Outreach Blog

Friday, September 30, 2022

Serious Doubts About the SEC's Short Sale Proposals

Disclosures Could be a Real Challenge for Managers and Brokers


Author: David Schwartz J.D. CPA

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:

  1. "buy to cover" order marking information, and 

  2. 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: 

  1. 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. 

  2. 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

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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