Download Trading Issues and Enhanced Regulatory Disclosures

Managed Funds Association
Regulatory Compliance Conference
The Princeton Club of New York, New York, NY
November 30, 2011
TRADING ISSUES AND ENHANCED
REGULATORY DISCLOSURES
Roger D. Blanc
Matthew Comstock
Willkie Farr & Gallagher LLP
New York, NY
November 21, 2011
© 2011 Roger D. Blanc. All rights reserved.
Note: The discussion set forth in this outline is for informational purposes only. It does not take into account the
qualifications, exceptions and other considerations that may be relevant to a particular situation. The discussion
should not be construed as legal advice, which would have to be addressed to the particular facts and circumstances
involved in any given situation.
MFA TRADING PANEL OUTLINE
I.
European Union Short Selling Initiatives and Certain U.S. Short Selling Issues
A.
Bans on Short Selling
1.
Belgian, Denmark, France (extended for three months as of November 11,
2011), Greece (expires on December 9, 2011), Ireland, Italy (expires on
January 15, 2012) have banned short selling in the stocks of specified
financial institutions (except Greece, which bans short sales of all shares
listed on the Athens Exchange).
2.
Investors are prohibited from creating or increasing net short positions in
the stocks of the financial institutions subject to the ban.
3.
The bans purport to apply irrespective of where a trade is placed and
irrespective of whether the trade is executed on a regulated market.
4.
The bans typically prohibit the use of derivatives to create economic short
exposure to the stocks of the financial institutions subject to the ban.
5.
Derivatives may be used for hedging purposes.
6.
References:
a.
Belgium: Royal Decree of 23 September 2008 on Certain
Operations Constituting Market Abuse, 25 Belgian Official
Gazette 50040 (September 2008); Decision by Financial Services
and Markets Authority to Modify Short Selling Rules, L'Autorité
des Services et Marchés Financiers (Aug. 11, 2011).
b.
Denmark: FSA Executive Order no. 1004, Danish Law Gazette A
(Oct. 10, 2008).
c.
France: MINISTÈRE DE L’ÉCONOMIE, DES FINANCES ET
DE L’INDUSTRIE, Arrêté du 9 novembre 2011 relatif à la
prolongation de l’interdiction des prises de position courtes nettes
sur une liste de valeurs financières françaises (Nov. 10, 2011).
http://www.amf-france.org/documents/general/10199_1.pdf.
FAQs
on
short
sale
ban:
http://www.amffrance.org/documents/general/10111_1.pdf.
d.
Greece: Guidance on HCMC’s Decision Regarding Short Selling
Ban, Hellenic Capital Market Commission (Aug. 9, 2011).
e.
Ireland: Market Abuse Rules, Section 10.1, Central Bank of
Ireland (May 2009).
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f.
B.
C.
Italy: CONSOB Resolutions nos. 17992 and 17993, Commissione
Nazionale per le Società e la Borsa (Nov. 11, 2011).
Bans on Naked Short Selling
1.
Austria and Spain prohibit naked short selling.
2.
Austria’s ban on naked short selling is limited to the stocks of four
financial institutions. Investors must “locate” the securities that they wish
to sell short.
3.
Spain has a broad ban on naked short selling. To sell a security short, the
investor must own the security, borrow the security or have a contractual
right to the security.
4.
References:
a.
Austria: Austrian Stock Exchange Act § 48(d)(12) FLG I No. 58
(2010).
b.
Spain: Preventative Ban on Transactions Which Might Constitute
or Increase a Net Short Position on Spanish Financial Stocks,
Comisión Nacional del Mercado de Valores (Aug. 11, 2011).
Reporting Requirements
1.
Ireland, Italy, Germany and Spain impose certain reporting requirements
relating to short positions.
2.
Typically, short positions of 0.2% or more are required to be reported to
the relevant regulatory authority in a country with a reporting requirement.
Short positions of 0.5% are disclosed publicly (Ireland has a reporting
threshold at 0.25% of an issuer’s capital).
3.
References:
a.
Ireland: Market Abuse Rules, Section 10.2, Central Bank of
Ireland (May 2009).
b.
Italy: CONSOB resolution no. 17862, Commissione Nazionale per
le Società e la Borsa (July 10, 2011).
c.
Germany: General Decree on the Extension of the Provisions of
the General Decree of the Federal Financial Supervisory Authority
(BaFin)
of
4
March
2010,
Bundesanstalt
für
Finanzdienstleistungsaufsicht (Jan. 31, 2011).
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d.
D.
Spain: Agreement of the Executive Committee of the CNMV on
the Disclosure of Short Positions, Comisión Nacional del Mercado
de Valores (May 27, 2010).
Proposed European Union Short Position Disclosure Initiative
1.
On October 18, 2011, the European Parliament, Commission, and Council
agreed on new regulations that prohibit naked short-selling of government
bonds and shares and naked sovereign CDS transactions.
a.
Short Sales – To effect a short sale of a security subject to the
prohibition on naked short selling, an investor must “locate” the
security to be sold short. The restrictions do not apply if the
transaction serves to hedge a long position in debt instruments of
an issuer, the pricing of which has a high correlation with the
pricing of the given sovereign debt.
b.
CDS - The buyer of the CDS is “naked” if it does not have an
exposure which it is seeking to hedge, either to the sovereign debt
itself, or to assets or liabilities whose value is correlated to the
sovereign debt.
2.
Disclosure
a.
For shares - Short positions in excess of 0.2% of the issued share
capital will have to be disclosed to the national regulator, while
short positions in excess of 0.5% will also have to be disclosed to
the market.
b.
For sovereign bonds - Such significant net short positions will have
to be disclosed only to the regulator. This includes notification of
significant CDS positions relating to sovereign debt issuers.
3.
Extraterritorial – Yes, if it involves securities whose principal market is
inside the EU.
4.
Discretion by Country – In order to address concerns that a ban on naked
sovereign CDS could negatively affect the liquidity of sovereign debt
markets, a country may temporarily suspend the restrictions if it believes
that its sovereign debt market is not functioning properly and that such ban
might increase its cost of borrowing or affect its ability to issue new debt.
5.
Exceptions – For certain market-making activities, certain primary market
operations related to market liquidity and stabilization schemes, and shares
whose principal market is outside the EU.
6.
Timeline: Expected to enter into force on November 1, 2012.
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E.
II.
7.
The United Kingdom has raised concerns that the proposed ban on naked
swaps
on
sovereign
debt
is
unlawful.
See
http://www.businessweek.com/news/2011-11-10/eu-nations-back-shortsale-law-over-u-k-s-legality-concerns.html.
8.
Reference: Eur. Parl. Doc. (COM(2010)0482) (2011).
Recent Regulation SHO Disciplinary Action
1.
UBS Securities LLC, a U.S-registered broker-dealer, was fined $12
million for failure to comply with Regulation SHO.
2.
UBS placed short sale orders without obtaining locates, including for
securities that were hard to borrow.
3.
UBS mismarked short sales as long sales.
4.
The firm misrepresented its aggregation units, i.e., the units within the
broker-dealer for which short positions are determined, in a manner that
may have led to locate and order marking failures.
5.
See Amanda Pollok, Impact of Regulation SHO on the Short Sale Activity
of Hedge Fund Managers and Broker-Dealers, Hedge Fund Law Report
(Nov. 10, 2011).
Large Trader Reporting
A.
The large trader reporting rule became effective October 3, 2011. Large traders
must comply by December 1, 2011 and broker-dealers must comply by April 30,
2012.
1.
B.
Large Trader Reporting, Exchange Act Release No. 64976, 76 Fed. Reg.
46960 (Aug. 3, 2011).
Under the rule, a “large trader” is a person or entity that
1.
Directly or indirectly, including through controlled persons, exercises
investment discretion over securities account;
2.
Effects transactions in NMS securities on behalf of such accounts; and
3.
Effects such transactions in an aggregate amount equal to or greater than,
during a calendar day, either two million shares or shares with a fair
market value of $20 million; or during a calendar month, either 20 million
shares or shares with a fair market value of $200 million (the “identifying
activity level”).
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C.
D.
E.
III.
A large trader must file Form 13H with the SEC through EDGAR and obtain a
large trader identifies (“LTID”).
1.
Form 13H requires the large trader to submit substantial information about
itself and certain of its affiliates (e.g., a description of the nature of its
business, other forms that it or its affiliates submit to the SEC, an
organizational chart and corporate governance information, among other
things).
2.
The large trader must provide its LTID to all of the brokers at which it
maintains a brokerage account
A parent company may be an organization’s large trader
1.
To determine if a parent company is a larger trader, the aggregate trading
activity of all entities controlled by the parent company must be collected.
2.
In a hedge fund complex, that could be the investment adviser.
3.
In the case of multiple advisers that are horizontally affiliated, the holding
company for those advisers could be the large trader.
4.
A large trader is relieved from having to comply with the identification
and reporting requirements of the rule if all persons controlled by such
large trader that exercise investment discretion with respect to the
purchase and sale of NMS securities collectively comply with all
requirements applicable to such large trader with respect to all of its
accounts.
What about an individual who owns a large trader?
1.
The individual could be a large trader.
2.
Trades included under the parent company’s LTID? The individual is
arguably an affiliate of the parent company under the rule.
3.
The individual probably should obtain his or her own LTID. The rule
seems to contemplate that parent and subsidiaries trading would be
included under LTID, not an individual owner’s trading.
Dark Pools
A.
Alternative Trading Systems.
B.
Dark pools do not publicly display quotations in the consolidated quotation date;
helps provide trading anonymity.
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C.
IV.
Dark pools are under SEC scrutiny. The SEC proposed increased disclosure by
dark pools in November of 2009. The SEC’s proposals would:
1.
Amend the definition of “bid” or “offer” in the Regulation NMS quoting
requirements to apply to “actionable” indications of interest (“IOIs”)
(generally described as IOIs that are functionally equivalent to quotes),
unless the actionable IOI is for a block-sized trade having a market value
of at least $200,000;
2.
Lower the Regulation ATS average daily trading volume threshold that
triggers quote display and execution access requirements for ATSs from
five percent (5%) to one quarter of one percent (0.25%); and
3.
Amend the joint-industry plans for publicly disseminating consolidated
trade data to require real-time disclosure of the identity of dark pools and
other ATSs on the reports of their executed trades.
4.
The proposing release is Regulation of Non-Public Trading Interest,
Exchange Act Release No. 60997, 74 Fed. Reg. 61208 (Nov. 23, 2009).
High frequency/algorithmic trading
A.
Under intense scrutiny
1.
SEC devoted a substantial portion of its market structure concept release,
issued in January 2010, to high frequency trading. See Concept Release
on Equity Market Structure, Exchange Act Release No. 61358, 75 Fed.
Reg. 3594 (Jan. 21, 2010).
2.
The SEC has concerns over whether high-frequency traders in fact provide
passive market making.
3.
The SEC is concerned that rather than provide liquidity, high frequency
traders set the bid and offer to take advantage of liquidity rebates.
4.
The “Flash Crash” in May 2010 raised concerns about whether high
frequency traders will provide liquidity in times of stress.
5.
Co-location services used by high frequency traders also under regulator
scrutiny.
a.
Provision of such services by exchanges is subject to the Exchange
Act.
b.
Given the requirements in Exchange Act Section 6(b) applicable to
exchange rules, the terms of co-location services may not be
unfairly discriminatory and fees must be equitably allocated and
reasonable.
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B.
Other issues relating to high frequency/algorithmic traders
The SEC proposed to ban so-called “flash orders” in September 2009.
Elimination of Flash Order Exception from Rule 602 of Regulation NMS,
Exchange Act Release No. 60684, 74 Fed. Reg. 48632 (Sept. 23, 2009).
1.
a.
“Flash orders” are types of orders that can be “executed
immediately” or “withdrawn if not executed immediately,” as set
out in Rule 602(a)(1)(i)(A) of Regulation NMS
b.
The SEC took the position that flash order should be included in
the consolidated quotation data.
c.
The flash ban has not yet been adopted.
2.
C.
V.
Stub Quote Ban
a.
In November of 2010, the SEC approved amendments to selfregulatory organization rules to prohibit so-called “stub quotes.”
Order Granting Accelerated Approval to Proposed Rule Changes
Exchange Act Release No. 63255, as Modified by Amendment No.
1, to Enhance Quotation Standards for Market Makers (Nov. 5,
2011).
b.
Stub quotes are quotations so far away from the prevailing market
that they are not intended to be executed.
c.
Executions against stub quotes represented a significant portion of
broken trades during the Flash Crash.
d.
The SRO rule amendments require market makers to maintain
continuous two-sided quotations throughout the trading day that
are within a specified percentage band (e.g., 8%) of the national
best bid and offer (“NBBO”). If the quote moves a certain
percentage away from the NBBO, the market maker must adjust
the quote to bring it back within the band.
Finally, high frequency/algorithmic trading would likely be picked up by the large
trader reporting requirements.
Direct/Sponsored Access – Rule 15c3-5 under the Securities Exchange Act of 1934
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A.
This type of access generally involves an institutional customer who uses a
broker-dealer’s market participant identifier (“MPID”) to access an exchange or
ATS electronically.
B.
Direct versus sponsored access
C.
1.
“Direct market access” typically refers to a customer securities order that
flows through a broker-dealer’s systems before entering the markets.
2.
“Sponsored access” typically involves a customer securities order that
flows directly to the markets without first passing through a brokerdealer’s systems.
3.
Irrespective of the type of access, the broker-dealer is responsible for all
trading that occurs using its MPID.
Rule 15c3-5 requires a broker-dealer with market access, or that provides another
party with access to an exchange or ATS through use of the broker-dealer’ MPID
or through other means, to establish, document, and maintain a system of risk
management controls and supervisory procedures designed to managed the
financial, regulatory and other risks associated with providing such access.
1.
D.
E.
17 C.F.R. §240.15c3-5; Risk Management Controls for Brokers or Dealers
with Market Access, Exchange Act Release No. 63241, 75 Fed. Reg.
69792 (Nov. 15, 2010).
Financial risk management controls must be reasonably designed to
1.
Prevent the entry of orders that exceed appropriate credit or capital limits
in the aggregate for each customer and the broker-dealer; and
2.
Prevent the entry of erroneous orders by rejecting orders that exceed
specified price or size parameters or that indicate duplicative orders.
Regulatory risk management controls must be reasonably designed to
1.
Prevent the entry of orders unless applicable regulatory requirements have
been met on a pre-order basis;
2.
Prevent the entry of orders for securities for a broker-dealer, customer, or
other person who is restricted from trading in such securities;
3.
Grant access to systems that provide market access only to those persons
and accounts authorized by the broker-dealer; and
4.
Provide surveillance personnel with immediate post-trade execution
reports resulting from market access.
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VI.
Rule 105
A.
B.
Rule: In connection with an offering of equity securities for cash pursuant to a
registration statement or notification on certain Securities Act of 1933 forms, it is
unlawful for a person to sell short the security that is the subject of the offering
and purchase the offered securities from an underwriter or broker-dealer
participating in the offering if short sale was effected during the period (the “Rule
105 restricted period”) that is the shorter of the period:
1.
Beginning five business days before the pricing of the offered securities
and ending with such pricing; or
2.
Beginning with the initial filing of such registration statement or
notification and ending with pricing.
3.
17 C.F.R. §242.105; Short Selling in Connection with a Public Offering:
Exchange Act Release No. 56206, 72 Fed. Reg. 45094 (Aug. 10, 2007).
Exceptions
1.
Bona Fide Purchase Exception
a.
The restricted period short seller may purchase offered securities if
the short seller makes a bona fide purchase of the same security no
later than the business day before the day of pricing.
b.
There must be a full business day between pricing and the bona
fide purchase. If, for example, pricing occurs after market close on
Wednesday, the bona fide purchase may be effected until market
close on the preceding Tuesday. If, however, pricing occurs before
market close on Wednesday, the bona fide purchase may be
effected only until market close on the preceding Monday.
c.
The bona fide purchase must be effected after the last Rule 105
restricted period short sale and in an amount equal to the entire
amount sold short during the restricted period.
d.
The bona fide purchaser may not effect any short sales during the
30 minutes before market close on the day before pricing.
2.
Separate Accounts Exception
a.
Under subparagraph (b)(2) of Rule 105, a person who has multiple
securities accounts may purchase an offered security in one
account even if he or she sold the same security short during the
Rule 105 restricted period in another, separate account “if
decisions regarding securities transactions for each account are
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made separately and without coordination of trading or cooperation
among or between the accounts.”
b.
Indicia of separate accounts:
c.
C.
1.
Separate and distinct investment and trading strategies for
each account;
2.
No coordination by personnel of trading among or between
accounts;
3.
Information barriers to separate accounts;
4.
Maintenance by each account of a separate profit and loss
statement;
5.
No allocation of securities between or among accounts; and
6.
Personnel with oversight or managerial responsibility over
multiple accounts in a single entity or affiliated entities, and
owners of multiple accounts, who do not have the authority
to, and do not, execute trades in the account or pre-approve
trading decisions for the accounts.
Aggregation Units
1.
A plain reading of the separate accounts exception would
appear to permit aggregation units within the same legal
entity, at least for purposes of Rule 105.
2.
Contrary to the plain language of the rule, the SEC staff has
indicated that separate aggregation units are not available
within the same legal entity.
Other Issues
1.
Derivatives
a.
The SEC stated in the release adopting amended Rule 105 that the
rule does not apply to derivatives, although it also stated that it
might reconsider that position in the future.
b.
The exercise of a short call against the call writer or a long put by
the put holder during the Rule 105 restricted period could result in
a short sale. If the option writer/holder did not own the underlying
security, it would effectively be agreeing to deliver a security that
it does not own upon the exercise of the option.
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2.
Enforcement Actions
a.
The SEC settled its first actions under Rule 105 against investment
advisers in two separate actions in January of 2010. In both cases,
the advisers sold short during the Rule 105 restricted period, then
participated in an offering of the subject security. Both advisers
agreed to pay disgorgement, a penalty and prejudgment interest.
See In re Palmyra Capital Advisors LLC, Exchange Act Release
No. 61421, Advisers Act Release No. 2976, Administrative
Proceeding File No. 3-13763 (Jan. 26, 2010) and In re AGB
Partners LLC, Gregory A. Bied, and Andrew J. Goldberger,
Exchange Act Release No. 61422, Administrative Proceeding File
No. 3-13764 (Jan. 26, 2010).
b.
The SEC also settled an action against an investment adviser in
which it concluded that the adviser’s short sales in certain advised
accounts during the Rule 105 restricted period were attributable to
other accounts’ participations in a follow-on offering of the same
security. The SEC determined that the separate accounts exception
was not available because, among other reasons, the managers for
the various accounts communicated regularly regarding strategies
generally and, at times, about particular trades. The managers
were also located near each other with potential access to one
another’s trading records. In re Carlson Capital, L.P., Exchange
Act Release No. 62982, Advisers Act Release No. 3086,
Administrative Proceeding File No. 3-14066 (Sept. 23, 2010).
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