Key E.U. Member State Regulators’ Implementation Of New Short-Selling Bans Shows Divisions And European Securities And Markets Authority’s Inability To Coordinate E.U. Action

In response to the spreading sovereign debt crisis in the European Union and its effect on financial institutions, several key E.U. member state regulators recently decided to impose or extend existing short-selling bans in their respective countries. They did so either to restrict the benefits that could be obtained from spreading false rumors or to achieve a regulatory level playing field, given the close inter-linkage among E.U. markets. These measures have been aligned as far as possible in the absence of a common E.U. legal framework in the area of short selling and in light of the very different national legal bases on which such measures can be taken.

Implications for Financial Industry Professionals

• Reinforcement of the monitoring of the E.U. markets.

• Short-selling ban affects Belgium, France, Greece, Italy and Spain and reveals divisions.

• Ban is on short selling of financial-sector equities and equity-linked derivative products.

• Bans are intended to deter rumors and level playing field.

What the New E.U. Rules Say

Following the market close on August 11, 2011, Belgium’s Financial Services and Markets Authority (FSMA), France’s Autorité des marchés financiers (AMF), Italy’s Commissione Nazionale per le Società e la Borsa (Consob) and Spain’s Comisión Nacional del Mercado de Valores (CNMV) simultaneously announced new bans on short selling or on short positions, which took effect the following day and were extended on August 25, 2011. This collective decision followed the decision by Greece’s Hellenic Capital Market Commission (HCMC) to temporarily ban covered short sales and sales which are settled with subsequent intraday purchases until October 7, 2011, and preceded the Austrian Financial Market Authority’s decision to extend the prohibition on uncovered short-selling transactions with respect to certain shares until November 30, 2011.

Belgium banned short selling of four financial-sector securities for an indefinite period; France banned short selling of 10 financial stocks until November 11, 2011; Italy banned net short positions or the increase of existing net short positions, including intraday, covering 29 companies in the banking and insurance sector until September 30, 2011; and Spain said it would protect 16 stocks, also until September 30, 2011.

Each regulator issued its own guidance, generally under the form of FAQs, describing the new rules, which affects both short sales of financial-sector equities and equity-linked derivatives. The FAQs explicitly state that trading strategies combining index-related transactions and other transactions with the aim of circumventing the short-selling rules are prohibited.

However, the FAQs recognize that investors holding an open long position on the equity markets may want to hedge this position against the general market risk. If there is no other reasonably efficient way to do this, they may hedge their portfolios through transactions related to indexes that contain one or more of the relevant issuers, even if this results in incidental and marginal net short positions in one or more of the relevant issuers.

The Belgian FSMA’s FAQs expressly state that fixed-income instruments or instruments that give an exposure to the creditworthiness of one of the relevant issuers (such as credit default swaps) should not to be taken into account for the calculation of the net short position. Although the other FAQs are not as explicit on this point, the regulators generally share the view that the latest restrictions cover equity and not debt securities.

In the area of short-selling regulation, many authorities already have either requirements for the disclosure of net short positions and/or bans of certain types of short sales in place. For example, in October 2010, France adopted the Banking and Financial Act n° 2010-1249 of October 22, 2010, and formally prohibited uncovered (naked) short sales by implementing a “locate rule,” but did not prohibit short sales per se, and instead attempted to discourage short sellers by reducing the maximum settlement period from three to two trading days and imposing reporting obligations on net short positions in excess of 0.2 percent of all French listed companies (see analysis by the authors at WSLR, December 2010, page 16).

French Finance Minister François Baroin welcomed the French ban and said it highlighted the government’s commitment to ensuring financial stability, avoiding market abuses and fighting against all forms of speculation. France and Italy also plan action against investors who combined rumor mongering and short selling to manipulate banking shares. The French Banking Federation said French banks were considering legal action, while Italy’s Consob said it would fine those who disregarded the short-selling ban.

These recent developments have meant that all competent E.U. authorities have reinforced the monitoring of their markets and are keeping their regulatory requirements under review.

ESMA, Other E.U. Member State Regulators

The European Securities and Markets Authority (ESMA) has coordinated discussions between the FSMA, the AMF, the Consob and the CNMV, specifically on the content and timing of any possible additional measures necessary to maintain orderly markets. Nevertheless, ESMA was not able to reach a consensus with all the E.U. regulators, and its incapacity to fulfill its role as E.U. coordinator has been criticized.

The United Kingdom and the Netherlands said they saw no need for action, while Germany said it would instead push for an E.U.-wide ban on so-called naked short selling. The United Kingdom temporarily banned short selling of financial stocks in 2008, in line with a U.S. ban imposed four days after the collapse of Lehman Brothers ushered in a dangerous new phase of the financial crisis. On the other side of the Channel, in July 2010, an amendment to the German Securities Trading Act came into force which introduced a general ban on naked short selling in shares in German listed issuers, in certain government debt and in credit default swaps linked to certain government debt (see analysis at WSLR, June 2010, page 40). The conflict between these two views shows ESMA’s difficult task, as the United Kingdom poses a main obstacle to a coordinated move against short sellers due to fears that such a ban would hurt its financial sector.

Although the proposed E.U. regulation on short selling and credit default swaps on E.U. sovereign debt is still under discussion prior to its expected effectiveness on July 1, 2012 (see WSLR, October 2010, page 4), and there is not a strict obligation of the authorities to take a common view, ESMA’s statement announcing the new ban rules in August 2011 ensures that the measures have been aligned as far as possible, and there is specific reference in the Consob resolution to the similar restrictive rules on net short positions adopted on August 11, 2011, by the competent authorities of France, Belgium and Spain.

The European Commission said an E.U. framework would be more effective, and ESMA’s chairman urged policy makers to adopt a plan for bloc-wide rules on short selling “as quickly as possible,” but said there were no concrete plans at this stage for other countries, without being able to rule out the possibility that this could change.

Actions to Consider

• Watch closely E.U. regulators’ actions, as they might decide to ban short sales, extend the existing bans or impose further restrictions.

• Review and closely monitor trading policies, particularly with respect to equity derivatives and index products linked to the covered securities in each country.

• Be prepared for reinforced supervision of the E.U. markets by the regulators, who will not hesitate to take enforcement actions against perceived market abuses.

Conclusion

Notwithstanding the lack of clear empirical evidence that short-selling restrictions actually reduce volatility and increase market stability, key E.U. regulators want to be seen as taking action to protect their countries’ financial institutions.

It is to be hoped that the proposed E.U. regulation scheduled to enter into effect throughout the European Union in July 2012 will allow the regulators to speak with one voice and provide greater clarity to market participants.

David Freedman is a Partner and Angélique Poret-Kahn is a Law Clerk (admitted in Paris only) with Baker & McKenzie LLP, New York. David Freedman is also a member of the World Securities Law Report Advisory Board. The authors may be contacted at david.freedman@bakermckenzie.com and angelique.poret-kahn@bakermckenzie.com.