The Regulation of Short Selling: A Transatlantic Discussion on Policy Issues and Instruments Corrado Malberti Associate Professor Universita di Trento Stéphane Rousseau Professor and Char in Business Law and Governance Université de Montréal Konstantinos Sergakis Senior Lecturer University of Glasgow ‘While it is by no meane a new trading strategy, shor selling hag attracted considerable attention on the part of regulae tors and the public over the last decade? In the midst of the nancial crisis, securities markets regulators across. the world imposed temporary bans or constraints on short sling" The regulators interventions sought "to restore the ‘orderly functioning of securities markets and limit unwar ranted drops in secuities prices capable of exacerbating the crisis" Following the crisis, the success of Michael Lewis ook The Big Short ~ and subsequent movie ~ heightened the interest of the public towards this controversial trading strategy. Although regulators have lifted rapidly the tempo- tary bane, the iseues raised by short selling have continsed to elicit debate inthe academic, business and policy-making 1 short selling attracts such attention, itis arguably because it poses challenges forthe goals of financial markets regula tion. Indeed, short selling involves market elficiency stability and integrity® More troubling, it ean both support Ahel-Dasprtue (accented 14 September 2018) ig SBN at Sem Gt ie 3A. ot al, "Wart each of shat ing reeston” 2513) vee Ge he nt Cra 013) 489 Ba 5+ 1 Payne The Regaaton of Shore Sllg sod Its Relore o Bs rope Gn) RBOR 43 a5. DOCTRINE and disrupt these goals, as underscore the mixed empirical record and the anecdotal evidence. Likewise, as commen- {ators have more recently pointed out, short selling has implications for corporate governance’ In particular, it can be a powerful tool to uncover fraud, but at the same time unsettle shareholder democracy. Given the breadth of the issues associated with short sell. ing, the academic literature, im both law and Linancial economics, is vast. Against this rich theoretical and empiti- ‘al backdrop, the purpose of this paper, which dows from a panel discussion between its three authors, is modest, At a feneral level, the paper secks to foster the Trans-Adlanic dialogue on’ financial markets regulation, ‘aking short selling as a cate study. Specifically i aime at providing a critical perspective on the regulatory choices and. tech- niques used in Europe and Canada for dealing with the issues raised by short selling ‘The paper ie siuctured as follows. Part 1 provides seme background on short selling by looking at the definition of thie trading strategy and fleshing out the policy issues that i raises, Part IT discusses the regslation of short selling from ‘8 comparative European Union-Canada perspective by focusing on three subjects that are transparency, market stability and enforcement, Part I ende with a discussion on future developments 1. Background on Short Selling 1. Defining Short Selling ‘A key issue of any regulation on short selling is that ofthe definition ef what constitute short selling. At a general level, the Technical Committee of the IOSCO emphasizes that short selling has some common features that are useful to craft a definition ofthis trading strategy? More particu lanl, for the Technical Committee, two factors characterize short selling (or regulatory purposes: “(j) a sale of stock that (i) the seller does not ovin atthe point of sale”? Although they are crafted in a more detailed fashion, the definitions of short selling under the European and Cana- dian regimes echo the IOSCO definition. Article 1()a) of the EU Regulation provides that a short sale means any sale of share or debt instrument "which the eller does not fown at the time of entering into the agreement to sell ‘ing mated snd marie egltortactons rpg dere of 7. WaG. Ring, Hedge Pus ad Rsk Decovptig Tc Empty Voting robin the Eatoean Union, GOL) 3 eae CL Re Ir, KSegucn he ees ofa tht wher in lS Bako, (2), Shaeolder Date Kise a nteranal 9) ‘eh 205 fern ber 1080 Tete Cooter ReptJCOcTRINE including such a sale where atthe time of entering into the agreement to sell the seller has borrowed or agreed to borrow the share of debt instrument for delivery at setle- meat’. The Canadian Uniform Market Integrity. Rules (UMAR) adopted by the Investment Industry Regulatory ‘Organization of Canada (IIROC)" detine short sale as "3 sale ofa security [..J which the seller does not own either directly or through an agent or trustee” The UMIR {urther specify that a seller “shall be considered not to own 8 security if namely the seller has borrowed the security to bbe delivered on the settlement of the rade and the seller is not othervise considered to own the security”? While the European and Canadian definitions remain ‘road, its worth noting that they hath exclude desivatives ‘Thus, even though derivatives fall within the scope of the EU Regulation, Article 2(1)(0)ii) states thatthe definition ‘of short selling does not include the “entry into a tutu ‘contractor other derivative contract where itis agreed to sell securities at a specified price at a future date.” Like wise, UMIR excludes derivative instruments from the deGnition of short selling ‘As the Canadian regulators have noted, derivatives can he used to create "a synthetic short position, where the holder hnas the same economic exposure as a short seller” * For this reaton, regulators could be tempted by the idea of extending the scope of the regulation on short selling also lo those alternative trading srategies. Stl, since in many cases derivatives do not have an actual link with their lundeslying nancial instrument, st might be dificult to determine what these alternative strategies could be, To provide some examples, in extending the scope of the limitation on short selling beyond simple shor sales, regula tors would have to decide whether to include only physially-settled derivatives or also cash-settled deriva- lives, In addition, the definition of the territorial scope of such’ regulation could be delicate, since securities and derivatives may be traded on diferent markets, and deriva tive contracts may he concluded in jusisdetions that are different and far from that where the underlying security is traded, Moreover, derivatives may take different forms, For ‘cxample, they may range Irom physically-setled derivatives ‘on single shares to cash-settled derivatives that replicate a basket of shares, or even indexes. Therefore, st might be difficult to decide where to draw the line between those derivatives that wil fallin the scope ofa regulation on short selling and those that will not 2, Policy Issues “Althovgh short selling is one of the mos eiicized activities in capital and financial markets, itis worth emphasizing the point made by Canadian regulators tht it “is a legitimate Trading practice which contributes to market liquidity, 10+ EU Reglaon om Shot Selig std cela spect of eed deat ‘etvon debe egy maeiplacesin Cra. 12. tvesmenttntusry Regullary Oran of Canes, Unjom NMvtertnegin Rare 1 ena CER} 4s CSAMROC fot Nols 2-52 ~Tenppareeyo Shot Sling sb Paleerace, 203) 08 CH 109,203, eifcieney and price discovery” Nonetheless, there is a broad consensus on both sides of the Atlantic that short selling raises four main policy issues that are summarized by the Technical Committee of 1OSCO. These issues have bbeen consistently used as a justification for regulation in thie area by referring to a serie of potential risks that they raise for market efficiency and stability, as well as investor protection, irstly, there isa risk that short selling may fuel disorder on the markets Speciially, the issue relates to the risk of a trading trend with the expectation of price falls that ean. result in prices being driven further down due to a constant pressure in that direction” The process of decline can be disorderly because of the speed or weight of selling, Tnci- dentally. where the price decline is excessive folvershooting can become a self-fulilling prophecy tor firme in sectors experiencing slzes, resulting in disorderly markets" In the BU the maintenance of an orderly market thows idiosyncratic characters since one of the main goals pursued by European institutions is that of ensuring financial stabil= ity, In fat, the FU Regulation on short selling, which was enacted in 2012 and devotes much attention to uncovered positions in sovereign eredit default swaps, should be un- erstood as a reaction to the financial crisis and the sovereign debt crisis, In Canada, if market stability was not 8 traditional goal of securities regulation, it has now boon, recognized as being past of the mandate of secutities regu lators.” In addition, the federal government has proposed a Capital Market Stability Act to adress speifeally systemic ‘sk wath a national regulatory framework. A second concern raised by short selling is that it may be associated with market abuse. For instance, short selling may be accompanied by the publication of fase or misiead~ ing report to create downward pressure on tbe stock price with the expectation of reaping greater profit on the trans- ction” As the Technical Committee of the IOSCO notes 15+ CSAMIROC Font Noe 2-319 ~Tenpateney o Sto Seng and alee aden n3) 3808 99,3108, 17. Dept is weDaaowe (nd Rhy pid) concer, mamerous ‘Coie ae a be orsign teach eines ‘Sipe te expen opts meee the abrce SSefunlieg stniee Botte oa, “Sack Shon See: Joe bts Shao Bane Qs) a0 Ren. Pace Std 168 Raia ine aly Market Decision Short Sling te Seaton” ‘nprkednphserbalepareSl Ba cen 2 Dee ier N= FSA, Comaton Paper 09, Temporary Shr Selling Messe 4 ean Gnioy sors SiS Rowse, “Badeame The Input of Rete hee fe Swag At on the Proje fo Greate Nal Sete Regal” Qld SCRE De 20. See, fer sme ree Cain czampls, DJ. Bell Ki. “Get Sry” Detannton sed Relry Caos ages Short Sets a {oprocer wane dematon sa et seorngy an th ae B Bian eM Pees. "Ae Shot eles neemena Ilona pe {olamigs Asacemesi?" 2014) 210 Einp Pane 12 a ‘endaons, 0219) 3 foural of Basking & Fine 14 Bure ‘lots NAG 6a. "Do ge Pande Tadeo vt ner {Goi so1 Fea term, 97 Mancove seein aspanet sled tothe ance mae sha rata ahr slang reed BoE Aves “A New Pramewort (rte Gaba Regionsuch bebaviour “designed to postion prices, distort markets ‘or mislead investors normally constitute, or at least st on Use edge of, market abuse" ‘A third sue ie setdement disruption that arises with “Called trades".® More particularly, failed trades occur where the seller is unable to deliver the securities to the buyer atthe time of delivery, which is typically T+3. Regarding short seling there wil be failed trades i the short seller is unable to purchase the shares or, more likely, has not made ade {quite arrangements fr the borrowing of securities. “The fourth issue, which has hitherto altracted less attention from regulators and policy-makers, pertains to corporate ‘governance, and is associaled with highly sophisticated risk eduction or elimination strategies, commonly known as ‘negative decoupling’, employed by shareholders (‘ypically hedge funds)" For instance, a sharcholder with a long, position could acquire an equivalent (or partial) short position to hedge the risk of an equity investment. In such 2 case, the shareholder obviously retains any voting rights attached to the long position and is therefore abe to infu fence corporate decisionmaking However, that the ‘ownership (e.g, voting) and the financial (economic expo- sure) inferesls become partially or entirely separate vath ‘the adoption ofthis risk hedging strategy. |A preoccupation associated with any combination of long ‘and short positions is that itereates an underlying disso nance with other sharcholders and the company. Indeed, it is unpredictable how these misaligned incentives will be ‘expressed not only in terms of voting strategies but, more ‘generally, in terms of shareholder engagement throughout the compaay’s lle. In fact, the combination of long and short positions has been identified as one of the many “empty voting’ techniques. By reinventing the shareholder status and iansforming voting rights into malleable insirument that market actors may potentially abuse, risk decoupling strategies can favor distorted corporate deck sion-making and weaken sharcholder democracy. From the European perspective another relevant policy issue is that of the balance between the powers of Europe- fan and national authorities, Ia particular, the EU Regulation on short selling is remarkle because it grants to BSMA direct and unprecedented powers of intervention ‘on short sales, which algo put into question the compliance ff the EU Regulation on short selling wit the EU law: Given the strong level of harmonization, the intended financial stability goal, the dizect powers of intervention {ranted to ESMA, and the detailed framework for coord fet" G01 18 Sun LB in 16 381 21 108C0 Teel Commitee Report, 2. 22+ Bids CSAMIROC Joint Notce 26512 = Tranpareney of Shot Sling ne Fated Trades, (02) 808 CH 2098 fs 28. Sezai apr a8 Us These aerate mee sled i a8 laporant decom othe by EU Repuatnn ce Cane C2IOL2 Unied Kingdom + Cou! {ihe Buropen Union and Buopea Primer BELA BU Co For tom comment on this eat see CE Beran “Soup he ‘New Sts lr Delegation of Pes to EU Agence: Und in fis» Ecupena Prams and Genel (Som Seng 015) ‘Common et Law Review 318,€ Di Non Gatun “Us Tbh he Harpesn Sais ane Market Ahoy Goversance intes (ene C212", QU) IS EBOR LE Howl “The yes Cove of ast Sellog Us Sho, aid) 11 ECP. DOCTRINE nating actions between ESMA and ational competent authorities, the EU Regulation has been considered an “avant-garde field of eaptal market law” * In this sense the legislation on short selling transcends the simple regula tion of these transactions, and it affects the political dimension of European financial market regulation, touch- ing the problem of the relationship between the different institutions of the European Union and those institutions sind the Member States, In closing, it must be emphasized that empirical studies do not establish a. clear astociation between short-selling activities and the market stability risks related to the firs tree concerns identified above. We do acknowledge that short sellers may engage in activities that can materialize these tks at the expense of other market actors and the market at large. However, as discussed below, the current regulatory framework in Canada and the EU does address these risks Similarly, with respect to corporate governance concerns recent empiical evidence shows no significant increase in| ‘manipulative practices in shor sellers vompared with long traders, with both categories being seen as equally manipu lative. In other words, the reduction or elimination of Tsk exposure is not the decisive tigger for corporate govern= ance concerns tine even shareholders with exclusively long. Positions are able to manipulate the corporate structure in border to serve ther own misaligned agendas. ‘To summarize, caution is warranted before reinforcing the regulatory iramework in the absence of strong evidence {ha itis ineectve in dealing with these concerns. Any new regulatory requirements could otherwise sk becoming ‘counterproductive and harming the short-selling market, * I. The Regulation of Short-Selling from a Comparative Perspective {ia Europe, the regulation of short selling has been laxgely harmonized by the adoption of the FU Regulation on Short Selling. In Canada, although secutities regulation is the ‘competence of the provinces, the regulation at been harmonized at the pancanadian level through the work of the Canadian Securities Administrators (CSA), an umbrel- la organization that coordinates the rule-making activities of provincial regulators. With respect to short slling, the regulatory framework is uniform across the country af itis set out in the UMIR that have been adopted by TIROC, which is a national self-regulatory organization recognized by securities authorities. 25+ F Walla, “Ston Sales ang Crest Dean Swap, aR. Vel 6 eae eee of or seling =a of» feu heen 0 fal art ieresng to examine, wate the patie Selig the Et of such sss om te EU inca sak ve ESSA, Mths tec advice onthe caso the Regan ft) aan ef betuopese Passel 2a athe Cousel 22 ‘GSoaaostnd 3 sone 2013, tulle st peso eaeo Pacaldoupenteoa tt2ys0%israetnisbsdveeshararingse fbnos)"Accoran fo ths nady the mpiementsion the BU fosid that a compaon wh he US mate he Potty Of he ‘tars eed on BU ears eighty dethoethe meade betwee Se eee de a ayo Dareslar Moles, BU Sener and Puna! Make Rega BontJCOcTRINE (ur comparative presentation ofthe frameworks governing short selling in Europe and Canada is organized around Lee of the four principles proposed by the Techical Committee of ISCO to guide Tegulatory approach to ‘wards short selling ‘+ Principle 1: Shor selling should be subject to appropri. ate controls to seduce of minimize the potential risks that could affect the orderly and eificient functioning and stability of financial markets. ‘+ Principle 2: Short selling should be subject to a report ‘ing regime that provides timely information to the ‘market or to market euthonities. ‘+ Principle 3: Short slling should be subject to an effec live compliance and enforcement system ‘Although we recognized its importance, we leave aside Principle 4 which states that Short seling regulation should allow appropriate exceptions for certain types of transac tions for efficient markel functioning and development 1. Transparency: A Reporting Regime Providing Information to Market Authorities and the Market ‘Transparency is one of the bedrocks of financial regulation, tis therefore not surprising that the Technical Committee ‘of TOSCO is of the view “that enhanced transparency of short soling has the potential {o etsume a greater role in ‘effective securities regulation” 2” Thus, transparency is one ff the four principles proposed by the Committee for the regulation of short selling: “Short selling should be subject {o'a teporting regime that provides limely information to the market or to market authorities"2* The European and Canadian regimes both pay heed to this principle trough reporting and transpareney measures, 1.1. Reporting to Regulators Regarding reporting to regulators, the EU Regulation provides that 2 natural or legal person with a net short postion equivalent to 02 % or higher ofa listed company's lssued share capital ha the obligation to notly lke national regulator ofthat position and of any further (LL % increase {in that position.” The notification to the regulator serves the basic purpose of keeping the competent authority informed so that it can efficiently supervise short-selling activities on an ongoing basis. Moreover the 02 % thresh ‘old theoretically makes it easier for the authority to submit further enquiries to the market actors concerned with the im to prevent aggressive short selling that may have det ‘imental effects on the investee company's operations and ‘the market functioning” The relatively low threshold applicable in this case is mainly justified by the need to supervise any potentially inappropriate and destabilizing short-selling practices ina timely manner, leaving. the dlisclosure to the market to a later stage, as will be shown below 11+ Teche Commit of 10SCO Report 8 ase 29. As 50) and Q) ofthe BU Regulation, 1-SA. Shot Seng Dicason Paper 9,28 (Febesty 2009) 31+ Tetepiring snd dora obesos mandated he EU Rega ono hr sling shai aio be sxe of he ee ‘Nevertheless, the intial 0.2% threshold has, unsurprisingly, been viewed by market actors (eg. institutional investors) as very easy to reach ina telatively short time and there‘ore unduly burdensome given the exposure, costs and time concerns involved in disclosure obligations." Moreover, the threshold has been criticized for potentially overloading regulators with notifications by short sellers, possibly reduce ing their capacity to make the best use ofthe available data (Other sources, such as the Committee on Legal Aiais of the European Parliament, have also noted the shortialls of such a low threshold and have proposed a 1 % threshold instead” ‘Although it remains unclear whether the futuze regulatory position will raise this threshold, the EU Regulation has, for the time being, provided Wat ESMA may issue an opinion to the Commission in order to adjust the theesh- olds, taking into consideration developments on tinancal markets. We should therefore not rule out such an amend ment inthe future, especially if we view the 02 % threshold 8 an inital safety valve’ the midst of a highly politicized ‘agenda that could be relaxed i there ate 0 major scan als involving short selling of listed companies’ share. A second layer of concerns relate to the lack of harmon ‘zation of reporting rules amongst regulatars at the EU level. This would ideally be resolved through the introduc- tion of a centralized system? The EU Regulation praises uniformity in the application of the reporting rues, but shy go shop lo eines ay a {sn tat he tol fv eporng ht srt poate fo eatin Sept sti a een bw fui tenis betes uae by tus evans 52+ Olver Wynn the The Bye of Shan Sling Public Dilsure egies on aay ares A Compare Ana, $8 pnw 8 [rerrymun emtigatepabeatonslotcin teeeabar Saeothtedacontensincromegy a (osce6 3 Demt 38. aropeasPahament, Repo the Poona fora Replat of he "Boopean Ptomer and te Coc on Shot Seng end Cea ‘Atpec ef Cet Def Sap (A088 01) 46 Foes ne pos itn om the London took Exchange (308) se Let! om Ata port CESR.” “Apfvww londonstocencaagseoxsnbou ie rtangtesstnerpone cnallevsene-sotesling pa ‘edo Deember 208). Sted agenda cn so bests ne power tha sna elton Le, rowing tar ‘i fhe EU Reqaiion to regare sate Iveta the man ich ty ae een by a epltroo ‘eaten menus wns beats au neigh he cs sa os he tan ton Bey in feats ote lore peso be exes teat. ae iid weed mane th ead och aon Seed by 1 Howe "Sha Slog Reporting Rules. A Greene ‘Ares ls) 120) Haropeas Company Law 98 Fore same fe is la evel ae the sna by Ke Zits The ska Dieta io Stost Sling Regulation 108CO + ntraation Dil deepen he eet fo Regn AE”) 35{his objective is left up to ESMA’s coordinating efforts that may not currently be sufficient due to different operational methods adopted at the aational level, One possible way Torward, which s unfortunately unlikely to receive support at the current stage.” would be the creation of an EU ‘website grouping together all disclosed data or the creation and circulation by ESMA of a reporting form that would iced to be used by all national regulators. While the first ‘option seems quite unpopular, the second could be much ‘more realistic at the ctrent stage and would mort likely censure uniformity amongst regulators, ‘To enhance the transparency of short selling, Canada relies ‘on two regulatory tools: order flagging and short position reporting. Specifically, according to the UMIR, “patic pants and access pettons”, ie. those who can Wansnit ‘orders to the market places, must mark any order to sell a security on a marketplace that on execution would const tute a short sale. To support this obligation which also fenists in the US. securities legislation provides that no person “may sella security short without previously notiy. fing. the dealer responsible for cazrying oul the transaction” Note that the “flagging” obligation is not subject to a threshold level. It applies \kerelore to any ‘order However, in 2012, a new order “short-marking ‘exempt” designation was introduced to provide regulatory relief to accounts that have a “ditectionaly neutral” posi tion” Thus, the short-arking exempt designation is used to signal that the order is entered by an account that is ‘exempted from the flagging obligation, “According to the Technical Committee of TOSCO, a firs Denelit of the lageing requirement is that it “provides market authorities with Feal time information of short seling, which may particularly be useful in a fast moving market" * Further flagging “creates an audit tail of short sales that allow market authorities to follow up of suspic cious activity”. Finally. it may facilitate the monitoring of the reporting obligation Despite these benefits, order Tagging remains a marginal regulatory tool, arguably be. ‘cause of the costs associated wath ite implementation.” ‘With respect to short position reporting, the UMIR Rulle 10.10 requires that Participants endl Accese Persons provide TIROC twice a month with a report of the aggregate short postion of each individual account in respect of each listed 37 Only a mal nro nina regulators wan fave of» eae Wd sytem at BU level te majony sang hatte are ttragement run sooty te cote would ence, they wold EEC yee ieraton maid be toed (on eprd tote lope of areata aration) lnc y woe restore Eat ip aM Tet Ace one Ean 9 anc on Short Slog and Cri pet of Coat ef Sap, GSMA Isis) 19 Lpesinme nce cust Warnist0rs.sttnasepor-onstevauaon el (aesed December 015) B95 O54, 198,50 ho OSA 1 1s Prone Respecting Regan of Sho Sle and Fale Tate ROE Notee 1-000 Mares, 2012 See UMIR, 11 Cet uksgesepl oe) 32 03 42. S00, ¢, RB. Blea, pe, 76 Europese Commision. npc ‘Asean = Accompanying Docent he Propet ors Refale Sd Certain Avec af Cet Dela Swaps (SEC010 1055) 7 Repeat DOCTRINE security and quoted security, To avoid confusion, MROC is the only facility the reporting to receive the short position reports, Using thete reports, ROC will soon stat publishe ing on ts web ste twice a month a new Consolidated Short Position Report (CSPR) that investors will be able to 1.2, Reporting to the Public "The EU Regulation introduced an obligation for natural or legal persons to disclose to the public any net short position of 05%, with additional disclosure obligations at every additional 0.1 %. Extending beyond the above-mentioned necessity for the regulator to monitor short-selling activities at azelativey early slage, the disclosure to the public occurs at @ later stage, with 0.5 % being considered an important Ueshold that needs to be known to the rest of the mar ket: The justifiations for such a disclosure obligation ae, at in similar disclosure obligations in capstal markets Law and amongst many factors, the increase i market transpar- tency, the possitusty for market aclors (o have greater insight into the dynamies of long and short positions in an ivestee company, a8 well as the constrain on inappropri= ate short selling practices It is hoped that shating this information with the rest of the market will make these activities subject to market serutiny and will enhance their legitimacy by enabling other actors to trade upon a wider informational spectrum, It therefore becomes obvious that the overall arguments for tke imposition of a ralker low threshold of 0S % rely upon market stability concerns with the aim to instrumentalze transparency in this area lo ensure an optimal trading framework. Although the transparency arguments are worthy of atten- tion and can clearly legitimize disclosure obligations, it should be borne in mind that eisclosure to the public may also have undesirable effects, Fitst ofall short slles might be unduly exposed to strategic market behavior that may compromise the beneficial aspects of their practies#* Secondly, they may find themselves in a ‘short squeeze! situation and ineur significant losses due to increased trans- pparency of their portions that could enable shareholders of the investee company to keep their shares and be reluctant to sell when the short sllers are interested in buying them back to fulfil their contractual duty towards the lender.” Thiedly, the above-mentioned undesiable effects may ‘make short selling a much less attractive activity and di 48 Gusdince on Soon Postion Colon aed Reporing, ROC. 481. An By provides be sane poner we reed oe postin dana std earesioa ese Gee I) wh vil get State of details of thee hot postion Tote wake The Ste ‘neque pepaston aad sipetsoncapcly of te eel ‘ch ml conics pom serention’ Moreover, the Rey 45+ cig Commie Ina cent = Acai De [ftv Coe Shor Selig and Can Arete of Cre Beat Shape (Cain 1035) 58, Bp lec espace iy eased olen lle 010 1085 cape (Geented a0 Desens 215 $6. J Raye pr 4 9-0, Real al, “Wh Sh Stig Repeltion i he Least ‘Bit Ree a Ee, AY) Kaman Tee looms Bad Spouin Capea Marae iow to Make ies Cie of Reptoy engl 208) 0 Geman Sara 6S oJCOcTRINE suade market actors from selling short (or simply maintain- ing their positions right under disclosure thresholds)" AS previously mentioned, this would inevitably lead to a de crease in market liquidity.” Adding Io that scenario, ‘market actors might find even more opaque areas of activi tiesto conduct their business without being subject to these slsclosure requirements. This will have the consequence not only of creating an even ‘darker operational spectrum’ Dut also of transforming the current rules into a ‘dead letter framework Lastly, the increase in transparency will inevitably tigger ‘excessive or unnecessary herding behavior ® This is due to ‘the fact that, although her phenomenon in financial markets, it ean prove to be disastrous in this area it market actors perceive net short positions a8 a constant precursor for abusive short selling and react accordingly ‘without realizing that these position may simply be a ‘mixture of legitimate hedging practices." Parallel to the Iherding issue is the ‘free vider" problem since other market actors will be tempted to mimic short-selling postions, benefiting from increased disclosure in this area without having to bear the disclosureselated costs? This can also lead to a decteaze in the incentives lo look for information since empirical studies have shown that high-quality disco. sure can discourage market actors from seeking new information, 28 they simply grow accustomed to depending, ‘on the enriched disclosed data” Disclosure of short-selling positions has nevertheless re ceived a considerable amount of support from some studies ‘hat show that, contrary to public perception, disclosure ddulies inthis area can actually enhance markel liquidity" ‘Short selling can therefore funetion asa highly informative signal lor other market actore who will be able to decipher (or at least understand for their own decisions) short seller trading behavior, namely trading upon the expect tion of a price decline. These signals will provide market actors with a more holistic view of market activity and will, make them more wiling to participate in transactions = 8. ESMA, Fina Report SMA‘ Tel Abc om the station of thr Rett (EU) 2460019 of the Baropenn aanet ond of ot anc on Short Sting and Crit pet of Cet ef Sap {ESMA BILD Ista cemactrope vader Faryusisnh A124 teal epor-an-ecalaetonpal ecened Le Decenber 089 ari Soe she etieng empl sty ith equ tothe recta of wan lua and resell yore comes of dine guess Beall, Bebavor abd avs (880) 80 Am Heen Rev 45 1+ easing expecially in mind that, pa om etna markt sear rift alormaton sad who wl be iin to ate tor scing Fete sons toatl nfntional aaa A See ISL Sommer “The Noe ade Appoues to aanee™ (98) & 5 Fron Pepecves 1 snaed is Avgoues pra 85 50 thease EZoaons apres 52 AN Lies, Regaitory Arbitat for Rest ltermatonl Seca (is 38 SS. 5 Brown & S.A. tilegest “How Duane Quay Alles the Eestot norman Ast 07) 12 Rev Acc Sad 83, Sort Sle (08 0 Ae Rey aT Aro et aly “The lee (as) ton Conti of Shor ees A ater xpeines 2 ‘The quest for transpareney is undoubtedly a legitimate one, but the thresholds that trigger such objectives may need to be fine-tuned inthe future sinee t would appear that short seller: as well as other sources Gnd them unreasonably burdensome, both for short sellers and regulators, and unnecessary. Most importantly, the evidence of the overall elfeet of disclosure remains inconclusive: although disclo- sure in this area may have some repercussions on short- selling activites, it seems unlikely that it would reduce short selling to level that would significantly affect market liquidity and the resulting informational quality * {As discussed above, Canada as different approach with respect 10 short sale transparency. First, it relies on short sale flagging, as UMIR requires that a marker be put on corders placed on a marketplace that would, on execution, ‘constitute a short sale” Order marking serves to establish fn accurate and complete aut trail which supports the monitoring of trading activity on Canadian marketplaces by TIROC However, the order flagging obligation does not Prport to provide information to investors Indeed, transparency is rather achieved trough the bi- monthly reports issued by IROC. Specially, TROC will, roll out a new Consolidated Short Position Report (CSPR)* in the fall of 2018 that wil provide information to investors on short tein. Indeed, the CSPR will disclose sggrepate short positions on all isved and quoted secusities| a5 of the current reporting date, aswell asthe net change in shott postions from the previous reporting date, on a per security basi, 2. Controls to reduce or minimize the poten- tial risks that could affect the orderly and efficient functioning and stability of financial markets At least some provisions of the EU Regulation pursue the goal of limiting settlement disruption. For example, this is the ease ofthe locate rule. Another provision with that goal was Article 15 of the original EU Regulation, whieh pro- vided for the buyin of the thares to ensure delivery for seillement. Yet, this article was deleted by Regulation (EU) No. 909/2014, which, among other things, also regu lated ina broader dimension the problem of failed trades. In principle, also the rules on disclosure may play a role in| preventing settlement disruption. This is the ease, for ex fmple, for regulation that imposes the flagging of short orders to signal the higher risks asseciated with short sales, such at the UMIR in Canada. However, in dratting the provisions on reporting and disclosure in Europe, it was preferred not to adopt this approach and market partic. pants were simply required (o report and disclose net short positions, an approach that certainly does not prioritize the ‘Prevention of setlement disruption” 56+ PK Stkouay, “The BU Short Slang Regi vadnce, Dern! Pengetne™ 015) 250) Fs Rented New St. UMERRue 22.03), St Updated Gadnae 09 “Skin Sl and “Sbes-Mastng Exempt ‘ser Deion ROE: Notes 160003, Ferary 136 59+ Guidance on Short Postion Cakaion and Report. moc, {1- Walla r,t 1, coe pls ht he Alte ues 8 ‘or crave onplessesed bythe obit Yo repo sscIn Canadla, ROC has published a series of tudes over the years on failed trades. In ¢ nutshell, the empirical studies Suggest that short selling has not distupted Canadian mar. ‘keiplaces!” Indeed, in a joint statement issued jointly by TIROC and the CSA in 2012, the regulators noted that “there afd] not been a significant problem with failed trades and trade failures are primatily associated with administrative problems with long sales" Thus, following these studies, Canadian regulators have decided to repeal the tick test rule (or uptick requirement) that required that short sale be entered ata price higher than the last trade “That is not to say thatthe Canadian regulatory regime does not provide rules ta ensure settlement discipline. Most notably, Part of UMIR Policy 22 sates that would const tute a manipulative and deceptive trading activity the Lact ff “entering an order for the sale of a security without, a Use time of entering the order, having the reasonable expec tation of setling any trade that would result from the ‘execution of the orders In addition, the stock exchanges and the Canadian Depository for Securities, which provide clearing, depository and settlement services, have buyin ‘mechanisms to enforce settlement Last, UMIR mandates the reporting of an extended failed (rade, that is trade ‘that has failed to settle at T=3, and remained unresolved for ten trading days. Once default is remediated, a second report must be filed with TIROC. The reports provide an ‘audit trail which allows IIROC t investigate whether the failure to settle results Grom an improper reason, such as an ‘undeclared short sale” 3. Compliance and Enforcement Systems ‘The EU Regulation devotes particular atteation to en. orcement and supervision, and it grants to ESMA and to national competent authorities. considerable powers of intervention to reduce risks to financial stability and market confidence arising trom short selling and credit default swaps. More precisely, national competent authorities may require (a) lenders of financial instruments to notify to them any significant change in the fees requested for such Tending, and (b) market participants to notify to them or disclose to the public net short positions, where such posi tions reach of fall below a notification theeshold fixed by the national competent authority. Both requests may be adopted when there is a serious thveat to financial stability fo to market confidence and the request of notification it necessary fo addess the threat. When these last two condi- tions are satisfied, that is when there isa serious threat 10 ‘iancial stability or to market confidence and the adopted ‘measure is necessary to address the threat, national auth ties may also impose on market participants restrictions on mandated by Anil 2 Regio (BU) No son (MUFTR). Ue JSeaneetbirereuuen, canes hat guy ar he (2+ ProvonsRetpectingReplaton of Sho Ses and Fed Takes (+ ovions Respecting Retslaton of Shon Set and Fi Tate, ROC Note ha earch 512 65- UMIR, Poey 22~ Manipulate snd Decepve Acie, ae 20) Secalba Compan ay CP 108, Pang Rar + 4G), 65 See CDS Parkipat Rules. 5 73.500, (51+ Poon Regaine Shr Sle and Falls Trades, EROC, Noe DOCTRINE shot selling and on sovereign credit default swap transac- tions. Finally, national authorities may also. impose restictons on short selling incase of a significant fallin the price of financial instruments, which, for liguid shares, Would be a fall, in a single trading day, of 10% or more in the value ofthe share. In this sramework, ESMA performs 4 facilitation and coordination tole in relation 10 the measures taken by the national competent authorities. However, in some siations, ESMA is also allowed to directly istervene, requiring the notification to the national competent authority or the disclosure to the public of net short positions, or prohibiting or restricting hort sales that confer a financial advantage in ease of dectease in value of another financial instrument. ‘This approach is notable because it provides a model of integration between national and European authorities that, if implemented in other areas of European financial market regulation, could improve the harmonization of ‘enforcement across the EU. However, even it the EU Regulation on shor selling is considered an advanced piece of legislation im devising the respective roles of ESMA and national competent authorities, it showld be admitted that Member States still adopt quite dillerent approaches to sanctions that may jeopardize the efficiency and harmoniza- tion of enforcement Tn Canada, although the rules relating to short selling are found in the UMIR for the moet pat, lie CSA and IEROC ‘conduct market surveillance to detect unusual activity and [possible violations of securities regulation and UMIR rules Both the securities commission and HROC have investiga- live and enforcement powers to sanction violation ol their respective rale books. For instance, where short selling is found to be a manipulative or deceptive activity, st can trigger enforcement actions by a securities commission andlor UROC depending on the trader and marketplaces involved. In this respect, ROC has made it clear in an interprotative release that it considers “naked short selling to bea manipulative and deceptive activity, and therefore is nt permitted by UMIR: “The entering of an order lor the sale of a security without, a the time of entering the ordes, hnaving the zoetonable expectation of setting any trade hat ‘would result isom the execution of the order constitutes ‘iolation ofthe prohibition on manipulative and deceptive activities" Moving from the general tothe particular, UMIR contains two provisions that can impose direct constraints on short selling. The lire concerns a security that has been subject to an extended failed trade, at defined above, In such a case, TIROC may designate the security as a "pre-borrow recur ty” with respect to the trader who triggered the extended fled trade.” The implication ofthis designation is that any ‘order Grom that trade, that on execution would be a short sale, may nol be enlered on a markeiplace unless arrange- ‘ments have been made to borrow the securities that would be necessary to seitle the trade prior to the entry of the oder Tum in ay sceve BUR I0808,005 (01. Proviaons RespecngRepulaton of Short Sls and Pied Tae 10+ Prion Repeing Regulation of Shr Sales and Fale Trae, ROE None Hs Nace. fhe UNaR,£15,82600) 8JCOcTRINE Secondly, as in Europe, since October 2008, the UMIR contains a direct constraint aimed at short selling Speci cally, UMIR authorizes IROC, with the approval of the CSA, (o designate a security as a “Short Sale Ineligible Security": A key purpose of this provision is to provide HROC with the flexibility to respond to evolving develop- ‘ments in the trading of a particular security of class of securities", Thus, the designation prevents a Participant or “Access Person ffom entering a short sale order on a mar. ketplace n the particular security. IIL. Future Developments 1. Enhanced Disclosure Duties One possible futher regulatory intervention in the area of disclosure duties would be to enhance such disclosure, ‘namely by introducing a disclosure obligation for any short position held with regard toa listed company’s issued share capital. As we have already seen, the curent disclosure obligations in Europe and Canada in the aca of short selling relate to net short postions. Moreaver, article 9 of the Transparency Directive” provides for ‘shareholder disclosure obligations of long positions, associated with voting rights, which must be notified to the iu” In theory, it would thesefore make sense to reinforce the current regulatory framework with disclosure of short positions in listed companies Would an enhancement of disclosure dutie foster trans- patency in short-celling activities, enable mazkol actors (0 Imake more informed decisions, and ensure an optimal ‘monitoring framework? To answer this question, we must first decipher the inherent justification for such an en- hancement. If the rationale bekind such an inate is ‘based on market stability concerns, it would be plausible to asset that a reinforcement inthis dzection would not serve fany additional purpose. Indeed, market stability is not necessarily threatened by any short position but potentially ‘when a net short position is of a certain size. Therefore, the duty to notify and disclose should arise as a preventive measure against abusive shor selling. Nevertheless, ifthe rationale behind such a reform is based ‘on corparate governance concerns, namely the need for the ‘company and other shareholders to be aware ol any shost position inorder to be able to anticipate furure potentially abusive practices, the answer might not be straightforward (On the one hand, the arguments for other shareholders and the company to be aware of any short position are reasons: Dle inthe sense that short-selling activities, whether or not combined with long positions, may consitute important signal of a behavior that does not necessarily coincide wath the company’s ‘conventional wisdom given the fact that profits expected out ofa fall inthe shate price. Under this, perspective, the members of the company and the company Pathabiest an of he Coune on te haroniation of aaspaedey ‘eguements i lito fo iomaton sextet who cae Se ponated when secs ne alert he pobe ot nde 0 trading std Commission Decne 007 14RC tpn dows led eotnsisc nts oF as “Te these ae 5%, 1%, 154, 29%, 28%, 3%, 50% and 5% itself would benefit from receiving information about & short position that would otherwise not be disclosed under the cttent framework This would enable them to be better prepared to react to an increased participation of a short seller in its ong and short positions, or simply an increased percentage of a short positon, both scenarios being potentially alarming asthe short sellers’ interests are not aligned with the company’s (On the other hand, clote attention must be paid to the overall ramifications of disclosure of any short position both inside the company and in the market at large. Fist of all, shareholders could be alarmed by any short pesition disclosed, without necessarily being equipped to distinguish between more and less important cases. This could acci- dentally tigger investment or divestment decisions based tupon less sophisticated factors and could potentially disrupt the regular investment flow in tke eompany. Secondly, the company itself could he unnecessarily alarmed by" the disclosure of all short positions and even invest resources ang time to analyze all the information received without nevessarly being ina position to prevent or contzol future ‘movements in this area. Thirdly, regulators (in case such an obligation were extended to the regulator) would be over- loaded by the increased volume of disclosure, facing the same problems with regard to resources and time invested in analyzing all the data, a well asthe fact that not all short positions would be alarming or relevaat Lor monitoring Purposes. Lastly, market actors would be much more ine ‘lined to herding behavior since the multipication of dat ‘would add substantial, constant ‘nose, giving the impres- sion tht all short positions are able to transmit a sigan signal and therefore influence other investors’ decision- making ‘The last factor, namely the inerease in herd behavior, seems to be the main argument against the introduction of rein- foroed disclosure’ duties in this area, Although it is reasonably expected that the information produced would theoretically benefit the company and its shareholders, any proposal in that direction must be weighed against the Inevitable increase in herd behavior ™ Such an increase ‘could prove tobe much more alarming or destabilizing than the short-selling activities themselves insofar as the unde~ sired risks would outweigh the expected benelits of increased disclosure, Tt is therefore supported that, for the time being, and inthe absence of major and repeated scan- dals in this azea, the most eificient approach isto continue ‘withthe current irameweork, namely diselosure of nel short postions Whatever the future implications of the above-mentioned proposals, it seems rather unlikely that the current disclo- sure rules will change in Europe, as has been stated by ESMA" and the Commission” In Canada, although the disruptive ellect of short selling on particular companies “More general on tht oner, he HSA now FCAT pied ot that ‘af aedyh pe Se ey ace okey Oventosig ca become tscstuilg prophecy fof in aectrexpencaog sen, rerting in rcry makes: FSA Caton Paper 9, Temporary Shot Selig Mewar (20) “t+ Commission, Report rom the Cami tthe atop Path teen andthe Caan on the evan fhe Regn (20) No CoM015) sal 13 December 28 Uvasparenoye geen BN TIL SA88 (aeeened 0 Decenber 915).‘remains debated, so far, no proposal to enhance disclosure requirements have been put forward. ly, atleast inthe EU, and although this possibility was discussed and discarded during the preparatory works, the introduction of provisions on order Hagging should be carefully considered, especially ifthe prevention of settle ‘ment disruption should stil be considered one of the intended goals of the EU Regulation on short selling, 2. Shareholder Disenfranchisement ‘Another line of argumentation could focus on alternative ‘ways that could effectively restrict the negative ramitica tions of short-selling practices and, asa result, ensure that shot sellers full their ongoing duties without destabilizing investee companies. For example, sharcholder disenfran- chisement in the case of risk elimination activities could prohibit short sellers trom indluencing corporate decision making with the ubimate aim of driving the company's share price down or. more generally, of serving their ova misaligned agenda, Of cours, risk elimination activities are not solely confined to short-selling practices, as seen above, land any reform in that respect must be applicable not only to these strategies but also to all strategies with tsk elimi nation results, ‘Amongst the proposals made in that respect, there seems to ‘be abroad consensus on the necessity to restrict sharehold ‘ere voting power in risklecoupling cases.” Nevertheless, ‘examining the concept of disenfranchisement for the pur- poses of our current study, it would be usetul to question ‘whether a general voting prohibition, applicable to share holders with risk elimination strategies, could reslve all the problems arising from abusive short selling. This assump. tion could be tre since voting power would be eliminated and the concerned shareholdets would in theory, be unable to impose their misaligned approach to the rest of the company. In practice, however, the same shareholders could have alleralive meant of influencing corporate boards, such as informal meetings, which could lead us to the conclusion that a general voting prohibition would not necessarily protect the company and its shareholders fom risks in this area. Moreover, such a prohibition could be seen a8 an overly cautious and unduly restrictive approach that could deter short selling at large in the frst place and thus deprive both the company and the market of some ‘beneficial aspects of thi kind of activity ‘A less strict solution would thus need to be found which ‘would enable an ad hoe intervention only in exceptional circumstances where voting prohibition would be justified ‘A very interesting proposal, with regard to risk-decoupling activities in general, has been advanced more recently™ Advocating the intzoduction of such an ad hoe power ac corded to national regulators. The latter would be able to ‘decide individually om each case taking into account a series fof factors, such as "the actual scope and extent of the rik decoupling situation. the timing of the situation... [and] ‘the potential harm of the itk-decoupled situation”. Such ‘a proposal would be welcome in short-selling activities, sit THe See for exatple, HEC. & B, Black, “Egy aod Debt Deca Pine std Ep Votoe I inporiance aa Extensa 2008) 196 ENR Reve 23, For tr selig is pala aml opanlby SP Marta &FPustooy "Hacobere Saree” 08) 3 1-6 Ring, pr, 11092112 DOCTRINE ‘would allow the regulator to decipher, insofar as this is possible, the distinctive features of each and every case and eventually impose voting restrictions in the presence of flhusive or overly aggressive strategies ‘A. significant problem would nevertheless remain with regard to such an additional power accorded to nation regulators (and combined with enhanced disclosure duties, namely disclosure of all short postions). The multiplication of disclosed data, along with the expectation for a regulator to intervene on an ad hoc basis, would inevitably alfect the latter's supervisory capacity and result in an overload that could lessen, in theory, its potential contribution to the timely confrontation of serious eases. It therefore remains to be seen whether policymakers would he willing to move in that ditectio in the future, acknowledging the limita- tions mentioned above (if national regulators were not ‘equipped with the staff and expertte to face these chal- lenges). 7.