Fund management firms, soon required to report their short sale positions with the US Securities and Exchange Commission, could end up scrambling at the last minute to make the necessary operational changes while praying the regulatory agency agrees with their interpretations of some of its unclear requirements.
Buy-side firms appear to be hoping the SEC will be forced at the eleventh hour to either change its mind or grant an extension to comply with the new Rule 13f-2. However, legal experts warn that the US Court of Appeals for the Fifth Circuit may not reach a decision on whether to overturn the SEC’s new rule by January 2, 2025, as requested by the Managed Funds Association, the National Association of Private Fund Managers and the Alternative Investment Management Association. That’s the date Rule 13f-2 must be applied. The first filings of the new Form SHO are due on February 14, 2025.
Although banks and broker-dealers would also be subject to Rule 13f-2 based on the SEC’s definition of institutional investment managers, hedge fund managers could be the most affected. They are the most active short sellers. “Even fund managers reporting their short positions to meet foreign regulations would have a hard time complying with Rule 13f-2 because of differences between foreign and US versions,” explains Aspasia Latsi, an international regulatory analyst with Confluence, a global regulatory reporting technology firm. Case in point: Unlike Europe’s short-sale reporting rule, Rule 13f-2 is based on monitoring of gross short position thresholds on a settlement date, not trade date basis.
“Many fund managers are likely behind the curve in preparing for Rule 13f-2 and will have to make up for lost time at the last minute,” says Richard Marshall, a partner with the law firm of Katten Muchin Rosenman in New York. Of the ten operations managers at East Coast fund management firms contacted by FinOps Report, only three say they are adjusting their technology and procedures. The remainder say they are waiting for either a cancellation or postponement.
While the SEC typically provides guidance on how to implement a regulation immediately after a final rule is published, it failed to do so in the case of Rule 13f-2. As a result, fund managers are left in a lurch. “The SEC can’t provide any guidance or postpone the implementation date for Rule 13f-2 until the 5th Circuit renders its decision,” says Marshall. Even if that decision comes by year-end, fund managers won’t have enough time to make the necessary changes to IT systems and procedures with enough confidence they made the right choices. Those wise enough to prepare early must make a best effort to interpret the SEC’s adopting release, whose language is sometimes muddled.
The SEC’s estimate of only 325 hours needed to prepare for Rule 13f-2 is far too little based on the massive data collection and processing requirements, say legal experts. The calculation presumes that fund managers which would file Form SHO have also filed Form 13F to comply with Rule 13f-1, which requires reporting of long positions. Therefore, they would incur only a minimal amount of additional work to prepare for Rule 13f-2.
However, there are three major differences between the two regulations. One of them is the number of securities affected. “The list of securities eligible for Rule 13f-2 reporting is far larger than for Rule 13f-1 which is published by the SEC on a quarterly basis,” says Latsi. “The SEC won’t be publishing a list of affected securities for Rule 13f-2, which will cover all public reporting companies, private companies and potentially foreign companies.”
In addition, unlike Rule 13f-2, Rule 13f-1 only applies to fund managers with at least US$100 million in assets under their belts in the securities on the SEC’s published list. It stands to reason that some fund managers filing under Rule 13f-2 may have never filed a Form 13F. As a result, they will have a steeper learning curve than their peers and could end up the least prepared. Under Rule 13f-2, fund managers will also have to monitor gross short-positions daily, instead of long positions monthly as required by Rule 13f-1.
Calls for transparency in the short-sale market are nothing new. The Dodd-Frank Act of 2010 stipulated that the SEC increase visibility about short-sales for regulators and investors after the financial crisis. However, it was the “short squeeze” in the stocks of US video-game retailer GameStop and others in early 2021 that prompted the SEC to take a closer look at the potential misuse of short sales. The retail buying frenzy forced hedge fund managers with short positions to repurchase stocks at very high prices to close out their short positions. As a result, they incurred hefty financial losses. After investigating, the SEC ultimately decided that it could have prevented the “short squeeze” and other illegal short sale conduct if it had obtained more data on short sale activity.
So far only broker-dealers have been required to report on some short-sale transactions under Regulation SHO, designed to prevent naked short selling. The information to be collected by the SEC under Rule 13f-2, according to the regulatory agency, would be more comprehensive than that gathered by the broker-dealer watchdog Financial Industry Regulatory Authority. It would also be more easily accessible to investors, and more easily digestible to the SEC to catch wrongdoing.
Under Rule 13f-2, if certain thresholds are met, fund managers must report information on short sale positions for each equity security in which they trade on a monthly basis to the regulatory agency’s EDGAR system on a new Form SHO. The report would be due 14 days after the month is over, instead of the 45 days required for Form 13F. Any mistakes on Form SHO must be reported to the SEC within 10 days after the mistake is discovered regardless of the size of the error.
For each affected equity security, fund managers must report the end of month gross short position in the equity security at the close of regular trading hours at the last settlement date of the calendar month. The net activity in the affected equity security must also be reported for each settlement date in the calendar month. For Rule 13f-2, the SEC adopted the same definition of gross short position it did for Regulation SHO. That means it is the number of shares of the equity security that are held short as a result of short sales without including any offsetting economic positions. Therefore, if a fund manager manages multiple positions, some of which are long an equity security and others of which are short the same equity security, the long positions will not reduce the short positions.
The SEC will then publish the month after it receives Form SHO from fund managers and others two types of information on an aggregated basis. The first is the gross short position for a particular security across all reporting firms at the end of the previous month. The second is the daily net activity for each settlement date during the previous month. The SEC did not agree to industry requests to publish information by each fund manager, or to verify the accuracy of the information. The regulatory agency’s contention was that it was the responsibility of the fund manager to be accurate and any inaccuracies would be caught during an exam. The SEC will publish its first data in April 2025.
Among the noticeable uncertainties upon reading the adopting release for Rule 13f-2 is whether all foreign fund managers trading in US securities must comply with Rule 13f2 or only those which file 13F reports, according to Steve Ganis, an attorney with the law firm of Mintz in Boston. Defining which “equity securities” to include when reporting on new Form SHO, monitoring whether a reporting threshold in an equity security has been met to file a report, and figuring out how to complete the documentation in an XML format are another three of the key challenges fund management firms will have to address, several operations managers at East Coast fund management firms tell FinOps Report.
The SEC provides two reporting thresholds– Threshold A and Threshold B– which must be reached for each equity security affected if a Form SHO is to be filed. Threshold A applies to reporting company issuers and Threshold B to non-reporting company issuers. There are two ways of calculating Threshold A. The first is the monthly average gross short position at the close of regular trading hours in the equity security in question with a value of US$10 million or more. The second way relies on a monthly average gross short position at the close of regular trading hours as a percentage of trading in the equity security of at least 2.5 percent. Threshold B is calculated only based on the gross short position in the equity security with a value of at least US$500,000 at the close of regular trading hours on any settlement date during the calendar month.
Determining whether an equity security meets either Threshold A or Threshold B to file Form SHO requires the fund manager to know whether the equity is issued by a public reporting firm or a non-reporting firm. Companies which are publicly traded file periodic reports with the SEC. Fund managers have to presume that non-reporting companies, or those which don’t file any reports, are all other companies even though the SEC has not clearly said so. Those companies would typically be private companies
The SEC’s stance on monitoring thresholds fund managers to research its EDGAR database either on their own or rely on third party vendors, such as Bloomberg, to do so. Without a list of issuers to follow, fund managers may need to evaluate all positions under the filing threshold for non-reporting issuers before determining if the relevant security qualifies as an equity security, according to some legal experts.
The list of “equity securities” under Rule 13f-2 is lengthy, but there are some uncertainties about which ones to include because of how an equity security is defined. All fund managers know for sure is that fixed-income instruments don’t qualify, but exchange-traded funds do. “The definition of equity security to calculate thresholds includes some options and other derivatives,” says Ganis. “However, the SEC’s adopting release for Rule 13f-2 also says derivative positions are excluded from threshold calculations.”
The regulatory agency has also given contradictory opinions about foreign securities. The adopting release of Rule 13f-2 indicates that foreign securities are in scope, but during its litigation with the fund associations seeking to overturn Rule 13f-2, the SEC said they are not. Therefore, fund managers will likely need to include foreign securities in their Reg SHO reports until they receive the SEC’s official guidance.
Dealing with foreign securities when filing a Form SHO appears to be causing the most angst for fund managers and their legal counsels for two reasons. The first is that identifying and aggregating positions in securities that trade in different jurisdictions using different symbols, such as dual-listed securities, and the securities of foreign issuers that trade in the US, will be difficult. There could be a multitude of applications involved with inconsistent data. The second problem lies in determining whether a foreign security which does not trade in the US meets the definition of equity security, whether its sale is a short sale, or whether the security falls under Threshold A or Threshold B.
Even if fund managers were to figure out which securities to include for their Rule 13f-2 reporting, they will have a difficult time monitoring whether a security meets Threshold A or Threshold B. Although the calculation can be made at the end of the month, information on trading activity must be gathered daily using settlement date positions and not trade date positions. Settlement date typically follows trade date– or the date a trade was executed– by one or two days. Fund managers cannot wait until the end of the month to find the data, because they could easily miss a day.
“Some position-reporting systems are geared to using trade date instead of settlement date positions,” explains Richard Clark, director of regulatory compliance for technology giant SS&C Technologies in New York. Front-order management systems typically register trade-date information while accounting systems use trade date and settlement date.
Fund managers may either have to rely on their accounting systems to aggregate the data or integrate their front and back-end systems to communicate in real-time. They would also have to code the systems to filter which equity securities are eligible for Rule 13f-2 reporting. Large asset management firms with multiple front and back-end systems for multiple legal entities or affiliated managers could face an operational nightmare in gathering the necessary data if their applications don’t speak to one another. Accounting, operations, and compliance staff will need to work together to ensure their firms have aggregation technology in place to monitor the thresholds for Form SHO reporting, says Clark.
Corporate actions could easily cause miscalculations. “Stock splits and reverse stock splits could erroneously affect the number of securities reported and the calculation of daily short positions unless recorded immediately in the accounting system,” cautions Clark. “Fund managers will need a comprehensive review and control process in place to check for positions affected by corporate actions.”
Once fund managers determine a short-position in a security must be reported on Form SHO based, their next step is also problematic– putting in the right data in the two required tables. The SEC has not updated its Edgar filer manual to accommodate Rule 13f-2 or published technical specifications on the custom XML format and electronic filing process.
Based on the SEC’s adopting release, Table One of the two information charts also appears to be geared to traditional US equities only. In Table One of Form SHO, a fund manager must identify the gross short position over which it exercised investment discretion at the close of regular trading hours on the last settlement date of the calendar month of the reporting period. The gross short positions must be identified both by the number of shares of the security involved and as a US dollar amount.
The calculation of the US dollar value of gross short positions is based on the closing price of regular trading hours in the last settlement date of the calendar month. US regulations dictate that regular trading hours end at 4PM EST. “How this timing requirement will be applied more broadly to the full universe of securities covered by Rule 13f-2 is unclear,” writes the law firm of Schulte Roth & Zabel in an article on Rule 13f-2. “There is no guidance as to how the notional value of equity securities that do not trade or get reported in US dollars should be reported or how share equivalents should be calculated for equity securities that do not trade as shares.”
With so little time left to prepare for Rule 13f-2, fund managers will be faced with two choices. they can either adapt their front and back-office platforms to gather all of the necessary information, make the calculations, and file the reports themselves. Alternatively, they can rely on third-party platforms to do some or all of the work. Fund administrators, such as SS&C, are also getting up to speed,
Numerous technology solutions have emerged to help comply with Rule 13f-2, including platforms operated by AQMetrics, Bloomberg, FIS, n-Tier, and Confluence. Bloomberg’s enterprise new data solution, available via Data License, identifies Rule 13f-2 eligible securities for reporting and non-reporting companies. Confluence’s Signal platform can do all of the work to file for Rule 13f-2 by relying on the list of covered securities provided by fund managers or by using its own list of covered securities. The aggregated data would be obtained from the fund manager’s accounting system and validated before being reported on Form SHO.
SS&C can also file Form SHO on behalf of fund managers using its GlobeOp fund administration service or for fund managers relying on rival administrators. According to Clark, if SS&C serves as the fund administrator it will depend on its internal accounting system for the data. If it is not the administrator, SS&C will use the data provided by the client. SS&C, which also validates aggregated data before reporting, relies on list of reporting and non-reporting issuers provided by Bloomberg. The firm has started test runs with some fund managers to verify the readiness for Rule 13f-2.
In determining whether to rely on a third-party technology firm or fund administrator for help in filing Form SHO, fund managers must consider just where the critical data is located. If the fund administrator holds a sufficient amount of the data it could take on the task. Yet another factor in the decisionmaking process, says Confluence’s Latsi, is the speed of data transparency required. She recommends that fund managers which want to optimize their investment decisions consider a technology firm which could provide a daily view of which positions and securities would be reported on Form SHO.
Regardless of whether a fund manager chooses an external technology platform or its administrator to comply with Rule 13f-2, they are still liable for any reporting errors. Outsourcing is not a defense. “Fund managers using third party vendors and fund administrators for help must review how vendor technology works and be comfortable with the vendor’s interpretations of Rule 13f-2 embedded in their data sets and calculations,” advises Mintz’s Ganis,
Faced with a high burden to comply with Rule 13f-2, fund managers could decide to curtail their short sale activity to avoid a reporting obligation. Therefore, as critics in the fund management community believe, the SEC’s well-intentioned idea may ultimately cause more harm than good. It could lower liquidity in some stocks and increase overall market volatility.
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