October 30, 2012
The European Union has adopted a new regulation on short selling and certain aspects of credit default swaps (Regulation (EU) 236/2012) (the “Regulation“). The Regulation takes effect from November 1, 2012. The Regulation has been supplemented by the Implementing Regulation (EU) 827/2012 of June 29, 2012 (the “Implementing Regulation“)[1] and three delegated regulations:
In addition, European Securities and Markets Authority (“ESMA“) published a Q&A on September 13, 2012 relating to the Regulation, which was updated on October 10, 2012 (the “ESMA Q&A“).[5] The Regulation, together with the Implementing Regulation, the Delegated Regulations and the ESMA Q&A, create an EU-wide framework for the coordinated regulation of short selling. This framework requires public disclosure of certain short positions in relation to covered financial instruments and restricts uncovered short positions for these same financial instruments. This client alert highlights several key features of the Regulation and the EU’s new short selling regulatory framework.
Scope
The Regulation applies to financial instruments traded on an EU-regulated market or multilateral trading facility.[6] The Regulation can also apply to these instruments when they are traded outside an EU-regulated market or multilateral trading facility. The ESMA Q&A states that the location of a transaction, and the domicile or location of the parties to the transaction, are irrelevant when assessing whether or not the Regulation applies.[7]
The Regulation also sets outs rules relating to short positions in sovereign debt and sovereign credit default swaps (“CDS“) issued by (i) the EU, (ii) any EU member state (including any government department, agency, or a special purpose vehicle of an EU member state), (iii) in the case of a federal EU member state, a member of the federation, (iv) a special purpose vehicle for several EU member states, (v) an international financial institution established by two or more EU member states for the purpose of providing assistance to EU members states experiencing severe financing problems, or (vi) the European Investment Bank.
Exemptions
- Principal Trading Venue Outside the EU: The Regulation does not apply to the shares of a company admitted to trading on a trading venue in the EU if the principal trading venue (i.e., the venue with the highest volume for the trading of the relevant shares) is located outside the EU. By way of illustration, the ESMA Q&A notes that a U.S. company with shares admitted to trading on a trading venue in Germany but whose principal trading venue is in the United States will not be subject to the notification and disclosure requirements, restrictions on uncovered short sales or the buy-in procedures in the Regulation.[8] ESMA is charged with regularly updating the list of securities for which the principal trading venue is outside the EU (and which are thus exempt from the Regulation). ESMA has published a list of shares whose principal trading venue is deemed to be outside the EU.
- Market Making Activities: The Regulation does not apply to market making activities, which are defined to mean activities of an investment firm, a credit institution or specified non-EU entity whose activities are regulated under a legal and supervisory framework that has been declared equivalent by the Commission pursuant to Article 17(2). These activities are limited to where the relevant entity deals as principal in a financial instrument, whether traded on or outside a trading venue, in a capacity (i) designed to assist with providing liquidity on a regular and ongoing basis to the market, (ii) where it would in its usual business fulfil orders initiated by clients or in response to clients’ requests to trade or (iii) involving hedging in connection with the foregoing. Making use of this exemption requires notice to be given to the competent authority in a firm’s home EU member state not less than 30 calendar days before using the exemption.
- Sovereign Debt: The Regulation does not apply to authorised primary dealers of sovereign debt in relation to primary or secondary market operations relating to the sovereign debt. Firms wishing to make use of this exemption must apply to the competent authority of their home EU member state not less than 30 calendar days before using the exemption.
- Stabilisation: The Regulation does not apply to stabilisation activities carried out in connection with buy-back programmes and the stabilisation of financial instruments.
Transparency Obligations for Shares
The Regulation sets out confidential notification and public disclosure requirements for significant net short positions in shares.
Confidential Notification Requirements
A net short position in relation to the issued share capital of a company that has shares admitted to trading on a trading venue must be notified to the competent authority of the EU member state in which the trading venue is located when:
- the net short position is equivalent to 0.2% of the issued share capital of the issuer of the relevant shares (the “Initial Confidential Share Notification Threshold“); and
- the net short position increases 0.1% above the Initial Confidential Share Notification Threshold.
Public Disclosure Requirements
A net short position in relation to the issued share capital of a company that has shares admitted to trading on a trading venue must be publicly disclosed when:
- the net short position is equivalent to 0.5% of the issued share capital of the issuer of the relevant shares (the “Initial Public Share Notification Threshold“); and
- the net short position increases 0.1% above of the Initial Public Share Notification Threshold.
Calculating Net Short Position for Shares
A net short position in relation to the issued share capital of a company is determined by calculating the difference between the long and short positions of a person in the issued share capital of a company using a delta adjusted model. For the purpose of determining a net short or long position, the calculation must take into account any position held by the relevant person, including through or by way of any index, basket of securities or any interest in any exchange-traded fund or similar entity. The calculation must also take into account:
- publicly available information as to the composition of the relevant index or basket of securities, or of the interests held by the relevant exchange-traded fund or similar entity; and
- any holding of shares through a basket of shares (in respect of either a long or short position).
The calculation should not take into account:
- whether cash settlement or physical delivery of the underlying asset has been agreed; or
- any short positions that give rise to a claim to unissued shares, and subscription rights, convertible bonds and other comparable instruments (in respect of the calculation of a net short position).
With respect to the calculation of the net short position for funds and other similar structures, the net short positions of the funds and portfolios under management by the same management entity for which the same investment strategy is pursued in relation to a particular issuer must be aggregated. As part of this aggregation, any positions of the funds and portfolios where management has been delegated to the management entity by a third party should be included. However, the positions of the funds and portfolios where management has been delegated by the management entity to a third party should be excluded.
Transparency Obligations for Sovereign Debt
Net short positions relating to sovereign debt are required to be disclosed on a confidential basis to the relevant competent authority when the amount of the positions exceeds certain thresholds published by ESMA. These thresholds are calculated as percentages of the monetary amount of the position as follows:
- for issuers with up to €500 billion in total of outstanding issued sovereign debt, the initial reporting threshold is 0.1% of an issuer’s total outstanding sovereign debt and subsequent reports must be made at each additional 0.05% above the initial reporting threshold; and
- for issuers with more than €500 billion in total of outstanding issued sovereign debt (or where there is a liquid futures market for the particular sovereign debt), the initial reporting threshold is 0.5% of an issuer’s total outstanding sovereign debt and subsequent reports must be made at each additional 0.25% above the initial reporting threshold.
Transparency Obligations for Sovereign CDS
If a competent authority in an EU member state suspends restrictions on sovereign CDS (see “Restrictions on Uncovered (naked) Short Sales — Sovereign CDS” below), an uncovered position on a sovereign credit default swap must be notified to the relevant competent authority where that position reaches or falls below the relevant notification thresholds for the sovereign issuer in respect of sovereign debt.
Calculation of Net Short Position for Sovereign Debt
A net short position in relation to the issued sovereign debt is determined by calculating the difference between the long and short positions of a person in the same sovereign debt using a delta adjusted model. Long positions in sovereign debt which are highly correlated with the pricing of the sovereign debt must be included as part of a person’s overall long position. The calculation of the net short position for sovereign debt must include CDS which relate to the sovereign issuer. For assets with a liquid market price, a high correlation between the pricing of a debt instrument of another sovereign issuer and the pricing of the debt of the given sovereign issuer must be measured on a historical basis. Where there is no liquid market, an appropriate proxy should be used. In addition, the same principles applicable to the calculation of the net short position for shares also generally apply to the calculation of the net short position for sovereign debt.
Timing of Notifications and Disclosures
The notifications or disclosures required under the Regulation must be made by 3:30 pm local time on the following trading day. Local time is determined by reference to the time in the EU member state of the relevant competent authority to which the relevant position must be notified. The first disclosures under the Regulation must be made by 3:30 pm local time on November 2, 2012.
Reporting Mechanics
Reports provided in compliance with the Regulation are required to be in English or the language of the relevant competent authority in an EU member state. Confidential notifications to a competent authority of net short positions in shares or sovereign debt must include certain specified information[9] and such information must be submitted on a particular form.[10] Likewise, public disclosures of net short positions in shares must also contain certain specified information.[11] The Implementing Regulation specifies how competent authorities should disclose this information to the public.[12] Holders of significant net short positions will also be required to keep records of the gross positions that make a significant net short position for a period of five years.
Competent authorities will also be required to provide ESMA with certain information relating to net short positions on a quarterly basis and the information requested by ESMA from time to time.[13] ESMA has published a document containing links to the websites of the competent authorities of various EU member states where the information on the process and forms for notifying the competent authority in each EU member state is made available.[14]
Restrictions on Uncovered (naked) Short Sales
Shares and Sovereign Debt
The Regulation also prohibits short selling of shares and sovereign debt admitted to trading unless one of the following conditions is fulfilled:
- the shares/debt securities have been borrowed or alternative arrangements with a similar legal effect have been made;
- an agreement has been entered into for the shares/debt securities to be borrowed or the person has another absolutely enforceable claim to be transferred ownership of a corresponding number of shares of the same class to effect settlement when due; or
- other arrangements have been entered into with a third party under which that third party has confirmed that the shares/debt securities have been “located” (and are subject to locate arrangements) and has taken measures to give the person a reasonable expectation that settlement can be effected when due.
In respect of futures and swaps, options and repo agreements, the contract must be in respect of at least the number of shares sold short, entered into no later than the time of the short sale and must specify a delivery or expiration date that ensures that the short sale can be effected when due.
Sovereign CDS
The Regulation prohibits uncovered sovereign CDS, which is defined as a sovereign credit default swap which does not serve to hedge against:
- the risk of default of the issuer where the holder has a long position in the sovereign debt of that issuer to which the sovereign credit default swap relates; or
- the risk of a decline of the value of the sovereign debt where holder holds assets or is subject to liabilities whose value is correlated to the value of the sovereign debt.
A competent authority may temporarily suspend the prohibition on uncovered sovereign CDS where it finds on objective grounds that its sovereign debt market is not functioning properly and that such restrictions might have a negative impact on the sovereign credit default swap market.
Buy-in Procedures
Central counterparties in EU member states should adopt procedures which comply with the following requirements:
- where a person who sells shares is not able to deliver the shares for settlement within four business days after the day on which settlement is due, procedures are automatically triggered for the buy-in of the shares to ensure delivery for settlement;
- where the buy-in of the shares for delivery is not possible, an amount is paid to the buyer based on the value of the shares to be delivered at the delivery date plus an amount for losses incurred by the buyer as a result of the settlement failure; and
- the person who fails to settle should reimburse all amounts to be paid in connection with the foregoing.
A central counterparty must ensure that a person who sells shares and fails to deliver the shares for settlement by the date on which settlement is due must make daily payments for each day that the failure continues. These penalties should be sufficiently high to act as a deterrent to failing to settle.
Next Steps
Participants in EU financial markets who trade shares of companies listed in the EU, EU sovereign debt or CDS in relation to the foregoing (including market participants in the U.S.) should:
- be mindful of the extraterritorial effect of the Regulation;
- monitor the list of companies whose shares’ principal trading venue is deemed to be outside the EU;
- monitor ESMA’s quarterly updates of the thresholds for significant short positions in debt of a sovereign issue; and
- ensure that back office systems are in place which allow the necessary calculation and required reporting of net short positions in the relevant financial instruments.
[1] The Implementing Regulation sets out implementing technical standards for the public disclosure of net position in shares, the format of the information provided to ESMA regarding net short positions, the types of agreements, arrangements and measures to adequately ensure that shares or sovereign debt instruments are available for settlement and the dates and period for the determination of the principal venue for a share according to the Regulation.
[2] Delegated Regulation 826/2012 supplements the Regulation by providing regulatory technical standards on notification and disclosure requirements of net short positions, details of information to be provided to ESMA in relation to net short positions and the method for calculating turnover to determine exempted shares.
[3] Delegated Regulation 918/2012 supplements the Regulation with regard to certain definitions, the calculation of net short positions, covered sovereign credit default swaps, notification thresholds, liquidity thresholds for suspending restrictions, significant falls in the value of financial instruments and adverse events.
[4] Delegated Regulation 919/2012 supplements the Regulation by providing technical standards for calculating the fall in value for liquid shares and other financial instruments.
[5] The ESMA Q&A and other guidance from ESMA are not legally binding and are not EU law. Nevertheless, ESMA guidance is viewed as significant by competent authorities and compliance with ESMA’s guidance may be viewed by competent authorities as an indication of compliance with the Regulation.
[6] The Regulation defines a multilateral trading facility as a multilateral system, operated by an investment firm or a market operator, which brings together multiple third‑party buying and selling interests in financial instruments — in the system and in accordance with non‑discretionary rules — in a way that results in a contract.
[7] See ESMA Q&A Question 1a.
[8] See ESMA Q&A Question 1d.
[9] See Table 1 of Annex I of Delegated Regulation 826/2012.
[10] See Annex II of Delegated Regulation 826/2012.
[11] See Table 2 of Annex I of Delegated Regulation 826/2012.
[12] See Article (2), Implementing Regulation.
[13] See Article 11(2) of the Regulation and Articles 4 and 5 of Delegated Regulation 826/2012.
Gibson, Dunn & Crutcher lawyers are available to assist you with any questions you may have relating to the subject matter of this update. Please contact the Gibson Dunn lawyer with whom you usually work, or any of the following lawyers in the firm’s London office:
Jeffery Roberts (+44 20 7071 4291, jroberts@gibsondunn.com)
Edward A. Tran (+44 20 7071 4228, etran@gibsondunn.com)
© 2012 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
