Short selling and public issues
When the Indian government company NTPC was conducting a public offering of share, it was alleged that many institutional investors short sold NTPC shares on a large scale (by selling stock futures). This gave rise to some talk about suspending futures trading in shares of a company while a public issue is in progress. Thankfully, the government and the regulators did not do anything as foolish as this.
The US has a different approach to the problem – Rule 105 (Regulation M) prohibits the purchase of offering shares by any person who sold short the same securities within five business days before the pricing of the offering. Last month, the SEC brought charges against some hedge funds for violating this rule.
Obviously, Rule 105 is a far better solution than shutting down the whole market, but it is necessary to ask whether even this is necessary. Take for example, the SEC’s argument that:
Short selling ahead of offerings can reduce the proceeds received by public companies and their shareholders by artificially depressing the market price shortly before the company prices its offering.
We can turn this around to say:
Short sale restrictions ahead of offerings can allow companies to sell their shares to the public at inflated prices by artificially increasing the market price shortly before the company prices its offering.
Why do regulators have to assume that issuers of capital are saints and that investors are the sinners in all this? Provided there is complete transparency about short selling (and open interest in the futures market), it is difficult to see why short selling with the full intention to cover in the public issue should depress the issue price.
The empirical evidence is that an equity issue has a negative impact on the share price. This is partly due to the signalling effect of raising equity rather than debt, and partly due to the need to induce a portfolio rebalancing of all investors to accommodate the new shares.
Now imagine that a hedge fund short sells with the intention to buy back in the issue. Since the short seller is committed to buying in the issue, a part of the issue is effectively pre-sold. To this extent, the price impact of an equity issue is reduced. While the short selling could depress prices, this would be offset by the lower price impact of the issue itself.
In short, the short sellers would not change prices at all. What they would do is to advance the effective date of the public issue. If there is a 100 million share issue happening on the 15th and the hedge funds short 20 million shares on the 10th, then somebody has to take the long position of 20 million shares on the 10th itself. For this amount of portfolio rebalancing to happen on the 10th, there has to be a price adjustment and this can be quite visible.
But the flip side is that on the 15th there are only 80 million shares to be bought by long only investors. There is less price adjustment required on that date. The total portfolio adjustment required with or without short selling is the same – 100 million shares. The only question is whether the price adjustment happens on the 15th or earlier.
In an efficient market, the impact of unrestricted short selling would be to force the entire price adjustment to happen on the announcement date itself. The issue itself would then have zero price impact and this would be a good thing.
Because of limited short selling in the past, we are accustomed to issues being priced at a discount to the market price on the pricing date. With unlimited short selling, this would disappear. If the short selling were excessive, the issue may even be priced at a premium as the shorts scramble to cover their positions. It will take some time for market participants to adjust to the new environment. Regulators should just step back and let the market participants learn and adjust.
Posted at 8:30 pm IST on Sat, 20 Feb 2010 permanent link
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