Alert September 25, 2008

REITs Included on the “No Short” List

SEC Emergency Orders on Short Sales

Although REITs were not explicitly included when the Securities and Exchange Commission initially restricted short-selling of financial institutions, it may come as no surprise that since that time several REITs have appeared on the list of entities covered by the short selling ban. As of the date of this REIT Alert, approximately 14 REITs were included on the no short list.

Initially, on September 18, 2008, the SEC issued an emergency order that, subject to limited exceptions, banned any short sale in the publicly traded securities of 799 financial firms listed in the order. On September 21, 2008, the SEC amended this order to, among other things, modify the list of financial firms subject to the ban. The SEC noted that difficulties with the classification criteria led to the omission of certain financial institutions from the list of financial firms included in the September 18 order. Therefore, the amended order provided that the listing exchanges (i.e., NYSE, NASDAQ and AMEX) would select the individual financial institutions to be covered by the temporary short sale restrictions as the exchanges were familiar with the nature of businesses of the financial institutions listed on the exchanges. The amended order stated that the SEC expected each national securities exchange listing financial institutions to publish a list on its Internet website of common equity that will be covered by the order’s prohibition on short sales. The SEC stated it expected that these lists would cover banks, saving associations, broker-dealers, investment advisers and insurance companies, whether domestic or foreign, and the owners of any of these entities.

Sources of Updated Lists

On its website, the NYSE notes that in addition to the companies that were on the original list attached to the September 18 order, additional companies to be included must be in one of the following categories:

  • banks, as defined in 15 U.S.C. 78c(a)(6);
  • saving associations, as defined in 15 U.S.C. 78c(a)(46);
  • registered brokers or dealers, as defined in 15 U.S.C. 78c(a)(48);
  • insurance companies, as defined in 15 U.S.C. 80a-2(a)(17);
  • banks, saving associations, brokers, dealers and insurance companies that are similar to those covered by the foregoing statutory definitions but which are regulated by a foreign (rather than U.S.) regulatory authority;
  • U.S. and foreign investment advisors, both registered and unregistered; and
  • companies that control or have majority ownership of companies that meet one of the above criteria.

REITs may not obviously fall into one of the foregoing enumerated categories,  although, for certain purposes, REITs have been classified as financial companies.1 However, some REITs may control directly or indirectly an entity that falls within one of the defined categories. For example, certain real estate analysts have speculated that some REITs have made a case to be added to the no-short list under the investment advisor category as a result of their asset management units.

Inclusion

The critical question that is posed by these developments is whether a particular REIT should consider approaching its applicable exchange to request inclusion on the no short list.2 The answer to this question is complex. As the SEC noted, sudden declines in the prices of a wide range of securities, have created a crisis of confidence, without a fundamental underlying basis. However, as market volatility over the past few days has shown, short-selling and short-sellers are obviously not solely responsible for declines in share price. Some shares of companies that were included in the initial order on September 18 still declined precipitously after short-selling in the company was banned. Conversely, in normal market conditions, the ability to sell a given stock short can generally be expected to decrease volatility and increase liquidity in that stock since holders of long positions are able to manage their market risk through short hedges. An inability to hedge may result in net selling of the stock as existing long investors seek to exit their positions and potential new investors pass in favor of less volatile investments. 

In addition, and more specifically, the inability to sell short makes certain derivatives securities based on an underlying equity stock difficult to manage and, ultimately, unappealing to investors. Convertible notes offerings, for example, are premised on the ability of note purchasers to simultaneously sell the underlying equity short, thus hedging their market risk exposure on the underlying stock. Without this ability, a convertible notes offering will often not be attractive to investors and result in the failure of such offering due to a lack of buyers. Any number of other types of equity derivatives (e.g., swaps, prepaid forwards, caps/collars) might also become difficult to execute in a no-short-hedge environment, since dealers that might otherwise be natural counterparties will be unwilling to take on heightened levels of market risk given their inability to execute short sales of the common stock of companies on the short sale ban list. In addition, if an investor wishes to enter into any transaction (options, swap or other derivative) with a broker-dealer that happens to be an options market maker (most of the large brokerages are), the broker-dealer is prohibited from effecting the transaction if it would have the effect of increasing the investor’s net short exposure with respect to a stock on the no-short list. As a result, many investors have found that it has become very difficult to put on options, swaps or derivatives positions relating to stocks on the no short list.

Accordingly, companies are strongly urged to consult their financial and legal advisors and to closely examine the potential risks and benefits of inclusion on the no-short list based on their own particular circumstances.

Further Information

For more information regarding materials relating to the SEC emergency orders concerning short-selling restrictions and related matters, including FAQs issued by the SEC, see the Financial Services Alerts issued by Goodwin Procter LLP