On September 17 and 18, 2008, (with amendments on September 21 and October 1, 2008) the U.S. Securities and Exchange Commission (SEC) took a number of emergency actions relating to short selling, both specifically of the stocks of financial institutions and with respect to short selling practices generally. Those actions and answers to certain questions concerning them are outlined below.
The Prohibition on Selling Short U.S. Financial Stocks
Between the close of the U.S. stock markets on Thursday, September 18, 2008, and the opening of the markets on Friday, September 19, 2008, the SEC imposed a flat prohibition, subject to very limited exceptions, on the short sale of the stocks of 799 companies in the bank, savings association, broker-dealer, investment advisory and insurance industries, whether domestic or foreign, and the owners of any of such entities. The companies whose stocks were initially affected were listed in the initial order, but because some companies in the affected industries were inadvertently omitted, on Sunday night, September 21, 2008, the SEC issued a modification providing that the affected companies would be designated by the principal U.S. stock exchanges on which the stocks are traded. Accordingly, the names of the affected stocks can be found on the websites of the relevant stock exchanges. Taken pursuant to the SEC’s authority under section 12(k) of the Securities Exchange Act of 1934, this action will expire (unless extended) at 11:59 pm EDT on the third business day after the enactment of “bailout” legislation, but in no case later than 11:59 EDT on October 17, 2008.
As modified by the second order, the exceptions are for (1) short sales that occur as a result of the automatic exercise or assignment of an equity option, or the expiration of a futures contract, held prior to the effectiveness of the initial order; (2) short sales that occur as a result of an assignment to a writer of a call option of an obligation to fulfill the call upon an in-kind exercise (regardless of when the call is written); and (3) market makers who engage in short sales as part of bona fide market making activities (provided that a market maker may not engage in short sales in connection with transactions for a customer if the market maker knows the transaction will create or increase a net economic short position for that customer).
The following are links to the relevant releases and interpretations:
Are any securities other than the designated common stocks covered by the SEC’s actions? What about derivatives whose value is affected by the price of the covered stocks?
Only the listed common stocks are covered. However, because short sales are frequently effected in connection with other kinds of trading strategies, including derivatives, an inability to engage in short sales affects other kinds of instruments as well. In addition, confining the market making exception to circumstances in which the market maker does not know that a short sale on its part will facilitate the creation or increase in a customer’s net economic short position could affect customers’ ability to engage in derivative transactions.
The UK Financial Services Authority (FSA) has promulgated similar but broader and longer lasting prohibitions on shorting the stocks of UK financial companies. How do those rules compare to the SEC’s?
Exercising a broader scope of authority than is available to the SEC, the FSA’s orders banned, also effective September 19, 2008, the creation or increase in economic net short positions through any mechanism whatever (including any kind of derivative) on stocks in designated, publicly quoted UK incorporated banks and insurers, purportedly in transactions conducted anywhere in the world. The FSA’s rules are in effect until January 16, 2009, but, having been issued on an emergency basis without public comment, are subject to mandatory review after 30 days. A list of the affected stocks is available on the FSA’s website. While the only express exception in the FSA’s rules is for market making, the broader scope of the FSA’s approach, keying in all cases off the creation or increase in net economic short positions, has the same (but broader) effect as the SEC’s non-market-maker exceptions. That is because the non-market-maker exceptions on short selling promulgated by the SEC apply in situations in which engagement in a short sale does not actually create or increase an economic net short position on the part of the short seller, with the result that the FSA’s prohibition would not cover such transactions in the first place.
Are there other new short sale reporting requirements that apply to all U.S. and UK listed stocks, not just those of the companies in whose stocks short selling is prohibited?
Yes, both the SEC and the FSA promulgated short selling reporting forms requiring the disclosure of short sales and related positional changes occurring from and after September 22, 2008. The SEC’s new Form SH requires reports each Monday beginning September 29, 2008, with respect to transactions occurring during the preceding week (unless they involve less than .25 percent of the shares outstanding and less than $1 million), by investors that are required to make quarterly positional filings on SEC Form 13F—a duty that, in general, applies to persons that either own or manage at least $100 million invested in publicly traded U.S. stocks. Though filed on the SEC’s EDGAR reporting system, the Form SH reports under the emergency order will not be publicly available. Also promulgated pursuant to the SEC’s emergency authority under section 12(k) of the Securities Exchange Act and subsequently amended to provide technical clarifications, Form SH and its related regulations are effective until October 17, 2008, but the SEC intends to extend the requirements thereafter in the form of an interim final rule. The orders in question, including SEC staff interpretations, can be found here:
The FSA has required, from September 23, 2008, the daily disclosure of all net short positions in excess of 0.25 percent of the ordinary share capital of the designated financial companies held at market close on the previous working day. Disclosure of such positions held at close on September 19, 2008, were also required on September 23, 2008. The FSA stands ready to extend this approach to other sectors if it judges it to be necessary.
Subsequent to the first disclosure deadline of September 23, 2008, a person must disclose any net short position of 0.25 percent or above by 3:30 pm on the day following each day on which the disclosable short position is held. The net short position disclosed should be that held at the end of the previous day. A disclosure is required even if the size of the short position has not changed since the previous disclosure. Disclosures are made by filling out form TR-4 and must be made through a Regulatory Information Service.
These new disclosure requirements are in addition to those required in relation to net short positions in the shares of companies (not just financial companies) involved in rights issues introduced by the FSA in June 2008.
Were there additional actions by either the SEC or the FSA?
On September 17, 2008, the day before issuing the orders described above, the SEC issued three other emergency orders designed to fully shut down the already illegal practice of failing to deliver shares to fulfill a short sale. Emergency rule 204T states that any participant in a registered clearing agency, and any broker-dealer from which such a participant receives trades for clearance or settlement, must deliver an equity security on the required settlement date and, if there is a delivery failure, must generally close out the fail within one settlement day. Marginally more lenient regimes apply in the case of long sales and sales pursuant to rule 144. If a failure to deliver nevertheless occurs and is not closed out, U.S. broker-dealers and other clearing agency participants are forbidden from engaging in short sales in the security in question for any customer (or on their own behalf) without first actually borrowing or arranging to borrow the security sold short until the broker-dealer or participant has closed out any outstanding failures to deliver. This latter prohibition applies regardless of representations by a participant’s customer that the customer has the security available for delivery. Certain related notification provisions also apply. Rule 204T will remain in effect until October 17, 2008; in its press release announcing its adoption the SEC also stated that it sought comments as to whether rule 204T should be made permanent.
In the same release the SEC stated that it was adopting permanently a previously proposed anti-fraud provision, rule 10b-21 under the Securities Exchange Act, making it an explicitly fraudulent practice to deceive a broker-dealer or a participant in a clearing agency concerning its intention or ability to deliver a security on or before the applicable settlement date. Finally, the SEC stated that it was adopting permanently a previously proposed elimination of an exception to Regulation SHO, the overall regulation that governs short sales, for options market makers when excessive fails to deliver have existed in a stock. Enforcement of emergency rule 204T would in any case appear to supersede this latter provision during the emergency rule’s tenure. Although adopted on an emergency basis, we anticipate that the SEC may take more formal action to put these two permanent rules in place.
The releases adopting and extending rule 204T and various related interpretations are available here and here. Click here for separate “tips” to broker-dealers on how to avoid failures to deliver securities.
In connection with the introduction of its disclosure rules in relation to short positions in companies undertaking rights issues in June 2008, the FSA announced that it was considering further measures in this area, such as restrictions on stock lending for the purposes of short selling. It has elected not to restrict stock lending at this time but does urge market participants to report suspicions of the borrowing of stock for prohibited short selling.