1 Ocean Financial Group Pty Limited ABN Level 14, 470 Collins Street, MELBOURNE Vic 3000 Telephone: Facsimile: Mobile: Attn: Mr. Stephen Powell Corporations Amendment (Short Selling) Bill 2008 Corporations and Financial Services Division The Treasury Langton Crescent PARKES ACT 2600 Sent by Dear Sir The abusive nature of short selling is now starting to be reveiled in overseas jurisdictions. In particular the co-relationship between failed trades and drop in share prices enough to account for 30 to 70 percent of the declines in Bear Sterns and Lehman and other stocks last year 1. This is only the tip of the ice-berg. When short-sellers manipulate the market, even the strongest companies can collapse. By creating a false impression of investor uncertainty, short-sellers can drive a stock lower and lower until the company itself is destroyed. According to the smart people who talk to me on TV, most short-sellers are not criminals. But whether or not they play by the rules, all short-sellers are inherently positioned against the health of our economic system. At best, short-sellers are rooting for a stock to go down; at worst, they are engaged in activity that unfairly drives down market prices and destroys small- and mid-sized companies. With so many investors pumping money into public companies, they say, it s useful to have someone on the other side selling securities and driving overinflated stock down. Short selling, they say, is a positive consequence of the free market at work. The benefits of short selling are very real, but the costs are much higher. While it s doubtful the collapse of AIG and Lehman Brothers was tied directly to market manipulation by short sellers, such manipulation has driven and will continue to drive strong companies out of business. Our economic system should be run by people who are invested in its success, not by people who cheer when stock prices go down. Unlike both the US and the UK which changed their regulatory regime at the top of the market in July 2007, the Australia regime was still very much in place when the market started to fall. This included: the uptick rule, the 10% cap on positions in short selling and with regard to fail trades the electronic script settlement system known as CHESS. In you analysed the existing law and the ASX Rules together, you would have said that Australia was meeting if not exceeding on the four principles currently being put forward by the IOSCO. So why did it fail? 1 Naked Short Sales Hint Fraud in Bringing Down Lehman, Bloomberg 23 March 2009
2 The reason can only be the lack of enforcement by the regulators. It is so easy to blame the fall of share price in Australia on events occurring elsewhere in the world. However, given the fact that there was suppose to be a much harsher regime in Australia, then in the US and the UK then the fact that Australia fell harder and faster than overseas jurisdictions can only be attribute to the fact that the Australian regime was not be enforced. I will address the rest of this paper in the order requested. But I query why this needs to be changed, if it had been enforced correctly. Even whose if the new regime is to be enforced by the ASX what assurances is the government giving that this situation will not happen in the future. In otherwords is the ASX prepared to spend the necessary enforcement dollars, something they have been reluctant to do in recent times In my opinion, the old regime stood the test of time in the 1980 s and 90 s, and only failed due to a dubious legal opinion, that should have been reviewed by the regulators well before it was needed in the marketplace. 2 A. POSITIONAL REPORTING Up until 19 November 2008, Australia did have a Positional Reporting Regime as opposed to having a Transaction Reporting Regime. This was through ASX Business Rule From that time the rule became a Transactional Rule. The new Rule : 2 Securities Lending of Equity Securities in Australia, John C King, Mallesons Stephen Jacques, 1999, Fourth Edition, pxxvii
3 Over the years, I have been a supporter of the Positional Rule and believed that it operated effectively until about 2002 (ie the time of the demerger of the ASX). The procedures accompanying the rule required ASX brokers to report their net short positions by 9:00am: However, it appears that the Positional Reporting Regime failed, not because of the lack of systems, but rather ASX s inability to enforce it or even worse it s desire due to the added liquidity no to enforce it. Part of the problem that we are current facing stems from the legal opinion that a covered short sale was not a short sale and therefore did not need to reported. I have always been firmly of the opinion that this was not the case. I also believe that over 80% of the financial community would have the same belief. It is clear from the new ASX Business Rule , which came into existence on 19 November 2008, that the ASX has now formed the opinion that a covered short sale should be treated as a short sale. Having formed this opinion, the ASX, should have know that the only way to enforce the short selling regime was by both a Positional and Transactional information being made available to it as the regulator and the transparency of the short selling to the market by Positional Reporting.
4 It must be remembered that the short selling regime is currently regarding against a number of specific abuses that were discovered due the Rae Royal Commission in 1974 and are extensive covered it the Committee s Report. In particular the report was damning on the ASX brokers who undertook short selling in Antimony Nickel, whereby seven of the top ten leading brokers were short the stock. The Committee recommended the introduction of the prohibition in short selling section 54(3) of the Securities Industry Act (NSW) of 1975, the forerunner of Sections 849(3)(a) - (d) of the Corporations Law now section 1020 of the Corporation Act. The prohibition was relented to allow short trading on the ASX, subject to very strict ASX enforcing a fair, orderly and efficient market through its rules in regard to: The type of stock that could be short sold. ASX Business Rule Only certain type and size of company s should be short sold whereby the added liquidity of supplied, the price efficiency achieved and enhanced market depth achieved by allowing short selling overrides the dangers of accelerated decline in prices, the creation of false markets from the lack of disclosure, the treat of default on delivery being detrimental to market efficiency and the developed of unfunded speculation due to the lack of margins being imposed. The total amount of short selling. ASX Business Rule and
5 The ASX therefore has the power to limit the total value of short selling to a defined amount. The ASX states this amount in Procedure Therefore the ASX in its wisdom has determined that securities should not be short sold greater than 10% of the company as the dangers of short selling greater number of share than that defeats the benefits that could be achieved. The actions of the short sellers. ASX Business Rule This rule is designed so that the actions of the short seller is not forcing the share price of a security lower, but rather the short sellers are adding to the liquidity and stability of the market. In a number of other jurisdictions it is also known as the zero-tick or up-tick rule. Whilst the SEC in the US dropped this rule in July 2007 (just at the time the biggest, ugliest, toughest bear market was about to rip the throat out of the global stock markets) 3, there has now been an outcry and it appears according to John Nester the rule maybe reinstated. 4 3 Business Speculator Commentary, 21 November SEC May Weigh Reviving Uptick Rule to Bolster Markets, Jesse Westbrook, 10 March 2009
6 Disclosure of short sales. ASX Business Rule There must be transparency in the market. If there is a lack of transparency, it leads to market manipulation or at the very less the perception of it, which can undermine the integrity of the marketplace and cause participants to withdraw. This is what we are currently seeing. Short sales generally increase the total number of securities owned beneficially by investors, of which some maybe need to reported. In the case of Antimony Nickel 51% was held by directors and 44% held by Gordon Barton. This lead to a situation whereby the short seller could not settle their short trades. Short selling also gives a misleading signal about supply to the market. Any expansion in the supply of a particular asset would according to Keynesian theory would normal drive prices down, unless there is perfect elasticity in the demand of the asset. Historically short selling accelerates a price decline and therefore increase the volatility in the market. Client to inform Broker of Short Selling. ASX Business Rule Historically, this involved marking the order and the contract note as a short sale. By the client informing their broker that the trade is short sale allows the broker to fulfil their obligation to the ASX with regard to the disclosure of the sale and the consolidation of short sales into their
7 reporting to the ASX, but more importantly, the short sale was also marked in the SEATS screen as a short sale. The mechanism of reporting through SEATS allowed the ASX to monitor in real time the short sales so there was no abuse of the zero-tick or up-tick rule. In addition the reporting of the short sale to the broker, allowed the broker to report to the ASX, so that there was no breach of the 10% limitation. In essence this is the current Transaction Reporting Regime, except the trade is no longer marked as a short trade. In my opinion, under the current regime I do not see how, the ASX can enforce its rule in regard to Short Sale Volume and in regard to Consecutive Trades (zero-tick rule). Even worse from my own examination I have found that everyone of the top20 ASX companies has over the last 12 months have breached the 10% limitation in regard to Short Sale Volume. I will discuss these breaches by the ASX later. Appropriate mechanism to ensure the short seller can fulfil the contract should the market gone against the short seller. This done by way of imposing a Margining Regime. ASX Business Rule This rule requires the short seller to lodge a margin of 20% of the sale value as collateral with the broker at the time of the short sale. It was this area that is critical in the?? case, as the script borrower was also the broker and did not hold the 20% collateral cover. Transparency of Short Sales. This historical has been done by the ASX supplying the current level of short sales as a percentage of the 10% allowable to information vendor via one of it s information signals. This information supplier sell the information through their system. An example from Iress is show below. In summation, I believe that it is important to have both Positional and Transactional reporting, as without both it is impossible to accurate monitor and enforce short selling. B. RBA DISCLOSURE In my opinion the disclosure regime of the RBA will shed significant light upon the abuses that have been occurring in the Australia market. As you have rightly stated stock can be lent for other reasons, however, in the downward part of the cycle very little to no stock are lent for those reasons. This
8 argument has been a fur fee by the short sellers. If this was the case, have the reasons disclosed and stop the debate. I am still very disappointed that we are having the argument about delayed disclosure when the integrity of the market is at stake. I will give you an example. Suppose both shareholder A and B each owned 40% of a company and the remaining 20% was held in mum and dads hands (not unusual on the ASX were by small groups control companies). A is currently in financial difficult and script lends his shares of which 15% is borrowed by C to facilitate a short trade. B acquires the shares from C as he is planning to launce a takeover for the rest of the company. B lodges his disclosure document showing that he now controls 55% of the company. The market is now perplex because they known that between A and B, 95% of the company is controlled, and all B needs to do is persuade A to sell and B would then be at compulsory acquisition stage. So therefore they believe that there is very little upside premium over the current price. But this would be totally wrong, as the fact that A does own 40%, but has lent 15% to a short seller who has sold tem to B, means that between A and B they still only hold 80% and 20% is still held by mum and dads. So a good premium should be possible to mop them up. Therefore in summary, I welcome the RBA reporting regime and believe that there should be no lag as it would confuse the market. C. INVESTOR DISCLOSURE I strongly support the notation that investor must disclose their short position. Whether it is reportable to their broker or to the ASX and even to ASIC, is immaterial so long as there is appropriate enforcement to ensure that abuses are stopped. It must also be remembered that if it is not reported to the broker then how can the zero-tick rule be enforced (see above). It is going to be interesting now for the SEC if it re-established the zero-tick rule, as to how it expects the Exchanges to enforce it. D. BROKER ACCESS TO INFORMATION I believe that brokers since November 2008 have now put in appropriate mechanisms to capture this information. A lot of them already had procedures for this under the old ASX regime (see above). Brokers would be unhappy if the money for these systems were wasted. Particularly those that have put in new systems like Etrade. The issue of an investor using multiple brokers only becomes an issue if there is a threshold imposed on reporting. If it was at the broker level and no threshold was imposed, then all trades that were reported to Broker would be reported to the ASX, subject to the client reporting them. If the client chooses not to inform the broker that it is a short sale, they are more than like also not going to inform the exchange. In this regard it is an enforcement action that has to be taken up. It is better that it done by the regulatory body rather than the broker. However, if no enforcement happens than the market abuse will still continue, as the client will not tell the broker it is a short trade will sell it on the market as normal sale and more than like will breach the zero-tick rule and therefore the market has already suffered the abuse.
9 The concept of a client splitting trades across multiple brokers is not unusual to cover a market abuses. For example, see ASIC v Nomura in which I was the principal expert witness for ASIC. Nomura used 10 brokers to facilitate this market manipulation. It is therefore important that the ASX has an independent mechanism to compare the reporting of the trades against i.e RBA number, without this it is impossible to have any enforcement. E. ENFORCING DISCLOSURE REQUIREMENTS Offshore entities imposes major issues for any enforcement action. However, they are possible and should be perused for the integrity of the market. Civil penalty orders similar to Nomura is a good starting point. It the allows the lead regulatory in the home jurisdiction to use it for other orders. F. DESSIMATION OF INFORMATION It is important that one regulator controls all the short selling reports, including the RBA. But it is more important, that the regulator spends appropriate dollars on enforcement. We don t want to be here again in a another years revisting the same old issue due to lack of enforcement. Why do I say it is a lack of enforcement? The ASX found itself in a predictament mid last year, when it was realised that covered short selling should be treated exactly the same as a short sale. Up until then investors through their brokers (who had legal opinion that a covered short sale was not a short sale) had not reported to the ASX, these as short sales. This explains why the ASX short sale numbers desimminated through information vendors like Iress appeared to be well understated. What is quite surprising is that a lot of short sales were reported. This means that these people (like myself and people I had discussed this with) did not believe the weight of the legal opinion. To my shock, having formed the view that a covered short sale was a short sale and imposing the new rule and (see above), the ASX did not enforce those people that had previously been breaching the rule. Even worst, the ASX did not known the full extent of short selling and therefore could not be enforcing it Rule I am of the opinion, that the ASX has turned a blind eye to this and still does not know the extent of the short selling that has occurred. This would not have been a difficult exercise as can be seen from the RBA requirement. The result was the markets integrity was at risk, and the ASX did nothing. Even worse the ban by the government into short selling and even now into short selling in financial stocks did not stop the short selling. Rather it sent it underground via the option, future and CFD markets. Each of these markets are run by specialist known as arbitrageurs. Arbitrageurs do not take risk on market direction, they principally make their money out of the bid-ask spread in the market and hedging their direction risk in stock. For example: In CFD s if a person wanted to obtained a short exposure to one of the banks, they could sell a CFD. This means that if the share price went down in the bank, they would benefit from the position. The arbitrageur would buy the CFD and to eliminate the risk sell borrowed stock. They would now report this to the ASX as a short sale. That s why we are seeing short sales in banks still occurring. The ASX should be adding together the current day short sales with the previous days accumulation to come to a total short sale position. Once 10% was reached no further short sales could occur. The issue was the ASX had no starting point because of the previous unreported covered short sales. So
10 therefore we now have the Transactional Regime rather than Positional Regime imposed by ASX Rule In additional, whilst a person cannot sell a security down due to the zero-tick rule (19.3.7), arbitrageurs in the mistaken belief, believe they are not breaching this rule. Even worst the ASX has no mechanism to monitor for breaches of this rule. It is my opinion that the ASX has left itself wide open for a class action to be launched from disgruntled investors, for its failure to enforce its own rules. The motivation for the ASX was increased turnover for its markets. In summation, I believe that the ASX has now failed twice, once in 1971 and now to enforce the rules on short selling and therefore should not be allowed to continue in any enforcement role. G. REPORTING THRESHOLD The issue here is if other jurisdictions re-impose the uptick rule, then how is the ASX proposing to enforce it, without the broker being aware that the trade is short at the time of the entry into SEATS. In this regard there is no mechanism in place for the ASX to know at the time of the trade and therefore no real-time enforcement. If the objective is too align the Australian regime with the US and the UK regime, and to drop the current restriction in short selling of 10% and to drop the up-tick rule and replace it with this regime, I would be totally opposed. I am of the firm belief that those regime will revert back to their old regimes. If the objective is too inform the regulator who are the biggest short sellers, then I would totally support it. It is this ambiguity that is intriguing. As previous discussed above, under the current old regime the ASX was informed of the level of short selling from brokers and this was passed to information vendor to enable transparency to the market. As clearly stated in Treasury s Consultation Paper (page 2) it would clearly understate the actual level of short selling. It would then create a misinformed or confused market, particular, if the RBA numbers are also dessiminated to the general public. As highlighted on Page 2 of Treasury s Consultation Paper, the aggregate short sale position of a given stock is a very useful indicator of the riskiness of entering a short sale. The level of aggregate short sales and the transparency of it, is no different to the disclosure of open position in future, options and CFD s or even the unlisted options that director s and associated may have over the shares of the company. Each of these imposes a risk on the investor when investing in the security. H. EXCLUDED REPORTING Only the very large top six brokers would have a reporting issue and potentially around the top 40 funds managers even at the 0.25%. The level of off-shore reporting obligation is more uncertain. With regard even to the 0.25% level we would have no reporting obligation. I. FREQUENCY OF REPORTING The frequency of reporting needs to be linked to the other transparency in the marketplace. It is very difficult for an investor to line up the short selling position against what was occurring in the market one
11 week yet alone two weeks before. In my opinion the level of transparency here is as important as the reporting of substantial shareholders. I therefore believe that the reporting needs to be done on a daily basis. During my time in the 1980 s I worked as an arbitrage / option specialist. As such we regularly held short selling positions. In this type of environment it is extremely import to know the open position and the market value of the position, as such major short sellers have complicated system to manage this risk. Therefore the report of individual stock levels should not be difficult. J. BANDED REPORTING If the banded report is to be only used by the regulator, then banded reporting should be similar to overseas regime. If however, it is be used as the transparency level of short sales, then I am not in support of it and would require any change to be reported. K. DELAY IN REPORTING As stated above any delay in reporting the level of short selling in confusing for investors. L. AGGREGATE V DISAGGREGATE BASIS The reporting regime in the US was no different to that was adopted by the ASX up until 19 November (the old ASX Rule ), were brokers aggregated the total short position of their clients and reported in to the ASX on an aggregated basis. I am of the opinion that this is the type of information that needs to be disclosed to the general public as it disclose the level and therefore the risks attached to short selling in the market, without giving away any intellectual property of an individual short seller. However, I also believe that the regulators need to understand the big players in the industry and what drives them. So therefore at this level I would support a disaggregated basis. I am of the opinion that the two regimes can work side by side. M. AGGREGATED BEING MISLEADING I am of the opinion that if the only transparency to the level of short selling is to be an aggregated reporting regime with a threshold, there is no way to value judge the true level of short selling, therefore it would create a high level of confusion in the market as different level of short selling would be reported based upon key assumptions. It also maybe even more confusion, particular with size and timing if it is compared to the RBA regime. N. PUBLIC DISCLSOURE OF MAJOR SHORT SELLERS If the only transparency to the market is to be threshold major short selling at 0.25% with 0.1% moves, then I am of the opinion that they should be then disclosed at the individual level. From this information and a few key assumptions a reasonable level of actual short selling could be predicted.
12 If however, the general public was offered a reasonably accurate and timely (daily) reporting of level of short sales in a security, then I believe individual short sellers should only be known to the regulators. O. DISCLOSURE OF TRANSACTION REPORTING The current Transactional Reporting Regime, is only reporting gross short sales and not net short sales (ASX Rule ). The consequences is that only new short sales are reported we no need to report the closing out of a short position. In this regard there is no way of actually predicting the level that a stock is short sold. This is most important position that a client needs. Not that yesterday that 60+% of the sales were short sales. This could be done by subtracting from the previous days position. The current regime has been more misinforming than having almost nothing, as it favours the existing short selling as new short sales are shown everyday. What keeps markets down is the fear and press dessiminating the new shorting. P. IMPROVING TRANSACTIONAL REPORTING Transactional Reporting needs to be on a net basis. Q. POSITIONAL REPORTING MANATORY Depends on the type of Positional Reporting and what is disclosed as the level on net short sales on a daily basis. For all the reasons above. R. DELAY IN REPORTING I am of the opinion that there should be no delay in reporting. Any delay will reduce the usefulness of the information and decreases the market integrity as information is misread. S. DAMAGING CONSEQUENCES I am not aware of any instances where this has occurred and I am of the opinion that a breach of this nature would be a breach of the Privacy legislation and should be protected in that way. T. DAMAGING CONSEQUENCES Yes, people who were use to the old regime whereby the net regime were reported and then accumulated by the ASX into a short sold position report believed that this was still occurring. Other investors did not realize that covering of short sales were not reportable. W. COST FOR BROKERS Up until November 2008, even broker was required to report net sales, ie both opening new sales by selling and closing an existing short sale by buying. What we did was to use the exactly same system, but
13 turned off the buying. So the cost for any broker should have been minor. Ongoing costs should also be minor and mainly involve the man-hours in having clients understand the changing regime. The investing public do not like changes. Switch back to the old regime should be minor, and having the ASX to turn back on the short selling on SEATS should also be minor so that you could have a Transaction Regime that consolidates in a Position Regime. AA. ALL STAKEHOLDERS Costs having mainly occur on a regime that was not broken. Hopefully this will not occur in the future under the new regime from the lack of enforcement.