In February of 2022, the Securities and Exchange Commission proposed new disclosures to provide more transparency into institutional investors' short-selling activity. According to Chairman Gensler, collecting more granular data from large short sellers "would help us to better oversee the markets and understand the role short selling may play in market events." Despite these lofty goals, industry commenters are raising serious questions about whether some elements of the proposed new disclosure regime are structurally and technologically feasible.
The Proposals
Proposed rule 13f-2 under the Securities Exchange Act of 1934 and Form SHO would require institutional investment managers[1] to file monthly reports to the SEC providing extensive information on specific "large" short positions and short sale transactions.[2] The SEC intends to use these reports to disclose publicly aggregate data about short positions and short sale activity in individual securities.
If adopted, new Rule 205 of Regulation SHO would require broker-dealers to mark purchase orders as "buy to cover" if a buyer has any short position in the same security when the purchase order is entered. The new rule would also require reporting to the consolidated audit trail (CAT) of:
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"buy to cover" order marking information, and
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situations where reporting firms complete short sales in reliance on the "bona-fide market maker exception" to the Regulation SHO "locate" requirement.
The Objections
a. Cost-Benefit Commenters raised serious objections to the significant reporting and monitoring burdens the proposals would impose on institutional investment managers. Implementing the Proposed Form SHO reporting infrastructure (as well as the monitoring of its accurate functioning), they urged, will "incur significant costs on investment managers and, ultimately end-investors."
Commenters also noted that "Form SHO data collection framework is not justified from a cost benefit perspective, given that it provides only very limited additional relevant insight compared to currently available data." FINRA already collects data on short sale activity and recently requested comment on "potential enhancements to its short sale reporting program" through Regulatory Notice 21-19 published on June 4, 2021. Instead of the entirely new process contemplated in rule 13f-2, commenters said the focus should "lie on making enhancements to FINRA's existing collection and dissemination of aggregate short interest data and making the existing CAT data collection related to short activity fit for purpose." [4]
b. Scope The scope of data collection under rule 13f-2 is too broad, according to some in the industry. Valerie Dahiya at Perkins Coie suggested that "the SEC should consider an exemption for certain types of managers that do not regularly utilize short positions or that only utilize short positions for passive investing purposes, or at a minimum impose a longer filing period for initial filing requirements."
Ms. Dahiya also indicated that the final rule should only include net short positions.
"The Proposal's "emphasis on gross short positions may overstate the effect (sic) to the market of the number of short positions outstanding. Rule 13f-2 should instead focus on net short positions."
Finally, Ms. Dahiya said the rule 13f-2 thresholds were too low and suggested that in formulating the final rule:
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The SEC should consider changing the dollar amount threshold under Threshold A of proposed Rule 13f-2 to $10 million net short position from gross, or include an exemption for hedged short positions.
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The SEC should consider raising the percentage threshold under Threshold A of proposed Rule 13f-2 from 2.5% to 5%.
c. Public Disclosure. Commenters objected to the publication of data under the proposal. Even in an aggregated state, public disclosure of the kind proposed by the Commission, according to commenters, "could allow for the reverse engineering of proprietary trading strategies."
Disclosure of the kind contemplated by the proposal is potentially harmful to markets, generally.
"Even if it is not possible to reverse engineer the trading strategy of a specific institutional investment manager, much of the contemplated data would be the result of proprietary trading strategies developed by institutional investment managers. Using this data, traders could still reconstruct these proprietary trading strategies and, in turn, create disincentives for institutional investment managers when considering trading strategies that involve short positions. This would ultimately be a detriment to market efficiency because, as noted by the Commission, short selling can be beneficial for the provision of information to markets." [5]
d. Affect on Securities Lending. The increased burden on market participants and additional costs associated with compliance with the proposed short sale reporting regime could have knock-on effects in the securities lending industry as well.
"Adoption of Rule 13f-2 as drafted could have a negative impact on the securities lending market, as short selling relies on the ability to borrow securities that are available for loan. As further noted by the SEC, the Proposal would increase the cost of short selling, particularly large short positions, which could potentially lead to less overall short selling.13 When investors borrow shares, they pay a borrowing fee to the owner of the share. These fees can represent a significant source of revenue for pension funds, mutual funds, and other market participants on the buy-side. Therefore, to the extent that the Proposal discourages short selling, it may also lower overall portfolio returns, not just for the clients of institutional investment managers, but also for institutional investors that rely on securities lending as a source of passive return." [6]
e. Feasibility of "Buy to Cover" The feasibility of the proposed "buy to cover" order marking requirement was a major issue raised by many commenters. Imposing the new order marking requirement would impose significant costs as well as technological and practical challenges. According to the Financial Information Forum, "every institution would need to develop and maintain processes to validate in real-time for every buy order whether the buy order is a buy to cover order. There also would be a significant cost for broker-dealers to accept and process this order marker."
Even the proposal's attempt to "minimize costs to broker-dealers" is problematic to the industry:
"The Rule Proposal proposes a new methodology for determining positions in an attempt to "minimize costs to broker-dealers," but this new methodology will actually significantly increase the costs because it will require market participants to create two separate positions in real-time, one for sell order marking and an entirely different set of positions for buy order marking." [8]
Financial data and technology companies, like S-3 Partners, raised concerns about whether current information systems employed by investment managers would be able to handle the kinds of reporting demanded by the Proposal, noting that, "certain provisions of the Proposed Rule, including the activity monitoring required by Information Table 2, will be a substantial lift on the part of the investment managers’ internal systems."
Conclusion
Given the strong pushback from investment managers and others, the SEC will have to seriously consider the final rule's cost, structure, and practical effect.
[1] Institutional Investment Managers as defined under Section 13(f)(6)(A) of the Exchange Act.
[2] The proposal would apply to certain institutional investment managers who hold, in an equity security of a reporting issuer, a short position of at least $10 million or the equivalent of 2.5 percent or more of the total shares outstanding, or who hold, in an equity security of a non-reporting issuer, a short position of at least $500,000.
[3] Notably, the proposal seeks comment on a potential alternative disclosure approach where, rather than aggregating managers' data together, each investment manager's Form SHO filings would be made publicly available (but masking the manager's name and other identifying information).
[4] Thomas Deinet, Executive Director, Standards Board for Alternative Investments Limited, London, April 26, 2022
[5] Valerie Dahiya, Partner, PerkinsCoie, Washington, D.C., April 26, 2022
[6] Id. at p. 5.
[7] Proposing Release, p. 14968.
[8] Howard Meyerson, Managing Director, Financial Information Forum, April 25, 2022, p. 2