Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Securities Regulation, September 2008
On Friday, September 19, 2008, after the close of trading, the Ontario Securities Commission (the "OSC") and a number of other provincial securities commissions issued a temporary order prohibiting the short selling of any securities of certain financial sector issuers that are listed on the Toronto Stock Exchange (the "TSX") and which are also interlisted on an exchange in the United States (the "Original CSA Temporary Order"). Thirteen issuers are covered by this temporary ban on short selling (the "Inter-Listed Financial Sector Issuers"), including each of Canada's Big Five banks as well as Fairfax Financial Holdings Limited, Manulife Financial and Sun Life Financial.
The OSC issued an amended and restated version of the Original CSA Temporary Order in the evening of September 22, 2008 (the "Revised OSC Temporary Order" and, together with the Original CSA Temporary Order, the "Canadian Temporary Orders") and the other Canadian Securities Administrators are considering those amendments. The same 13 Inter-Listed Financial Sector Issuers are covered by the Revised OSC Temporary Order.
In response to the action taken by the United States Securities and Exchange Commission (the "SEC") on September 18, 2008 (the "Original SEC Emergency Order") prohibiting the short selling of any publicly traded securities of 799 financial firms listed in the SEC order (including many of the Inter-Listed Financial Sector Issuers), the Canadian Temporary Orders were issued as a precautionary matter to prevent regulatory arbitrage with respect to short selling in Canada of the securities of financial sector issuers subject to the Original SEC Emergency Order and also to promote fair and orderly markets in Canada for the affected securities. The OSC has also announced that it "will take the appropriate steps necessary to protect our markets and ensure that they are not used for purposes of regulatory arbitrage" and that it "will monitor trading in securities of other Canadian financial issuers and take action if necessary". The UK Financial Services Authority also imposed a similar ban on short selling at the end of last week.
The Original SEC Emergency Order was amended on September 21, 2008 (as amended, the "SEC Emergency Order") and these amendments were reflected in the Revised OSC Temporary Order along with new exemptions from the short selling ban for certain block trades, trades conducted to adjust pre-existing hedged derivative positions and certain off-exchange sales of securities which are subject to marketplace restrictions.
The Revised OSC Temporary Order also provides that, unlike the Original CSA Temporary Order which applied to all securities of an Inter-Listed Financial Sector Issuer, the short-selling ban only applies to common equity securities as is the case with the revised SEC Emergency Order.
The Investment Industry Regulatory Organization of Canada ("IIROC") also published a Guidance Note on September 22, 2008 reminding marketplace participants of their obligations under the Temporary Order and the Universal Market Integrity Rules ("UMIR"). This Guidance Note was restated and reissued on September 23, 2008 to reflect the OSC amendments included in the Revised OSC Temporary Order.
The Canadian Temporary Orders and the SEC Emergency Order will expire before the start of trading on October 3, 2008, unless extended.
Scope Of The Ban On Short Selling
"Short sale" under the Canadian Temporary Orders has the meaning provided in UMIR section 1.1. Generally, a short sale is a sale of a security, other than a derivative instrument, which the seller does not own either directly or through an agent or trustee and, for this purpose, a seller shall be considered to own a security if: the seller has purchased or has entered into an unconditional contract to purchase the security, but has not yet received delivery of the security; the seller has tendered some other security for conversion or exchange into the relevant security or has issued irrevocable instructions to convert or exchange such other security; the seller has an option to purchase the security and has exercised the option; or the seller has a right or warrant to subscribe for the security and has exercised the right or warrant. A seller shall be considered not to own a security if: the seller has borrowed the security to be delivered on the settlement of the trade (and the seller is not otherwise considered to own the security in accordance with the definition); the security held by the seller is subject to any restriction on sale imposed by applicable securities legislation or by a marketplace as a condition of the listing or quoting of the security (a "Marketplace Restricted Security"); or the settlement date or issuance date pursuant to a contract to purchase, tender of a security for conversion or exchange, exercise of an option, or an exercise of a right or warrant would, in the ordinary course, be after the date for settlement of the sale.
Holding an economic interest in equity securities which are the subject of a sale or holding borrowed shares does not exempt the seller from the ban on short selling.
The Revised OSC Temporary Order provides an exemption from the prohibition on short selling in connection with:
- (a) "Program Trades" involving securities underlying a designated index, (b) trades in furtherance of market maker obligations and (c) certain market making and hedging transactions by derivatives market makers, if the short sale is made in accordance with UMIR sections 3.1(2)(a), (b) or (d), respectively, provided, however, that a dealer fulfilling market maker obligations may not effect a short sale in the common equity securities of the Inter-Listed Financial Sector Issuers if the market maker ought reasonably to know that the client's or counterparty's transaction will result in the client or counterparty establishing or increasing an economic net short position (i.e., through actual positions, derivatives, or otherwise) in the issued share capital of the relevant Inter-Listed Financial Sector Issuer (the "Market Maker Knowledge Proviso");
- sales conducted by a registered dealer acting as principal to facilitate a transaction with a client that has a current market value of C$200,000 or more in a single transaction (or in several transactions at approximately the same time) provided that the dealer's position is liquidated or hedged as soon as possible (the "Block Trade Exemption");
- short sales conducted in order to comply with best price execution obligations for client orders under UMIR Rule 5.2; and
- short sales completed as a result of the automatic exercise or assignment of an equity option held prior to the effectiveness of the relevant Temporary Order, or in connection with settlement of a futures contract, due to expiration of the option or futures contract;
- a sale of a Marketplace Restricted Security, where that security is beneficially owned by the seller and the sale is made under an exemption from the prospectus requirements in accordance with applicable securities legislation (the "Off-Market Restricted Security Sale Exemption"); or
- conducted to adjust a pre-existing hedged derivative position in order to maintain the risk exposure that existed at the time the Original CSA Temporary Order became effective (the "Derivatives Hedging Exemption").
The Canadian Temporary Orders do not require pre-existing short positions to be unwound although pending short sales must be cancelled.
The Inter-Listed Financial Sector Issuers affected by the Canadian Temporary Orders are: Aberdeen Asia-Pacific Income Investment Company Ltd., Bank of Montreal, The Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Fairfax Financial Holdings Limited, Kingsway Financial Services Inc., Manulife Financial Corporation, Quest Capital Corp., Royal Bank of Canada, Sun Life Financial Inc., Thomas Weisel Partners Group Inc., The Toronto-Dominion Bank and Merrill Lynch & Co., Canada Ltd. Merrill Lynch & Co., Canada Ltd.'s shares are exchangeable shares rather than inter-listed shares.
The Market Maker Knowledge Proviso, the Block Trade Exemption, the Off-Market Restricted Security Sale Exemption and the Derivatives Hedging Exemption were added to the Revised OSC Temporary Order. The Market Maker Knowledge Proviso reflects amendments to the SEC Emergency Order but may have only limited application as dealers effecting trades as market makers on the Montreal Exchange will not have knowledge of the positions of counterparties which are not their clients.
The Derivatives Hedging Exemption appears to respond to the needs of dealers to dynamically hedge pre-existing derivatives positions involving securities of the relevant Inter-Listed Financial Sector Issuer.
The IIROC Guidance Note summarizes the Revised OSC Temporary Order and also refers to market participants' obligations to police compliance with the Revised OSC Temporary Order by clients with direct market access and to ensure that short sales are properly declared.
The SEC Emergency Order
The Original SEC Emergency Order issued before the start of trading on Friday, September 19, 2008 was intended to prohibit short selling in financial companies to "protect the integrity and quality of the securities market and strengthen investor confidence." A statement from SEC Chairman Christopher Cox indicated: "The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets. The emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets. This action, which would not be necessary in a well-functioning market, is temporary in nature and part of the comprehensive set of steps being taken by the Federal Reserve, the Treasury, and the Congress".
The Original SEC Emergency Order applied in respect of 799 listed financial institutions. However, the September 21, 2008 amendment to the SEC Emergency Order specified that the SEC Emergency Order "applies to the publicly traded common equity securities of any issuer identified by any national securities exchange listing such securities as being a financial institution."
This change is intended to allow individual securities exchanges to ensure that the list of issuers covered by the SEC Emergency Order is comprehensive and accurate. Moreover, issuers which do not wish their shares to be covered by the SEC Emergency Order may opt out by requesting that the relevant exchange not include the issuer in its listing of covered issuers.
The UK FSA Restriction Of Short Selling
The FSA implemented a similar restriction on short selling by adding to its Market Conduct rulebook a provision which states that: "A person who enters into a transaction that (whether by itself or in conjunction with other transactions) has the effect of: (a) creating a "net short position" in a UK financial sector company; or (b) increasing any net short position in a "UK financial sector company" that the person had immediately before 19 September 2008; is, in the opinion of the FSA, engaging in behaviour that is "market abuse" (misleading behaviour)." The definition of "net short position" which is provided refers to the net economic exposure of a person to the issued share capital of a company. The calculation of whether a person has a short position must take account of any form of economic interest in the shares of the company. The FSA order expires January 16, 2009.
A copy of the Revised OSC Temporary Order, the Original CSA Temporary Order issued by certain other provincial securities commissions and IIROC's revised Guidance Note are available on Blakes Web site in our Publications – Corporate Finance and Securities Regulation section , together with a copy of this bulletin.