FSLA UPDATE
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FSLA Update
The FSA’s ‘ban’ on short-selling of
financial stocks: regulation by smoke
and mirrors?
Authors Nathan Willmott and Polly James
A great deal of controversy has surrounded the Financial
Services Authority (‘FSA’)’s temporary ‘ban’ on short-selling
of shares in UK banks and insurance companies, introduced on
19 September 2008. The criticism has ranged from the manner
in which the new provisions were introduced,1 to the broader
question of whether preventing short-selling in financial stocks
would have the intended impact on the financial markets at all.
However, this article examines a different, and perhaps more
fundamental, aspect – namely whether the ‘ban’ introduced by
the FSA in fact prohibits short-selling of financial stocks at all.
Although the FSA has described the provisions relating to shortselling introduced on 19 September 2008 as a ‘prohibition’, the reality
is that the statutory definition of market abuse remains unchanged
and unless short-selling UK financial stocks falls within the scope of
the statutory definition then it will not amount to market abuse.
To explain why this is the case, this article first examines the market
abuse regime and the operation of the Code of Market Conduct, before
assessing the true legal effect of the temporary ‘ban’ on short-selling
financial stocks.
THE MARKET ABUSE PROHIBITION
The civil offence of market abuse is defined at s 118 of the Financial
Services and Markets Act 2000. 2 Section 118 identifies various
types of conduct, each of which constitute different types of market
abuse.
One of these categories of market abuse is known as ‘misleading
behaviour’ and is defined at s 118(8)(a). Conduct amounts to
‘misleading behaviour’ for the purpose of the market abuse regime if it:
‘is likely to give a regular user of the market a false or
misleading impression as to the supply of, or demand for or
price or value of, qualifying investments’. 3
The FSA is required to issue a Code (known as the Code of
Market Conduct) which expands on the various types of conduct
amounting to market abuse listed in s 118. 4 The Code may, among
other things, specify descriptions of behaviour that, in the opinion of
the FSA, amount to market abuse; and also descriptions of behaviour
that, in the opinion of the FSA, do not amount to market abuse. 5
Where the Code of Market Conduct specifies conduct that, in the
FSA’s view, does not amount to market abuse then this is conclusive
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December 2008
– if a person behaves in that way then, even if that conduct falls
within one of the statutory definitions of market abuse contained at s
118, it will not amount to market abuse.6
However, the reverse is not true. If the Code of Market Conduct
specifies conduct that, in the FSA’s view, does amount to market abuse,
that is not conclusive. In cases where it is unclear whether or not
particular conduct falls within the statutory definition, such provisions
will certainly be relevant to assist in determining whether market abuse
has occurred.7 However, the FSA does not have the power, through the
Code, to expand the statutory definition of market abuse itself. As one
commentator has put it:
‘whilst the Code will inevitably form the centrepiece of any
consideration by firms or individuals as to whether they can
or cannot undertake a particular course of action, it remains
subsidiary to the statutory definition. In other words, conduct
that does not fall within the statutory definition cannot amount
to market abuse, whatever the Code says.’8
HOW THE SHORT-SELLING ‘BAN’ WAS IMPLEMENTED
Rather than amend the statutory definition of market abuse or
introduce new rules into the FSA Handbook,9 the FSA chose to
implement its temporary prohibition on short-selling UK financial
stocks by introducing new provisions into the Code of Market
Conduct.10
The purported prohibition is at para 1.9.2C of the Code of Market
Conduct and reads as follows:
‘A person who enters into a transaction that (whether by itself or
in conjunction with other transactions) has the effect of:
(a) creating a net short position in a UK financial sector company;
or
(b) increasing any net short position in a UK fi nancial sector
company that the person had immediately before 19
September 2008;
is, in the opinion of the FSA, engaging in behaviour that is
market abuse (misleading behaviour).’
This new provision was stated to take effect from 19 September
2008 but due to cease to have effect on 16 January 2009. No similar
Butterworths Journal of International Banking and Financial Law
provision was introduced in respect of short-selling stocks in nonfinancial companies.
Although the Code of Market Conduct does not itself refer to
this new provision as a ‘ban’ or a ‘prohibition’ on short-selling in UK
financial stocks, it was clearly publicised by the FSA as amounting to
a prohibition. The press release issued by the FSA on 18 September
2008 states that the Board of the FSA had, earlier that day, ‘agreed to
introduce new provisions to the Code of Market Conduct to prohibit
the active creation or increase of net short positions in publicly quoted
financial companies from midnight tonight’.
The press duly reported the new provisions as amounting to a
prohibition on short-selling on UK financial stocks.11 As a result, the
market appears to have responded by treating the new provisions of the
Code of Market Conduct as a binding prohibition on short-selling in
the selected financial stocks.
LEGAL EFFECT OF ‘PROHIBITION’ ON SHORT-SELLING UK
FINANCIAL STOCKS
However, regardless of the FSA’s opinion as stated in the Code
of Market Conduct, its press releases and speeches, if a person’s
behaviour in creating a net short position in a UK fi nancial sector
company does not fall within the statutory defi nitions of market
abuse, then market abuse will not have been committed.
The key question is, therefore, whether creating a net short
position in a UK financial sector company will in all situations
be ‘likely to give a regular user of the market a false or misleading
impression as to the supply of, or demand for or price or value of,
qualifying investments’.12
Plainly it is possible to identify circumstances where that would be
the case. However, it is equally the case that a net short position could
be taken in a UK financial sector company in a way that is not likely
to give a regular user of the market a false or misleading impression
as to the supply of, or demand for or price or value of, qualifying
investments. In such a case, despite the ‘prohibition’ implemented by
the FSA, such conduct would not amount to market abuse.
FSA’S BASIS FOR REFERRING TO THE NEW PROVISIONS AS
A ‘PROHIBITION’
It is unclear whether the FSA appreciates that the new provisions
of the Code of Market Conduct do not, as a matter of law, amount
to a prohibition on short-selling UK financial sector stocks. If the
FSA had knowingly referred to the new provisions as a ‘prohibition’
in circumstances where it was aware that they did not amount to a
prohibition, this would indeed be a serious matter for the regulator.
It would plainly be wrong for the FSA to mislead those around the
world as to the true legal effect of the new provisions, even if for
the legitimate purpose of encouraging them to stop taking short
positions in UK fi nancial stocks while markets remained so volatile.
This would amount to regulation by assertion rather than regulation
by obligation.
The only alternative rational explanation is that the FSA genuinely
believes that, in current market conditions, any transaction (or series
Butterworths Journal of International Banking and Financial Law
FSLA UPDATE
FSLA Update
of transactions) by a person which results in that person having a new
net short position in a UK financial sector company automatically
leads to a false or misleading impression being created (within the
meaning of s 118(8)(a)).
However, this analysis cannot be correct. If a person is transparent
in the transactions he enters into, and does so for legitimate
investment purposes, it would be difficult for the FSA to argue that
his behaviour was likely to give a regular user of the market a false or
misleading impression as to the supply of, or demand for or price or
value of, the relevant shares.
ARBITRARY OUTCOMES?
The new provisions in the Code of Market Conduct lead to some
arbitrary distinctions which plainly cannot have been intended by
the legislature when s 118 (in its current form) was enacted. For
example:
 Is it really the case that such conduct in relation to the selected
banks and insurance companies prescribed by the FSA would
amount to creating a false or misleading impression, while
exactly the same conduct in respect of a listed fund manager or
insurance broker would not?
 Why would the same conduct have been permissible on 18
September 2008 (the day before the new provisions were
introduced) but not on 19 September 2008?
 Why will entering into a net short position in a UK financial
stock be acceptable on 16 January 2009 (the day that the new
provisions cease to have effect) but the previous day they would
have created a false or misleading impression to a regular user of
the market?
 In circumstances where the FSA’s chief executive, Hector
Sants, has stated as recently as 22 October 2008 that the
regulators ‘still regard short-selling as a legitimate investment
technique which can contribute to market efficiency and is a
genuine approach based on a view of value’ is it really the case
that acting in this way, in relation to UK fi nancial stocks,
automatically leads to a false or misleading impression being
created in the mind of a regular user of the market?
Each case needs to be examined on its own facts. If a trader were
today to enter into a new net short position in a UK financial sector
stock, the issue of whether or not he had committed market abuse
would not be clear cut. Rather, he must be judged against the statutory
definition of market abuse. If, in the particular circumstances, his
conduct was not likely to give a regular user of the market a false or
misleading impression as to the supply of, or demand for or price or
value of, the relevant shares, then he will not have committed market
abuse (misleading behaviour).
The Financial Services and Markets Tribunal has in the past proved
to be an independent and robust court which is not afraid to dismiss
cases pursued by the FSA where the regulator fails to prove its case.13
In such a case it must be expected that the tribunal would determine
the proceedings in favour of the trader rather than the FSA.
December 2008
623
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FSLA UPDATE
FSLA Update
Biog box
Nathan Willmott and Polly James are members of the Financial Services and Markets
Group at the law firm Berwin Leighton Paisner. Both specialise in representing
individuals and firms in regulatory investigations and enforcement actions, including
defending allegations of market abuse.
Email: nathan.willmott@blplaw.com polly.james@blplaw.com
CONCLUSION
Finally, there has been some publicity indicating that hedge funds
and other entities routinely involved in short-selling of UK financial
sector stocks are considering bringing legal proceedings against the
FSA for losses sustained as a result of the implementation of its
prohibition.14
Firms considering commencing legal proceedings against the FSA
will need to keep in mind that the regulator has the benefit of statutory
immunity from damages in all cases save for unlawful conduct as a result
of s 6(1) of the Human Rights Act 1998 and conduct in bad faith.15
Perhaps more fundamentally, however, firms will also need to assess
whether a legal prohibition on short-selling UK financial sector stocks
has been implemented at all.
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1 The new provisions were announced by press release on the FSA’s website
during the evening of 18 September 2008 and were stated to take effect
at 0.01am the following day, 19 September 2008. However, at that time
the list of financial stocks which the new provisions covered had not been
published. When the list was published later on 19 September 2008,
it contained various material inaccuracies – for example, the original
list included Resolution plc which had ceased to be listed some months
previously.
2 All statutory references in this article are to the Financial Services and
Markets Act 2000.
3 Other conditions must also be satisfied, including in particular that the
relevant conduct must be ‘likely to be regarded by a regular user of the
market as a failure on the part of the person concerned to observe the
standard of behaviour reasonably expected of a person in his position in
relation to the market’ (s 118(8)).
4 Section 119(1).
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December 2008
5 Section 119(2).
6 Section 122(1) provides that ‘If a person behaves in a way which is
described (in the code in force under section 119 at the time of the
behaviour) as behaviour that, in the [FSA’s] opinion, does not amount to
market abuse that behaviour of his is to be taken, for the purposes of this
Act, as not amounting to market abuse.’
7 The exact effect of s 122(2) is unclear on its terms: ‘Otherwise [ie where
s 122(1) does not apply], the code in force under s 119 at the time when
particular behaviour occurs may be relied on so far as it indicates whether
or not that behaviour should be taken to amount to market abuse’.
8 Financial Services: Investigations and Enforcement (published by Tottel,
2nd edition, 2005) at para 13.20.
9 Amending primary legislation on an urgent basis is difficult, particularly
in view of the fact that Parliament does not sit during mid-September.
New binding rules could have been introduced into the FSA Handbook on
an urgent basis but these would only apply to firms who are authorised by
the FSA.By contrast, the market abuse regime is of general application.
10 This replicated its approach in June 2008 when it introduced, through the
Code of Market Conduct, a regime for making disclosure to the FSA of
short positions in companies undertaking rights issues.
11 See, for example, the lead story in the Financial Times, 19 September
2008.
12 A key element of the statutory definition of market abuse (misleading
behaviour) at s 118(8)(a).
13 See, for example, the market abuse cases of FSA v Timothy Baldwin and
WRT Investments Limited (FSMT Decision No 026) and FSA v Paul
Davidson and Ashley Tatham (FSMT Decision No 031).
14 ‘Hedge funds plan to sue the FSA over short-selling ban’, The Daily
Telegraph, 22 September 2008.
15 Paragraph 19 of Sch 1, Financial Services and Markets Act 2000.
Butterworths Journal of International Banking and Financial Law