CSA and CIRO review comments but come to no conclusion (yet) on short selling regulatory regime

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On November 16, 2023, the Canadian Securities Administrators (CSA) and the Canadian Investment Regulatory Organization (CIRO) jointly published Staff Notice 23-332 [PDF], which summarizes comments and responses to Staff Notice 23-329 [PDF], Short Selling in Canada, published in December 2022. Staff of the CSA and CIRO (Staff) ultimately concluded that there was no consensus on the appropriate regime for short selling and did not propose any regulatory amendments at this time. However, Staff signaled incoming changes, advising that a working group to examine short selling issues in Canada more broadly is forthcoming in 2024.

Staff Notice 23-329

On December 8, 2022, the CSA and CIRO jointly released Staff Notice 23-329, which provided an overview of the legal framework for short selling in Canada and solicited public feedback on areas for regulatory consideration.

In this notice, Staff acknowledged the legitimacy of short selling, noting that it can promote transparency in the financial markets and contribute to liquidity and price discovery, thus bolstering market integrity and investor protection. However, Staff expressed concern that short selling can be improperly used as a market manipulation tactic and highlighted that certain issuers have criticized Canada’s regulatory regime for being less stringent than other jurisdictions.

While Staff took the position that Canada’s regulatory regime governing short sales was consistent with the principles published by the International Organization of Securities Commissions, they nevertheless welcomed the comments and concerns of various stakeholders. Accordingly, Staff Notice 23-329 posed a variety of questions for public comment related to Canada’s short selling regulatory landscape.

Public feedback to Staff Notice 23-329

In response to Staff Notice 23-329, CSA and CIRO received 23 comment letters from a wide range of stakeholders, including industry associations, exchanges, dealers, issuers and individuals. These comment letters were categorized, summarized and reviewed in Staff Notice 23-332.

The vast majority of commenters were of the view that short selling is a legitimate trading practice that is critical for capital markets. commenters were split on most issues, however, and there was no real consensus on what an appropriate regulatory regime for short selling would include. For instance, some commenters believed that the current rules were adequate and needed only minor amendments, while others believed that more substantial amendments were needed.

In Staff Notice 23-332, Staff summarized and flagged the following topics as those in need of further study.

Pre-borrow requirements

As described in Staff Notice 23-329, IIROC imposed certain “pre-borrow” requirements in March 2012. These requirements are intended to deter market participants from entering short sell orders without any intention to settle the resulting trades on the settlement date. Such a practice is done solely to drive down the price of an issuer’s securities.

When asked whether the existing requirements around pre-borrowing should be strengthened, some commenters argued for more rigorous requirements comparable to those found in the U.S. and the E.U. Other commenters were in favour of a less stringent “locate” rule, which would impose a duty on a dealer making or facilitating a short sale to have only a reasonable belief that the shares are readily available to borrow. Conversely, other commenters strongly opposed the imposition of pre-borrow or locate requirements, arguing that the costs to implementing a pre-borrow requirement would be significant and potentially inhibitive.

In response to these conflicting positions, CIRO is considering ways to strengthen and clarify its requirement to have a reasonable expectation to settle a short sale trade on the settlement date. CIRO noted that it expects to publish such proposals for public comment in early 2024.

Different treatment of junior associates

IIROC’s study of failed trades, highlighted in Staff Notice 23-329, identified stronger correlations between short sales and settlement issues with junior issuers as opposed to their more senior counterparts. Ultimately, as reported in Staff Notice 23-332, there was minimal support for a regime that differentiates between junior and senior issuers. Staff did not indicate any anticipated changes in this area in the near term.

Shortening timeline for reporting failed trades

As outlined in Staff Notice 23-329, a “failed trade” generally occurs when a seller fails to deliver securities to the buyer or a buyer fails to pay funds to the seller when a delivery/payment is due. At present, a failed trade can be reported up to 10 trading days following the settlement date; this theoretically allows sufficient time to account for administrative delays that may impact settlement and identify higher-concern transactions.

When asked whether this 10-day timeline was appropriate, commenters were split on whether to shorten the timeframe: some suggested a two- or three-day window, others recommended alignment with the close-out requirements in the U.S. and others opposed the change entirely (citing additional compliance burdens and costs for market participants). Staff did not suggest any forthcoming changes with respect to this timeframe.

Transparency and reporting

In Staff Notice 23-329, Staff discussed whether additional public transparency and/or reporting requirements of short-selling activities or short positions should be considered. As summarized by Staff, IIROC has implemented efforts to increase transparency, such as by publishing the Consolidation Short Position Report and Short Sale Trading Corrections Report on a regular basis.

When asked, commenters were split on whether additional transparency requirements should be considered. Suggestions for alternative transparency regimes ran the gamut from regular public short position reporting (at the seller level) to publishing failed trade data as seen in the U.S., Australia and the E.U. and to prohibiting brokers making a short sale from using the “anonymous” broker number. Many commenters expressed views that more transparency would be beneficial, while others cautioned that it could inhibit short selling. With respect to reporting, most commenters expressed satisfaction with the current regulatory reporting regime, although a handful encouraged more stringent reporting requirements to address the frequency of “short and distort” campaigns and predatory short selling.

Staff did not suggest any anticipated changes to the transparency and reporting requirements at this time.

Mandatory close-outs/buy-ins of short positions

In Staff Notice 23-329, Staff described how eligible debt and equity securities in Canada are cleared and deposited through CDSX, which has a Continuous Net Settlement Service (CNS) to clear and settle trades transacted on a Canadian marketplace. Within CNS, a “buy-in” process allows a buyer to accelerate the settlement of outstanding, unsettled CNS positions from sellers that are identified as “to-receive”. This buy-in process is initiated when a buyer chooses to enter an “intent to buy-in” outstanding to-receive positions in CDSX against an outstanding quantity of shares owed to them. This opt-in approach is uniquely Canadian; in the U.S. and E.U., for instance, there are mandatory close-out or buy-in provisions.

In its Final Report in 2021, the Capital Markets Modernization Task Force (which we previously wrote about) recommended that, should a short sale fail to settle, the short seller be subject to a mandatory buy-in to be triggered at settlement plus two days. When asked whether Canada should implement mandatory buy-ins or close-outs of short positions similar to the rules found in the U.S. and E.U., many commenters were in favour, noting that it would increase investor confidence and market efficiency and better align Canada’s regulatory environment with practices seen in global markets. Other commenters, however, opposed this proposed implementation, arguing that it would create inefficiency in securities settlement, act as a barrier to entry and negatively impact market liquidity.

Similar to the points above, Staff did not suggest any incoming changes with respect to mandatory close-outs/buy-ins of short positions.

Next steps

Although there are no specific amendments being proposed in respect of Canada’s short selling regulatory environment at this time, Staff acknowledged in Staff Notice 23-332 that they are mindful of public feedback and continue to review whether any changes may be appropriate. Staff Notice 23-332 noted that the CSA and CIRO are expected to form a working group in early 2024 to further examine short selling issues in the Canadian market context, beginning with an analysis of potential mandatory close-out or buy-in requirements. Any proposed rule changes will be published for public comment.

Key takeaways

While largely serving as a summary of public comment, the publication of Staff Notice 23-332 suggests that Staff are increasingly interested in and concerned about the short selling regulatory landscape in Canada. Buyers and sellers of short positions should be vigilant in their compliance with the existing regulatory landscape, and entities that participate in the buying and selling of shorts must similarly be nimble and prepared to adjust to regulatory changes. The formation of a working group in early 2024 suggests more examination and consideration lies ahead before  regulatory changes can be said to be on the horizon.