Palace Fund

Regulation SHO — Short Selling Rules

What It Is

Regulation SHO (17 CFR 242.200-204) governs short selling in US equity markets. Short selling is selling a security you do not own, with the intent to buy it back later at a lower price.

Key Rules

Locate Requirement (Rule 203(b)(1))

Before executing a short sale, the broker-dealer must have reasonable grounds to believe the security can be borrowed and delivered by settlement date.

  • This is the broker’s obligation, but as a fund manager you need to ensure your broker has a locate before you short.
  • Your prime broker will typically handle this. You submit a short sell order, and the broker confirms or denies the locate.
  • Hard-to-borrow securities: Some stocks have limited shares available for lending. Your broker will flag these. Short selling hard-to-borrow stocks may incur higher borrowing costs or be unavailable.

Close-Out Requirement (Rule 204)

If a short sale results in a failure to deliver (FTD) — meaning the shares are not delivered by settlement date — the broker must close out the position by purchasing the shares:

  • T+1 (next settlement day) for FTDs that existed before settlement
  • For market makers, an extended T+3 close-out may apply

Repeated FTDs in a security cause it to be placed on the Threshold Security List, which imposes additional restrictions.

Short Sale Price Restrictions (Rule 201 — Alternative Uptick Rule)

  • A circuit breaker is triggered when a stock’s price drops 10% or more from the previous day’s close.
  • Once triggered, short sales in that security can only be executed at a price above the current national best bid for the remainder of the day and the following day.
  • This is handled by the exchange and broker systems, not by the fund manager directly.

Naked Short Selling

“Naked” short selling — selling short without borrowing or arranging to borrow the shares — is prohibited. This is what the locate and close-out requirements are designed to prevent.

Reporting and Disclosure

  • Short interest reporting: Exchanges report aggregate short interest in each security twice monthly. Individual fund positions are not publicly disclosed through this mechanism.
  • Form SHO: Not a form you file. The broker reports data to FINRA.
  • 13F-HR: Short positions are not reported on Form 13F (13F only covers long positions). However, the SEC has proposed short position reporting requirements that may take effect.

How It Applies to a Small Fund

  • If Palace Fund engages in short selling, the primary operational concern is ensuring your prime broker handles locates properly.
  • Short selling costs include: stock borrow fees (can range from negligible to 50%+ annually for hard-to-borrow names), margin requirements, and the risk of a short squeeze or buy-in.
  • Short positions create unlimited loss potential. Risk management is critical.

Action Items for Palace Fund

  1. Establish a prime brokerage relationship that supports short selling if you plan to short.
  2. Understand your broker’s locate process. Ensure locates are obtained before every short sale.
  3. Monitor borrow costs. High borrow fees can significantly erode short trade profitability.
  4. Risk management: Set position limits and stop-losses for short positions. Short squeezes can cause rapid, extreme losses.
  5. Disclose short selling in the PPM. If the fund’s strategy includes short selling, disclose this to investors along with the associated risks.
  6. Margin requirements: Short positions require margin. Ensure adequate margin capacity with your broker.