Nasdaq would like to remind its members of their obligations related to activity in securities subject to initial public offerings (IPOs), including short selling activity and activity in shares subject to “lock ups” and transfer restrictions.

What is a short sale

A short sale is the sale of a security that the seller does not own and any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller.

What is Regulation SHO?

Pursuant to Section 10(a) of the Securities Exchange Act of 1934, the SEC has the authority to regulate short sales of securities registered on a national securities exchange. Regulation SHO generally provides the regulatory requirements concerning short sales.

Regulation SHO has four general requirements:

• Marking Requirements (Rule 200(g)) – broker-dealers must mark all sell orders of any equity security as “long,” “short” or “short exempt”;
• Short Sale Price Test Circuit Breaker (Rule 201) – trading centers, including Nasdaq, must have policies and procedures in place to restrict short selling when a covered security has triggered a Regulation SHO circuit breaker;
• Locate Requirements (Rules 203(b)(1) and (2))

Rule 203(b)(1) - broker-dealers are generally prohibited from accepting a short sale order in any equity security, or effecting a short sale order in an equity security for its own account, unless the broker-dealer has:

• borrowed the security;
• entered into a bona-fide arrangement to borrow the security; or
• reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due.

Rule 203(b)(2)(iii) - provides an exception to the locate requirement for short sales effected by a market maker in connection with bona-fide market making activities.

• Close-out Requirements (Rule 204) - participants of a registered clearing agency must deliver securities to a registered clearing agency for clearance and settlement on a long or short sale transaction in any equity security by settlement date, or must close out a fail to deliver in any equity security for a long or short sale transaction in that equity security pursuant to the timing provided by the rule.

Can participants sell short IPO shares immediately after the offering?

Yes, but the short seller must "locate" the shares in compliance with Rule 203(b)(1) of Regulation SHO. The broker-dealer executing a short sale order has to reasonably believe that the equity to be sold short can be borrowed and delivered on a specific date before short selling can occur.

Who holds inventory of the stock on the day of the IPO?

The underwriters, institutional and retail investors receiving allocations from the underwriter.

Who can lend shares following an IPO?

Institutional investors and retail investors get the allocation from the IPO typically the day before or in the morning of the IPO. These entities can lend shares received in the allocation based on the knowledge that the shares will be in their account on settlement day, T+2.

What is an IPO lock up agreement?

A lock-up agreement is a provision or a clause agreed on between underwriters and insiders of the firm going public with an IPO. It prohibits insiders from selling their stake in the firm for a specified duration from the date of the closure of the IPO. Depending on the terms of the lock up agreements, shares subject to a lock up agreement may not be available to cover Regulation SHO locate requirements or available for any swap, option or other derivatives transactions where the economic risk is transferred to a third party.

How does a lock up agreement impact compliance with the locate requirement under Regulation SHO?

The locate requirement of Regulation SHO requires a broker-dealer to have reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due before effecting a short sale order in any equity security. The locate must be made and documented prior to effecting the short sale. Depending on the terms of the lock up agreement, shares in a lock up agreement may not be available to cover Regulation SHO locate requirements as they would not be available for delivery by the settlement of a short sale transaction.

What are a broker-dealer’s obligations to determine that a security may be subject to a lock up or other contractual agreement?

Where circumstances indicate that the security may be subject to a lock up or other contractual agreement that renders those shares not freely tradeable, a broker-dealer shall exercise reasonable diligence to confirm that it is not acting on behalf of a customer to facilitate transactions that could violate such contractual agreement.

Nasdaq may review a broker-dealer’s compliance with its obligations to exercise reasonable diligence for consistency with rules governing just and equitable principles of trade. See, e.g., Nasdaq Rule 2010A; Nasdaq BX Rule 2110; Nasdaq PHLX Rule 707; Nasdaq ISE Rule 400.

What are circumstances that indicate a security may be subject to a contractual agreement that renders those share not freely tradeable?

A broker-dealer may be aware of a contractual agreement that renders shares not freely tradeable based on a course of dealing with the customer or the customer’s affiliate. In the context of an IPO, a broker-dealer may be aware of a contractual agreement that renders shares not freely tradeable if the customer or the customer’s affiliate is listed as an investor subject to a lock-up agreement in a registration statement filed with the SEC.

Can I use options to hedge an IPO security?

Yes, however, Nasdaq rules prohibit trading in options until the fourth business day after an IPO (see Phlx Rule 1009 Commentary .01(4)(i), NOM Chapter IV Sec. 3(b)(v)1), BX Options Chapter IV Sec. 3(b)(v)1), Nasdaq ISE Chapter 5, Rule 502(b)(5)(i), Nasdaq GEMX Chapter 5, and Nasdaq MRX Chapter 5).