The SFC has issued Conclusions on Further Consultation on the Securities and Futures (Short Position Reporting) Rules, and revised draft rules, with a proposed commencement date of 18 June 2012. We expect that the rules will shortly pass negative vetting by the Legislative Council, so market participants should start preparing the necessary changes to their monitoring and reporting systems now.
Who must report
The revised rules define reportable short positions with respect to short positions that a person “has as a result of selling” the shares. References to short positions that a person “beneficially owns” have been removed. This new formulation creates some ambiguity. For example, an investment manager may sell shares on behalf of a fund, but the intention is that the fund (rather than the manager) has the reporting obligation.
Complications also arise with respect to short positions attributable to some kinds of investment or trading structures. Short positions “attributable to [a] partnership” need only be reported by one of the partners, or “another person authorized by all [the] partners”. This addition to the rules endeavours to address the concerns of respondents who commented that, in the case of jointly held short positions, the rules as previously drafted imposed a separate disclosure obligation on each of the joint owners. Such duplication would cause unnecessary burden, as well as inaccuracy in the aggregate data. The SFC had said it would issue FAQ or guidance clarifying that only one report by a “designated partner or joint owner” should be filed – but the FAQ or guidance would in that case have been inconsistent with the rules.
The revised rules resolve this problem with respect to partnerships (such as funds structured as limited partnerships), but not with respect to other forms of joint ownership, such as joint owners of managed accounts. Short positions of a trust (such as short positions of a fund structured as a unit trust) will be reportable by the trustee “as if that person were the beneficiary”. The beneficiaries of a trust are expressly exempted from reporting obligations. So the meaning of the words “as if that person were the beneficiary” is unclear, particularly given that it will be the trustee (as legal owner), not the beneficiary, that sells the shares to create the short position.
There is a new provision that positions “attributable to a particular collective investment scheme” are to be treated separately and not aggregated with those attributable to other collective investment schemes. Consequently, in the case of an umbrella fund structured as a single corporation, the corporation may have separate reporting obligations with respect to each of the sub-funds. Short positions are to be reported net, but there is to be no netting of short and long positions between different sub-funds.
A person’s positions attributable to a partnership are to be treated separately and not aggregated with those attributable to another partnership. Implicitly, they are also to be treated separately from any other positions the person may have, such as through a managed account. The consultation conclusions contain no explanation as to why SFC did not consider it necessary to have an equivalent provision with respect to the positions of a trustee. However, the intention is that positions of a trust are to be treated separately and not aggregated with a trustee’s other positions, such as in another trust.
Somewhat inconsistently, there is no provision enabling an owner of managed accounts to treat each of the managed accounts separately. Consequently, an investment manager for a segregated account mandate may be unable to assume the reporting obligation for its clients (even if it is willing to do so), as the investment manager will not necessarily know a client’s overall holdings.
“To enable those market participants whose trading activities are conducted on a trading unit/book basis to leverage on their current trading infrastructure for short position reporting”, the SFC has said it will issue guidelines showing how to report the sum of the net short positions across trading units/books, without netting off positions against different trading units/books. Whereas the consultation paper implied this approach would be mandatory, the conclusions indicate that it will be optional. In any event, it may be risky for a reporting entity to comply with the guidelines, as they will not have the force of law and will be inconsistent with the rules. In particular, rule 3(2)(a) requires calculation of net positions simply on a legal entity basis. A legal entity that has net long positions in some of its trading units or books would, as the rules are drafted, be required to net those long positions against any net short positions in its other trading units or books.
Criminal penalties and “reasonable excuse”
Despite strong objections during public consultation, the SFC remains unswayed from its view that a breach of the reporting requirements should constitute a criminal offence, with the same maximum penalties ($100,000 fine and two years’ imprisonment) as under the disclosure of interests regime in Part XV of the Securities and Futures Ordinance. It dismissed arguments that breaches are unlikely to be intentional, and that individual reporting failures will generally have a lower market impact than failure to disclose the transactions of insiders and substantial shareholders under Part XV.
The SFC concluded: “We see no merit in the respondents’ argument to deviate due to concerns with inadvertent non-compliance as only a contravention of the Rules, without reasonable excuse, would constitute an offence.” However, it seems likely that in many cases of inadvertent non-compliance the “reasonable excuse” exemption would not apply.
Under the short position reporting regime, unlike under Part XV, the reporting requirement will arise irrespective of knowledge. And in some situations, a person with a short position will not immediately know about it – such as in the case of a segregated account managed by an investment manager. A genuine lack of knowledge might constitute a reasonable excuse, but this is by no means clear where there is an element of negligence or other culpability. A person who has appointed an agent to transact on his behalf, for example, but not instituted procedures to keep him informed of transactions, would likely fail the reasonable excuse test, by reason of wilful blindness. In practice, the owner of a managed account might (if properly advised) appoint an agent to perform the reporting obligations on the owner’s behalf. Where an investor has multiple accounts with different managers, someone will need to calculate the aggregate the position. But it is uncertain whether the owner could establish a reasonable excuse defence in the event that an agent fails properly to report.
As the reporting requirements and criminal penalties will apply only to short positions created through borrowing and selling of shares, it is possible that the new regime will distort market behaviour by shifting activity to the derivatives markets. In that case, banks will enjoy higher fees dealing in swaps, at the expense of investors who might otherwise have achieved the same economic exposure more cheaply through physical shorting. The new regime is intended to enhance market transparency. But there appears to have been little, if any, analysis as to what it is going to cost to implement, and whether it is really worth it.