On 12 June 2008 the FSA introduced, virtually overnight, a new rule requiring public disclosure of “significant” short positions in shares of an issuer pursuing a rights issue. Not only was this introduced without prior consultation, but also it came into force just one week later on 20 June 2008. This interim period was characterised by intense activity by market participants trying to put in place systems and controls to identify and announce the holding of relevant positions. Now is a good time to take stock of the new rule, and to reflect on the way in which it was introduced.

The requirement

The new rule applies in relation to issuers listed on a UK recognised investment exchange (the LSE, SWX Europe Limited (formerly virt-X), AIM and PLUS Markets), including those that have a secondary listing on any of those markets. To the extent that a relevant UK issuer has announced a rights issue, anyone holding a net short position equal to, or greater than, 0.25% of the undiluted issued share capital of the issuer must disclose this to the market (via an RIS announcement) by 3:30 pm on the business day following the date on which the short position is reached or exceeded. The rule applies to all holders of relevant short positions wherever located and regardless of whether they are FSA-regulated or not.

Failure to make proper disclosure is considered by the FSA as evidence of market abuse. This could result in a fine and significant damage to reputation.

What is a rights issue?

understood definition of a rights issue is appropriate in this context. On that basis, a rights issue involves an offer by an issuer to existing shareholders of new shares or other securities in proportion to their existing holdings. The offer is made by means of a letter which provides for a date when the rights will lapse unless the shareholder accepts the offer and subscribes for the shares. Subscription is in cash, nearly always at a discount to the market price. What distinguishes a rights issue from other open offers is the fact that during the period before the deadline for acceptances and payment (typically 21 days) the shareholder is able to trade the rights to subscribe for the shares on a “nil paid” basis. Without this feature, an issue will not fall within the scope of the new disclosure rule.

The FSA has confirmed that for the purposes of the rule a rights issue commences when it is formally announced by the issuer via an RIS announcement and ends when the newly-issued fully-paid shares are admitted to trading (ie. after any nil paid trading period and the last date for acceptances). This period is referred to as the “rights issue period”.

Points to note

Amongst other things, the FSA has clarified the following points via a series of frequently asked questions (FAQs).

• In calculating the net position it is necessary to take account of all economic interests in the issuer’s shares (whether physical or synthetic), as well as short positions in the rights themselves. However, positions in the shares arising as a result of index or basket trades, and positions in bonds which are convertible into newly-issued shares (as opposed to shares held in treasury) do not count.
• Long positions in the rights themselves can only be included in the calculation to the extent that there is a corresponding short position in the rights (eg. they cannot be set off against short positions in the shares).
• Positions in non-delta one instruments (such as options) are included in the calculation using their delta-adjusted value (ie. how many shares would be required to neutralise moves in the price, rather than the number of shares the derivative gives the right to buy or sell).
• The disclosure obligation is a one-off obligation. It only applies to the position as at midnight on the day on which the 0.25% threshold is first reached or exceeded. An increase (or decrease) in the position on the following business day (or thereafter) would not need to be reported. However, if an investor discloses the fact that its short position has fallen below the threshold, it will have to make a separate disclosure if its position subsequently reaches or exceeds the threshold.
• A relevant short position established before the commencement of a rights issue period will be disclosable if it is still held at midnight on the day the rights issue is announced. This is difficult to reconcile with the wording of the rule which, as drafted, is limited to relevant short positions “reached or exceeded” during a rights issue period.
• Discretionary fund managers must aggregate the positions across all of their discretionary funds and make disclosure in the name of the fund manager if necessary. If any of the underlying funds also has a relevant short position in its own right, the fund will need to make a separate disclosure (although the FAQs on this point are inconsistent).
• As regards groups, it is possible for one disclosure to be made on behalf of all group members holding disclosable positions, as long as it is clear which group member has which position.

Lack of consultation

The FSA issued the new rule without following the normal (statutorily prescribed) consultation process (which includes a requirement to conduct a cost-benefit analysis and give the industry an opportunity to respond). Although there is a limited facility under Sections 121(6) and 155(7) of the Financial Services and Markets Act 2000 for the FSA not to consult on the introduction of new provisions of its Handbook, in order to introduce a new “rule” (as opposed to an evidential or guidance provision) without consultation it must consider that the delay involved in consulting would be “prejudicial to the interests of consumers”. The potential prejudice, in this context, that would justify reliance on this provision is not immediately apparent.

In any event, the FSA did not state the precise statutory powers purportedly relied on to avoid the consultation requirement, which in itself potentially renders the new provisions void. Indeed, the FSA’s ability to make a “rule” within its Code of Market Conduct (the part of the FSA Handbook in which the new rule appears) is questionable. This all raises the question as to whether the FSA has acted ultra vires in making the new rule (and, therefore, the possibility that the new rule is susceptible to legal challenge).

Now that the dust has settled …

The FSA’s failure to consult has produced a disclosure rule of questionable validity, the implementation and interpretation of which has been difficult, and which may not achieve its desired result.

When initially published, the open-ended nature of the rule begged more questions than it answered. This necessitated clarification from the FSA via the FAQs, which were produced late in the day (in some cases after the rule had come into force). While helpful, the FAQs reveal an interpretation of theunderlying rule by the FSA which, in some respects, is creative (to say the least). Further confusion was created by the FSA appearing to reverse its previously stated position on a couple of occasions. The effort needed to get to grips with the requirements ate into an already short period for market participants to make the necessary preparations.

An interesting post script is that, on the day that the initial disclosures were made (23 June), the price of HBOS’s shares dipped below the rights issue price. The FSA seems not to have considered the potential for others to follow the example of well-respected investors known to have taken significant short positions in an issuer. This might have come to light during the course of a proper consultation.