Three hedge fund associations have sued the SEC, hoping to vacate two new rules aimed at boosting transparency of short selling. The risky trading strategy involves speculation, since the trader is counting on a stock’s decline.
The petitioner hedge funds are the Alternative Investment Management Association, the Managed Funds Association, and the National Association of Private Fund Managers. The lawsuit was filed in the US Fifth Circuit Court of Appeals located in Louisiana with jurisdiction over that state, plus Texas and Mississippi.
SEC’s new rules on short sales
In October, the SEC issued two rules aimed at enhancing the transparency of short selling and securities lending insofar as those two activities are connected.
In short selling, a position is opened by borrowing shares of a stock, bond, or other asset that the investor believes will decrease in value. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline and they can purchase the shares at a lower cost. The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.
One of the SEC’s short-selling rules requires certain fund managers to report their short sales to the SEC within 14 days of the end of the month. The SEC would then aggregate and publish the data on a delayed basis, keeping the fund manager information confidential.
“Despite our best efforts, the SEC decided to ignore the interconnected nature of these two rulemakings and failed to apply a consistent approach or principle to regulating these related markets.”
Bryan Corbett, President and CEO, Managed Funds Association
The second rule requires that financial companies that facilitate securities loans disclose information about those transactions to the Financial Industry Regulatory Authority, or FINRA, the self-regulatory organization overseen by the SEC, on a daily basis.
The lawsuit
The lawsuit argues that the two rules take a “fundamentally contradictory approach” because one rule acknowledges that “frequent, detailed disclosures about short sale activity” can be harmful to markets while the other requires “daily public disclosure of individual transaction information” that can be used to learn which funds hold a particular short position.
The petitioners claim the rules will discourage short selling because they would reveal confidential information about trading strategies and enable market participants to imitate or trade against funds deploying a short-selling strategy. The groups also argue the rules burdened markets with “substantial costs” and are at odds with the SEC’s statutory authority and US laws on regulatory rulemaking.
“Despite our best efforts, the SEC decided to ignore the interconnected nature of these two rulemakings and failed to apply a consistent approach or principle to regulating these related markets,” said Bryan Corbett, President and CEO of the Managed Funds Association, one of the trade groups, said in a press release.
Why the new rules?
The SEC’s short-selling requirements mandate that certain investors must report information about securities loans to FINRA and that FINRA make publicly available certain information that it receives regarding those lending transactions.
It also requires some institutional investors to report short-selling activity that is then shared publicly on an aggregated and delayed basis. Names of the parties involved are not made public.
The new rules are intended to increase the transparency and efficiency of the securities lending market. Investment managers will report to the SEC, and an aggregated, anonymized version of that information will be disclosed to the public by the agency, Chair Gensler explained.
They were passed in a 3-2 vote, with Republican Commissioners Hester Peirce and Mark Uyeda dissenting in both instances.
The SEC noted how a broker-dealer’s failure to notice such errors involving short sale data could have negative downstream consequences on the accuracy of the firm’s electronic records and reporting.
The move is designed to provide access to timely, comprehensive securities loan information to market participants, the public, and regulators, which will help provide borrowers and lenders with better tools to assess the terms of their securities loans and enhance the ability of regulators to oversee the securities lending market.
Short selling drew renewed attention in 2021 when retail investors drove up the price of shares in GameStop, causing heavy losses for hedge funds that had shorted the company.
Following the saga and responding to Congress’s attention to the short-selling issue, Gensler told lawmakers he would increase the transparency of that part of the market. His initiative has had a mixed reception among US industry participants and trade groups, leading to this lawsuit.
Recent cases over short selling
The SEC has recently brought charges related to short selling, charging investment adviser Sabby Management LLC and its managing partner, Hal D. Mintz, with illegal “naked short selling” in June. The SEC said the business and Mintz intentionally and improperly placed short sales when they knew or were reckless in not knowing that they had not borrowed or located the shares, and then failed to make timely delivery of the shares.
In its recent enforcement 2023 roundup document, the SEC specifically refers to a case involving short sales, but with a focus on how the business, Citadel Securities LLC, inaccurately characterized certain short sales as long sales and vice versa by improperly using its financial technology and not catching the mistake for five years.
The SEC noted how a broker-dealer’s failure to notice such errors could have negative downstream consequences on the accuracy of the firm’s electronic records, including its electronic blue sheet reporting, depriving the SEC of important information about the markets it regulates.