FSA and short selling

Neil Hodge

Like something out of Lewis Carroll's Alice in Wonderland, the UK's financial regulator has set in motion plans to stop short selling – while still insisting that the practice is legitimate and without the resources, it seems, to actually check whether it can control the abuse anyway

In June, and to much fanfare due to its harsh, rash and – the jargon word of the moment – its “proactive” nature – the FSA boldly issued new provisions in its Code of Market Conduct that any person with a short position of 0.25 percent or above in a company in a rights issue period must disclose that information. This was done so that incidents of market abuse – particularly in economically volatile times – could be curbed, especially as rumours were rife that shares in banking group HBOS were being sold short ahead of its planned rights issue.

However, just six weeks later on August 1, the regulator announced that it had been unable to prove that short sellers deliberately trashed the bank’s shares to profit illegally from the falling price – despite its assertion that there was "no doubt" that false rumours were spread through the market in March, resulting in the value of the company’s shares dropping by 17 percent in just half an hour at one point.

The admission is a blow to market confidence – particularly as the regulator had rushed in the rules specifically in the wake of HBOS’ planned rights issue. The FSA called off its investigation, saying it was “extremely difficult” to prove individuals had profited from market manipulation. But why did the FSA think it would be easy?  Did it not occur to the City watchdog that such evidence would be buried or disguised?

The key to effective enforcement is knowing what is permissible and what is not, and it is in this basic logic that the financial watchdog became unstuck. It is ludicrous for the FSA to say in one sentence that short selling – aiming to profit by borrowing shares and then selling them in the expectation that the price will fall before they have to return the shares to the lender – is a legitimate technique, but then claim in the next that the practice can lead to market abuse and needs to be checked. The argument is neither consistent nor a thought-through response to a perceived problem.

Those affected by short selling see the practice in very clear terms, however. Sir John Ritblat, honorary president of the British Land Company, has described the business of taking temporary and often damaging short positions as little more than “corporate whoring” – because the real estate sector is one of the most shorted on the London stock exchange. Even some fund managers are taking aim at the practice. Henderson Global Investors, which runs a £1.5bn property securities business, has now blocked lending its property equities to short-sellers after finding that almost its entire holdings in certain companies were being borrowed. Patrick Sumner, the head of property equities, said the fund manager now has a permanent instruction to its bank not to lend for shorting purposes, saying “why should we help people to short stocks that we are long in?”

It is now clear that the FSA acted too hastily, and many have queried the justification for its invocation of special powers of the Financial Services and Markets Act 2000 which enabled it to take this measure without consultation. Even at the time, the FSA accepted that it may have to adapt the rules “according to what other issues may arise” as it accepts that “there may be loopholes”.

If regulation is going to be effective, people need to be clear about what they are enforcing. To vilify short selling in some circumstances and not all will only result in more confusion and inadequate protection.