CSA and IIROC Seek Guidance on Regulatory Framework for Short Selling in Canada

The Canadian Securities Administrators (“CSA”) and the Investment Industry Regulatory Organization of Canada (“IIROC”) have released a joint Staff Notice 23-329 (the “Staff Notice”) seeking feedback from investors, market participants, and the public on a broad range of issues relating to the regulatory framework surrounding short selling in Canada. Short selling is the practice of a seller, anticipating a decline in the price of a certain security, selling securities that the seller does not own with the intention of acquiring the securities at a lower price in the future.

The Staff Notice offers an overview of the existing regulatory landscape for short selling in Canada, provides an update on current initiatives relating to short selling, and describes recent international developments and the results of a study completed by IIROC on failed trades. The CSA and IIROC are accepting comments on the Staff Notice until March 8, 2023.

Current Canadian Regulatory Framework

The practice of short selling is subject to a well-developed regulatory framework in Canada, involving Canadian securities legislation and IIROC requirements. While all market participants are subject to Canadian securities legislation and are required to comply with Canadian securities laws relating to short selling (as described below), the short selling regime is primarily overseen by IIROC, allowing the organization to monitor and supervise potentially inappropriate short selling practices in a timely manner.

CSA Framework

Provincial securities legislation requires a person or company who places an order for the sale of a security with a registered dealer to declare to such dealer at the time of placing the order that such person or company does not own the security.

As well, provincial securities legislation and National Instrument 23-101 – Trading Rules prohibit activities that are manipulative and/or deceptive, which can occur in the context of short selling.

IIROC Framework

Similar to the CSA Framework, IIROC’s Universal Market Integrity Rules (“UMIR”) prohibit activities that are manipulative and/or deceptive, such as entering an order for the sale of a security without, at the time of entering the order, having a reasonable expectation of settling any trade that would result from the execution of the order on the settlement date. IIROC also monitors for potentially abusive trading activities, by using algorithms to search for unusual activity, monitoring social media and chat rooms, and reviewing Extended Failed Trade Reports (as described below). IIROC has additional alerts set up that detect changes in the historical pattern of short selling for a particular security, allowing IIROC to determine if short selling is becoming concentrated within a particular dealer or client. If unusual levels of short selling are detected, IIROC has broad powers to intervene, including but not limited to the ability to cancel a trade, impose a market halt, contact the listed issuer, and refer matters to IIROC enforcement for further review and potential discipline.

Further, UMIR requires Participants (defined as dealers that are members of an exchange, users of a quotation or trade reporting system, and subscribers of an alternative trading system) and Access Persons (defined as persons other than Participants that are subscribers or users of a marketplace) to calculate and report to IIROC the aggregate short positions of each individual account twice a month.

UMIR imposes several requirements related to short selling on Participants and Access Persons, and grants IIROC certain protectionary abilities:

• Participant and Access Person Requirements

• Marking Orders. Participants and Access Persons are required to mark all orders representing a short sale as either “short” or “short-marking exempt”. A short-marking exempt order includes an order for a security from an account that is (i) an arbitrage account, (ii) an account of a market maker for that security, or (iii) certain other specified accounts that buy and sell securities and that, at the end of any trading day, do not have more than a nominal long or short position in a particular security.

• Extended Failed Trade Reports. Participants and Access Persons are required to report Extended Failed Trades to IIROC. An Extended Failed Trade is a trade that did not settle and was not rectified within 10 trading days from the original settlement date.

• Prior Arrangements. If an Extended Failed Trade Report is filed with IIROC, further short sales generally cannot be made by that Participant or Access Person without having made prior arrangements to borrow the securities necessary for settlement.

• IIROC Capabilities

• Pre-Borrow Security Designation. IIROC has the ability to designate a security as a “Pre-Borrow Security”. A Pre-Borrow Security is a security that has been designated to be a security in respect of which an order that on execution would be a short sale may not be entered on a marketplace unless the Participant or Access Person has made arrangements to borrow the securities that would be necessary to settle the trade prior to the entry of the order.

• Short Sale Ineligible Security. IIROC has the ability to designate a security as a “Short Sale Ineligible Security”. A Short Sale Ineligible Security is a security or class of securities that has been designated to be a security in respect of which an order that, on execution, would be a short sale may not be entered on a marketplace for a particular trading day or trading days.

Key Issues for Consultation

IIROC and the CSA are soliciting feedback from stakeholders on a broad range of issues, including questions and concerns relating to:

• the 2012 repeal of the “tick test”, being a restriction on the price at which certain types of trades can occur;

• short selling and pre-borrow requirements;

• IIROC’s Extended Failed Trades requirements;

• transparency of short selling positions; and

• buy-in and close-out requirements of CDS.

There has been a lot of discussion in the media about the potential abusive practice of activist short selling. However, the empirical evidence seems to suggest this issue may not be one of material significance. At the same time, there is always the potential for abuse, particularly in an area of limited regulation. Any reforms that IIROC and the CSA ultimately choose to adopt need to be data driven and need to carefully balance investor protection and market efficiency objectives.

A copy of the Staff Notice, which includes eight specific questions the CSA and IIROC are hoping stakeholders will address, can be found here. Please feel free to reach out to any member of our Capital Markets or Financial Services Regulatory groups to discuss.