SEC and FSA Clamp Down on Short Selling of Financial Firms
SEC and FSA Clamp Down on Short Selling of Financial Firms
Elliot R. Curzon, Jennifer Epstein, David A. Vaughan, Richard L. Heffner, Alan Rosenblat, Patrick, W. Dennis and Darina F. O’Connor, Dechert LLP.
The US Securities and Exchange Commission (SEC) and the UK Financial Services Authority (FSA) have released regulations designed to limit short selling of financial firms and increase market transparency and liquidity. On 17 September 2008, the SEC issued an emergency order, adopting a new temporary rule imposing restrictions designed to curb naked short selling and the resulting delivery failures and a new anti-fraud rule applicable to short sellers who fail to deliver securities by the delivery dates (the ‘September 17 Order’).1 The FSA also had agreed to introduce new requirements to prohibit the active creation or increase of net short positions in publicly quoted financial companies from midnight 18 September 2008.
In this article (dated 24 September), we discuss three further emergency orders issued by the SEC on 18 September 2008, as amended by the SEC on 21 September 2008, and expand on the FSA’s short selling limitations announced on 18 September 2008, including further requirements and amended informal guidance issued by the FSA on 23 September 2008.
United States
On 18 September 2008, the SEC released three further emergency orders to increase market transparency and liquidity. According to the SEC press release, the SEC, ‘acting in concert with’ the FSA, took these temporary actions to prohibit short selling in financial companies ‘to protect the integrity and quality of the securities market and strengthen investor confidence’. On 21 September 2008, the SEC released technical amendments to two of those orders.
Ban on short selling ‘covered securities’
The first of the three emergency orders imposes a ban on short selling in the securities of financial institutions (the ‘Financial Firms Order’).2 This action follows an SEC emergency order issued in July limiting short sales in Fannie Mae, Freddie Mac, and 17 other financial firms.3 In the Financial Firms Order, the SEC explained that ‘[r]ecent market conditions have made [the SEC] concerned that short selling in the securities of a wider range of financial institutions may be causing sudden and excessive fluctuations of the prices of such securities in such a manner so as to threaten fair and orderly markets.’ The SEC also states that the recent sudden price declines in a wide range of securities ‘can give rise to questions about the underlying financial condition of an issuer, which in turn can create a crisis of confidence, without a fundamental underlying basis. This crisis of confidence can impair the liquidity and ultimate viability of an issuer, with potentially broad market consequences.’4
The SEC amended the original Financial Firms Order on 21 September 2008, in order to ‘ensure the continued smooth operation of orderly markets, and to coordinate to the extent possible with similar actions restricting short sales by foreign regulators.’ The discussion below includes the details of the Financial Firms Order as revised by the amending order released on 21 September.5
To prevent substantial disruption in the securities markets, the Financial Firms Order (as amended) temporarily prohibits any person from effecting a short sale in the publicly-traded common equity securities of any issuer identified by any US national securities exchange listing such securities as being a financial institution (each a ‘covered security’ and collectively, ‘covered securities’). Each national securities exchange has published a list on its website of the individual listed companies with common equity that will be covered by the Financial Firms Order (as amended), and these lists are expected to include banks, savings associations, broker-dealers, investment advisers, and insurance companies, whether domestic or foreign, and the owners of any of those entities.6 The national securities exchanges are authorised to exclude any issuers that do not want to be treated as a covered security under the Financial Firms Order (as amended).
Positioning Investors for Opportunities in the Credit Cycle
John E. Dunn, III, Oak Point Investments, Geneva and Craig Brownell, Muirfield Capital Managment, New York.
Introduction
There is a growing consensus that one of the better financial market investment opportunities in the next three to five years will be a trade of credit and distressed assets. This is a strategy that we have been studying in detail and a story that is not new to the market, but, in our opinion, is one of the best investment themes of the decade. In this short article, we present a summary of how we believe the credit/distressed theme will play out over the next few years and how investors should position themselves to best take advantage of this opportunity.
Credit dislocation and opportunities created
Credit dislocation has been a theme over the past year, as evidenced by events in the sub-prime mortgage markets, and as witnessed by the enormous returns some investors made in 2007 being significantly short (as well as the significant amounts of money some investors have lost being long in the collaterialised debt obligation (CDO) space). This credit market liquidity breakdown, the record amounts of debt heaped on corporate balance sheets over the past three years, combined with a slowing economy, is setting the stage for multiple opportunities in the credit/distressed markets going forward. Almost everyone seems to agree, and it does seem to be a reasonable prediction, that the credit markets are poised for further turmoil, setting the stage for significant investment opportunities for those who can capitalise on these trends.
Yet, predicting the timing of how the credit turbulence might play out in the coming months and years is no easy task, because, until now, the lower quality credit markets have dislocated on relatively small liquidity and the timing of further weakness will really depend upon a host of economic/political/market factors which are beyond the scope of this article. But all participants seem to be in agreement as to how the sequence of opportunities in the credit markets will play out. We strongly believe that fundamental research-driven hedge funds are best positioned to exploit this evolving opportunity as it works through the capital structure over the next several years. It will be very important to have professional oversight on these investments as the opportunity evolves.
Leverage loan inventory clearance and sweetened deals
With the spate of leveraged buyout (LBO) financing for the past several years and the breakdown of the natural collateralised debt obligation (CDO) buyers of the great majority of this paper in 2007, investment opportunities which seem likely to appear the soonest will be the trades in clearing the ‘hung inventory’ of bank-issued leveraged loans. How much of this enormous inventory has already been cleared is quite difficult to guess, street estimates of the size of the inventory ranges from 80-50% of the $700 billion in new leveraged loans financed in 2007 and are still on bank balance sheets. In more general terms, John Paulson, founder of Paulson & Co., speaking at the GAIM Monaco conference in June 2008, believes that banks are only a third of the way through credit-related write-downs. The only remaining natural, but selective, buyers of this leveraged loan paper are principally the hedge fund industry, and although prices have come off sharply (in fact, significantly lower than pricing in the previous credit cycles), industry participants are divided as to how much of the inventory has actually been sold off.
Comparing this credit crisis to 2001
A key differentiating factor in this credit crisis, compared to that of 2001 and 2002, is the fact that the great majority of these ‘over-leveraged companies’ are still, relatively, ‘quality’ companies with good underlying businesses, a completely different scenario from the credit crisis of 2001, where the credit culprits were technology start-ups and telecommunications disasters, many of which were only good business plans and did not become secure operating businesses. Yet, prices of leveraged loans (remember, this is mainly senior secured paper of operating businesses with real cash flows which just happen to be over leveraged) have corrected much farther than prices in the 2001 credit cycle. For a variety of reasons, however, the buyers seem still to be waiting on the sidelines for bids on these securities at still lower levels.
Monday 22 September: The Day the Contrails Faded
Chris Holt, www.AllAboutAlpha.com.
Climate researchers have long debated the effect of airplane contrails on the average ground temperature. They theorised that contrails prevented sunlight from hitting the ground and warming the lower atmosphere. But while each individual contrail could, in theory, create a slight shadow over a wide area, it was impossible to really gauge the effect of these ubiquitous clouds on the overall climate, unless people literally stopped flying for several days.
Of course, this is exactly what happened during the week of 11 September 2001. And researchers subsequently discovered that contrails did affect climate after all. As CNN reported at the time, the average temperature volatility in the US actually rose significantly:
‘During the three-day commercial flight hiatus, when the artificial clouds known as contrails all but disappeared, the variations in high and low temperatures increased by 1.1 degrees Celsius (2 degrees Fahrenheit) each day, said meteorological researchers.’
The recent moves by the SEC and the FSA to curtail shorting of financial stocks provides researchers with a similarly unique opportunity to examine the effect of this equally ubiquitous phenomenon.
Academics have theorized that shorting causes increased market volatility — particularly downside volatility revealed in the negative skew of market returns. A 2004 study by Arturo Bris, William Goetzmann and Ning Zhu of Yale concluded that countries with no short-selling restrictions (in light grey below) had less negative skew than countries with rules preventing short-sales (in dark grey).
The skew of each country’s market returns is captured by the horizontal axis on the chart below. The vertical axis shows the extent to which each market is ‘efficient’ at pricing individual securities.
Airlines: A Play on Oil or a Real Investment Opportunity?
Dr. Fred Lazar, Schulich School of Business, York University, Toronto.
If we look at the airline industry over a long period of time, and we include not only the airlines, but also all of the suppliers to the airlines — aircraft manufacturers, airports, ground handling companies, IT firms, management consultants, leasing companies, freight forwarders, global distribution systems, engine and airframe maintenance and repair organisations, flight simulator manufacturers, pilot training companies and air traffic control operators — we find an industry with very attractive investment characteristics.
The industry is critical for the global economy. It connects people, so it is important for business as well as tourism. It moves freight, so it is important for world trade, especially for time-sensitive products.
The total revenues of the entire industry have grown more rapidly than world GDP during each decade in the past 50 years. Total revenues have rarely declined from one year to the next.
The industry is technologically advanced, from the engines, the airframes, the IT systems and financial engineering inherent in leasing. At one time, American Airlines had the largest computer network outside the US Pentagon.
Everyone in this industry, with the exception of the airlines themselves, seems to make profits consistently. Indeed, tens of billions of dollars are invested annually in this industry, whether it is developing new airports or expanding existing ones, or building new planes and engines, or creating new software and acquiring new hardware, or training pilots, flight attendants, mechanics and other maintenance workers.
But for the airlines, it is either feast or famine. Since the deregulation of the US airline industry in 1978, there is an ever-expanding graveyard filled with new and old airlines. Almost every business model has failed at one time or another.
Warren Buffett, after his experience investing in US Airways, now avoids this sector like the plague. He views airlines as a black hole that devours investors and their money.
Part of the problem facing airlines is the legacy of regulation. Yes, most countries have ‘deregulated’ this industry, but it is still subject to countless regulations. There are foreign ownership restrictions, a throwback to the days when every country believed that it needed its own flag carrier. There are the bilateral treaties which impose limitations on who can fly between cities in different countries, how often they can fly and what they can charge. Both Emirates and Etihad Airlines want to provide daily service to Toronto, but are prevented from doing so by the existing bilateral treaties. And, of course, there are labour laws, environmental laws, consumer protection laws, pension laws, occupational health and safety laws, product safety laws and the list goes on.
Governments have also created an asymmetrical relationship between airlines and airports, which strongly favours the airports — not surprising, since there was money in doing so for governments. The International Air Transport Association (IATA), the lobbyist for all the major world airlines, has been arguing for years that this asymmetrical relationship greatly threatens the viability of airlines and, thus, the ‘goose’ that lays the golden eggs for the airports. So far, the IATA has had limited success in changing the relationships and costs for the airlines.
KPMG's Latin American Capital Flows Survey
Jose Aldrich, KPMG’s Iberoamerica Tax Services, Miami.
Introduction
KPMG’s 2008 Iberoamerica Tax Summit in São Paulo, Brazil, coincides with a major global reassessment of the economic assumptions that have driven world commerce for the past decade.
The reasons for this change are many and varied, from the immediate impact of the credit crunch, to the longer term influence of globalisation, increased mobility of capital and labour, and the inexorable march of new technology. But businesses all over the world are being required to look again at their methods of working, adopt a global mindset and reassess the opportunities open to them.
To find out how these changes are affecting businesses in Latin America, we have commissioned a survey of nearly 140 senior corporate decision makers covering Mexico, Brazil, Argentina, Chile, Colombia, Peru and Venezuela. To build up a picture of how Latin American business is reacting to these global challenges, we followed the pattern established by KPMG’s global study of future capital flows (published earlier in the year) and asked the corporate executives about their companies’ investment plans now and in five years’ time.
More specifically, we asked them what view they took of proposals from the Organisation for Economic Co-operation and Development (OCED) for a new way of working between taxpayers, tax authorities and tax advisers, based on mutual trust and voluntary disclosure of information.
This is our report on what these forward-thinking executives said. It paints a fascinating picture of a set of economies in transition. We hope it adds real value to the debate on the future direction of Latin American business.
Commentary
This is the second of KPMG’s 2008 inquiries into international capital flows. The first, published at the Europe, Middle East and Africa Tax Summit in Barcelona in June, looked at capital flows across 15 countries around the world, and concluded that we may be seeing the emergence of a roughly equal, three-bloc world economy, comprising the Americas, Europe and Asia Pacific.
For this study, we have focused on seven large Latin American economies, Mexico, Brazil, Argentina, Chile, Colombia, Peru and Venezuela. Researchers asked nearly 140 senior corporate decision makers which countries (other than their own) they intend to invest in during 2008/09 and where they are looking to invest in five years’ time.
This group of people was chosen because their investment decisions are medium to long term, they are intended to generate real growth for the companies they run, and they are usually made on the basis of careful analysis of the underlying prospects for markets and countries.
The results show a strong preference this year for investment in the Americas, especially in Latin America. In fact, of all the investment decisions our respondents have made for this coming year, 63% have resulted, or will result, in an investment in a Latin American country.
Brazil heads the table with 21% of respondents planning an investment in the next year, followed by the US with 19%, and Argentina and Chile with 15% each.
An Open Letter to the Financial Times
Simon Ruddick, Albourne Partners, London.
The following letter was written by Simon Ruddick, Managing Director of Albourne Partners, on 3 October 2008, and he has kindly granted Alternative IQ permission to have it reprinted here.
Albourne is not a hedge fund, but it helps pension plans, university foundations and charities and the like allocate money to them. We are hugely proud of this work because we are utterly convinced that hedge funds are good for our clients; good for the markets and good for the average man and woman in the street.
For all our sakes, discussion of the role and impact of hedge funds has to be disentangled from the populist politics of envy. For the record, although it should be completely irrelevant: I have never voted Conservative; I was the first in my family to stay in school after 15 and I am hugely proud of my family’s union roots; I am writing this from our offices, which are juxtaposed between a gas-works and a home for lost dogs. I feel compelled to ‘stand up and be counted’ at this time exactly because it will be the vulnerable in society who end up bearing the brunt of the current meltdown in common sense, if it continues on its current path.
Canadian Hedge Fund Industry Celebrated the Best-of-the-Best
The Hedge Funds Awards, The Boiler House, Toronto.
The night of 16 September 2008 was one of celebration for hedge fund managers and service providers in the alternative asset space, as the Hedge Fund Hotel and ISI Publications hosted the inaugural Canadian Hedge Fund Awards.
The event, sponsored by KPMG, Belzberg Technologies Inc and RBC Dexia, was held at the Boiler House in the historic distillery district — a beautiful venue just as unique as the funds celebrated during the evening. Though the market is currently experiencing a time of turmoil, the financial services industry took the time to come together and honour the innovative and top-performing funds of the past year.
Janet Ecker, President of the Toronto Financial Services Alliance and former Ontario Finance Minister, the keynote speaker, began the evening and spoke on the developments in the financial services industry here in Toronto, as well as in the rest of Canada, that will continue to make Canada competitive on the world stage.
The award ceremony was kicked off after dinner, with the winners of the Best Sharpe Ratio group; Creststreet Energy Hedge Fund L.P. taking home that prize in the AUM under $25 million category and CI Trident Global Opportunities Fund winning the AUM over $25 million award. In the Best Overall Return group, Creststreet again took home the AUM under $25 million category, while Sextant Strategic Opportunities Hedge Fund L.P. was the winner in the AUM over $25 million category, with an amazing return of 139.56% this year.