Bills Digest no. 65 2008–09
Corporations Amendment (Short Selling) Bill 2008
WARNING:
This Digest was prepared for debate. It reflects the legislation as
introduced and does not canvass subsequent amendments. This Digest
does not have any official legal status. Other sources should be
consulted to determine the subsequent official status of the
Bill.
CONTENTS
Passage history
Purpose
Background
Financial implications
Main provisions
Contact officer & copyright details
Passage history
Date introduced:
13 November 2008
House: House of Representatives
Portfolio: Treasury
Commencement:
Schedule 2 of the Act
commences on the 28th day after the day the Act receives the Royal
Assent. Schedule 3 commences on a day to be fixed by Proclamation,
or 12 months after Royal Assent, whichever occurs first. The
remainder of the Act commences on the day the Act receives Royal
Assent.
Links: The
relevant links to the Bill, Explanatory Memorandum and second
reading speech can be accessed via BillsNet, which is at http://www.aph.gov.au/bills/.
When Bills have been passed they can be found at ComLaw, which is
at http://www.comlaw.gov.au/.
To give effect to three key
measures:
- to clarify ASIC s powers to regulate and ban short selling of
financial products
- to amend the Corporations Act 2001 (the Corporations
Act) to prohibit naked short selling, and
- to increase disclosure requirements related to covered short
sale transactions.
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The immediate genesis of the current global financial crisis
occurred around the end of 2004 with a spike in loan delinquencies
in the United States. This spike was triggered by the federal funds
target rate (the US equivalent of the Reserve Bank of Australia s
cash rate target) increasing from 1 per cent in mid‑2004 to
5.25 per cent by mid‑2006, where the rate stayed, until
September 2007. The problem of rising housing defaults did not
manifest itself immediately (the US mortgage market is
substantively different from Australia s, with a much heavier
reliance on fixed-rate mortgages and adjustable-rate mortgages,
rather than variable rate mortgages).
Due to innovations in securitization, the risks related to the
inability of homeowners to meet mortgage payments have been
distributed broadly, with a series of consequential impacts. The
crisis can be attributed to a number of factors, such as the
inability of homeowners to make their mortgage payments due to
rising adjustable mortgage rates; poor judgment by either the
borrower or the lender (or both), and inappropriate mortgage
incentives. Further, declining home prices have made re-financing
more difficult.
Since the end of 2007, what began as a bursting of the U.S.
housing market bubble and a rise in foreclosures had ballooned into
a global financial crisis. Some of the largest and most venerable
banks, investment houses, and insurance companies have either
declared bankruptcy or have had to be rescued financially. In
October 2008, credit flows froze, lender confidence dropped, and
one after another the economies of countries around the world
dipped toward recession. The crisis exposed fundamental weaknesses
in financial systems worldwide, and despite coordinated easing of
monetary policy by governments and trillions of dollars in
intervention by governments and the International Monetary Fund,
the crisis continues.[1]
Policy-makers around the world have responded to these
developments in a number of ways. Central banks have been adding
liquidity to their financial systems, and they have been cutting
official interest rates. Some governments, including Australia,
have announced substantial fiscal stimulus packages. Governments
around the world have taken direct measures to strengthen their
financial systems, including capital injections, enhanced
protection for retail deposits, and the offer of guarantees to
various types of wholesale lending. These steps should help to
stabilise conditions over time, but sentiment is still
fragile.[2]
In net terms, US equity prices have fallen by around 30 per cent
since the Lehman Brothers collapse (15 September 2008) and the
Australian market is down by 25 per cent over the same
period.[3] From their
2007 peak, the US S&P 500 Index is down by around 40 per cent
and Australia s ASX 200 Index is down by almost 50 per cent.
Coupled with declining trends in several other economic
indicators, these developments led experts to believe that
Australia would expect a contraction of the economy and a higher
rate of unemployment in the coming months. Reserve Bank of
Australia stated:
With the ongoing stresses in financial markets, it is possible
that the deterioration in the external environment could continue.
Even if this did not occur, the effects on domestic activity of the
deterioration that has already occurred could be deeper or more
persistent than expected in this outlook. In particular, a more
rapid unwinding of the resources boom than (sic) has been assumed
would have significant negative effects throughout the economy,
resulting in softer growth in domestic incomes and spending...
[4]
Against this backdrop of chain of events, the Australian
Government has embarked upon a series of measures so as to contain
the fallout of the crisis in the financial markets. The restriction
and tightened regulation of short selling on the stock exchange is
one such measure.
When individuals invest in shares they will generally want to
buy low and sell high , that is, they purchase shares which they
expect will go up in price. This is known as buying long , as any
profits will be delivered down the track.
Short sellers do the opposite. They want to gain from a fall in
price, so they are looking for shares they think will go down in
price.
Unlike other share traders, short sellers do not own the shares
they sell. They sell them hoping that the price will fall before
they have to hand over shares in settlement of the sale.
In a conventional short sale, the investor usually a hedge fund
or large investment bank takes the view that shares in a particular
company are set to fall. The investor then borrows shares in that
company from someone who does own them. Most often the owner will
be a large pension fund or insurance company. The investor then
sells the shares in the market. Once the shares have fallen in
value, the investor buys them back at the lower price and returns
them to the original owner. If all goes according to plan, the
investor will pay less to buy back the shares than they received
for selling them. There are some costs involved, notably that the
lender of the shares charges a fee for loaning out the shares.
However in a market where the price of the particular shares is
dropping the short seller can still make a profit.
The chart below[6]
provides an example of how short selling works. There is a share
valued at $5.00 which the short seller thinks will go down in
price. On day 0 the short seller enters into a contract to sell
that share for $5.00.
If, prior to the settlement date for the sale, the price falls
from $5.00 to $3.00 as in the blue line, the short seller makes a
gain. To settle the sale the short seller can buy the share for
$3.00 and then use that share to fulfil the contract, making $2.00
profit.
However, if the price of the share goes above $5.00 to $7.00 as
in the red line, the short seller makes a loss of $2.00. To settle
the contract, the short seller now has to buy the share for
$7.00.
Short selling takes two forms, namely covered short
selling and naked short
selling. One approach to facilitating the practice of
short selling is where the investor who is borrowing the relevant
shares has in place an arrangement whereby another person (the
lender) makes securities available to settle the short sale. Under
the arrangement, the investor will have an obligation to transfer
equivalent securities to the lender at a later time. The practice
of short selling securities with an arrangement of this kind in
place is a form of covered short
selling.[7]
The practice of short selling securities without such an
arrangement is known as naked short
selling. In a naked short sale, the seller does not
own and has not borrowed or arranged to borrow securities at the
time of sale, but intends to purchase or borrow securities in order
to meet the delivery obligation.[8]
There are two main motivations to engage in short
selling:[9]
The most obvious reason to short is to profit from an overpriced
stock or market. A famous example of this was when George Soros, an
American financial speculator and stock investor, "broke the Bank
of England" in 1992. He risked $10 billion that the British pound
would fall and he was right. The following night, Soros made $1
billion from the trade. His profit eventually reached almost $2
billion.[10]
Very few sophisticated money managers short as an active
investing strategy (unlike Soros). The majority of investors use
shorts to hedge. This means they are protecting other long
positions with offsetting short positions.[11]
If lots of traders are short selling a particular share then the
first thing they do is borrow the shares. Once they have borrowed
the shares they must sell them. This means that at the current
share price, more people are trying to sell the share than are
trying to buy it and that pushes down the share price.
This is particularly so where an institution is known to be a
specialist short seller. Once it is known that such an institution
has sold a large amount of shares in a particular company, then
there is a danger that there will be a panic in the market as other
shareholders worry that the price could plunge.
Section 1020B of the Corporations Act regulates the short
selling of certain financial products. Under current provisions,
while short selling is technically prohibited, there are some
exceptions provided in the legislation that allow covered and some
naked short selling to occur. These include where the seller:
- has in place before the time of the sale an arrangement that
will enable delivery of the product within three business days;
or
- effected the sale in accordance with the Australian Stock
Exchange (ASX) Market Rules.
In both of these cases a person selling through a financial
services licensee must tell the licensee that the sale is of this
kind.[13] Licensees
(brokers) who are participants in the financial market operated by
ASX must give the ASX certain aggregated information about such
sales on a daily basis.
There is a view in the financial markets that securities
acquired under at least some short selling arrangements (for
instance, those where the short seller has an arrangement already
in place to borrow the relevant securities) give rise to a
presently exercisable and unconditional right to vest those
securities for the purposes of section 1020B. In these
circumstances, the securities may in substance be short sold
without complying with the reporting and other requirements
applying to some of the exceptions to the short selling
prohibition.[14]
In September 2008, the Australian Securities and Investments
Commission (ASIC) responded to turmoil in international and
Australian financial markets by introducing measures aimed at
limiting the potential for Australian markets to become disorderly
due to short selling. Under ASIC Class Order [CO 08/751] (as
amended by ASIC Class Orders [CO 08/752], [CO 08/753], [CO 08/763]
and [CO 08/801]), ASIC prohibited covered short selling of all
securities, managed investment products and stapled securities
quoted on licensed markets in Australia, subject to certain
exceptions.
ASIC also provided relief under ASIC Class Order [CO 08/764] for
a person from having to comply with subsection 1020B(2) in relation
to the naked short sale of a security or managed investment product
that results from the exercise of an ASX exchange traded
option.
Where covered short selling is permitted, the short selling
transaction is subject to a reporting regime in accordance with
ASIC Class Order [CO 08/751]. The prohibition on covered short
selling came into effect on 22 September 2008.
The class order was made under paragraph1020F(1)(c) of the
Corporations Act 2001, which effectively allows ASIC to
apply all or any part of Part 7.9 of the Corporations Act (Part 7.9
deals with the issue, sale and purchase of financial products) to
particular persons and/or financial products, or classes of persons
of products.
On 13 November 2008, ASIC lifted the ban on short selling of
non-financial securities effective 19 November, but kept the lid on
short selling of financial securities until 27 January
2009.[15]
The securities (non financial securities) for
which covered short selling will be permitted are those which are
not constituents of the S&P/ASX 200 Financials index or one of
the five entities named in the instrument.[16]
In the US, Regulation SHO was the
Security and Exchange Commission s (SEC's) first update to short
selling restrictions since 1938. It established locate and
close-out requirements for broker-dealers, in an effort to curb
naked short selling.[17]
Regulation SHO (most recently amended on 17 October 2008), which
became fully effective on 3 January 2005, sets out the regulatory
framework governing short sales. Among other things, Regulation SHO
imposes a close-out requirement to address failures to deliver
stock on trade settlement date and to target potentially abusive
naked short selling in certain equity securities. While the
majority of trades settle on time, Regulation SHO is intended to
address those situations where the level of fails to deliver for
the particular stock is so substantial that it might impact the
market for that security.[18]
In the US, initial public offerings (IPOs) cannot be sold short
for a month after they start trading.[19] This mechanism is in place to ensure
a degree of price stability during a company's initial trading
period.[20] Canada
and other countries do allow selling IPOs (including U.S. IPOs)
short.
In the US, a similar response was made by the Securities and
Exchange Commission with a ban on short selling on 799 financial
stocks from 19 September 2008 until 2 October 2008. Greater
penalties for naked short selling, by mandating delivery of stocks
at clearing time, were also introduced. Some state governors have
been urging state pension bodies to refrain from lending stock for
shorting purposes.[21]
In the UK, the Financial Services Authority has a moratorium on
short selling 29 leading financial stocks, effective from 2300 GMT,
18 September 2008 until 16 January 2009.[22]
Germany, Ireland, Switzerland and Canada have banned short
selling leading financial stocks,[23] and France, The Netherlands and Belgium have
banned naked short selling leading financial stocks.[24]
By contrast, Chinese regulators have responded by allowing short
selling, along with a package of other market reforms.[25]
The issue of short selling was considered by the Parliamentary
Joint Committee on Corporations and Financial Services in June 2008
(before the stock market crash in September which sparked
Governments to temporarily ban or restrict short selling in many
countries). The Committee was examining trading practices in the
Australian equities market, remarking that there was a widespread
view that (short selling activities) are not subject to
sufficiently rigorous disclosure requirements to ensure
shareholders remain adequately informed .[26] In the Committee s inquiry, the
disclosure requirements for the practice of short selling attracted
considerable attention. The committee reported that:
The committee is of the view that while short
selling is a legitimate trading tool, it is necessary to ensure it
is appropriately disclosed to the market to ensure that undesirable
practices that potentially accompany short sales can be identified
by regulators. Further, the committee does not oppose institutional
investors lending their stocks to maximise returns, but considers
that funds should be required to disclose their stock lending
practices or policies to members.[27]
There appears to have been no formal Government response to the
Parliamentary Joint Committee report as yet.
The Bill has been referred to the Senate Economics Committee for
inquiry and report by 27 November 2008. Details of the inquiry are
at the
Committee Inquiry page.
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The Explanatory Memorandum states that the Bill has no
significant impact on Commonwealth expenditure or revenue.[28]
It is hard to estimate the impact of withdrawing the ban on
covered short selling at this stage. Only about A$60 billion of
stock is short in the Australian market, but of that, it is
estimated that only A$15 billion is reported.[29] The Bill s Regulation Impact
Statement states that:
.... it is estimated that the upper limit of
short selling activity in Australian securities is approximately
$60 billion. This equates to approximately 4 per cent of the total
capitalisation of Australian listed securities (based on a total
ASX market capitalisation of $1.5 trillion). The majority of this
is expected to be in the form of covered short sales. The current
uncertainty surrounding the actual level of short selling activity
in Australian securities is compounding the direct impact of this
activity as it is resulting in rumour and speculation in the
marketplace.[30]
The Australian ban imposed in September 2008 went further than
its international counterparts by covering all listed
companies.[31] In
the United States and in the UK, the ban is limited to financial
stocks only. This reflects the fact that banks in those countries
are the most exposed to massive write-downs of structured-debt
products, which have lost most of their values, blowing holes in
their balance sheets and undermining investor and counterparty
confidence.[32]
The broader ban reflected concerns that, given the relatively
small size of the share market, non-financial services firms
carrying large amounts of debts (such as real estate investment
trusts), could be targeted by hedge funds shut out of short-selling
strategies in other majority markets. [33]
According to some critiques of such a wholesale ban:
...(the government has) restricted the
efficiency of the market... Short-selling basically refers,
generally takes place because people have a view about where a
price is going. It's not necessarily that they intend to manipulate
the price.[34]
AMP Capital Investors chief economist Shane Oliver said the ban
on all stocks - over and above moves by international markets - may
reflect a degree of panic.[35]
In a clarifying statement on 28 September 2008, ASIC said that
the ban would not apply to market makers' hedging of positions that
were taken out prior to 28 September 2008. The ASX also issued a
statement, noting that certain market instruments would be exempted
from the short-selling ban. [36]
The Investment and Financial Services Association and the
Australian Council for Super Investors, which represents pension
funds, reiterated their support for the practice of short-selling
despite the temporary ban. They consider that withdrawal of the ban
would contribute to market liquidity, efficiency and assist to
ensure market price efficiency for both underlying securities and a
variety of derivative contracts that are used for risk management
and hedging. [37]
While appreciating the measures to introduce a greater
transparency in the short selling regime, the Australian Financial
Markets Association (AFMA) have raised some concerns about the
exclusive power conferred on ASIC in imposing restriction in the
market:
The objective of the amendment to section 1020F
is to clearly indicate that ASIC has the power to impose
restrictions and prohibitions on covered short selling in the
future. Granting ASIC the express power to impose a temporary
restriction is a sensible measure to provide legal certainty.
However, the proposed new subsection 1020F(8)
contains a number of broad powers allowing ASIC to introduce new
and varied rules. The rules under which a future prohibition of
covered short selling should operate should be governed by
regulations which are the subject of policy development and control
by the Government. Such rules should be developed in consultation
with stakeholders and available before the event so that they can
be factored into contingent business system plans. [38]
The Australian Custodial Services Association (ACSA), a
registered entity representing members holding securities in excess
of $1.3 trillion in custody and administration, raised a point of
dichotomy in the legislative provisions. They argued that:
due to contractual arrangements, a custodian
cannot provide additional information to the market unless it has
legal obligation to do so. Accordingly, any requirement to disclose
must be a market mandate to ensure custodians do not breach client
agreements.[39]
In conclusion they stated that:
Imposing a requirement on custodians to
disclose all lending related activity is not only impractical, but
would result in the collection of a large quantity of information
which would be of questionable use. This could lead to a lack of
transparency surrounding the activity of covered short sellers in
Australian securities and cause investors to make an incorrect
determination regarding the real level of securities lending and
short selling in the Australian market.[40]
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Item 1, Schedule 1 inserts a new
subsection 1020F(8) to the Corporations Act. The new
subsection clarifies that the power to make a declaration under
existing subsection 1020F(1) can be used to restrict or change the
rules relating to short selling (including activity that has
substantially the same effect as short selling) on the stock
exchange. The purpose of the subsection is to remove any doubt of
the authority to make such declarations under the Corporations Act.
Of particular note is new paragraph 1020F(8)(c)
which clarifies that a declaration by ASIC under existing paragraph
1020F(1)(c) can exempt a transaction from the rules against short
selling (i.e. thereby allowing short selling to occur once a
declaration has been made). No specific information is provided
about the sources of the possible doubt in ASIC s powers that this
item seeks to address.
Item 2 inserts a new Part
10.10 into the Corporations Act to clarify that certain
instruments made under paragraph 1020F(1)(c) earlier in 2008 were
validly made under the authority of the Corporations Act.
Technically, item 2 has a retrospective effect,
although an amendment of this kind is not uncommon and should not
be controversial.
Schedule 2, item 2 repeals existing subsections
1020B(4), (5) and (6) from the Corporations Act, and replaces them
with a new subsection 1020B(4). Existingsubsection
(4) allows for some instances of naked short selling to occur.The
proposed subsection clarifies that a person can sell products
previously purchased under agreement, even though they have not yet
acquired the rights to vest the products (due to a condition of the
purchase agreement). According to the explanatory memorandum, the
existence of the prior purchase agreement means that the
transaction falls short of true naked short selling. For this
reason, it is not necessary to repeal this exception .[41]
The remainder of the items in Schedule 2 are
consequential to the repeal of subsections 1020B(4), (5) and (6) in
item 2.
Schedule 3 inserts a number of new disclosure
requirements for allowable (i.e. covered) short sales. Item
3 inserts a new Division 5B into the
Corporations Act. Proposed section 1020AA contains
the definitions which are relevant to the Division. In that
Division, new section 1020AB deals with seller
disclosure. It requires a person who is making a short sale to
notify their financial services licensee that the sale is a short
sale (or, if the seller is a financial services licensee, to notify
the ASX). The particulars that must be provided in the notification
are to be set by regulation. Failure to comply is a criminal
offence under subsection 1311(1) of the Corporations Act see item 6
below.
New section 1020AC deals with licensee
disclosure. The section creates an obligation on financial services
licensees to disclose to the ASX (or any other entity specified in
regulations) when they have been instructed to make a short sale
for a seller, and pass on all the particulars that have been
provided to them by the seller under section 1020AB. Failure to
comply is a criminal offence under subsection 1311(1) of the
Corporations Act. The manner and timeframe for the disclosure will
be set by regulation.
New section 1020AD deals with public disclosure
of information. Where disclosure has occurred (whether from seller
to financial services licensee, or financial services licensee to
market operator, or to another entity prescribed by regulation),
the market operator (or other entity, if prescribed) must make
public disclosure of the information about the short sale. Failure
to comply is a criminal offence under subsection 1311(1) of the
Corporations Act. The manner and timeframe for the disclosure will
be set by regulation.
New section 1020AE creates an obligation for
financial services licensees to ask short sellers for a
confirmation about whether they will need to make a declaration
under section 1020AB (and thereby confirm that the sale is a short
sale), and to record that answer in writing. Similar to the other
proposed provisions in the Division, failure to comply is a
criminal offence.
New section 1020AF provides a regulation-making
power, and enables regulations to be made for specific matters or
circumstances.
Item 6 inserts the offences for new
sections 1020AB 1020AE into a table containing penalties
for offences under the Act. The new offences contained in this Bill
all attract a penalty of 25 penalty units or imprisonment for 6
months, or both.
[17] U.S. Securities and Exchange Commission, Release
No. 34-58775; File No. S7-19-07, available at http://www.sec.gov/rules/final/2008/34-58775.pdf
[accessed 24 November 2008].
[20]. Tim Jenkinson and Howard Jones, The economics of
IPO stabilization, syndicates and naked shorts, December 2006,
available at:
http://www.finance.ox.ac.uk/file_links/finecon_papers/2006fe14.pdf
[accessed 24 November 2008].
[27]. ibid., p.
41.
Kali Sanyal and PaoYi Tan
25 November 2008
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