EU Short Selling Regulation is Effective November 1, 2012 and Appears to Have Cross-Border Reach

The EU Short Selling Regulation, No. 236/2012, that took effect on November 1, 2012 is essentially based on two pillars: 1) prohibiting provisions for uncovered short sales and certain transactions in credit default swaps; 2) transparency provisions for net short positions. An exemption is provided for the activities of market makers. As a prerequisite for the exemption, the activity must be notified to the competent authority and the respective transaction must be rendered as part of a market maker activity. Moreover, according to BaFin, it will also be possible in future for primary dealers to use the exemption. The Short Selling Regulation is binding and has immediate effect; and thus does not have to be transposed into national  legislation.

The Short Selling Regulation sets out three prohibiting provisions: for uncovered short sales in shares, for sovereign debt and for uncovered sovereign credit default swaps A short sale is allowed only if at the time of the short sale one of the coverage options provided by Article 12(1a)-(1c) of the Regulation has been used. The prerequisite for this is that the transaction is capable of being settled when due.

The prohibition of uncovered short sales in sovereign debt pursuant to Article 13 of the Regulation is similar to the prohibition of uncovered short sales in shares. Similar conditions have to be satisfied, particularly with regard to coverage. However, this prohibition, unlike the prohibition on short sales in shares, may be suspended by the competent national authority for up to twelve months if it has negative effects on the liquidity of the sovereign debt.

A credit default swap (CDS) is covered if the collateral taker holds a long position in a debt instrument of the reference entity and by means of the CDS wishes to hedge the default risk of the sovereign issuer. The CDS is also covered if it hedges a risk of a decline in value of a sovereign debt instrument and the collateral taker holds assets or has liabilities that are correlated with the sovereign debt instrument.

The Regulation lays down transparency requirements for shares. In contrast to the existing rules, however, transparency requirements in future will also apply to sovereign debt, and, subject to certain conditions, to credit default swaps..

The purpose of notifications of net short positions is to provide national authorities as well as ESMA, to which certain notifications and positions are forwarded by the national authorities on a quarterly basis, with an overview of the short positions that are potentially relevant by reason of their size. If a net short position in shares reaches or falls below the thresholds, the position must be notified to the national authority and published. Unlike the transparency requirement for shares, sovereign debt instruments are subject only to a notification requirement

Notification of uncovered positions in sovereign credit default swaps is required only if a supervisory authority suspends the restrictions on uncovered swaps pursuant to Article 14(2) of the Short Selling Regulation (Article 8 of the EU Short Selling Regulation). The respective reporting thresholds are then equal to the thresholds for net short positions in the respective 
sovereign debt instruments.

The calculation of net short positions in shares must include all financial instruments held by the respective holder, such as exchange traded funds or futures. If several funds or portfolios are managed by one management entity, the net short position is initially calculated at the level of each individual fund or portfolio according to the general rules. The existing net short positions are not notified individually for the funds but are initially aggregated depending on the investment strategy of the management entity. The investment strategy may be oriented towards a net short position or a net long position of the respective fund. In the second step, net short positions with the same investment strategy are aggregated at the level of the management entity. This total net short position must be notified to the competent authority and, if applicable, published. If the management activity is delegated to an external third party, the latter aggregates its net short positions of the same investment strategy.

The relevant time for calculating the net short positions is at midnight at the end of a trading day (Article 9(2) of the Regulation). Notifications and, where applicable, publications in future must be submitted not later than 3.30 p.m. on the following trading day. The time in the Member State whose authority has to be notified of the relevant position is decisive.

According to BaFin, the provisions of the EU Short Selling Regulation are also applicable outside the EU and to natural or legal persons from third countries. In this regard it does not matter where the transaction in question is concluded, nor what nationality the involved parties have nor where they have their registered office.

In the view of the Alternative Investment Management Association, there has been a lack of clarity on the question as to whether the provisions of the Regulation, either in whole or in part, apply to persons situated outside the EU. AIMA noted that an EU Regulation passed by the legislative institutions of the European Union under Article 114 of the Treaty on the Functioning of the European Union will bind persons domiciled and established within the EU, but will not apply to persons domiciled and established outside the EU unless expressly stated otherwise in the relevant EU Regulation.

Article 10 of the Short Selling Regulation explicitly states that the transparency requirements contained in Articles 5 to 8 apply to natural or legal persons domiciled or established within or outside the Union. Thus, AIMA said that  persons domiciled or established outside the European Union should be required to comply with the transparency requirements. But the Regulation does not expressly apply the restrictions on short selling of shares. 

But the Regulation makes no attempt to apply the restrictions on short selling of shares and sovereign debt or on the taking of uncovered positions in credit default swaps to persons domiciled or established outside the EU. After seeking clarification on this issue from both ESMA and the European Commission, AIMA was informed that the informal opinion of EU legal services is that the Regulation was intended to have, and so has, global applicability in respect of both the transparency requirements and the restrictions it imposes. This position is reflected in ESMA’s answer to Q1a in its first set of Q&As, dated 13 September 2012. Whether or not the Commission’s analysis is correct, AIMA advised its members that unless and until such view is successfully challenged in court it is likely that it will be this view upon which any enforcement actions will be based.