The Securities and Futures Commission (SFC) has invited the public to comment on draft subsidiary legislation for a weekly short position reporting regime. Breaches of the proposed regime will incur a maximum fine of HK$500,000 and imprisonment for two years. The SFC has provided no rationale for criminal penalties, which were not canvassed in the SFC's July 2009 consultation paper and March 2010 conclusions on which the current consultation is based. Whilst not surprising, the offhand manner of the announcement is a reminder of lawmakers' dismal tendency to impose criminal penalties without pausing to consider whether the behaviour involves criminal intent.
The potential impact of this proposal may be gauged by considering the corresponding penalty provisions for disclosures of interests in listed securities under Part XV of the Securities and Futures Ordinance (SFO). Inadvertent breaches of Part XV are common, and some fund managers have a misconception that the SFC doesn't criminally prosecute such cases. In fact, firms and individuals are routinely prosecuted and convicted. There were ten such cases in the first four months of this year, with fines ranging from HK$2000 to HK$42,000. Though a fine may be a less fearsome prospect than imprisonment, it is not a mere administrative penalty – conviction results in a criminal record. Convicted Part XV offenders include tycoons and investment management companies, as well as many small potatoes. The latter are, perhaps, easier prosecution targets than large organisations or individuals at the helm of corporate empires, which in many cases file disclosure notices but do it incorrectly due to misunderstanding the complicated provisions regarding the nature and attribution of interests.
The penalty provisions are a particular concern as they may create a strict liability offence. Under Part XV no offence is committed if a party is not aware of its disclosable interests, or has a “reasonable excuse” for failing to disclose them. There are no such carve outs under the draft rules for the new short position reporting regime.
As can similarly be said for aspects of Part XV, in several important respects the proposed regime is ill-conceived and unduly onerous. Most controversially, the SFC has decided upon a reporting threshold of 0.02%. As we reported previously, this is far lower than in most other jurisdictions, where the threshold typically ranges from 0.2% to 1%. The SFC's justification was that the short selling/turnover ratio and short exposure/market capitalisation ratio in Hong Kong “is much lower than in London and New York” and that “if a similar trigger level is used in Hong Kong, only very large short positions in the shares of very few companies might exceed the threshold”. It is illogical to argue that Hong Kong therefore requires drastically lower trigger levels. A more reasonable conclusion would be that short positions are less of an issue here, as would be demonstrated under a reporting regime with trigger levels broadly consistent with those in other jurisdictions.
Also somewhat illogically, the SFC wants a dollar value trigger as well as the percentage trigger, so that a reporting requirement will arise when a short position reaches 0.02% or HK$30 million, whichever is lower. This second element to the threshold test was not anticipated in the July 2009 consultation paper, so the public has previously been given no formal opportunity to comment on it. The SFC argued “it is not feasible to use the same percentage trigger” for all companies (which is patently wrong, as a single percentage trigger is the approach taken in most other jurisdictions), because 0.02% of a large-cap stock is, as a dollar amount, “very significant”. The SFC produced no evidence to show, and made no attempt to explain, how a short position that (whilst large in absolute terms – if indeed HK$30 million can be considered large) is small in relative terms could be systemically important. If a dollar value trigger were necessary, which it isn't, it would be more sensible to use it to exclude short positions which meet the percentage threshold but which are a small dollar amount, than, as the SFC proposes, to include those which do not meet the percentage threshold but which are a large dollar amount.
There is a danger that the SFC will be unable to interpret the volume of data that could be generated using such low thresholds. As the Committee of European Securities Regulators stated, “an initial threshold set too low could generate a great deal of data of little value, creating an unnecessary compliance burden on investors and administrative challenges to regulators but questionable regulatory dividend” (CESR/10-089, 2 March 2010). The SFC is to have discretion to increase reporting frequency in circumstances “that would pose a threat to the financial stability of Hong Kong”, but has abandoned its intention also to have power in contingency situations to lower the trigger thresholds. The SFC has not responded to suggestions that a power to lower the thresholds would permit less onerous thresholds to be imposed in the first place, only to be lowered if they should prove inadequate in abnormal market circumstances.
What must be reported
Short positions are to be reported gross, with no netting-off of long positions. The reporting requirements will apply to constituent stocks of the Hang Seng Index and the H-Shares Index as well as other “designated securities” (securities permitted for short selling by the Stock Exchange) which are “financial stocks”. Consequently, of the 748 designated securities (as at 9 June 2011), about 87 will be subject to the new short position reporting regime. These 87, accounting for approximately 70% of market capitalisation, represent a focus on shares whose performance is more likely to affect market stability.
Short positions created by derivatives (such as put options, short futures contracts, and contracts for difference) will be excluded for reporting purposes. From a perspective of controlling the compliance burden, this is one positive aspect of a rather sorry tale. The SFC claimed, “the argument of having a trigger threshold that is consistent with other jurisdictions is not tenable because the short position reporting regime the Commission is proposing differs from those jurisdictions with a trigger threshold of 0.25%, in particular, we do not intend to include derivatives.” However, the SFC provided no data to suggest that the use of derivatives is so extensive as to warrant such a radically lower threshold if derivatives are not included.
Excluding derivative interests from the reporting requirements might discourage physical shorting through stock borrowing, and shift activity to the derivatives market – especially if fund managers see this as a way to mitigate the risk of criminal prosecution for inadvertent breaches of the new regime. On balance, the SFC was more concerned that the inclusion of derivatives would increase compliance costs and complicate the information reported. We support this view. Short positions created via OTC trading also need not be reported. However, in response to comments that reporting systems maintained by financial firms typically cannot distinguish between positions created on or off exchange, the SFC decided that it will be permissible to include OTC positions for reporting purposes. This seems sensible.
Who must report and when
Under the new regime, any short positions reaching the thresholds each Friday must be reported to the SFC the following Tuesday (subject to public holidays). The SFC will publicly disclose only anonymous aggregate data on a delayed basis. This is intended to discourage free-riding on others' proprietary trading strategies, avoid subjecting short position holders to short squeezes when covering their positions, and discourage a herding effect where investors blindly follow a big-name short position holder. A consequence of this approach is that the SFC will hold secret price sensitive information, giving rise to potential illegal leaking of that information.
The SFC has considered who will be responsible for reporting short positions and decided it will be “the person who beneficially owns the short position”. Aggregation and attribution of holdings, one of the horrors of Part XV, is therefore not required. There is an exception “In the case of trusts including funds,” when the trustee (and not the investors, or beneficiaries of the trust) will be responsible for reporting. This ignores the fact that many funds are structured as corporations or partnerships. However, a “person” in this context is a legal entity, so it appears that a corporate umbrella fund or SICAV, in which sub-funds are created within a single legal entity, must report on an umbrella fund basis (aggregating the positions of each sub-fund). The position of joint owners, including partners, is unclear. In particular it remains to be seen whether the SFC will take the view, as it does for Part XV, that the short positions of a limited partnership must be disclosed by the general partner and not by each partner in respect of an undivided share.
A fund manager (or other agent) may report the position on behalf of each of the funds it manages but will not be required to aggregate the short positions of different funds or be permitted to net positions between different funds. The corporate fund or the trustee, as applicable, will remain legally responsible for the reporting. In the case of corporate groups, reporting on a legal entity basis may pose practical problems, as some monitor their positions across business lines which cut across different legal entities.
Multiple reporting regimes
A particularly disappointing aspect of the consultation process is that the SFC did not make any serious attempt to incorporate the new reporting requirements into the existing Part XV disclosure regime, or to align the new reporting calculations and methodologies with that regime. It should be possible to increase short position transparency by modifying the existing transactional reporting requirement for short positions under Part XV. This could give Hong Kong a regime similar to that proposed by the European Commission, under which investors will have to disclose to regulators when their net short positions first cross 0.2% (and to the market when they first cross 0.5%) and when they subsequently cross incremental bands of 0.1%.
Unfortunately, the SFC appears to have decided that the existing Part XV regime is too complicated to mess with, and proposals in 2005 to reform Part XV have sunk without trace. As a result, Hong Kong will have two co-existing but inconsistent regimes, each imposing separate monitoring and reporting requirements for short positions. In addition, there are requirements under the SFO to mark short sale orders on the Hong Kong Stock Exchange and under the Securities and Futures (Contracts Limits and Reportable Positions) Rules to report large open positions in futures or stock options contracts.
Despite additional reporting requirements under the new regime, the information elicited will remain incomplete. In particular, there is a significant likelihood of non-compliance by short sellers who have no presence in Hong Kong. There is also a risk that excessive regulatory burdens in Hong Kong will not only be ignored, but will encourage short sellers of dual listed stocks to use the overseas exchange, which would to some extent compromise Hong Kong's position as an international financial centre.
In September 2008, regulators in other jurisdictions imposed emergency bans or restrictions on short selling, which later were widely judged to have been futile or even to have exacerbated the financial crisis. The SFC won much kudos for not reacting in the same panicked fashion. It now risks undoing its good reputation.