Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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