Short selling is a trading strategy that seeks to ‘sell high’ and ‘buy low’. An investor will typically borrow a stock he does not own to sell, making a profit when he later purchases it at a lower price and returns the borrowed stock back to the original holder. In Hong Kong, investors must arrange to borrow the stocks before executing the short trade or risk being guilty of illegal short selling—they must ‘cover’ their position.
Naked vs covered shorts
When the investor borrows the security to be sold – usually from a broker – and later repurchases the stock, the act of repurchasing is known as ‘covering’ the investor’s short position.
By contrast, a ‘naked’ short is where a stock is sold short without first borrowing the security or obtaining an unconditional right to borrow it. Naked short selling is prohibited in Hong Kong under s. 170 of the Securities and Futures Ordinance (Cap. 571) (the “SFO”). Investors must therefore arrange to borrow stocks before they execute short sales. Failure to do so could result in a maximum fine of HK$100,000 and two years’ imprisonment if convicted. However, SFO s.170 applies only to short sales conducted at or through a recognized stock market, for example, the Stock Exchange of Hong Kong Limited “SEHK”). It does not apply to off-exchange short sales.
Reference: Securities and Futures Ordinance, s 170
Short selling in rights issues
There are circumstances which fall outside the scope of s. 170 of the SFO. The SFC accepts that a seller may have a “presently exercisable and unconditional right to vest the securities in the purchaser of them” even in circumstances where the seller does not actually have the securities at the time of placing the sale order.
However, when a rights issue is taking place, the shares are conditional on SEHK granting the placement and will remain so until the placement is completed. Accordingly, if an investor sells the rights issue shares before the placement has completed, he run the risk of illegal short selling unless he holds shares to settle the trade or he has borrowed the stock in advance. Failure to do so may result in conviction.
In April 2012, seven investors were fined HK$71,000 at the Eastern Magistrates Court for illegal short selling of shares held in Imagi International Holdings Limited (Imagi). The defendants had placed orders to sell the shares but did not have reasonable grounds to believe that they had a presently exercisable and unconditional right to do so, which constituted illegal short selling.
In May 2010, Imagi had conducted a rights issue entitling shareholders to subscribe. Not all shareholders exercised their rights to subscribe for the new shares, leaving excess rights which other shareholders could apply to subscribe for on top of their own entitlements. The defendants subscribed for Imagi excess rights shares and placed orders to sell the amount of shares they thought they would be allocated or would be able to receive in time for settlement. When short selling Imagi shares, they had not received the excess rights shares, nor did they have confirmation as to the quantity of excess rights shares they would receive.
‘Taking advantage of a rights issue to sell shares in expectation of an allotment constitutes illegal short selling if the investor has no presently exercisable and unconditional right to sell the shares. It is also an abuse of the rights issue and the excess rights process,’ Mr Mark Steward, the SFC’s Executive Director of Enforcement said.
Hong Kong Exchanges and Clearing (HKEX) has set out details of regulated short selling in Hong Kong. These include:
- Structured Product Hedging Short Selling: the short selling of an underlying stock of a single stock derivative warrant or single stock Callable Bull/Bear contract, which is conducted by a Structured Product Hedging Participant as part of a Structured Product Hedging Transaction
- Structured Product Liquidity Provider Short Selling: the short selling of a Structured Product which is conducted as part of the activities for providing liquidity to an issue of Structured Product by a Structured Product Liquidity Provider
- Designated Index Arbitrage Short Selling: the short selling of the underlying stocks of an index or indexes prescribed by the Exchange from time to time which is conducted by a Designated Index Arbitrage Short Selling Participant as part of a Designated Index Arbitrage Transaction.
- Options Hedging Short Selling: the short selling of an underlying stock of an Options Contract, which is conducted by a Market Maker or an Options Hedging Participant as part of an Options Hedging Transaction
- Securities Market Maker Short Selling: the short selling of a Market Making Security which is conducted by a Securities Market Maker for its own account, or for the account of any of its affiliates or for the account of any of its Designated Specialists as part of its market making activities
- Stock Futures Hedging Short Selling: the short selling of the underlying stocks of Stock Futures Contracts traded on the Hong Kong Futures Exchange Limited (HKFE), which is conducted by a Designated Stock Futures Hedging Short Selling Participant as part of a Stock Futures Hedging Transaction
References: HKEX, Regulated Short Selling
The SEHK Trading Rules set out regulations for short selling in the Eleventh Schedule, while the Fifteenth Schedule deals with Designated Arbitrage Short Selling, Stock Futures Hedging Short Selling, Structured Product Hedging Short Selling and Options Hedging Short Selling regulations.
HKEX, Short Selling Regulations, Sch 11
HKEX, Designated Index Arbitrage Short Selling, Stock Futures Hedging Short Selling, Structured Product Hedging Short Selling and Options Hedging Short Selling Regulations, Sch 15
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