The recent volatility in equity markets led to a variety of responsesby regulators. A particularly popular response internationally was theintroduction of limits to short sales of securities, a tool used in anattempt to ease the downward pressure on the value of certaincompanies. In the United States, for example, the Securities and Exchange Commission (SEC) prohibited short selling in the shares of financial companies in the fall of 2008, a move followed by the Ontario Securities Commission(OSC) restriction on short sales of securities of companies that wereinter-listed on a US exchange and on the SEC’s restricted list. Whilethese particular restrictions soon lapsed, the general rules respectingshort sales in Canada have been under consideration by regulators forsome time. Further, the Investment Industry Regulatory Organization of Canada (IIROC) recently released two studies related to short sales,one of which considered the effects of the recently imposedrestrictions. This update, meanwhile, seeks to review the current rulesrespecting short sales in Canada, recent amendments and the proposalsfor change.
Regulatory Regime
In Canada, most of the rules respecting short sales are governed by the Universal Market Integrity Rules (UMIR or Rules), a common set of equity trading rules applicable across the country. Section 1.1of UMIR defines a “short sale” as the sale of a security other than aderivative that “the seller does not own either directly or through anagent or trustee.” The definition also lists a number of circumstancesunder which a seller will be (or will not be) considered to own asecurity. Under section 3.1of UMIR, a Participant (dealer) may not make a short sale of a securityunless the price is at or above the last sale price for that security,subject to certain exceptions (the tick-test or the “uptick rule”). Thisrestriction is not subject to the liquidity of the security or thedegree of difficulty of borrowing the security in order to settle theshort sale. The policy rationale for the tick-test is the avoidance ofundue downward pressure on the trading price of a particular securityfrom sellers who do not own the security. Due to the repeal of thetick-test in the U.S., however, the prohibition was relaxed in Canada onJuly 6, 2007 with respect to shares inter-listed in the United States.Canadian regulators made the change to allow for consistent treatment ofthe securities of companies that list in both countries.[1] IIROC's Dealer Member Rules,meanwhile, prescribe the margin requirements applicable to securities,including rights and warrants, listed on any recognized stock exchangein Canada or the U.S. with respect to dealer members.
Contrasted with the U.S. requirements imposing a duty to locate shares in order to initiate a short sale, section 2.2of UMIR provides that a Participant (dealer) must only have a“reasonable expectation” of settling the trade. The Rules also requirethat short sales be marked as being a short sale or as exempt andParticipants must have adequate policies and procedures in place toensure the proper marking of orders. Under section 10.10 of UMIR, Participants and Access Persons (ATS subscribers) must also prepare and file a short position report twice-monthly.
The disclosure of short positions by clients to dealers is alsogenerally required under securities laws. In Ontario, for example, section 48 of the Securities Actrequires that “[a]ny person or company who places an order for the saleof a security through an agent acting for him, her or it that is aregistered dealer and who,
- at the time of placing the order, does not own the security; or
- if acting as agent, knows the principal does not own the security,
shall, at the time of placing the order to sell, declare to the agentthat he, she or it or the principal, as the case may be, does not ownthe security.”
No distinction is made in the regulation between “naked” or “covered”short sales. However, the practice of “naked” short selling, while notspecifically enumerated or proscribed as such, may violate otherprovisions of securities legislation or self-regulatory organizationrules where the transaction fails to settle. Specifically, section 126.1 of the Securities Actprohibits activities that result or contribute “to a misleadingappearance of trading activity in, or an artificial price for, asecurity or derivative of a security” or that perpetrate a fraud on anyperson or company. Part 3 of National Instrument 23-101 Trading Rulescontains similar prohibitions against manipulation and fraud, although aperson or company that complies with similar requirements establishedby a recognized exchange, quotation and trade reporting system orregulation services provider is exempt from their application. Under section 127(1) of the Securities Act,the OSC also has a “public interest jurisdiction” to make a wide rangeof orders that, in its opinion, are in the public interest in light ofthe purposes of the Securities Act (notwithstanding that the subject activity is not specifically proscribed by legislation). The TSX Rule Bookalso imposes certain obligations on its “participating organizations”in connection with trades that fail to settle (see, for example, Rule 5-301 Buy-Ins).
The Canada Business Corporations Actalso prohibits certain insiders from effecting short sales, subject tolimited exceptions, as well as from dealing in puts or calls onsecurities of the applicable corporation.
2007 Proposals
On September 7, 2007, Market Regulation Services (RS), the precursor to IIROC, released a Request for Commentsregarding proposals to amend the UMIR Rules on short selling (the 2007Proposals). In the release, RS noted that various studies suggested thatthe tick-test was of limited use in stemming market declines and thatits possible negative impact on price discovery may outweigh anybeneficial effect. As stated by the Notice, the review of the academicliterature on short selling “concluded that price restrictions typicallyact to restrict price discovery by limiting arbitrage and creatingoverpricing of securities, thus affecting overall market efficiency andliquidity.”
As such, the proposed amendments called for:
- the repeal of the tick test, instead allowing the regulator to designate a particular security or class of securities as being ineligible for short selling;
- repealing the twice-monthly requirement for short position reports once adequate information on short sales was generally available;
- requiring notice to regulators if a trade was varied after the execution of a short sale;
- providing a definition of “failed trade” and requiring that the reason for failure be reported if it was not resolved within ten days;
- providing that a regulator may cancel, under certain circumstances, a failed trade;
- deleting provisions for the “short exempt” order marker (used for, among other things, the resale of U.S.-legended securities); and
- clarifying the requirements surrounding whether a seller was considered the owner of securities at the time of sale.
Measures similar to U.S. locate and “close-out” requirements,however, were not proposed by RS “based on the results of empiricalstudies in Canada indicating that the rates of trade failure aresignificantly lower than in the U.S.” and the lack of connection betweenshort sales and trade failures in Canada. RS invited comments on itsproposed amendments until October 9, 2007.
Market Challenges
Increased volatility, however, began plaguing the markets before anyof the proposed amendments were adopted. While equity markets begantheir decline in 2007, the challenges facing American financial andinvestment institutions in the summer and fall of 2008 caused aprecipitous drop in markets and increased pressure on the value ofsecurities. In the U.S., the SEC responded on September 17, 2008by prohibiting “naked” short selling, requiring that securities atissue in a short sale be delivered by the end of business on thesettlement date. The action was taken due to the SEC’s concern regarding“the possible unnecessary or artificial price movements based onunfounded rumors regarding the stability of financial institutions andother issuers exacerbated by 'naked' short selling.” The next day,meanwhile, the SEC prohibited the short selling of a number of financial firms (with certain exceptions) in an attempt to further protect those firms. On September 19, 2008, the OSC moved to restrict short selling in certain TSX-listed financial companiesthat were inter-listed in the U.S. or that had outstanding securitiesthat were exchangeable into shares of a financial company listed in theSEC order. The stated purpose of the OSC's order was "to preventregulatory arbitrage with respect to short selling in Ontario of...andpromote fair and orderly markets in Ontario" for the relevantsecurities. The OSC and SEC orders prohibiting short sales of thesecurities of financial companies expired on October 8, 2008. On October15, 2008, the SEC released an interim final temporary rulewith respect to the disclosure of short sales and short positions byinstitutional investment managers. The U.K. Financial ServicesAuthority, meanwhile, also banned short sales with respect to certain financial securities, a temporary measure that lapsed in January 2009.
IIROC Notice of Approval - October 15, 2008
On October 15, 2008, IIROC published a Notice of Approval(the 2008 Amendments) respecting the adoption of certain provisionsfrom the 2007 Proposals. The proposed removal of the tick-test, however,was deferred “in light of recent actions taken by the SEC on atemporary basis to restrict or prohibit short sales on securities offinancial issuers or issuers generally and given the concern expressedin the media that the repeal of price restrictions on short sales in theUnited States may have contributed to any volatility experienced inU.S. markets”, as was the proposed requirement to file short positionreports. The 2008 Amendments also did not proceed with the proposalsthat would have allowed a regulator to cancel failed trades.Interestingly, more recently in April 2009, the SEC also voted to seekpublic comments on proposals to impose further restrictions on shortsales, including the re-introduction of uptick restrictions.
In summary, the 2008 Amendments:
- require that notice be provided to a regulator if a trade is varied or cancelled after the execution of a trade. The purpose of the provision is to ensure that such action “is not effected outside the normal processes of the marketplaces and CDS (the depository that is active in the settling process) unless IIROC is notified…and has the opportunity to review the change for possible market integrity concerns”;
- allow a regulator to designate a particular security or class of securities as being ineligible for short selling, subject to a number of exemptions. IIROC states that such restrictions will likely be relatively rare, however, this tool is being created “to provide additional flexibility to the Market Regulator to respond to developments in trading of a particular security or class of securities if rates of failed trades become…excessive.” Criteria to be considered in determining whether to enact such a restriction on short sales are also set out in the 2008 Amendments;
- provide a definition of “failed trade” and require a report of failed trades if the reason for failure is not resolved within ten trading days following the original settlement date. The report is intended to allow IIROC “to determine if the trade has failed to settle for an ‘improper’ reason”; and
- clarify certain requirements that must be met for sellers to be considered the owner of securities.
The provisions related to providing notice of extended failed tradesand reports of trade variations and cancellations were originallydeferred until March 1, 2009, but IIROC has since advisedthat the implementation date will be further deferred to a future dateto be announced. IIROC is also expected to publish a notice setting outthe specific content and procedures for such reports. Further, IIROCintends to undertake a study with respect to the impact of the 2008Amendments, the effects of the exemptions to interlisted issuers and thepotential effects of a repeal of all price restrictions on short sales.[2]The impact study is to be completed by a third party and the results of the study are to be released for public comment.
Conclusion
Thus, while the 2008 Amendments adopted a number of the provisions ofthe 2007 Proposals, short sales are permitted but the tick-test remainsin effect in Canada for non-inter-listed securities. As well, failed,cancelled and amended trades will be subject to greater regulation, andspecific securities can be declared ineligible to be sold short.Further, as discussed above, the proposal to implement pre-borrowrequirements is expected from IIROC shortly, while the study on theeffects of price restrictions and the impact of the 2008 Amendments maylead to further proposals for change.
[1]Itshould be noted, however, that the SEC has recently announced that itis considering proposals to impose restrictions on short sales, whichinclude uptick restrictions. The SEC voted on April 8, 2009 to seekpublic comment on these “Short Sale Price Test and Circuit Breaker Restrictions”.
[2]It should be noted that subsequent to the release of the 2008 Amendments, IIROCreleased two studies related to short sales. The first study, "Recent Trends in Trading Activity, Short Sales and Failed Trades",reviewed trading trends during the period of May 1, 2007 to September30, 2008 with a particular focus on short selling and failed trades. Thestudy found that despite the fact that the average number of dailytrades increased "significantly" during the study period, "there was nosignificant change" with respect to short sales. The second studyreleased was the "Study on the Impact of the Prohibition on the Short Sale of Inter-Listed Financial Sector Issuers".The purpose of this study was to review the impact of recentrestrictions by the OSC in September and October of 2008 to curb shortselling in the face of increased market volatility. Notably, the studyfound that the OSC orders "did not appear to have had any appreciableeffect on the price" of either the securities of restricted ornon-restricted financial issuers. The orders, however, had "asignificant impact on market quality" for the trading of restrictedfinancial securities, as the orders reduced the liquidity available inthe restricted financials and increased the spread between the ask priceand closing bid. The effect of the studies on future regulatory actionis not yet clear, however, IIROC's release stated that the studies"provide data and analysis that are integral to our effectivepolicy-making."