Short stuff

Last week the Financial Services Authority (FSA) took the unexpected step of intervening to require disclosure of short positions in respect of companies undertaking rights issues. The FSA is introducing a provision to its Code of Market Conduct, to come into effect from 20th June, which will require the disclosure of positions of 0.25% or more of the issued shares achieved via short selling or by any instruments giving rise to an equivalent economic interest. The obligation will be to disclose positions exceeding this threshold to the market by means of a Regulatory Information Service by 3.30pm the following business day.

However, the regulator’s interest is not restricted to disclosure. Rather more radically, the FSA is also considering restricting the lending of stock of securities in rights issues for the purposes of enabling short selling, and restricting short sellers from covering their positions by acquiring the rights to the newly issued shares.

Announcing its plans, the FSA stated: “In current market conditions, there is increased potential for market abuse through short selling during rights issues. As a result, there has been severe volatility in the shares of companies conducting rights issues. This is potentially damaging not only to the issuers in question but also to confidence in the overall fairness and quality of the UK market. It can be particularly prejudicial to the interests of small investors.”

Responses to the FSA’s intervention have been notably mixed. Not surprisingly the International Securities Lending Association (ISLA) warned that the move would damage the equity market as a whole. The ISLA also contrasted the position on shorting with the similar disclosure of long positions, which need only be disclosed when representing 3% or more of the company’s shares.

On the other hand the Investment Management Association welcomed the decision, arguing that the wider economic picture should be heeded.

“Banks have been told to come clean and raise capital where needed. Rights issues should be the mechanism of choice. Shorting so as to suppress the share price below the underwritten price, knowing this will force underwriters to sell at a discount, is fuelled by an absence of transparency. If banks cannot raise capital, house-builders and other major contributors to the economy will suffer,” said IMA director of wholesale Guy Sears.

Investment banks also seem broadly supportive, though the FSA’s intervention will no doubt benefit them as it should make it less likely that rights issues flop.

The FSA’s decision also taps into the wider, and as yet unresolved, concern that shorting may not always be a positive feature of the capital markets. Although the FSA’s statement repeats that shorting is “a legitimate technique which assists liquidity” its latest move suggests that it believes that there maybe times when shorting is problematic for the market.

Critics of shorting argue that it can destabilize companies unfairly and push up their cost of capital at a difficult time. They also suggest that it is self-defeating for long-term investors such as pension funds to loan their stock out to be shorted. If the short-seller is successful, the stock they return will have a lower value (though this is offset by the income the loaner has made from the deal). But then if the company was over-valued, and shorting it helped reveal problems that the inflated share price was disguising, isn’t that in shareholders’ long-term interest?

Meanwhile, defenders of shorting argue that it plays a vital role in ensuring that prices are set fairly. More shorting, some suggest, might have punctured the TMT bubble earlier. And if shorting pushes prices too low, other investors can go long and thus push it back up to a reasonable level. But this does assume that investors are both informed and relatively rational, and, in turn, that markets tend towards equilibrium. And as experienced traders such as George Soros suggest, these are big (and possibly misplaced) assumptions.

Needless to say the argument about shorting (and stock-lending) is far from over. In recent years it had appeared that opinion was largely on the side of shorting. But market volatility, frayed nerves and now the FSA’s foray into the debate suggest that opinion maybe turning. It’s just another example of how the financial crisis is leading to a re-appraisal of many of the things we have been taking for granted.

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