The long and short of unfair trade rules

Earlier this year, several high-profile initial public offerings (IPOs) traded below their initial offering price and some blamed short sellers for these difficult starts. Unfortunately, these companies had no way to know who may have been shorting their stock and no opportunity to ask why.

For decades, the U.S. securities laws have required certain investors to disclose their long positions after the end of each quarter and when their position reaches or exceeds 5 percent of a company’s outstanding shares, but there are no corresponding requirements for investors who hold short positions.

{mosads}There is no public policy rationale that allows for this clear regulatory gap between long and short sellers. Rules that require some market participants to disclose their positions while other market participants are allowed to hide their intent simply because their investment thesis is different represent neither good investor protection policy nor good economic policy.

This lack of parity has significant consequences: It deprives companies of insights into trading activity and limits their ability to engage with investors, denies the market information to ensure it functions efficiently and fairly and impedes investors from making investment decisions with full information.

The lack of disclosure around short positions also means companies and investors have no visibility into trading strategies that could create short-term pressures. It may also give rise to possibly abusive trading behavior that could make long-term investors wary about providing the capital necessary to fund research and development.

Smart companies want to understand the motivations of their investors, including short sellers, and engage with them. They should have the tools to do that. That is why we petitioned the SEC in 2015 to require parity in the disclosure obligations between long and short sellers.

The transparency we propose would allow companies to see who is shorting their stock and ask why, helping newly public companies find and maintain their bearings as they emerge into the public marketplace. This would make the public markets fairer and more appealing.

Lack of transparency also affects investors by denying them the necessary information to make informed decisions about the company. Without disclosure of this information, investors and the market will be forced to speculate on the extent and motives of short activity and, as a result, stocks may be buffeted by rumor, speculation and innuendo, instead of facts.

Simply put, this regulatory gap works against the ability of markets to act efficiently, engage in price discovery and operate fairly with the most current and accurate information available.

The disclosure we are proposing is not onerous or burdensome. It would parallel and complement existing long disclosure rules, a regime that has been in place for many years and is familiar to market participants. As with long-position disclosure, investors would publicly file disclosure forms with the SEC within a prescribed time period.

The disclosure forms would contain information about the investor’s holdings, including aggregate short interest, as well as basic information about themselves and affiliates, again, similar to information long investors are required to disclose.

Technological advances have undoubtedly reduced the burden and challenge to investors in compiling, calculating and disclosing this information.

To be clear, Nasdaq is not opposed to short sellers. Many companies have been sold short and prospered. There is ample evidence that legitimate short selling contributes to efficient price formation, enhances liquidity and facilitates risk management.

Evidence also shows that short sellers benefit the market and investors by ferreting out instances of fraud and other misconduct at public companies.

Transparency is the great equalizer and a key part of our rule book. In a Wall Street Journal opinion piece earlier this summer, “The CEOs Who Didn’t Deserve the Boot”, professor Jeffrey Sonnenfeld from the Yale School of Management writes about how short-term investor pressures can lead to boards ousting strong CEOs who favor long-term visions over short wins.

These short-term pressures are one of the costs of being public that make private companies question the benefits of going public. Fewer public companies means fewer opportunities for investors to benefit from their growth and buy a house, pay for their children’s college or fund their retirements. Studies show short-term pressures can also result in slower growth, which means fewer jobs.

Proxy advisory firms are another area where the rules could achieve a better balance between all market participants. We know they provide a valuable service to institutional investors, but we also know that their methodologies can be considered opaque and their business models and ownership structure conflicted. That is why Nasdaq has called for new oversight and transparency in this area — an initiative that has received wide support.

From its inception in 1971 as the world’s first electronic stock exchange, Nasdaq has stood for a balanced approach to regulation. One goal of that regulation is to make room for all investors — we must not benefit one type of investor over another, and we must provide equal access to all.  

For our markets to operate fairly and efficiently, we must constantly adjust our rules to ensure they take a balanced approach in how we treat all types of investors. Fortunately, there are tools to achieve this. Transparency is one. Shining a light on short positions can help restore the balance. If we lose our balance, there can be serious consequences.

Edward Knight has served as the general counsel and chief regulatory officer for Nasdaq since 2001 and is based in Washington, D.C. Knight is responsible for providing legal counsel to senior management and for overseeing the quality of legal services across the global organization.