opes:how things change in 3 weeks

Short-circuiting the rules

Bryan Frith | March 06, 2008
AT least one brokerage is actively promoting stock lending as a means of bypassing legal restrictions on short selling of stock.

Opes Prime Stockbroking's website promotes securities lending as an "alternative to short selling, with similar benefits but fewer restrictions". It also describes securities lending as "a flexible way to go short".

The stockbroker is part of the Opes Prime Group, which is seeking a backdoor listing through a reverse takeover of Reco Financial Services. Ironically, the latter describes itself as a provider of insolvency services and turnaround solutions for companies.

Reco yesterday announced that it had signed an agreement to acquire Opes Prime Group, subject to the approval of shareholders, who must be provided with the information needed to meet the rules for admission the ASX official list.

Grant Thornton has been retained to provide an independent expert's report. If the proposal goes ahead, Reco will issue 400 million shares, with Opes Prime ending up with 93.4 per cent of the capital. Reco will change its name to Opes Prime Group and the board will be reconstituted.

The principal shareholders of Opes Prime are Laurie Emini, Julian Smith and Anthony Blumberg.

Attention has focused on short selling, stock lending and margin lending following dramatic price falls in a number of companies, particularly Allco Finance and ABC Learning, which involved dumping shares associated with major shareholders as a result of margin calls, and the collapse of the stockbroker Tricom Securities -- heavily involved in stock lending.

Moreover, the collapse in the share prices of Centro Properties and MFS almost certainly involved short selling.

ASIC is investigating whether hedge funds have indulged in market manipulation by colluding to force down the price of shares by selling short where major shareholders are known to have margin loans.

The ASX has also suggested that changes to the rules about short selling are needed.

Short selling -- the sale of shares that aren't owned with the intention of profiting by subsequently buying them back at a lower price -- is governed by the Corporations Act and the ASX market rules.

Shorting is not allowed in all stocks. The ASX has an approved list, and generally the stocks must have reasonably deep market liquidity. The ASX also imposes a number of rules, including that no more than 10 per cent of the securities on issue can be sold, and that shares cannot be shorted below the previous price.

That's known as the up-tick rule, and it's designed to prevent shorters from simply forcing a share price to plummet by selling at ever lower prices.

All brokers must daily report their net short-sold positions to the ASX, which releases the list to keep the market informed.

That, however, is only the tip of the iceberg. Investors have found an unofficial way to short by borrowing stock to cover the sale of shares they don't own.

That's not treated as shorting under the Corporations Act or the ASX rules because stock is delivered to cover the transaction. In reality, it's shorting by another name, as the seller doesn't own the stock delivered to cover the selling, and still has an obligation to "cover", that is, supply, the borrowed stock.

The Opes website explains that securities lending involves the lender giving up legal title to securities in exchange for a payment. The borrower takes the legal title and can dispose of the securities in any way they like.

The lender retains the right to repurchase the securities and the borrower has the right to resell (return) the securities to the lender at any stage.

"This provides the basis for profiting from a falling market because the borrower can sell the security on the market, buy it back at a lower price, and then return it to the lender at the original off-market price (plus margin)," the Opes website explains.

Noting that short selling is governed by ASIC and the ASX, the website says Opes provides an alternative to short selling, with a method that provides similar benefits but fewer restrictions.

"We use securities lending to give our clients legal title to securities prior to them being sold. Because of this, the sale is not a short sale under the Corporations Act or ASX market rules," the website says. It goes on to point out that this practice has "certain advantages".

One is that a bigger list of securities is available for trading -- Opes Prime claims it can access 500-plus securities to short via securities lending, and trading is "more reliable, with greater certainty of price" because the sale does not have to satisfy the up-tick rule.

"So, while our service is not short selling within the meaning of the law, our clients still get the benefits of being able to sell securities into a falling market for repurchase at a lower price" the website trumpets.

Opes Prime could hardly put it more clearly.

ASIC, the body responsible for licensing brokers and other financial intermediaries, and the ASX, the body responsible for running the stockmarket, are showing concern about short selling, but the practice of short selling via stock lending can hardly have been a surprise to them. Certainly, Opes Prime has been public about its activities.

Opes Prime's website didn't mention two other advantages of shorting via stock lending. One is that the limit on shorting no more than 10 per cent of company's capital doesn't apply.

The other -- and the most important -- is that there is no disclosure requirement.

Margin lending, stock lending and short selling all have legitimate uses. The problem is the ability of market participants to secretly use borrowed stock to enable covert short selling.

Requiring disclosure would resolve the mischief. That could be achieved simply by requiring investors to disclose whether they intend to sell shares and cover by borrowing stock. This would be similar to the disclosure already required for approved shorts.

Moreover, such trades should come within the 10 per cent limit on shorting and be subject to the up-tick rule.

Forcing disclosure of stock lending shorts would introduce much more risk for short sellers because other investors would be able to monitor the situation and if they considered that a stock had been oversold they could buy heavily and push up the share price, forcing the shorters to cover at an even higher price.

The ASX-approved list of stocks that can be shorted also needs culling. There are now 419 companies on the list, and they include stocks that had limited market liquidity -- such as Allco, ABC Learning, MFS, Centro Properties, MFS and City Pacific. Such stocks should never have been on the list.

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