September 2010

European Commission: Proposal for a Regulation on Short Selling and Sovereign Credit Default Swaps

The European Commission (the “Commission”) has published a proposal for a regulation (the “Regulation”) on short selling and certain aspects of credit default swaps (“CDS”). The Regulation is accompanied by a press release, a set of FAQs and an impact assessment. At a glance: >

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Transparency: private disclosure to competent authorities, and public disclosure to the market, of net short positions in shares traded on an EU trading venue and at or above certain thresholds; flagging of all short sales of shares executed on an EU trading venue; and private disclosure of net short positions in EU sovereign debt and uncovered CDS referencing EU sovereign debt. Uncovered short selling: restrictions on uncovered short sales of shares and EU sovereign debt instruments with proposals for buy-ins, cash compensation, fines and prohibitions on further short selling to deter settlement failures. Powers of Intervention: national powers for competent authorities to impose additional transparency requirements and restrict short selling activities in emergency situations, subject to the overriding powers of the European Securities Markets Authority (“ESMA”) to take similar measures.

Background Short selling (i.e. the sale of a financial instrument by a seller who does not own the instrument but borrows the instrument to settle the sale) is, as the Commission acknowledges, a legitimate activity used by a variety of market participants for market making, hedging long positions, speculation and arbitrage. Short selling is generally viewed as enhancing market liquidity and contributing to efficient pricing. However, some EU Member States were concerned that, in the recent climate of financial instability, short selling could amplify declines in share prices, especially shares in banks and financial institutions, ultimately posing a risk to financial stability where the viability of such institutions is threatened. More recent concerns focused on CDS related to sovereign debt, amid fears that such instruments may drive down prices in sovereign bond markets. Such concerns led a number of Member States to Proposal for a Regulation on short selling activities Issue  1

Contents Background....................... 1 Scope of the Regulation ... 2 Improving Transparency of Short Sales and Net Short Positions ........................... 3 Identifying short positions ...................................... 3 Disclosure of net short positions in shares ........ 3 Flagging of short sales in shares ........................... 3 Disclosure of net short positions in EU sovereign debt and CDS................ 3 Technical standards for disclosure ...................... 4 Reduction of Uncovered Short Selling Settlement Risk ................................... 4 Restrictions on uncovered short selling . 4 Incentives to timely settlement...................... 4 Powers of Intervention ...... 5 National powers ............ 5 ESMA powers ............... 6 Next Steps ........................ 6 Comment .......................... 6

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adopt measures restricting or banning certain short selling activities and/or uncovered CDS. With fragmented and incoherent rules on short selling within the European Union, and pressure from some Member States for strong measures against short selling and the use of CDS, especially in the sovereign bond markets, the Commission rushed out a consultation paper in the summer setting out various policy options, leading, after a brief consultation period, to the proposed Regulation. In formulating its proposals, the Commission also took into account the short selling measures that apply in the United States of America (the “US”) and Hong Kong. The proposed Regulation is intended to introduce a harmonised European regulatory framework for short selling activities that: increases transparency of net short positions; reduces the risk of negative price spirals arising from short selling activities and CDS; ensures Member States have clear powers to restrict or ban short selling activities in distressed markets; ensures coordination between Member States and ESMA of measures in exceptional situations; and reduces settlement and other risks that are perceived to be associated with uncovered short selling.

Scope of the Regulation Whilst the proposals relate primarily to short selling activities relating to shares in companies traded on a relevant EU trading venue and to EU sovereign debt instruments and CDS relating thereto, the Regulation provides for extension to other financial instruments, albeit on a temporary basis, in the event of a serious threat to financial stability or market confidence. The Regulation would have extraterritorial effect as the proposals described below intentionally capture short selling activities of non-EU persons and apply to shares of non-EU entities if the principal trading market for such shares is an EU trading venue. However, a number of important exemptions are provided in the Commission’s proposals. The disclosure provisions, flagging requirement for short sales of shares and restrictions on uncovered short selling would not apply in connection with market makers, authorised primary dealers in sovereign debt or stabilisation activities. The use of these exemptions would be subject to a notification requirement set out in the Regulation (e.g. at least 30 days’ prior notice to the relevant competent authority) and to the consent of the relevant competent authority. Note, however, that proprietary trading is subject to the proposal. An exemption is also provided in respect of the shares of a company where the principal market for the shares is outside the EU. To address the lack of detail regarding the scope and application of the exemptions, ESMA is required to flesh out the details in technical standards to be delivered by 31 December 2011.

Proposal for a Regulation on short selling activities  Issue  1

“The Regulation would have extraterritorial effect as the proposals described below intentionally capture short selling activities of non-EU persons and apply to shares of non-EU entities if the principal trading market for such shares is an EU trading venue. However, a number of important exemptions are provided in the Commission’s proposals.”

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Improving Transparency of Short Sales and Net Short Positions Identifying short positions A short position created by the following transactions would be caught by the Regulation: >

a short sale of a share or an EU sovereign debt instrument; or

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a transaction creating or relating to any other financial instrument where the effect (or one of the effects) of the transaction is to confer a financial advantage on the investor in the event of a fall in the value or price of the share or sovereign debt instrument.

“The definition of a short position is deliberately broad in order to capture purchasers of CDS and other financial instruments which provide a short economic exposure.”

The definition of a short position is deliberately broad in order to capture purchasers of CDS and other financial instruments which provide a short economic exposure.

Disclosure of net short positions in shares The Regulation would introduce disclosure obligations for end-of-day net short positions in shares admitted to trading on an EU trading venue at certain thresholds: >

private disclosure: net short positions of 0.2 per cent. of the relevant issued share capital would have to be disclosed to the competent authority of the most relevant market in terms of liquidity for such shares. The thinking underpinning this rule is that notification to the regulator should enable it to monitor and, if necessary, investigate short selling which may create systemic risks or be abusive; and

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public disclosure: net short positions of 0.5 per sent. of the relevant issued share capital would trigger additional disclosure to the market.

Fluctuations in the net short position at increments of 0.1 per cent. above the relevant threshold, and any fall in the net short position below the threshold, would trigger additional disclosure. Notifications and disclosure of net short positions would have to be given by 3:30pm the following trading day.

Flagging of short sales in shares Controversially, the Commission’s proposals include a new requirement for all short sales of shares executed on an EU trading venue to be marked as “short” (commonly referred to as “flagging”), with daily summaries of the aggregate volume of flagged short sales to be published by such trading venues. Similar flagging regimes currently operate in the US and Hong Kong, as well as Greece and Poland.

Disclosure of net short positions in EU sovereign debt and CDS End-of-day net short positions relating to the issued sovereign debt of a Member State or of the EU, and uncovered positions under a CDS relating to an obligation of a Member State or the EU, above certain notification thresholds (to be determined by the Commission under delegated powers), would also have to be notified to the relevant competent authority. No public Proposal for a Regulation on short selling activities  Issue  1

“Controversially, the Commission’s proposals include a new requirement for all short sales of shares executed on an EU trading venue to be marked as “short” (commonly referred to as “flagging”), with daily summaries of the aggregate volume of flagged short sales to be published by such trading venues.” 3

disclosure obligation is proposed in relation to such net short positions or uncovered CDS positions on the basis that such disclosure could negatively impact liquidity in such instruments. Under the Regulation, a buyer of a CDS referencing sovereign debt of the EU or a Member State would have to include such CDS in any calculation of its net short positions. As noted above, the acquisition of the CDS could also trigger a separate disclosure of an uncovered CDS position unless the CDS was entered into to hedge a long position and is therefore regarded as covered. The hedging exclusion would only be available where the buyer has a long position in the underlying EU sovereign debt (or in debt obligations whose price is highly correlated to obligations of the relevant Member State or the EU). The hedging exclusion may be of limited benefit to market participants given the narrow scope of the proposed rules for when a CDS could be treated as covered for these purposes.

Technical standards for disclosure ESMA is to prepare by 31 December 2011 technical standards detailing the information to be included in the public and private disclosures, and the means by which information may be disclosed to the public.

Reduction of Uncovered Short Selling Settlement Risk

“Under the Regulation, a buyer of a CDS referencing sovereign debt of the EU or a Member State would have to include such CDS in any calculation of its net short positions. The acquisition of the CDS could also trigger a separate disclosure of an uncovered CDS position unless the CDS was entered into to hedge a long position and is therefore regarded as covered.”

Restrictions on uncovered short selling The Regulation would restrict sellers from entering into short sales of shares and EU sovereign debt instruments unless the seller has either borrowed (or entered into an agreement to borrow) the financial instrument or made other arrangements with a third party to ensure that the financial instrument can be borrowed in time to settle the sale. The Commission did not opt for an outright ban on uncovered CDS due to uncertainty as to the effectiveness of such measures on reducing the risk of negative price spirals in the bond markets. The Commission was apprehensive of including proposals which could reduce the market’s ability to trade credit risk and effect proxy-hedging. Technical standards are to be prepared by ESMA by 1 January 2012 regarding the types of arrangements and agreements that will be recognised for the purposes of the restriction. Notwithstanding that ESMA is expected to recognise the current locate and borrowing arrangements with prime brokers and settlement systems used by market participants, concerns have been voiced that a requirement to pre-locate and reserve financial instruments for all short sales will have cost and operational implications for market participants.

Incentives to timely settlement The proposals include provisions designed to incentivise sellers of shares and EU sovereign debt financial instruments to settle their short sales within four trading days of the relevant trade date (or within six trading days for market making activities). To this end, the Regulation would require trading venues and central counterparties to have arrangements in place for buyingProposal for a Regulation on short selling activities  Issue  1

“The Regulation would restrict sellers from entering into short sales of shares and EU sovereign debt instruments unless the seller has either borrowed (or entered into an agreement to borrow) the financial instrument or made other arrangements with a third party to ensure that the financial instrument can be borrowed in time to settle the sale.”

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in the shares or EU sovereign debt instruments or, where a buy-in cannot be effected, for paying cash compensation to the buyer in the event of a settlement failure. The seller would be obliged to reimburse the trading venue or central counterparty for the cost of effecting any such buy-in or cash compensation, thereby exposing the trading venue or central counterparty to credit risk on the seller. Trading venues and central counterparties may therefore impose margin or other requirements on short sellers in respect of any credit exposure in respect of potential reimbursements. As a further deterrent and to prevent sellers profiting from settlement failures, settlement failures would attract daily fines and trading venues would be able to prevent sellers entering into further short sales on the trading venue whilst a settlement failure is continuing.

Powers of Intervention

“The proposals include provisions designed to incentivise sellers of shares and EU sovereign debt financial instruments to settle their short sales within four trading days of the relevant trade date (or within six trading days for market making activities).”

National powers The Regulation would provide competent authorities with powers to respond to serious threats to financial stability or market confidence by: >

imposing additional transparency requirements;

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prohibiting or imposing conditions on short sales and transactions creating short positions;

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preventing persons entering transactions relating to financial instruments or limiting the value of such transactions that may be entered into; and

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preventing persons entering into sovereign CDS or limiting the value of uncovered sovereign CDS that may be entered into.

Any measures imposed pursuant to such powers would be subject to a maximum initial period of three months, with the potential for extension. Member States would have to notify ESMA and other competent authorities of any proposed measures and ESMA would have 24 hours to confirm whether it agrees that: >

the notified events or developments constitute a serious threat to financial stability or to market confidence in one or more Member States;

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the notified measures are appropriate and proportionate to address the threat; and

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the proposed duration of the measures is justified.

In addition, the Regulation would introduce a “circuit breaker” by empowering competent authorities to temporarily prohibit or restrict persons entering (until the end of the next trading day) into short sales and other transactions relating to a financial instrument admitted to trading on a relevant EU trading venue whose price has fallen significantly from the previous day’s closing price on such trading venue. In the case of shares, this means a fall of 10 per Proposal for a Regulation on short selling activities  Issue  1

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cent. or more. ESMA is to prepare technical standards for the thresholds to be applied to other financial instruments by 31 December 2011.

ESMA powers Where ESMA itself determines that there is a threat to the financial markets or the stability of the EU financial system and there are cross-border implications, and in its view one or more competent authorities have not taken measures to address the threat or such measures are insufficient, ESMA would be given direct powers, subject to consultation with the European Systemic Risk Board, to take any of the measures described above. Measures imposed by ESMA would substitute and prevail over any national measures taken by Member States. The ability of ESMA, without reference to the Parliament and the Council, to intervene at a national level in emergency situations is likely to prove controversial. During the discussions on the powers to be conferred on the new European supervisory authorities, the UK took a stand against their ability to intervene at a domestic level where there may be a fiscal consequence. To ensure the effectiveness of the extraterritorial provisions of the Regulation, ESMA would be tasked with co-ordinating the development of co-operation agreements between competent authorities of Member States and third countries concerning the exchange of information and the enforcement of obligations arising under the Regulation in third countries.

“The ability of ESMA, without reference to the Parliament and the Council, to intervene at a national level in emergency situations is likely to prove controversial. During the discussions on the powers to be conferred on the new European supervisory authorities, the UK took a stand against their ability to intervene at a domestic level where there may be a fiscal consequence.”

Next Steps The Regulation will now pass to the Council and the European Parliament who will need to agree the text. The Regulation is intended to be fully in place and operational by 1 July 2012. Since the Commission has opted for legislation in the form of a regulation as opposed to a directive, its provisions will have direct effect in EU Member States and will not require domestic legislation to implement them.

Comment Whilst it will be some time before market participants can identify precisely how the Regulation will operate in practice, the Regulation may: >

introduce onerous new flagging requirements for participants and trading venues in relation to short selling of shares on a relevant EU trading venue, with brokers having to monitor whether the orders they receive from clients involve shorting;

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increase costs for short sales on trading venues if any margin requirements are introduced for settlement failure risk in relation to any buy-ins and compensation on a settlement failure; and

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have a negative impact on the sovereign bond markets resulting from the need to disclose uncovered CDS positions.

Proposal for a Regulation on short selling activities  Issue  1

“The Regulation may increase the cost of short selling activities for market participants and negatively impact the sovereign bond markets.” 6

Compliance challenges may be presented by the detail of the new rules, unless there is significant consultation on the technical standards and sufficient time is provided between the finalisation of the standards and their coming into effect as market participants with significant operations will need time to develop, test and implement automated compliance solutions. No indication is given as to whether financial instruments are to be accounted for on a “delta-adjusted basis”, rather than a notional basis, in calculating a net short position. Also, no indication is given that short selling by underwriters and sub-underwriters, in accordance with risk management models, or any hedging of underwriting exposures, in the case of secondary share sales, will escape the disclosure requirement. Concerns have also been raised that the proposed public disclosure threshold for shares may be too low. Investors may try to manage their net short positions to avoid triggering a public disclosure, resulting in a reduction in short selling. A significant reduction in short selling could negatively impact liquidity and price transparency and cause spreads to widen.

Proposal for a Regulation on short selling activities  Issue  1

“Investors may try to manage their net short positions to avoid triggering a public disclosure, resulting in a reduction in short selling. A significant reduction in short selling could negatively impact liquidity and price transparency and cause spreads to widen.”

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Contacts For further information please contact: Pauline Ashall Partner, Derivatives and Structured Products, London (+44) 20 7456 4036 [email protected] Mark Middleton Partner, Derivatives and Structured Products, London (+44) 20 7456 4643 [email protected] Michael Kent Partner, Financial Regulation Group, London (+44) 20 7456 3772 [email protected] Lucy Fergusson Partner, Corporate, London (+44) 20 7456 3386 [email protected]

Contributors: Lala Phillips, Pauline Ashall, Anne Kirkwood and Kirsty Gibson Doc Number: A12498527 This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. © Linklaters LLP. All Rights reserved 2010 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC326345. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ or on www.linklaters.com and such persons are either solicitors, registered foreign lawyers or European lawyers. Please refer to www.linklaters.com/regulation for important information on our regulatory position.

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Proposal for a Regulation on short selling activities  Issue  1

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