Reflections on the New Pan-European Regime for Short Selling and Credit Default Swaps

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1 Herbert Smith e-bulletin Reflections on the New Pan-European Regime for Short Selling and Credit Default Swaps The Council gave its approval today to ground-breaking legislation aimed at unifying a myriad of short sale rules across the 27-nation bloc of the European Union (EU). The Regulation of the European Parliament and of the Council on Short Selling and Certain Aspects of Credit Default Swaps (CDS) is expected to be published in the Official Journal shortly and will enter into force on the following day. The Regulation will apply from 1 November 2012 and shall be binding and directly applicable in all Member States. To view our briefing discussing the main aspects of the Regulation, please click here. To subscribe or unsubscribe To enquire about further publications or to unsubscribe from this e-bulletin, please us, or visit the Herbert Smith website here. The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication. Herbert Smith LLP February 2012 Contacts Martyn Hopper Partner Clive Cunningham Partner Karen Anderson Partner Nikunj Kiri Partner Shoshana Wainer Professional Support Lawyer (New York) Related links Herbert Smith website Herbert Smith publications Herbert Smith news Page 1

2 Reflections on the New Pan-European Regime for Short Selling and Credit Default Swaps The Council gave its approval today to a ground-breaking regulation aimed at unifying a myriad of short sale rules across the 27-nation bloc of the European Union (EU). The Regulation of the European Parliament and of the Council on Short Selling and Certain Aspects of Credit Default Swaps (CDS) is expected to be published in the Official Journal shortly and will enter into force on the following day. The European Securities and Markets Authority (ESMA) is required to submit draft technical standards to the Commission by 31 March The Regulation shall apply from 1 November 2012 and will be binding and directly applicable in all Member States. This briefing discusses the main aspects of the regulation and includes a checklist for in-house counsel and compliance officers. Background 1 Legislative proposals 2 Disclosure requirements 2 Marking requirements 4 Ban on naked short sales of shares and sovereign debt 4 Ban on naked sovereign CDS positions 5 Buy-in procedures and fines for late settlement 6 Exemptions 6 Circuit breakers 7 Intervention powers 7 ESMA's role 8 Enforcement 9 In-House Counsel Checklist 9 Contacts 10 Background Both market users and regulators agree that the current fragmented approach to Related links short selling, especially as relates to mainstream equity, limits the fluidity of the European market. Herbert Smith website Divergent rules cause confusion as to applicable rules and increase regulatory Herbert Smith publications compliance costs. They also hamper supervision and result in regulatory arbitrage, Herbert Smith news as traders circumvent the rules of one jurisdiction by carrying out effectively the same transaction in another jurisdiction. The goals of the new legislation to harmonise short selling requirements and harmonise the powers that regulators may use in exceptional circumstances are largely welcome. However, as noted below, the legislation will require significant changes in trading, reporting and securities lending behaviour, and will in many ways present tremendous practical and technical difficulties and novel costs. The notification requirements will also make it relatively easy for regulators to introduce reporting related fines. 1 For further information on the background to this legislation please see our November 2010 bulletin here. 1 The FSA has sharpened its focus on transaction reporting failures, as demonstrated by a series of significant fines on sizeable financial institutions. In April 2010, Credit Suisse, Getco Europe Ltd, Instinet Europe Ltd and Commerzbank AG received substantial fines of 1.75 million, 1.4 million, 1.05 million and 595,000, respectively, for transaction reporting breaches; in August 2010, Société Générale received a million fine. Further in January 2011 City Index was fined 490,000 for transaction reporting breaches. As we noted in our UK market abuse update, the FSA has invested in a new surveillance and monitoring system, Zen, which replaces the existing Sabre II system. This system went live in August 2011 and is expected to strengthen market abuse monitoring, alerting and reporting functions in the UK. 1

3 Legislative proposals Disclosure requirements At the heart of the new regulation are several rules relating to transparency: Equity: Private notification to the competent authority Notification must be made privately to the relevant competent authority if net equity short positions equal 0.2% of issued share capital. Additional disclosures are required if the net short position falls below this level, or increases, with notification being required at additional increments of 0.1% up until 0.5% of issued share capital. This rule will enable regulators to monitor and, where necessary, investigate short selling that may create systematic risks or be abusive. o o For purposes of shares, "relevant competent authority" means the competent authority of the Member State where the relevant share was first admitted to trading on a regulated market or was first admitted to trading on a trading venue. 2 If the share was first admitted to trading on more than one regulated market simultaneously than notification must be made to the competent authority of the Member State which hosts the market where the turnover of that instrument is highest. "Issued share capital" in relation to a company means the total of ordinary and any preference shares issued by the company but does not include convertible debt securities. Equity: Public notification Notification must be made to the public 3 if net equity short positions equal 0.5% of issued share capital, with additional disclosure required at 0.1% increments, with the aim of increasing transparency to other market participants. Sovereign Debt: private notification Notification of significant net short positions in sovereign debt must be made privately to the relevant competent authority. The Regulation permits private notification in this manner, reflecting concerns that public reporting would have a detrimental effect in cases where liquidity is already impaired. o o Included in this requirement is debt issued by the EU, by Member States (including any ministry, agency or special purpose vehicle), by one of the members of the federation in the case of a Member States that is a federal state, by the European Investment Bank, or by any ministry, agency, special purpose vehicle or international financial institution established by two or more Member States such as the European Financial Stability Facility or the European Stability Mechanism. Debt issued by regional and local bodies and quasi-public bodies in a Member State is excluded. For sovereign debt of a Member State, notification must be made to the competent authority of that member state. For sovereign debt of the Union, the European Investment Bank, the European Financial Stability Facility, the European Stability Mechanism, or other similar special purpose vehicle or entity, notification must be made to the competent authority of the jurisdiction in which the department/institution issuing the debt is situated. 2 For ordinary equity, we anticipate that the relevant competent authority may be identified by electronic feed providers and tied to CUSIPs. However, for some products companies may face significant burden and costs in identifying the proper competent authority. 3 The Regulation specifies that public disclosure must be made in a manner ensuring fast access on a non-discriminatory basis. The public information will be posted on a central website operated or supervised by the relevant competent authority. ESMA will have a link to all such central websites on its own website. 2

4 o The relevant notification thresholds for each Member State and the Union will be set by the Commission by means of delegated acts taking into account several factors including the total amount of outstanding issued sovereign debt, the average size of positions held by market participants, and the liquidity of each sovereign bond market. ESMA will publish on its website the notification thresholds for each Member State. The task of maintaining and disseminating relevant notification thresholds will certainly present a significant administrative challenge to the Commission. It will also present practical compliance challenges for companies that need to feed in moving thresholds into their automated and manual notification systems. Sovereign CDS: private notification In situations where restrictions on uncovered positions in sovereign CDS are suspended, then notification must also be made regarding uncovered positions in sovereign CDS to the relevant competent authority when such positions fall below the thresholds established by the Commission. Record-keeping The legislation introduces a five year record-keeping requirement, requiring parties to keep records not just of their short positions but of the gross positions which support net short position calculations. Calculating net short positions The regulation requires net short positions to be determined at midnight at the end of the trading day, with net short positions to be calculated on a natural or legal person basis. Disclosure must then be made by 15:30 on the next trading day. All times are calculated according to the time in the Member State of the relevant competent authority to whom the relevant position must be notified. With three different time zones within the EU, this rule will require entities to perform multiple short sale analyses on a daily basis. Challengingly, the Regulation requires all short positions to be reported within the same time frame, even though certain derivative positions (eg, those resulting from baskets) may require more time to evaluate. This requirement may add time and cost to the creation of bespoke financial products for clients and parallel hedge positions for investment banks. In calculating long or short positions, entities will be required to include not only direct long or short positions, but all transactions the effect of which is to confer a financial advantage in the event of an increase/decrease in the price or value of the share or debt instrument. Calculations must include indirect positions such as by way of any index, basket of securities, interest in any exchange traded funds or similar entity, options, futures, contracts for differences and spread bets relating to shares or sovereign debt. Calculations regarding such indirect short or long positions must be made reasonably, having regard to publicly available information as to the composition of the relevant index, basket or exchange traded fund. Disclosure is required regardless of whether the short position is accumulated on a trading venue 4 or outside trading venues (such as over-the-counter (OTC)), and regardless of where the person effecting the sale is domiciled or established, including outside the EU. The calculation of net short positions includes transactions executed on a manual basis and those executed after-hours. The legislation provides that ESMA may issue an opinion to the Commission on adjusting the thresholds taking into account developments in the financial markets. Notifications will include the identity of the position holder at legal person level, the size of the position, the issuer, and the date on which the position was created, changed or closed. As discussed below, ESMA is in the process of developing draft technical legislation specifying the details of the information to be reported and the means by which information may be disclosed to the public. The regulation seems to imply that disclosure of short positions should be made at the legal entity level, even though, depending on the internal structure of the firm, disclosures at group level may be more meaningful. The Commission will therefore be empowered to adopt delegated acts providing 4 A "trading venue" is defined as an EU regulated market (eg, the main markets of the London Stock Exchange or Luxembourg Stock Exchange) or a multilateral trading facility (eg, Chi-X Europe, BATS Europe). 3

5 methodologies for calculating net positions in complex corporate structures such as when different entities in a group hold separate long and short positions or for fund management activities related to separate funds. Significant negotiation is likely to go into the final wording of these delegated acts, but the regulation does already specify that the method of calculation should take into account whether different investment strategies are pursued in relation to a particular issuer, and whether more than one portfolio within the same entity is managed on a discretionary basis pursuing the same investment strategy in relation to a particular issuer. As discussed below, the Competent Authority of a Member State may in exceptional circumstances require disclosure of positions in other financial instruments where there are adverse developments which constitute a serious threat to financial stability. Commentary Reporting short sale positions to regulators is workable, even if costly and cumbersome, and industry members understand this requirement as being part of a long-standing compliance trend towards greater transparency. Much more troubling to the trading community is the public disclosure aspect, as many trading strategies rely on relative secrecy for success. In particular, for funds that focus their investments in small and mid-cap names, as many European and UK funds do, a short position of 0.5% of outstanding capital is quickly reached. Short position transparency can lead to increased short squeezes and may also contribute to herding behaviour thereby exacerbating the very same downward spirals these rules are meant to prevent. Overall, however, when balanced against more interventionary tools for regulating short selling, such as bans or up-tick rules, non-anonymous public disclosure is a cost-efficient and preferred tool since short sellers are required to consider for themselves whether they wish to be identified to the market when they approach threshold levels. Many industry participants are also happy to trade lower public disclosure thresholds, such as the UK's at 0.25% of ordinary share capital for UK companies that undertake rights issues and for UK financials, for the Commission's proposal of 0.5% of share capital accompanied by a lower private disclosure threshold. Marking requirements Previous versions of the legislation required marking of short sales in transaction reports to competent authorities on a non-public basis. 5 The final version passes consideration of this matter to the Commission in its consideration of revisions to the Markets in Financial Instruments Directive 2004/39/EC. 6 Ban on naked short sales of shares and sovereign debt The Regulation will also ban naked short sales in equity securities and sovereign debt such that short sales will only be permitted where the seller has: borrowed the share or sovereign debt; entered into an agreement to borrow the shares or sovereign debt or has another absolutely enforceable claim under contract or property law to be transferred ownership of a corresponding number of securities of the same class; or made other arrangements with a third party under which that third party has confirmed the share or sovereign debt has been located and 7 there is a reasonable expectation that settlement can be effected when it is due. The ban on naked short sales is not intended to capture repo and securities lending agreements, futures contracts or other derivative contracts where it is agreed to sell securities at a specified price at a future date. As discussed below, ESMA's first consultation paper on technical standards also clarifies that only 5 See eg, Text adopted by Parliament, partial vote at 1st reading/single reading (5 July 2011) Art For comparison, in the US, Rule 200 of Regulation SHO requires that sales in all equity securities be marked long, short, or short exempt. 7 With regard to sovereign debt, the word "and" in the last criterion is replaced by the word "or". 4

6 subscription rights that can be converted into new shares before or at the settlement date may be used to cover short selling. The hard locate and reserve requirement presented in early drafts of the legislation is softened in the final text to allow parties to rely on arrangements that provide a "reasonable expectation" that settlement can be effected, with the recitals explaining that parties will be permitted to rely on confirmations by third parties that they consider the share as easy to borrow or purchase (eg, prime broker s easy to borrow list for intra-day trading). However, in its recent consultation paper on technical standards, ESMA seems to take a step backwards by implying that for borrowing of liquid shares (as defined in MiFID) and/or intraday borrowing, the investor must specify to the third party the maximum number of shares to be sold short, and the third party must confirm that the shares for the requested amount are easy to borrow or purchase in prevailing market conditions. If such an understanding is correct, than any existing practice of relying on prime brokers' same day easy to borrow lists, without prior communication to the prime broker of one's plans, may be impaired. In the same consultation paper ESMA also proposes that the third party should have skin in the game such that data providers and stock loan desks that do not sit within registered entities would be excluded from lending. ESMA also proposes that the third party must be a different legal entity. This means that locate arrangements between trading desks and lending or repo desks within the same legal entity would not be permitted. As we discuss in the section below on technical standards, these ESMA proposals are currently under review and will be the subject of public hearings before they are finalised. The ban on uncovered short sales in sovereign debt does not apply if the transaction serves to hedge a long position in debt instruments of an issuer, the pricing of which has a high correlation with the pricing of a given sovereign debt. Where the liquidity of sovereign debt falls below set thresholds, the restrictions on short sales of sovereign debt may be temporarily suspended by competent authorities for a maximum of six months, renewable for periods of six months at a time. If the suspension is not renewed after that six-month period, it will automatically expire. The Commission, by means of delegated acts, will specify parameters and methods for calculating the set liquidity thresholds, with such thresholds to represent a significant decline relative to the average liquidity for the sovereign debt concerned. ESMA will issue an opinion regarding any suspension within 24 hours. Ban on naked sovereign CDS positions The most controversial part of the Regulation was originally its ban on uncovered sovereign debt CDS. This provision has been softened significantly since early drafts of the legislation and now prohibits uncovered CDS on sovereign debt only where the CDS is being used to speculate on the price of sovereign debt. The regulation permits entering into a sovereign debt CDS as long as there is an "insurable interest" in the underlying sovereign debt position. Market participants may therefore purchase CDS to hedge a long position in the sovereign debt or other securities, assets or liabilities that are correlated, directly or indirectly, to the value of that sovereign debt. The recitals indicate that such insurable interests would likely include: exposure to central, regional or local administrative bodies, or other public sector entities, or exposure guaranteed by such entities; exposure to private sector entities established in the Member State, such as securities of a domestic bank in the same country as the sovereign issuer; exposure to financial contracts or a portfolio of assets or financial obligations the value of which is correlated to the value of the sovereign debt (eg, index positions); interest rate or currency swap transactions with respect to which the sovereign CDS is used as a counterparty risk management tool; loans, counterparty credit risk, receivables and guarantees; and indirect exposures to any of the referred entities obtained through, inter alia, exposure to indices, funds or special purpose vehicles. Even this softened ban on naked sovereign CDS left some Member States concerned that their sovereign debt market would not function properly. As a compromise measure the final Regulation empowers competent authorities to lift the ban on unhedged CDS for a maximum of twelve months where they find, looking at specified objective elements, as well as other indicators, that the sovereign debt market is not functioning properly. Indicators would include high or rising interest rates, widening of sovereign debt or CDS spreads compared to other sovereign issuers, and the amount of sovereign debt that can be traded. 5

7 Such suspension periods may be renewed for further periods not exceeding six months at a time. If the suspension is not renewed after that six-month period, it will automatically expire. ESMA shall issue an opinion within 24 hours after notification by the relevant competent authority regarding a suspension or renewal. A negative opinion from ESMA would likely have political weight that could lead to the competent authority revising its decision, although ESMA would not have veto power over the decision. Buy-in procedures and fines for late settlement The Regulation will require central counterparties that provide clearing services for shares to ensure that there are adequate arrangements for buy-in of securities where there is a failure to settle a transaction within four business days after the day on which settlement is due. Earlier versions imposed buy-in procedures on the sale of sovereign debt instruments as well. If the buy-in of shares for delivery is not possible, then compensation must be paid to the buyer based on the value of the shares at the delivery date, plus reimbursement for any related losses incurred by the buyer. Ultimately, the selling entity that caused the failure will be required to reimburse all such amounts, eg, if they are paid by the trading venue or central counterparty on the seller's behalf. Central counterparties that provide clearing services for shares will be required to impose daily fines in cases of non-settlement. The fines must be sufficiently high not to allow the seller to make a profit from the settlement failure and to thereby act as a deterrent to settlement failures. Earlier drafts also required trading venues to establish rules enabling them to prohibit those who have failed to settle in the past from entering into further trades. However, this measure is not present in the final Regulation. Exemptions The Regulation provides for exemptions for shares for which the principal market is outside the EU. Market makers and dealers performing primary market operations related to sovereign debt are also subject to significant exemptions. Principal market outside the EU The rules discussed above relating to disclosure and restrictions on naked short sales in shares and buy-in procedures do not apply to shares of a company for which the principal trading venue is outside the EU. Notably, issuers domiciled outside the EU whose principal trading venue is inside the EU are still covered. This means that, at least every two years, the competent authority of the Member State in which the relevant share was first admitted to trading on a regulated market (or if not applicable, a trading venue) must analyse which shares are traded both in the EU and outside of the EU and notify ESMA of shares they have identified as having their principal trading venue outside the EU based on turnover. If the share was first admitted to trading on more than one trading venue in the EU simultaneously, then the competent authority of the Member State which hosts the EU market where the turnover of that instrument is highest performs the calculation. As discussed below, ESMA will develop draft implementing technical standards to be submitted to the Commission setting out the period in respect of which calculations regarding principal trading venue are to be made, and the date by which competent authorities must notify ESMA of the shares they have identified as having a principal venue outside the EU. ESMA will publish a list of such shares every two years, to be effective for a two-year period. Market makers and authorised primary dealers The disclosure and naked short sale rules also do not apply to transactions performed due to market making activities, since market makers often need to take short positions to perform their crucial rule of providing liquidity, and generally do so only for short time periods. Market making activities include activities of an investment firm, credit institution, third country entity or local entity that is a member of a third country market or trading venue, as long as in the latter two cases the third country's legal and supervisory framework has been declared equivalent by the Commission. To qualify for the market making exemption such entities must be dealing as principal in the relevant financial instrument in any of the following capacities: (a) by posting firm, simultaneous two-way quotes of comparable size and at competitive prices, with the result of providing liquidity on a regular and on-going basis to the market; (b) (c) as part of its usual business, by fulfilling orders initiated by clients or in response to clients' request to trade; or by hedging positions arising out of tasks under (a) or (b). 6

8 This definition neatly parallels the current UK market making exemption, making a transition for UK companies relatively easy. Authorised primary dealers dealing as principal in financial instruments in order to assist issuers of sovereign debt would also be exempt from the relevant notification rules and the restrictions on naked short sales. Primary dealers are also exempt from the notification and naked short selling requirements where acting in relation to a buy-back programme or stabilisation scheme. Market makers and primary dealers must notify the competent authority of their home Member State (or if they are located in a third country, the competent authority of their main EU trading venue) at least 30 days in advance if they wish to rely on this exemption, and up to 60 days before the date of application of the Regulation, ie, effectively from 3 September Competent authorities will have the power to prohibit those who do not fulfil the relevant criteria from relying on the exemption either at the initial request stage or subsequently in the event of a change in circumstances. The 30-day notification period is a relatively easy way of weeding out non-genuine market makers. The requirement for pre-notification also creates a bright line rule and eliminates the need for regulators and industry members to apply facts and circumstances tests to particular activities. Those relying on the exemption may be subject to information requests related to trading under the exemption from their competent authorities and must be prepared to respond to such requests quickly, namely within four calendar days. Competent authorities must notify ESMA within two weeks of all market makers and primary dealers making use or no longer making use of the exemption. ESMA will keep an up-to-date list of those parties relying on the exemption on its website. Circuit breakers In the case of a significant fall in the price of a financial instrument on a trading venue, the competent authority of the home Member State for that venue would be permitted to intervene rapidly and impose a prohibition on short selling of the instrument on that trading venue until the end of the next trading day. This power would be triggered by objective criteria. In the case of liquid shares, the fall in value must be 10% or more relative to the closing price on that venue on the previous trading day. In the case of illiquid shares and other financial instruments, the amount will be specified by the Commission in delegated acts, taking into account the specificities of each class of financial instrument. If at the end of the second trading day there is a further significant fall in the value of the financial instrument, then the competent authority may extend the prohibition for a further period of two more trading days. This further significant fall is set at 5% or more for liquid shares and for other instruments will be set at half of the amount required to initiate an intervention. Intervention powers The Regulation provides that in the case of adverse developments that constitute a serious threat to financial stability or market confidence, competent authorities have various exceptional powers, including: Competent authorities may require private or public disclosure of net short positions in instruments that are not currently covered by the Regulation as necessary to address a relevant threat. Competent authorities may require securities lenders to notify them of significant changes in fees charged for the lending of specific instruments. Competent authorities have temporary powers to prohibit or impose restrictions on the short selling of financial instruments for up to three months, extendable for further periods of three months at a time. Such measures may be imposed even on market making and primary market activities. Competent authorities may prohibit entering into sovereign CDS or limit the value of sovereign CDS for up to three months, extendable for further periods of three months at a time. Such measures may be imposed even on market making and primary market activities. As noted above, where the liquidity of sovereign debt falls below set thresholds, the restriction on uncovered short sales in sovereign debt may be temporarily suspended by competent authorities for a maximum of six months, renewable for periods of six months at a time. If the suspension is not renewed after that six-month period, it will automatically expire. 7

9 As noted above, where the sovereign debt market is not functioning properly, competent authorities will have the right temporarily to suspend the restriction on uncovered CDS for a maximum period of twelve months. Such suspension periods may be renewed for further periods not exceeding six months at a time. If the suspension is not renewed, it will automatically expire. The final Regulation stresses that a competent authority may only take such interventionary measures when the measure will not have a detrimental effect on the efficiency of financial markets which is disproportionate to its benefits. Competent authorities will be required to publish any such measures on their websites, with the measure taking effect only on or after such posting date. Competent authorities must also notify ESMA and other competent authorities of the measures they intend to adopt or renew not less than 24 hours before the measure is intended to take effect. ESMA's role ESMA, which is based in Paris and includes representatives of Member States' regulators, will play a key role in developing technical standards and coordinating intervention measures by different authorities and will be required to issue a reasonableness opinion on any proposed measure or extension. Interestingly, the Regulation envisages that competent authorities may proceed and take measures contrary to an ESMA opinion, and states that where they choose to do so, they must publish a website notice fully explaining their reasons. ESMA will then consider if the situation calls for use of its exceptional powers of intervention, as discussed below. Intervention power In the case of a financial emergency, ESMA will have its own powers to demand disclosure of short positions or intervene to bar or limit short selling of financial instruments for a period of three months where a situation has cross-border implications and competent authorities have not adequately addressed the threat. The ability to impose a ban would not extend to sovereign debt and related CDS or other related derivatives. If the ESMA measure is not renewed, it will automatically expire. ESMA measures may apply to market making and primary market activities. ESMA would be required to consult with the European Systematic Risk Board (ESRB) and other relevant authorities whenever possible, especially where measures could impact other markets such as physical commodities. Measures taken by ESMA would arguably override any inconsistent measures by competent authorities. However, in reality a financial institution could easily become stuck in the midst of a conflict between ESMA and a competent authority, or two different competent authorities, and opportunities for regulatory arbitrage will need to be watched closely. Some Member States and industry leaders have expressed concerns regarding ESMA's intervention powers. The UK and Czech Republic have issued a statement explaining that "Article [28] would be unlawful and contravene the principle set out in the judgment of the Court of Justice of the European Union in the case of Meroni." The Meroni doctrine is used to determine the extent to which the European Union can delegate powers to agencies. The looming vagueness of such powers could exacerbate market instability and volatility by reducing access to credit and increasing borrowing costs. The statement continues that the "British and Czech governments cannot therefore support the text in Article 28 and will be considering how best to ensure legal certainty is provided." Other powers ESMA will also have the power to conduct its own inquiries into a particular issue or practice relating to short selling or CDS to assess whether that issue poses any potential threat to financial stability, and must publish a report with its findings within three months of the inquiry ending. Competent authorities will be required to provide summary data to ESMA on a quarterly basis. ESMA will have the power to undertake broad inquiries into issues or practices and may request additional information from the competent authorities, with such information to be provided within seven calendar days, or within 24 hours in the event of developments which constitute a serious threat to financial stability. Technical standards The legislation provides for the Commission to adopt delegated acts and binding technical standards, including: details on calculating net short positions, including handling of nil-paid rights, convertible bonds, equity warrants, and preference shares, details on when CDS is considered to be hedging against a default risk, and methodologies for netting in corporations with various divisions and entities; 8

10 definitions for uncovered/naked short positions and technical standards to clarify what borrowing agreements are acceptable; determining principal trading venues; establishing criteria for the onset of circuit breakers, taking into account the specificities of various classes of financial instruments; and defining adverse events. Because of the tight timetable established by the text of the Regulation, the process for the production of technical standards and advice is being compressed. On 24 January 2012 ESMA issued its first consultation paper on draft regulatory and implementing technical standards, responses to which were due on 13 February For our briefing on this consultation please click here. ESMA is holding an open hearing on short selling on 29 February A second consultation paper on proposed technical advice from ESMA to the Commission on delegated acts was issued on 15 February 2012, responses to which are due on 9 March We will publish a further briefing on this consultation shortly. The Regulation requires ESMA to submit draft technical standards to the European Commission by 31 March However, ESMA has indicated that it expects to publish a final report and submit draft advice on Delegated Acts by mid-april Enforcement The legislation envisions that Member States and their relevant competent authorities will provide rules on administrative measures, enforcement powers, sanctions and pecuniary measures, including powers to make document, telephone, data records and other information requests, carry out on-site inspections with or without prior announcement, demand the attendance of relevant persons, bring enforcement actions and freeze assets. The legislation specifically anticipates that competent authorities may request further information directly from natural or legal persons about the purpose for which a CDS is entered into and information verifying the underlying risk where the transaction is for hedging purposes. This may impose a significant compliance burden for traders who trade quickly and frequently. Member States will need to establish rules on administrative measures, sanctions and pecuniary penalties applicable to infringements of the Regulation. ESMA will adopt guidelines to ensure a consistent approach concerning Member State sanctions and penalties. In-House Counsel Checklist In-house counsel and compliance officers preparing for the advent of the new EU short selling rules may find this brief "to do" checklist helpful. Please contact us if you would like our assistance in developing a personalised checklist for your business. Identify legal entities that will be required to disclose short sale information and consider whether reporting capacity is in place at the entity level. Make necessary amendments to prime brokerage or master security lending agreements to reflect ESMA standards on measures necessary for a short seller to have a reasonable expectation that settlement can be effected when it is due. Amend and test relevant back office systems so as to be in a position to calculate net short positions at midnight of the trading day and make reports to the relevant regulators no later than 3:30 pm of the following trading day. Monitor development of technical measures and consider participating in ESMA consultation procedures and hearings. Develop systems for retaining relevant trade documentation for five years. Companies will need to be able to produce not just their short positions but the gross positions which underlie net short positions. Develop clear and validated reporting procedures that enable differentiation between market making and proprietary business. Apply for relevant market making exemptions and develop processes to respond to information requests relating to trading under the exemption within the short four calendar day requirement. 9

11 Prepare for reinforced supervision, including document production and trade information requests. Firms will need to ensure that they have centralised teams that can handle information requests and on-site inspections seeking explanations of various trades and reporting methodologies. Make necessary changes to written policies and procedures. Prepare training for traders, compliance officers, operations and other personnel regarding new rules. Contacts Martyn Hopper (Partner) Clive Cunningham (Partner) Karen Anderson (Partner) Nikunj Kiri (Partner) Shoshana Wainer (Professional Support Lawyer (New York)) If you would like to receive more copies of this briefing, or would like to receive Herbert Smith briefings from other practice areas, or would like to be taken off the distribution lists for such briefings, please You can also contact us to say whether you would prefer to receive these publications in a printed or electronic form. Herbert Smith LLP 2012 The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on the information provided herein. 10

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