Risk & Economy » Regulation » FSA issues rights warning

Services Authority
has rushed in new rules requiring investors to
disclose the scale of their short-selling in companies that are executing rights
issues. The move is designed to allay fears that the market is being manipulated
by deliberate attempts to scupper banks’ recent fund-raising exercises.

There has been strong suspicion that the share price fall at HBOS was driven
by short-sellers deliberately aiming to tip the shares below their (fixed)
rights issue price, leaving the unsold stock with the underwriters and prompting
a further wave of selling.

Asked by an attendee at a shareholder’s meeting in June whether the share
price had been driven down by short-selling, HBOS chairman Lord Stevenson
replied, “There is a lawyer over there and a company secretary who will take me
off the stage if I tell you what I think about hedge funds.”

Short-sellers aim to profit by borrowing shares and then selling them in the
expectation that the price will fall before they have to return the shares to
the lender. The practice has long been used as a hedging strategy aimed at
protecting “long” investors against the risk that prices fall and they lose
money. “Longs” take out small short positions so they can profit whichever way
the market goes. But others ­ mostly hedge funds ­ may “short” a stock simply
because they see it as overvalued, vulnerable and due for a correction.

The issue is particularly sensitive now because the most popular targets are
banks, which are susceptible to a loss of confidence in a way that industrial
companies currently are not.

While the FSA views short-selling as a legitimate technique which assists
market liquidity and is not in itself abusive, it says that “it is also the case
that the rights issue process provides greater scope for what might amount to
market abuse, particularly in current conditions.”

Greater transparency
As a result, the regulator believes that “in the first instance, improving
transparency of significant short-selling in such shares would be a good means
of preventing the potential for abuse. In these circumstances non-disclosure of
significant short positions gives the market a false and misleading impression
of supply and demand in the securities concerned.”

As part of the new provisions introduced in its Code of Market Conduct, from
midnight on 20 June 2008, any person with a short position of 0.25% or above in
a company during a rights issue period must disclose that information. As of 30
June, there were 36 disclosures of investors taking short positions in companies
with rights issues under way. The FSA says it will keep this approach under
review and may consider the introduction of an incremental disclosure
requirement “should experience suggest that this would add value to the regime”.

Face the penalties
The regulator warns that the consequences of non-disclosure will be the same as
for any other breach of the market abuse regime, which could culminate in a fine
or a public censure.

The effectiveness of the measure will be considered as part of a wider
review, which includes whether to restrict the lending of stock of securities in
rights issues for the purposes of enabling short-selling and whether to restrict
short-sellers from covering their positions by acquiring the rights to the newly
issued shares.

The UK is not alone in introducing tighter regulation. In late 2007, the US
Securities and Exchange Commission introduced rules prohibiting short-selling
during a company’s initial public offering, while India and several other Asian
countries have restricted the practice this year.

Not everyone is taken with the new rules ­ particularly hedge funds, where
short-selling is the most popular strategy, with long/short funds accounting for
more than 40% of the total $2,800bn invested in them. The
Investment Management Association
(AIMA), the leading global
representative association for the hedge fund industry, has queried the
justification for invoking special powers under the Financial Services and
Markets Act 2000, which enabled the FSA to take this measure without

AIMA says that academic research supports the “additional benefits” that
short-selling can bring to markets, such as increased liquidity and more
efficient price discovery. It says that there is also evidence that prices
incorporate negative information more efficiently in countries where short sales
are allowed.

Furthermore, investment bodies say that compared with the rules that require
long investors to disclose holdings of 3% in any company (and 1% for a group in
a takeover situation), the shorting threshold of 0.25% appears very low.

But those who are at the short-sellers’ mercy quickly see the benefits that
the FSA is trying to bring. Sir John Ritblat, honorary president of the British
Land Company, has hit out at short-selling ­ describing the business of taking
temporary and often damaging short positions as little more than “corporate

Even some fund managers are taking aim at the practice. Henderson Global
Investors, which runs a £1.5bn property securities business, has blocked lending
its property equities to short-sellers after finding that almost its entire
holdings in certain companies were being borrowed last year.

Patrick Sumner, head of property equities, said it now has a permanent
instruction to its bank not to lend for shorting purposes, saying “why should we
help people to short stocks that we are long in?”

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