2008

THE PARLIAMENT OF THE COMMONWEALTH OF AUSTRALIA

HOUSE OF REPRESENTATIVES

EXPLANATORY MEMORANDUM

(Circulated by the authority of the
Minister for Superannuation and Corporate Law, Senator the Hon Nick Sherry)

Glossary                                                                                                               1

General outline and financial impact................................................................ 3

Outline                                                                                                                  3

Summary of regulation impact statement........................................................ 4

Regulation impact on business........................................................................ 4

Chapter 1           Introduction............................................................................. 5

Chapter 2           Schedule 1 — Amendments commencing on Royal Assent    7

Chapter 3           Schedule 2 — Amendments commencing on the 28^th day after Royal Assent   11

Chapter 4           Schedule 3 — Amendments commencing on Proclamation    15

Chapter 5           Regulation impact statement.............................................. 25

Index                                                                                                                   35

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The following abbreviations and acronyms are used throughout this explanatory memorandum.

Outline

The Corporations Amendment (Short Selling) Bill 2008 (the Bill) addresses certain aspects of the regulation of short selling.  The Bill contains three key measures:

•       Clarification of ASIC’s powers:  The Bill clarifies ASIC’s powers to regulate short selling of financial products and transactions that have a substantially similar market effect as short sales under the Corporations Act.  These amendments are for the avoidance of doubt and aim to provide certainty to both ASIC and industry regarding the scope of ASIC’s powers in this area.

•       Prohibition on naked short selling:  The Bill repeals sections of the Corporations Act that allow certain financial products to be sold even though the seller does not have a presently exercisable and unconditional right to vest the products in the buyer.  In a general sense, these transactions are commonly known as ‘naked short sales’.

•       Disclosure of covered short sales:  The Bill requires the disclosure of covered short sale transactions.  Covered short sales are sales supported by securities obtained under a securities lending agreement.  Regulations will set out the timing and manner of the disclosures.

Date of effect: Sections 1 to 3 of the Bill commence on Royal Assent.  Schedule 1 of the Bill commences on Royal Assent.  Schedule 2 commences on the 28^th day after Royal Assent.  Schedule 3 commences on a single day fixed by Proclamation but no later than 12 months after the Act receives Royal Assent.

Financial impact:  This Bill has no significant impact on Commonwealth expenditure or revenue.

Compliance cost impact:  In relation to the clarification of ASIC’s powers (Schedule 1), these measures are not considered to have a regulatory impact because they are designed to provide certainty in relation to the scope of ASIC’s powers.

In relation to the prohibition on naked short sales (Schedule 2), these measures have a low compliance cost impact on business because of the limited occurrence of naked short selling on Australian financial markets.

In relation to the disclosure regime (Schedule 3), these measures have a transitional and ongoing compliance cost impact on business.  The amount of the compliance cost impact will be determined by the details to be prescribed through Regulations.  As such, it is not possible to quantify the costs until the Regulations are made.  These issues are outlined in the Regulation Impact Statement.[1]

Summary of regulation impact statement

Regulation impact on business

Impact:  The amendments have a transitional and ongoing regulatory impact on investors that engage in covered short sale transactions, AFS Licensees (brokers) that execute covered short sale transactions and financial market operators.

Main points:

•       The disclosure regime will mean greater transparency in relation to covered short sales in Australian financial markets.  This will assist in enhancing market confidence by reducing market rumour and speculation about the activity of short sellers.

•       The main cost of the regime is the compliance burden for investors, brokers and market operators that are required to collect and report information relating to covered short sales.

Clause 1: Short title

1.1                   The Act may be cited as the Corporations Amendment (Short Selling) Act 2008.

Clause 2: Commencement

1.2                   Sections 1 to 3 are formal provisions and commence on Royal Assent.  Schedule 1 is to commence on Royal Assent.  Schedule 2 is to commence on the 28^th day after Royal Assent.  Schedule 3 is to commence on a date to be fixed by proclamation.  However if the provisions do not commence within 12 months of the Act receiving Royal Assent, they commence on the first day after the end of that period.

1.3                   Schedule 3 contains the amendments to require the disclosure of covered short sale transactions.  This provision will commence on proclamation to provide sellers and AFS Licensees with a transitional period before compliance with the law is required.  It is understood that the new disclosure regime will require IT and other administrative changes.  While the scope of the IT and other administrative changes will not be fully known until regulations are in place, some parts of industry have suggested the changes may take up to 12 months to complete in order to enable electronic reporting of these transactions.

Clause 3: Schedules

1.4                   Schedule 1 amends existing section 1020F of the Corporations Act and inserts new section 1484 to clarify ASIC’s existing powers in relation to short selling.  Schedule 2 amends existing section 1020B to prohibit certain short sales.  Schedule 3 inserts new Division 5B in Part 7.9 to require the disclosure of covered short sale transactions.

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Outline of chapter

2.1                   Schedule 1 of the Bill contains amendments to clarify ASIC’s powers under the Corporations Act 2001 in relation to short selling.

Context of amendments

2.2                   ASIC has the power under paragraph 1020F(1)(c) of the Corporations Act to omit, modify or vary certain parts of the Corporations Act through declarations.  These declarations generally take the form of Class Orders issued by ASIC.

2.3                   In September 2008, ASIC used this power to issue a declaration that required the disclosure of covered short sales.  However, shortly after this declaration, ASIC took further action to ban covered short sales.  The disclosure requirements applied to covered short sale transactions taking place because of the exceptions to the ban.  This declaration was made in light of the unprecedented volatility experienced on Australian and global financial markets during this period and international regulatory developments occurring at the time.  ASIC has since made a number of other declarations providing limited relief from the short selling ban.

2.32.4          ASIC’s power to omit, modify or vary the Corporations Act through declarations is general in nature.  Given that ASIC may be using these powers to respond to emergency situations, it is essential to address any possible uncertainty surrounding the scope of ASIC’s powers.  The amendments are designed to put the matter of ASIC’s powers in relation to short selling beyond doubt.

Summary of new law

2.5                   The Schedule contains two key reforms:

•       The first reform amends ASIC’s general exemption and modification power in section 1020F of the Corporations Act to clarify that it includes specific actions in relation to any form of short selling and transactions with a substantially similar market effect as short selling.

•       The second reform amends the Corporations Act to expressly state that the declarations made by ASIC in relation to short selling were within the scope of its power to omit, modify or vary certain parts of the Act.

2.6                   Both reforms are for the avoidance of doubt only.

Comparison of key features of new law and current law

Detailed explanation of new law

2.7                   Item 1 of Schedule 1 to the Bill amends existing section 1020F of the Corporations Act to clarify the application of ASIC’s powers under paragraph 1020F(1)(c) in relation to any form of short selling of financial products and transactions with the same or substantially similar market effect as a short sale of financial products.  Transactions with a substantially similar market effect are not limited to transactions that occur on a market licensed under the Corporations Act.  It may include transactions that occur off a licensed market if it can be proven that the transaction has the same or substantially similar market effect as a short sale transaction.  [Schedule 1, item 1]

2.72.8          Item 1 clarifies the application of ASIC’s powers under paragraph 1020F(1)(c) in relation these transactions.  In particular, it amends section 1020F to state that ASIC has the power to make declarations:

•       suspending, prohibiting or limiting these transactions;

•       varying requirements under Part 7.9 that apply to these transactions;

•       removing some or all requirements under Part 7.9 that apply to these transactions; and

•       imposing requirements that apply to these transactions.

[Schedule 1, item 1]

2.9                   The amendments are made for the avoidance of doubt and are intended to remove any uncertainty in relation to the application of ASIC’s powers to short selling transactions and transactions with the same or substantially similar market effects as short sale transactions.

2.10                Item 2 of Schedule 1 to the Bill is designed to put beyond any doubt that the Class Orders specified in new subsection 1484(2) were validly made.  These Class Orders were made by ASIC under paragraph 1020F(1)(c) of the Corporations Act.  In substance, the Class Orders imposed a ban on covered short selling subject to limited exemptions and required disclosure in relation to the exempted transactions.  The Class Orders were made publicly available by being published on the Federal Register of Legislative Instruments and on ASIC’s website.  Steps were also taken to through the Australian Securities Exchange to inform market participants.  [Schedule 1, item 2]

2.102.11   The amendment is necessary, in order to put beyond any doubt that individuals who organised their affairs in accordance with the Class Orders have complied with the requirements of the Corporations Act and may, with confidence, continue to conduct their affairs accordingly.  The Class Orders were publicly available and expressed to have valid and binding legal effect.  The amendment operates for the benefit of parties who organised their affairs in accordance with the Class Orders, and will, importantly, provide certainty to business.

2.12                Further, new subsection 1484(3) puts beyond any doubt that Class Orders that are of substantially the same nature as the instruments mentioned in subsection 1484(2), and that are made after 24 October 2008 and before commencement of section 1484, are validly made.  These Class Orders (if any) should be publicised in essentially the same way as the Orders specified in subsection 1484(2).  The amendment also clearly alerts market participants to the future status of such Orders under the Corporations Act.

Application and transitional provisions

2.13                Item 1 of Schedule 1 applies from the date of commencement (that is, on Royal Assent).  Item 2 of Schedule 1 applies on and from 19 September 2008.  This is date on which ASIC issued its first declaration relating to short selling (it was subsequently lodged on the Federal Register of Legislative Instruments on 22 September 2008).  [Schedule 1, item 2]

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Outline of chapter

3.1                   Schedule 2 of the Bill contains amendments to prohibit certain short sale transactions.

Context of amendments

3.2                   The Corporations Act, at subsection 1020B(2), provides that a person can only sell certain financial products if the person has, or believes on reasonable grounds that they have, a presently exercisable and unconditional right to vest the products in the buyer.  If the person is selling the products on behalf of another person (for example, a broker selling on behalf of a client), the other person (the client) must have, or believe on reasonable grounds that they have, a presently exercisable and unconditional right to vest the products in the buyer.

3.3                   The Act, however, allows certain exceptions to this rule.  For the most part, the exceptions to this rule are commonly referred to as ‘naked short sales’.

3.33.4          Various concerns have been expressed in relation to naked short selling.  Transactions of this nature may have a higher risk of settlement failure (because the seller does not have a presently exercisable and unconditional right to vest the products at the time of sale).  They may also distort the operation of financial markets by causing increased price volatility and potentially facilitating market manipulation.  In addition, the perceived activity of naked short sellers is likely to damage market confidence particularly among retail investors.  For these reasons, naked short selling has the potential to damage the integrity of Australian financial markets.

3.5                   In light of this, and given the limited evidence of any significant, market-wide benefits from naked short sale transactions, it was considered appropriate to remove the general ability for people to enter into these transactions under the Corporations Act.

Summary of new law

3.6                   The amendments prohibit naked short selling.

3.63.7          Under section 1020F of the Corporations Act, ASIC has the ability to grant exemptions from this prohibition.

Comparison of key features of new law and current law

Detailed explanation of new law

3.8                   The amendment removes the exceptions from the existing requirement in subsection 1020B(2) for a person selling a section 1020B product to have, or believe on reasonable grounds they have, a presently exercisable and unconditional right to vest the products in the buyer.  If the person is selling the products on behalf of another person (for example, a broker selling on behalf of a client), the other person (the client) must have, or believe on reasonable grounds they have, a presently exercisable and unconditional right to vest the products in the buyer.

3.83.9          In particular, Schedule 2 repeals exceptions from subsection 1020B(2) relating to:

•       odd lot transactions (existing paragraph 1020B(4)(a));

•       arbitrage transactions (existing paragraph 1020B(4)(b));

•       transactions where arrangements have been made before the time of sale that will enable delivery of the products in time for settlement (existing paragraph 1020B(4)(d)); and

•       transactions made under a declaration from the operator of a licensed market in accordance with the operating rules of the market (existing paragraph 1020B(4)(e)).

[Schedule 2, item 2]

3.10                In addition, existing subsections 1020B(5) and 1020B(6) and section 1020C relating to the operation of subsections 1020B(4)(b), 1020B(4)(d) and 1020B(4)(e) are repealed because they are no longer necessary.  [Schedule 2, items 2 and 3]

3.11                Schedule 2 inserts new subsection 1020B(4) made up of the existing paragraph 1020B(4)(c).  This subsection applies to circumstances where a seller has previously purchased the section 1020B products being sold, but that purchase agreement is conditional only upon a limited range of factors.  This subsection allows a seller to sell the products acquired through the purchase agreement even though the seller may not have a presently exercisable and unconditional right to vest the products in the buyer because the purchase agreement to acquire the products is still conditional at the time of sale.  The existence of the prior purchase agreement means that the transaction falls short of true naked short selling.  For this reason, it is not necessary to repeal this exception.  [Schedule 2, item 2]

3.113.12   ASIC has the power under section 1020F to issue exemptions for subsection 1020B(2) that would allow naked short sales in certain circumstances.

Consequential amendments

3.13                Schedule 2 amends subsections 1020B(1), 1200F(1) and Schedule 3 of the Corporations Act to remove references to sections that are repealed by the Bill.  [Schedule 2, items 1, 4 and 5]

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Outline of chapter

4.1                   Schedule 3 amends the Corporations Act 2001 (the Corporations Act) to require the disclosure of transactions to sell section 1020B products when the seller has entered into a securities lending arrangement.

Context of amendments

4.2                   The Corporations Act, at section 1020B, currently regulates short selling of securities, managed investment products and certain other financial products (section 1020B products).

4.24.3          Section 1020B generally prohibits the sale of a section 1020B product unless a person has a ‘presently exercisable and unconditional right’ to vest the product at the time of sale.

4.4                   Short sellers need to make arrangements to cover their delivery obligations before they fall due.  This is normally done by:

•       making a matching purchase at some point following the sale but before delivery falls due; or

•       borrowing an equivalent amount of securities before delivery falls due, either before they enter into the sale or at some time between making the sale and when required to make delivery.

4.5                   A naked short sale occurs where a seller does not own or has not borrowed or arranged to borrow securities at the time of sale but intends to purchase or borrow securities in order to meet the three business day settlement obligation.

4.6                   There is some discussion about what constitutes a covered short sale.  The broadest approach is to focus on whether borrowing takes place to meet delivery obligations.  On this approach a covered short sale occurs where the seller has arranged to borrow stock in order to meet their delivery obligations.

4.64.7          A borrowing arrangement (or securities lending arrangement) occurs where the seller enters into an agreement or arrangement with a lender under which the section 1020B products will be delivered to the seller, and title transferred, on the condition that the seller will return, at a future date, the original or equivalent replacement section 1020B products to the lender.  Loans in Australia are often made using a standard form of contract, the Australian Master Securities Lending Agreement.

4.8                   While a borrowing agreement is economically a loan, there is a legal transfer of title between the lender and borrower, which allows the borrower to vest title to the section 1020B products in another person.

4.9                   There is uncertainty around the use of stock lending agreements, the application of subsection 1020B(2), and therefore the requirement to disclose to a financial services licensee, in certain circumstances, that the transaction is a short sale (subsection 1020B(5)).  It is understood that most market participants consider that a covered short sale falls within subsection 1020B(2) and so need not be disclosed.

4.94.10       Market practice has developed so that covered short sales are not usually reported to the market on the argument that they are not truly ‘short’ because the seller, relying on the borrowed stock, has a ‘presently exercisable and unconditional right to vest the product’ at the time of sale.  Some limited reporting does occur.

4.11                While a person may borrow stock any time after the sale in order to meet delivery, subsection 1020B(2) requires that a person has a ‘presently exercisable and unconditional right to vest the product’ at the time of sale.  If this is not the case, section 1020B applies to the sale.

4.12                ASIC Regulatory Guide 196 sets out the circumstances in which a seller has a ‘presently exercisable and unconditional right to vest the product’ in relation to a borrowing agreement.

4.124.13   The amendments will ensure that covered short sales are disclosed.

Summary of new law

4.14                The amendments require sellers of section 1020B products to advise their executing AFS Licensee when the sale is a covered short sale (a short sale supported by a securities lending arrangement).  In turn, the AFS Licensee must report the disclosed covered short sales to the relevant market operator.  AFS Licensees must also report principal covered short sales to the relevant market operator.

4.15                The market operator must publicly disclose reported short sale information.

4.16                The disclosure regime applies to sales made on a licensed market (such as the ASX) and sales that occur through on or off market crossings.

4.17                The disclosure requirement applies whether the seller is inside or outside Australia.

4.18                It is an offence if sellers and AFS Licensees do not provide particulars of the sale of section 1020B products, at the time and in the manner required by the regulations.  Regulations will set the mechanics of disclosure from sellers to AFS Licensees and AFS Licensees to the market operator, including when and how disclosure occurs.  Regulations will also set the manner and time of public disclosure by the market operator, which will include the disclosure of aggregate short sale information.

4.184.19   To complement the disclosure regime, AFS Licensees must also ask whether the sale is a covered short sale before making the sale.  This should assist in ensuring that clients, particularly overseas clients, understand their obligations to report those short sales.  It is an offence if AFS Licensees do not make these inquiries.

Comparison of key features of new law and current law

Comparison of key features of new law and current law (continued)

Detailed explanation of new law

4.20                Schedule 3 inserts Division 5B of Part 7.9 of the Corporations Act to require disclosure of short sales of section 1020B products covered by a securities lending arrangement.  [Schedule 3, item 3]

Key definitions for Division 5B

4.21                crossing:  an AFS Licensee makes a sale of section 1020B products either on behalf of the buyer and seller of the products, or on behalf of a client on one side of the trade and as principal on the other side.  [Schedule 3, item 3, subsection 1020AA(1)]

4.22                sale:  the entering into an agreement to sell section 1020B products is treated as the sale of the products.  [Schedule 3, item 3, subsection 1020AA(2)]

4.224.23   section 1020B products:  securities, managed investment products, a debenture, stock or bond issued or proposed to be issued by a government or financial products prescribed by regulation (existing subsection 1020B(1)).  Regulation 7.9.80B prescribes certain financial products for the purposes of subsection 1020B(1).  [Schedule 3, item 3, subsection 1020AA(1)].

4.24                securities lending arrangement:  the lender agrees to deliver particular financial products to the borrower, and vest title, on the condition that the borrower will return, at a future date, the original or equivalent replacement financial products to the lender, and vest title.  The definition of securities lending arrangement also encompasses the possibility that the lender will deliver, and vest title in, the particular financial products to a third party on the instruction of the borrower, and in return, the borrower may return the financial products to a third party nominated by the lender.  [Schedule 3, item 3, subsection 1020AA(1)]

Client and principal disclosure

4.25                The amendment governs client and principal disclosure of short sales of section 1020B products covered by a securities lending arrangement.  [Schedule 3, item 3, subsection 1020AB(1)]

4.254.26   The disclosure requirement applies:

•       where an AFS Licensee makes a sale of section 1020B products on a licensed market, on its own behalf, or on behalf of a person, to a buyer; [Schedule 3, item 3, paragraph 1020AB(1)(a)]

•       before the time of sale, the seller entered into, or gained the benefit of, a securities lending arrangement; [Schedule 3, item 3, paragraph 1020AB(1)(b)]

•       at the time of sale, the seller intends that the securities lending arrangement will ensure that some or all of the section 1020B products can be vested in the buyer.  [Schedule 3, item 3, paragraph 1020AB(1)(c)]

4.27                The disclosure requirement applies to both client and principal trading in section 1020B products on a licensed market.  A crossing of a section 1020B product is treated as being made on a licensed market.  On the ASX, a crossing is conducted by an ASX participant but may occur on or off‑market.  Crossings are treated as being made on a licensed market, whether the crossing occurs on or off‑market.  [Schedule 3, item 3, subsection 1020AA(4)]

4.28                The definition of securities lending agreement covers the circumstances where a seller has entered a securities lending arrangement, or received the benefit of such an arrangement, before the time of sale.  Such a benefit could arise if the borrower directed the lender to vest the section 1020B products in a third party, who subsequently short sells.  [Schedule 3, item 3, subsection 1020AA(1) and paragraph 1020AB(1)(b)]

4.284.29   For the avoidance of doubt, the amendments clarify that a sale in economic substance is treated as if the sale is made by an AFS Licensee on behalf of a person.  An example includes that a sale request is passed from the person to the AFS Licensee through a chain of intermediaries.  [Schedule 3, item 3, subsection 1020AA(3)]

Mechanics of disclosure

4.30                It is an offence if client and principal sellers (AFS Licensees) do not provide particulars of the sale of 1020B products, at the time and in the manner required by the regulations.  The particulars include when disclosure occurs and the manner of such disclosure.  [Schedule 3, item 3, subsection 1020AB(3)]

4.31                This will facilitate disclosure from client sellers to AFS Licensees, and AFS Licensees (as principal sellers) to the market operator.  [Schedule 3, item 3, subsection 1020AB(4)]

4.314.32   Details about the mechanics of disclosure are to be included in the regulations so that the regime is able to adapt more readily to the rapid and ever evolving changes in markets, and the mechanisms by which transactions occur.  The matters to be contained in the regulations will specify the technical requirements of disclosure.

4.33                The penalty for the offence is the same as the penalty that was in place under the former short selling disclosure regime under repealed subsection 1020B(5).  [Schedule 2, item 2]  The penalty is 25 penalty units or imprisonment for six months, or both.  [Schedule 3, item 6]

4.34                The requirement to provide particulars of the sale of section 1020B products, at the time and in the manner required by the regulations, applies whether the seller is inside or outside Australia.  [Schedule 3, item 3, subsection 1020AB(2)]

4.344.35   The ability of the regulations to allow things to be specified differently for different kinds of persons, things or circumstances may be relevant in this context.  For example it may not be possible for all kinds of sellers to comply with the same mechanics of disclosure under the regulations.  [Schedule 3, item 3, section 1020AF]

AFS Licensee disclosure

4.36                AFS Licensee must disclose short sales covered by a securities lending arrangement where an AFS Licensee receives information from a client on the particulars of the sale of section 1020B products on a licensed market.  [Schedule 3, item 3, paragraph 1020AC(1)(a)]

Mechanics of disclosure

4.37                It is an offence if AFS Licensees do not provide particulars of disclosed client sales of section 1020B products, at the time and in the manner required by the regulations.  The particulars include when the disclosure occurs and the manner of such disclosure.  [Schedule 3, item 3, subsection 1020AC(2)]

4.374.38   This will facilitate disclosure from AFS Licensees to the relevant market operator.  [Schedule 3, item 3, subsection 1020AC(3)]

4.39                The penalty for the offence is the same as the penalty for non disclosure by the seller under section 1020AB.  The penalty is 25 penalty units or imprisonment for six months, or both [Schedule 3, item 6].

Public disclosure of information

4.40                The relevant market operator must make a public disclosure of the sale of section 1020B products on a licensed market where they receive information from:

•       the AFS Licensee who provides proprietary short sale information to the market operator in accordance with section 1020AB.  [Schedule 3, item 3, subparagraph 1020AD(1)(a)(i)]

•       the AFS Licensee who provides client short sale information to the market operator in accordance with section 1020AC.  [Schedule 3, item 3, subparagraph 1020AD(1)(a)(ii)]

•       Directly from the seller (client) mentioned in subparagraph 1020AB(1)(a)(i).  This relates to where regulations specify that the client seller discloses to another entity other than the AFS Licensee under subparagraph 1020AB(4)(a)(ii) (see further regulation making power) [Schedule 3, item 3, subparagraph 1020AD(1)(a)(iii)]

Mechanics of disclosure

4.41                It is an offence if the relevant market operator does not provide particulars of disclosed client and proprietary sales of section 1020B products, at the time and in the manner required by the regulations.  The particulars include when the disclosure occurs and the manner of such disclosure.  [Schedule 3, item 3, subsection 1020AD(2)]

4.414.42   This will facilitate the public disclosure of aggregate and reportable short sale information.

4.43                The penalty for the offence is the same as the penalty for non disclosure by the seller under section 1020AB.  The penalty is 25 penalty units or imprisonment for six months, or both.  [Schedule 3, item 6]

Licensee’s obligation to ask seller about short sale

4.44                Where an AFS Licensee is to make a sale of section 1020B product, on behalf of a person (client), and the AFS Licensee is responsible under section 1020AB for receiving short sale information from client sellers, the AFS Licensee must, before the sale:

•       ask the seller, orally or in writing, whether the seller is required under section 1020AB to give them information in relation to the sale; and

•       record the seller’s answer in writing [Schedule 3, item 3, section 1020AE].

4.45                Under section 25 of the Acts Interpretation Act 1901, writing includes any mode of representing or reproducing words, figures, drawings or symbols in a visible form.

4.454.46   It is an offence if the licensee does not comply with section 1020AE.  The penalty for the offence is the same as the penalty for non disclosure by the seller under section 1020AB.  The penalty is 25 penalty units or imprisonment for six months, or both.  [Schedule 3, item 6]

Other regulation making powers

4.47                New Division 5B of Part 7.9 permits other regulations to be made, which could amend the operation of the disclosure requirement to:

•       require the client (seller) to disclose to an entity other than the AFS Licensee; [Schedule 3, item 3, subparagraph 1020AB(4)(a)(ii)]

•       require the AFS Licensee to disclose short sale information (from proprietary or client trading) to an entity other than the market operator.  [Schedule 3, item 3, subparagraph 1020AB(4)(b)(ii) and paragraph 1020AC(3)(b)]  That entity will also be responsible for public disclosure; [Schedule 3, item 3, section 1020AD]

•       specify the kind of section 1020B products the disclosure regime applies to; [Schedule 3, item 3, subparagraphs 1020AB(1)(d)(i)(ii), 1020AC(1)(b)(i)(ii)) and 1020AD(1)(b)(i)(ii)]

•       specify circumstances in which the sale is made; and [Schedule 3, item 3, subparagraphs 1020AB(1)(d)(iii), 1020AC(1)(b)(iii)) and 1020AD(1)(b)(iii)]

•       allow matters or things to be specified differently for different kinds of persons, things or circumstances.  [Schedule 3, item 3, section 1020AF]

4.48                This does allow, in future, an alternative approach to disclosure, which could change the vehicle for disclosure (for example, requiring sellers to disclose direct to a regulator) and target disclosure of covered short sales to particular circumstances.  This flexibility is included:

•       to allow the law to respond to an environment of rapid change, including technological innovation and ongoing developments in the conduct and structures of financial markets; and

•       because the new disclosure requirement will facilitate greater understanding of this area and may reveal a case for change to target the disclosure requirement to better serve the objectives of disclosure.  One example could include targeting of reporting requirements to particular kinds of section 1020B products, such as securities of a particular sector.

Consequential amendments

4.49                The amendment reflects that new Division 5B applies in relation to securities and debentures, stocks and bonds issued by government. [Schedule 3, items 1 and 2]

4.50                The amendment reflects that the definition of section 1020B products is applicable also to Division 5B.  [Schedule 3, item 4]

4.51                The amendment reflects that the new short selling disclosure provisions are not excluded from recognised offers under Chapter 8 of the Corporations Act.  Section 1200F(1) of the Act lists provisions that do not apply to recognised offers with New Zealand.  Short selling provisions, however, do apply.  [Schedule 3, item 5, subsection 1200F(1)]

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Policy objective

5.1                   There has been significant speculation in recent months regarding the activity of short sellers in Australian listed securities.  Short selling is an activity where a person enters into an agreement to sell a security that the person does not currently own.  Short sellers need to make arrangements to cover their delivery obligations to the buyer before they fall due (usually three trading days after the transaction is executed).  This is normally done by:

•       making a matching purchase at some point following the sale but before delivery falls due; or

•       borrowing an equivalent amount of securities before delivery falls due, either before they enter into the sale or at some time between making the sale and when required to make delivery.

5.2                   There are two types of short sale transactions: naked and covered.  A naked short sale occurs when a seller does not own and has not borrowed or arranged to borrow securities at the time of sale but intends to purchase or borrow securities in order to meet the delivery obligation.  A covered short sale occurs when the seller has entered into an agreement to borrow the security in order to meet their delivery obligations prior to entering into the arrangement to sell the security.

5.3                   Currently, short selling of Australian securities is prohibited under the Corporations Act 2001 unless a person has a ‘presently exercisable and unconditional right’ to vest the product at the time of sale.  The prohibition is subject to a number of exemptions, which permit short selling in a defined range of circumstances.  The most commonly used exemption allows a person to enter into naked short sale transactions subject to some conditions imposed by the Australian Securities Exchange (ASX) through its Market Rules.  These conditions place a limitation on the range of securities that can be subject to naked short sales and requires disclosures surrounding these transactions.  Reported end of day net‑short positions reported to ASX are between 0 and 2 per cent of share trading volume.

5.35.4          In relation to covered short sale transactions, market practice has developed so that these transactions avoid the prohibition in the Corporations Act on the grounds that the seller is not truly ‘short’.  This is based on the argument that the seller, relying on the agreement to borrow stock, has a ‘presently exercisable and unconditional right to vest the product’ at the time of sale.  As a result of this, there is currently very little regulation relating to covered short sale transactions involving Australian securities.  As a result of this, there is currently no disclosure applicable to these transactions.  This makes it difficult to determine the amount of covered short sale activity taking place in Australian securities.  However, it is believed that covered short sales are more common than naked short sales.  An estimate of the amount of covered short selling activity can be derived from measures of the total value of securities available for lending.  The Reserve Bank of Australia has reported that the value of equities loans outstanding was around $60 billion at the end of 2007.

5.5                   It should be noted that some borrowed securities are used for purposes other than short selling (for example, parties may enter into a securities lending agreement to facilitate an arbitrage transaction relating to the security or to cover potential settlement failures), so this figure overstates the amount of covered short sale activity.  It is impossible to determine exactly the proportion of stock lending transactions that are used for covered short sales.  For this reason, stakeholders, including the ASX, have questioned whether stock lending data can be used as a reliable proxy for the amount of covered short sales.

5.6                   Based on the data above, it is estimated that the upper limit of short selling activity in Australian securities is approximately $60 billion.  This equates to approximately 4 per cent of the total capitalisation of Australian listed securities (based on a total ASX market capitalisation of $1.5 trillion).  The majority of this is expected to be in the form of covered short sales.  The current uncertainty surrounding the actual level of short selling activity in Australian securities is compounding the direct impact of this activity as it is resulting in rumour and speculation in the marketplace.

Issue

5.7                   The current degree of uncertainty surrounding the activity of covered short sellers in Australian securities is having a significant impact on Australian capital markets.  Currently, when a security experiences a significant decline in price, it is unclear whether this is attributed to short selling activity or other factors, which is resulting in considerable rumour and speculation regarding short selling activity and potentially adding to price volatility.  Speculation regarding the level of short selling activity in Australian securities is also having broader market implications.  Confidence in the market, particularly among retail investors, is likely to be damaged as investors express concern about the perceived activity of short sellers in the market.  A fall in market activity, and investor confidence about the integrity of Australian capital markets, will make it more difficult for companies to raise additional capital leading to an increase in the companies overall cost of capital and a fall in investment activity.

Objectives

5.8                   The objective of Government action in this area is to increase transparency surrounding the activity of covered short sellers in Australian securities.  This would provide useful information to investors and regulators and also contribute to confidence and market integrity.  In particular, disclosure of covered short selling activity:

•       will provide an early signal that individual securities may be overvalued;

•       will indicate that a proportion of the sales in an individual security will need to be reversed by new purchases (to cover the short seller’s settlement obligations);

•       will enhance investors’ willingness to participate in the market by removing uncertainty surrounding the level of short selling; and

•       may deter market abuse or reduce the opportunities for market abuse.

5.9                   The Government is not seeking to prohibit or discourage covered short selling activity.  It is recognised that covered short selling activity, appropriately regulated, is beneficial to the operation of capital markets by increasing market liquidity and pricing efficiency.

Implementation options

Option one: Retain the status quo (no regulatory action)

5.10                This involves retaining the current regulatory arrangements and seeking to encourage voluntary disclosure of covered short sales.

Option two: Disclosure of covered short sales to brokers

5.11                This involves placing an obligation on investors to disclose covered short sale transactions to their broker.  The broker will then be responsible for reporting this information to the relevant entity, for example, the market operator.

5.12                Under this option, the general disclosure requirement and the penalties for failing to disclose information would be contained in the Corporations Act.  However, supplementary regulations would be used to outline the technical aspects of the requirement including the timing of any disclosure and whether the investor is required to disclose transactions on a gross or net basis (gross disclosure would encompass any covered short sale transaction entered into by the investor whereas net disclosure would take into account any offsetting transactions entered into by the investor so only their net exposure was disclosed).  Specifying the technical aspects of the disclosure requirement in regulations provides sufficient flexibility so the requirements can be amended to take account of any changes in market activity in the future.  Given the ongoing and rapid development in the conduct and structure of financial markets, the regulations may also allow for the disclosure regime to be targeted to particular areas in the future.

Option three: Direct disclosure of covered short sales to the market operator

5.13                This involves placing a direct obligation on investors to disclose covered short sale transactions to the market operator.  As discussed under option two, this requirement would be implemented through the Corporations Act supported by supplementary regulations covering the technical aspects of the disclosure requirement.

Option four: Disclosure of stock lending transactions

5.14                This involves requiring disclosure of all stock lending transactions on the grounds that it is a sufficient proxy for the level of covered short selling activity in a particular security.  Similar to options two and three above, this option could be implemented through the Corporations Act supported by supplementary regulations.

Option five: Review existing short selling regime

5.15                This involves a wholesale review of the regulatory framework governing all short selling transactions (both naked and covered).  This review would cover the existing rules relating to short sales in the Corporations Act.

Assessment of impacts

Option one: Retain the status quo (no regulatory action)

5.16                This option has the benefit of imposing no additional regulatory costs on businesses.  However, it will not address the current issues caused by the uncertainty in the market place regarding the level of covered short selling activity.  There is no incentive for investors to disclose this information to the market.  In addition, there is little capacity for the Government to encourage investors to voluntarily disclose this information particularly in circumstances where short selling activity is being driven by foreign investors.  This means that without some level of Government intervention in the market, this information is unlikely to be disclosed.

Option two: Direct disclosure of covered short sales to brokers

5.17                This option has the benefit of ensuring the market is fully informed regarding the actual level of covered short selling activity.  As discussed above, the removal of the current level of uncertainty surrounding short selling activity will benefit the market by promoting greater market confidence, increasing the information available to investors and assisting regulators to identify potential market abuse.

5.175.18   Targeted consultation with stakeholders has indicated that the implementation of this option is likely to impose costs on market participants, particularly the market operator (ASX) and brokers.  The ASX will need to amend its trading system for Australian securities to facilitate the reporting of covered short sales by brokers.  This will also require the systems used by brokers to process sales transactions to change so that it is in line with the ASX trading system.  In addition, they may be required to amend other trading systems they offer investors for example direct market access systems.  This will be particularly relevant for those brokers that are not currently reporting naked short sales to the ASX.  The extent of these costs and the proportion of brokers that will offer their clients the ability to execute covered short sales are currently unknown.  The extent of any changes to systems is only likely to be known once the precise details of the disclosure regime are settled through any supplementary regulations.

5.19                For investors, the cost of reporting covered short sale transactions to their broker will depend on the size and complexity of their operations.  For individual investors, the costs should be relatively minimal.  However, for larger companies, particularly those with multiple trading desks, the costs could be significant.  This is because different trading desks within the company may be taking different positions in the same security at the same point in time.  The potential for simultaneous trading activity in the same security by different parts of the company makes it difficult for companies to know whether they are long or short a particular security on a real time basis.  This situation can be further complicated when the company acts as both a broker and an investor (for example, an investment bank).  Stakeholders have indicated that these costs become less significant in situations where reporting of covered short sale transactions is delayed.  The timing of any disclosure requirement under this option would be determined through the supplementary regulations.

5.20                In addition, some investors have expressed concerns surrounding the potential loss of confidentiality regarding their trading activities.  It is intended that the disclosure regime would only result in the reporting of aggregated data, so individual trades cannot be identified.  However, there may be indirect information leakage when the investor reports the trade to their broker (for example, by the broker disclosing this information to other investors).  The potential costs associated with any loss of confidentiality will be influenced by the timing of the disclosure.  For example, if disclosure is required at settlement rather than when the order is executed, the costs associated with the loss of confidentiality is reduced.  However, the information will be less useful to investors if only delayed disclosure is required.  Decisions regarding the timeliness of reporting obligations will be settled through any supplementary regulations.

Option three: Direct disclosure of covered short sales to the market operator

5.21                As this option also results in the full disclosure of covered short sales, it will have the same benefits as option two outlined above.  The primary difference between this option and option two relates to the incursion of regulatory costs.

5.22                Relative to option two, this option imposes less of a regulatory burden on brokers.  This is because investors will no longer be required to report covered short sales to their broker.  However, it is expected that it would impose a significantly greater regulatory burden on the market operator and investors.  In relation to the market operator, it is expected that the implementation costs would be significantly greater if they receive the information directly from investors rather than through brokers as proposed under option two.  This is because the market operator will need to establish processes and systems for this reporting of information directly from investors.  In contrast, under option two, the market operator would be able to take advantage of processes and systems already in place for the reporting of information between brokers and the market operator.

5.23                Investors will also be required to make significant changes to their processes and systems to facilitate the reporting of this information directly to the market operator.  These would be in addition to the costs for investors identified under option two in relation to determining their exposure on particular securities.  However, a relative advantage of this option over option two for investors relates to confidentiality.  In particular, by requiring this information to be reported directly to the market operator (rather than through a broker), there is a significantly reduced chance of information leakage regarding individual trades.  As discussed under option two, the costs to investors associated with this loss of confidentiality will be largely influenced by the timing requirements placed on disclosure which will be determined through any supplementary regulations.

5.235.24   It is expected that the additional costs incurred by investors and the market operator under this option will be greater than the costs incurred by brokers under option two.  This is because there are a smaller number of brokers (relative to investors) and the extent of change necessary to the systems will be less as brokers are already required to report information of a similar nature to market operators.

Option four: Disclosure of stock lending transactions

5.25                The benefit of requiring the disclosure of stock lending transactions is that it would provide information to the market that could act as a proxy for the level of short selling activity in Australian securities.  However, as noted above, some stakeholders have questioned whether stock lending data will provide a sufficient indication of short selling activity given stock lending transactions are used for a range of other purposes in addition to short selling.  Given this, disclosure of stock lending alone is unlikely to fully address the uncertainty in the market relating to the activities of short sellers.

5.26                The implementation of a stock lending regime will involve some regulatory costs for investors that would be required to report these transactions.  In particular, the Government understands that IT infrastructure changes would almost certainly be needed to facilitate the reporting of this information to the securities settlement systems.  Industry has informed the Government that the costs of making these changes will be influenced by the service agreements individual participants have with vendors.  However, the total regulatory cost of implementing these changes is likely to be less than the regulatory costs associated with options two and three.

Option five: Review existing short selling regime

5.27                It has been a number of years since there was a comprehensive review of the short selling regime in the Corporations Act.  A review of the existing regime would assist in ensuring the regulatory requirements reflect current market conditions and trading behaviour.  While a review of the existing short sale review may be useful in the long term, it will not assist in resolving any of the uncertainty surrounding short sales in the near term.  In addition, implementing a disclosure regime for covered short sales prior to the commencement of a more general review of regulatory arrangements would allow the information resulting from the disclosure regime to inform the review and lead to a more effective regulatory outcome.

Consultation

5.28                To date, the Government has engaged in targeted consultation with stakeholder groups regarding the disclosure of short sales.  Discussions at this meeting focused on identifying current market practice, the scope for additional disclosure of covered short sales and the likely impact on industry of any regulatory change.  This includes meetings with ASIC, the Association of Superannuation Funds of Australia, Australasian Investor Relations Associations, Securities and Derivatives Industry Association, Australian Shareholders’ Association, Australian Securities Lending Association, Australian Financial Markets Association, Investment and Financial Services Association, the Alternative Investment Management Association and the ASX.  These meetings were high level in nature and did not seek specific comments from stakeholders on each of the options identified above.  However, the feedback from these meetings, in particular as it relates to possible implementation costs for investors and brokers, has been drawn on to develop the impact analysis section of this paper.

5.29                In addition, the ASX issued a consultation paper on short selling in April 2008.  The Government considered the submissions received by the ASX on this paper as part of developing and considering its options for reform in this area.  Submissions were received from a broad range of stakeholders including institutional investors, brokers, investment banks and investor associations.  The ASX has not made these submissions publicly available.

5.295.30   The Government will also engage in public consultation by exposing draft legislation for public comment of any regulatory option adopted.  This will ensure the views of the wider public are taken into account on this issue.

Conclusion and recommended option

5.31                This document outlines a range of possible policy options relating to the regulation of covered short sale transactions.  Options considered include:

•       no regulatory response;

•       disclosure of covered short sales by investors to brokers;

•       direct disclosure of covered short sales by investors to the market operator;

•       disclosure of stock lending transactions; and

•       review of the existing short sales regime.

5.32                Based on the impact analysis outlined above, option two has been selected as the recommended approach.  Under this option, investors that enter into covered short sale agreements will be required to disclose this transaction to their broker.  Technical aspects of the disclosure requirement, for example the timing of disclosure and whether disclosure of transactions is on a net or gross basis, will be specified through supplementary regulations (still to be issued).

5.33                Implementation of option two will result in the actual level of covered short selling in a particular security being disclosed to the market.  This will provide confidence to investors and also facilitate the identification of market abuse by regulators.  However, it is recognised that this option will involve some regulatory costs, particularly by brokers and large investors that are required to update their existing systems to facilitate reporting of covered short sale transactions.  While the precise amount of these costs cannot be determined until the technical aspects of the disclosure requirement is settled, it is expected that the regulatory costs associated with this option is less than what would result from the adoption of option three.  The remaining options fail to sufficiently address the identified issue because they would still result in uncertainty surrounding the actual level of short selling activity in Australian securities.

Implementation and review

5.34                The Government is conscious of the need to effectively engage with industry to ensure the preferred approach is implemented in a way that minimises regulatory costs.  The first stage in this process will be to consult with industry on the technical aspects of the disclosure requirement as part of developing the supplementary regulations.  By specifying these issues by way of supplementary regulation, the regime will have sufficient flexibility to adjust to changes in trading behaviour of investors in the future and the conduct and structures of financial markets.  Following this, a transitional period is likely to be offered to allow brokers sufficient time to make the necessary changes to their IT infrastructure in order to enable reporting of these transactions.

5.35                As the regime will be implemented through the Corporations Act, ASIC will be responsible for monitoring compliance behaviour of investors and brokers and taking enforcement action where appropriate.  The Government will also continue to monitor the application of the regime to ensure that it is operating effectively.  The Government intends to formally review the measures once they have been in operation for two years.

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Schedule 1:  Amendments commencing on Royal Assent

Schedule 2:  Amendments commencing on the 28^th day after Royal Assent

Schedule 3:  Amendments commencing on Proclamation

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