Term and Fundamentals: “Short” in the Legal Context
The term “Short” (also: short position, short sale) refers, in finance and capital market law, to a position in which a party speculates on falling prices of a security or commodity. In doing so, a market participant borrows or sells assets they do not own, with the intention of buying them back later at a lower price. In the legal context, “short” describes key business practices which are subject to far-reaching regulatory measures, especially in stock exchange, banking, and securities law.
Legal Classification of Short Positions
Short Selling – Short Sale in Securities Law
Definition and Functionality
Short selling, in legal terms, is the sale of financial instruments which the seller does not own at the time of concluding the contract, but rather borrows from third parties in order to sell them on the market. The intention is then to repurchase the financial instrument at a lower price, thereby generating profit from the price difference.
Forms of Short Sale
- Covered short sale: Here, the security is lent or available beforehand, ensuring the transaction can be settled immediately.
- Naked short sale: The security to be sold is neither reserved nor borrowed at the time of contract conclusion.
Legal Basis and Regulations
European Union (EU)
The regulations on short sales in the European Union are primarily governed by the Short Selling Regulation (EU Regulation No. 236/2012) This regulation contains extensive disclosure requirements, prohibitions, and restrictions on naked short selling:
- Disclosure requirements: Market participants must report net short positions above certain thresholds both to the competent supervisory authorities (e.g., Federal Financial Supervisory Authority – BaFin) and to the public.
- Ban on naked short selling: Naked short selling of certain financial instruments, in particular shares and government bonds, is prohibited. It must be ensured that the financial instrument is actually borrowed or deliverable before initiating the transaction.
- Loan prerequisites and settlement discipline: To prevent market manipulation and settlement risks, there are detailed regulations on the process and risk management of short sales.
Federal Republic of Germany
In addition to the EU regulation, the Securities Trading Act (WpHG) contains regulations on reporting requirements, prohibition orders and measures to stabilize financial markets in connection with short positions. In addition, BaFin can impose temporary restrictions and bans to protect market integrity and financial stability.
Short Positions in Further Areas of Law
Insolvency Law Implications
Short positions can present particular challenges in the event of the insolvency of a counterparty. In the event of insolvency of a securities lender or purchaser, claims for return, delivery obligations or balancing payments may arise, the enforcement of which can be influenced by insolvency law barriers such as insufficient estate assets or avoidance.
Tax Law
The tax treatment of profits and losses from short positions is governed by the Income Tax Act (EStG) and Corporation Tax Act (KStG). This results in particular requirements regarding the accounting and determination of profits from short sales. The allocation to types of income (especially income from capital assets) and loss compensation is specified by legislation and case law.
Civil Law Aspects
In private legal relationships, civil law contracts (such as securities lending agreements, framework agreements under the German Securities Lending Master Agreement) primarily govern the modalities of short sales and short positions. Here, liability, transfer of ownership, and contract settlement play a decisive role, especially in cases of delivery delays or insolvency of a contracting party.
Market Abuse and Short Positions
Insider Trading and Market Manipulation
Short sales can be used as instruments for market manipulation or insider trading, for example, if targeted misinformation (“short and distort”) is used to drive prices down, thereby benefiting short positions. The European provisions of the Market Abuse Regime (Market Abuse Regulation – MAR, Regulation EU No. 596/2014) therefore include special rules and supervisory obligations to prevent abuse and increase transparency.
Supervisory Measures and Sanctions
Authorities such as BaFin or the European Securities and Markets Authority (ESMA) can impose restrictive measures due to suspicious activities. These include stricter reporting requirements, short-term trading bans (“Short Selling Bans”), or substantial fines for legal violations related to short positions.
Reporting Obligations and Transparency
According to EU and German law, investors and institutional market participants are subject to extensive reporting duties, particularly when certain thresholds are exceeded:
- Reporting obligations to the supervisory authorities: These serve to monitor potentially market-influencing short positions and to identify risks to market stability at an early stage.
- Public disclosure of significant short positions: Certain short positions must be disclosed without exception as soon as they attain public relevance. This creates increased transparency for all market participants.
Sanctions for Violations of Short Selling Rules
Violations of short selling regulations, such as particularly reporting infringements, naked short positions, or market manipulation, can result in severe sanctions. These range from fines and trading bans to criminal consequences. Furthermore, civil law claims for damages may arise between contracting parties.
Summary and Practical Significance
The term Short in the legal context describes holding or entering into a position speculating on falling prices via short sales. The legal framework is complex and ranges from extensive disclosure and reporting obligations to prohibitions of naked short sales, as well as regulatory intervention rights in the case of market abuse. Short sales offer opportunities but also carry considerable risks—both economic and legal—for all parties active in the capital market.
Further Provisions (Selection):
- Regulation (EU) No. 236/2012 on short selling and certain aspects of credit default swaps
- § 38 ff. Securities Trading Act (WpHG)
- Market Abuse Regulation (EU) No. 596/2014
- Deutsche Börse regulations on short selling
This article provides a comprehensive overview of the term “short” in the legal context and serves as a central reference work for the legal assessment of short selling practices.
Frequently Asked Questions
What legal framework applies to short selling in Germany?
The short sale of financial instruments in Germany is strictly regulated and subject to both national and European provisions. Of particular importance is the EU Short Selling Regulation (EU Regulation No. 236/2012), which is directly applicable in all member states and is supplemented by the Securities Trading Act (WpHG). According to these rules, naked short sales of certain securities, especially shares, are generally not permitted. Instead, short selling is only allowed if a “borrow-locate requirement” for the deliverable securities is met in advance. Certain financial institutions are also required to report to the Federal Financial Supervisory Authority (BaFin) and, above specified thresholds, must publicly disclose net short positions. Additionally, BaFin may, in exceptional circumstances, impose temporary bans on certain short selling practices.
What are the reporting obligations for short sale positions?
Legally, if certain thresholds (0.1%, 0.2%, 0.5%, and every further 0.1%) of the issued share capital of a listed company are reached, exceeded, or undershot, net short positions must be reported to BaFin within a trading day. From a threshold of 0.5%, the position must also be made public. These reporting duties serve market transparency and are intended to prevent market manipulation and unexpected price movements. Breaches may result in significant fines, which are defined in the Market Abuse Regulation (EU Regulation No. 596/2014) and the WpHG in terms of amount and structure.
Are there specific bans or restrictions for short selling in exceptional phases?
Yes, both at the European and national level, temporary short-selling bans can be imposed. BaFin has the authority to impose temporary bans on entering into or increasing short sales positions during exceptional market circumstances, such as extreme volatility or crises (e.g., during the corona pandemic in 2020). These measures can affect certain stocks or market segments and serve to protect financial market stability. Such interventions are publicly announced and are generally temporary. The European Securities and Markets Authority (ESMA) can also implement measures that apply across all member states.
What criminal and regulatory consequences may arise from breaches of short selling rules?
Violations of supervisory regulations on short selling constitute administrative offences and can be punished with fines of up to several million euros. In particular, unauthorized entry into naked short positions, missing or late reporting of short sales, and circumventing bans are covered. In particularly serious cases, especially when market manipulation or insider trading is proven, criminal sanctions including imprisonment may occur. The practice of sanctions is determined by the provisions of the WpHG and the relevant EU regulations.
Who is authorized under German law to conduct short sales?
In principle, only market participants with the necessary license under the German Banking Act (KWG) may engage in short sales. This usually concerns banks, securities trading firms, and other professional market participants. Private individuals may participate in short sales only through broker services, which often takes place via derivative instruments (e.g., CFDs, options)—thus not as a “classic” short sale in the legal sense. Brokers and financial service providers must also ensure that all their clients comply with legal requirements, for which they themselves can be held liable.
What special documentation and due diligence obligations exist for short transactions?
All institutions involved in short selling have extensive recording and documentation obligations. Trading activities, order routes, hedging mechanisms, and reports must be fully, promptly, and audit-proof documented. This is mandatory to provide transparency during official inspections, for instance by BaFin or audit associations. Furthermore, institutions are required to establish internal control mechanisms to ensure compliance with the legal short sale provisions. They must also retain all relevant trading documents for at least five years.
Are there differences in the legal treatment of covered and naked short selling?
Yes, covered and naked short sales are treated very differently under the law. While covered short sales—in which the seller can ensure the availability of the borrowed securities at the latest upon order execution—are legal if certain requirements are met, naked short sales of shares and certain debt instruments are generally prohibited under the EU Short Selling Regulation. Exceptions require a separate permit and must be extensively justified and documented. This difference is crucial for the lawfulness and scope for structuring short selling transactions.
