SHORT SELLING A BRIEF OVERVIEW AND REGULATORY UPDATE

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Short Selling

Contents Executive Summary What is Short Selling? How Does Short Selling Work? The Benefits of Short Selling How is Short Selling Regulated in the U.S.? Regulation SHO European Short Selling Regulations Short Selling Regulation in the EU Short Selling Bans Effects of Short Selling Bans References

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Short selling is a strategy used by investors to balance portfolio allocations and manage risk. It also performs a number of important roles in the marketplace aiding with price discovery and providing much-needed liquidity. This presentation offers a brief overview of short selling, the benefits it provides for investors and the marketplace, and how it is regulated in the United States and European Union.

Executive Summary:

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What is Short Selling?

Short selling is a trading strategy fund managers and other investors employ when they believe that shares of a particular stock are overpriced. It generally means borrowing a security (or commodity futures contract) from a broker and selling it, with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker. The short seller closes out the short position by purchasing equivalent securities on the open market, or by using an equivalent security it already owned, and returning the borrowed security to the lender. Short selling can be used to profit from an anticipated downward price movement, to provide liquidity, or to hedge the risk of a long position in the same security or in a related security or other type of long exposure.

Source: http://www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm.

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What is Short Selling?

In covered short selling, the investor has made arrangements to either borrow the securities or to ensure that they can be borrowed to perform the transaction.

A naked short sale is one in which the investor does not own the securities at the time of the sale and has not made arrangements to borrow them in time to make delivery to the buyer within the standard three-day settlement period. If the seller does not deliver shares within the required time frame, that is known as a failure to deliver. A failure to deliver generally does not occur in a covered short sale because an investor has ensured that shares can be borrowed and delivered.

Types of Short Selling:

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How Does Short Selling Work?

John Doe holds 100 shares of XYZ Co. - valued at $25 per share as a long investment position.

Mr. Doe is worried about XYZ Cos upcoming earnings report, however, and decides to offset this long position by selling short ABC Inc. stock - which is in the same market sector as XYZ Co. and would likely also lose value should XYZ report poor earnings.

Mr. Doe makes arrangements to borrow 100 shares of ABC Inc. stock at $25 per share and immediately sells it in the marketplace netting $2,500. Mr. Doe must return the borrowed shares at a specified date.

As anticipated, the earnings report is negative and XYZ Co. and ABC Inc. stocks both decrease in value to $20 per share. Mr. Doe buys back the quantity of ABC Inc. stock needed to cover his short position (100 shares at $20 per share for a total cost of $2,000).

Mr. Doe has earned a profit of $500 on the short sale and offset the decrease in value of the long position held in XYZ Co.

BORROW 100 shares ABC @$25/share

SELL 100 borrowed shares ABC @$25

PROFIT FROM SALE of ABC shares = $2500

BUY 100 shares ABC@$20

RETURN 100 shares ABC to lender

COST TO PURCHASE 100 shares ABC @$20

= $2000

100 SHARES XYZ = $2500 VALUE

PROFIT from short sale of ABC shares =

$500

LOSS on100 shares XYZ =

-$500

6 * SEC Securities Lending and Short-Selling Roundtable : 9/29/09-9/30/09

The Benefits of Short Selling

The ability to quickly blend positive and negative information into share prices is essential for markets to work efficiently. Short selling provides the following benefits in the marketplace:* Increased liquidity Increased capital formation Improved price discovery, which bolsters investor confidence Decreased transaction costs (e.g. smaller bid-ask spreads) Decreased occurrences of price bubbles and / or crashes Efficient risk allocation Hedging against long term investment positions

How Does Short Selling Affect Markets?

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How is Short Selling Regulated in the U.S.?

The SEC is the government agency tasked with regulating securities markets in the U.S. Throughout the years, the SEC has developed and implemented various regulations related to short selling, including Regulation SHO, which it finalized on August 6, 2004 and has supplemented in recent years. Regulation SHO was adopted under the Securities Exchange Act of 1934 to meet the following goals, according to the SEC:

Source: http://www.sec.gov/spotlight/keyregshoissues.htm

Establishing uniform locate and close-out requirements to address problems associated with failures to deliver, including potentially abusive naked short selling.

Creating uniform order marking requirements for all equity securities sales, requiring participants to label orders placed with broker-dealers as long, short, or short exempt.

Short Selling Regulations in the U.S.:

Regulation SHO requires a broker-dealer to have reasonable grounds to believe the specified security can be borrowed so that it can be delivered on the due date before executing a short sale. Broker-dealers are required to document the location before making the transaction.

Broker-dealers must close-out any outstanding failure-to-deliver positions (open-fails) by the settlement day, following the settlement date.

Locate Requirement

Close-out Requirement

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Regulation SHO applies to short sales of equity securities and includes, among others, the following key components:

Regulation SHO

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Regulation SHO has been amended since implementation in 2005 to include new rules governing certain aspects of short selling:

Rule 201

Known as the alternative uptick rule, the SEC approved Rule 201 in February 2010 as an amendment to Regulation SHO. The rule includes a short sale-related circuit breaker, which is triggered when a securitys price declines by 10 percent or more in a day. Once triggered, short selling of that security is only permitted if the price is above the current national best bid. Rule 201 applies to all equity securities listed on a national securities exchange, regardless of whether they are traded in an exchange or over-the-counter markets.

Rule 204 In July 2009, the SEC amended Regulation SHO to include Rule 204 to reduce fails-to-deliver and curb abusive naked short selling. The SEC developed this rule in response to persistent fails to deliver in the marketplace, penalizing firms if they do not close out fails in a timely fashion.

Short Sale Data

Several self-regulatory organizations (SROs) provide daily aggregate short selling volume in formation on their websites and on a one-month delayed basis, information regarding individual short sale transactions in all exchange-listed securities. All of this information can be found on the SECs website: http://www.sec.gov/answers/shortsalevolume.htm.

Regulation SHO

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European Short Selling Regulations

European nations traditionally regulated short selling individually, rather than collectively through the European Union (EU). For example, during the financial crisis in 2008, several EU member states independently implemented independent emergency measures restricting or banning short selling. Subsequently, the European Commission released a proposed regulation in September 2010 related to short selling and certain aspects of credit default swaps (CDS). The proposal introduced common requirements for EU Member States and powers to harmonize regulation across Member States. After months of negotiations among the European Parliament, the Council of the European Union and the European Commission, a final text was agreed to in October 2011, and it was officially signed on March 14, 2012 by MEP Martin Schulz, the President of the European Parliament, and Nicolai Wamman, the EU Affairs Minister of Denmark (which held the rotating presidency of the Council of the European Union).

European Union and Member State Regulations:

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European Short Selling Regulations

Short selling Regulation was signed on March 14, 2012.

The European Securities and Markets Authority (ESMA) developed its draft advice and presented it to the European Commission on April 20, 2012.

The European Commission adopted its final delegated acts and regulatory technical standards on July 5, 2012.

The Regulation takes effect on November 1, 2012.

European Union and Member State Regulations:

European Short Selling Regulations

The regulation requires reporting of net short positions to regulators over a certain threshold, and public disclosure of net short positions over a higher threshold.

The regulation requires parties entering into a short sale to have borrowed the instruments, entered into an agreement to borrow them or made arrangements with a third party under which that third party has confirmed that the share has been located.

Reporting & Disclosure

Location

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The new regulation covers a number of items,* including:

Transparency & Restrictions

The regulation also provides competent authorities with power to require greater transparency or impose certain restrictions on short selling in emergency situations.

* The regulation also imposes restrictions on EU sovereign CDS, which are not covered in these materials. More information on EU short selling regulation can be found here.

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Short Selling Bans

During the height of the financial crisis, several international regulators put in place emergency measures to restrict the short selling of various financial companies and other issuers. In September 2008, the U.S. SEC issued an Order Halting Short Selling of certain financial securities in an attempt to restore equilibrium to the markets. The SEC acted in conjunction with the UKs Financial Services Authority (FSA), which instituted a similar ban.

U.S. and UK Short Selling Bans and the Financial Crisis:

14 *"The effects of short-selling public disclosure regimes on equity markets, Oliver Wyman, pp. 7. =**Why Banning Short-Selling Doesnt Do Any Good. August 12, 2011. CNBC.com

Effects of Short Selling Bans

Made capital raising more difficult for certain issuers;

Reduced market efficiency;

Decreased trading volume and market liquidity; and

Increased bid-ask

spreadsfrom a normal average of 17 basis points in 2008, to 60 basis points by October 8, 2008.

Following the SECs Order Halting Short Selling, numerous studies were conducted that analyzed the effects of the ban on markets. The studies generally found that the ban:

Did not stop the steep price declines (see chart below, from study by Oliver Wyman,* on stock declines during the U.S. and UK short sale bans noted in gray);

Increased volatility;

SEC Short Selling Ban:

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Effects of Short Selling Bans

A number of EU Member States took regulatory action in 2011 attempting to reduce market volatility resulting from the sovereign debt crisis. France, Italy, Spain and Belgium instituted temporary bans on short selling of financial companies in August 2011. The bans were lifted in February 2012. Further bans on short selling were instituted in Italy, Spain, and Greece in July 2012.

Short Selling and the European Debt Crisis:

U.S. Regulatory Agencies: Securities and Exchange Commission (SEC) www.sec.gov European Resources: 1. European Commission http://ec.europa.eu/internal_market/securities/short_selling_en.htm 2. Council of the European Union http://ue.eu.int/ 3. European Parliament http://www.europarl.europa.eu/news/en/headlines/ 4. European Securities and Market Authority (ESMA) www.esma.europa.eu/ 5. Financial Services Authority (UK) http://www.fsa.gov.uk/ Additional Resources: International Organization of Securities Commissions http://www.iosco.org/

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References

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