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FSA To Re-Examine Short Selling

by Philip Morton, Investors

02 December 2003

The UK's Financial Services Authority (FSA) is set to re-examine the practice of short selling by hedge funds and market-makers, after it emerged that more shares had been sold in AIM-listed firm, Room Service than actually exist, a situation which has left many small investors out of pocket.

Although following criticism of the practice last year by Legal and General chief executive, David Prosser, the FSA had concluded that shorting boosts market efficiency, it announced this week that:

"We have not changed our general view, but we will reflect on the issues that this case has raised in terms of large short positions."

Usually when an institution takes a short position in a stock, it will borrow the stock from elsewhere and return it at a later date. However, in the case of Room Service, market-makers were taking what is known as 'naked positions', which means that they were shorting the shares without having agreed to borrow the underlying stock from long term shareholders.

These positions were assumed on the understanding that a planned Room Service rights issue would mean that more shares were coming onto the market. However, the rights issue failed to take place, meaning that the short sellers were unable to settle their trades.

The shares have since been suspended, in a move which has left many smaller Room Service shareholders also unable to settle their trades.

However, speaking to the Financial Times at the weekend, an unnamed hedge fund manager suggested that the problem was not the short selling itself, but the fact that the institutions in question did not ensure that their positions were covered.

"This is not about shorting per se. It is about a lack of enforcement on the part of the London Stock Exchange on forcing the market-maker to deliver the stock," he observed, continuing:

"It also means that the market price is the wrong price. The market-makers were shorting the stock knowing full well they could not deliver it back. That was depressing the price unfairly."

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