In this Ropes & Gray podcast, asset management partner Anna Lawry and litigation partner Judith Seddon discuss the Short Selling Regulation (SSR) and the recent enforcement action taken by the Financial Conduct Authority (FCA). They provide a brief explanation of the SSR and its requirements, followed by a discussion of the FCA's first enforcement action under the SSR in October 2020.
Judith Seddon: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Judith Seddon, a partner in the litigation group in the London office. Joining me today is my colleague and partner, Anna Lawry, a partner in our asset management group, also in the London office. Today, we're going to talk about the short selling regulation and the recent enforcement action the FCA has taken in relation to it. Anna is going to start by giving you an overview of the short selling regulation, and then I will turn to the recent enforcement action that was brought by the Financial Conduct Authority.
Anna Lawry: Thank you, Judith. The Short Selling Regulation, or SSR, came into effect in November 2012. The SSR imposes certain restrictions on short selling and requires investors to make disclosures to relevant regulators when they hold certain short positions. At a high-level, the SSR regulates the taking of short positions in shares traded on a regulated market and sovereign debt. The regulation is intended to improve transparency within financial markets, support the effective operation of markets and prevent short selling creating disorderly markets.
Firstly, the SSR bans "uncovered" or "naked" short selling, meaning that if an investor wants to sell short shares or sovereign debt, it must cover the position by borrowing the asset in question, or entering into a contractually equivalent arrangement. "Uncovered" or "naked" sovereign credit default swaps are also prohibited. The SSR recitals make clear that this restriction on naked short selling is intended to tackle the risk of "settlement failure" and reduce volatility.
Secondly, the SSR introduces a transparency and notification regime that requires persons holding net short positions at or above certain thresholds to disclose those positions to both the regulator and the public. In relation to shares:
- The first requirement relates to notifying regulators. The normal position is that if an investor holds a net short position that reaches or exceeds 0.2% of the issued share capital of an issuer, it should notify the relevant regulator. This threshold has been temporarily reduced to 0.1% of issued share capital in an attempt to reduce volatility during the COVID-19 pandemic. This reduction has been in force since March 2020 and has been extended twice. It is currently in effect until 18 December this year.
- The second requirement relates to disclosure to the public. If an investor holds a net short position that reaches or exceeds 0.5% of the issued share capital of an issuer, it must disclose its short position to the public, through the channel prescribed by the regulator.
- The third requirement relates to further incremental increases and decreases in net short positions. To the extent an investor increases its net short position so that it reaches or exceeds a further 0.1% over the 0.2% or 0.5% thresholds, and each 0.1% after that (or decreases its net short position so that it crosses back down through one of these thresholds), it must again notify the regulator and the public of its increased or decreased net short position.
Derivatives are included in the net short position calculation, as are indirect exposures to shares through index-linked transactions and products such as ETFs.
The notifications and disclosures must be made by a prescribed time on the trading day following the day on which the net short position was acquired.
Judith Seddon: Thank you, Anna. Despite being in force since 2012, the FCA only issued its first penalty under the SSR in October this year. The FCA issued a fine of just over £870,000 to an Asia-based asset manager (which I will call the "firm") for failures to disclose its net short positions in a company admitted to trading on the main market of the London Stock Exchange.
First, let's have a look at the facts in question. The firm invested in the issuer in October 2016, by building a credit position through the secondary market. The firm first built a short position in the issuer in February 2017 by entering into equity swap transactions with the intention of hedging the credit risk it had built through its secondary market transactions. The net short position built by the firm in February 2017 through these transactions moved its net short position over the threshold of 0.2% of the issuer's equity, triggering the requirements to notify the relevant regulator – in this case, the FCA, since the issuer was listed in London. By the end of February 2017, after a further equity swap, the firm also surpassed the 0.5% threshold for notifying the public of its position. Neither such notification was made.
Between February 2017 and July 2019, the firm continued to build its net short position in the issuer. Over this period, the firm failed to make 155 notifications to the FCA and 153 disclosures to the public of its net short position. By July 2019, the firm had built a net short position in the issuer of 16.85% of the issued share capital of the issuer. The firm held its net short position for a further 106 trading days prior to notifying the FCA and disclosing its positions to the public in December 2019.
In assessing its penalty, the FCA considered that the failings were particularly serious given that:
- First, the failures to comply with the SSR obligations were multiple and continued over a significant time period.
- Secondly, the firm did not inform the FCA promptly upon discovering its failure to comply with the relevant obligations under the SSR, and instead notified the Authority only after it had reviewed and collated the relevant data for disclosure. The firm determined on 8 November 2019 that it was under an obligation to make the disclosures, but did not notify the Authority until 29 November.
- Thirdly, the size of the net short position was very significant, constituting the largest ever net short position held in an issuer admitted to the FCA's Official List with shares admitted for trading on the London Stock Exchange.
In mitigation, the FCA recognized that the breaches were not committed deliberately or recklessly, and although large in number, all stemmed from the same root cause failure in the firm's compliance system. The FCA recognized that the firm cooperated fully with the FCA's investigation and sought to remediate its underlying controls to prevent re-occurrence. The firm qualified for a 30% penalty discount under the FCA's executive settlement procedures.
The key takeaways for firms from the FCA's first enforcement action under the SSR include the following:
- First, it appears that the firm in question, based in Asia and not Europe, was not aware of its obligations under the SSR. In the FCA's Final Notice, it points out that the firm had relied on third party materials to understand its regulatory requirements when investing in UK listed companies. According to the Final Notice, such third party materials did not sufficiently explain that derivatives, as well as shares, were captured by the SSR. This highlights the need for firms to seek specific, tailored legal advice with respect to their regulatory obligations.
- Secondly, if firms become aware that they have failed to meet their disclosure obligations under the SSR, they must act quickly to remedy this. The Final Notice highlights as an aggravating factor the fact that the firm had not immediately notified the FCA of its disclosure failures, but rather waited to review and collate the relevant data first. It is clear that the FCA expects to be notified of any such breaches as soon as possible following discovery.
- Thirdly, although this is the FCA's first enforcement under the SSR, more can be expected. Following the end of the Brexit transition period, the SSR will be "onshored" into UK law through the Short Selling (Amendment) (EU Exit) Regulations and further enforcement action should be anticipated.
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