Love them or loathe them, short sellers have a role to play, but that role has been tightened as a result of measures taken during and after the GFC. Post-GFC, ASIC has continued to issue individual no-action positions in appropriate circumstances to allow for certain trades by short sellers. The number of applications has increased significantly, leading ASIC to begin a consultation process which has now culminated with legislative relief being released on 8 October 2018, ASIC Corporations (Short Selling) Instrument 2018/745, and amended Regulatory Guide 196 on Short Selling.
The relief to the general prohibition on naked short selling in respect of Exchange Traded Product (ETP) market maker activities, bona fide hedging, exchange traded options, deferred purchase agreement and for initial public offering (IPO) sell downs through a special purpose vehicle is mostly similar to that set out in the Consultation Paper, but the relief for IPO sell downs on a deferred settlement basis has undergone some changes which better clarify the scope and extent of this part of the relief.
ASIC has also clarified the scope of existing exemptions and changed the time of reference for reporting on covered short sales.
The blanket prohibition on naked short selling in the Corporations Act
Short sales may either be "naked" short sales or "covered" short sales.
There is a blanket prohibition on naked short selling in section 1020B of the Corporations Act. This section prohibits a person from short selling securities, managed investment products and other financial products unless that person has, or believes on reasonable grounds to have, a presently exercisable and unconditional right to vest the securities, managed investment products or other financial products in the buyer at the time of the sale. A sincere belief is insufficient.
This section prohibits naked short selling but not covered short selling, that is, where the person could derive an exercisable and unconditional right from lending agreements (with respect to securities, managed investment products or financial products) that the person has entered into prior to the time of the short sale.
Section 1020B(4) of the Corporations Act provides an exemption to the prohibition in circumstances where there is a prior purchase agreement in place. These include:
- short selling odd lot transactions by a financial services licensee;
- short selling that is part of an arbitrage transaction;
- short selling by a person who before the sale has entered into a contract to buy those products and has a right to have those products vested in in the person;
- short selling by a person who is not an associate of the issuer and where arrangements have been made before the sale that enable delivery of the products in time for settlement; and
- market operator approved short sale transactions.
There are other exemptions set out in the Regulations.
ASIC is also empowered under section 1020F to provide relief from the naked short selling prohibition where necessary for the market's orderly operation, which it has exercised to a number of classes of persons (through issuing certain class orders (CO)), including where:
- the short sale is carried out by the giving or writing of certain exchange traded options (CO 09/1051);
- at the time of sale, the person is able to obtain at least the number of financial products of the same class by exercising exchange traded options (CO 09/1051);
- a short sale of bonds issued by a government, or a short sale of bonds or debentures issued by a body corporate if the amount on issue exceeds $100 million and has the same maturity and coupon terms (CO 09/1051);
- a short sale resulting from the exercise of exchange traded options. Short positions created need to be reported by sellers (CO 08/764);
- the short sale is of a security or managed investment product that is on the S&P/ASX 300 and is made by a market maker (ie. an entity that holds, or is exempt from holding, an AFS licence) to hedge its risk from market making activities. By the end of the day of the sale the market maker must have purchased or secured the right to unconditionally vest the financial products in the purchaser by the time of delivery. Short positions created need to be reported by sellers (CO 09/774);
- the short sale is the result of entering into a deferred purchase agreement (CO 10/111); or
- the short sale is for a small position ie. value of less than $100,000 and is no more than 1% of the total quantity of securities or financial products in the same class of securities or financial products that day (CO 10/135).
Also, individual no-action positions have been taken by ASIC upon prior application in the following circumstances:
- a short sale of certain exchange traded funds (ETF) by an ETF market maker in the act of making a market in ETFs where, as soon as possible after the sale, the ETF market maker purchases or applies for the issue of equivalent ETFs to settle the sale. Short positions created need to be reported by sellers;
- the short sale is completed before loaned securities are recalled;
- a sale of CHESS Depository Interests (CDIs) prior to conversion. This type of short sale must be reported by sellers to the ASX;
- a short position is created by virtue of trading in unissued securities during a deferred settlement trading period – this occurs in certain IPOs and for other corporate actions; or
- a short sale of securities by a stockbroker to a client in the ordinary course of a client facilitation business. Short positions created need to be reported by sellers.
Exchange Traded Product (ETP) market maker activities
ASIC will grant legislative relief to permit market makers of certain exchange traded products (only in relation to exchange traded funds (ETFs) and exchange traded managed funds) to undertake naked short sales. This is a change from the current "no-action" letter position taken by ASIC. However note that one of the requirements for relying on this relief includes the requirement that the fund is listed on ASX or Chi-X and the sale occurs on a day where the operator of the fund or the foreign company (as applicable) allows applications for and redemptions of interests or securities in the same class as the shorted product.
This amended position is made in recognition of the important role that market makers play in promoting liquidity in the market for ETPs.
This amendment will not change the position of how short selling reporting obligations apply to market makers. ETP market makers that execute naked short sales when relying on this legislative instrument will not be subject to the transactional reporting requirements. It is noted that ETP market makers that make covered short sales when making a market in ETPs are not required to report such sales.
Deferred settlement trading
Corporate actions (such as issues under a disclosure document or PDS, a compromise or arrangement under Part 5.1 Corporations Act, a rights issue, a dividend or distribution reinvestment plan or a bonus issue) which involve the commencement of trading of products (on a deferred basis) on a licensed market before they are issued will be eligible for relief. Currently, ASIC deals with these circumstances through the issue of a 'no-action' letter for the deferred trading period.
Initial public offering (IPO) sell downs
An IPO of a company where official quotation commences on a conditional and deferred basis. This usually occurs for an IPO with an offer of at least $100m. The relief permits naked short selling for unissued products during the deferred settlement trading period by a person with an unconditional entitlement to be issued with the products under the IPO or the corporate action mentioned above.
Relief is also available for IPOs involving existing shareholders seeking to sell some or all of their shares through a special purpose company (Saleco) with the selling shareholders agreeing to transfer their shares to Saleco for the purposes of the IPO. Typically, the existing shareholders agree to transfer their shares to Saleco conditional on ASX granting approval for the admission of the listing company to the official list and quotation of its shares. This condition ensures that the existing shareholders do not have to transfer their shares if the IPO does not proceed. Saleco thus does not have a presently exercisable and unconditional right to vest the shares in IPO applicants, and means Saleco is technically engaging in naked short selling if they start selling shares prior to ASX's approval, including by seeking IPO investors at the prospectus stage. The proposed change will grant legislative relief for situations involving sales prior to receiving ASX's approval, where agreements are in place for the transfer of shares to Saleco conditional upon receipt of ASX's approval of the IPO.
Extending Class Order relief
ASIC also proposes to reissue, without significant changes, six of its class orders (as legislative instruments) that will be expiring in the next two years:
- CO 08/764, CO 09/1051 and 10/111 extended beyond 1 October 2018 by their inclusion in the proposed new consolidated legislative instrument;
- CO 09/774 extended so that a market maker may make a naked short sale of units in the SPDR S&P/ASX 200 Fund (STW ETF) in order to hedge risks arising from making a market in listed options over the STW ETF; and
- CO 09/774 modified to confirm that the exemption in that legislative instrument does not extend to pre-emptive hedging.
CO 10/288 extended so that the relief that exempts market makers from the requirement to report its covered short sales will now include ETP market makers that engage in covered short sales of quoted managed funds on the ASX.
Calculating short positions as at a global end calendar time
Recognising the global nature of business and that trading desks operate in multiple time zones, the time of reference to which a short sale position report for a covered short sale is now calculated occurs at the end of the calendar date in the reporting entity's location.
This will be a welcomed change in order to make reporting more a manageable, but will further delay the reporting of short sales to the Australian market; a delay which is already criticised as it does not give real-time information to investors.