September 10, 2006
Thank you for the opportunity to comment on proposed rule - short sale ammendments. This comment will serve as part three of my comments.
Transparency - continued
Short squeeze red herring/ volatility canard
One final point on the absurdity of the SEC mentioning a short squeeze risk or concerning themselves with volatility regarding the FTD data. First of all the FTD data is considered market neutral by the SEC. As the SEC states, "failing to deliver" can occur on both the long or the short side. In addition, while there are numerous exemptions contained in the short sale reporting rules, there is no exemption for "failing to deliver". Thus, if a short sale is executed that fails to deliver it is not exempted from the reporting requirements simply because it fail to be delivered. This nonsense about short squeezes and volatility regarding FTD data is absurd. The reportable short interest is already baked in the cake under the NASD and NYSE rules for short sale reporting.
Convertible Arbitrage is not dynamic hedging, or is it?:
In January of 2004 the Managed Funds Association submitted a comment letter to proposed rule - short sale that claims hedge fund "current practice" has surreptitiously morphed the SEC's definition of arbitrage into a dynamic hedging strategy. The question is why didn't the SEC take a stand in final rule-short sale after being presented with this conflict and how widespead is this "current practice" in the absence of a clarification from the SEC. The letter from the Managed Funds Association sought clarification regarding dynamic hedging under the arbitrage exemption and stated the following:
"Those changes would resolve confusion about how the exception applies to dynamic hedging on a ratio basis (which we believe would not in any event involve more than the total number of shares receivable upon full exercise of the overlying position in equity-linked Securities) and
would clarify that the exception applies to current practices among market participants involving convertible and exchangeable securities, in which the expectation of profit is based on projected current practices among market participants involving convertible and exchangeable securities, in which the expectation of profit is based on projected changes in the volatility of the embedded call option in the Equity-linked Security will translate into changes in the market price of the Equity linked security that will make the arbitrage profitable. Such practices of dynamic hedging and of performing convertible arbitrage on the basis of computer-driven options pricing models do involve a legitimate arbitrage strategy, although a more sophisticated one than the arbitrage practices that existed when paragraph (e)(7) of Rule 10a-1 was first written."
The comment above indicates the regulation of convertible arbitrage is, for some unknown reason, a fuzzy gray area in the minds of the Hedge Fund Industry and it has possibly opened the door to some very questionable "current practices among market participants". The question is WHY?
The definition of convertible arbitrage is the simultaneous purchase of a convertible bond and shorting of the common stock in order to exploit pricing inefficiencies between a convertible bond and the underlying stock. The SEC defines arbitrage as "an activity undertaken by market professionals in which essentially contemporaneous purchases and sales are effected in order to lock in' a gross profit or spread resulting from a current differential in pricing." However, according to the Managed Funds Association somewhere along the lines Hedge Funds took the liberty to morph those definitions into a two pronged investment "current practice" allowing two types of arbitrage while taking adavatage of the the exemptions afforded bona fide arbitrage. The first type of arbitrage, and consistent with the SEC definition of arbitrage above, is the initial or simultaneous arbitrage that is executed contemporaneously with the convertible debt issueance. The second, less known and questionable type is the dynamic adjustment arbitrage.
The Managed Fund Associations comment letter provided some insight into the concept of dynamic arbitrage wherein they stated "the value of Equity-linked Securities reflects a complex, dynamic relation between an issuer's credit quality and the prospective dynamics of the underlying equity. The efficiency of the Equity-linked Securities market depends critically on investors' willingness to commit capital whenever Equity-linked Securities prices deviate from their estimated values. These values normally presume an ability to offset the equity exposure of the Equity-linked securities by selling the equity short and altering the hedge dynamically thereafter."
As you know the SEC affords bona fide arbitrage with certain exemptions including an exemption from short sale reporting and from complying with the tick test. The Managed Funds Association sought a clarification to apply these exemptions to the "current practice" of dynamic adjustments when they asked that the rules "be clarified to indicate that the market participant can hedge an Equity-linked security (Convertible Bond) by selling the underlying stock short without complying with the short-sale price test as long as the total amount of short sales does not exceed the amount of stock underlying the Equity-linked Security. For Equity-linked Securities to be attractive, investors should be unfettered in how much they hedge (up to the equivalent amount of shares), when they hedge, and the exception should apply wherever the arbitrage is designed to take advantage of mispricing (present or expected).
Unfortunately, I do not see where the SEC unambiguously addressed this question in Final Rule-Short Sale. It is important because the Managed funds Association is seeking a clarification for the "current practice" of dynamic adjustments and tick test relief where no such relief presently exists even though Hedge Funds are "practicing" same and where the SEC has previously been concerned about manipulation. The SEC convertible arbitrage exemption (below) to the tick test and short sale reporting requirements is very clear and you will note that the words "dynamic", "reasonably expected" or "hedge" are not in it. The question is why do Hedge Fund current practices assume they are and why is there any confusion:
"Any sale of a security for a special arbitrage acccount by a person who then owns another security by virtue of which he is, or presently will be, entitled to acquire an equivalent number of securities of the same class as the securities sold provided such sale, or the purchase with such sale offsets, is effected for the bona fide purpose of profitting from a current difference between the price of security sold and the security owned and that such right of acquisition was originally attached to or
represented bt another security or was issued to all the holders of any such of securities of the issuer."
The SEC needs to unambiguosly address the Managed Funds Association's question this time around in Regulation SHO. "Current practice" suggested by the Managed Funds Association implies that hedge funds are dynamically hedging while utilizing the advantages provided by the arbitrage exception. The arbitrage definition/exemption is clear and it does NOT have the word dynamic in it and it does not cover hedging and trading positions. The Managed Fund Association would not be asking for an ex post facto clarification if it did. They are admitting they know they are walking on thin ice, straddling legality or illegality and need SEC guidance. The SEC should unambiguously provide such guidance so that all investors are aware of it.
In conclusion the Managed Funds Association letter indicates much latitude is being surreptiously assumed by hedge fund "current practices" even though the SEC has not explicitly granted such latitude. It is time to address the Managed Funds Association question with a clarification or pass the investigation of inconsistent "current practices" on to the Enforcement Division. The MFA comment letter has been in SEC Market Reg hands for two years, it is inexusable that the issues raised have not been unambiguously addressed in that time thus ensuring "current practices" are consistent with current rules.
Managed Funds Comment Letter - http://www.sec.gov/rules/proposed/s72303/managedfunds012604.htm
Thank you,
Thomas Reilly