FSA has made emergency measures to ban further short selling of certain financial sector investments and to impose new disclosure requirements in relation to existing positions.

Background

FSA made new rules last night amending its Code of Market Conduct effectively:

  • l to ban creation or increase in net short positions in the shares of UK financial sector companies from 00:01 am on 19 September; and
  • l to require firms to disclose net short positions in these shares of 0.25% or more of the issued share capital of those companies.

There is an exception from the prohibition allowing market makers to meet demand.

These rules will remain in force at least until 16 January 2009. FSA has published the new rules with FAQs, but inevitably there are many unanswered questions.

Only relates to shares in UK financial sector companies

The new rules make entering into a transaction that (by itself or with other trades) has the effect of creating or increasing a "net short position" in the shares of a "UK financial sector company" market abuse.

A "UK financial sector company" means:

  • l a bank incorporated in the UK;
  • l an insurer with its head office in the UK (other than pure reinsurers or "non-directive insurers", which are limited scope insurers mainly comprising mutuals); and
  • l a UK incorporated parent of a UK bank or insurer.

FSA has published a list of these companies, which it warns should not be treated as definitive.

Prohibition has no retrospective effect

The prohibition does not apply to transactions entered into or orders placed before 19 September 2008. There is no requirement to unwind pre-existing net short positions.

However, the disclosure requirements apply to any disclosable net short positions held as from the close of business on 19 September. Firms are first required to disclose these positions by 3.30 pm on Tuesday 23 September, by which time they must disclose them in respect of 19 and 22 September. Thereafter, disclosure is required by 3.30pm on disclosable net short positions held the previous trading day.

Intra-day net short positions

Firms do not have to disclose net short positions held intra-day, if they are reduced before the end of the day. But the prohibition bans firms taking net short positions even on an intra-day basis.

Market Maker exemption

There is a specific exemption from the prohibition for a person "acting in the capacity of a market maker". There is no formal definition of "market maker", but FSA states in its FAQs:

"A market maker is an entity ordinarily as part of their business dealing as principal in equities, options or derivatives (whether OTC or exchangetraded) to fulfil orders received from clients, to respond to a client's requests to trade or to hedge positions arising out of those dealings."

The exemption covers market makers only when they act in that capacity – so proprietary position-taking by a firm which happens to be a market maker would not be exempt.

The guidance aims to allow firms to create or increase net short positions to fulfil client orders and to respond to client demand and should be construed as limited to that context.

The reference to hedging positions arising out of client orders or requests means the ban will not cover a net short position taken to hedge either:

  • l the fulfilling of a client order; or
  • l trading carried out to fulfil a client's request to trade.

What investments does the ban cover?

The prohibition applies to any kind of transaction or combination of transactions which creates or increases a net short position in a UK financial sector company. This could catch a single transaction or a group of transactions provided they have the effect of creating or increasing a net short economic exposure to the shares.

A "net short position" is defined as "a net short position that gives rise to an economic exposure to the issued share capital of a company".

This is very widely drawn. FSA says it can arise from any instrument that gives rise to an exposure to the "equity share capital" of the company, which includes convertible bonds as well as ordinary shares. So the ban extends to investments such as contracts for differences, spread bets, futures, options, warrants and depository receipts.

The prohibition also covers economic interests held as part of a basket or index, but only "where all of the components in the index or basket are UK financial sector companies".

Entity not group

The rules apply to each legal entity in a group separately, rather than to net short positions held by a group.

Conflicts for Fund managers

The prohibition and the disclosure requirements apply to fund managers where they hold positions for discretionary clients on an aggregated basis.

So a discretionary fund manager will have to consider the net short position in relevant equities across all of its discretionary clients and this will inevitably lead to conflicts for that manager. Managers may be prevented from taking action to protect the exposure of one underlying client if doing so would put the manager in a net short position!

The FSA has rushed these rules out and the FAQs and the treatment of discretionary fund managers is described in much the same way as in the previous short-selling rules. But in that case the rules required only disclosure. Here, the prohibition could effectively prevent fund managers from performing their duties for their clients.

For non-discretionary clients, the rules apply in respect of the underlying client.

Does it matter where the trading takes place?

No. Transactions in the OTC market or on foreign markets are also covered.

How and when to disclose

From 23 September firms must make daily disclosure of all net short positions of 0.25 per cent or more of the ordinary share capital of the relevant companies held on the previous working day.

Firms do not have to give a breakdown of how the positions are made up. The disclosure requirement applies every day, so that a firm which discloses a position on Tuesday, must also disclose it on each subsequent day on which it holds that position.

They must also make a disclosure when a previously disclosed position falls below the 0.25% disclosure limit.

One firm may make disclosure on behalf of its group companies, but the disclosures must be made on an entity by entity basis.

Disclosures must be made by a Regulatory Information Service announcement, and FSA suggests using its TR4 form.

Do market makers have to disclose?

Yes. The market maker exemption applies only to the prohibition.

A market maker which legitimately increases or creates a net short position will have to disclose that position if it were to reach the 0.25% disclosure threshold overnight.

Where are the new rules?

The new rules are at MAR 1.9.2 in FSA's Handbook of Rules and Guidance. There are also some new defintions in the Glossary. FSA's FAQs go with the new rules, and FSA may update them as further common questions come up.

What happens next?

The new rules within will have effect until 16 January, though FSA will review them after 30 days. It may also decide to widen the scope of the ban to other sectors.

In January, FSA will report in more detail on short selling.