City investors urge ban on short-selling by underwriters

Underwriters of rights issues should be banned from short-selling their clients’ shares during the offer period, a group of major institutional investors has proposed.

The suggestion from the Association of British Insurers (ABI) follows widespread anger at the recent activities of investment banks such as Morgan Stanley, which took a massive short position in HBOS despite being one of the two lead underwriters for that bank’s failed rights issue.

The Morgan Stanley short position – equivalent to some 2.3% of the bank’s value and put on before the result of the offer was made public – enabled the investment bank to avoid massive losses that it would otherwise have sustained. Following the offer period the two lead underwriters, Morgan Stanley and Deutsche Bank, were left with more than 60% of the issue, purchased at a price way above the market value.

However, the short position allowed the bank to profit from the HBOS share price falling, which it subsequently did in the wake of the official announcement that fewer than 10% of existing shareholders had taken up the offer.

Critics have complained that the move allowed Morgan Stanley to profit from information that was not yet in the public domain. Existing investors have also grumbled that the short position forced down the share price, thereby disadvantaging existing investors.

When shorting a bank normally borrows stock from other investors and then sells it immediately in the hope of buying back it later at a lower price; the difference in price, minus the lending cost, is the short-seller’s profit. However, one natural effect of short selling is to push down prices by introducing more supply to the market.

The latest discussion paper from the ABI, however, makes clear institutional investors’ disdain for such tactics. The ABI argues the case for new rules in which underwriters would ‘refrain from short-selling of shares and, possibly, stock lending, throughout the issue period.’

In any case, the ABI, says, ‘issuers and their advisers should seek to ensure that underwriting risk is not allocated to parties who in turn have the intention of laying this risk off through selling short.’

The ABI argues that the new rules may be better enshrined within an industry code rather than imposed by formal regulation. However, it warns that such a code should also look to clean up the underwriting business by covering ‘who should receive information and to whom sub-underwriting is made available’.

More generally, the ABI paper argues for a strengthening of the rules supporting the principle of pre-emptive rights, as well as a number of other measures designed to ‘improve the rights issue process, while retaining core principles’. These include speeding up the timetable, simplifying prospectus requirements, and considering ‘alternative structures such as those common in Australia.’

In the US, meanwhile, the US regulator has extended its ban on the ‘controversial practice of ‘naked short selling’ in 17 high profile Wall Street firms. In this practice investors sell the stock without owning it, or without even having identified an owner willing to loan it.

The ban, intended to combat excessive share price volatility, was originally due to expire on 31 July, but will now be extended to 12 August. However, it will not be extended beyond this date, the Securities and Exchanges Commission said.