Market Regulation Update
On May 18, 2010 the German Federal Financial Services Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – "BaFin") published three general decrees (Allgemeinverfügung) banning (a) “naked short sales” (as defined below) of shares in ten specifically named German financial enterprises, (b) naked short sales of government bonds of the Member States of the Eurozone and (c) naked CDS relating to government bonds of the Member States of the Eurozone. On May 20, 2010 BaFin issued a set of FAQs for each decree.1
Each of the prohibitions is in effect until March 31, 2011.
2. First Decree Regarding Naked Short Sales of Shares
The first Decree prohibits naked short sales in shares of the following 10 specified German financial institutions:
Aareal Bank AG
Generali Deutschland Holding AG
Deutsche Bank AG
Deutsche Boerse AG
Deutsche Postbank AG
Hannover Rueckversicherung AG
Muenchener Rueckversicherungs-Gesellschaft AG
2.2 Naked Short Selling
The Decree defines Naked (ungedeckte) Short Selling as taking place when at the time of the relevant transaction the seller of the securities:
a) does not own them, and
b) does not have an unconditionally enforceable legal claim under the law of obligations or under property law entitling the seller to the transfer of title to an equivalent quantity of securities of the same class.
In this context it could be assumed that “borrowing” the securities (Wertpapierleihe) would also be recognized as a transfer of title, since the borrower of the securities would normally, depending on how the borrowing is structured, also acquire title to the securities, thus rendering the subsequent sale covered and not "naked" within the meaning of the Decree. This understanding is confirmed by the relevant FAQ stating that borrowing is sufficient to exclude a short sale from the prohibition but that the borrowing must be done prior to or at least simultaneously with the relevant transaction; further, the relevant FAQ states that if the seller has an unconditionally enforceable legal claim to obtain the borrowed securities, it is not necessary that the securities be received (Einbuchung in das Depot) (FAQ Questions 2 and 3).
Exempted from the prohibition are the transactions (i) of market makers, i.e. persons who have undertaken by contract to continuously (dauerhaft) sell or purchase financial instruments (Finanzinstrumente) by way of trading for their own account (Eigenhandel) at self-set (selbst gestellten) prices, to the extent the relevant transactions are required for performance of their contractual obligations and (ii) transactions which the trade participants enter into for the purpose of fulfilling their obligations to perform a share transaction entered into with a customer at a fixed or determinable price. Also exempted are short sales used to hedge2 already existing positions. Further exemptions may be granted upon written application.
2.4 Geographic Scope
Neither the Decree nor the FAQs on their face limit the prohibition to transactions in Germany or to market participants who are in Germany. They also do not address the question of whether the prohibition applies to ADRs based on the stocks of the relevant issuers.
The U.K. Financial Services Authority was reported as having stated on May 19, 2010 that it understood the German prohibitions to apply only to “German participants or business taking place inside Germany ….” The basis for this statement is not known, and it is inconsistent with an oral position taken by BaFin prior to the publication of the FAQs that the prohibition on naked short sales of the 10 specified stocks applies outside Germany and that it also applies to ADRs based on those stocks.
Based on calls with the staff of the U.S. Securities and Exchange Commission (“SEC”), we understand that there is no present agreement in place between the SEC and BaFin to assist in enforcement of the ban extraterritorially, however the SEC is taking the position that Regulation SHO would continue to apply with respect to the short sales in the ADRs in the US. In this regard, it was noted that firms would need to be particularly vigilant with respect to their respective “locate” and “close-out” obligations under Regulation SHO for ADRs overlying the specific German issuers (e.g., the German ban might make ADRs more difficult to borrow).
3. Second Decree Regarding Naked Short Sales of Government Bonds
3.1 Application and Geographic Scope
The second Decree of BaFin banning the Naked (ungedeckte) Short Selling of Government Bonds (Schuldtiteln) ("Bonds") issued by Member States of the Eurozone applies to such securities that are listed on a German exchange for regulated trading. Furthermore, the relevant FAQ (at Q. 2) states additionally that the relevant transaction (regardless whether a regulated trade or OTC transaction) has to be entered into in Germany.
3.2 Naked Short Selling
The Decree defines Naked (ungedeckte) Short Selling in the same manner as the definition discussed above relating to naked short sales of the stocks of 10 specified German financial institutions, including the use of borrowed securities to prevent a transaction from being subject to the prohibition.
The same exemptions apply as discussed above in the case of naked short sales of 10 specified German financial institutions.
4. Third Decree Regarding Transactions in Credit Derivatives Referenced to Obligations of the Member States of the Euro-zone
4.1 Application and Geographic Scope
Protection buyers are prohibited from contracting a credit derivative as defined in Section 2 (2) no. 4 of the Securities Trading Act (meaning "firm contracts or option contracts in the form of acquisitions, swaps or in other forms which are to be settled at a future date and are intended for the transfer of credit risk (credit derivatives)") or from entering into a transaction on the same if:
1. as part of such transaction the protection seller has an obligation, upon the occurrence of a previously specified credit event, to pay the protection buyer a compensation payment, regardless of the form of the compensation payment (Credit Default Swap), and also regardless of whether the compensation payment is embedded in a Credit-Linked Note or a total return swap; and
2. at least also one obligation of a Member State of the EU whose legal currency is the Euro serves as a reference obligation, or such a Member State is a reference obligor (the "Member State Reference Obligation").
The Decree does not define its scope of applicability. However, the relevant FAQ states at Q. 3 that this Decree only applies to transactions entered into in Germany and that the question whether a transaction is entered into in Germany is to be decided in accordance with the general rules of German civil law.
The ban does not apply where the protection buyer is entering into the transaction to reduce a not insubstantial amount of risk (based on economic substance) associated with an existing position in a Member State Reference Obligation or an existing position in another financial instrument (whether a government or a corporate obligation) that would lose value if the creditworthiness of the relevant Member State were to worsen.
In addition, transactions that reverse CDS positions established prior to the issuance of the Decree and transactions relating to CLNs issued prior to May 19, 2010 are not affected.
There are no express grandfathering rules contained in the three Decrees. However, the Decrees also do not contain an express obligation to unwind existing positions. Accordingly, and based on general principles of interpretation, the Decrees should not have retrospective effect but apply only to transactions and contracts entered into on or after May 19, 2010. This is confirmed by the relevant FAQs.
If you have questions about any of these items, please contact your regular Sidley Austin LLP contact.
1 English BaFin site:
To view the German BaFin site, copy the following URL into your Web browser:
2 Please note that BaFin does not use the word "hedge" but translates in its English version of the decree the German word "Absicherung" by "to secure".
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