The SFC has issued a third consultation on its proposed new short position reporting regime, together with conclusions on its May 2011 consultation. It now seeks comment by 4 November 2011 on amended draft rules requiring weekly reporting of short positions on a net basis – rather than gross, as previously proposed.
Reporting on a net basis
Under the SFC’s amended draft rules, short positions are to be calculated as the number of shares sold short, minus the number of shares beneficially held. The rationale is that this will enable some holders of short positions to develop reporting systems based on systems they already have for collecting net position data. The SFC concluded, “requiring the firms to report short position on a gross basis as originally proposed would take longer to implement”.
However, the new consultation conclusions have raised a complication, in that the SFC now says, “With regards to a legal entity that organises and conducts its trading activities on a trading unit/book basis, each of which has its own trading objectives and strategies, the SFC expects the legal entity aggregates the net short positions of the trading units/book, and reports to the SFC, the consolidated net short position of the different trading units/books… There should not be any netting off positions against different trading units/books.” This requirement is inconsistent with the draft rules, which contain no references to “trading units/books”.
Whilst this approach is arguably preferable in the context of investment banking and brokerage business, it is unclear how it would work in the context of funds, some of which operate multiple trading strategies within a single legal entity. It could be the case that each umbrella fund structured as a single legal entity, for example, will be expected to report the consolidated net short positions of the different sub-funds, without netting off positions among them.
Aside from the basis on which reportable short positions are to be calculated, the SFC concluded that respondents’ feedback to the previous consultation “indicates broad market support for the Rules”. Unfortunately, in reaching this conclusion, the SFC has paid scant regard to some significant concerns raised by many of the 23 respondents.
A particular concern was that the proposed penalty provisions would have created a criminal offence with absolute or strict liability. The SFC has addressed this to some extent by conceding that there should be a “reasonable excuse” exemption. Nonetheless, the SFC hasn’t articulated any rationale for criminal sanctions. Unlike insider dealing or market manipulation, failure to report short positions will in most cases lack criminal intent, so it cannot simply be assumed that criminalisation is appropriate.
Referring to Part XV of the Securities and Futures Ordinance, the SFC asserts that the proposed maximum penalties are “in line with the penalties already prescribed … for offences of a similar nature.” But the short position reporting regime is intended to capture aggregate market data and will have extremely low reporting thresholds, so individual reporting failures will usually create less market mischief than failure to disclose the transactions of insiders and substantial shareholders under Part XV.
Even if one accepts that criminal sanctions are appropriate, the circumstances that may give rise to criminal liability are too broad. For example, breaches of reporting requirements caused by negligence may still be punishable by imprisonment. This is particularly significant when considering which individuals may be punished for breaches by a corporation. The SFO attributes liability in certain circumstances to a corporation’s officers, such as executive and independent directors. In the case of short positions held by offshore funds, the directors might not be in Hong Kong and in most cases will not have day-to-day control over short position reporting, but could nonetheless suffer criminal sanctions if a breach is attributable to their recklessness.
Informally, the SFC might remark that such concerns are unfounded, and that in practice the SFC will never criminally prosecute individual directors for such breaches. Indeed, to our knowledge, no individual officer has been prosecuted for Part XV breaches of his or her employer’s reporting obligations (as opposed to prosecution of an individual for breaches of the individual’s reporting obligations). But this is cold comfort; a statutory penalty provision, even if unenforced, creates regulatory risk. Consequently, if directors potentially are subject to criminal sanction for somebody else’s negligence, it might be more difficult for funds to find competent directors. It would decrease the attraction of Hong Kong as a fund management centre, relative to jurisdictions where short reporting obligations will instead be enforced by civil penalties. Also, criminal sanctions might distort market behaviour by encouraging the use of derivatives – which currently are not included in the proposed regime – instead of physical shorts.
Jointly held positions
The draft rules have the effect that jointly held positions (other than those of unit trusts) must be reported by all joint holders. For example, every limited partner, as well as the general partner(s), would have reporting obligations with respect to the interests of a limited partnership. Properly designating a responsible party for reporting of jointly held positions is important for two reasons: to limit the burden of the new rules, and to ensure the accuracy of the data. Unlike under Part XV, the regime will involve anonymous public disclosure on an aggregate basis, so duplication needs to be avoided.
The SFC has said they’ll address this later: “We will lay down FAQ or guidance with the reporting obligation under the Rules in scenarios where more than one person beneficially owns a reportable position. Our current thinking in this regard is that a robust reporting system should be established where one report by a designated partner or joint owner should be filed in respect of that reportable short position.”
But the FAQ or guidance will then be inconsistent with the rules. From a risk management perspective this is not ideal, especially in light of the Court of Appeal’s comment in Hantec that “the SFC’s view [of the meaning of certain provisions of the SFO] can be of no relevance as a matter of law unless it is a tool of statutory interpretation”. However, some imperfection is perhaps inevitable. It is similarly the case under Part XV, with respect to reporting by interests held in partnerships, that the SFC’s guidance (that interests of a limited partnership need only be reported by the general partner) is inconsistent with a strict reading of the legislation.
It’s not clear that the SFC has conducted any cost-benefit analysis, though a number of respondents submitted that the compliance cost will exceed the regulatory benefits. Further, the consultation conclusions ignore submissions from multiple respondents that the proposed reporting thresholds of 0.02% and HK$30 million thresholds are too low and, in the case of the dollar threshold, unnecessary.
The draft rules give the SFC power to require daily (rather than weekly) position reporting within one business day (instead of two business days) in circumstances “which threaten or may threaten the financial stability of Hong Kong”. Some respondents argued that this would be operationally difficult, if not impossible, but the SFC concluded receipt of timely information in a crisis is critically important.
Prepare for the (somewhat) inevitable
It may take some firms considerable time and effort to develop systems to enable them to comply with the new short position reporting requirements. Should you start preparing now, before the new regime is finalised? In this context it is worth noting a recurring theme with Part XV: in the eight years since its enactment, the SFC has expressed an intention to implement various reforms, most of which have been sensible, but many of which then never materialised. Whilst some of those proposals would require legislative amendment, beyond the SFC’s control, others (such as mandatory electronic reporting) simply seem to have fallen off the public agenda.
Similarly, the SFC has changed tack with regard to short selling. Before the financial crisis in 2008, the SFC considered Hong Kong’s relatively onerous short selling restrictions a hindrance to competition with other financial centres, and on 2 September 2008 approved plans to relax the uptick rule. Three weeks later the plans were suspended and they have not been revived. Now, international momentum has swung towards greater regulation, and the SFC cites global developments as a driver to increased short position transparency. Because of this perceived pressure, our expectation is the proposed short position reporting regime will be implemented, around the end of Q1 2012. Accordingly, as the SFC warns, “it is important for market participants to start planning for this reporting obligation.”