On 6 February 2009, FSA published its long awaited discussion paper on a proposed permanent regime to regulate short selling in the UK.

In response to the severe falls in the share prices of financial institutions in September last year, FSA introduced, without consultation, a set of temporary emergency measures in relation to short selling which was perceived to be partly responsible for these falls (to read our previous Law Now on these measures please click here). The measures taken at that time were:

  • a purported ban on holding any new net short position in respect of stocks in certain prescribed financial institutions; and
  • disclosure of any significant existing net short positions in the same institutions.

These measures remained in place until 16 January 2009 when, following a short consultation, FSA chose to allow the ban to lapse but preserve an amended disclosure requirement until 30 June 2009 (to read our Law Now on the amended requirements please click here). A short analysis of the effects of the ban on the UK market for the period September 2008 to January 2009 is enclosed as Annex 2 of FSA's discussion paper - these should be interpreted, according to FSA, "with caution".

The latest discussion paper sets out FSA's proposal for a permanent regime to regulate short selling in respect of stocks issued by all UK incorporated issuers (not simply the prescribed financial institution stocks subject to the current disclosure requirement). It seeks to balance the "legitimate" but often controversial market technique of short selling with FSA's objectives of maintaining orderly and efficient markets and reducing financial crime. This, FSA hopes, will be achieved by an enhanced disclosure regime.

However, the proposals have dismayed a number of fund managers who see the measures as excessive in the context of the particular problems raised last year for certain financial sector stocks. Market participants are invited to raise their queries and provide comments to FSA by 8 May 2009 before near final rules are set by FSA.

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Full Article

FSA published a discussion paper (Discussion Paper 09/01) on its proposed permanent regime to regulate short selling on 6 February 2009.

The discussion paper considers a wide range of options that are available for the regulation of short selling (see summary of options below). Having considered the options available to it, FSA concludes that its preferred regime is one that focuses on disclosure. It argues that the absence of mandatory disclosure requirements may result in market transparency failures although it also acknowledges that excessive disclosure is likely to disincentivise investors and traders.

The proposed regime, which will ideally have European and/or international consensus, will have the following elements:

  • Enhanced public disclosure obligation in relation to
    • significant short positions in stock issued by UK incorporated firms; and
    • rights issues.
  • Exemptions for Market Makers and in the Credit Default Swaps market; and
  • Emergency powers to re-introduce a prohibition when this is warranted.

Public Disclosure

The current disclosure regime, in place until 30 June 2009, applies only in relation to positions in a specified list of financial institutions (banks and insurance companies) and disclosure is required when the aggregate net short position meets or exceeds 0.25% of the issued share capital (or related investments) and again when the net short position falls below 0.25%. An ongoing disclosure requirement was introduced in January 2009 for 0.1% increments (rather than any increases as had been the case between September 2008 and January 2009).

The new proposal makes some significant changes and is more extensive than the current requirement:

  • first, the disclosure obligation will be extended to cover net short positions held in the stock (or related investments) of all UK incorporated issuers;
  • secondly, FSA proposes to increase the minimum threshold to 0.50% although it is keen to receive wide consensus on this trigger point and is open to alternative figures. This is contrary to FSA's position at the time of lifting the ban (January 2009), which stated that the trigger point would remain at 0.25%. The discussion paper already makes it clear that triggers used in the long disclosure regime (DTR - i.e. 3% and every subsequent 1%) are inappropriate to mitigate the risks posed by short selling; and
  • thirdly, in addition to the initial trigger, market participants will be subject to ongoing disclosure requirement when bands fixed at increments of 0.1% are reached (as has been the case since January).

Whilst there has been a disclosure requirement in place since September 2008, for the majority of this period the practice was effectively prohibited so there is little evidence of what the cost will be to FSA. In addition, FSA has brought no enforcement action during the period of the prohibition or the existing disclosure requirements so the costs of enforcement in this area are equally unknown.

FSA expects that the publicity that comes with public disclosure of short positions will act as a deterrent to abusive strategies and will enhance transparency by disclosing significant positions. However, FSA acknowledges that any measure that discourages short selling will have an adverse effect on the availability of the stock in the market (liquidity) and on the efficiency of news reaching the market (price correction).

FSA favours public disclosure to the market on the basis that one of the intended benefits of the regime is to preserve orderly markets. However, public disclosure will require short position users - in particular hedge funds that currently benefit from a very light touch regulation - to disclose aspects of their trading strategies to their commercial disadvantage. FSA acknowledges that some market participants will seek to push back on this and opt for private disclosure or at least disclosure that is 'filtered' by FSA and then reported, only if necessary, to the market.

However, public disclosure is in line with the Disclosure and Transparency Rules (DTR) and is more cost effective - it is likely to be adopted in the long run unless FSA can be persuaded otherwise.

Exemptions

Market makers acting in that capacity are exempted. FSA also exempts Credit Default Swaps as transactions in these investments are already reported to FSA and are adequately monitored for market abuse.

International cooperation

FSA is eager that international consensus should be reached on the regulation of short selling and will liaise with IOSCO (internationally) and CESR (Europe) on achieving this. As FSA is working to a deadline of 30 June 2009, when its current temporary measures expire, it may have to consider extending its current measures or introducing further temporary rules if it genuinely seeks an international consensus.

Right Issues

In addition to the general disclosure requirement, FSA will maintain its existing disclosure requirement for short positions in companies undertaking rights issues. Disclosure is triggered when the 0.25% threshold is breached and ongoing disclosure requirements will be at the same bands as the general disclosure obligation - i.e. 0.1%. Additional disclosure is required for the position held falls below the minimum 0.25% threshold.

The discussion paper refers to the inherent conflict between underwriters of rights issues and issuers and considers whether short selling by underwriters should be prohibited. Such measures, however, are likely to 1) decrease innovation/competition; 2) increase fees which may be passed on to the cost of the issuers capital and/or 3) fetter the proper operation of the market. FSA therefore dismisses this option as "excessive".

Statutory powers

FSA has also has asked the industry for comment on new statutory powers to enable it to introduce its proposed rules. FSA introduced the prohibition and disclosure obligation in September 2008 as regulator of the financial services sector - and limited its measures to banks and insurance companies. Although there was some initial debate in the legal community about the legal basis to introduce these measures, FSA maintained (and continues to maintain) that its actions were based on the existing market abuse regime and, perhaps because FSA brought no enforcement actions during the prohibition, this has remained unchallenged.

Because the proposed regime will have 1) a wider scope that will cover non-financial services stock and 2) the rules are not solely drafted to address market abuse, FSA believes additional statutory powers will now be required.

Alternative methods considered ...and dismissed

Short selling prohibition

FSA rejects this idea in relation to both financial services and non-financial services stock on the basis that the beneficial aspects of short selling, in particular enhancing liquidity, outweigh the potential negative effects. In addition, FSA acknowledges that settlement risk, which is particularly relevant to 'naked' short selling, is mitigated in the UK by existing arrangements between the Recognised Investment Exchanges and Recognised Clearing Houses.

FSA maintains, however, that an emergency prohibition is possible, with or without consultation.

Circuit breakers

Circuit breakers refer to the temporary suspension of trading in a listed stock where its price falls below a certain level or by a certain percentage. These are uncommon in the UK and FSA does not consider it necessary to introduce this. In addition, the London Stock Exchange has an existing system to suspend trading to address temporary imbalances, where this is necessary.

Tick rules

Tick rules prevent a short sale from occurring at successively lower prices. These rules are not common in the UK and FSA takes the view of the US Securities and Exchanges Commission that such rules provide limited protection against the effects of short selling.

The FSA is open to consider any other proposals that it has not covered in the discussion paper.

Next steps

The closing date for responses to the discussion paper is 8 May 2008. The responses received and any developments from FSA's international counterparts will colour the proposed regime set out in the discussion paper and FSA's near final thoughts will be consolidated into a detailed consultation paper. We will update you further once the consultation paper has been published.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

The original publication date for this article was 16/02/2009.