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Posthaste: Regulator’s fresh short-selling guidance raises eyebrows over possible future crackdown

Could this new, gentle reminder from IIROC be a prelude to future enforcement action?

By Barbara Shecter

Short selling is often controversial, and fresh guidance from one of Canada’s main market regulators suggests there is continued friction over what is acceptable and how the rules are being applied.

In a short transaction, a share or other security is borrowed in hopes the price will drop and it can be bought at a lower price when it’s time to return the share, and thus profit from the difference. Some view short selling as a vital component of active capital markets where liquidity is ensured and long and short strategies lead to valid price discovery. But others see it as a tool ripe for abuse through so-called “short-and-distort” campaigns where stock is borrowed, rumours are floated and profits are taken on the slide before the truth eventually comes out.

For regulators, the job of setting and enforcing rules that satisfy both sides is tough.

Even when there are clear rules about shorting — such as Canada’s ban on “naked” shorts, which prohibits borrowing to short unless there is a reasonable expectation that shares will be available to purchase to close out the arrangement — the waters tend to be muddy.

Case in point: The Investment Industry Regulatory Organization of Canada (IIROC) just published a document that essentially reminds market participants that naked short selling is prohibited.

There “are no new requirements” in the latest notice, according to Sean Hamilton, director of public affairs and member education services at IIROC. So why issue it?

One can guess at some questionable behaviours that might have prompted the reminder by reviewing the frequently-asked-questions section of the short document (by regulatory standards, anyway).

Shorting may be occurring when the borrowed shares are subject to a restriction, one that renders them inaccessible or unavailable until after the established settlement date, which takes place two days after a trade.

“Because the securities subject to a statutory hold will not be available to settle any resulting short sale trade on the settlement trade, this would not support a reasonable expectation to settle,” IIROC said, stating that securities that are “subject to a statutory restriction are not in an acceptable form to settle a short sale trade.”

Another questionable behaviour the regulator hints at is shorting using shares that market participants are set to acquire through financings but don’t have yet. Again, IIROC makes clear that this falls outside the rules.

“Because the financing will not have closed when the short sale trade is scheduled to settle, those shares will not be available on settlement date of the short sale trade,” the notice says, reminding market participants that they must have a reasonable expectation “prior to the entry of a short sale order” that sufficient shares will be will available on the settlement date.

The fresh guidance also raises the question of whether IIROC is on the lookout for, or has seen evidence of, repeat offences. It advises that market participants may not be able to demonstrate a reasonable expectation that sufficient shares would be available on settlement date in cases where “the person on behalf of whom the short sale order is entered has previously executed trades where shares were not available to deliver on settlement date.”

Could this new, gentle reminder be a prelude to future enforcement action? There have been repeated calls over the years to crack down on short sellers, particularly in periods when activist campaigns picked up steam.

In 2020, IIROC and the Ontario Securities Commission encouraged tips from the public about abusive trading, saying regulators had “reason to believe that certain market participants may be engaged in abusive short selling practices.”

And last year, the Ontario Capital Markets Modernization Taskforce said the province’s rules were not stringent enough, with Ontario’s short selling regime standing in contrast the U.S. and European Union, “where there are pre-borrow or locate requirements for short sales as well as mandatory close-out or buy-in provisions.

In addition, the task force report highlighted concerns about “short and distort” campaigns and recommended a new prohibition to deter and prosecute anyone making “misleading or untrue statements” to tank stock prices.

IIROC’s Hamilton declined to say whether the latest guidance from the national markets regulator would make enforcement easier.

“The intent of the Notice clarifies the rules and ensures everyone is applying the rules in the same manner,” he said.

Source: Financial Post