The Australian regulatory environment for the short selling of shares has been significantly altered since September 2008. In response to concerns about its effect on market volatility, the previous regulatory exemptions in respect of short selling were tightened and the ability to place short sales was circumscribed (particularly in financial securities). These restrictions continued through to 25 May 2009.
The current regulatory regime reflects the evolving compromise between concerns about increased volatility and the role played by short sales in hedging risk in an efficient market.
From 18 November 2008, an interim disclosure and reporting regime in relation to short selling transactions involving securities lending arrangements has been in place. This will be replaced by a more sophisticated reporting system from 1 April 2010.
What is short selling?
Short selling involves a person selling financial products that they do not own at the time of sale. The rationale behind this is that the person expects the price will decline, allowing them to borrow or purchase the financial products at a lower price than they were sold for, to allow delivery of the financial products to the purchaser.
The financial markets distinguish between two forms of short selling:
- naked short selling – a sale by a market participant of financial products without existing arrangements for delivery of the financial products to the buyer; and
- covered short selling – a sale by a market participant of financial products with arrangements in place for the delivery of the traded financial products to the buyer, typically by borrowing those products.
Section 1020B(2) of the Corporations Act 2001 (Cth) prohibits the sale of securities, managed investment products and certain other prescribed financial products (together, Section 1020B Products) unless at the time of sale the person has a "presently exercisable and unconditional right to vest" the products in the buyer (i.e., a covered short sale). That is, the person must have the power to direct a transfer of the products, and the transfer must provide the person with the absolute ability to give the buyer title to the products.
This right to vest is typically obtained by a securities lending arrangement, with securities being transferred temporarily from the lender to the borrower and the borrower being obliged to return equivalent securities at an agreed time (or on demand). Where the right to vest is a result of securities obtained under a securities lending arrangement, ASIC requires the lender to give the borrower, at the time of sale, a legally binding commitment to deliver the products.
Where is the current regulatory scheme situated?
The principal changes are a reflection of a combination of ASIC Class Orders and the Corporations Amendment (Short Selling) Act 2008 (Cth) (the Amending Act), as set out below.
(a) Previous exceptions to the prohibition on short selling removed
Most of the former exceptions to the s 1020B(2) prohibition on short selling were repealed as at 8 January 2009 through the Amending Act. The only exception that survived is that which was formerly section 1020B(4)(c). Accordingly, even if a seller of Section 1020B Products does not have a "presently exercisable and unconditional right to vest" the products in the buyer at the time of sale, they may still sell those products if they entered into a contract to buy those products before the time of sale and have a right to have those products vested in the person that is conditional only upon all or any of the following:
- payment of the consideration for the purchase;
- the receipt by the person of a proper instrument of transfer in respect of the products; and/or
- the receipt by the person of the documents that are (or are documents of title to) the products.
Three additional exemptions to the prohibition, relating to certain transactions involving options and debentures, are set out in ASIC Class Orders CO 08/764 and CO 09/1051.
(b) Naked short-selling exemption for market makers reinstated
On 24 September 2009, ASIC issued Class Order [CO 09/774] providing a narrow exemption from the prohibition on naked short-selling. It provides market makers with relief in limited circumstances from section 1020B(2) of the Corporations Act in relation to the sale of a security or managed investment product to hedge risk from market making activities.
A market maker regularly states prices at which it proposes to buy or sell financial products on its own behalf. Where a market maker enters a transaction with a counterparty that creates a 'long' exposure to a given product, it may attempt to hedge the risk associated with the long exposure by short-selling that product.
Although market markers are generally permitted to hedge risk by engaging in covered short-selling of Section 1020B Products, there are practical difficulties with this approach (in that it requires market makers to carry the costs of maintaining an inventory of long or borrowed products, and it is impossible for market makers to predict the volume of products required to cover possible future positions). The relief offered by ASIC is designed to address these shortcomings.
The relief provides that a market maker does not have to comply with section 1020B(2) of the Corporations Act in relation to the sale of a security or managed investment product (the shorted product) where all of the following apply:
- the market maker makes a market for a financial product;
- the market maker issues, acquirer or disposes of a financial product (the hedged product) in the course of making that market;
- the market maker holds, or is exempt from holding, an Australian financial services licence for making a market;
- the sale of the shorted product is a bona fide transaction to manage, avoid or limit the financial consequences of the person issuing, acquiring or disposing of the hedged product in the course of making a market in the hedged product; and
- at the time of the sale, the shorted product is a constituent of the S&P/ASX 200 index.
In addition, market makers must have reasonable grounds to believe securities lending arrangements can be put in place to allow delivery and must acquire or borrow sufficient products by the end of each day to ensure that they can deliver all products sold during the day at the time delivery is due. If the market maker is ever unable to do so, it must notify ASIC in writing by 9:00am the following business day.
A similar exemption that operated under the previous short-selling regulatory regime was repealed on 8 January 2009.
(c) Enhanced disclosure requirements in interim term
Since 18 November 2008, a greater level of disclosure has been required by ASIC in respect of short sales. Brokers have been required to establish whether a client's sale is a long sale, short sale or an exempt covered short sale. Brokers then report each day's short sales to ASX via on online facility by 9am the following day.
Under the reporting arrangements between ASIC and ASX, data on short sales is collated and a market figure by security is released each day. The report shows, by security, the total volume of short sales executed on the previous trading day.
(d) Permanent disclosure regime
Regulations under the Amending Act provide that this disclosure and reporting role will be taken over by ASIC on 1 April 2010. Short sellers will have to report their short positions to ASIC rather than ASX. The process of ongoing disclosure will be carried out via FIX Position Reports.
This information will be aggregated by ASIC and released to the public four business days after the positions are taken.