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A coalition of hedge fund groups has sued to invalidate a pair of US rules on short selling that they claim are in conflict and risk revealing investors’ positions.
Three industry groups on Tuesday told the US federal appeals court for the fifth circuit that the Securities and Exchange Commission had taken an “arbitrary and capricious” approach when adopting two measures aimed at broadening short-selling disclosure.
Short sellers, typically hedge funds, that want to wager that securities will fall in value must borrow stocks and bonds to make the bets before returning them to their owners. Securities lenders profit by charging a fee for the borrowed assets.
Industry groups have been arguing for months that the SEC has adopted too many rules too quickly without considering their combined impact on the securities markets, but this is the first time they have made the alleged clash the basis for a lawsuit.
The challenge takes aim at two SEC rules adopted on the same day in October. One measure requires securities lenders to report each loan individually as well as information including lending rates by the end of the day, data that is made public the next business day. Loan sizes are published 20 business days later.
The other rule requires some institutional investors to report short-selling activity that is then shared publicly on an aggregated and delayed basis. Names of the parties involved are not made public.
Short selling has long been a controversial practice with only very limited disclosure. It garnered regulatory attention most recently with the 2021 meme-stock boom and bust, when retail traders bought stocks such as retailer GameStop in the hope of financially hurting short sellers betting on price falls.
The 2010 Dodd-Frank financial reforms that followed the 2008 global financial crisis also required the SEC to collect more information on short selling, of which the October rules were the result.
The groups said the SEC “adopted fundamentally contradictory approaches” by opting for an aggregate, delayed disclosure regime on short positions, aimed at avoiding harms such as revealing confidential investment strategies, while requiring individual, daily disclosure of the securities loans associated with them “in a manner that effectively serves as a proxy for short-sale activity”, according to court filings.
“Despite our best efforts, the SEC decided to ignore the interconnected nature of these two rulemakings and failed to apply a consistent approach or principle to regulating these related markets,” said Bryan Corbett, president and chief executive of the Managed Funds Association, one of the plaintiffs.
Jack Inglis, chief executive at the Alternative Investment Management Association, which also joined the lawsuit, added that the SEC had “ignored calls from industry, market participants and Congress to consider the interconnectedness and aggregate impact of its rulemakings”.
The groups also argued the rules burdened markets with “substantial costs” and were at odds with the SEC’s statutory authority as well as US laws on regulatory rulemaking.
The SEC said in a statement: “The commission undertakes rulemaking consistent with its authorities and laws governing the administrative process, and we will vigorously defend challenged rules in court.”
The lawsuit over the new US disclosure rules comes as the UK is going in the opposite direction, removing transparency from the practice. Last month the UK government introduced a draft statutory instrument that will remove the requirement for hedge funds to publicly disclose when they have a short position in individual firms, replacing it with an aggregate overall figure for companies.
When adopting the rules, SEC chair Gary Gensler said it was “important for the commission and the public to know more about short-sale activity in the equity markets, especially in times of stress or volatility”.
The lawsuit has been filed with one of the most conservative courts in the country, rather than in Washington where most SEC-related appeals are heard. This is possible because the third plaintiff — the National Association of Private Fund Managers — is based in Texas, part of the fifth circuit. The group was founded last year as the SEC’s rule blitz gathered pace.
Additional reporting by Costas Mourselas in London
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