New EU Short Selling Regulation to Introduce Restrictions and Disclosure Requirements
On November 15, 2011, the European Parliament approved the final text of the Regulation on Short Selling and certain aspects of Credit Default Swaps (the “Regulation”). Subject to being formally approved by the EU Council in the coming weeks, the Regulation is to come into effect on November 1, 2012, and will introduce restrictions and disclosure requirements on persons short selling EU shares and sovereign bonds and prohibit naked or uncovered credit default swaps (CDSs) relating to EU sovereign debt.
According to the European Commission, the Regulation comes in response to the fragmented reaction of member states of the European Union during the financial crisis and, more recently, in the context of market volatility in euro-denominated sovereign bonds, to the issues raised by short selling and credit default swaps.
The three main risks of short selling that the European Commission sought to address in the Regulation are: (i) transparency deficiencies, (ii) the risk of negative price spirals and (iii) settlement risk associated with naked short selling. The Regulation covers both short selling and CDSs because the latter can be used “to secure a position economically equivalent to a short position in the underlying bonds.”
The final wording of the Regulation differs from that published on July 5, 2011, as it incorporates certain concessions to the European Parliament and member states with regard to the banning of uncovered sovereign CDSs.
Key Provisions of the Regulation
Disclosure of Short Positions
The Regulation introduces a requirement to make a private notification to member states’ competent authorities of “net short positions” above 0.2 percent of the issued share capital of an issuer and further notifications at each further 0.1 percent increment, as well as public disclosure when such position crosses 0.5 percent and further public disclosures for each further 0.1 percent increment. These disclosures must include the identity of the person holding the net short position.
Notification relating to “net short positions” in sovereign bonds need only be made to regulators and will not be made to the public. The notification requirements relating to each member states’ sovereign debt will be published by the European Securities Markets Authority (ESMA) on its Web site.
A net short position is calculated after netting off any long positions held. The definition of “net short position” for both shares and sovereign bonds includes any position arising through the use of derivatives, including CDSs.
Restrictions on Uncovered (Naked) Short Sales
Short sales of shares are restricted by the Regulation with the effect that the short seller must either have—
- borrowed the shares or have made alternative provisions resulting in a similar legal effect; or
- entered into an agreement to borrow the shares or have another absolutely enforceable claim under contract or property law to be transferred ownership of a corresponding number of securities of the same class so that settlement can be effected when it is due; or
- entered into an arrangement with a third party under which that third party has confirmed that the share has been located and have taken measures vis-à-vis third parties necessary for the investor to have reasonable expectation that settlement can be effected when it is due.
For short sales of sovereign debt, the restrictions are more relaxed due to successful lobbying by member states, which were concerned with ensuring liquidity of their debt markets. For sovereign debt, a short seller must either have—
- borrowed the debt instrument or have made alternative provisions resulting in a similar legal effect; or
- entered into an agreement to borrow the debt instrument or have another absolutely enforceable claim under contract or property law to be transferred ownership of a corresponding number of securities of the same class so that settlement can be effected when it is due; or
- entered into an arrangement with a third party under which that third party has confirmed that the sovereign debt has been located or have otherwise reasonable expectation that settlement can be effected when it is due.
In addition, the restriction on short sales of sovereign debt does not apply to hedges of long positions in debt instruments of issuers, where the pricing has a “high correlation” with that of the given sovereign debt.
After first notifying ESMA and the competent authorities of the other member states, member states’ competent authorities may suspend the restriction for six months (which period can be renewed), where liquidity in its sovereign debt falls below certain thresholds to be set by ESMA. ESMA shall give an opinion with regard to any such suspension.
Prohibition on Uncovered Sovereign CDSs
The Regulation prohibits uncovered CDSs in the sovereign debt of an EU member state. A position in sovereign CDSs will be considered uncovered if the investor does not have an exposure that it is seeking to hedge either to the sovereign debt itself or to assets or liabilities whose value is correlated to the sovereign debt.
After first notifying ESMA and the competent authorities of the other member states, a competent authority of a member state may suspend the prohibition in relation to its own sovereign debt for 12 months and then additional six-month increments where it believes the market is not functioning properly in relation to its sovereign debt or where the prohibition might negatively impact the member state’s sovereign CDS market. ESMA shall issue an opinion on the proposed suspension, but cannot prevent it from occurring.
Powers During Stressed Markets
During times of stressed markets, the Regulation allows competent authorities of member states to prohibit or restrict short sales, limit sovereign CDS transactions, impose emergency disclosure requirements and require lenders to notify competent authorities of significant changes in fees required for lending in relation to these transactions. Such powers may be exercised by competent authorities on a temporary basis up to a three-month period and may be extended by further periods up to three months if grounds continue.
Competent authorities may also impose a restriction on short selling of any financial instrument where that instrument has suffered a significant fall in price in a single day. This may be extended up to a further two days if there is a further significant fall in price.
ESMA will be notified of any emergency measures taken by competent authorities in member states and will be responsible for coordinating action to be taken by member states.
Competent authorities in the member states will have all powers necessary to enforce the Regulation, including sanctions and pecuniary measures.
There will be certain exemptions for market makers and in relation to issuers where the principal market for the shares is outside the EU.
CDS positions relating to sovereign debt concluded before November 1, 2012, may be held until the maturity date of the CDS contract.
ESMA shall issue implementing technical standards to clarify certain terms in the Regulation and set the liquidity thresholds in relation to sovereign debt, as well as provide other technical standards. The technical standards are to be issued by March 31, 2012. In addition, the EU Commission, in consultation with ESMA, will issue secondary legislation to further define how net short positions are to be calculated.
The press release announcing Parliament’s approval of the Regulation can be found here.
The Web site of the European Securities Markets Authority can be found here.
If you have any questions regarding this alert, please contact—
|Mark H. Barth
|Graeme D. Bell
|Patrick J. Dooley
|Prakesh H. Mehta
|Eliot D. Raffkind
|Stephen M. Vine