New rules on short selling of shares during public offerings

Author: | Published: 23 Dec 2011
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Nagashima Ohno & Tsunematsu

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Motoki Saito

The amendment to the Cabinet Orders and Cabinet Office Ordinances with respect to the Financial Instruments and Exchange Act (FIEA) prohibiting investors from acquiring shares through a public offering for the purposes of settling the short selling of such shares during the interim period between the announcement of such public offering and the determination of the offering price was promulgated in August 2011 and became effective in December.

Short selling is the practice of selling shares that have been borrowed from a third party with the intention of buying identical shares back at a later date to return to that third party. In conducting short sales, investors seek to benefit from a future decrease in the price of the shares, such that the investor will repurchase the shares at a price lower than the amount at which it initially sold them. Short selling by investors, which is permitted under the FIEA provided certain conditions are met, can cause the value of shares to fluctuate greatly.

Generally, however, it is considered that the short selling of shares contributes to the fairness and liquidity of the capital markets, in part because these transactions add insight as to what investors’ believe will be the future price of such shares.

Where investors engage in short selling during the period between the announcement of a public offering and the determination of its offering price, whereby such short sale transactions would be settled with the offered shares in the public offering, the Financial Services Agency (FSA) has noted that investors may unfairly manipulate the price of such shares to the detriment of the market.

In Japan, when listed companies raise funds by way of public offering, such companies typically first announce the public offering and then, after the process of book-building, which usually takes a number of days, determine the offering price. In order to encourage investors to subscribe to an offer it is common for the shares to be offered at a discount.

During the period between the announcement of the public offering and the determination of the offering pricing, some investors have engaged in transactions whereby the price of shares subject to a public offering has been decreased as a result of short selling, whereby those investors were able to unfairly obtain benefits as a result of acquiring such shares at an excessive discount.

Further, it has been noted that short selling during this limited period results only in the unjust decrease in the price of the shares because investors settle these transactions with shares acquired through the public offering itself, not the market. It has therefore been determined that such transactions prejudice the fairness and transparency of Japan’s public markets and damage confidence among domestic and foreign investors.

The purpose of the amendment is to prevent such abusive transactions. Investors who have entered into short selling arrangements during the period between the announcement of a public offering and the determination of its offering pricing are now generally prohibited from settling such transactions with shares acquired through the public offering.

In order to ensure the effectiveness of this restriction, shares brokers (financial instruments business traders) who engage in the public offering of shares are required to notify investors in advance, in writing or by electronic means, that they are prohibited from selling those shares to investors if such a sale would result in the violation of the above restriction.

Further, under the new rules of the Japan Shares Dealers Association underwriters of public offerings are now required to ask the issuer to disclose in the prospectus that brokers are prohibited from selling shares to investors if such a sale would result in the violation of the aforementioned restriction.

Because of the relative novelty of the amendment it is still not clear how much of an effect it will have on the market. It is expected, nevertheless, that the amendment will help prevent unfair transactions and contribute to the transparency and liquidity of the Japanese market.

Motoki Saito