Effective from midnight on Thursday 18 September, the Financial Services Authority has introduced new provisions to the Code of Market Conduct effectively to prohibit the active creation or increase of net short positions in publicly quoted financial companies. An exception for market makers enables them to meet client demand.
In addition, the provisions require daily disclosure of all net short positions in excess of 0.25% of the ordinary share capital of the relevant companies held at market close on the previous working day, on and from Tuesday 23 September. Disclosure of any such positions held at close on Friday 19 September, must also be made.
Whilst confirming that the FSA still regards short-selling as a legitimate investment technique in normal market conditions, in the current extreme circumstances which had given rise to disorderly markets, Hector Sants said the action had been taken "to protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector".
The provisions, and in particular the prohibition, give rise to some significant and problematic issues for firms, on which further guidance would be welcomed. The provisions are to remain in force until 16 January 2009, although they will be reviewed after 30 days.
The new regime
In June this year, we reported that the FSA had amended the Market Conduct Sourcebook to create a disclosure regime in respect of short positions in companies undertaking rights issues. This was effected by including a provision stating that failure by a person to give adequate disclosure that he had reached or exceeded a disclosable short position in relation to securities the subject of a rights issue, and during the rights issue period was, in the FSA's opinion, behaviour which amounted to market abuse (misleading behaviour) under section 118(8)(a) of the Financial Services and Markets Act 2000 ("FSMA").
The latest amendments to the Market Conduct sourcebook adopt a broadly similar approach. The FSA has incorporated several evidential provisions which characterise the following conduct as behaviour which, in its opinion, amounts to market abuse (misleading behaviour):
- Entering into a transaction that (whether by itself or in conjunction with other transactions) has the effect of:
- creating a net short position in a UK financial sector company; or
- increasing any net short position in a UK financial sector company that the person had immediately before 19 September 2008.
This does not apply to a person acting in the capacity of a market maker.
- Failure by a person who has a disclosable short position in a UK financial sector company to provide adequate ongoing disclosure of their position.
A "net short position" is a net short position which gives rise to an economic exposure to the issued share capital of a company. In calculating whether a person has a short position, any form of economic interest in the shares of the company must be taken into account.
A "disclosable short position" is a short position which represents an economic interest of 0.25% of the issued capital of a company. In calculating whether a holder has a disclosable short position, the holder should take into account any form of economic interest it has in the shares of an issuer, excluding any interest which he holds as a market maker in that capacity.
“Adequate ongoing disclosure” means disclosure made on a RIS by no later than 3.30pm on the business day following each day on which the disclosable short position is held. The disclosure must include the name of the person who has the position, the amount of the position and the name of the company in relation to which it has that position.
The FSA has now published some Frequently Asked Questions (FAQs) to provide firms with guidance on operational issues arising from the new provisions to facilitate compliance with the new regime. The following key points emerge:
- To which (listed) companies do the provisions apply?
- A "UK financial sector company" is a company that is a UK bank, a UK insurer, or a UK incorporated parent undertaking of a UK bank or a UK insurer.
- The prohibition applies in respect of UK financial sector companies on all markets established under the rules of a UK recognised investment exchange, and to OFEX.
- The FSA has published a list of UK incorporated banks and insurers in connection with the amending instrument. This list is provided on a best endeavours basis only - originally 29 companies, it was updated during the course of yesterday day (Resolution was removed as it is not longer a listed entity) and now includes 32 entities. Other names may be added to the list.
- To what do the provisions apply?
- The provisions apply to all types of short -selling instruments regardless of how they are obtained.
- The provisions cover related investments, such as CFDs, spread bets, options, futures and depositary receipts.
- OTC transactions are also covered.
- Is the threshold the same for the prohibition as for the disclosure requirement
- No - the prohibition applies to any transaction that creates any net short position or increases any existing net short position.
- A net short position that arises after 18 September, but not as a result of any transaction being entered into, is not caught by the prohibition, but may still be disclosable if it exceeds the disclosure threshold.
What is the format for disclosure?
- Form (TR4) for short position disclosure has been made available on the FSA's website to assist firms in complying with the disclosure obligation. Use of the form is not mandatory, but all disclosures must contain the information contained in TR4 – i.e. the full name of the person holding the disclosable short position, the name of the issuer of the relevant securities, the size of the position as a percentage of the issued share capital, and (over and above what is required by the definition of "adequate disclosure" in MAR) the date that the 0.25% threshold was reached or exceeded.
- The disclosure must be made by means of a Regulatory Information Service using RIS shortcode SSD.
- Who should make/be named in the disclosure?
- The obligation to make the disclosure lies with the holder of the short position.
- Disclosures should be made at the level of each legal entity (although one entity may make the disclosures on behalf of each individual entity within the group, provided the positions of each entity are clearly stated).
- The disclosure must name the owner or controller of the interest: the naming of nominees or vehicle companies is insufficient.
- Where a fund manager is managing positions for clients on a discretionary basis, the underlying clients do not need to be named. Where, however, positions are being managed by a fund manager on a non-discretionary basis, the disclosure obligation falls on the client.
- How is the size of the position calculated?
- Long and short positions may be netted off – disclosure only has to be made of any aggregate net short position of 0.25% or above.
- The percentage is to be calculated on the basis of the entire share capital of the issuer.
- The component parts of an aggregate net short position (e.g. individual long and short positions, or different types of economic interest) do not have to be disclosed.
- As explained above, economic interests are to be taken into account when calculating the size of the position. The FSA considers that (subject to the points below) this would cover any instrument which gives the holder an exposure, direct or indirect, to the shares of the company.
- Any economic interest held as part of a basket or index where all of the components in the index or basket are UK financial sector companies must be included.
- For disclosure purposes, calculations need not be made on an intra-day basis – they should instead be made on the basis of the size of the position as at midnight on the relevant day. Note, however, that the prohibition prevents a person from actively increasing his short position intra-day.
- Positions held in a person's capacity as market maker can be disregarded. Firms should ensure that they genuinely fall within the definition; reliance on this exemption will be carefully monitored by the FSA. Positions held by an investment bank's proprietary trading desk are therefore subject to the regime.
- A fund manager must aggregate the positions held across all of its discretionary funds.
- Is there any obligation to update the disclosure?
- Following the first disclosure, net short positions of 0.25% or above by 3:30 pm must be disclosed on the day following each day on which the disclosable short position was held.
- The fact of a net short position falling below the 0.25% threshold must also be disclosed.
- How does the new instrument affect rights issue disclosures?
- The disclosure regime in relation to securities subject to a rights issue continues to apply. The two disclosure regimes would overlap if a UK financial sector company were to conduct a rights issue.
In his Mansion House speech on Thursday, the FSA Chairman highlighted concerns that movements in equity prices due to extreme short-selling pressures on financial institutions could be translated into uncertainty in the minds of those who place deposits with those institutions with consequent financial stability issues. Yesterday, the US Securities and Exchange Commission (SEC), acting in concert with the FSA, announced similar temporary measures to prohibit short-selling in 799 financial companies in the US, in order to protect the integrity and quality of the securities market and strengthen investor confidence. Interestingly, however, there were also reports that some of the largest institutional investors, both in the US and in the UK, had already suspended all or part of their stock lending.
As was the case in June, these new short-selling measures have been introduced within a very short timeframe. Although the FSA has provided some guidance in the form of the FAQs, it is clear that further elaboration will be required. The guidance predominantly addresses issues surrounding the calculation of positions for the purposes of disclosure. There are, however, some significant and problematic issues which arise for firms when applying the guidance in respect of the prohibition to intra-day positions.
A discretionary fund manager, for example, who operates both long-only fund and hedge fund strategies, may need to liquidate long positions on the long-only fund in order to implement that fund's strategy, but might thereby create or increase a net short position when the position of all its discretionary funds are taken into account. The guidance states clearly that in calculating a disclosable short position, the manager should aggregate the position of all its discretionary funds. Although the guidance is not so explicit as to how the net short position is to be calculated (it does specify that financial instruments should be accounted for on a delta adjusted basis), the amending instrument states that any calculation must take account of any form of economic interest in the shares of a company. The manager is under a regulatory duty to act in the best interests of his clients, but if he complies with COBS 2.1.1R, he creates or increases a net short position, behaviour which in the opinion of the FSA amounts to market abuse (misleading behaviour).
As indicated above, the FSA states in FAQ 11 that any economic interest held as part of a basket or index where all of the components in the index or basket are UK financial sector companies must be included. The rationale for this guidance is unclear, given that any calculation of a net short position must take account of any form of economic interest in the shares of a company: a counterparty could effectively achieve an economic exposure equivalent to a net short position by reversing out short positions in respect of the components which were not related to UK financial sector companies. The FSA has indicated that it may amend the guidance to cover any economic interest held as part of composite baskets or indices where the components include "predominantly" UK financial sector companies. It is not entirely clear what the FSA would intend by "predominantly" - more than 50%? - but if the changes were implemented in that form, it would arguably still be permissible to short a basket or index whose components were not "predominantly" UK financial sector companies.
Further FSA action
The FSA intends to review these provisions after 30 days in any event, although its stated intention is that they should remain in force until 16 January 2009. The FSA has, however, also indicated that it would be prepared to extend this approach to other sectors if it judges it to be necessary.
A comprehensive review of the rules on short-selling is to be published in January 2009.