# 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.