SJ Berwin’s financial markets group discusses the legal implications of the FSA’s ban on short selling.

It has been reported that a number of hedge funds are considering challenging the FSA’s imposition, on 18 September, of a temporary ban on the short selling of shares in several ‘financial institutions’. The ban was mirrored by the SEC which implemented a similar ban over the following weekend. Similar action has been taken by regulators in Australia and the Asian markets: largely, it has to be said, to protect those markets from heightened short-selling activity from overseas rather than as a necessary step in stabilising domestic markets. Since the SEC handed custodianship of the prohibited list of stocks to NYSE, the NYSE has quickly extended the list of stocks to non-financial institutions with a finance element such as General Motors, and the US ban now covers some 800 traded stocks. In the UK, Man Group asked the FSA to add it to the list of proscribed institutions following fears that it could be used as a proxy for short sales.

Under the Short Selling (No 2) Instrument 2008, the FSA proscribes as market abuse any transaction (whether alone or in conjunction with other transactions) which has the effect of creating or increasing a “net short position” which gives rise to an economic exposure to the issued share capital of any “UK financial sector company” (defined widely, so as to include banks, insurers and their parent undertakings).

The FSA says that it regards short-selling (ie. selling stock you don’t hold against a commitment to buy it back later at what you hope is a lower price) as a legitimate investment activity in “normal” market conditions. However, the FSA explains that a temporary measure is necessary in order to reduce instability in the financial markets and to allay the concerns of consumers (meaning, chiefly, depositors with the high street banks). Hector Sants, Chief Executive of the FSA, described the action as necessary in order to protect “the fundamental integrity and quality of the markets”. Its chief concern appears to relate to the circulation of rumours in the market that consequently depresses share prices and may result in profitable short selling transactions. The prohibition of short-selling per se in financial sector stocks seems to be the FSA’s way to deal with this particular problem. In so doing one wonders whether the FSA, having identified a potentially undesirable nut, has reached for the sledgehammer.

The announcement, together with the news of the US Treasury Secretary’s US$700 billion proposal to buy up the toxic assets of US Banks, precipitated a spike in the price of financial sector shares when the markets opened on that Friday and, it is reported, a large-scale move by hedge funds to close out short positions in those UK financial sector companies, most likely incurring significant losses in so doing. The popular press has offered little sympathy for these losses, although more reasoned sentiment in some quarters has attempted to see both sides of the argument.

However, leaving the press reactions on one side, it is important to consider what has happened from a legal perspective. In circumstances where many millions of clients’ money may have been lost, future trading strategies may be frustrated and the survival of some hedge funds may even be in doubt, it is legitimate to ask whether it is lawful for the FSA to impose such a draconian measure, and at such short notice, even in timesof extreme volatility. And to ask, if it is not, what are the possible remedies that might be available?

The public law implications of the
FSA’s decision

Decisions made by regulators, administrative authorities and others exercising quasi-governmental (or public) functions in England are amenable to ‘judicial review’ in order to ensure that the decisions that are made by those bodies are lawful, fair, reasonable and, in certain cases, proportionate. The point is that the introduction of this ban is arguably open to criticism on three distinct public and administrative law grounds.

First, the FSA has assumed the power to bring proceedings for market abuse against any person who enters into a short sale during the moratorium period. Is this extension of the Code of Market Conduct (MAR) in this way permissible? Is the FSA allowed to do what it has done ‘within the four walls of the statute’? While it is true that short-selling on the back of first circulating false pessimistic rumours is likely to be market abuse (and is already caught by the existing market abuse regime), short selling as such is a recognised investment technique that, used correctly, assists in the conduct of an orderly market.

Second, the FSA is required to have regard to its statutory objectives in s2 FSMA, which include maintaining market confidence and securing appropriate consumer protection. Imposition of the short-selling rules has arguably done nothing to meet those objectives. Indeed the short notice ban on established, commercially accepted forms of trading actually runs contrary to these objectives.

Third, the FSA’s decision does not appear based on objective evidence that short-selling has had a detrimental effect on financial sector stocks. The FSA produced no evidence to support this view, and nor has it stated that it has any intention to produce a cost-benefit analysis or to consult in relation to the new rules. Under s121 FSMA, the FSA is obliged to consult before adding to MAR, although it is excused from consulting where an “urgent” change is needed. However, the implication of s121 FSMA is that the FSA has to have some consultative interaction with the financial services sector, even in circumstances where it has already acted in response to an urgent need. We are being told that it will not review the new rules for 30 days. The FSA’s evolving FAQ is not the equivalent of a proper consultation.

Remedies

The standard ‘judicial review’ remedy against a rule-maker that makes or enforces rules improperly is expensive to pursue and may not achieve a commercially desirable result. The result the applicant would want is that the FSA lacks the relevant rule-making power, full stop. More likely would be a conclusion that the rules were deficient in their introduction or implementation, and this merely affords the FSA the chance to make a replacement set of rules after proper consideration. The court has an absolute discretion in public law terms when deciding on the appropriate relief: it could even refuse to grant relief at all, even though an authority has infringed public law principles. And historically, judicial review cases against the FSA and its predecessor regulators have largely failed, on grounds that the courts have had a high overall regard for the regulators’ positions as market policemen.

However, win or lose at judicial review, the applicant is still likely to be out of pocket. Who can he sue for damages? A damages claim against the FSA itself faces almost insuperable legal hurdles. Leaving aside questions of what caused the loss and how it could be quantified (the rules were not the only significant development which affected the markets on 19 September), the FSA has statutory protection against liability in damages “for anything done or omitted in the discharge, or purported discharge, of the Authority’s functions” unless the act is done in bad faith or the actcontravenes the Human Rights Act 1998. A case against the old Securities and Investments Board in 1993 holds that bad faith amounts to fraud, pure and simple; and although litigation under the Human Rights Act has become popular, judicial approval for the idea that hedge funds have human rights cannot be taken for granted.

Private law issues

The introduction of the new rules points to unwelcome consequences for hedge funds in dealings with their customers. It may not be possible to comply with investment mandates. More particularly, the rules may trigger force majeure clauses entitling funds, their investors or counterparties (including prime brokers) to unwind their trades or their investments. Information memoranda in respect of established funds which employ short-selling strategies could now be misleading unless they are speedily updated. And until the new rules are successfully challenged there is also the operational question of precisely which trades now need to be reported and when, and whether certain types of composite transaction can be restructured so as to avoid the application of the rules altogether. As matters stand, these are issues which the FSA is addressing piecemeal in its evolving FAQ.

This is not a satisfactory state of affairs. The FSA’s intervention to steady markets and restore consumer confidence actually risks creating further (though different) market disorder, as well as punishing inculpable users of bona fide trading strategies who now risk financial failure. Something needs to be done about this – and quickly. THFJ

“A damages claim against the FSA itself faces almost insuperable legal hurdles”