Hong Kong and China stand out in short-selling developments

briefing summary 21 October 2008 Hong Kong and China stand out in short-selling developments Financial services market developments In spite of the recent expiry of the US s dramatic ban on short-selling financial stocks, a number of other countries that have similarly clamped down on the practice are maintaining their bans. In stark contrast to these bans, Hong Kong has adopted a more low-key approach to short-selling and China has been planning to introduce the practice. This briefing provides a round-up of recent developments concerning shortselling regulations. In particular, it examines why Hong Kong and China have adopted a different approach. Do we need short-selling? Short-selling is the practice of borrowing shares and selling them in the expectation of a price decrease. The short-seller will buy them back later and return the borrowed shares to the lender. The lender is usually a custodian bank that lends shares it looks after on behalf of its institutional borrowers. One of the abuses associated with this practice is the technique of naked short-selling. In this type of transaction, the seller promises to sell shares without having the position covered. The recent restrictions on short-selling by securities regulators worldwide have been aimed at mitigating further catastrophes in the wake of the financial crisis. Short-selling has been identified as correlated with market volatility and deep stock price declines, especially for the stocks of financial institutions such as the nowcollapsed Bear Stearns. It is nevertheless acknowledged that short-selling can promote economic growth and efficiency through increased stock turnover. Hedge funds that benefit from short-selling have been key proponents of this view. In line with the recent expiry of the US ban on short-selling, a number of securities exchanges have also defended the practice. For example, William Brodsky, chairman and chief executive of the Chicago Board Options Exchange, has stated that short-selling brings equilibrium and a recognised value mechanism to share trading and allows investors to hedge and insure their investments. A key reason for the use of covered short-selling is to reduce overall market risk. As explained by Tom Holland of the South China Morning Post, the strategy is adopted by equity portfolio managers, futures brokers and other investors. For example, it is possible to offset a short position in Bank A with a long position in Bank B. The net exposure to the banking sector is therefore neutralised and a profit is made if Bank A underperforms. A ban on covered short-selling prevents pension funds and other investors from hedging their risk in this way. Yet, Holland argues, such a ban is of limited use in preventing malicious speculators from driving down the prices of vulnerable stocks. Holland explains that it is extremely difficult for speculators to borrow target shares for covered shorting because the pension funds that own most of the shares, and stand to lose from a drop in the share price, instruct their custodian banks not to lend the shares. He argues that the fees for borrowing the stock then become prohibitive. If covered short-selling is beneficial and malicious speculators can easily be prevented from misusing the technique, then it is natural to ask why the US banned it and whether other regulators are justified in maintaining the bans they have imposed. These questions are difficult to answer, because the response depends on what would have happened if the bans were not in place. As Mozaffar Khan, a professor at the Sloan School of Management at the Massachusetts Institute of Technology, said in an interview with The New York Times on the link between the ban and stock prices: If there had been no ban, 1 Freshfields Bruckhaus Deringer LLP, 21 October 2008

would they have gone down even more? Normally the studies that we do are in normal times and we just don t know in a state of panic what the outcome would have been. The ban s effect on hedge funds performances, as with its effect on financial institutions share prices, is not clear. According to the hedge fund research index HFRX, hedge fund performance is now around 10 per cent worse than it was this time last year. Citadel Investment, one of the biggest hedge funds, has lost 18 per cent of its value so far this year, with 15 per cent of the losses occurring in September. Hedge funds have attributed much of their poor performance to the US ban on shortselling, which has hindered their ability to hedge risk. They point to the fate of hedge funds such as TPG-Axon and Canyon Capital, which lost money after being prevented from short-selling financial stocks to offset the losses from their investments in Washington Mutual. However, under the US ban hedge funds could still shortsell non-financial stocks. There are also other factors apart from the short-selling restrictions that explain the poor performance of hedge funds, such as borrowing constraints that have prevented the use of different investment strategies, including statistical arbitrage. US and UK developments To set the scene, it is helpful to look specifically at the recent US and UK regulation of short-selling. In response to the market turmoil, the US Securities and Exchange Commission issued a first emergency order on 15 July 2008 requiring that short sales in the shares of 19 financial institutions be subject to pre-arranged borrowing and delivery at settlement. It made a further emergency order on 18 September 2008 banning short sales of the shares of some 799 financial institutions until 2 October 2008. The ban was extended until 11.59pm (eastern time) on 8 October 2008, when it was lifted following the enactment of the US$700bn financial rescue package aimed at stabilising fragile markets. With effect from 19 September 2008, the UK Financial Services Authority (FSA) also introduced a ban on short-selling shares in quoted financial institutions, and a requirement for disclosure of all net short positions over 0.25 per cent of the ordinary share capital of such companies on the previous working day, until 16 January 2009. As discussed above, the effectiveness of the US shortselling ban is unclear. It is similarly unclear precisely how the UK ban will affect the market as a whole, but it seems likely that the ban will restrict both financial stock price movements and hedge fund profits. Developments in the Asia-Pacific region In line with the moves by US and UK regulators, and to the displeasure of Asian hedge fund managers, a number of Asian regulators have recently moved to restrict shortselling. These are outlined in the table on page 3. Hong Kong maintains the status quo The chief executive of the Hong Kong Securities and Futures Commission (SFC), Martin Wheatley, has said that Hong Kong is potentially the most important market in the world and that with the right measures it would realise this potential. Given the effects of the present financial crisis on markets in New York and London, commentators are increasingly asking whether these markets will be overtaken by those in Asian financial capitals such as Hong Kong. The time when Asian financial capitals could catch up with New York or London still seems quite far off, given the need to gradually build up market size and sophistication. However, the purchase of Lehman Brothers by Nomura may well signal Asia s burgeoning role. In this context, Hong Kong s relatively low-key and consistent approach to short-selling could help to facilitate its emergence as a more vital financial centre. Short-selling in Hong Kong is regulated by the uptick rule, under which only a certain number of designated securities eligible for covered short-selling (there are 504) can be short-sold, provided such sales are not made below the best current ask price. Any otherwise eligible stocks that are also listed on the London Stock Exchange (such as HSBC and Standard Chartered Bank) cannot be short-sold because the UK FSA s ban on short-selling covers short sales of such dual-listed stocks on the Hong Kong Stock Exchange. The uptick rule adds waiting times for those who wish to build positions quickly. Shortsellers have to place their orders on the best current ask price and wait for the bid price to tick up and match the best ask price before an order can be executed. 2 Freshfields Bruckhaus Deringer LLP, 21 October 2008

Asian regulators restrictions on short-selling Regulator Australian Securities and Investments Commission (ASIC) Financial Supervisory Commission of Taiwan Singapore Exchange Korea Exchange (KRX) India Restriction Naked and covered short-selling of all listed shares banned from 22 September. The ban on covered short-selling is subject to certain exceptions (eg for hedging existing positions, dual-listed entities, exchange-traded options, index arbitrage transactions and market makers). In the limited circumstances in which short-selling is permitted, disclosure is required. ASIC will update the market 30 days from the start of the ban on whether, at that time or later, it will reopen covered short sales for non-financial stocks. Following the previous bans on short-selling (from 22 September to 3 October 2008 concerning 150 specified stocks on the Taiwan Stock Exchange and GreTai Securities Market, if they were trading below the previous trading day s closing price), a ban was introduced from 1 to 14 October 2008. On 30 September the ban was extended to the end of 2008. To deter naked short-selling, with effect from 25 September the penalties for failed trades increased to 5 per cent of the value of the trade, with a minimum penalty of S$1,000 (US$710). Short-selling in the buying-in market is banned and the penalty for failure to deliver shares in that market is a maximum of S$50,000 (US$35,500) plus a prohibition on future buying-in activity. The Financial Services Commission has announced the prohibition of short-selling on borrowed stocks listed on the KRX with effect from 1 October 2008. Stocks that have been borrowed, including stocks that have been borrowed previously, are prohibited from being sold on KRX. Short-selling by retail and institutional investors is allowed. The Securities and Exchange Board of India has stated that no changes to the short-selling rules are expected, but there is increasing pressure to ban the practice. For stocks that are eligible to be short-sold, Hong Kong s Securities and Futures Ordinance (SFO) requires short-sellers to identify each short-selling order at the time it is made and to confirm that the sale is covered. Subject to certain exceptions, the SFO prohibits naked short-selling unless at the time of sale the seller has or reasonably believes he has a right to deliver the shares to the purchaser. Since 1998, there has been much discussion about easing restrictions on short-selling in Hong Kong. The uptick rule in particular has been criticised for constraining trading activity and undermining market efficiency and price discovery. At the beginning of 2007, the SFC called for a relaxation of the rule to allow more short-selling on the condition that the rule could be reinstated when market conditions dictate. In the light of global stock market troubles, however, on 26 September 2008 the SFC decided to uphold the uptick rule and doubled the penalties imposed by the Hong Kong Securities Clearing Company (HKEx) for the failed settlement of short-selling transactions. The SFC has stated that it will not hesitate to act against abusive shortselling and is prepared to implement more aggressive measures if abusive short-selling is identified, including market-wide controls and/or targeted action against individual persons or entities. Thus, Martin Wheatley 3 Freshfields Bruckhaus Deringer LLP, 21 October 2008

recently told a fund industry conference that [i]f shortselling increases from 8 per cent (of market volume) or if we see significant settlement failures, we will act. Current short-selling levels have remained in line with those of the past two quarters; however, the SFC is monitoring the market closely. For example, the SFC website states that between 22 and 29 September 2008 average daily short-selling turnover was $4.6bn (7.2 per cent of the total market turnover) compared with $5.7bn (7.4 per cent of the total market turnover) for the second quarter and average daily short-selling turnover for the 10 top stocks sold was $2.1bn (10.8 per cent of their underlying turnover) compared with $1.9bn (10.9 per cent of the total market turnover) in the second quarter. It therefore appears that Hong Kong is not being targeted for aggressive short-selling by hedge funds. China goes against the tide Although short-selling has been strictly prohibited in China until now, it has recently been reported that several securities companies have obtained or will soon obtain approval from the China Securities Regulatory Commission to conduct short-selling (and margin trading). The first batch of securities companies eligible to participate in the pilot programme will be selected from 11 top-tier securities companies, including CITIC, Haitong, Galaxy, Shenyin, Everbright, Huatai, Orient and Guotai. The target securities products for the trial will be limited to 80. The new virtual trading system to be used is scheduled for testing on 25 October 2008 and 1 November 2008, with the participation of the Shanghai and Shenzhen Stock Exchanges, selected securities companies and banks and the China Securities Depositary and Clearing Corporation. The official launch of the trial programme may be as early as December this year. Although short-selling was initially provided for under article 142 of China s Securities Law, as amended and promulgated on 27 October 2005, this legislation did not contain any detailed rules on short-selling. Efforts were made to bridge the gap in April 2008, when China s State Council promulgated the Provisions on the Administration and Supervision of Securities Companies. Section 5 chapter IV of these Provisions provides some detailed principles and requirements on securities lending in general and article 56 permits short-selling. However, no detailed operational guidance is offered. China s aims in allowing short-selling are mainly to boost trading volumes and investor confidence and to restructure the Chinese share trading system. Given the expected rise in revenue of the firms that are permitted to short-sell, which some analysts value at 10-15 per cent or more, the share prices of the listed securities companies set to participate in the trial have already been increasing in anticipation. As in the rest of the world, however, the average value of China s stock markets has been gradually falling, with the Shanghai composite index now worth only one-third of what it was a year ago. Indeed, the commission earned by domestic stock broking firms in the first three quarters of this year is only 40 per cent of what it was over the same period last year. In such conditions, it is not difficult to see why China s regulators wish to stimulate activity by trying a different approach. However, some commentators, including Tom Holland, say that rather than introducing new investment tools such as short-selling, China should strengthen the existing market through efforts such as improving corporate governance, increasing minority shareholder rights, sanctioning market abuses and increasing investor education. Outlook The new restrictions on short-selling are likely to be maintained in most Asian markets for some time to come. As two notable Asian jurisdictions that allow or seem to be planning to allow short-selling, Hong Kong and China should therefore remain alert to the consequences of attracting too much short-selling activity. Still, in the face of the financial crisis, Hong Kong s short-selling regulations have proved to be some of the most robust in the world. Martin Wheatley has therefore commented that the move to impose a blanket ban on short-selling is a bit of a kneejerk reaction. What should be done is to remove naked short-selling and perhaps if that had been done earlier in other markets there wouldn t have been such an extreme move now. The fact that we did remove it ten years ago has meant that Hong Kong s got a system that appears, so far, at least, to be working well. Wheatley attributes Hong 4 Freshfields Bruckhaus Deringer LLP, 21 October 2008

This material is for general information only and is not intended to provide legal advice. Freshfields Bruckhaus Deringer LLP 2008 www.freshfields.com Kong s leading regulatory approach to the lessons it learned from surviving the 1997-98 financial crisis. Other markets may be able to catch up with the Hong Kong model by making similar structural changes on short-selling. China, a newcomer to allowing short-selling, should look to the precedent set by Hong Kong and proceed with caution by offering clearer guidance on which sorts of trading practices will be permitted. It plans to phase in short-selling in a staged manner, halting it in the event of troubles. This seems sensible; however, the transition could be smoother still were it not for the current global conditions and the lack of regulatory guidance that has been given (eg although China will initially restrict the number of securities that can be short-sold and the brokers that will sell them, it has not indicated that it will impose other regulatory measures such as a prohibition on naked short-selling or requirements to disclose short positions). In jurisdictions where short-selling is permitted or will soon be permitted, such as Hong Kong and China, companies may well ask themselves what they can do to prevent their share prices from being forced down by short-sellers. If cash is available, one possible measure is share repurchasing by the companies, their directors or controlling shareholders. Such repurchases create a buying demand for shares and express confidence by management or controlling shareholders, propping up share prices in falling markets. By so signalling to the market that management feels the company is undervalued, companies can deter short-selling. There are detailed rules on how to conduct on-market share repurchases, so the process is not always possible and if it is possible it needs to be conducted carefully. However, it is an option that is receiving more and more attention in the current climate. For further information please contact Robert Ashworth T +852 2846 3460 E robert.ashworth@freshfields.com Lea-Anne Lee T +852 2846 3323 E leaanne.lee@freshfields.com Freshfields Bruckhaus Deringer LLP is a limited liability partnership registered in England and Wales with registered number OC334789. It is regulated by the Solicitors Regulation Authority. For regulatory information please refer to www.freshfields.com/support/legalnotice. Any reference to a partner means a member, or a consultant or employee with equivalent standing and qualifications, of Freshfields Bruckhaus Deringer LLP or any of its affiliated firms or entities. 5 Freshfields Bruckhaus Deringer LLP, 21 October 2008 24782