Alternative Investment Management Association
Patrick James, Claire Hemming and Joseph Snaddon
The adequacy of the regulation of short selling in Australia and around the world has prompted much discussion and commentary in the past few months. Recently, emergency measures have been imposed by the Securities and Exchange Commission (SEC) in the United States and by the Financial Services Authority (FSA) in the United Kingdom. Even though many would say that the regulatory approach under Australian law and market rules is uniquely onerous and prohibitive, in a case before the Federal Court of Australia earlier this year, Mr. Justice Finkelstein noted that overall the current level of regulation of securities lending and short selling in Australia is relatively light when compared to some other jurisdictions. The Australian Government is now expected to accelerate its review of the legal and regulatory environment in relation to short selling.
Whilst the detail of the changes to be made in Australia are not as yet clear, it is likely that a revised regulatory framework will increase disclosure requirements, implementation costs and reporting obligations, with a view to increasing transparency and price discovery in the market. When developing legislative and regulatory reform, it is critically important to strike the correct balance between the protection of investors and the market on the one hand, against the principles of an efficient market and the ability of market participants legitimately to be able to manage risk and hedge their investment positions.
Short selling in Australia
The general principle is that short selling is prohibited, unless certain statutory conditions are met. Closer scrutiny of the finer detail of the relevant legislation and market rules, however, reveals that a significant amount of trading which might otherwise be regarded as short selling is not regulated as short selling at all. The reality is that the legal definition of short selling under Australian law, coupled with the standard securities lending documentation and market practice, leads most market participants to conclude that covered sales are not regulated as short sales. In other words it is only naked short selling which is prohibited and, where an exemption applies, only naked short sales are subject to regulation by way of disclosure.
Short selling in Australia is regulated by the Corporations Act and, in the case of securities traded on the Australian Securities Exchange (ASX), the market rules of ASX. A sale is only classified as a short sale where the seller does not have a "presently exercisable and unconditional right to vest the products" in the buyer. Under an Australian Securities Lending Agreement, pursuant to which stock is borrowed in connection with taking a short position, there is an outright transfer of that stock from the lender to the borrower who proposes to sell the stock short. It is common in the Australian market for the seller to assume that the Australian Securities Lending Agreement gives it a "presently exercisable and unconditional right” to vest the products in the buyer, so that there is no short sale for the purposes of Australian law.
It follows that where a person sells stock, if they have entered into an Australia Securities Lending Agreement before entering into the sale, then under Australian law there is no obligation to treat the sale as a short sale, and therefore no obligation to comply with the uptick rule or any of the other statutory requirements; no requirement to inform the broker that the sale is a short sale and no obligation on the broker to include the sale in disclosing its net short sales position to the ASX. Covered sales appear to fall under the regulatory radar.
Where an arrangement does fall within the legal definition of a short sale, it is prohibited unless certain exemptions apply. There are various exemptions which may be available, each with a number of conditions attached, the purpose of which is to recognise the validity of short selling but to attempt to create a legislative environment which minimises the risk of short sales being used as a tool for market abuse. For example, a short sale may be permitted where:
• Arrangements are made before the time of sale that will enable the delivery of the products on a T+3 basis:
• The uptick rule is satisfied (i.e., the price cannot be below the price at which the immediately preceding ordinary sale was effected):
• ASX includes the products on its list of "approved short sale products" and the requirements under the ASX rules for short sales of those products are followed.
When a permitted short sale is entered into, the ASX market rules create a disclosure regime in relation to short selling activities. The ASX market rules require brokers to disclose their net short sale positions on a daily basis. In turn, clients are required under the Corporations Act to inform brokers when a sale order is a short sale. In this way, ASX is kept informed.
Bear in mind that many take the view that these requirements do not apply to covered sale positions – that is because they are not short sales at all.
Further, in the Federal Court decision in Beconwood Securities Pty Ltd v Australia and New Zealand Banking Group Limited in May this year, Mr Justice Finkelstein's recognised that,
"in other jurisdictions there is a regulatory and statutory framework that provides a measure of protection to investors that is lacking in Australia".
The short selling regulatory framework in the United States was specifically identified by Justice Finkelstein. Short selling is regulated in the United States under the Securities Exchange Act 1934 and captures both covered and naked short selling. Further, the United States Securities Investor Protection Act 1970 (SIPA) established the Securities Investor Protection Corporation, which is responsible for the protection of individual investors from financial hardship arising from the insolvency of registered brokers and dealers (most SEC registered brokers and dealers are now members of SIPA). SIPA is supervised by the United States SEC and it facilitates the return of customer property held by insolvent brokers and dealers and reimburses customers for cash and securities mishandled or misappropriated by the brokerage firm or its agents.
Whilst the approach taken in the United States clearly goes further, in some respects, than that which is taken in Australia or the United Kingdom, it is clear that the industry there still faces many of the same issues which affect the industry in Australia and other jurisdictions, especially when the price of shares in a company begin a dramatic collapse. This was made very clear in July this year when the SEC considered itself forced to step in and impose a 30 day ban on naked short sale of securities of nineteen major financial firms when the price of shares in Fannie Mae and Freddie Mac began to tumble.
Similarly, in the United Kingdom, the FSA recently considered the introduction of a new disclosure regime in relation to short selling of shares in companies undertaking a rights issue so urgent, that it did so at very short notice and without the standard prior consultation with the industry. The FSA acted so urgently because it perceived the potential for market abuse to be so great as to demand immediate implementation of the new disclosure regime, in the interests of protecting consumers, without the delay which would result if the usual consultation process were followed.
In most cases, the use of short selling is a legitimate risk management and hedging tool, and it is used very widely on a day to day basis in the UK, the US and Australia. It also plays an integral and important part in the economic theory of market efficiency. On the flip side, the private sector must accept that there is the potential for short selling to be used to abuse markets, even outside the classic short and distort tactics employed by the unscrupulous. Short selling, for example, has recently been implicated in the decline in value of shares in a number of high profile companies.
There are many aspects of the existing short selling regulatory environment in Australia which are robust and effective. There are also some aspects which could stand review and reform. It seems clear, however, that there is no simple solution and no model in perfect working order in any other jurisdiction, which can simply be adopted by Australia and other jurisdictions around the world.
The Australian Government has publicly acknowledged its intention to consider legislative change in relation to securities lending and short selling in Australia, and importantly has acknowledged that it is in consultation with certain key agencies in undertaking this process. In any legislative review of this nature, it is crucial to engage properly with the private sector so as to ensure that regulatory change and relevant guidance is well balanced, appropriate, clear and workable.
It is likely that any reform will include changes to disclosure and reporting requirements in respect of short selling activity. Any such changes are likely to be based on a desire to increase transparency, to facilitate price discovery and to limit potential mechanisms for abuse. Some participants in the Australian markets will support greater transparency in this area. Others will argue that increased disclosure and reporting of short selling and covered selling activity will not assist price discovery, because it is just one component of the market and over the counter activity. It will impose cost and technical burdens on the industry. No doubt the process may also include an examination of short selling regulation in other major jurisdictions and some thought will be given to the extent to which a global approach to the harmonisation of regulation is practical or desirable.
Whenever Governments have cause to consider regulatory change, one of the key issues that they face is to ensure that the increased costs and burden of compliance under the new regime are justified by the benefits achieved. Whilst the Australian Government's current proposals or thinking have not yet been disclosed, the hope is that the private sector and the Government will work together to ensure any regulatory change is effective and consistent with complementary legislation and will go towards legitimising the practice of short selling in Australia.Back to Listing