SEC Follow Up Exhibits Part C SEC_OEA_FCIC_001760-2501

the buyer when settlement is due (known as a “failure to deliver” or “fail to deliver”).” 28 Thus,
failures to deliver are often used as a measure for “naked” short selling. 29
In this section, we attempt to distinguish whether short sellers are avoiding borrowing
constraints by analyzing whether IPOs with large short selling have subsequent failures to
deliver. To our knowledge, ours is the first analysis of the relationship between short selling and
failures to deliver in any context. 30 Failures to deliver are examined both on the daily aggregate
level and by whether the IPO has persistent delivery failures. We use data on failures to deliver
sent to the SEC from the National Securities Clearing Corporation’s (NSCC) Continuous Net
Settlement (CNS). The NSCC reports the level of failures to deliver to the SEC and several
28 Regulation SHO or Reg SHO, for short, was adopted in 2004 and provides regulations, among others, that govern
locating shares prior to a short sale as well as the delivery of shares. Under Rule 203 of Regulation SHO, the broker
facilitating a short sale must “locate” the stock prior to the trade. “Locate” refers to the requirement under
Regulation SHO that a broker-dealer have reasonable grounds to believe that the security can be borrowed for
delivery on the T+3 settlement date. Note that the locate requirement is not the same as actually borrowing the
security. The broker may locate these shares in its own inventory, from a prime broker, or large institutional
investors through a custodial bank. The broker-dealer can rely on “easy to borrow” lists for a locate if they satisfy
the “reasonable grounds” standards of Regulation SHO Rule 203. Brokers may satisfy the reasonable grounds
requirement if they rely on easy to borrow lists so long as those lists are less than 24 hours old, and the securities on
the list are readily available such that it would be unlikely that a failure to deliver would occur. These standards are
described in Section V.A. of release number 34-50103. See http://www.sec.gov/spotlight/keyregshoissues.htm for
more information.
29 See, for example, Angel (2006) and plus press articles such as “Games Short Sellers Play,” by Bob Drummond,
Bloomberg Markets, September 2006, and “Failed Trades” by Liz Moyer, Forbes, August 18, 2006. The media has
referred to the Regulation SHO threshold list as the “naked short selling” list.
30 There is no empirical evidence that failures to deliver affect prices despite the potential for buying pressure when
the failures are closed-out under Regulation SHO and concerns about the impact naked short selling (see e.g.,
Boulton and Braga-Alves (2009), Fotak, Raman, and Yadav (2009), and Gjerde (2009)). In addition to potential
naked short selling, failures to deliver may also occur on long sales and possibly around other corporate actions such
as follow-on offers and proxy voting. However, these events are not likely to occur within three months after the
IPO and thus, will most likely have little impact on our findings. Further, any potential counterparty risk from
failures to deliver are managed by a central clearing agency such that the incremental risk and economic
consequence from failures to deliver should be minimal. As of this writing, the Commission has imposed temporary
rules that require delivery of “securities by settlement date, or if the participants have not delivered shares by
settlement date, immediately purchase or borrow securities to close out the fail to deliver position by no later than
the beginning of regular trading hours on the settlement day following the day the participant incurred the fail to
deliver position” ( http://www.sec.gov/rules/final/2008/34-58773.pdf). For further discussion on some of the
economics and mechanics of failures to deliver see Evans, Geczy, Musto, and Reed (2006) and Boni (2006).
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