On 23 July 2010, the UK’s financial regulator, the Financial Services Authority (“FSA”), published its consultation paper CP 10/18, entitled Feedback on CP 10/11, final rules and further consultation (“CP 10/18”)1 which incorporates the final text of the new Financial Stability and Market Confidence sourcebook (“FINMAR”2). The new sourcebook, which forms part of the FSA Handbook, contains the FSA’s recast and slightly revised rules on short selling3 (and incorporates many of the FSA’s existing frequently asked questions as guidance).
In response to widespread criticism for permitting the FSA to become a “light-touch” regulator, the UK’s outgoing Labour government granted a range of new powers to the FSA under the Financial Services Act 20104 (the “FS Act”), including powers to:
- Require disclosure of information about short selling and prohibit short selling in specified cases;
- Require information or documents to be produced to determine whether short-selling rules have been contravened; and
- Impose penalties or issue censures when a person has contravened short-selling rules.
Short-Selling Rules Recast
The FINMAR rules on short selling5 incorporate, with minor amendments, the existing FSA short-selling disclosure regime (currently set out in the FSA Code of Market Conduct (“MAR”)6), which requires:
- Disclosure7 of net short positions of 0.25% or more in companies undertaking rights issues (and whose shares are admitted to trading on a UK prescribed market), with a further disclosure required when the net short position falls below 0.25%; and/or
- Disclosure8 of net short positions in UK financial sector companies in excess of 0.25% of ordinary share capital. Additional disclosures are required if the short position reaches, exceeds or falls below 0.25%, and each 0.1% thereafter, of the share capital of the company (i.e., disclosures required at thresholds of 0.25%, 0.35%, 0.45% etc). Where a net short position decreases below the 0.25% threshold, a final disclosure must be made.
Where a fund has appointed a discretionary investment manager, the fund can either make its own disclosure or can authorise the investment manager to make the disclosure. If such manager is managing investments for more than one client, the manager must provide disclosure in respect of the aggregate net short positions of all the portfolios that it manages9.
In transposing these rules from MAR to FINMAR, the principal change that the FSA has made is to narrow the scope of the rights issue disclosure obligation so that the disclosure regime will be restricted to only UK companies and companies for which a UK prescribed market is the main or sole trading venue.
The FSA has also revised its position on how to calculate a net short position for purposes of the disclosure rules. Under FINMAR, the short-position holder is still required to take into account positions held through indices, baskets and exchange traded funds when calculating whether a disclosable net short position is held. However, this is no longer an absolute obligation, but rather "guidance". The effect of this seemingly minor change is to permit market participants to undertake the necessary calculations of such positions on a best-efforts basis. The FSA in CP 10/18 gives the example that it would not be necessary for such persons to have a daily feed of relevant data; instead, historical information about the weighting of a stock in an index could be used as long as it was reasonably up-to-date10.
The FINMAR short-selling rules also incorporate the FSA’s frequently asked questions on its short-selling disclosure regimes11 and have generally been recast as FSA guidance in support of the relevant short-selling disclosure rules. The FSA has confirmed that after FINMAR comes into force, the FAQs will fall away and cease to have any legal effect and therefore market participants should review the rules and guidance in FINMAR instead of relying on the FAQs.
Interaction with Proposed New EU Short-Selling Regime
The FSA notes in CP 10/1812 that neither the short-selling disclosure regime in connection with a rights issue, nor the regime in connection with short sales of stocks in the UK financial sector is permanent; both regimes eventually will be superseded by the pan-European short-selling regime proposed by the Committee of European Securities Regulators (“CESR”)13 (the “Proposals”). The Proposals involve a two-tier model for the disclosure of significant individual net short positions in all shares that are admitted to trading on a European Economic Area14 (“EEA”)-regulated market and/or an EEA multilateral trading facility, when the primary market of those shares is located in the EEA.
Under the Proposals, a short seller would be required to make:
- A private disclosure to the relevant regulator of any net short position in a company's issued share capital that reaches a threshold of 0.2% of the issuer company's issued share capital. Any increases or decreases of 0.1% above the 0.2% threshold would trigger further disclosure obligations, meaning that, for example, notifications would need to be made to the relevant regulator at 0.3% and 0.4% and so on; and
- A public disclosure to the market as a whole, as well as to the relevant regulator once the short seller's net short position reaches 0.5%, and at every 0.1% above that (for both increases and decreases (i.e., disclosure required at 0.5%, 0.6%, 0.7% etc), with the final downward disclosure only required when a short seller’s net short position falls below 0.5%).
In calculating whether a disclosure is required, market participants will be required to aggregate any position resulting in an economic exposure to a particular share. Positions held in exchange-traded and OTC derivatives will be included, as will short positions in cash markets. Disclosure calculations and reports will be required on a net basis, with any positions involving long economic exposures to a share deducted from aggregate short positions. Disclosure reports of short positions (to the market and/or to the regulator) will be required to be made on the trading day following the day on which the relevant threshold has been crossed. Intra-day positions that breach a disclosure threshold, but that return below that same threshold before the end of the trading day, will not be captured. Market makers will be exempt from the disclosure requirements.
Until such time as the Proposals gain force of law through implementation in an EU directive or other EU regulation (there is currently no indication as to when this date might be) the FSA’s short-selling rules in FINMAR will remain in effect.
New Short-Selling Powers and Penalties
The FS Act also provides that the FSA has the power to:
- Require a person to provide information and documents that the FSA reasonably requires for the purpose of determining whether a person, or a person connected to them, has contravened any provision of short-selling rules15; and/or
- Impose a financial penalty or public censure on a person that contravenes any provision of short-selling rules or on a person who was knowingly concerned in the contravention16.
The FSA states in CP 10/1817 that it will only use these powers when information or documents are, or may be, relevant to UK financial stability. However, the point at which an entity or instrument becomes relevant to financial stability will depend on, among other things, the size and liquidity of the relevant market, the proportion of the market the entity’s investments account for, the interconnectedness of the entity to other market players and the volatility of the market. Activities that may not be considered a risk to financial stability during ”normal” market conditions may, in fact, create such risks if the markets they relate to are under stress or become unusually volatile.
The FSA’s power to impose financial penalties18 on persons who breach short-selling prohibition rules or short-selling disclosure requirements came into force on 8 June 2010.
The new FINMAR sourcebook will come into force on 6 August 2010, on which date the revised and recast rules will come into effect and the existing short-selling rules in MAR will be deleted.