Short Selling

Under SFO, "uncovered" short selling of SEHK listed securities is illegal, which means that at the time of sale the seller does not have a "presently exercisable and unconditional right to vest the securities in the purchaser", or does not have a "reasonable belief" of having such right. Typically a short seller can cover its short sale by arranging stock borrowing in advance or holding a physically settled derivative of the underlying stock.

While it is an intermediary's duty to check if its clients have adequate securities to sell, error trades resulting in short positions do occur from time to time. Though SFC has stated its policy for not penalizing genuine mistakes, in certain cases SFC disciplined some brokers who failed to prevent short sales arising from operational errors.

In US, short selling penalty is even extended to non-public offering of securities issued by listed companies, i.e. Private Investment in a Public Equity (PIPE). PIPE is a private offering in which accredited investors agree to purchase restricted, unregistered securities of public companies. PIPE shares can only be offered to "accredited" investors - investors with assets of US$1m or more. Only after the PIPE shares registration is approved by the SEC are investors free to sell them on the open market.

Last month Friedman, Billings, Ramsey & Co., Inc. (FBR), an investment banking and brokerage firm agreed to pay more than US$7.7m to NASD and SEC to resolve charges arising from FBR's improper trading in shares of Compudyne Corporation, in a PIPE deal it structured and managed for the Maryland-based security firm.

in Sep 2001, Compudyne Corporation and FBR, its placement agent, offered accredited investors - on a confidential basis - a PIPE deal proposing to sell 2.45 million shares of common stock, which raised more than US$29m. The restricted stock was offered at the below-market price of US$12 per share. FBR failed to maintain an information barrier to prevent trading by FBR personnel who were aware of this information.

As part of efforts to make a market in Compudyne, supply liquidity, and advertise FBR's capabilities, FBR's head trader, who was aware of material, nonpublic information about the PIPE, engaged in trading in Compudyne before the PIPE was announced to the public. By the time the PIPE was announced on 9 Oct 2001, FBR had a net short position of approximately 179,495 shares. FBR eventually covered its short position by buying shares of Compudyne after the shares that had been purchased in the private placement were registered and became tradable in the market. FBR made a profit of approximately $343,773 on the short sales of Compudyne that were executed before the public announcement of the PIPE.

FBR also failed to enforce its written supervisory procedures designed to protect confidential information, failed properly to locate stock to borrow in order to sell Compudyne shares short, and misinformed NASD about the departure from the firm of a broker involved in selling the Compudyne PIPE.

In HK, while the Hang Seng Index has continually recorded a new high, more people are expected to engage in intentional short selling, resulting in more SFC investigations.