Short-Selling and Securities-Lending Rules Meet Legal Resistance

Pressing ahead with rulemakings rooted in the post-financial crisis Dodd-Frank Act, the Securities and Exchange Commission on a single day last October approved separate sets of requirements for short selling and securities lending.

One of them, Rule 13f-2, requires investment managers to report to the regulator equities short-position and activity data in order to “promote greater transparency about short selling both to regulators and the public,” as SEC Chair Gary Gensler put it. The compliance deadline is January 2, 2025.

By a year later, transparency would be enhanced on the securities lending side through Rule 10c-1a. Certain confidential information is to be reported to a registered national securities association (RNSA) for oversight purposes and for public release of aggregated data.

There may, however, be a snag. In March, the National Association of Private Fund Managers (NAPFM), Alternative Investment Management Association (AIMA) and Managed Funds Association (MFA) filed a lawsuit seeking to vacate the rules. They argued that each is “invalid in its own right,” with further complaints including that the public was “deprived of a meaningful opportunity to comment”; and that “the commission did not reasonably explain why It refused to adopt a less burdensome alternative” to the short sale rule.

Operational Burdens

Firms subject to the requirements already collect most if not all the required data, said Josh Galper, managing principal of consulting firm Finadium. They may nevertheless face operational challenges, with 13f-2 being more of an issue in the way it relates to some firms’ short-selling strategies.

Josh Galper of Finadium

“If the Reddit crowd, for example, sees XYZ hedge fund has a short on a certain stock, those investors could buy the stock in mass and cause a short squeeze, along the lines of GameStop,” Galper said, referring to so-called meme stock disruptions.

Data from Form SHO reports, due within 14 days of the end of a calendar month for securities shorted above a certain threshold, would be published with a “slight delay” via the SEC’s EDGAR system. It would include certain short-sale-related information on each equity security, such as an aggregated number of shares across all managers and their gross short position at the close of the last settlement date of the month.

“If short squeezes appear likely,” said Galper, “hedge funds could leave the short-selling market.” Or they could limit the periods over which they short a stock, perhaps to the day before they must report. “The delay on the public side must be long enough to give safety to hedge funds to protect their strategies,” the analyst added.

Collection by Finra

Regarding 10c-1, Galper said he has not encountered a market participant who is concerned about releasing the required securities loan data.

Those he has spoken to don’t consider this data very useful to them, according to Galper, who noted that at least three data vendors already collect and offer more accurate securities lending data and provide the terms of securities loans to prime brokers.

Nevertheless, agent lenders facilitating securities lending transactions for custodial clients, and those lending directly through their own programs, will have to report three types of data, either themselves or through a reporting agent, to a RNSA, in this case the Financial Industry Regulatory Authority (Finra). These are material terms of the securities loan; any modifications to it; and confidential information that includes the legal names of the parties to the loan, whether it is from a broker-dealer’s inventory, and if it will be used to close out a failure to deliver the securities.

Quick Turnaround

Meeting the January 2, 2025, compliance deadline may be challenging.

Finra revealed in a proposal on May 1 some but not all of the architecture and mechanisms of the reporting framework and data elements for securities loans.

Anna Pinedo of Mayer Brown

On June 17, the SEC extended the date for its decision on Finra’s proposal (Rule 6500 Series: Securities Lending and Transparency Engine) to August 5, from June 21.

Mayer Brown partner Anna Pinedo said the extension “was helpful, but the SEC didn’t say precisely what is in scope.” It didn’t provide a definition for what constitutes a securities loan. So “it will be difficult to identify all the positions that will require reporting and form a good compliance program.”

Leading Indicator?

On June 5, the U.S. Court of Appeals for the Fifth Circuit in New Orleans – where the NAPFM-AIMA-MFA v. SEC suit is pending – vacated the SEC’s Private Fund Adviser rule. A three-judge panel found that the agency had exceeded its statutory authority. Compliance was to begin this September.

Seeing similarities between the complaints, Pinedo said that “there is reason to be hopeful” for a similar outcome on short selling and securities lending.

The three associations filed a brief on May 28 arguing the SEC misused its authority by failing to consider the rules’ economic impact, how they would interact, and the inconsistent nature of the disclosure regimes.

“This is a textbook example of unreasoned and arbitrary agency action,” the brief said.

Citing the SEC’s contention that it isn’t obligated to ensure the loan disclosure regime doesn’t conflict with the statute authorizing limited short-sale disclosures, the plaintiffs asserted, “That argument violates basic interpretive principles requiring that courts harmonize separate provisions and prefer the specific over the general.”

Reckonings with the Courts

Another Fifth Circuit ruling, dated June 26, went against Gensler and the SEC for acting “arbitrarily and capriciously” in reversing some proxy advisory rules that were adopted in the previous administration. And it was a Fifth Circuit decision in SEC v. Jarkesy, objecting to the SEC’s in-house administrative proceedings for enforcing civil money penalties, that the Supreme Court upheld on June 27.

CFTC Commissioner Caroline Pham

Around the time of those rulings, Gensler was quoted as saying, “If the courts adjust, we adjust.”

On the Jarkesy decision, Caroline D. Pham of the Commodity Futures Trading Commission issued a statement that the agency serving as “prosecutor, judge and jury lack[s] the checks-and-balances imposed by separation of powers between the executive and judicial branches of government to ensure a fair hearing and due process . . . There’s more work to be done at the commission to ensure that our adjudications and settlements can withstand scrutiny, particularly when they deprive others of property without appropriate due process and in violation of the Constitution.”

Wary of Jarkesy’s far-reaching regulatory implications, Representative Maxine Waters of California, the top-ranking Democrat on the House Financial Services Committee (HFSC), said that it “significantly weakened the ability of the federal government to protect our consumers and investors, our housing and financial markets, our food supply, healthcare, and even the air we breathe or the parks we visit. [It] blocks the authority of the SEC and countless other critical government agencies . . . to quickly impose penalties against bad actors. Even more concerning, the Supreme Court ruling in Loper Bright Enterprises v. Raimondo undermined the authority of our government agencies to issue rules that protect our country as our economy and world change.”

HFSC Chairman Patrick McHenry, Republican of North Carolina, viewed that overturning of the so-called Chevron deference, along with Jarkesy, as “a welcome check to this administration’s overzealous regulators and their weaponization of the federal bureaucracy.”