On November 1, 2012, the regulation (the “Regulation”)1 of the European Parliament and Council of the European Union on short selling and certain aspects of credit default swaps became effective.2 The Regulation may have a substantive impact on U.S. issuers of structured products linked to securities that trade in the European Union, as well as other participants in structured product transactions, and this article is intended to discuss some of these impacts.
The Regulation was conceived out of the need to harmonize the fragmented approach of different regulators throughout the EU towards restricting short selling and the use of credit default swaps (“CDS”), which limits the effectiveness of adopted measures and results in regulatory arbitrage. The Regulation seeks, in particular, to improve the transparency related to significant short positions and address risks of negative price spirals and settlement failures, especially in relation to uncovered or ‘naked’ short selling. Although the issuance of structured products does not necessarily relate to these issues, structured product transactions are among the transaction types impacted by the Regulation.
Scope of the Regulation and Key Provisions
The Regulation has been broadly drafted to include the short selling of equity securities admitted to trading on an EU regulated market or a multilateral trading facility, certain types of EU sovereign debt3 (as well as derivatives and structured product transactions referencing and providing exposure to these securities) and the buying of credit protection through CDS in relation to EU sovereign debt. As a result, structured products that reference relevant securities will potentially be affected by the Regulation.
The Regulation creates a two-tier disclosure regime of public and private disclosure of net short positions in relation to equity securities. The Regulation also introduces disclosure requirements for the shorting of EU sovereign debt and trading in naked sovereign CDS. Structured products linked to sovereign debt tend to be limited to the institutional market in the U.S.
The Regulation requires market participants to effect (by 3:30pm on the following trading day) a private notification of a net short position, calculated at midnight in the relevant EU member state at end of a trading day on which its net short position reaches or falls below 0.2% of the relevant issuer’s issued share capital, and each 0.1% above that, up until 0.5%. A public notification must be made when the relevant entity’s net short position at midnight in the relevant EU member state at end of a trading day reaches or falls below 0.5% of the applicable company’s issued share capital, and each 0.1% above that.
The calculation of net short positions is required to take into account all long and short positions which the holder has in relation to the relevant shares or EU sovereign debt, as well as any other form of economic interest in those instruments. In particular, it is required to take into account interests obtained directly or indirectly through the use of derivatives (including options, futures and contracts for differences) and indices, baskets of securities and exchange traded funds.
In determining net short positions in relation to EU sovereign debt, a disclosing entity is also required to take into account its positions under CDS trades relating to the relevant EU sovereign debt issuer. Disclosure need only be made to the national regulator of the relevant sovereign issuer. There is no equivalent public disclosure requirement and the notification thresholds vary by member state.4 However, uncovered EU sovereign CDS entered into on or after March 25, 2012 are no longer permitted. Those trades entered into prior to March 25, 2012 may be held until the maturity date of the contract.
For purposes of the Regulation, it does not matter when the trade creating a particular long or short position was effected. An issuer’s only concern is whether it has an open net short position on or after November 1, 2012. It is also worth bearing in mind that the Regulation allows any existing member state rules relating to short selling to remain in place until July 1, 2013. As such, it is important (for now) to be aware of any local member state rules which may apply in addition to the Regulation.
The Regulation also obliges holders of short positions to keep for five years records of their net short positions, as well as the gross positions supporting these net short positions. However, the requirement to identify short sales in (private) transaction reports to competent authorities, which was in previous versions of the Regulation text, has been deferred to the Commission in its consideration of amendments to the Markets in Financial Instruments Directive 2004/39/EC.
The Regulation applies to parties anywhere in the world, regardless of their jurisdiction of organization or operations. The Regulation also applies to transactions that are effected within or outside of Europe.
The Regulation does not apply to shares for which the principal trading venue is outside the EU. As a result, for example, a French company that has its primary market in Paris, but also trades to a lesser degree in ADRs on the New York Stock Exchange will be covered. In contrast, a U.S. company that has its primary market in the U.S., but also has some trading on the London Stock Exchange, will not be subject to the Regulation.
Types of Transactions Impacted: Issuers
A variety of typical U.S. structured note transactions will be subject to the Regulation.
For example, a U.S. issuer issues a registered structured note linked to the positive performance of the NYSE ADRs of a French company traded in Paris. The issuance of the note creates a “net short position” for the issuer. If the U.S. issuer enters into a corresponding swap transaction with an unrelated third party through which it passes along all of its exposure to the upside performance of the ADRs, the net short position will revert to zero. On the other hand, if it enters into the same swap transaction with an affiliated entity, the corporate group as a whole will retain that net short position. Of course, it’s entirely possible that the related-party entity will offset some or all of its exposure to the ADRs through one or more transactions with other entities, and reduce the net short position.
Similar results arise from linking to an index or an exchange-traded fund that includes European securities. For example, the EURO STOXX 50 Index and the MSCI EAFE Index (and ETFs that track those indices) are common underlying assets for U.S. structured notes. As to each relevant European security within the index or ETF, the Regulation requires the issuer to recognize a portion of the principal amount of each relevant structured note as a short position in the relevant security, according to its weighting in the index or ETF.
Types of Transactions Impacted: Investors
Investors, particularly institutional investors, may enter into transactions that are regulated by the rules. For example, an investor with a particular market view may purchase a note that is linked to the negative performance of a particular stock or index. If the transaction is large enough, it can trigger the provisions of the Regulation. On the other hand, investing in a structured product that is bullish on a particular stock may offset a net short position that the investor otherwise may have.
Needless to say, the Regulation creates a substantial compliance challenge for multi-national market participants. At any one time, these entities will have (whether directly, or through their affiliates) a wide variety of long and short positions in a large number of European stocks, and indices and ETFs that include European stocks. In some cases, the short position will arise from their issuance of a structured product. In other cases, the short position may arise due to its involvement in the hedging transactions for another issuer’s structured products. These types of transactions need to be evaluated together with the myriad of transactions outside of the structured products world that the issuer may be undertaking. It seems inevitable that there will need to be new compliance units established (to the extent that this has not been done already) in order to track and match long and short positions across an institution’s various affiliates and subsidiaries. This will likely be the case with respect to global institutions with multiple affiliates and branches and, to a lesser extent, institutions with narrower trading strategies (such as hedge funds).