On February 25, 2022, the U.S. Securities and Exchange Commission (SEC) published and requested comment on proposed new Rule 13f-2 (the Rule) under the Securities Exchange Act of 1934 (Exchange Act) and Form SHO, which would require institutional investment managers (as such term is defined under Section 13(f)(6)(A) of the Exchange Act (Institutional Investment Managers)) to report to the SEC extensive information on certain “large” short positions and short sale and other transactions on a monthly basis. The SEC would then use this data to make publicly available aggregate data about short positions and short sale activity in individual securities.
The SEC also proposed a new Rule 205 of Regulation SHO to require broker-dealers to mark purchase orders as “buy to cover” when purchasing to cover short positions for the broker-dealer’s own account or for the accounts of customers and require the reporting to the consolidated audit trail (CAT) of such “buy to cover” order marking information as well as situations where short sales are effected in reliance on the “bona-fide market maker exception” to the Regulation SHO “locate” requirement.
Notably, although the SEC indicated that the new proposals were designed to meet the mandates provided by Section 13(f)(2) of the Exchange Act, which was enacted as part of Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) initiatives, they actually impose requirements likely beyond the Section 13(f)(2) mandate to prescribe rules providing for the public disclosure of short sales. Indeed, in certain respects the requirements of proposed Rule 13f-2 and Form SHO would be much more substantial than the current disclosure of long positions by certain Institutional Investment Managers under Rule 13f-1 and Form 13F as well as beneficial ownership reporting under Section 13(d) and Schedule 13D/G.
The proposed Rule and Form SHO raise many questions concerning the scope of certain information required to be reported and would impose significant operational and compliance burdens on a number of market participants, most notably managers of hedge funds and family offices as well as broker-dealers. The proposed Rule is the latest in a series of initiatives by the SEC and the Financial Industry Regulatory Authority (FINRA) to increase public access to information on short positions and borrows related to short positions.1
Once published in the Federal Register, the release will be open for a short comment period that will likely close no later than April 26, 2022. Accordingly, affected market participants wishing to provide comments should take prompt action to prepare their submissions.
Summary of Proposed Rule 13f-2 and Form SHO
- Securities Covered: The reporting requirements contained in proposed Rule 13f-2 and Form SHO would apply to equity securities over which an Institutional Investment Manager and all accounts over which the Institutional Investment Manager (or any person under the Institutional Investment Manager’s control) has investment discretion where the following thresholds are met:
- each equity security of an issuer registered pursuant to Section 12 of the Exchange Act or for which the issuer is required to file reports pursuant to Section 15(d) of the Exchange Act (Reporting Equity Securities) with either (i) a gross short position in the equity security with a U.S. dollar value of $10 million or more at the close of regular trading hours on any settlement date during the calendar month or (ii) a monthly average gross short position as a percentage of the issuer’s total shares outstanding of 2.5% or more
- each equity security of an issuer that is not registered pursuant to Section 12 of the Exchange Act or for which the issuer is not required to file reports pursuant to Section 15(d) of the Exchange Act (Nonreporting Equity Securities) that has a gross short position with a U.S. dollar value of $500,000 or more at the close of regular trading on any settlement date during the calendar month
- Gross Short Position Definition: The reporting thresholds referenced above for Reporting Equity Securities and Nonreporting Equity Securities are based on an Institutional Investment Manager’s gross short position in the equity security itself, and do not include short positions established through derivatives, such as options or swaps. However, as referenced below, the proposed Rule would require Institutional Investment Managers to report daily changes in their gross equity short position derived from acquiring or selling the equity in connection with derivative activity, such as exercising or getting assigned on an option. “Gross short position” would mean the number of shares of the equity security that are held short, without inclusion of any offsetting long positions or economic long positions, including shares of the equity security or derivatives of such equity security.
- Parties Covered and Responsible to Report: The proposed reporting requirements would apply to Institutional Investment Managers, as such term is defined for purposes of 13F reporting under Section 13(f)(6)(A) of the Exchange Act, that exercise investment discretion with respect to short positions meeting the above-described thresholds for Reporting Equity Securities and Nonreporting Equity Securities. Notably, however, while 13F reporting is limited to Institutional Investment Managers that generally exceed a threshold of exercising investment discretion in equity securities of $100 million, that would not be the case for Rule 13f-2 and Form SHO. Stated another way, Institutional Investment Managers that are not required to file Form 13F would still need to file Form SHO if they exceeded the above-described thresholds for Reporting Equity Securities and Nonreporting Equity Securities.
- Deadlines for Reporting/Other Affirmative Notification to SEC: Institutional Investment Managers, with respect to short positions in Reporting Equity Securities and Nonreporting Equity Securities meeting the above-described thresholds, would need to file on Form SHO within 14 calendar days after the end of each calendar month. Amendments would be required for any errors and must restate Form SHO in its entirety. If the data being reported in the amendment affects the data reported on Form SHO reports filed in at least three of the immediately preceding Form SHO reporting periods, the Institutional Investment Manager would also within two business days after filing the amendment be required to notify the SEC staff of the amendment and provide an explanation of the reason for the amendment.
- Information to Be Reported on Form SHO: Institutional Investment Managers, with respect to short positions in Reporting Equity Securities and Nonreporting Equity Securities meeting the above-described thresholds, would be required to provide extensive information concerning the end-of-month gross short position (both the number of shares and U.S. dollar value) and whether the identified short position is fully hedged or partially hedged. In addition, extensive information is required, with respect to short positions meeting the aforementioned requirements, concerning daily activity affecting the Institutional Investment Manager’s gross short position for each settlement date during the calendar month reporting period. Such daily activity includes, among other things, (i) the number of shares sold short (including the number of shares sold in a put exercise or call option assignment); (ii) the number of shares purchased to cover an existing short position (including the number of shares purchased in a call exercise or put option assignment); (iii) number of shares obtained through secondary offering transactions; (iv) other activity that creates or increases a short position (including but not limited to shares resulting from exchange-traded fund (ETF) creation and redemption); (v) other activity that reduces or closes a short position (including but not limited to shares resulting from ETF creation and redemption).
- Aggregate Public Reporting by SEC: The SEC estimates that it would make public aggregated information derived from data reported on Form SHO within one month after the end of the reporting calendar month; for example, for data reported by Institutional Investment Managers on Form SHO for the month of January, the SEC would expect to publish aggregated information derived from such data no later than the last day of February. The aggregated information to be published would include the following:
- the issuer’s name and other identifying information related to the issuer
- the equity security’s title of class, CUSIP number, and Financial Instrument Global Identifier (if applicable)
- the aggregated gross short position across all reporting Institutional Investment Managers in the reported security at the close of the last settlement date of the calendar month of the reporting period as well as the corresponding dollar value of the reported gross short position
- the percentage of the reported aggregate gross short position reported as being fully hedged, partially hedged, or not hedged
- for each settlement date during the calendar month reporting period, the “net” activity in the reported security as aggregated across all reporting Institutional Investment Managers
Summary of Proposed Regulation SHO and CAT Changes
- New “Buy to Cover” Order Marking Requirement: Proposed Rule 205 of Regulation SHO would require a broker-dealer to mark a purchase order as “buy to cover” if, at the time of order entry, the purchaser (either the broker-dealer or another person) has a gross short position in such security in the specific account for which the purchase is being made at such broker-dealer. A broker-dealer would be required to mark a purchase order as “buy to cover” regardless of its size in relation to the size of the purchaser’s gross short position in the account and regardless of whether the gross short position is offset by a long position held in the purchaser’s account at the time of order entry. For example, if the purchaser has a gross short position of 100 shares in a security in an account at a broker-dealer, then purchases 50 shares of such security for the same account at the same broker-dealer, the broker-dealer would be required to mark the purchase “buy to cover.” If, instead, there was a purchase of 150 shares of such security for the same account at the same broker-dealer (i.e., a purchase for an amount in excess of the total gross short position), then the SEC states that the broker-dealer would also be required to mark the purchase “buy to cover.”
- Reliance on Bona-Fide Market Making Exception: The SEC is also proposing to require CAT reporting firms that are reporting short sales to indicate whether such reporting firm is asserting use of the “bona-fide market maker exception” to the Regulation SHO “locate” requirement.
SEC Objectives of the Proposed Short Sale and Short Position Reporting Requirements
The SEC stated that the additional information about the short sale and short sale activity of Institutional Investment Managers “may promote greater risk management among market participants, and may facilitate capital formation to the extent that greater transparency bolsters confidence in the markets.” In this regard, the SEC notes its view on forms of manipulation that can be advanced by short sellers to illegally manipulate stock prices, such as “bear raids,” and states that “greater transparency into the activities of Institutional Investment Managers holding large short positions in a security could help regulators’ oversight of short selling and deter these and other types of manipulative short selling campaigns potentially by alerting regulators to suspicious activity.” The SEC also notes that in recent years, “market volatility associated with short selling has brought heightened attention to the difference in long and short position reporting requirements, and, more generally, the lack of transparency into the circumstances surrounding short sale transactions.” In this regard, the SEC states that it has received requests to increase transparency into short-sale-related activity “through the adoption of reporting requirements similar to those currently required by holders of long positions above certain thresholds,” specifically citing to petitions from the New York Stock Exchange and Nasdaq for short disclosure regimes consistent with long disclosure regimes on Form 13F.
In this regard, it is notable that the proposed short disclosure under Rule 13f-2 and Form SHO would be different from long disclosure under Rule 13f-1 and Form 13F. In certain respects, the proposed short disclosure regime would be more stringent than long reporting, namely requiring monthly disclosure of short positions (filed via the EDGAR database within 14 calendar days after the end of each month) versus the quarterly disclosure required for 13F reporting (filed via EDGAR within 45 calendar days after the end of each quarter) as well as requiring in Form SHO more detailed daily short position and short sale transaction activity as opposed to simply a snapshot of gross long positions as of the last day of each quarter in Form 13F. However, in other respects the proposed short disclosure regime would be less onerous than long reporting on Form 13F in that the Institutional Investment Manager would not need to include on Form SHO all short positions in all equity securities, as is generally required for reporting long equity positions on Form 13F (absent certain de minimis positions). (However, due to the fairly low thresholds for disclosure of Reporting Equity Securities and Nonreporting Equity Securities, it is anticipated that many short positions would be picked up.) Moreover, importantly, whereas long reporting on Form 13F specifically publicly identifies the particular Institutional Investment Manager and attributes long positions held by such Institutional Investment Manager, proposed Rule 13f-2 provides that any public reporting of short position and short sale activity would only be on an aggregated basis and would not identify the short positions of any particular Institutional Investment Manager.
It is also notable that in proposing Rule 13f-2 and Form SHO, the SEC has seemingly elected to interpret expansively the mandate of Section 929X of the Dodd-Frank Act, which added Section 13(f)(2) to the Exchange Act directing the SEC to “prescribe rules providing for the public disclosure of the name of the issue and the title, class, CUSIP number, aggregate amount of the number of short sales of each security, and any additional information determined by the Commission following the end of the reporting period” and noting that “at a minimum, such public disclosure shall occur every month.” More specifically, rather than just requiring the reporting of short position information, the SEC has elected to also require the onerous reporting of daily short sale and purchase activity, including but not limited to exercises/assignments of options. In this regard, the SEC reasons that such additional information “would fill an information gap for market participants and regulators by providing insights into the lifecycle of a short sale,” which information the SEC states is not currently provided through the aggregate data on short interest positions that is published twice per month by FINRA and the exchanges, as well as additional aggregate published short sale data. However, as noted, the SEC is also not requiring disclosure of short positions that are attributable to specific Institutional Investment Managers.
SEC Objectives of the Proposed Buy to Cover Marking and Bona-Fide Market Maker Requirements
The SEC stated its belief that having “buy to cover” order marking information, combined with amending the CAT National Market System Plan to require participants to report “buy to cover” orders to the CAT Central Repository, would provide additional context to the SEC and other regulators regarding the lifecycle of short sales by identifying the timing of purchases that close out, in whole or in part, open short positions in a security. The SEC believes that this would assist in reconstructing market events and would be useful in identifying potentially abusive trading practices including potentially manipulative short squeezes. In this regard, the SEC stated that having “buy to cover” information that coincides with an increase in price and/or borrowing costs in the same equity security may identify where “short squeezes” may be occurring.
The SEC also proposed to require CAT reporting firms that are reporting short sales to indicate whether such reporting form is asserting use of the bona-fide market making exception from the Regulation SHO “locate” exception. While, currently, the SEC must request information from a broker-dealer to determine which short sale orders have been submitted pursuant to such exception, the SEC believes that requiring such reporting to CAT would provide an additional tool to determine whether such activity qualifies for the exception or conversely “could be indicative of, for example, proprietary trading instead of bona-fide market making.” The SEC and other regulators have been very active recently in examining for compliance with the use of the bona-fide market making exception.
What This Means to You
Institutional Investment Managers: Suffice it to say, the proposed short sale/short position reporting and disclosure requirements will impose tremendous burdens on Institutional Investment Managers, including primarily hedge fund managers and family offices, as well as broker-dealers and other market participants. Specifically, Institutional Investment Managers will be required to build out systems to track whether short positions established through short sales exceed the Reporting Equity Securities and Nonreporting Equity Securities thresholds as well as the daily trading activity that affects such short positions. Based on the relatively low thresholds established, it can be expected that many Institutional Investment Managers will be required to report on Form SHO a number of different securities on a monthly basis, and thus will also need to build out compliance and operational processes to complete and file Form SHO.2 It is also notable that Rule 13f-2 and Form SHO would impose on Institutional Investment Managers a “self-reporting obligation” to the SEC staff with respect to amendments filed to correct mistakes in Form SHO reports filed in at least three of the immediately preceding Form SHO reporting periods. As noted above, certain of the proposed information to be included in Form SHO is extremely tedious and raise interpretive questions, including the following:
- Determining whether the reported short position is “fully hedged,” “partially hedged,” or “not hedged.” The current proposal appears to indicate that such determination must be made at the level of the overall Institutional Investment Manager, rather than at the level of an individual portfolio manager or fund, and thus may be challenging for multistrategy funds as well as funds that use both internal portfolio managers and external managers delegated investment discretion under an investment management agreement (i.e., including raising the question whether, where a long position is held for one strategy and a short position is held for another unrelated strategy, the short position should be deemed to be “hedged”).
- The requirement to identify the daily activity that leads to an increase or decrease in the reported short position (including through exercise/assignment of options) will be very burdensome and also raises similar questions regarding whether such determination must be made at the overall level of the Institutional Investment Manager or at the level of an individual portfolio manager or fund.
The requirement to identify “other activity” on each day that creates or reduces an Institutional Investment Manager’s reported short position raises significant interpretive questions, most notably whether such requirement would extend to synthetic long and short positions established through single-name or portfolio securities-based swaps.
Furthermore, it is very likely that Institutional Investment Managers filing on Form SHO will be subject to follow-up inquiries from the SEC concerning their trading activity and compliance with short sale regulations, such as Regulation SHO as well as Rule 105 of Regulation M (i.e., it is notable that one of the Form SHO requirements is to disclose number of shares obtained through secondary offering transactions).
Finally, beyond the operational and compliance challenges inherent in tracking instances where a Form SHO is required and gathering the necessary data to complete the filing, with any disclosure of short position and short sale information (even if on an aggregate basis) there arises the potentially significant economic risks of an Institutional Investment Manager’s being subjected to a short squeeze.
Broker-Dealers and Affiliates: As referenced above, broker-dealers and their affiliates would also be picked up as Institutional Investment Managers and thus could similarly be required to complete the onerous requirements of Form SHO on a monthly basis for short positions in Reporting Equity Securities and Nonreporting Equity Securities exceeding the relatively low thresholds for reporting (including with respect to short positions established to facilitate customer transactions, such as short positions established to hedge derivative transactions with customers).
Moreover, broker-dealers would be subject to the new requirements of Rule 205 of Regulation SHO to mark as “buy to cover” purchase transactions made by the broker-dealer for its own account or to purchases made by the broker-dealer on behalf of another person through the person’s account held at that broker-dealer. While the SEC has not specifically addressed this in the proposing release, the assumption would be that executing broker-dealers should be able to reasonably rely on representations from customers concerning “buy to cover” purchase transactions effected for such customers; however it could be prudent for commenters to raise such point for confirmation. In this regard, such reliance on customers would be essential for executing brokers who do not custody the customer’s positions (i.e., where the positions are custodied away, such as at a prime broker or bank). Furthermore, such reliance on customer representations on “buy to cover” purchases will likely even be necessary for situations where the executing broker is also custodying and clearing the customer purchase — at the time of trade, the broker-dealer will likely not be aware of its customer’s intentions on purchasing to close out an existing short position (i.e., which should be identified as “buy to cover”) or whether the customer intends to “box” the position (i.e., not identify the purchase as “buy to cover” and rather maintain simultaneous long and short positions in the security).
Similarly, requiring reporting to CAT of instances where short sales are effected in reliance on the bona-fide market maker exception from the Regulation SHO “locate” requirement will not only impose additional compliance and operational challenges on broker-dealers but will also no doubt further exacerbate instances of regulatory examinations and investigations concerning the use of such exception.
The full text of the release is available here. The SEC’s proposal stems from direct congressional authorization in the Dodd-Frank Act, and it is therefore reasonably likely that the SEC will adopt some form of short position and short sale transparency. Thus, market participants may want to focus on such issues as whether the proposed thresholds should be calibrated to truly capture “large” short positions, the operational challenges created by potential requirements to report substantial amounts of granular daily information regarding purchase/sale activity contributing to the reportable short positions, and the expedited timeframes for reporting (which are more aggressive than for reporting of long positions).
Notwithstanding all of the questions and issues that arise from the proposed reporting requirements, including the significant interpretive, operational, and compliance challenges that are likely to arise, the SEC announced a very short comment period of 30 days after publication in the Federal Register, which will likely close no later than April 26, 2022. As such, interested market participants must act very quickly to gather information and submit comments during the comment period, which overlaps with several other important proposed rulemakings by the SEC.
1 See, e.g., Sidley Update, SEC Proposes to Shorten Beneficial Ownership Reporting Deadlines, Expand Scope — How Will It Affect You? (February 24, 2022), available here; Sidley Update, SEC Proposes Extensive Reporting and Disclosure of Securities Lending Information (November 23, 2021), available here; Sidley Update, “Get Shorty” — FINRA Requests Comment on Proposed Significant Changes to Short Position and Stock Loan Reporting (June 7, 2021), available here.
2 For example, based on the current market price of $838 in Tesla, Inc. (TSLA) as of the time of this Client Alert, a short position of 12,000 shares in TSLA would exceed the threshold (i.e., would have a market value of $10,056,000) and be required to be reported.
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