Last September the UK Financial Services Authority (the "FSA") introduced a temporary ban on the short selling of specified UK financial stocks and required disclosure to the market of net short positions in excess of 0.25% of the issued share capital of those stocks. The temporary ban expired on 16 January 2009; however, in order to mitigate the potential risk of the sharp share price declines in individual banks returning, the FSA decided to retain the temporary disclosure obligations regarding UK financial stocks until 30 June 2009. When it imposed the ban, FSA announced that it would conduct a comprehensive review of short selling in the UK. This review has now been completed and, in Discussion Paper 09/1 issued on 6 February 2009 (the "Discussion Paper"), the FSA has set out its analysis and initial conclusions, inviting comments by 8 May 2009. The FSA has concluded that there should be no permanent restrictions on short selling and has proposed that a general short selling disclosure requirement be introduced for all net short positions of 0.5% or more of the issued share capital of any company listed on a UK exchange. The FSA believes that international consensus on the key issues relating to short selling is crucial and reiterated its desire to use the feedback to its proposals to "inform the international debate."
Impact Of Short Selling
The Discussion Paper examines the pros and cons of short selling. Whilst acknowledging that short selling is regarded as a controversial technique, particularly in falling markets, the FSA reiterates that it regards short selling as a legitimate investment technique in normal market conditions and considers that short selling contributes to the efficient functioning of the market, enhances liquidity by increasing the number of potential sellers in the market and enhances price efficiency in normal conditions. However, the Discussion Paper also notes that short selling can lead to the following four potential problems:
- Market Abuse
Short selling can be used abusively to create misleading signals about the supply and correct valuation of a stock and to push down the price of a stock being shorted. - Disorderly Markets
Short selling can convey a signal to the market that a company is overvalued and, if investors act appropriately, this improves the accuracy of the value of the stock in question. However, if investors overreact the price decline may be excessive and may spread to related stocks. This "contagion effect" can ultimately result in disorderly markets, as seen in September 2008. - Transparency Deficiencies
Information asymmetries between informed short sellers and uninformed market participants could result in price inefficiency. However, studies have shown that excessive transparency can reduce liquidity because traders are unwilling to reveal their trading strategies. - Settlement Issues
Naked short selling gives rise to a risk of settlement failure where the seller may be unable to deliver stocks to the buyer. The FSA has previously made it clear that short selling without any intention or reasonable plan to settle the short position will be considered to be market abuse and has already taken enforcement action on this issue.
The FSA outlined in the Discussion Paper that it considered that there were two main strands to mitigate the potential negative effects of short selling:
- introducing potential constraints on short selling; and
- enhanced transparency.
Regulatory Options: Potential Constraints On Short Selling
A range of potential constraints on short selling are canvassed in the Discussion Paper, as follows:
- Prohibit short selling of all stocks;
- Prohibit naked short selling;
- Prohibit short selling of financial sector stocks;
- Prohibit short selling of companies engaging in rights issues;
- Prohibit short selling by underwriters of rights issues; and
- Prohibit short selling where there is urgent need. FSA discusses the use of "circuit breakers" and "tick rules" which may prevent or impede short selling if certain preconditions are met or not met.
A circuit breaker involves a suspension of trading in a share whenever there is an abnormal rise or fall in its price. Traditionally the UK has not used circuit-breakers.
There are two types of 'tick' rule. An up-tick rule provides that the last sale must have been at a higher price than the sale preceding it before a share can be short sold. A zero-plus tick rule provides that if the last transaction price is unchanged but higher than the preceding different sale then the stock can be shorted. Tick rules allow relatively unrestricted short selling in a flat or advancing market, but prevent short selling at successively lower prices.
The UK has no direct experience of tick regimes but the US Securities and Exchange Commission (SEC) carried out a comprehensive study into the impact of its up-tick rule which led to the conclusion that the rule be removed in 2007 on the basis it modestly reduced liquidity and did not appear necessary to prevent manipulation.
The FSA agrees with the SEC that tick rules provide limited protection as regards the negative effects of short selling and, at most, simply act to decelerate share price declines. The FSA notes that tick rules come at substantial cost if none of the necessary infrastructure is already in place and since they apply only to the cash markets, derivatives can be used to circumvent the rules.
At this stage, the FSA has concluded that direct constraints on short selling are not currently justified and would be a disproportionate response in light of the beneficial functions of short selling outlined above (notably the promotion of price efficiency and providing liquidity) and the actual cost of introducing any permanent restriction on short selling in the UK would outweigh the benefits.
Regulatory Options: Enhance Transparency
The FSA considers that the two principal reasons for improving the transparency of short selling are:
- providing additional valuable information to the market (e.g. that a firm is overvalued); and
- mitigating some of the problems associated with short selling.
The FSA states that market participants have indicated that there would be value in increasing transparency for short selling on an ongoing basis. Such a disclosure requirement could partially address some of the issues associated with abusive short selling as it would help in detecting short selling that is being used to commit market abuse. Furthermore, greater transparency could help identify when investors are acting irrationally over abrupt price changes and ongoing disclosure requirements would give the FSA more advance warning of conditions in which it may have to consider regulatory intervention. Finally, the FSA recognises the potential deterrent effect that disclosure obligations will have on those considering aggressively taking large short positions, particularly in times of market turbulence.
The Discussion Paper acknowledges that there are potential disadvantages in increasing transparency. If any new transparency obligations had the effect of significantly reducing the overall level of short selling then this would have an impact on price formation and liquidity in general. Other downsides include the 'herding effect' of other short sellers following a 'big name' short seller who has disclosed a significant short position to the market. Lastly, the FSA is aware of the direct financial costs to firms of implementing and operating systems in order to comply with the disclosure obligations.
The FSA concludes that the benefits of disclosure obligations outweigh the costs and that experience of the existing temporary short selling disclosure requirements has indicated that some short sellers are deterred from holding positions above disclosure thresholds.
FSA Proposals Relating To Enhanced Disclosure Obligations
The FSA proposes to implement a permanent disclosure regime for all stocks listed on a UK exchange which is similar to the temporary regime currently in force for specified UK financial stocks only.
The FSA considers there are two approaches that could be used to increase transparency in short selling (which are not necessarily mutually exclusive):
- disclosure of aggregate short positions for a particular security; and
- disclosure of significant individual short positions either privately to the regulator or publicly to the market as a whole.
The Discussion Paper proposes there should be one threshold applied to all UK stocks traded on prescribed markets in order to avoid making the regime too complicated. The temporary short selling disclosure measures were based on a minimum amount of 0.25% of the issued share capital of a company, however, the FSA does not think this is an appropriate threshold as there are varying degrees of size and liquidity to consider. The FSA's analysis shows that when firms made their first short selling disclosures to the market under the temporary measures, the mean short position size was approximately 1.05% and the median short position size was approximately 0.51%, indicating that these sizes may be meaningful to the market. Taking into account variations in the size of companies' market capitalisation, liquidity in the markets in companies' shares, and the sizes of positions that would be disclosed, the FSA concludes that 0.50% of a company's issued share capital could represent an appropriate threshold for triggering disclosure obligations for net short positions. The Discussion Paper further proposes that additional disclosures should be fixed in increments of 0.1% of the issued share capital of the company.
As short positions entail more risk for market makers than long positions (which they have to disclose, albeit at higher thresholds than those otherwise applicable), there is a proposed exemption for market makers.
Credit Default Swaps And Rights Issues
The FSA does not propose extending any enhanced disclosure obligations to credit default swaps (CDS) because it already receives CDS transaction reports and under the proposals above would receive disclosure of significant short positions. Also, the FSA does not intend to amend the existing disclosure requirements in relation to the short selling of shares during rights issues where the initial threshold is 0.25%.
We will monitor the progress of FSA's proposals and the published feedback they generate.
The full text of the Discussion paper can be found on the FSA website at the following address: www.fsa.gov.uk/pubs/discussion/dp09_01.pdf
Related Proskauer Rose articles can be found on the Proskauer Rose website at the following address: www.proskauer.com/news_publications/client_alerts/content/2008_09_23_b.
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