When looking for parties to blame for the current banking sector turmoil, one of the groups consistently singled out as culprits by the tabloid press and politicians (apart from bankers, regulators and rating agencies) are short-sellers.
The heightened disclosure regime introduced by the regulator as a result of this criticism has brought with it some challenges for lawyers and the institutions they advise.
As most of us now know, ‘short-selling’ is where a person agrees to sell shares it does not yet own in the expectation that the market price for such shares will fall, enabling it to make a profit by acquiring the shares needed to complete the sale at a much lower price. At the height of the financial crisis in September 2008, a time of unprecedented volatility in the UK financial sector, the Financial Services Authority (FSA) announced a temporary ban on the short-selling of stock in UK financial institutions. It stated that, despite the ban, it regarded short-selling as a legitimate technique “in normal market conditions” that can enhance market efficiency and liquidity.
The FSA stated, however, that in the extreme market conditions then prevalent, its concerns with short-selling stemmed primarily from its potential for market abuse, creating negative rumours or misleading impressions about a stock’s valuation in order to drive down the price of a stock. The FSA also believed that short-selling could give rise to more volatile markets and was concerned that a lack of transparency could lead to price inefficiencies.
Coupled with the ban on short-selling, the FSA also imposed a public disclosure requirement ;on holders of a net short position representing 0.25 per cent or more of the issued capital of any company whose shares were subject to the short-selling ban. Despite the ban, a person may already have held a disclosable short position or may have a non-disclosable position that subsequently becomes disclosable due to extraneous factors. A similar disclosure requirement already existed in respect of net short positions in the stock of a company subject to a rights issue. A ‘net short position’ includes short positions under options and other derivative contracts, but allows a person to deduct from such position any long positions that it also holds in the relevant stock.
The rules initially required a daily update of a disclosed position to be provided, even if the net position remained unchanged. Not surprisingly, this attracted significant criticism for being unduly burdensome. The FSA therefore subsequently announced that further disclosure was required only when the net short position had changed. Both the ban and the disclosure regime contained a market-maker exemption to cover short positions that arose through a market participant’s genuine market making activities.
Although the short-selling ban was a popular political move, it has been widely criticised in the financial services industry, with some criticism directed towards the additional legal and practical challenges. There is no strong evidence that the ban, or its recent removal, have had a significant effect on the price of bank stocks, and the price of many stocks in affected companies continued to slide, notwithstanding the ban. Short-selling may also aid liquidity in stocks, and an increased lack of liquidity may have caused bid/offer spreads for many companies to widen, making transactions more costly.
Christopher Cox, the former chairman of the Securities and Exhange Commission, commented that he believed a similar ban imposed for a three-week period in the US was not productive and was the biggest mistake of his tenure. From a legal perspective, there were additional compliance and legal costs involved in ensuring that transactions did not contravene the ban and complied with the disclosure regime.
In early January this year, the FSA announced that the ban on short-selling would expire on 16 January, but made it clear that it is prepared to reintroduce the ban if circumstances warrant. At the same time, it announced a continuation of the obligation to disclose net short positions until 30 June 2009, but with additional disclosure only being required if such position increased or decreased by 0.1 per cent increments.
The FSA also acknowledged that a set of permanent and cohesive short-selling regulations are needed for the UK and accordingly published a discussion paper in February setting out its proposals as to the long-term regulation of short-selling and inviting comments up to 8 May 2009.
The FSA’s discussion paper confirmed its view that there should be no permanent ban on short-selling in any sector. It also proposed a permanent continuation of the obligation to disclose net short positions, but with the obligation being triggered at a figure of 0.5 per cent (or 0.25 per cent during a rights issue period) of the issued share capital of the stock issuer, and where the net position changed upwards or downwards by 0.1 per cent increments. Significantly, the FSA proposed that the disclosure obligations should extend to all listed UK stocks.
Short-sellers will be relieved that, absent exceptional circumstances, the ban will not be reinstated. However, despite their concerns as to the additional cost and administration involved, they are likely to have to live with a permanent disclosure regime across all listed UK stocks.
Peter Green and Jeremy Jennings-Mares are partners in the UK capital markets practice at Morrison & Foerster