Playing by Hong Kong's new rulebook on short selling
Hong Kong lawyer Greg Heaton examines new regulations and reporting requirements from the Securities and Futures Commission
Short sellers of Hong Kong-listed securities are now required to report their short positions to the Securities and Futures Commission, which publishes the data. To discourage free-riding and herding, where investors blindly follow a big-name short position holder, names of the short sellers are not revealed and the data is aggregated for each stock.
What is short selling?
Short selling is when you sell an asset you don't own, with the intention of buying it to transfer to the purchaser at a later date. If the price of the asset falls, the seller can make a profit.
Short selling can make the market more efficient and aid with price discovery, helping ensure shares are accurately priced, considering all available information. But it can also exacerbate market instability, so most countries regulate it.
In Hong Kong, short selling of certain listed shares is allowed, provided the seller has an exercisable right to vest the shares in the purchaser. In other words, the seller must have "borrowed" the shares, typically from a bank that holds them in custody for other investors. This is called "covered" short selling. "Naked" short selling is banned.
What must be disclosed?
The new reporting requirements apply to listed shares of large companies and financial institutions. Short positions reaching prescribed thresholds each Friday must be reported to the SFC the following Tuesday. The SFC also has power to require daily reporting during market crises.
The reporting threshold is 0.02 per cent of the company's listed shares, which is far lower than in most jurisdictions.
A reporting requirement also arises when a short position reaches HK$30 million, even if it is under 0.02 per cent.
The SFC says these low thresholds are necessary because there is relatively little short-selling activity in Hong Kong. It has not explained how a short position that is small in percentage terms could be systemically important.
Who must report jointly owned positions?
Without careful legal drafting, duplicate reporting requirements would arise in cases of joint ownership - leading to greater regulatory burden and inaccuracy in the aggregate data. Accordingly, short positions of a trust are reportable by the trustee, while beneficiaries of a trust are expressly exempted from reporting.
Short positions attributable to a partnership need only be reported by one of the partners. There is no equivalent exemption for joint owners of managed accounts, so the rules impose a separate disclosure obligation on each joint owner.
A person's positions attributable to a partnership must be treated separately and not aggregated with those attributable to another partnership. Implicitly, they must also be treated separately from any other positions the person may have. There are no equivalent provisions for trustees, although the intention is that positions of a trust must not be aggregated with a trustee's other positions, such as in another trust.
What about multiple positions within one entity?
An entity may simultaneously have both long and short positions in one stock. The rules require reporting only of net short positions - where an entity's short position is greater than its long position. However, some large market players, such as banks, typically conduct trading activities through a number of trading units. Although parts of a single legal entity, the trading units may have different strategies, and the bank may monitor their positions separately.
The SFC has issued guidance that such market participants should report the sum of short positions across the trading units, without netting off positions against different trading units. This guidance is inconsistent with the legislation, which requires calculation of net positions on a legal entity basis.
There is an exception for positions attributable to a managed fund, which must be treated separately and not aggregated with those of other funds.
Accordingly, in the case of an umbrella fund structured as a single corporation, the corporation may have separate reporting obligations with respect to each sub-fund, and there is no netting of short and long positions between different sub-funds.
Somewhat inconsistently, there is no provision enabling an owner of managed accounts to treat each of the managed accounts separately. Consequently, an investment manager may be unable to assume the reporting obligation for its clients, as the investment manager will not necessarily know a client's overall holdings.
What are the penalties for non-compliance?
Despite strong objections during public consultation, the SFC insisted that a breach of the reporting requirements should constitute a criminal offence, punishable by a HK$100,000 fine and two years' imprisonment.