The City regulator has rushed to change its emergency rules on disclosure of short-selling during rights issues after discovering a loophole that would have let hedge funds avoid stating their holdings.
The Financial Services Authority reversed its position on how to take options into account when calculating the size of positions, according to Darren Fox, partner at Simmons & Simmons, legal adviser to many of London’s biggest funds.
The rapid change of tack occurred just two days before the rules come into force demanding public disclosure of short positions of more than 0.25 per cent during a rights issue.
It was made amid claims from many opposed to the rules that the watchdog introduced them to help bank rights issues, particularly that of HBOS. Short-sellers profit when prices fall.
The FSA had told the industry that options should be considered at their notional value – the amount of shares the holder of the derivative has the right to buy or sell. Mr Fox said he was told that had now changed to the “delta-hedged” valuation – how many shares would be required to neutralise moves in the price, a much smaller number.
The previous interpretation allowed a hedge fund to avoid disclosure of a short position by buying heavily out of the money call option, the right to acquire shares at a high price, which would be very cheap. This would give the fund a net long holding, avoiding disclosure.
David Rule, chief executive of the International Securities Lending Association, said: “The easiest way to avoid disclosure would be to take out a huge out of the money option.
“No one would do it because it would be flagrantly taking the mickey but it just highlights that [these rules] are half-baked.”
The FSA said it would address the issue in a second clarification of the rule “later this week” but could not confirm what it had told Mr Fox. It said: “We are not making any apologies. We made the rule in haste: there will be bits around the edges that become clear and we will fix them.”
On Wednesday hedge funds urged the watchdog to delay the rule to allow systems to be changed, and to explain why it was introduced and under what legal powers.
Andrew Baker, deputy chief executive of the Alternative Investment Management Association, which wrote to the FSA, said: “Whatever it is that they’re trying to stop, these measures will not even begin to achieve that objective”.