Article by Patricia A. Koval and Joris M. Hogan

First published in Canadian Hedge Watch, Volume 7, Issue 5, Oct/Nov 2007.

On September 7, 2007, Market Regulation Services Inc. (RS), which administers and enforces trading rules for Canadian marketplaces (including the TSX, TSX Venture Exchange, CNQ and ATS systems), published for comment a series of proposed changes to the existing rules governing short selling. The proposals were subject to a one-month comment period that expired on October 9, 2007.

Most significantly, these proposed rules would repeal the existing "tick test"—in other words, remove the restrictions on the price at which a short sale may be made. Under the current rules, market participants may not generally make a short sale of a security that is not inter-listed on U.S. markets unless the price is at or above the last sale price for that security (normally determined by reference to trading information from the principal market for that security). The proposed rule would, however, provide a new discretion to RS to designate a security as ineligible to be sold short. RS has indicated that it would expect to exercise that discretion if, in its view, there is evidence of excessive "failed trade" rates in a security, and that the discretion would be exercised only with the agreement of the applicable Canadian securities regulators.

Another important proposed change, from the perspective of market participants, is to remove the requirement that they file twice-monthly short-position reports, subject to the future general availability of information on short sales. RS has indicated that, in its view, the availability criteria will be met if third parties regularly (that is, no less frequently than semi-monthly) disseminate periodic summary reports of short sales effected on marketplaces in particular securities. In this regard, it is anticipated that marketplaces would compile the information on short positions using trade markers that require short sales to be identified as such.

The proposed rule changes would also require market participants to get RS approval before varying or cancelling a trade, and to report to RS if a trade that has failed to settle on the settlement date remains unresolved for 10 trading days following the settlement date, with a second report to be filed once the default has been cured. RS would have the discretion, in certain circumstances, to cancel failed trades. It is anticipated that this discretion would most likely be exercised when trades remain unsettled within 15 days of the settlement date and there appears to RS to be no valid reason for the continuing default.

These proposed rule changes follow a study of short selling rules begun by RS in October 2004, which encompassed, among other things, a close review of evolving short selling rules and market impact studies conducted in the United States, the United Kingdom and elsewhere. In particular, RS conducted a significant study in 2006 on failed trades in Canadian marketplaces using data from 25 dealers. The study found that, among other things, failed trades accounted for only 0.27% of the total number of trades executed by the study participants; less than 6% of fails resulting from the sale of a security involved short sales; and fails involving short sales accounted for only 0.07% of total short sales. The study also found that the predominant cause of failed trades was administrative delay or error and that approximately 96% of the failed trades examined were settled within 10 trading days of the expected settlement date.

The proposed Canadian rule changes also follow a significant recent change in U.S. marketplaces: the July 2007 Securities and Exchange Commission’s repeal of tick tests in all U.S. marketplaces. The U.S. repeal itself followed considerable market study and analysis by the SEC, including the two-year SHO Pilot Project, which focused on stocks contained in the Russell 3000 index. When the SEC announced the repeal of tick tests, RS implemented a rule change to remove the tick tests for inter-listed securities to eliminate inconsistencies between Canada and the United States. This change was effective when compliance with the new U.S. rules became mandatory.

The harmonized elimination of the tick test rules in Canada and the United States will significantly move short selling rules and Canadian marketplace practices closer to those in the United States; in other ways, however, the Canadian rules do, and will continue to, differ significantly from the U.S. rules. Unquestionably, it will remain easier and less administratively complex for traders to short sell securities in Canadian marketplaces rather than in those south of the border.

The most significant reason for this difference is the decision by RS not to import certain burdensome U.S. requirements, including, in particular, the "locate requirement," which requires a broker, before effecting a short sale, to either borrow or enter into an agreement to borrow the security sold short, or have reasonable grounds to believe that it can be borrowed, so that it can be delivered in normal course settlement. RS’s decision in this regard appears to be based on its belief, largely resulting from the empirical evidence obtained in its market study, that market participants are conducting themselves prudently in short selling activities. As well, RS’s position is bolstered by policy statements made under both Universal Market Integrity Rules (UMIR) and CSA Trading Rules (National Instrument 23-101, Trading Rules), which essentially state that market participants can enter short sales until such time as they know, or should reasonably have known, that they can no longer borrow the securities to effect settlement. RS has also indicated that when determining whether a dealer has a "reasonable expectation" of settling a trade, RS will look to whether the dealer is in compliance with the recently implemented National Instrument 24-101, Institutional Trade Matching and Settlement.

The proposed Canadian rules also do not import the SEC’s uniform "close-out requirements," whereby broker-dealers in the United States are subject to additional delivery requirements on securities in which there are a substantial number of delivery failures at a clearing agency ("threshold securities"). Effectively, broker-dealers that are participants of a registered clearing agency must take action to close out failureto- deliver positions ("open sales") that have persisted for 13 consecutive settlement days in threshold securities. (There is currently a well-known and muchdebated exception for options market makers, which the SEC is proposing to eliminate because of a concern about persistent fails to deliver in certain equity securities.) Closing out requires the brokerdealer to purchase the same kind and quality of securities. Until the position is closed out, the broker-dealer and any broker-dealer for which it clears transactions, including a market maker, may not effect further short sales in that threshold security without borrowing, or entering into a bona fide agreement to borrow this security (known as "preborrowing requirement"). "Threshold securities" are equity securities that (i) have an aggregate fail-todeliver position for five consecutive settlement days at a registered clearing agency totalling 10,000 shares or more and are equal to at least 0.5% of the issuer’s total outstanding shares and (ii) are included on a list that a self-regulatory organization (SRO) disseminates to its members. Under the U.S. rules, each SRO is responsible for providing the threshold security list for those securities for which the SRO is the primary market.

RS is also not proposing to impose documentation requirements for sales indicated as from a "long" position as the SEC is now doing. Under proposed amendments published on August 7, 2007 (SEC Release Number 34-56213), the SEC is proposing rules to require broker-dealers that are marking a sale as "long" to document the present location of the securities being sold. This proposal, which has significant administrative ramifications for broker-dealers, has already been the subject of much comment and is expected to continue to be so.

Furthermore, there is no indication that RS intends to propose rules comparable to the SEC’s rules governing short selling in connection with a public offering. Effective October 9, 2007, Regulation M, "Anti- Manipulation Rules Concerning Securities Offerings," prohibits any person who sells short an equity security that is the subject of a public offering from purchasing the offered securities from an underwriter or broker or dealer participating in the offering, subject to very limited exceptions. That rule is specifically intended to protect the independent pricing of equity securities in a public offering—in other words, to ensure that the prices at which securities are offered to the public are a function of supply and demand rather than manipulative activity that can reduce an issuer’s offering proceeds and dilute value to securityholders.

In Canada, although RS has chosen not to formulate a specific rule for this purpose, it certainly retains the jurisdiction to deal with trading strategies or market conduct that could be deemed abusive or manipulative in this context.

The adoption of the new Canadian rule-changes proposed by RS—and the concomitant decision not to adopt rules identical or comparable to those south of the border—can be expected to make short selling easier and less costly for market participants trading Canadian securities in Canadian marketplaces. Canadian dealers who sell short Canadian securities in U.S. marketplaces must, of course, comply with the applicable U.S. rules. RS has indicated that if the proposed rules are implemented, it will be important to assess their effect on Canadian marketplaces and that it will conduct a study to examine, among other things, the impact of the new rules on volatility and fail rates.

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