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The Regulation of Short Selling and Its Reform in Europe

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Abstract

The issue of whether and how to regulate short selling has vexed regulators for some time. While there are a number of potentially damaging consequences that are said to stem from short selling, there is also evidence that it can have beneficial effects on financial markets. In the wake of the collapse of Lehman Brothers in September 2008, and more particularly the falls in the prices of listed financial securities that followed, the regulation of short selling has come back onto the regulatory agenda with a vengeance. Various regulatory techniques, some temporary and some more permanent, have been adopted to deal with short selling. This paper explores those implemented in the US, the UK, Germany and France. The EU has also been developing its regulatory response and in March 2012 the final text of a Regulation dealing with short selling was published. This paper considers the arguments for and against the regulation of short selling, and considers the EU’s Short Selling Regulation in the light of these arguments. It is suggested that although the provisions of the EU’s Regulation introducing disclosure to the regulator are broadly sensible, as are the provisions designed to foster a stricter settlement regime, other provisions are more problematic and have the potential to cause damage to European financial markets.

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References

  1. Regulation (EU) No 236/2012 of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of credit default swaps, OJ 2012 L 86/1 (EU Short Selling Regulation).

  2. The term ‘short selling’ carries significantly different meanings in different jurisdictions: IOSCO Technical Committee, Regulation of Short Selling: Consultation Report (March 2009), at p. 8. The IOSCO Technical Committee defines short selling simply as a sale of stock that the seller does not own at the point of sale (at p. 24). This paper concentrates on the short selling of stocks, but similar hedging techniques also exist in the commodities markets.

  3. See, e.g., FSA, Short Selling, Discussion Paper 09/1 (February 2009), paras. 2.3 and 2.4.

  4. See, e.g., J. Rothschild, The Bear Book: Survive and Profit in Ferocious Markets (New York, John Wiley & Sons 1998): ‘Known short sellers suffer the same reputation as the detested bat. They are reviled as odious pests, smudges on Wall Street, pecuniary vampires.’

  5. The SEC has recently cited concerns that short selling may deprive shareholders ‘of the benefits of ownership’ as part of the justification for its regulation of short selling: SEC, Amendments to Regulation SHO, Release No. 34-58775 (Final Rule) (2008).

  6. E.g., F. Allen and D. Gale, ‘Arbitrage, Short Sales, and Financial Innovation’, 59 Econometrica (1991) p. 1041; A. Bernardo and I. Welch, ‘Liquidity and Financial Market Runs’, 119 Quarterly Journal of Economics (2004) p. 135.

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  7. A study conducted by the Office of Economic Analysis in the US suggests that long sellers (those selling a stock they actually own) were primarily responsible for the price falls: Office of Economic Analysis, Analysis of Short Sale Price Test Using Intraday Quote and Trade Data (December 2008).

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  10. FSA, supra n. 3, para. 3.6.

  11. E.g., FSA, supra n. 3, para. 3.7. This is the rationale for the FSA’s current disclosure obligation, which requires disclosure on a one-off basis of net short positions of 0.25 per cent or more in companies that undertake rights issues whose shares are admitted to trading on a regulated market: FSA Handbook, Financial Stability and Market Confidence Sourcebook, FINMAR 2.2.1, discussed at 3.2, infra.

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  14. In the UK, for example, the regulator has a wide range of options: see Financial Services and Markets Act 2000, Part VIII (implementing Market Abuse Directive 2003/6/EC); Financial Services and Markets Act 2000, s. 397; and Criminal Justice Act 1993, Part V.

  15. See, e.g., FSA, supra n. 3, para. 2.5.

  16. These are discussed further at 3.2, infra.

  17. FSA, supra n. 3, para. 3.7. See also J. W. Christian, R. Shapiro and J.-P. Whalen, ‘Naked Short Selling: How Exposed Are Investors?’, 43 Houston Law Review (2006) p. 1033.

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  26. Miller, supra n. 19.

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  28. M. Clifton and M. Snape, The Effect of Short-Selling Restrictions on Liquidity: Evidence from the London Stock Exchange (2008). See also FSA, Temporary Short Selling Measures: Feedback on CP 09/1, Policy Statement 09/1 (2009).

  29. A. Bris, Short Selling Activity in Financial Stocks and the SEC July 15th Emergency Order (2008), available at: <http://www.imd.ch/news/upload/Report.pdf>; E. Boehmer, C.M. Jones and X. Zhang, ‘Shackling Short Sellers: The 2008 Shorting Ban’ (2008), available at: <http://www.ssrn.com/abstract-id=1412844>. For a broader, international, study on the effect of the temporary regulatory constraints imposed in 2007–09, see A. Beber and M. Pagano, ‘Short Selling Bans Around the World: Evidence from the 2007–09 Crisis’, CSEF Working Paper No. 241 (2009).

  30. The potentially beneficial effects of short selling are, on the whole, appreciated by regulators. For example, it is notable that, according to IOSCO, the main objectives of the regulation of short selling should be to protect the beneficial role short selling plays in capital markets, especially with respect to efficient price discovery, increasing market liquidity and facilitating hedging and other risk management activities: IOSCO, Regulation of Short Selling: Final Report (June 2009), para. 1.3. See also European Commission, Proposal for a Regulation of the European Parliament and of the Council on short selling and certain aspects of credit default swaps, COM(2010) 482 final (September 2010), at p. 2.

  31. Securities Exchange Act 1934, Rule 10a-1, which was in force in some form or other from its introduction in 1938 until its repeal in July 2007 (see SEC, Regulation SHO and Rule 10a-1, Release No. 34-55970 (Final Rule) (2007)). This rule (the ‘tick test’) provided that, subject to exceptions, a listed security could be sold short (i) at a price above the price at which the immediately preceding sale was effected (plus tick), or (ii) at the last sale price if it was higher than the last different price (zero plus tick). Other US regulations also existed pre-crisis (e.g., Regulation SHO, which was introduced in 2004).

  32. SEC, Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments, Release No. 34-58592 (18 September 2008).

  33. FSA, Short Selling (No. 2) Instrument 2008 (relating to UK Financial Sector Companies), FSA 2008/50 (18 September 2008). The ban expired on 17 January 2009.

  34. CESR, Measures Recently Adopted by CESR Members on Short Selling, CESR/08-742 (September 2008).

  35. European Financial Management Association, Reply to CESR’s Call for Evidence on Regulation of Short Selling by CESR Members (January 2009) (in which concerns were also raised regarding the legal uncertainty and regulatory arbitrage opportunities created by the lack of harmonisation).

  36. Since 1 August 2009, the SEC has been working with self-regulatory organisations to make short selling volume and transaction data available to the public through the latter’s websites. The Dodd-Frank Wall Street Reform and Consumer Protection Act includes certain provisions on short selling, notably it requires the SEC to adopt rules for public disclosure (see SEC, Short Sale Reporting Study Required by Dodd-Frank Act Section 417(a)(2), Release No. 34-64383 (May 2011)) although there is currently no timetable for the proposal and adoption of these rules.

  37. Regulation SHO, introduced in July 2004 and subsequently amended several times.

  38. Threshold securities are equity securities with respect to which there is an aggregate fail-to-deliver position for five consecutive settlement days at a registered clearing agency of 10,000 shares or more that equals at least 0.5 per cent of the issuer’s outstanding shares and is included on a list disseminated by an existing self-regulatory organisation (SRO). If a clearing broker has a fail-to-deliver position in a threshold security for 13 consecutive settlement days, the broker is required to close out the position by buying securities to cover the fail. Until the position is closed out, the clearing broker and any other broker-dealers for which it clears transactions are prohibited from engaging in further short sales in the security (see Regulation SHO, rule 203(b)(3), as amended by SEC, Amendments to Regulation SHO, Release No. 34-58775 (September 2008) (Final Rule)).

  39. SEC, Amendments to Regulation SHO, Release No. 34-60388 (July 2009) (Final Rule). Participants who do not comply with the requirement, and any broker or dealer from whom they receive trades for clearance and settlement, will not be able to sell short the security either for themselves or on account of a third party until the fail-to-deliver position is closed out, unless they have previously arranged to borrow the security.

  40. See Securities and Exchange Act 1934, s. 10(b).

  41. SEC, Naked Short Selling Antifraud Rule, Release No. 34-58774 (September 2008) (Final Rule), introducing a final rule under the Securities and Exchange Act 1934 (Rule 10b-21). This rule does not substantively extend the existing regulations on naked short selling or market manipulation, but simply specifies ‘abusive naked short selling’ under the general antifraud provisions of the federal securities laws.

  42. SEC, Amendments to Regulation SHO, Release No. 34-61595 (February 2010) (Final Rule). For discussion of the original uptick rule, see G. J. Alexander and M. A. Peterson, ‘Short Selling on the New York Stock Exchange and the Effects of the Uptick Rule’, 8 Journal of Financial Intermediation (1999) p. 90.

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  43. FSA, Short Selling (No. 2) Instrument 2008, supra n. 33.

  44. FSA, Temporary Short Selling Measures, Consultation Paper 09/1 (January 2009), and FSA, supra n. 3.

  45. Introduced via the Financial Stability and Market Confidence Sourcebook Instrument 2010, FSA 2010/25.

  46. FSA Handbook, FINMAR 2.2.1.

  47. Ibid., FINMAR 2.2.1(c).

  48. Ibid., FINMAR 2.2.3.

  49. Financial Services Act 2010, s. 8, which inserts a new Part 8A into the Financial Services and Markets Act 2000.

  50. Financial Services and Markets Act 2000, s. 131E-F (inserted by Financial Services Act 2010, s. 8).

  51. See, e.g., FSA, The FSA’s International Agenda (October 2010).

  52. The Abusive Securities and Derivatives Trades Prevention Act (Gesetz zur Vorbeugung gegen missbräuchliche Wertpapier und Derivategeschäfte) (July 2010). These new provisions have been added to the German Securities Trading Act (Wertpapierhandelsgesetz — WpHG). The provisions relating to bans of short selling came into force on 27 July 2010.

  53. This is in contrast to the General Decree issued by the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht — BaFin) (18 May 2010), which these new provisions replaced and which had related only to shares in specific German companies from the financial sector.

  54. I.e., the debt securities of ‘central governments, regional governments, and local authorities’ of eurozone Member States which are admitted to trading on the regulated market in Germany.

  55. German Securities Trading Act (WpHG), § 30h. There are also provisions regarding naked CDS transactions: § 30j.

  56. Ibid., § 30i (introduced by the Abusive Securities and Derivatives Trades Prevention Act, July 2010) (effective from 26 March 2012).

  57. See <http://www.bafm.de/en/Supervision/StockExchangesMarkets/ShortSelling/Transparency>.

  58. Banking and Financial Regulation Act (Loi de régulation bancaire et financière), No. 2010-1249 of 22 October 2010, which was published in the Journal Officiel on 23 October 2010. In parallel with this Act, the General Regulation of the Autorité des marchés financiers (AMF) was amended by an order on the disclosure of net short positions, which implemented a new reporting regime for net short positions, adding new articles, Arts. 223–237 (Net Short Position Order, issued 28 October 2010).

  59. CESR, Proposal for a Pan-European Short Selling Disclosure Regime, CESR 10-088, 2 March 2010.

  60. General Regulation of the AMF, Arts. 223–237. The AMF has posted on its website the list of equities whose principal market is outside France, thereby making it possible to identify issuers to which the new requirements do not apply.

  61. The meaning of this term is not clear-cut. For discussion, see AMF, Working Group on Short Selling: Report (23 February 2009).

  62. Note that, in contrast to the transparency rules, this obligation relates only to shares listed on regulated markets: the ban related to naked short selling only concerns shares traded on regulated markets: French Monetary and Financial Code, Art. 211-17-1, I, § 2.

  63. See the French Monetary and Financial Code, Art. L. 621-15: a penalty of ¬100m or up to 10 times the profits generated by the wrongful act violating the provisions set out in Art. L. 211-17-1.

  64. For example, the Act provides that the general prohibitions on insider trading, market manipulation and dissemination of insider information, as well as the obligation on market professionals to declare suspect transactions to the AMF, are extended to derivative products and CDS.

  65. France decided not to follow the German prohibition of CDS transactions relating to government bonds of eurozone member countries or of their subdivisions, etc., leaving the regulation of CDS on sovereign eurozone debt to be introduced via the EU Short Selling Regulation, discussed in section 4 of this paper.

  66. Italy, Spain and Belgium also announced short selling bans: ESMA, ‘ESMA Promotes Harmonised Regulatory Action on Short-Selling in the EU’, ESMA/2011/266, 11 August 2011.

  67. AMF, News Release, 11 August 2011.

  68. AMF, News Release, 13 February 2012.

  69. See, e.g., European Commission, supra n. 30, at p. 2.

  70. IOSCO, supra n. 30, para. 1.4.

  71. European Commission, supra n. 30.

  72. EU Short Selling Regulation, supra n. 1.

  73. European Commission, supra n. 30, at p.3.

  74. EU Short Selling Regulation, supra n. 1, Art. 3(4).

  75. European Commission, supra n. 30, Art. 6, i.e., a requirement for all short sales of shares executed in an EU trading venue to be marked as short, with daily summaries of the aggregate volume of flagged short sales to be published by such trading venues.

  76. EU Short Selling Regulation, supra n. 1, Art. 7(1).

  77. Ibid., Art. 8. Note, however, the definition of an ‘uncovered’ position in a sovereign CDS: Art. 4.

  78. Ibid., Art. 9(4). This provision stipulates that information shall be posted on a central website operated or supervised by the relevant competent authority. The competent authorities shall communicate the address of that website to ESMA, which, in turn, shall put a link to all such central websites on its own website.

  79. Ibid., Art. 9(5). On 28 March 2012 ESMA published its draft technical standards and on 19 April 2012 it published its final technical advice on the Regulation.

  80. European Commission, Delegated Regulation of 29.6.2012 supplementing Regulation (EU) No 236/2012 of the European Parliament and of the Council with regard to regulatory technical standards on notification and disclosure requirements with regard to net short positions, the details of the information to be provided to the European Securities and Markets Authority in relation to net short positions and the method for calculating turnover to determine exempted shares (C(2012) 4362 final); (draft) European Commission Implementing Regulation laying down implementing technical standards with regard to the means for public disclosure of net position in shares, the format of the information to be provided to the European Securities and Markets Authority in relation to net short positions, the types of agreements, arrangements and measures to adequately ensure that shares or sovereign debt instruments are available for settlement and the dates and period for the determination of the principal venue for a share according to Regulation (EU) No 236/2012 of the European Parliament and of the Council on short selling and certain aspects of credit default swaps (29 June 2012); (draft) European Commission Delegated Regulation (EU) supplementing Regulation (EU) No 236/2012 of the European Parliament and of the Council on short selling and certain aspects of credit default swaps with regard to definitions, the calculation of net short positions, covered sovereign credit default swaps, notification thresholds, liquidity thresholds for suspending restrictions, significant falls in the value of financial instruments and adverse events (5 July 2012); (draft) European Commission Delegated Regulation supplementing Regulation (EU) No 236/2012 of the European Parliament and of the Council on short selling and certain aspects of credit default swaps with regard to regulatory technical standards for the method of calculation of the fall in value for liquid shares and other financial instruments (5 July 2012).

  81. EU Short Selling Regulation, supra n. 1, Art. 16.

  82. Ibid., Art. 13(3). Special provisions have also been put in place to deal with naked, or uncovered, sovereign CDS. This was a controversial issue during negotiations of the EU Short Selling Regulation. The compromise reached in the Regulation is that natural or legal persons are prevented from entering into naked CDS in the sovereign debt of any of the 27 Member States of the European Union (Art. 14(1), and for the definition of naked or ‘uncovered’ sovereign CDS, see Art. 4). However, the Regulation permits the competent authority of a Member State to suspend this ban in relation to its own sovereign debt (initially for up to 12 months and then for further periods of up to six months at a time) where it believes that the sovereign debt market in that Member State is ‘not functioning properly’ and the restriction might have a negative impact on the Member State’s sovereign CDS market (Art. 14(2)). A competent authority which intends to suspend this ban must first notify ESMA and the other competent authorities of its intended action and the objective elements on which the suspension is to be based.

  83. The Commission’s proposal contemplates only temporary action (for up to a three-month period). A temporary measure can be extended for further periods not exceeding three months at a time, but this must be fully justified: EU Short Selling Regulation, supra n. 1, Art. 24.

  84. Ibid., Art. 23(5). The EU Short Selling Regulation adopts the definition of liquid share found in Article 22 of Regulation (EC) No 1287/2006. It is stated that for illiquid shares and other classes of financial instruments the amount will be specified by the European Commission (Art. 23(5)).

  85. In the case of an emergency situation relating to sovereign debt or sovereign credit default swaps, Arts. 18 and 38 of Regulation (EU) No 1095/2010 shall apply: ibid., Art. 29.

  86. Office of Economic Analysis, supra n. 7; FSA, supra n. 3, Annex 2.

  87. See, e.g., Clifton and Snape, supra n. 28.

  88. Directive 2003/6/EC, supra n. 13.

  89. European Commission (draft) implementing Regulation laying down implementing technical standards, supra n, 91.

  90. See, e.g., FSA, supra n. 3, para. 5.28.

  91. Ibid., para. 5.10. The FSA’s view is that the benefits of reducing disorderly markets can outweigh the cost associated with impaired market efficiency arising from any reduction in liquidity. Avgouleas has suggested that a compromise might be possible: ‘Although it is a costly exercise, disclosure of aggregate short positions several times throughout the day, instead of publication of this data just once in the beginning of the trading day would be sufficient to serve the public interest objectives of disclosure-based regulation of short sales without having to disclose on a real time or nearly real time basis individual significant short positions’ (Avgouleas, supra n. 8, at p. 420).

  92. It has also been suggested that the disclosure level should be adjusted according to the liquidity of the stocks: Avgouleas, supra n. 8. Avgouleas suggests, for example, that the threshold for listed stocks that are a composite of the market’s main index might be 0.3 per cent, that for less liquid stocks outside the main market the threshold might be 0.6 per cent, and for stocks traded exclusively OTC, 1 per cent.

  93. IOSCO Technical Committee, supra n. 2, at p. 14.

  94. See, e.g., S.E. Christophe, M.G. Ferri and J. Angel, ‘Short Selling Prior to Earnings Announcements’, 59 Journal of Finance (2004) p. 1845. More timely disclosure would have a beneficial effect on reducing the potential for insider trading.

  95. For an argument in favour of a sophisticated circuit breaker system to supplement disclosure rules in regulated short selling, see Avgouleas, supra n. 8.

  96. J. R. Macey, M. Mitchell and J. Netter, ‘Restrictions on Short Sales: An Analysis of the Uptick Rule in View of the October 1987 Stock Market Crash’, 74 Cornell Law Review (1988) p. 799; G.J. Alexander and M.A. Peterson, ‘Short Selling on the New York Stock Exchange and the Effects of the Uptick Rule’, 8 Journal of Financial Intermediation (1999) p. 90.

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Payne, J. The Regulation of Short Selling and Its Reform in Europe. Eur Bus Org Law Rev 13, 413–440 (2012). https://doi.org/10.1017/S1566752912000298

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