Short Sale Restrictions

A short sale is generally a sale of a security by an investor who does not actually own the stock. To deliver the security to the purchaser, the short seller will borrow the security. The short seller later closes out the position by returning the security to the lender, typically by purchasing securities on the open market. In general, short selling is utilized to profit from an expected downward price movement, to provide liquidity in response to buyer demand, or to hedge the risk of a long position in the same or a related security.

The SEC has traditionally held the belief that protections against abusive short selling are important for issuer and investor confidence, and has enacted prophylactic rules designed to curb manipulative behavior. The rules investors must follow are:

Exchange-Listed Securities

Rule 10a-1 under the Securities Exchange Act of 1934 governs securities registered on an exchange. The core requirement of Rule 10a-1 is commonly referred to as the "tick test." The tick test provides that, subject to certain exceptions, an exchange-listed security may only be sold short: (i) at a price above the immediately preceding reported price ("plus tick"), or (ii) at the last sale price if it is higher than the last different reported price ("zero-plus tick"). Subsection (c) and (d) of Rule 10a-1 also require broker/dealers effecting sell orders for exchange-listed securities to mark such orders "long" or "short."

Rule 10a-2 of the Exchange Act generally prevents a broker-dealer from lending an exchange-listed security, or failing to deliver on a sale marked "long," subject to various exceptions. The SROs also have adopted rules generally requiring that, prior to effecting short sales, member firms must "locate" stock available for borrowing, so that the short seller may effect delivery to the purchaser. For more information, see NYSE Rule 440C and NASD Rule 3370.

Nasdaq Stock Market Securities

NASD Rule 3350 prohibits NASD members from short selling in Nasdaq National Market System securities at or below the inside best bid when the best bid is below the previous inside best bid for that stock. The inside best bid is the highest bid by all market makers quoting a particular stock.

Stocks in a Securities Offering

Rule 105 of Regulation M governs short sales immediately prior to offerings where the sales are covered with offering shares. Specifically, Rule 105 prevents persons from covering short sales with offering securities purchased from an underwriter, broker, or dealer participating in the offering if the short sale was effected during the Rule's restricted period, which is typically five days prior to pricing and ending with pricing. Its aim is to promote offering prices that are based upon open market prices determined by supply and demand rather than artificial forces. In this way, the Rule safeguards the integrity of the capital raising process.

There are other restrictions on short selling, including margin requirements, net capital requirements for broker-dealers, capital and risk management standards, and costs imposed by the equity lending market.