In response to the continued volatility of share prices in global financial institutions, FSA has introduced new provisions to its Code of Market Conduct (MAR 1) prohibiting the activity of actively creating or increasing “net short positions” in publicly listed UK financial institutions. The provisions, as well as enhanced disclosure obligations, came into effect at 00.01am today (19 September 2008).
The new provisions only apply to the UK banks and insurers (or their UK incorporated parent companies) listed in the Schedule to the revised Code of Market Conduct.
Key points
Although these are only temporary measures, the effect of the prohibition and disclosure obligation is quite significant. The key points to note are:
- creating or increasing a “net short position” in relation to a UK financial sector company will, in FSA’s view, amount to market abuse in the UK;
- the prohibition applies to any ‘economic exposure’ to the issued share capital of a UK financial sector company. This includes holding ordinary share capital and convertible bonds as well as any instrument (CFDs, spread bets, options etc) giving rise to an exposure, whether direct or indirect, in the equity share capital of a UK financial sector company - debt securities are excluded;
- from 23 September, daily disclosure of net short positions in excess 0.25 per cent of the ordinary share capital in a UK financial institution will be required by 3:30pm (UK) on the day following each day on which the disclosable short position is held. The net position held at close of business 19 September will also be required on this date – note that you cannot now take any action to increase the net short position (see above);
- when calculating a ‘net short position’, any financial instruments should be accounted for on a delta adjusted basis rather than on a notional basis;
- the relevant denominator for the calculation of short positions is the entire issued share capital of the company;
- although only a significant net short position held at the end of the day requires disclosure, the short selling requirements do not allow a person to actively increase their short position intra-day;
- 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 prohibition covers all prescribed markets under the Code of Market Conduct and OTC transactions;
- the prohibition only applies to orders entered after 00:01am (UK time) on 19 September 2008;
- discretionary fund managers holding short positions are required to comply with the prohibition on behalf of clients – in the case of non-discretionary fund mangers, the prohibition applies to the client;
- where a fund manager that is a legal entity has a mandate to manage more than one individual fund, the fund manager should aggregate the positions of all of its discretionary funds for the purposes of determining whether it has a disclosable short position;
- disclosures of net short positions should be made by means of a Regulatory Information Service announcement;
- if a person’s previously disclosed net short position falls below the 0.25% disclosure threshold one last disclosure of this fact is required; and
- the prohibition may be extended to additional sectors, if necessary.
Failing to comply with the new rules may result in an offence under section 118 Financial Services and Markets Act 2000.
Only market-makers are exempt. FSA’s view of market makers for this purpose is not the FSA Handbook definition of ‘market maker’, but those entities dealing as principal in equities, options or derivatives (whether OTC or exchange-traded) to fulfil client orders received from clients, to respond to a client’s request to trade or to hedge positions arising out of those dealings.
Length of prohibition
The prohibition will remain in force until 16 January 2009 although it will be reviewed after 30 days. Rules on short selling will be published in January 2009 following a comprehensive review by FSA.
FSA’s stance
As with its amendments to the rules on short positions during rights issues in June this year, FSA did not enter into its usual consultation process with the market before introducing the prohibition, citing the need to “protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector.”
This latest move by FSA is clearly intended to prevent continued volatility in the markets. Speaking yesterday, Callum McCarthy, Chairman of the FSA, said of the prohibition:
“It is designed to have a calming effect – something which the equity markets for financial firms badly need. I hope that practitioners will support both the ambition and the chosen means of achieving it.”
Hector Sants, Chief Executive of FSA, has also reiterated FSA’s view that short selling is a “legitimate investment technique in normal market conditions”, but that in the current extreme circumstances, it has given rise to disorderly markets.
U.S Securities and Exchange Commission (SEC)
In a related move, the SEC has also moved to impose a similar ban on the short selling of securities in 799 financial institutions, with immediate effect. The list of companies can be found in the Appendix to the SEC’s Emergency Order (Release No. 34-58592), which is available on the SEC’s website.
The SEC’s ban will be in place until 11:59p.m. (Eastern Time) on 2 October 2008.
Definition of ‘short selling’ and background
‘Short selling’ or ‘shorting’ usually describes the sale of securities that the seller has borrowed. Once the securities are sold into the market, the seller waits, hoping that the price will fall. The seller then buys the same number of securities at the lower price and returns them to the original lender and pockets the difference (i.e. the profit).
The practice is well established but has come under some criticism in recent times. In June this year, the practice was criticised in connection with share price fluctuations during rights issues. Companies undertaking rights issues were thought to be targets of ‘bear raids’ by short sellers who aimed to push their share price down.
In some cases (most notably HBOS) the share price fell below that of the rights issue, which reduced the share price yet further but increased the short sellers’ profit. This led to an allegation of potential market abuse. On the 1 August 2008, FSA completed its investigation into the alleged market manipulation surrounding the HBOS rights issue, concluding there was no evidence of a concerted attempt to profit by manipulating the share price.
Recently, the practice of short selling has been cited as contributing to the general volatility of share prices, particularly the price of shares in financial institutions.
