Managed Funds Association

Regulatory Compliance Conference

The Princeton Club of New York, New York, NY

November 30, 2011

TRADING ISSUES AND ENHANCED

REGULATORY DISCLOSURES

Roger D. Blanc

Matthew Comstock

Willkie Farr & Gallagher LLP

New York, NY

November 21, 2011

© 2011 Roger D. Blanc. All rights reserved.

Note: The discussion set forth in this outline is for informational purposes only. It does not take into account the qualifications, exceptions and other considerations that may be relevant to a particular situation. The discussion should not be construed as legal advice, which would have to be addressed to the particular facts and circumstances involved in any given situation.
MFA TRADING PANEL OUTLINE

  1. European Union Short Selling Initiatives and Certain U.S. Short Selling Issues
  1. Bans on Short Selling
  1. Belgian, Denmark, France (extended for three months as ofNovember 11, 2011), Greece (expires on December 9, 2011),Ireland, Italy (expires onJanuary 15, 2012)have banned short selling in the stocks of specified financial institutions (except Greece, which bans short sales of all shares listed on the Athens Exchange).
  2. Investors are prohibited from creating or increasing net short positions in the stocks of the financial institutions subject to the ban.
  3. The bans purport to apply irrespective of where a trade is placed and irrespective of whether the trade is executed on a regulated market.
  4. The bans typically prohibit the use of derivatives to create economic short exposure to the stocks of the financial institutions subject to the ban.
  5. Derivatives may be used for hedging purposes.
  6. References:
  7. Belgium: Royal Decree of 23 September 2008 on Certain Operations Constituting Market Abuse,25 Belgian Official Gazette 50040(September2008); Decision by Financial Services and Markets Authority to Modify Short Selling Rules, L'Autorité des Services etMarchés Financiers(Aug. 11, 2011).
  8. Denmark: FSA Executive Order no. 1004, Danish Law Gazette A (Oct. 10, 2008).
  9. France: MINISTÈRE DE L’ÉCONOMIE, DES FINANCES ET DE L’INDUSTRIE,Arrêté du 9 novembre 2011 relatif à la prolongation de l’interdiction des prises de position courtes nettes sur une liste de valeurs financières françaises (Nov. 10, 2011). . FAQs on short sale ban:
  10. Greece: Guidance on HCMC’s Decision Regarding Short Selling Ban, Hellenic Capital Market Commission (Aug. 9, 2011).
  11. Ireland:Market Abuse Rules,Section 10.1, Central Bank of Ireland (May 2009).
  12. Italy: CONSOB Resolutions nos. 17992 and 17993, Commissione Nazionale per le Società e la Borsa (Nov. 11, 2011).
  1. Bans on Naked Short Selling
  1. Austria and Spain prohibit naked short selling.
  2. Austria’s ban on naked short selling is limited to the stocks of four financial institutions. Investors must “locate” the securities that they wish to sell short.
  3. Spain has a broad ban on naked short selling. To sell a security short, the investor must own the security, borrow the security or have a contractual right to the security.
  4. References:
  5. Austria:Austrian Stock Exchange Act § 48(d)(12) FLG I No. 58 (2010).
  6. Spain: Preventative Ban on Transactions Which Might Constitute or Increase a Net Short Position on Spanish Financial Stocks, Comisión Nacional del Mercado de Valores (Aug. 11, 2011).
  1. Reporting Requirements

1.Ireland, Italy, Germany and Spain impose certain reporting requirements relating to short positions.

2.Typically, short positions of 0.2% or more are required to be reported to the relevant regulatory authority in a country with a reporting requirement. Short positions of 0.5% are disclosed publicly (Ireland has a reporting threshold at 0.25% of an issuer’s capital).

3.References:

  1. Ireland:Market Abuse Rules,Section 10.2, Central Bank of Ireland (May 2009).
  2. Italy: CONSOB resolution no. 17862, Commissione Nazionale per le Società e la Borsa (July 10, 2011).
  3. Germany:General Decree on the Extension of the Provisions of the General Decree of the Federal Financial Supervisory Authority (BaFin) of 4 March 2010, Bundesanstalt für Finanzdienstleistungsaufsicht (Jan. 31, 2011).
  4. Spain: Agreement of the Executive Committee of the CNMV on the Disclosure of Short Positions, Comisión Nacional del Mercado de Valores (May27, 2010).
  1. Proposed European Union Short Position Disclosure Initiative

1.On October 18, 2011, the European Parliament, Commission, and Council agreed on new regulations that prohibitnaked short-selling of government bonds andshares and naked sovereign CDS transactions.

a.Short Sales – To effect a short sale of a security subject to the prohibition on naked short selling, an investor must “locate” the security to be sold short. The restrictions do not apply if the transaction serves to hedge a long position in debt instruments of an issuer, the pricing of which has a high correlation with the pricing of the given sovereign debt.

b.CDS - The buyer of the CDS is “naked” if it does not have an exposure which it is seeking to hedge, either to the sovereign debt itself, or to assets or liabilities whose value is correlated to the sovereign debt.

2.Disclosure

a.For shares- Short positions in excess of 0.2% of the issued share capital will have to be disclosed to the national regulator, while short positions in excess of 0.5% will also have to be disclosed to the market.

b.For sovereign bonds- Such significant net short positions will have to be disclosed only to the regulator. This includes notification of significant CDS positions relating to sovereign debt issuers.

3.Extraterritorial – Yes, if it involves securities whose principal market is inside the EU.

4.Discretion by Country– In order to address concerns that a ban on naked sovereign CDS could negatively affect the liquidity of sovereign debt markets, a country may temporarily suspend the restrictions if it believes that its sovereign debt market is not functioning properly and that such ban might increase its cost of borrowing or affect its ability to issue new debt.

5.Exceptions–For certain market-making activities, certain primary market operations related to market liquidity and stabilization schemes, and shares whose principal market is outside the EU.

6.Timeline: Expected to enter into force on November 1, 2012.

7.The United Kingdom has raised concerns that the proposed ban on naked swaps on sovereign debt is unlawful. See

8.Reference: Eur. Parl. Doc. (COM(2010)0482) (2011).

  1. Recent Regulation SHO Disciplinary Action

1.UBS Securities LLC, a U.S-registered broker-dealer, was fined $12 million for failure to comply with Regulation SHO.

2.UBS placed short sale orders without obtaining locates, including for securities that were hard to borrow.

3.UBS mismarked short sales as long sales.

4.The firm misrepresented its aggregation units, i.e., the units within the broker-dealer for which short positions are determined, in a manner that may have led to locate and order marking failures.

5.SeeAmanda Pollok, Impact of Regulation SHO on the Short Sale Activity of Hedge Fund Managers and Broker-Dealers, Hedge Fund Law Report (Nov. 10, 2011).

  1. Large Trader Reporting
  1. The large trader reporting rule became effective October 3, 2011. Large traders must comply by December 1, 2011 and broker-dealers must comply by April 30, 2012.

1.Large Trader Reporting, Exchange Act Release No. 64976, 76 Fed. Reg. 46960 (Aug. 3, 2011).

  1. Under the rule,a “large trader” isa person or entity that
  2. Directly or indirectly, including through controlled persons, exercises investment discretion over securities account;
  3. Effects transactions in NMS securities on behalf of such accounts; and
  4. Effects such transactions in an aggregate amount equal to or greater than, during a calendar day, either two million shares or shares with a fair market value of $20 million; or during a calendar month, either 20 million shares or shares with a fair market value of $200 million (the “identifying activity level”).

C.A large trader must file Form 13H with the SEC through EDGAR and obtain a large trader identifies (“LTID”).

1.Form 13H requires the large trader to submit substantial information about itself and certain of its affiliates (e.g., a description of the nature of its business, other forms that it or its affiliates submit to the SEC, an organizational chart and corporate governance information, among other things).

2.The large trader must provide its LTID to all of the brokers at which it maintains a brokerage account

D.A parent company may be an organization’s large trader

1.To determine if a parent company is a larger trader, the aggregate trading activity of all entities controlled by the parent company must be collected.

2.In a hedge fund complex, that could be the investment adviser.

3.In the case of multiple advisers that are horizontally affiliated, the holding company for those advisers could be the large trader.

4.A large trader is relieved from having to comply with the identification and reporting requirements of the rule if all persons controlled by such large trader that exercise investment discretion with respect to the purchase and sale of NMS securities collectively comply with all requirements applicable to such large trader with respect to all of its accounts.

E.What about an individual who owns a large trader?

1.The individual could be a large trader.

2.Trades included under the parent company’s LTID? The individual is arguably an affiliate of the parent company under the rule.

3.The individual probably should obtain his or her own LTID. The rule seems to contemplate that parent and subsidiaries trading would be included under LTID, not an individual owner’s trading.

III.Dark Pools

  1. Alternative Trading Systems.
  2. Dark pools do not publicly display quotations in the consolidated quotation date; helps provide trading anonymity.
  3. Dark pools are under SEC scrutiny. The SEC proposed increased disclosure by dark pools in November of 2009. The SEC’s proposals would:
  1. Amend the definition of “bid” or “offer” in the Regulation NMS quoting requirements to apply to “actionable” indications of interest (“IOIs”) (generally described as IOIs that are functionally equivalent to quotes), unless the actionable IOI is for a block-sized trade having a market value of at least $200,000;
  2. Lower the Regulation ATS average daily trading volume threshold that triggers quote display and execution access requirements for ATSs from five percent (5%) to one quarter of one percent (0.25%); and
  3. Amend the joint-industry plans for publicly disseminating consolidated trade data to require real-time disclosure of the identity of dark pools and other ATSs on the reports of their executed trades.
  4. The proposing release is Regulation of Non-Public Trading Interest, Exchange Act Release No. 60997, 74 Fed. Reg. 61208 (Nov. 23, 2009).

IV.High frequency/algorithmic trading

  1. Under intense scrutiny

1.SEC devoted a substantial portion of its market structure concept release, issued in January 2010, to high frequency trading. See Concept Release on Equity Market Structure, Exchange Act Release No. 61358, 75 Fed. Reg. 3594 (Jan. 21, 2010).

2.The SEC has concerns over whether high-frequency traders in fact provide passive market making.

3.The SEC is concerned that rather than provide liquidity, high frequency traders set the bid and offer to take advantage of liquidity rebates.

4.The “Flash Crash” in May 2010 raised concerns about whether high frequency traders will provide liquidity in times of stress.

5.Co-location services used by high frequency traders also under regulator scrutiny.

  1. Provision of such services by exchanges is subject to the Exchange Act.
  2. Given the requirements in Exchange Act Section 6(b) applicable to exchange rules, the terms of co-location services may not be unfairly discriminatory and fees must be equitably allocated and reasonable.
  1. Other issues relating to high frequency/algorithmic traders

1.The SEC proposed to ban so-called “flash orders” in September 2009. Elimination of Flash Order Exception from Rule 602 of Regulation NMS, Exchange Act Release No. 60684, 74 Fed. Reg. 48632 (Sept. 23, 2009).

a.“Flash orders” are types of orders that can be “executed immediately” or “withdrawn if not executed immediately,” as set out in Rule 602(a)(1)(i)(A) of Regulation NMS

b.The SEC took the position that flash order should be included in the consolidated quotation data.

c.The flash ban has not yet been adopted.

2.Stub Quote Ban

a.In November of 2010, the SEC approved amendments to self-regulatory organization rules to prohibit so-called “stub quotes.” Order Granting Accelerated Approval to Proposed Rule Changes Exchange Act Release No. 63255, as Modified by Amendment No. 1, to Enhance Quotation Standards for Market Makers (Nov. 5, 2011).

b.Stub quotes are quotations so far away from the prevailing market that they are not intended to be executed.

c.Executions against stub quotes represented a significant portion of broken trades during the Flash Crash.

d.The SRO rule amendments require market makers to maintain continuous two-sided quotations throughout the trading day that are within a specified percentage band (e.g., 8%) of the national best bid and offer (“NBBO”). If the quote moves a certain percentage away from the NBBO, the market maker must adjust the quote to bring it back within the band.

  1. Finally, high frequency/algorithmic trading would likely be picked up by the large trader reporting requirements.

V.Direct/Sponsored Access – Rule 15c3-5 under the Securities Exchange Act of 1934

A.This type of access generally involves an institutional customer who uses a broker-dealer’s market participant identifier (“MPID”) to access an exchange or ATS electronically.

B.Direct versus sponsored access

1.“Direct market access” typically refers to a customer securities order that flows through a broker-dealer’s systems before entering the markets.

2.“Sponsored access” typically involves a customer securities order that flows directly to the markets without first passing through a broker-dealer’s systems.

3.Irrespective of the type of access, the broker-dealer is responsible for all trading that occurs using its MPID.

C.Rule 15c3-5 requires a broker-dealer with market access, or that provides another party with access to an exchange or ATS through use of the broker-dealer’ MPID or through other means, to establish, document, and maintain a system of risk management controls and supervisory procedures designed to managed the financial, regulatory and other risks associated with providing such access.

1.17 C.F.R. §240.15c3-5; Risk Management Controls for Brokers or Dealers with Market Access, Exchange Act Release No. 63241, 75 Fed. Reg. 69792 (Nov. 15, 2010).

D.Financial risk management controls must be reasonably designed to

1.Prevent the entry of orders that exceed appropriate credit or capital limits in the aggregate for each customer and the broker-dealer; and

2.Prevent the entry of erroneous orders by rejecting orders that exceed specified price or size parameters or that indicate duplicative orders.

E.Regulatory risk management controls must be reasonably designed to

1.Prevent the entry of orders unless applicable regulatory requirements have been met on a pre-order basis;

2.Prevent the entry of orders for securities for a broker-dealer, customer, or other person who is restricted from trading in such securities;

3.Grant access to systems that provide market access only to those persons and accounts authorized by the broker-dealer; and

4.Provide surveillance personnel with immediate post-trade execution reports resulting from market access.

  1. Rule 105
  1. Rule: In connection with an offering of equity securities for cash pursuant to a registration statement or notification on certain Securities Act of 1933 forms, it is unlawful for a person to sell short the security that is the subject of the offering and purchase the offered securities from an underwriter or broker-dealer participating in the offering if short sale was effected during the period (the “Rule 105 restricted period”) that is the shorter of the period:

1.Beginning five business days before the pricing of the offered securities and ending with such pricing; or

2.Beginning with the initial filing of such registration statement or notification and ending with pricing.

3.17 C.F.R. §242.105; Short Selling in Connection with a Public Offering: Exchange Act Release No. 56206, 72 Fed. Reg. 45094 (Aug. 10,2007).

  1. Exceptions

1.Bona Fide Purchase Exception

a.The restricted period short seller may purchase offered securities if the short seller makes a bona fide purchase of the same security no later than the business day before the day of pricing.

b.There must be a full business day between pricing and the bona fide purchase. If, for example, pricing occurs after market close on Wednesday, the bona fide purchase may be effected until market close on the preceding Tuesday. If, however, pricing occurs before market close on Wednesday, the bona fide purchase may be effected only until market close on the preceding Monday.

c.The bona fide purchase must be effected after the last Rule 105 restricted period short sale and in an amount equal to the entire amount sold short during the restricted period.

d.The bona fide purchaser may not effect any short sales during the 30 minutes before market close on the day before pricing.

2.Separate Accounts Exception

a.Under subparagraph (b)(2) of Rule 105, a person who has multiple securities accounts may purchase an offered security in one account even if he or she sold the same security short during the Rule 105 restricted period in another, separate account “if decisions regarding securities transactions for each account are made separately and without coordination of trading or cooperation among or between the accounts.”

b.Indicia of separate accounts:

  1. Separate and distinct investment and trading strategies for each account;
  2. No coordination by personnel of trading among or between accounts;
  3. Information barriers to separate accounts;
  4. Maintenance by each account of a separate profit and loss statement;
  5. No allocation of securities between or among accounts; and
  6. Personnel with oversight or managerial responsibility over multiple accounts in a single entity or affiliated entities, and owners of multiple accounts, who do not have the authority to, and do not, execute trades in the account or pre-approve trading decisions for the accounts.

c.Aggregation Units

  1. A plain reading of the separate accounts exception would appear to permit aggregation units within the same legal entity, at least for purposes of Rule 105.
  2. Contrary to the plain language of the rule, the SEC staff has indicated that separate aggregation units are not available within the same legal entity.
  1. Other Issues

1.Derivatives

a.The SEC stated in the release adopting amended Rule 105 that the rule does not apply to derivatives, although it also stated that it might reconsider that position in the future.

b.The exercise of a short call against the call writer or a long put by the put holder during the Rule 105 restricted period could result in a short sale. If the option writer/holder did not own the underlying security, it would effectively be agreeing to deliver a security that it does not own upon the exercise of the option.