What it means
When someone sells a share, the seller must deliver it to the buyer within the standard settlement period. A failure to deliver occurs when the seller does not supply the shares on time.
Occasional failures are normal, but a large and persistent number can indicate that someone has sold shares they could not borrow, a practice known as naked short selling. To address this, Regulation SHO, a set of rules from the US securities regulator, requires exchanges to publish a threshold list each day.
A security joins the list when the amount of failures stays above levels set by the regulation for a number of consecutive settlement days. The thresholds relate to the number of shares and to the proportion of the company's shares outstanding.
Once a security is on the list, firms that have a persistent failure in it must close the position by buying or borrowing shares within a set time. The aim is to stop failures from lingering and to reduce the risk of manipulation.
A security leaves the list when failures fall back below the thresholds for a period. Investors and issuers watch the list for several reasons.
A company on it may suspect its shares are being targeted by manipulative selling, while traders may see an opportunity in forced buying to close positions. Appearing on the list is not in itself a sign of wrongdoing, since failures can arise for innocent reasons such as paperwork delays.
For finance professionals, the list is an example of how regulators use transparency to police markets. Brokers must have systems to monitor their positions against it, and failures to comply can lead to penalties.
The detailed numbers and timing are set by regulation and can be amended, so the current rules should be checked at the source. Related rules include the locate requirement, which says a broker must have reasonable grounds to believe shares can be borrowed before accepting a short sale order.
Together these rules aim to make sure that sold shares can actually be delivered. Companies and investors who suspect abuse can raise concerns with the regulator and the exchange.
In practice
Real-world examples.
Example
A small listed biotechnology company sees heavy trading and an unusual number of failed deliveries. The exchange adds its shares to the threshold list after the required number of days. The broker-dealers with open failures must buy or borrow shares to close them.
Example
A prime broker uses an internal report to compare its clients' positions against the daily list. When it finds a client has a long-standing failure in a listed security, it contacts the client to arrange delivery. This helps the firm avoid penalties.
Example
A company's investor relations officer notices that her shares have appeared on the list. She asks the company's lawyers to check the position and to talk to the exchange. She also explains to the board that the listing is a data point and not a finding of misconduct.
Formula
Calculation
Failure ratio (%) = Aggregate fails to deliver / Shares outstanding x 100
Suppose a company has 20,000,000 shares outstanding, and the settlement system shows 150,000 shares failed to deliver on each of several consecutive days. The failure ratio is 150,000 / 20,000,000 x 100 = 0.75%. If the regulator's criteria for inclusion are a failure total above a minimum number of shares and above a set fraction of shares outstanding, this security would be tested against both conditions. For illustration, if the proportion limit were 0.5% and the share limit 10,000, then 0.75% and 150,000 exceed both, so the security would qualify for the list once the required number of consecutive days is reached.Case study
Seen in the real world.
Tidewater Therapeutics is an illustrative, fictional listed company whose share price fell sharply over a month, with unusually high trading volume. The chief financial officer suspected that some traders were selling shares they had not borrowed.
She checked the daily threshold list and found her company named on it. She asked the company's lawyers to contact the exchange and her investor relations team to prepare a statement for shareholders that explained the listing in plain terms.
In this illustrative case, the failures were closed out within the required period, as brokers bought shares to deliver, and the price recovered part of its fall. The CFO noted that the list had given her useful evidence, but that she could not treat it as proof of manipulation.
Watch out
Common mistakes.
- Assuming that being on the list proves illegal short selling, when failures can have innocent causes.
- Believing the list is a recommendation to buy or sell the shares.
- Treating the thresholds as fixed forever, when regulation can change them.
Questions
People also ask.
Who publishes the list?
The exchanges and self-regulatory bodies publish it daily, following the rules set by the regulator. The list can be viewed free of charge, which makes it a handy source for issuers and analysts.
What happens to firms with failures?
They are required to close out the failing positions within a set period by buying or borrowing the shares.
How does a security get off the list?
Its failures need to fall below the thresholds for the period the rules specify. Once that happens, the extra close-out requirements no longer apply to the security.
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