Restrictions On Short Sales Of Securities

A short sale of a security is a sale of the security by an investor before the investor actually owns the security being sold. The investor profits if the value of the security declines between the time of the sale and the time of delivery of the security. Short sales may also allow an investor to lock in changes in value shares already held or to hedge against significant changes in value in securities.

Pursuant to the Securities Exchange Act of 1934, the Securities and Exchange Commission (SEC) has established rules regarding short sales to prevent manipulation of securities. For securities listed on exchanges such as the New York and American stock exchanges, Rule 10a-1 provides that the “tick test” that must be met. The tick test generally requires that a security may be sold short only:

• At a “plus tick” or at a price above the last reported sales price of the security
• At a “zero-plus tick” or at a price equal to the last sales price of the security so long as that price is higher than the last reported price of the security

Rule 10a-1 also requires labeling by a broker-dealer of sell orders for exchange-listed securities as long or short sales. Rule 10a-2 in turn requires a broker-dealer to deliver the security if a sale is marked long and not to lend that security to the selling investor in order to settle the transaction.

Self-regulating organizations such as the exchanges and Nasdaq have adopted additional rules governing short sales. For example, member firms of the self-regulating organization are required prior to handling a short sale to locate securities that will be available for borrowing in the event that the short seller will have to deliver securities to the purchaser. Rule 3350 of the National Association of Securities Dealers bars members of the Association from selling short securities traded through the Nasdaq system at a price at or below the “inside best bid” or highest bid from a market maker providing quotes on the securities.

Rule 105 of Regulation M of the Securities and Exchange Commission restricts short selling of securities just before their public offering if the short sales will be covered by shares from the offering. During the restricted period (usually the five days prior to the offering), persons making short sales may not cover those sales with shares purchased from an underwriter or dealer participating in the offering.

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