Short Selling and Rights Issues

Once again short selling has come under fire, this time from the UK Financial Services Authority (FSA).  On Friday, June 13th, 2008, the FSA gave a shocked financial community one week’s notice that short sellers holding more than .25% of any stock undergoing a rights issue would have to disclose those holdings.  The FSA said that the new rules would be effective on June 20th, 2008, the following Friday.

 The FSA noted further in its Friday the 13th press release that while short selling is “…a legitimate technique which assists liquidity and is not in itself abusive…” nevertheless “…the rights issues process…” currently before the market – Halifax Bank of Scotland (HBOS) and Bradford & Bingley (B&B), came to mind – “…provides greater scope for what might amount to market abuse…”  It had anecdotal evidence of this, the FSA indicated, although week-long efforts by the financial press, the International Securities Lending Association (ISLA) and the Alternative Investment Market Association (AIMA) to prise that evidence loose were unavailing. 

So the weeklong episode amounted to whatever headline writers and others said it was: an attempt to create transparency, a “clamp down” on hedge funds, or an attack on short selling, among other things.  At the end of the week, the early morning BBC Radio 4 news programme interviewed a representative of AMIA who asked the FSA to reveal any evidence of “Bad apples, so the good apples can get on with doing business.”  The BBC presenter said that the FSA had declined to send a representative to be interviewed on the programme.  Later on Friday, despite the immediate prospect of short sellers’ registration, HBOS shares dipped below the right issue price (275 pence).

The FSA’s move, and the securities lending industry’s vigorous defence, played out against the months-long background of the sub-prime mortgage crisis and the fall of Northern Rock Bank.  Several affected institutions eventually came to the market to raise funds through rights issues, among them HBOS and B&B.   During the protracted rights process, prices in the whole sector deteriorated; analysts both in the UK and in Europe lowered estimates, and the stocks were widely shorted.  No one singled out HBOS, particularly.  Finally, two weeks before the FSA’s shock announcement, HBOS stock price dipped for the first time (briefly) below the projected price of the rights issue, sending the issuing banks running to the FSA, the Chancellor and anyone in the media who would listen.  Confidence in rights issues must be restored, they argued.  Otherwise, London’s reputation as the best place to raise capital would be undermined. But, as US hedge fund guru David Einhorn pointed out, when people start complaining about short sellers, it’s a sign that they’re trying to distract everyone from more serious problems. 

So the securities lending organization (ISLA), the representative of the hedge fund industry (AIMA), and the financial press in general churned out a week of discussion that produced a definitive defence of short selling and the securities lending business that supports it. Especially cogent is material by ISLA Chief Executive David Rule, “Why asset management arms of banks should continue to lend bank shares,” at www.ISLA.co.uk.  In response, a succession of interesting twists and wrinkles emerged from the FSA, and related agencies.

On Monday (June 16th), UK Chancellor Alastair Darling announced that he intended to set up working parties in the City to give more input into policy problems and solutions. 

On the same day, an FSA FAQ sheet stated that short positions (and their exact amount) would need to be disclosed only once, when they exceeded the .25% short position threshold; later increases (or decreases) need not be revealed, a move that defeated most efforts to understand or explain it.

A barrage of questions from the industry on problems of implementation followed, and finally, on Friday June 20th, the FSA announced an extension of the deadline for reporting until Monday (June 23rd).  Also on Friday the 20th, the HBOS share price dipped below the rights offering for a third time. 

By the weekend, two things had become clear enough to be printable.  First, the FSA move against short sellers had been made to protect the interests of the banks holding the rights issues.  Indeed, short sellers began to seem an almost incidental target; otherwise, why the one-time reporting feature?  Second, the fault for the decline in stock prices lay not with short sellers, but with the general downward drift of the market, the quality of the sector and analysts’ opinions of it, and the particular prospects of HBOS.  Imposing “transparency” on short sellers did nothing to maintain or lift the price of rights issues.  Finally, FSA restrictions on short selling were termed “half-baked” in print.  Another writer pointed out that the FSA rules were really skewing the price discovery process and if the rules were made permanent, rights issues raised in the protective environment proposed by the FSA would be suspect in the larger global market.

On Monday, June 23rd, several HBOS short sellers duly registered with the FSA, and HBOS shares once again dipped below their rights offer level. B&B, in an unprecedented move, repriced (lowered) its rights offering.  By close of business on Monday, three hedge funds registered HBOS short sales above the .25% level, and eleven others registered anyway, just to be on the safe side.  HBOS shares closed below the rights offering level.  Headlines were blunt: the FSA move had failed to “curb” short selling.

Why was short selling even targeted?  Much discussion over the week (and some entertaining letters to the editor of the Financial Times) focused on this question, which has been dealt with both legislatively and academically for a very long time.  Why is the short seller a Usual Suspect, especially when markets dive?

To the casual observer, the short seller seems to make something out of nothing, almost magically, pocketing the difference between the price of a stock when it is first borrowed and then sold on, and the price of the same stock later, at payback, or short-covering time.  At least, that’s what happens when share prices fall, as the short seller thinks they will.  If a short seller calculates wrong and the stock he’s borrowed to sell short actually goes up in value, he faces unlimited loss until he covers the stock at the increased and presumably increasing price. 

Again, targeting short sellers may be the product of not very deeply buried resentment of people who make money in a falling market, when most people are racking up losses.

But more importantly, short selling is alleged to “drive” markets down, a persistent example of the post hoc fallacy that just because short selling follows in time the decline in a stock price doesn’t mean that it causes that decline.  Furthermore, when short sales are “covered,” and the stock is purchased in the market to return to the person from whom it was originally borrowed, a sufficiently large buy back trade may slow or even halt a market price decline.

Shorting stock isn’t easy, it’s not for the fainthearted, it is usually only done by serious investors such as hedge fund managers, and then only after intensive research.  However, because they constitute the other side of the market, short sellers provide liquidity, and insure the price discovery process that is fundamental to the operation of the market.