The European Union Short Selling Regulation (the Regulation), which includes implementing and delegated regulations, came into force on March 25, 2012 and takes effect beginning November 1, 2012, although certain indirect provisions have applied since March. Transitional provisions provide that existing measures within the scope of the Regulation that were in force before September 15, 2010 may remain applicable until July 1, 2013.
Once in force, the Regulation and related delegated regulations will have direct effect in the European Economic Area (EEA)1 member states, meaning that no local legislation needs to be passed to give legal effect to the Regulation.
On September 13, 2012, the European Securities and Markets Authority (ESMA) published questions and answers (Q&As) on the implementation of the Regulation, which help clarify issues raised and are sourced in this article.
What Is the Purpose of the Regulation?
The Regulation has been introduced, among other things, to:
- Prohibit short selling of Relevant Instruments (defined below) unless certain conditions are fulfilled
- Require disclosure of net short positions in shares admitted to trading on a trading venue in the European Economic Area (EEA), e.g., listed on the London Stock Exchange (LSE), as well as in sovereign debt (each a “Relevant Instrument”)
- Grant powers to member state regulators, also known as “competent authorities,” and ESMA to intervene in the markets where there is a threat to the orderly functioning and integrity of financial markets
- Prevent dealing in uncovered credit default swaps (CDS) on EEA-related sovereign debt unless there is an insurable interest (as described below) in the underlying sovereign debt position.
What Is the Scope of the Regulation?
The Regulation applies in any case where a transaction in a Relevant Instrument is within its scope. Neither the location of the short sale transaction nor of the person effecting it is relevant. It applies as much in North America and Hong Kong, for example, as it does in the EEA.
As referred to above, the Regulation applies to shares that are admitted to trading on a trading venue in the EEA (except when the principal trading venue of the shares is in a third country), including when they are traded outside a trading venue. For sovereign debt instruments and sovereign CDS, the Regulation applies if they are issued by an EEA member state or the EU itself.
When a person has a reportable net short position in a Relevant Instrument (see “Transparency” below), it needs to be reported wherever the relevant transaction(s) is or are executed or booked. So if, for example, a Singapore branch of an EU broker executes a short sale transaction in a Relevant Instrument, it falls within the scope of the Regulation.
In assessing whether shares of a particular issuer fall within the scope of the Regulation, the key condition is that the principal trading venue is in the EEA. For instance, shares of a US company that are admitted to trading on the LSE but whose principal trading venue is the New York Stock Exchange are exempt from the notification and disclosure requirements and the restrictions on uncovered short sales.
What Is “Short Selling” for the Purposes of the Regulation?
The Regulation defines a short sale as any sale of a Relevant Instrument that the seller does not own at the time of entering into the agreement to sell, including such a sale where at the time of entering into the agreement to sell, the seller has borrowed or agreed to borrow the Relevant Instrument for delivery at settlement. A short sale does not include:
- A sale by either party under a repurchase agreement in which one party has agreed to sell to the other a security at a specified price with a commitment from the other party to sell the security back at a later date at another specified price
- A transfer of securities under a securities lending agreement
- Entry into a futures contract or other derivative contract in which it is agreed to sell securities at a specified price at a future date.
Key Provisions of the Regulation
- Uncovered (Naked) Short Selling
The Regulation prohibits short selling of Relevant Instruments unless one of the following conditions is fulfilled:
- The Relevant Instruments have been borrowed (or alternative arrangements with a similar legal effect have been made)
- An agreement has been entered into for the Relevant Instruments to be borrowed, or the person has another absolutely enforceable claim to be transferred ownership of a corresponding number of Relevant Instruments of the same class to effect the settlement when due
- Other arrangements have been entered into with a third party to give the seller a reasonable expectation that the settlement can be effected when due.
In relation to sovereign debt, notwithstanding the above, an uncovered short position is permitted if it is used to hedge a long position in the debt instruments of an issuer, the pricing of which has a high correlation with the pricing of the sovereign debt.
A firm is not permitted to enter into an uncovered CDS on sovereign debt unless there is an “insurable interest” in the underlying sovereign debt position. That means, in effect, that a person may buy CDS to hedge a long position in the sovereign debt or other securities, assets or liabilities that are directly or indirectly correlated to the value of that sovereign debt.
The Regulation sets transparency requirements for net short positions relating to share capital and sovereign debt.
In the case of shares, this involves:
- Notifying the competent authority of a net short position whenever it reaches or falls below 0.2 percent of the issued share capital of a company and each 0.1 percent above that
- Disclosing details of the position to the public when it reaches 0.5 percent and each 0.1 percent above that, and when it falls below 0.5 percent.
ESMA has said in the Q&As that claims to as yet unissued shares (such as subscription rights or convertible bonds) may only be used to cover a short sale if those claims can be converted into shares that would be available when settlement is due.
The Regulation requires that a list of shares not covered by the Regulation (exempted shares) is published by ESMA on its website on the basis of information provided by national competent authorities (see http://www.esma.europa.eu/page/short-selling). Therefore, any share not mentioned in that list that is admitted to trading in the EEA is subject to the requirements of the Regulation.
It should be noted that ESMA has already published a list of shares admitted to trading on an EEA-regulated market (mifiddatabase.esma.europa.eu), which identifies the relevant competent authority for each share for the purpose of the Regulation.
In the case of sovereign debt disclosure, this involves reporting net short positions in EEArelated sovereign debt, including CDS positions, by reference to the outstanding issued sovereign debt and the liquidity of the sovereign debt market measured in terms of total turnover.
There is an initial reporting threshold of 0.1 percent (and at intervals of 0.05 percent thereafter) in relation to EEA member states whose total issued sovereign debt is up to €500 billion.
Where the member state’s total issued sovereign debt is more than €500 billion, or if there is a liquid futures market for the sovereign debt, the reporting threshold is 0.5 percent and at 0.25 percent intervals thereafter.
With respect to sovereign debt and CDS on sovereign debt, ESMA is required to publish on its website the net short position notification thresholds (as above) for each relevant sovereign issuer, and to identify the relevant competent authority for each sovereign issuer.
The notification to the competent authority must contain the information specified in, and be made using, the form issued by the relevant competent authority, which should be contained within the form specified in the delegated regulations. The disclosure to the public must contain the information set out in such regulations.
The relevant competent authority is, in the case of non-sovereign securities, e.g., shares, the authority that oversees the trading of the relevant instrument, and in the case of sovereign debt, generally the competent authority of the issuing member state, as described above.
The Q&As make clear that existing holders of net short positions will have to re-notify those positions still held on November 1, 2012 in order to comply with the format specified in EU regulatory and technical standards.
- Emergency Powers of Competent Authorities
In the case of adverse developments that constitute a serious threat to financial stability or market confidence in a member state, the Regulation provides that competent authorities will have temporary powers to restrict or prohibit short-selling activities and CDS transactions, or to impose additional disclosure obligations where the measure is necessary to address the threat and will not have a detrimental effect on the efficiency of the financial markets that is disproportionate to its benefits. Such measures could apply for a period of no more than three months but could be renewed for further periods of up to three months at a time.
Short selling may also be temporarily prohibited or restricted in the case of a significant fall in the price of a financial instrument (in the case of liquid shares, being 10 percent or more) during a single trading day.
The initial prohibition or restriction on short selling may be for one trading day. This can be extended for an additional period of up to a further two trading days if, despite the measures, there is a further significant fall in the value of the securities.
The Regulation and related regulations shed light on the following matters:
- A person is considered to own a Relevant Instrument for the purposes of the definition of a short sale when it holds legal or beneficial ownership in accordance with the respective civil law or securities law applicable for the relevant sale. The beneficial owner is the person who assumes the economic risk of acquiring a financial instrument.
- The holding of a share via a long position in a basket of shares or the short sale of a share through the short sale of a basket of shares should, in relation to the specific share, be taken into account to the extent that the share is represented in the basket.
- A person is considered to hold a long position with respect to a share if either it owns the share or it has a legally enforceable claim to the transfer of the ownership of the share according to the civil law or securities law applicable to the relevant sale.
- The Regulation sets out the method of calculating positions for a group whose members have long or short positions in relation to a particular issuer. Generally, individual and group disclosures should be made.
- In relation to fund management, net short positions must first be calculated for each individual fund and managed account managed by a fund manager. These positions should then be aggregated if they relate to the same investment strategy with respect to a particular issuer and reported when applicable reporting thresholds are reached. When the fund management is delegated, then the sub-manager is responsible for disclosure.
- The Regulation includes exemptions for certain market-making and stabilization activities.
As emphasized above, the Regulation applies both in and outside the EEA and it is therefore necessary for all investment managers and advisors, and brokers who effect short sales in EU-traded shares and sovereign debt, to be aware of and to comply with the Regulation. Because the Regulation has direct effect in each EEA member state, failure to comply will constitute a breach, or violation, of local law in the member state where the shares are admitted for trading or whose sovereign debt is shorted. Consequently, awareness of the impact of the Regulation is important.