Hedge funds, for better or worse, exploit weaknesses in markets and market participants. An economist may well regard this as healthy, at least on a theoretical level, if it promotes efficiency. However, the markets are not a jungle and participants are entitled to expect that rules designed to protect the integrity of markets will be observed and enforced.
In recent weeks, sensing a growing controversy, the ASX and ASIC have issued a number of media releases reminding market participants of a range of laws designed to protect the integrity of markets, including laws relating to continuous disclosure (and the disclosure of substantial holdings), short selling and market manipulation. These public statements are responding to a growing chorus of concerns being expressed by market commentators and participants that some market participants, including hedge funds, appear to be sailing close to the wind and have perhaps even crossed the line to engage in illegal conduct.
This may well be true – but at present we do not know, although ASIC has indicated it is investigating. However, part of the immediate solution proposed by the ASX and ASIC has the potential to exacerbate the problem, by exposing listed entities and their shareholders to further predatory action by hedge funds and other market participants.
Margin loans and material events
On February 29, 2008, the ASX and ASIC issued a joint media release relating to the disclosure of directors’ margin loans and the disclosure of material events under financing arrangements. Accompanying the media release was a new guidance note on the application of the continuous disclosure obligation under ASX Listing Rule 3.1, which requires a listed entity to disclose immediately any information that it is aware of concerning it that a reasonable person would expect to have a material effect on the price or value of securities. Noting that the expectations of the reasonable person will evolve over time, the ASX expressed the view that these evolving standards may now require disclosure of:
- The key terms of margin loan or similar funding arrangements for a material number of securities entered into by a director, including the number of securities involved, the trigger points, the right of the lender to sell unilaterally and any other material details. However, disclosure is only required "in appropriate circumstances”. Whether a margin loan arrangement is material is a matter which the company must decide having regard to the nature of its operations and the particular circumstances of the company.
- Material financing arrangements which include terms that may be activated on the occurrence of certain events (particularly those beyond the control of the entity, such as market events), when those terms are activated or become likely to be activated. The disclosure required may include the nature and terms of the arrangements, the trigger events, and any other material information such as any impact that triggering of the term may have on the entity’s relationship with its bankers, or financial position or financial performance.
To date, the reaction to this new guidance note has been interesting. Some commentators have expressed the view that nothing has changed, as disclosure of this nature has always been required. Others have expressed the view that disclosure of this nature goes beyond previous market expectations.
Directors could be forgiven for hesitating before disclosing their margin loan arrangements given anecdotal evidence that some market participants, particularly some hedge funds, may be engaging in potentially illegal conduct to exploit disclosure of this nature. For example, ASIC announced on 6 March 2008 its concern that false or misleading information about listed securities was being spread in order to artificially provoke sales of securities and to reduce their market price. It warned that conduct of this nature is illegal and that, in conjunction with the ASX, it will be vigilant in monitoring the market to detect and prosecute conduct of this nature.
The motivation for driving down the market price of listed securities is of course to profit from short selling – selling shares that are not owned with the intention of making a profit by buying an equivalent number of shares to cover the sold position at a lower price. When this is done on a large scale it can have a powerful downward effect on a company’s share price. Stocks which have been targeted in recent months include Primary Health Care, City Pacific and, most dramatically, Allco Finance Group, Centro and MFS. Indeed, it is quite possible that this short selling activity has contributed to what appears to be a disproportionate fall in our market compared with other leading markets.
Given the potential for market abuse, there are a number of restrictions on short selling in Australia. For example, under the so-called ‘up tick rule’ a short sale may only take place if the market price moves up to the price at which the sale is being offered. There is also a 10 per cent restriction on the overall number of securities of an entity that can be short sold at any point in time.
However, many of these restrictions can be avoided through securities lending, a form of ‘covered’ short selling involving the sale of securities which have been temporarily borrowed from an investor (such as an institution). Under a typical securities lending arrangement, the legal title to shares is transferred from the lender to the borrower, with the lender having a right to re-purchase the securities from the borrower (and the borrower having a right to re-sell the securities to the lender). It is then argued that the borrower has ‘a presently exercisable and unconditional right to vest the [securities] in the buyer’ and hence will not be engaging in short selling by selling the securities.
The ASX and ASIC take the view that market efficiency requires transparency of short selling activity, irrespective of whether short selling is ‘naked’ (where the seller does not have in place arrangements for delivery of the securities) or ‘covered’ (where the seller does have such arrangements in place). Accordingly, on March 6, 2008, the ASX and ASIC issued a further joint media release designed to ‘remind’ market participants of existing obligations relating to both ‘naked’ and ‘covered’ short selling:
- clients must inform their brokers when a sale is a short sale (and brokers must advise their clients of this obligation)
- brokers must advise their clearers that the sale is a short sale, and must ensure that the clearer has secured a minimum 20 per cent initial margin over the short position
- brokers must advise the ASX as soon as practicable that they are executing a short sale and
- brokers must report to the ASX their unsettled net short sale position as at 7pm by no later than 9am on the next trading day. The ASX then publishes the aggregate net short sale positions.
The problem, of course, is the view by some market participants that these obligations do not apply to the sale of securities borrowed under securities lending arrangements, on the basis that these sales are not regulated short sales. The ASX and ASIC appear to acknowledge this, by stating that to the extent that legislative amendments are needed to remove the scope of differing interpretations of key obligations under the law, appropriate representations have been made to Government. However, in the meantime, the ASX and ASIC expect that, where a broker has reason to believe that a client is placing an order for either a ‘naked’ or ‘covered’ short sale, it will make appropriate enquiries in order to satisfy its disclosure obligations relating to both ‘naked’ and ‘covered’ short selling.
Because short selling activity has the potential to give rise to settlement risk, the ASX limits the class of securities in which ‘naked’ short selling can occur (an ‘approved list’ of stocks which pass certain liquidity and capitalisation criteria comprising roughly one-fifth of all listed stocks). In light of the increased number of settlement failures and settlement delays relating to naked short sales, the ASX has indicated it is presently reviewing its approved list with a view to removing certain stocks and amending the scale of its late fees for delayed settlement.
By a separate media release on 6 March 2008, ASIC reminded market participants that a borrower of securities under a typical securities lending arrangement will acquire a ‘relevant interest’ in the securities, which may trigger an obligation to disclose a substantial holding (5 per cent) or a change in a substantial holding (1 per cent).
The concerns raised by the ASX and ASIC in relation to disclosure of margin loans and short selling are linked. Short sellers will naturally seek out those companies whose directors have highly geared margin loans in the hope of triggering a sell-off.
In this environment, directors are faced with a ‘Morton’s Fork’ dilemma. By not disclosing margin loan arrangements, listed entities risk contravening continuous disclosure obligations, with potential legal consequences. However, disclosing margin loan arrangements will attract potential predatory behaviour from market participants, such as hedge funds. The ASX and ASIC claim that they are monitoring the market with a view to detecting and prosecuting illegal conduct. However, hedge funds move quickly and are often located off-shore. Investigating and prosecuting illegal conduct takes time, and this will not help listed entities that are targeted by illegal short selling activity, as the charred carcasses of a number of entities littering our corporate landscape amply demonstrate.
It is clear that before making any disclosure of margin lending arrangements, listed entities should carefully consider the consequences – there have already been some spectacular examples of the consequences that can follow ill-considered disclosure. By contrast, there have also been other examples of disclosure being used to actively inform the market and dampen the potential for trading based on rumour and speculation. For example, Asciano disclosed details of margin loan arrangements of its CEO, Mark Rowsthorn and assured the market that even if Asciano’s share price fell to zero a margin call would not be made.
Exposure to predatory short selling, with a view to triggering margin calls, can of course be avoided by collapsing the margin loans. However, this will most likely involve financial pain for the shareholders concerned. Notwithstanding the pain involved, this was the strategy adopted by the CEO of United Group, Richard Leupen who reluctantly sold half his stake in the company in order to discharge his remaining shares as security under margin loans.
In both of these examples, the entities concerned have made loud, public announcements in order to deter would-be short sellers and reassure the market.
In addition, there are a couple of other practical suggestions that listed entities should consider:
- Re-finance or restructure existing material financing arrangements to remove market events.
- Implement a policy that prohibits margin loans over entity securities by employees or officers. A policy of this nature would also assist in overcoming potential inadvertent contraventions of insider trading laws and internal trading policies.
Listing entities will also need to review internal policies relating to disclosure by directors of margin loan arrangements.
Tim Woodforde is a corporate and securities lawyer, specialising in mergers and acquisitions, private equity, equity capital markets and corporate finance. He is a partner at Deacons.