Rules are Arbitrary and Capricious and Will Harm Investors and Markets.

AIMA, the global representative of the alternative investment industry, along with the National Association of Private Fund Managers (NAPFM) and Managed Funds Association (MFA) have filed a lawsuit asking the U.S. Court of Appeals for the Fifth Circuit to invalidate two rules recently adopted by the Securities and Exchange Commission (SEC) that require reporting and public disclosure of securities loans and short selling activity. The petition for review can be found here.

As noted in the petition, despite finalising the two closely related rules on the same day, the SEC disregarded the interconnectedness of the rules and adopted vastly different reporting requirements. As a result, the rules would apply contradictory and incoherent approaches to two aspects of the same underlying transaction: the short sales themselves and the loans of securities to facilitate those short sales. In particular, the SEC protects the value of anonymity for short sellers in one rule, —where it acknowledges short sellers’ contributions to liquidity and price efficiency—but then in the other rule exposes short sellers’ confidential securities lending and position information on a granular basis. The SEC entirely disregarded the impact of one rule on the other, including by failing to conduct a sufficient cost-benefit analysis of both rules’ cumulative impact.

Because of these and other flaws, the petitioners argue the rules are arbitrary and capricious under the Administrative Procedure Act and run counter to the SEC’s stated mission to protect investors and maintain fair, orderly, and efficient markets. The petitioners worked constructively to raise these issues during the rulemaking process and chose to litigate only as a last resort.

“These two rules underscore how the SEC has ignored calls from industry, market participants, and Congress to consider the interconnectedness and aggregate impact of its rulemakings. The rules follow inconsistent approaches with broad extraterritorial scope and contain conflicting analyses and rationale even though they both address similar markets. The rules will impair market efficiency and price discovery and harm market participants and investors. The SEC should instead take into account their connected nature and apply consistent reporting and disclosure frameworks for these positions, which are designed to protect both market efficiency and market participants,” said AIMA’s CEO Jack Inglis.

“Despite our best efforts, the SEC decided to ignore the interconnected nature of these two rulemakings and failed to apply a consistent approach or principle to regulating these related markets. The resulting rules are arbitrary and capricious. The SEC needs to go back to the drawing board and develop a consistent, coherent approach that will protect investors and avoid undermining the resilience of our capital markets,” said Bryan Corbett, MFA President and CEO.

Securities lending and short selling are foundational practices for investment and portfolio management. Mutual funds, pension plans, central banks, insurance companies, private funds, broker-dealers, and other sophisticated investors are involved in the lending and borrowing of securities. Securities lending improves investor returns by providing additional portfolio income. Borrowing securities is a necessary component of effecting short sales, which support price discovery, promote market stability, and reduce market risks.    

The newly adopted rules create inconsistent and burdensome reporting regimes that will increase the frequency and detail of disclosure of securities loan and short positions data, allowing market participants to imitate or trade against the underlying position holder, harming investors. In effect, the rules will discourage short selling.

The petitioners are represented by Jeff Wall and Judd Littleton of Sullivan & Cromwell LLP.