Something We Can All Agree On? SEC Unanimously Approves Proposed Short-Seller Disclosure Rules

Section 929X of the Dodd-Frank Act requires the SEC to implement a regulatory framework around the public disclosure of short sale information. On Feb. 25, 2022, the SEC unanimously approved proposed rules aimed at satisfying this mandate. SEC Chair Gary Gensler praised the new proposed rules, noting that, if ultimately adopted, they will "strengthen transparency of an important area of our markets that would benefit from greater visibility and oversight." Meanwhile, sole Republican SEC Commissioner Hester Peirce similarly welcomed the proposed rule, noting it "responds to a statutory directive and, if adopted, should help to provide needed transparency around short interest." Given the disparate partisan views on much of the Commission's recent rulemaking, the four commissioners' agreement on the need for a proposed framework around short-seller disclosure is newsworthy in and of itself.

As for the proposed rules,¹ this SECond Opinions Blog digs into a brief background on short-selling aspects of the agency's rule proposal,² current disclosure framework for short-selling, and some key takeaways.

But, before we do, let's revisit what a short sale is using a basic example:

• First, an investor – for this example, Jane³ – engages in a securities transaction involving stock in a publicly traded company, fictitious widget-maker ABC Corp. (ABC)
• But Jane does not engage in the transaction using ABC shares she owns. Instead, Jane borrows 100 shares in ABC Corp. from a brokerage firm
• Jane then sells the 100 borrowed ABC shares to the market at $30 per share, receiving total proceeds of $3,000 (excluding trading fees)
• Jane is betting the price of ABC stock will drop. She may think so for a variety of reasons, such as her belief that ABC's business is suffering, that market conditions will pose significant challenges to its ability to operate profitably, among other reasons
• After the transaction, ABC's share price drops to $20 per share
• Jane, having sold 100 borrowed shares of ABC for $3,000, now buys 100 shares of ABC for $2,000
• Jane then returns 100 shares of ABC Corp. to the broker from whom she borrowed them, having made $1,000 (excluding fees and borrowing interest) in the short sale

Background on Short-Selling and Current Disclosure Obligations

There is nothing unlawful or inherently wrong with short-selling. In fact, certain financial experts have noted that it provides for market efficiency and an appropriate price finding mechanism.

Over the years, the Commission has implemented certain short-selling regulations – such as Reg SHO – around marking requirements, price test circuit breakers for exchanges, and "locate" and "close out" requirements for broker-dealers.⁴ Additionally, in October 2008, the Commission adopted interim temporary Rule 10a-3T, which required institutional investment managers to file weekly nonpublic reports regarding their short sales and positions in certain securities (the rule expired in 2009).

However, in recent years, many companies and subject matter experts have raised concerns about undisclosed short-selling activity in connection with negative activism campaigns.⁵ For example, on Feb. 12, 2020, Professors John C. Coffee Jr. and Joshua Mitts of Columbia Law School filed a petition with SEC for proposed rulemaking related to short seller activity. Professors Coffee and Mitts requested that the Commission utilize its rulemaking power under Sections 10(a)(1) and 10(b) of the Securities Exchange Act of 1934 to: 1) "…impose a duty to update promptly a voluntary short position disclosure which no longer reflects current holdings or trading intention"; and 2) "…clarify that rapidly closing a short position after publishing (or commissioning) a report, without having specifically disclosed an intent to do so, can constitute fraudulent scalping in violation of Rule 10b-5."⁶

Although the Proposed Rule does not squarely address the issues raised by Coffee and Mitts,⁷ it's worth highlighting that calls for short-seller disclosure rules predated the "short squeezes" and market volatility events in 2021 around meme stocks. Coincidentally – or perhaps not – the SEC's rule proposal comes on the heels of reports that the U.S. Department of Justice is investigating whether short-sellers conspired to drive down stock prices by sharing damaging research reports ahead of time and engaging in illegal trading tactics (such as "bear raids" and "short and distort schemes").

While the SEC's Proposed Rule does not impose broad-based disclosure requirements for all short-sellers, the rule does seek to lay bare certain short-sale activity.

Proposed Rules and Key Takeaways

Under the Proposed Rule, certain market participants would be required to collect and report certain short-sale data confidentially to the SEC on a monthly basis.⁸ The SEC would analyze the reported data, and make certain aggregated aspects of the data from the reporting parties available to the public for each individual security. Here are some key takeaways:

• Definition of Institutional Money Managers is Broad: Proposed Rule 13f-2 and Form SHO would require that "institutional money managers" (hereinafter, managers)⁹ file certain short-sale-related data with the Commission on a monthly basis. The definition of managers is broad, as the SEC noted that the term "can include investment advisers, banks, insurance companies, broker-dealers, pension funds and corporations."¹⁰ Companies across a variety of industries should be aware of the rule's contemplated broad scope.

• Proposed Rules Do Not Apply to All Short-Sale Activity: The Proposed Rule does not require all managers to file the proposed Form SHO.¹¹ Instead, the gating requirements would depend on whether a manager meets certain short position "reporting thresholds" for accounts over which they have "investment discretion":¹²

1. for any equity security of reporting issuer¹³ in which the manager meets or exceeds either (a) a gross short position of $10 million or more at the close of any settlement date during the calendar month, or (b) a monthly average gross short position – as a percentage of shares outstanding in the equity security – of 2.5 percent or more; and
2. for any equity security of an issuer that is not a reporting company in which the manager meets or exceeds a gross short position of $500,000 or more at the close of any settlement date during the calendar month.

This means that managers may be subject to the reporting requirements at certain points in time while otherwise exempt from reporting at other times in a given year. This possibility will impose additional requirements on internal legal and compliance staff to carefully monitor and track to avoid lapses in required reporting (or unnecessary reporting when not required). This is another regulatory hurdle for broker-dealers and advisers still adapting to Reg BI and Form CRS requirements and private fund advisers who may well find themselves implementing a whole slate of new rules.

• Unclear If Hedging Classifications on Proposed Form SHO Will Allow SEC to "Eliminate Noise" in Trading Data: Under the Proposed Rule, managers would submit certain information concerning their "gross short positions" to the SEC within 14 calendar days after the end of each calendar month. A "gross short position" would mean the number of shares of the equity security that are held short, without inclusion of any offsetting economic positions, including shares of the equity security or derivatives of such equity security.¹⁴

Given that "gross short positions" do not factor in any hedged positions, on Column 9 of the proposed Form SHO, the manager is to indicate whether the identified gross short position is fully hedged, partially hedged or not hedged at the close of the last settlement date of the calendar month of the reporting period.¹⁵ According to the Proposed Rule, "[t]he Commission believes that hedging information also can assist with distinguishing position trading, which typically has corresponding hedging activity, from other strategies such as arbitrage."¹⁶ It's unclear whether such broad categorization can sufficiently classify complex and nuanced trading strategies to enable the agency to adequately data crunch in a way that is meaningful to both regulator and market participant.

• SEC Aims to Supplement Existing Short Data … But Will It Be Stale Upon Publishing?: The aim of the proposed rule is for managers to frequently provide granular data, from which the SEC will consolidate, anonymize and then produce aggregated information – by security – to the public.¹⁷ Although certain short-sale data is currently available to the public through the Financial Industry Regulatory Authority (FINRA) and various exchanges, the Commission believes that the proposed data requirements will, in the words of Chair Gensler, "supplement the short interest data that is currently available, providing the public and market participants with more visibility into the behavior of large short sellers."

The Commission would publish, based on information reported in proposed Form SHO, the following aggregated data:

1. the issuer's name and other relevant identifying information
2. the aggregated gross short position at the close of the last settlement date of the calendar month
3. the corresponding dollar value of this reported gross position
4. the percentage of the reported aggregate gross position as fully hedged, partially hedged or not hedged, and
5. for each reported settlement date during the calendar reporting month, the net activity in the security, as aggregated across all reporting managers

However, given that the Commission's plan to produce data "within one month after the end of the reporting calendar month," it's unclear how beneficial this data will be to market participants dealing with rapidly evolving market trends.

The public comment period for the rule proposals will remain open for 60 days following publication of the proposing release on the SEC's website or 30 days following publication of the proposing release in the Federal Register, whichever period is longer.

The SECond Opinions Blog will continue to monitor the agency's proposed rulemaking and provide further updates. If you need any additional information on this topic – or anything SEC – or internal-investigations-related, please contact the authors or another member of Holland & Knight's Securities Enforcement Defense Team.

¹ See Short Position and Short Activity Reporting by Institutional Investment Managers, (Release No. 34-94313; File No. S7-08-22), Feb. 25, 2022.

² To supplement the short sale data available to regulators, the Commission proposed a new provision of Regulation SHO (Reg SHO) – Proposed Rule 205 – as well as amendments to the consolidated audit trail plan created pursuant to the requirements of Rule 613 of the Exchange Act. Collectively, these amendments would require broker-dealers to collect and submit additional data on purchases to cover short sales. The Commission also reopened the comment period for Proposed Exchange Act Rule 10c-1 related to the securities lending market. 

³ In many instances, Jane may be an entity not an individual.

⁴ See Reg SHO: Rule 200, 201, 203, and 204.

⁵ See Proposed Rule at 12, FN 22 for examples.

⁶ On July 22, 2021, Rep. Maxine Waters (D-Calif.) introduced – and the House Financial Services Committee later advanced to the Floor, H.R. 4618 – The Short Sale Transparency and Market Fairness Act, to amend the Securities Exchange Act of 1934 to "modernize reporting requirements under Section 13(f) of the Act." The bill proposed to shorten timelines for 13(f) reporting from quarterly to monthly and required disclosure about short positions.  Professor Mitts took issue with the bill's provision for potential confidential treatment of Form 13-F filings.

⁷ Notably, Coffee and Mitts specifically stated "[w]e are not advocating that the Commission mandate the disclosure of short positions."

⁸ The Commission noted that "[t]he proposed changes would fulfill the Congress's mandate under Section 13(f)(2) of the Securities Exchange Act, added under Section 929X of the Dodd-Frank Wall Street Reform and Consumer Protection Act, to prescribe rules to make certain short sale data publicly available."

⁹ As defined in Section 13(f)(6)(A) of the Exchange Act and for purposes of Proposed Rule 13f-2,

"institutional investment manager" includes any person, other than a natural person, investing in or buying and

selling securities for its own account, and any person exercising investment discretion with respect to the account of

any other person.

¹⁰ See Proposed Rule at 8 FN 15.  

¹¹ The Proposed Rule requires the following information: 1) the name of the eligible security; 2) end of month gross short position information; and 3) daily trading activity that affects a manager's reported gross short position for each settlement date during the calendar month reporting period.

¹² For purposes of Proposed Rule 13f-2, the term "investment discretion" has the same meaning as in Rule

13f-1(b) under the Exchange Act.  17 CFR 240.13f-1(b). This rule cross references 15 U.S.C. 78c(a)(35), which includes, in the SEC's words, a "comprehensive" definition of investment discretion. Specifically, "a person exercises ‘investment discretion' with respect to an account if, directly or indirectly, such person (A) is authorized to determine what securities or other property shall be purchased or sold by or for the account, (B) makes decisions as to what securities or other property shall be purchased or sold by or for the account even though some other person may have responsibility for such investment decisions, or (C) otherwise exercises such influence with respect to the purchase and sale of securities or other property by or for the account as the Commission, by rule, determines, in the public interest or for the protection of investors, should be subject to the operation of the provisions of this chapter and the rules and regulations thereunder."

¹³ A reporting issuer is an issuer that has a class of securities 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.

¹⁴ Proposed Rule at 20 FN 57.

¹⁵ A position is "fully hedged" if the manager also holds an offsetting position that reduces the risk of price fluctuations for its entire position in that equity security. A partially hedged offsetting position is less than the

identified price risk associated with the reported gross short position in that equity security.

¹⁶ Proposed Rule at 31-32.

¹⁷ The agency explicitly noted that it tried to strike a balance between confidential submissions and public disclosure. "The Commission believes that publicly disclosing the identity of individual reporting Managers may not currently be necessary to advance the policy goal of increasing public transparency into short selling activity, and that aggregating across reporting Managers would help safeguard against the concerns noted above related to retaliation against short sellers, including short squeezes, and the potential chilling effect that such public disclosure may have on short selling." Proposed Rule at 18.