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Amending short selling in Japan

Takasumi Munakata
On March 7 2013, the Financial Services Agency of Japan (FSA) published its proposal for the comprehensive revision of short selling regulations. Those proposed revisions will be subject to public comment until April 8, at which point the FSA will consider any comments received and amend the relevant regulations and ordinances. The FSA has advised that it expects the proposed new regulations to come into force around November 2013.

Short selling is the sale of security by a party that does not hold the security at the time of sale. The short selling of securities benefits the market, as it allows for investors who do not hold the subject securities and expect that the price of the subject securities will decrease to express this opinion to the market, which can then be reflected in the price of such share. In addition, short selling also contributes to market liquidity. Where the market price of a security is declining, however, short selling of the security may exacerbate such decline, and may encourage unfair trading practices, such as so-called bear raids. In order to mitigate this risk, as well as other risks associated with it, short selling is carefully regulated in Japan.

There are five broad principles applicable to short selling on Japanese stock exchanges: an obligation to disclose whether the proposed transaction is a short sale; a prohibition, in principle, against short selling at a price equal to or less than the latest disclosed trading price of the subject security (the so-called uptick rule); a prohibition against short selling without ensuring that the subject securities will be delivered (naked short selling); an obligation for those who have a short position volume at or above a prescribed threshold (in principle, 0.25% of the issued shares of the entity) to report to the relevant stock exchange, through the applicable securities company, the balance of the short position, which the relevant stock exchange will then publish to the market; and a prohibition, in principle, against the settlement of a short sale by securities that are acquired by way of, for example, a public offering (regulation M).

From among the principles set forth above, the first two items came into force before 2008, while the last item is a new regulation that was introduced in 2011 to address issues concerning the credibility of the capital markets which were sparked by allegations of insider trading related to several large public offerings.

The other two items were introduced in October 2008 as temporary regulations to address capital market disruptions that were triggered by the collapse of Lehman Brothers. These regulations, however, have been extended many times for a number of reasons, including the European debt crisis and the Great East Japan Earthquake. The expiry date for these regulations is the end of April 2013; however it is likely that they will be extended through to the introduction of the proposed new regulations (as discussed below), which are scheduled to come into force in November 2013.

The amended regulations

Under the proposed new regulations, the uptick rule will be applicable only where the price of the applicable securities decreases by 10% or more from the closing price of those securities on the immediately preceding date. It seems that the purpose of this amendment is to regulate the price of short selling only when market confidence in a particular security is deteriorating in a material manner. Under the current uptick rule, it was argued that short-selling was difficult to conduct in practice and also did little to prevent unfair trading. It is expected that the proposed new regulation will improve the liquidity of the Japanese stock exchanges.

The fourth item listed above (the obligation to report the balance of a short position to the stock exchange) will remain in force; however, the reporting requirement will be amended such that a seller will be required to provide notice at a short sale volume of 0.2%. Further, the obligation of the exchange to publish the notification to the market will be amended such that this requirement will only be triggered where the short sale volume reaches 0.5%.

These amendments seem to reflect the belief that the previous publication threshold of 0.25% was too low and prevented short-selling, because investors who triggered such obligation would face the risk of being subject to a short-squeeze (a surge in share price due to the buyback of shorted shares at a loss). The reporting obligation threshold was lowered, however, and will help ensure the relevant authorities were aware of market behaviours so that appropriate steps can continue to be taken to ensure market stability.

In addition, trades through the Proprietary Trading System (PTS) will also become subject to short-selling regulations. It seems that this amendment is intended to create parity between standard stock exchanges and the PTS, in particular given the recent popularity of the PTS among institutional investors.

Takasumi Munakata

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