The FSA has announced new rules for investors shorting shares during right issues. Is it a bold step in the right direction or too little, too late?
The Financial Services Authority isn't renowned for moving the market but that's exactly what it did on Friday when it released a short statement concerning how investors shorting shares during a rights issue should disclose their holdings.
What is shorting?
Shorting is essentially betting that a share price will go down. So it's the opposite of the normal practice of buying a share and hoping to profit from a rise in its price (also known as going long).
Here's how it works in practice. An investor thinks that a share will go down in value. So he borrows some shares held by an institution such as a pension fund and sells them into the market. He pays the institution a small fee for this service. Then at a later date, the investor will buy back the shares in the market and give them back to the institution. This is known as covering the short. If the share has fallen between the two dates, the investor makes a profit.
Shorting is popular with hedge funds and private investors have taken an interest in it in the last few years, mainly by using spread bets and contract for differences rather than borrowing shares.
What did the FSA do?
On Friday June 13, the FSA announced new disclosure rules for shorting. If a company is in the process of raising money via a rights issue, anyone shorting more than 0.25% of the company's shares must publicly disclose their position. This rule change comes into effect on June 20.
It seems that many shorters decided to close their positions rather than having to disclose them.
On Friday the shares of HBOS
(LSE: HBOS)
, currently seeking to raise £4bn, increased by 14%. Local newspaper group Johnston Press
(LSE: JPR)
led the pack with a 20% gain and three housebuilders, Redrow
(LSE: RDW)
, Taylor Wimpey
(LSE: TW.)
and Barratt Developments
(LSE: BDEV)
jumped by 16%, 16% and 13% respectively. Other notable movers were Alliance & Leicester
(LSE: AL.)
, up 11%, and the owner of Dixons and PC World, DSG International
(LSE: DSGI)
, which was 16% higher.
The FSA's move has caused considerable anger in the City due to the lack of prior consultation and the short time before it comes into effect. It's undoubtedly somewhat of a kneejerk reaction to the troubles in the banking sector. Shares in HBOS fell below its right issue price earlier last week, jeopardising its chances of raising the funds it needs to steady its business.
Is this a good idea?
Many people, including myself, would argue that such a move is long overdue. Investors holding shares already have to disclose positions of 3% or more. Additionally, trades of those holding more than 1% have to be disclosed if a company is in takeover talks.
While it's true that the disclosure levels for shorting have been set much lower than this, it is only for certain circumstances. There is already some form of disclosure in relation to shorting as CREST, the share settlement system, publishes the lending statistics for shares on the UK market. However, it's an imperfect measure and not widely available. Certainly, as an investor or prospective investor in a company I want to know when a share is being heavily shorted, so I welcome the move.
Those criticising the FSA's actions don't seem to have taken on board that this is only a first step in a wider review. The limits may be changed in future and higher disclosure limits could be set for all shorting positions. Additionally, the FSA has made the hugely unsubtle threat that it may restrict the lending of shares during right issues, making it much harder for investors to go short in the first place. It seems unlikely that it would go this far but the FSA obviously wanted to warn the ne'er-do-wells of the shorting world.
Other countries already restrict shorting in some fashion. Indeed, for over 75 years the US had the uptick rule meaning that you could only short a share if the last movement in its price was up. However, this was consigned to dustbin last July, in retrospect perhaps not the greatest example of market timing.
For the moment though, we're only talking about disclosure of shorting positions rather than any restriction of its practice.
It's fair to say there are other areas that need to be addressed here. The willingness of institutions to lend shares in the first place is something many people find bizarre as it can lead to a permanent reduction in the value of their holdings, far outweighing the fees they get in return.
The long lead-time with rights issues is a problem too. HBOS announced its rights issue on April 29 but the details are only being sent to shareholders this week and they have until July 18 to decide what to do. If the rights issue process is altered as a result of all this, private shareholders may no longer be able to participate in future fundraisings of this kind.
The problem with shorting is that it creates the opportunity for market mischief. Just as money isn't evil but the love of money is, it's the temptation that comes with shorting that causes all the trouble.
That's because it's far easier to cause a fall in a company's share price by spreading negative rumours. Indeed, HBOS fell prey to just such a situation in March when its share price fell 20% in a day. An investigation was launched into what happened and the results are expected soon. Last month it was reported that someone close to the investigation said people would be surprised by the findings. If another major UK bank was responsible things could get a little frosty!
This story is only just starting and there's likely to be further jockeying from both sides in the coming months. Too much restriction on shorting would be wrong as the additional trading it generates oils the wheels of the market and helps price shares more accurately. It also provides a useful disincentive for directors that play fast and loose with the businesses they are charged with protecting. But a fairer disclosure policy is required and it looks like we're finally moving in the right direction.
More: Shorters Are Greedy Speculators
