The challenging, costly, and rather complex new SEC Rule will require a high level of expertise and a great deal of work to prepare for.
By Aspasia Latsi, International Regulatory Analyst, Confluence
The introduction of a Short Selling rule is now a thing in the U.S. The Securities and Exchange Commission (‘SEC’) was urged to adopt a new short sale disclosure rule, Rule 13f-2, to increase transparency in the aftermath of the GameStop saga. Who then will need to comply with Rule 13f-2, and what steps need be taken to prepare for the new requirements?
New SEC Rule on Short Selling will affect not only broker-dealers, but also a wider group of filers
As to the question of who would need to comply with the new requirements, the answer is “institutional investment managers”, as the title hints. Until now, broker-dealers under the authority of Financial Industry Regulatory Authority (‘FINRA’) have been submitting certain short sale-related data in equity markets. The public availability of information is expected to be supplemented upon the adoption of Rule 13f-2, given that the new rule is applicable to institutional investment managers (hereinafter ‘the Managers’), a much wider category of investors.
The crucial question here is who falls under this definition. Since this very term applies to Exchange Act Rule 13f-1(b) as well, the SEC gives the following definition: “any person, other than a natural person, investing in or buying and selling securities for its own account and any person [including a natural person] exercising investment discretion with respect to the account of any other person”. Banks, insurance companies, broker-dealers, as well as corporations and pension funds that manage their own investment portfolios fall under the first sub-category, while investment advisers that manage private accounts, mutual fund assets or pension plan assets, and the trust department of banks and trustees fall under the second sub-category. As a first step, it is therefore essential to check with your compliance team whether you recognize yourself in any of the afore-mentioned categories; if so, it is highly likely that you need to comply with the new short selling reporting regime.
Reporting thresholds for reporting and non-reporting issuers
Different thresholds will apply to reporting and non-reporting issuers. The filing thresholds will be as follows:
- For reporting issuers: a monthly average of daily gross short positions of at least (i) $10 million or more, or (ii) 2.5% of the issuer’s shares outstanding (at the close of regular trading hours);
- For non-reporting issuers: $500,000 or more at the close of regular trading hours on any settlement date during the calendar month.
Managers will report such information regarding each equity security to the SEC via EDGAR, and the submission deadline will be 14 calendar days after each calendar month. The SEC will then make use of the information provided in Form SHO and proceed with the publication of aggregate information on large short positions pertinent to individual equity securities and net activity of the month concerned. Managers will have to stay vigilant, as they need to check on a month-by-month and security-by-security basis whether they should or should not comply with the filing requirements[1].
Equity securities
Institutional investment managers will be required to submit disclosures for certain equity securities. For the purposes of calculating, each class of exchange listed and over-the-counter securities, such as certain derivatives, options, warrants, other convertibles, and ETFs will be included. Next to the U.S. listed equity securities, the SEC also extends the scope of securities to non-U.S. listed ones: that is, equity securities of non-reporting company issuers, with a view to increasing transparency regardless of where those short sales take place.
In calculating the thresholds, special attention should be paid to short positions created through the use of equity derivatives. Only when the reporting threshold for an underlying equity security is met or exceeded, is it then required for the Manager to take into consideration activity in options, tendered conversions, secondary offering transactions, and other equity derivatives or activity that might affect the reported short positions on Form SHO.
Short positions that the ETF holds in individual underlying equity securities – as part of the ETF basket – are also excluded from the calculation of the gross short position in an equity security. Hence the importance of employing highly qualified personnel, such as compliance teams and/or third-party vendors, to ensure the inclusion of the “right” securities for the correct calculation cannot be stressed enough.
Form SHO
It goes without saying that the preparation of the filing itself is of utmost importance. Those professionals instructed to prepare the submission would need to get acquainted with Form SHO, as it constitutes a new form to be submitted via EDGAR. Managers would have to familiarize themselves with the content of the form; this being divided into two Information Tables, each of which requires certain short position data and short activity data for certain equity securities, and a Cover Page. Regarding the use of an XML-based data language, the Commission notes that this requirement for Form SHO is consistent with other EDGAR filings that employ form-specific XML-based languages.
Compliance dates
The effective date for the new SEC rule will be January 2, 2024. However, bear in mind that the Commission aims to provide Managers with adequate time to develop their systems before they come into full compliance with the new reporting requirements. Therefore, the SEC set January 2, 2025, as the compliance dates for Rule 13f-2 and Form SHO.
Implementation and Compliance costs for Institutional Investment Managers
Implementation and compliance costs for Managers and their compliance teams are not to be neglected either. Quite a few institutional investment managers would have to develop and implement new in-house reporting systems, to ensure that reporting thresholds are effectively and adequately monitored before they are met or exceeded. Setting up such monitoring systems is a costly process. It could become costlier should the Managers opt for daily monitoring on the basis that any activity needs to be recorded, as it could possibly be subject to disclosure requirements consistent with Form SHO as explained earlier. Managers may alternatively choose to calculate the threshold either on a rolling basis or after the end of the respective month, on the grounds that the gross short position is not based on a single trading date.
It follows from the above that we are discussing a challenging, costly, and rather complex new SEC Rule, requiring a high level of expertise and a great deal of work to prepare for appropriate implementation and operational build. On this note, Managers may also outsource these services to third-party vendors to ease their burden. No matter which option is chosen, Rule 13f-2 will continue to draw attention in the foreseeable future, as both institutional investment managers and financial industry professionals grapple with its effects on their compliance processes.
[1] Section 3(a)(11) of the Exchange Act and Rule 3a11-1.
