarily the large clearing firms that are direct participants in DTCC's clearing and settlement system — rather than to all broker-dealers.
Rule 203's locate requirement applies at the order entry stage — the locate must be completed and documented before the short sale order is accepted or effected, not at the time of execution or settlement. A broker-dealer that accepts a customer's short sale order and then attempts to complete a locate before settlement has not complied with Rule 203(b)(1)'s pre-trade requirement, regardless of whether the locate is ultimately successful.
Relationship to Related Rules and Regulations
Rule 203's locate requirement operates in direct sequence with Rule 200's marking requirements. The Rule 200 marking framework determines which orders are classified as short sales, and Rule 203's locate requirement then applies to all orders so classified. An order that is improperly marked long to avoid the locate requirement constitutes simultaneous violations of both Rule 200(g) and Rule 203(b)(1), since the improper marking enables the short sale to be effected without a locate.
Rule 204 — the close-out requirement — is Rule 203's operational successor for the close-out function. Rule 204's T+2 close-out requirement for fail-to-deliver positions arising from short sales is faster and more comprehensive than Rule 203(b)(3)'s thirteen-day threshold security mechanism, and in practice governs the majority of short sale-related close-out obligations. The two rules operate in parallel rather than exclusively — Rule 204 applies to all fail-to-deliver positions within its scope, while Rule 203(b)(3) provides a targeted supplementary mechanism for threshold securities where thirteen consecutive days of settlement failure have accumulated.
Rule 203's bona fide market making exception has been closely examined in the context of the Commission's efforts to define the boundaries of legitimate market making activity. The Commission has confirmed through guidance and enforcement actions that the bona fide market making exception requires genuine market making — activity characterised by regular, continuous two-sided quoting and risk-taking to facilitate customer order flow — and does not extend to directional trading, speculative short selling, or positions established to benefit from anticipated price declines rather than to provide liquidity to market participants.
Amendment History and Regulatory Evolution
Rule 203's amendment history is limited — the August 2007 amendment addressed technical issues in the locate requirement's application to specific transaction types, and the October 2008 amendment addressed the treatment of certain categories of fail-to-deliver position. The broader evolution of the short sale regulatory landscape since Rule 203's adoption has been shaped primarily by Rule 204's 2009 adoption rather than by amendments to Rule 203 itself, with Rule 204 assuming primary responsibility for the close-out function while Rule 203 retained its foundational locate requirement role.
The October 2023 adoption of Rule 13f-2 — requiring institutional investment managers to report short positions and short activity data monthly on new Form SHO — significantly expanded the public transparency of short selling practices without amending Rule 203's operative requirements. The Commission continues to monitor the adequacy of the short sale reporting and locate framework, and the regulatory agenda under Chair Atkins includes consideration of the regulatory infrastructure for short sale oversight, though no formal proposals to amend Rule 203 had been published through June 2026.
Enforcement Context and SEC Action Patterns
Rule 203 enforcement has concentrated on two categories of violation. The first involves systematic failure to complete locates before accepting or effecting short sale orders — cases where broker-dealers accepted customer short sale orders without completing any locate process, or where the locate process was performed after the fact rather than before order acceptance. FINRA has identified inadequate locate procedures as a recurring examination finding, particularly among smaller broker-dealers and online trading platforms that process high volumes of short sale orders from retail customers without implementing robust real-time locate systems.
The second enforcement category involves misuse of the bona fide market making exception — cases where broker-dealers or their personnel invoked the market making exception to avoid the locate requirement for short positions that were not established in the course of genuine market making activity. The Commission and FINRA have brought enforcement actions against firms and individuals that used the market making exception as a general exemption from locate requirements rather than as a narrowly applicable accommodation for specific liquidity-provision activities.
Examination Relevance and Key Takeaways
Rule 203 and the locate requirement are examined at the Series 7 level as the primary mechanism through which Regulation SHO addresses naked short selling. The three-part locate requirement — borrowed or bona fide arrangement to borrow, or reasonable grounds to believe borrowable, plus documentation — and the pre-trade timing requirement are the primary examination concepts. The bona fide market making exception — permitting market makers to sell short in connection with genuine liquidity provision without completing a pre-trade locate — is examined as the most significant exception to the universal locate obligation.
The threshold security concept — equity securities with fail-to-deliver positions of 10,000 shares or more representing at least one-half of one percent of total shares outstanding for five consecutive settlement days — is examined in the context of the Rule 203(b)(3) thirteen-day mandatory close-out requirement and the distinction between the Rule 203 threshold security mechanism and Rule 204's faster and broader close-out framework.
The key points to retain are these. Rule 203(b) prohibits broker-dealers from accepting short sale orders or effecting short sales in equity securities unless they have borrowed the security, entered into a bona fide borrowing arrangement, or have reasonable grounds to believe the security can be borrowed — and have documented compliance before the short sale is effected. The locate must be completed prior to order acceptance, not at settlement. Three exceptions apply: bona fide market making, overallotment-related short positions in securities offerings, and certain Rule 10b-18 repurchase contexts. A threshold security is defined as an equity security with five consecutive days of fail-to-deliver positions at a registered clearing agency of 10,000 shares or more equal to at least one-half of one percent of total shares outstanding. Participants of registered clearing agencies with fail-to-deliver positions in threshold securities for thirteen consecutive settlement days must close out those positions immediately through purchase. Rule 203 was last amended October 2008 and no pending rulemaking proposes changes through June 2026.
