SEC and FSA Take Action to Limit Abusive Short Sales
In the last 48 hours, securities regulators on both sides of the Atlantic have taken actions designed to curtail abusive short selling in an effort to stabi- lize the financial markets. This client memo summarizes these recent regulatory actions. Further regulatory actions with regard to short selling are expected from both regulators in the days and weeks to come.
On September 17, 2008, the Securities and Exchange Commission (“SEC”) issued an emergency order adopting a new temporary rule imposing restrictions designed to curb naked short selling and the resulting delivery failures and a new anti-fraud rule applicable to short sellers who fail to deliver securities by the delivery date (the “Short Selling Emergency Order”).1 The Short Selling Emergency Order, which applies to all transactions in equity securities effected, cleared, or settled by or through U.S. broker-dealers or clearing agen- cies, took effect at 12:01 a.m. EDT on Septem- ber 18, 2008, and expires, unless extended, at 11:59 p.m. on October 1, 2008.2 At the same time, SEC Chairman Christopher Cox and Director of the Division of Enforcement Linda Thomsen announced expanded efforts to investigate and prosecute market manipulation effected through abusive short-selling. On September 18, New York Attorney General Andrew Cuomo announced “a wide-ranging investigation” into short selling in the stock of financial services firms.
In general, a short sale is the sale of a security that the seller does not own or any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. In a short sale transaction, if the price of a stock decreases after the stock is sold, the short seller makes a profit equivalent to the difference between the sale price and the price at which the stock was bought back (a covering or close out transaction) in the open market. A “naked” short sale occurs when a party sells a stock short but does not own for delivery or intend to deliver stock at settlement and does not enter into a corresponding transaction to borrow the stock for delivery, thereby resulting in a “fail to deliver.” Extensive naked short selling in a company’s stock or large numbers of fails to deliver on short sales are believed by some to be abusive and to create downward pressure on the price of the company’s stock. The new SEC regulations are intended to prevent such abuse by preventing continued short selling under conditions where there are large numbers of lingering fails. However, the new regulations do not reinstate the recently expired July Emergency Order3 that precluded naked short sales in the securities of Fannie Mae, Freddie Mac, and several other large financial institutions engaged in commercial banking, investment banking, and capital markets activities.
The SEC addressed three particular aspects of short selling in the Short Selling Emergency Order.
Delivery or Close Out
The first of the new temporary regulations will require sellers and their broker-dealers to deliver the securities for settlement of any long or short sale in any equity security to the buyers by the regular settlement day (T+3). If a short seller fails to deliver, the broker-dealer acting on the short seller’s behalf will be prohibited from short selling those securities for any client or for its own account without first borrowing them or entering into a bona-fide arrangement to borrow the securities, until the fail to deliver position is closed out. Because the Short Selling Emergency Oder also eliminates the exception to these requirements that applied to market makers (see below), these short selling borrowing requirements if a broker-dealer has a fail to deliver on settlement day will now also apply to market makers. Thus, a broker-dealer or market maker will be unable to accept or enter any further short sales unless it borrows the security for delivery or closes out the fail.
Elimination of the Options Market Maker Exception to Rule 203(b)(3) in Regulation SHO
Regulation SHO, which first went into effect in January 2005, requires short sellers in all equity securities to borrow or locate securities to borrow before selling and also imposes additional requirements on broker-dealers with respect to securities in which a substantial number of failures to deliver have occurred. Rule 203(b)(3) of Regulation SHO provided, under certain circumstances, an exception to the close-out requirements for options market makers, thereby permitting such market makers to short securities even if they have not borrowed, or located to borrow, the relevant security. The SEC’s new regulations will eliminate the options market maker exception to Rule 203(b)(3) of Regulation SHO, thereby requiring options market makers to abide by the same close-out requirement as all other short sellers.
Applicability of the Order
The Short Selling Emergency Order is limited to short sales effected by broker-dealers who are direct or indirect participants in a registered clearing agency. Accordingly, the Short Selling Emergency Order applies to orders entered through any U.S. registered broker- dealer that receives, clears, or settles transactions in the U.S. The Short Selling Emergency Order does not apply to transactions effected on non-U.S. markets that are not cleared or settled through U.S. clearing facilities or participants.
Short Selling Anti-Fraud Rule
The Short Selling Emergency Order also addresses fraudulent short-selling transactions by providing that lying about one’s intention or ability to deliver securities within three days after a short sale constitutes a violation of the law when the seller fails to deliver. The anti-fraud rule imposed in the Short Selling Emergency Order is substantially similar to the rule the SEC proposed on March 17, 20084. The comment period for the proposed rule ended on May 20, 2008.
Chairman Cox and Director Thomsen emphasized that the SEC will back these new rules, as well as existing anti-fraud and anti-manipulation rules, through ex- panded enforcement efforts. In a statement5, Chairman Cox said: “The Enforcement Division will obtain disclo- sure from significant hedge funds and other institutional traders of their past trading positions in specific securities. Those institutions will also be required immediately to secure all of their communication records in anticipation of subpoenas for these records.” Director Thomsen concluded: “We are committed to using every weapon in our arsenal to combat market manipulation that threatens investors and capital markets.” New York Attorney General Cuomo noted that his office had received numerous complaints about false rumors spread by short sellers and suggested that the SEC should have gone even further than it did, including an outright freeze on short sales of the stocks of financial services companies.
Disclosure of Short Positions by Managers with More Than $100 Million Under Management
In a press release dated September 18, 2008, Chairman Cox stated:
In addition to these initiatives, which will take effect at 12:01 a.m. ET on Thursday, I am asking the Commission to consider on an emergency basis a new disclosure rule that will require hedge funds and other large investors to disclose their short positions. Prepared by the staffs of the Division of Investment Management and the Division of Corpo- ration Finance, the new rule will be designed to ensure transparency in short selling. Managers with more than $100 million invested in securities would be required to promptly begin public reporting of their daily short positions. The managers currently report their long positions to the SEC.6
On September 18, 2008, the Board of the UK Financial Services Authority ("FSA") agreed to introduce new provisions to the Code of Market Conduct designed to prohibit the active creation or increase of net short positions in publicly quoted financial companies from midnight on September 18.7 In addition, the new provisions will require that, beginning on September 23, 2008, daily disclosure of all net short positions in excess of 0.25% of the ordinary share capital of the relevant companies held at the market close on the previous working day. On September 23, market participants will also be required to disclose all such positions held at the close on September 19, 2008.
For now, this ban is limited to publicly-quoted financial companies,8 but the FSA may later extend this ban to other sectors if it judges such action to be necessary.
The provisions will remain in effect until January 16, 2009, but will be reviewed by the FSA in 30 days.
In the FSA Statement, Hector Sants, chief executive of the FSA, is quoted as saying:
While we still regard short-selling as a legitimate investment technique in normal market conditions, the current extreme circumstances have given rise to disorderly markets. As a result, we have taken this decisive action, after careful consideration, to protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector.
1) Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments, SEC Rel. No. 34-58572 (Sept. 17, 2008).
3) On July 15, 2008, the SEC issued an Emergency Order (the “July Emergency Order”) restricting naked short selling of the securities of certain financial institutions, and on July 18, 2008, amended the July Emergency Order to ex- empt short selling in connection with market making, un- derwriting and restricted securities. See Dechert Special Alert, July 2008.
4) "Naked" Short Selling Anti-Fraud Rule, SEC Rel. No. 34-57511, 73 Fed. Reg. 15,375 (Mar. 21, 2008).
5) Statements of SEC Chairman Christopher Cox and Enforcement Division Director Linda Thomsen Regarding Immediate Commission Actions to Combat Market Ma- nipulation, http://www.sec.gov/news/press/2008/2008- 209.htm
7) FSA Statement on short positions in financial stocks (Sept. 18, 2008) available at http://www.fsa.gov.uk/pages/Library/Communication/PR /2008/102.shmtl (the “FSA Statement”).
8) Detailed changes to the Code of Market Conduct and the list of financial companies covered by the ban will be pub- lished before the markets in London open on September 19, 2008.