Overview
The Ontario's Capital Markets Tribunal's recent decision in Cormark Securities Inc (Re),2024 ONCMT 26, provides important guidance on hedging transactions made concurrently with a private placement. The OSC impugned the bona fides of a multi-step trading strategy where an investor used borrowed freely tradeable shares to cover a short sale that was made concurrently with the investor pledging as collateral the same amount of shares received in a private placement. The Tribunal rejected Staff's allegations that an illegal distribution had occurred. It remains to be seen whether this type of strategy with different facts would withstand scrutiny on other grounds.
Facts
In March 2017, Cormark (a registered investment dealer) approached Canopy (a reporting issuer) to propose a private placement of 2.5 million shares1 to a Cormark client, Saline. Since Saline qualified as an "accredited investor", the private placement did not require a prospectus, but did require Saline to hold those shares for four months before trading them.
Canopy's board approved the private placement, with the condition that the cost of the private placement could not fall below a 10% discount to Canopy's current trading price. If it did, Canopy could walk away from the private placement.2 The private placement was ultimately executed at a 9% discount to Canopy's current trading price.
Saline "shorted" 2.5 million Canopy stocks in the open market before the private placement — meaning Saline sold shares it did not own, and was required to deliver those shares to the purchasers within a few days. There was some conflicting evidence about whether Canopy knew about Saline's short strategy.
At the same time, Saline entered a loan agreement with one of Canopy's directors and shareholders, Goldman. Goldman received a $875,000 loan fee to deliver 2.5 million unrestricted Canopy shares to Saline in exchange for the 2.5 million trade-restricted shares Saline received under the private placement.3 Saline used the shares acquired from Goldman to close its short position. Since the shares Saline used to fill the short sales were 9% cheaper than the price of Canopy shares when Saline shorted the stock, Saline made a 9% profit on the shorts ($1.27 million total profit).
The OSC alleged that:
- The transaction was an illegal "distribution" of Canopy's shares, because it effectively gave Saline access to 2.5 million unrestricted trading shares without any prospectus.
- Canopy was Cormark's client, and Cormark failed to deal fairly, honestly, and in good faith with Canopy by not disclosing Saline's short strategy.
- In the alternative, Cormark's conduct was contrary to the public interest.
The Tribunal finds Cormark and Saline did nothing wrong
The Tribunal found against OSC Staff on all issues:
- There was no illegal distribution because the restricted shares were never traded: The Tribunal rejected Staff's argument that the transactions effectively converted the restricted shares into free-trading shares. Saline used free-trading shares acquired from Goldman to settle its short positions, not the restricted shares (which never traded before the four month holding period expired). The "fact that the parties may have understood that the Transactions were designed to work together does not change the reality that the Transactions involved two separate sets of securities."4 Investors buying Canopy shares through Saline's short sales on the market did not require the protections of a prospectus, since they bought free-trading shares that had been issued earlier.5 "Hedging or managing risk is a normal and accepted part of participating in the capital markets. Merely because a structure might reduce or eliminate risk does not make it contrary to the animating principles of the Act."6
- Canopy was not Cormark's client: The circumstances did not establish a client relationship because: (i) Canopy had an experienced Board, its own lawyers and advisors, and was not "vulnerable" to Cormark;7 (ii) there was no compelling evidence that Canopy believed it was Cormark's client, or that Cormark believed Canopy was its client;8 (iii) Cormark frequently referred to Saline as its client in communications with Canopy,9 and (iv) there was no documented agency or underwriting agreement.10
- The public interest jurisdiction was not engaged as the transactions were not abusive: While Canopy may not have understood that Saline was shorting its stock,11 there was no obligation on Cormark to proactively disclose or explain the transactions to Canopy. Canopy had the opportunity to ask questions about the issues important to it and was not misled. Canopy mostly cared about the price of the private placement, and Cormark did not mislead Canopy on that issue.12 There was no evidence that Canopy would not have proceeded with the private placement if it had known about the short sales.13 The Tribunal also rejected the OSC's argument that the transaction was contrary to the public interest because it earned Saline a profit "virtually risk-free." The Tribunal emphasized that "[h]edging or managing risk is a normal and accepted part of participating in the capital markets. Merely because a structure might reduce or eliminate risk does not make it contrary to the animating principles of the Act."14
Takeaways
- The Tribunal will not legislate further limits than the legislative scheme: in effect, the OSC asked the Tribunal to find that Saline was prohibited from using the restricted shares it acquired in the private placement as collateral for a loan for unrestricted shares. But a pledge of shares as collateral for a loan is excluded from the definition of a "trade" in s.1(1) of the Securities Act. If the OSC was correct that this was an improper distribution, the Tribunal would have effectively created further limits on the use of restricted shares that the Securities Act does not contemplate.
- Sophisticated market actors should protect their own interests: the Tribunal justified its rulings by emphasizing that Canopy was a sophisticated, well-resourced market participant who could protect its own interests. In doing so, the Tribunal indicated an unwillingness to use its public interest jurisdiction to protect sophisticated market actors, as opposed to "vulnerable individual investors."15
- These transactions could still be impugned under insider trading rules: even though the Tribunal did not impugn this transaction as an illegal distribution, market actors who engage in similar deals face some risks under insider trading rules. In this case, the Tribunal did not consider whether Saline engaged in insider trading by shorting Canopy stocks with knowledge that Canopy was about to engage in a private placement, apparently because the OSC alleged Saline and Cormark structured the deal so it would be "immaterial" (and therefore not require them to disclose the details of the transaction in a press release, which the OSC unsuccessfully argued was abusive). In other cases, the OSC may take a more aggressive approach on materiality. Materiality is determined objectively.16 So, even if market actors believe they are engaged in an immaterial transaction, the OSC could impugn a similar transaction to what Saline did on the basis that Saline was trading on material non-public information (knowledge of the pending private placement), which is insider trading. Market actors like Cormark could also be guilty of "tipping" if they disclose information about the private placement to other market participants other than in the "necessary course of business" (which the Tribunal in a different case has recently clarified is a high bar).17
Footnotes
1 Cormark Securities Inc (Re), 2024 ONCMT 26, at paras. 116-117.
2 at paras. 118-119.
3 at para. 158.
4 at para. 48.
5 at para. 57.
6 at para. 154.
7 at paras. 81, 98.
8 at para. 96.
9 at para. 98.
10 at paras. 88-89.
11 at para. 123.
12 at paras. 118-120.
13 at para. 114.
14 at para. 154.
15 See para. 98.
16 Kraft (Re),2023 ONCMT 36, at para. 259.
17 See Kraft (Re), 2023 ONCMT 36.
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