The National Association of Private Fund Managers (NAPFM), MFA, and Alternative Investment Management Association (AIMA) challenged two rules recently adopted by the Securities and Exchange Commission (SEC) that require reporting and public disclosure of securities lending and short selling activity in an opening brief filed in the U.S. Court of Appeals for the Fifth Circuit. The brief can be found here.

This litigation is about two rules finalized by the SEC that impose inconsistent requirements for the public disclosure of the same market activity: short sales of securities. Although the rules are indisputably interconnected and were finalized on the same day, neither rule considered how the two disclosure requirements interact.

In the final Short Sale Rule, the SEC acknowledges the benefits of short selling to price discovery, liquidity, and good corporate governance. When explaining its rationale for a short sale disclosure framework with aggregated, anonymized, and delayed public reporting, the SEC cited the benefits of short selling and the Commission’s desire not to inhibit the practice. However, on the same day, the SEC adopted the Securities Lending Rule that has the opposite effect. The securities lending disclosure framework will reduce short selling by publishing granular data on individual securities loans almost immediately.

The SEC never evaluated the cumulative economic effect of the two rules on affected parties or the harms to price efficiency, market liquidity, competition, or capital formation. Instead, the SEC adopted contradictory disclosure frameworks in the rules without any acknowledgment or explanation.

“The SEC’s defective rulemaking process produced two flawed, inconsistent rules that will harm investors and the markets. The rules should be vacated,” said Bryan Corbett, MFA President and CEO. “Adopting two rules with contradictory approaches to the disclosure of data regarding short selling on the same day without explanation is arbitrary and capricious. The SEC needs to go back to the drawing board and craft rules with a consistent, coherent approach that will not harm market participants or undermine the US capital markets.”

“The adoption of these two rules epitomises arbitrary and capricious rulemaking by adopting inconsistent disclosure frameworks for interlinked transactions. These rules will unnecessarily impair market efficiency and price discovery, thereby harming both markets and market participants. Accordingly, the court should vacate both rules and direct the SEC to adopt consistent reporting and disclosure regimes that take into account the interrelated nature of securities loans and short sales and are designed to protect both market efficiency and market participants,” said AIMA CEO Jack Inglis.

Accordingly, the petitioners request that both rules be vacated based on their arguments that, among other things:

• The SEC engaged in arbitrary and capricious rulemaking when it adopted two interrelated rules without acknowledging or explaining their contradictory approaches to disclosure of the same market activity.
• The SEC violated the Securities Exchange Act of 1934 (Exchange Act) and the Administrative Procedure Act (APA) by conducting separate economic analyses that ignored the cumulative impact of the two interrelated rules.
• The Securities Lending Rule is contrary to the statute and the SEC’s own prior views.
• The SEC deprived the public of a meaningful opportunity to comment on material changes to the securities lending rule.
• The SEC did not reasonably explain why it refused to adopt a less burdensome alternative than the regime it ultimately adopted in the Short Sale Rule.

The brief highlights the SEC’s failure to acknowledge its diametrically opposed, incoherent approaches to these two rules and provide sufficient justification for that inconsistency as required by the APA.

In the short sale rule, the Commission concluded that publicly disclosing short sales can substantially harm markets and investors by revealing short sellers’ investment strategies, and by Increasing the threat of retaliation against short sellers by other market participants. It therefore determined that short-sale information should be published only on an aggregated and delayed basis. In the securities lending rule, however, the Commission took the exact opposite approach, requiring the publication of granular detail reflecting short-sale activity on a transaction-by-transaction, next-day basis. Not only did the Commission fail to justify that contradictory approach; it did not even acknowledge the issue.

The brief also emphasizes the SEC’s failure to consider the cumulative economic impact of the two rules on affected parties when it conducted the economic analysis required under the APA and Exchange Act.

The Commission’s economic analysis in each rule was just as deficient, because the Commission never assessed both rules in combination. Incredibly, the Commission stated that it would ignore the Short Sale Rule’s requirements in its economic analysis of the Securities Lending Rule because the former “remained at the proposal stage”—even though it was scheduled to be finalized minutes later at the same open meeting. And the Short Sale Rule considered only the effects of any overlap in “compliance periods” between the two rules—not any substantive overlap.

In addition to the SEC’s failure to consider the rules in tandem, the brief argues that each rule suffers from flaws that render it invalid in its own right. As it relates to the Securities Lending Rule:

The Commission’s decision to require next-day publication of granular information about individual securities loans—again, proxies for short sales—directly conflicts with Congress’s directive in the Dodd-Frank Act to only publish short-sale information on a periodic, aggregate basis. And it also departs from the Commission’s own prior findings in a report prepared pursuant to the Dodd-Frank Act without any explanation. Furthermore, the Commission also violated the APA’s procedural requirements when it made significant changes in the final rule—including changes it wrongly believed would address concerns about overly granular short-sale disclosure—without giving the public a meaningful opportunity to comment on whether those changes would actually solve the problem.

With respect to the Short Sale Rule:

The Commission failed to explain why it imposed the substantial costs and increase in security risks of a brand-new reporting regime instead of simply expanding an existing regime that already publishes similar information. The Court should likewise reject the Commission’s attempt to invent a global short sale reporting regime by extending this rule’s reporting requirements to short sales of foreign securities traded on foreign exchanges. Congress gave the Commission no such authority to apply its rule extraterritorially, and doing so makes no sense in its own right. 

The two rules represent unlawful exercises of rulemaking authority, both in combination and on their own, and must be vacated in order to protect investors and the markets.

The petitioners are represented by Jeff Wall and Judd Littleton of Sullivan & Cromwell LLP.

Source: MFA