Introduction

Since September 2008, significant regulatory changes have occurred in response to concerns that extensive short selling of shares has contributed to extreme market volatility.  These changes effectively prohibit naked short selling and certain "covered" short selling.  A disclosure regime has also been implemented in relation to short selling transactions involving securities lending arrangements.

What is short selling?

Short selling involves a person selling financial products that they do not own at the time of sale.  The rationale behind this is that the person expects the price will decline, allowing them to purchase the financial products at a lower price than they were sold for.

Section 1020B(2) of the Corporations Act 2001 (Cth) prohibits the sale of securities, managed investment products and certain other prescribed financial products (together, Section 1020B Products) unless at the time of sale the person has a "presently exercisable and unconditional right to vest" the products in the buyer.  That is, the person must have the power to direct a transfer of the products, and that transfer must provide the person with the absolute ability to give the buyer title to the products. 

Where this right to vest arises as a result of securities obtained under a securities lending arrangement, ASIC requires the lender to give the borrower, at the time of sale, a legally binding commitment to deliver the products.

What is the practical effect of the changes?

Three key changes have been effected through ASIC Class Orders and the introduction of the Corporations Amendment (Short Selling) Act 2008 (Cth) (the Amending Act), as set out below.

(a) Repeal of previously existing exceptions to the prohibition on short selling

The 5 former exceptions to the s 1020B(2) prohibition on short selling have been repealed, with effect from 8 January 2009. The only exception that survives is that which was formerly s 1020B(4)(c). Accordingly, even if a seller of Section 1020B Products does not have a "presently exercisable and unconditional right to vest" the products in the buyer at the time of sale, they may still sell those products if they entered into a contract to buy those products before the time of sale and have a right to have those products vested in the person that is conditional only upon all or any of the following:

• payment of the consideration for the purchase;
• the receipt by the person of a proper instrument of transfer in respect of the products;
• and / or the receipt by the person of the documents that are (or are documents of title to) the products.

Further exemptions to the prohibition, are set out in ASIC Class Orders CO 08/764 and CO 09/1051.

(b) General prohibition of short selling of financial securities where securities lending arrangements are in place

If the seller's presently exercisable and unconditional right to vest the security or product in the buyer arises because of a securities lending arrangement entered into before the time of sale, ASIC Class Order CO 08/751 prohibits short selling of certain securities, being those in the S&P/ASX 200 Financials and shares in 5 specified companies with APRA regulated businesses (together, Financial Securities).  ASIC has indicated that the ban on this kind of "covered short selling" of Financial Securities is expected to continue until 6 March 2009.

The following transactions are exempt from this prohibition:

• hedging by market makers to manage the financial consequences arising from their market making activities;
• selling Financial Securities as part of a dual listed entity arbitrage transaction or index arbitrage transaction;
• managing the risk of underwriting dividend reinvestment plans, share purchase plans and convertible bonds and hybrids; and hedging to manage the financial consequences of pre-22 September 2008 exposures.

(c) Enhanced disclosure requirements

A greater level of disclosure requirements has also been introduced.  Class Order CO 08/751 requires certain disclosures in respect of sales of s 1020B products, and Schedule 3 of the Amending Act introduces disclosure requirements in relation to short sales covered by securities lending arrangements of listed Section 1020B Products.  As of 30 January 2009, the commencement date of Schedule 3 had not been specified.

The view from here

The changes introduced by the Class Orders and the new legislation provide a level of comfort to market participants and their advisors in relation to the short selling regulatory environment.  It seems that the regulatory regime is, at least for now, fairly certain.  How the market will react to the commencement of the disclosure requirements in Schedule 3 of the Amending Act and the lifting of the ban on "covered short selling" of Financial Securities remains to be seen.

Authors: Jason Lambeth (partner, Gilbert + Tobin); Emma Ringland (lawyer, Gilbert + Tobin) and Jade Droguett (lawyer, Gilbert + Tobin)