Securities rules short on practicality

Even the best of legal amendments can go awry if they are based on knee-jerk reactions. Such is the case with Hong Kong's latest rules on reportable short selling activities. From July 3, offenders under the new regime will face a maximum fine of $50,000 and one year's imprisonment.

The requirement for financial institutions and investors to report short selling orders where the securities concerned are borrowed or on loan was first mooted in the summer of 1998. Hong Kong's financial regulators felt at the time the territory was besieged by hedge traders determined to destroy the local currency's peg to the US dollar through heavy selling in local markets.

A 30-point program was subsequently formulated to "safeguard the markets from the failure of price-discovery and lack of transparency brought about by non-compliance with the disclosure rules of short selling".

Market confusion

The rules announced this week contain three main elements:

• maximum penalties for naked short selling increased to a fine of $100,000 and two year's imprisonment;
• requirement for sellers and intermediaries to disclose and confirm whether the transactions are short selling orders; if so, do the sellers have a securities borrowing and lending agreement (SBL);
• SFC empowered to make rules to require stock lenders to keep records of their lending activities.

The sections that have caused much confusion in the market are what constitute a short selling order under the new rules, when does it become reportable, and how it can be proved that the order has been reported.

Under the original draft, for example, a fund manager who shorts securities that are held by their custodian would have breached the new rule if its custodian has lent the securities concerned to other parties and the manager fails to report this to the trader.

Legislators have now excluded transactions so arranged from the definition of a short selling order after much negotiation with the industry, but not before being confronted with the prospect that more than 80% of all Hong Kong equities available for stock lending would have to be recalled and lending terminated if the rules remained unchanged. This is according to figures provided by PASLA (Pan Asia Securities Lenders Association), a group of 36 companies engaged in the securities borrowing and lending business.

But impracticalities still mar the present laws. Under the new rules, a fund manager acting as an agent to convey short selling orders to a broker is required to obtain documentary assurance from its principal that there is an SBL in place.

But as the Securities Law Committee of the Law Society of Hong Kong points out, since the fund manager is vested with discretionary authority, it serves absolutely no purpose for the fund manager to seek an assurance from the principal - in this case, the trustee or the underlying beneficiaries of the fund, not to mention that it would be impractical to do so.

As to market-neutral strategists, such as hedge fund managers, whom the legislation primarily targets, they would carry the heaviest burden of reporting, as most of their investment strategies revolve around short selling borrowed securities and derivatives.

The trader conducting the transaction is also legally bound to confirm with the seller whether it's a short selling order. Failing to do so could land the trader in jail.

What's next?

Furthermore, the laws require that the assurance of whether the short selling order is backed by an SBL be recorded in "documentary form", and be retained for one year, so that the industry watchdog, the Securities and Futures Commission, could have an audit trail to sniff for irregularities if it wishes.

The industry says this is going to be a headache as retaining the tapes for 12 months would be "burdensome". They are also understandably peeved that their colleagues in futures trading are only required to keep their tapes for three months.

Pauline Ashall, partner at law firm Linklaters & Alliance, is concerned Hong Kong may lose some securities lending departments to other countries since the revenue generated by securities lending desks are regional and as such could be moved to other regional centres. There are 21 companies in Hong Kong that have securities lending desks, some of which are the lead product for their Hong Kong office.

Where market-neutral strategists are concerned, the truth of the matter is approximately 90% of hedge selling is for arbitrage purposes, not for unhedged directional short position taking. And it has been predicted that alternative investment today could be the mainstream investment 10 years from now. Pension funds and fund managers are increasingly using market-neutral strategies to hedge their risk because of their low risk appetites.

If a couple of hedge fund managers can force the Hong Kong government to impose such backward rules now, what's next?