1. Development of a Strategy for the Canadian Market

Since a number of amendments to UMIR regarding short sales and failed trades were approved in October of 2008, IIROC has undertaken a process of evaluating additional steps which IIROC might take in Canada to deal with issues related to short sales and failed trades.  In developing the proposals for the further regulation of short sales and failed trades, IIROC sought to ensure that any rules, guidance and monitoring regime is:

• supported by the empirical evidence regarding short sales and failed trades in the Canadian market;
• part of a comprehensive monitoring of market integrity risks (e.g. restricting short sales may not be the appropriate response to all “rapid” price declines);
• neutral, in that it treats “unusual” price movements of a security, whether up or down, as a reason for increased regulatory scrutiny;
• focused, in that the burden for compliance is placed on those that have failed to comply with the requirements;
• practical, in that marketplaces and dealers can comply with the requirements in a cost effective manner;
• proportionate, in that the proposals do not invoke a regulatory response which results in a deterioration of market quality for all market participants; and
• effective, in that the proposals do not impede the proper uses of short selling and the liquidity that such proper activity provides to the market.

The overall strategy on the regulation of short sales and failed trades includes:

• repealing the tick test;
• increasing transparency of information regarding short sale activity and failed trades;
• monitoring of regulatory arbitrage opportunities related to short sales;
• enhancing investor education and confidence regarding the role of short selling in the operation of the market and the reasons for trade failures;
• disclosing the criteria for regulatory intervention for variation or cancellation of trades in the event of significant price volatility;
• enhancing monitoring of short sales and failed trades; and
• imposing pre-borrow requirements for short sales made in certain circumstances.

While the Amendments, including the repeal of the tick test, represent an important component of the strategy, Appendix “C” outlines the various initiatives which IIROC has undertaken since October of 2008 or plans to take to execute this strategy.

1. Repeal of Price Restrictions on Short Sales

Studies by IIROC support the premise that the tick test has no appreciable impact on pricing3 and, in light of that, IIROC believes that there are better mechanisms to detect and address abusive short selling.  Under the Amendments, the tick test has been repealed but IIROC will continue to work with other Canadian regulators to enhance measures intended to identify and address incidents of “abusive” short selling.

1. Transparency

In an effort to enhance the transparency of short selling activity in the Canadian market, IIROC:

• will, following the implementation of the Amendments, be in a position to produce, and to disseminate publicly, a semi-monthly report on the proportion of “short sales” in the total trading activity of each security across all marketplaces which should help establish a better appreciation for the “normal” levels of short selling for each security; and
• withdrew a proposal to repeal the requirements for the preparation of short position reports and, as a result, the Consolidated Short Position Report (“CSPR”)4 will continue to be produced on a semi-monthly basis. 

In addition to the Amendments and other IIROC initiatives described in this IIROC Notice, the Canadian Securities Administrators (“CSA”) and IIROC have published a joint notice to solicit feedback on whether other proposals to enhance transparency of short sale and failed trade information are required or appropriate (“Joint Notice”).5  Based on responses to the Joint Notice, IIROC may propose additional rule changes or other initiatives.

1. Monitoring of Regulatory Arbitrage Opportunities

In the United States, the Securities and Exchange Commission (“SEC”) adopted Rule 201 which was implemented on February 28, 2011 and which provides that there is no price restriction or “tick test” for a short sale unless a circuit breaker has first been triggered by a 10% price decline in a particular security, in which case a short sale must be entered at a price that is one increment above the best bid price for the balance of that trading day and the next trading day.6  Given the required price decline, coupled with the relatively short period of time during which price restrictions on short sales apply after imposition, the majority of U.S. market activity is not subject to a tick test.

Concurrent with the issuance of this Rules Notice, IIROC has published the results of a study of the effects of short sale circuit breakers in the U.S. on the trading of inter-listed securities in Canada (“Short Sale Circuit Breaker Study”).7  The Short Sale Circuit Breaker Study analyzed the effect that the triggering of a short sale circuit breaker in the U.S. of a security inter-listed with the Toronto Stock Exchange (“TSX”) or the TSXV Venture Exchange (“TSXV”) had on trading activity in Canada, particularly short selling, during the period immediately before, during and immediately after the imposition of short sale price restrictions on the trading of the security on U.S. markets.  The Short Sale Circuit Breaker Study suggests that, overall, there was minimal impact on short selling activity of inter-listed securities on marketplaces in Canada when price restrictions on short sales were in effect following the triggering of a short sale circuit breaker. 

In the view of IIROC, Canada does not need to adopt the same short sale circuit breaker system and alternative uptick rules.  In part, this view is due to the fact the empirical studies undertaken by IIROC did not find a relationship between rapid price declines and unusual short selling activity.  In addition, IIROC believes that the Canadian market is able to demonstrate that its trade monitoring regime effectively addresses “abusive” short selling through other mechanisms, including real-time alerts based on trading activity across all Canadian marketplaces. 

IIROC has introduced an alert for its surveillance system that monitors for unusual levels of short selling activity, coupled with significant price movements.  If unusual levels of short selling are detected which are disruptive to the market, IIROC also has the ability to intervene to vary or cancel the prices of any trade that is “unreasonable” or, in particularly egregious circumstances, to impose a halt on trading of a particular security across all marketplaces.  In addition, IIROC has the ability to designate a security as a “Short Sale Ineligible Security” for a period of time.

1. Enhancement of Investor Confidence

In the view of IIROC, investor confidence is best bolstered by:

• educating investors and, to a lesser extent, the industry as to the role of short selling in ordinary trading activity (including releasing existing empirical studies undertaken by IIROC and supporting future academic research, particularly on the impact of the repeal of the tick test);
• greater disclosure of the monitoring undertaken by IIROC and the circumstances when IIROC would pursue “regulatory intervention” given rapid, significant and unexplained price declines in the price of particular securities;8 and
• adherence to the general principles of short sale regulation enunciated by the International Organization of Securities Commissions (“IOSCO”) taking into consideration the unique characteristics and practices of  the Canadian market.9  

IIROC has published a number of studies on short sales and failed trades including:

• the Short Sale Circuit Breaker Study which suggests that, overall, there was minimal impact on short selling activity of inter-listed securities on marketplaces in Canada when price restrictions on short sales were in effect following the triggering of a short sale circuit breaker;10 
• a study of the relationship between price movement and short selling activity for securities listed on the TSX Venture Exchange during the period May 1, 2007 to April 30, 2010, which found that prices and rates of short selling activity tended to move in tandem and that, in the periods of the most significant price decline, “shorts” were in the market purchasing securities to cover their positions thereby providing price support;11
• a study of trends in trading activity, short sales and failed trades that covered the three-year period May 1, 2007 to April 30, 2010, which found that rates of short selling were relatively constant throughout the period and that rates of trade failure generally declined over the period (“Trends Study”);12  
• a prior study of trends in trading activity, short sales and failed trades that covered the period May 1, 2007 to September 30, 2008 and generally identified trends consistent with those identified in the Trends Study;13  
• an analysis of the impact of the prohibition on the short sale of certain financial sector issuers listed on the TSX that were also listed on a U.S. exchange that was in effect between September 22, 2008 and October 8, 2008 which found that the prohibition had a significant impact on market quality by reducing liquidity and increasing “spreads” while not having any effect on price volatility;14 and
• a study of failed trades undertaken by Market Regulation Services Inc. in 2006 that, among other findings, determined that a short sale had a lower probability of failing than trades generally and that the principal reason for trade failures was administrative error.15 

Taken together, the results of the empirical studies indicate that the Canadian market has not had the problems with short sales, particularly naked short sales, and failed trades that may have been evident in other jurisdictions.

1. “Regulatory Intervention”

Currently, IIROC’s policies and procedures for undertaking a regulatory intervention to halt trading in a security or to vary or cancel trades are not publicly disclosed.  In a separate initiative, IIROC has published for public comment draft guidance that would provide greater transparency of IIROC’s existing policies and procedures relating to the variation or cancellation of “unreasonable” trades and trades which are not in compliance with the requirements of UMIR.16  In addition, IIROC has published guidance respecting the implementation of “Single-Stock Circuit Breakers” that would halt trading in a particular security for a short period of time if that security experienced rapid, significant and unexplained price movement.17  

1. Enhanced Monitoring

IIROC has taken steps to enhance its monitoring of short sales and failed trades.  In particular:

• Effective June 1, 2011, IIROC has implemented a web-based system for the reporting of “Extended Failed Trades”, defined as trades which the client has failed to resolve within 10 business days following the regular settlement date, that helps to identify “problem” fails and allow IIROC to assess the reasons for the failure and monitor the steps being taken to resolve the problem.18 
• IIROC has deployed a new surveillance alert which looks for declines in the price of a security associated with changes in the rate of short selling, based on a comparison to historical short selling patterns for the particular security.
• CDS Clearing and Depository Service Inc. (“CDS”) is providing to the Ontario Securities Commission data on daily trade failures for trades settling in the continuous net settlement facilities (“CNS”) of CDS.  IIROC is in the process of obtaining access to this database which would allow IIROC to determine, from time to time, variations in trade failures from historic patterns for particular securities and Participants. 
• As part of the Amendments which become effective on September 1, 2012, purchase and sale orders from arbitrage accounts, accounts of persons with Marketplace Trading Obligations and certain accounts that adopt a “directionally neutral” strategy in the trading of securities would carry a “short-marking exempt order” designation.  The use of this order designation will permit the data on “short sales” to better reflect the activities of persons who may have adopted a “directional” trading strategy.

1. Pre-Borrow Requirements

Rule 2.2 of UMIR deals with those activities which are considered to be “manipulative and deceptive” and, as such, prohibited.  The entering of an order for the sale of a security without, at the time of entering the order, having the reasonable expectation of settling any trade that would result from the execution of the order constitutes a violation of the prohibition on manipulative and deceptive activities.  As such, “naked short selling”, as that term is sometimes understood, is not permitted under UMIR.19  The provisions of Rule 2.2 of UMIR do not require the Participant or Access Person that is entering a short sale to have made a “positive affirmation” prior to the entry of the order that it can borrow or otherwise obtain the securities that would be required to settle a short sale.  However, once a Participant or Access Person is aware of difficulties in obtaining particular securities to make settlement of any short sale, the Participant or Access Person would no longer have a “reasonable expectation” of being able to settle a resulting trade and therefore would not be able to enter further short sale orders.  For trading in a particular security, certain Participants or Access Persons who do not have the ability to borrow that security may be precluded from entering short sales while other Participants or Access Persons with the ability to borrow that security may continue to undertake additional short sales.

Even when the person entering an order has “reasonable expectations” of being able to settle any resulting trade, there may be circumstances in which the person should be required to have made arrangements to “pre-borrow” the securities which are the subject of a short sale.  These types of circumstances may include when:

• the person making the short sale has previously executed trades which have failed to settle on the date scheduled for settlement and within a reasonable time after that date; and
• rates of settlement failure for a particular security have increased above historic levels and the increase is attributable to short selling activity.

1. Discussion of the Amendments

1. Repeal of Price Restrictions on Short Sales

The Amendments repeal all restrictions on the price at which a short sale may be made.  The Amendments parallel action taken by the SEC to repeal price restrictions on short sales in the U.S. effective July 7, 2007 but the Amendments do not introduce a short sale circuit breaker as was done by Rule 201 in the U.S.

While the restrictions on the price at which a short sale may be executed are repealed under the Amendments, the requirement to mark an order as “short” continues. 

1. Pre-Borrow Requirements

Under the Amendments, a Participant or Access Person would be given specific direction as to the need, subject to certain exceptions, to have made arrangements to borrow securities when entering an order that on execution would be a short sale of:

• any listed security on behalf of a client or non-client20 that previously had an Extended Failed Trade in any listed security; or
• a particular security by the Participant or Access Person acting as principal if the Participant or Access Person had previously had an Extended Failed Trade in respect of a principal trade in that particular security.

An Extended Failed Trade is one in respect of which notice of the failed trade was required to be provided to IIROC in accordance with Rule 7.10 of UMIR as the reason for the failure had not been rectified within ten trading days following the date for settlement contemplated on the execution of the failed trade.

If an Extended Failed Trade report has been filed previously at any time by a Participant with IIROC with respect to an Extended Failed Trade in the account of a client or non-client, that client or non-client would not be able to enter an order that on execution would be a short sale without having made arrangements to borrow the securities necessary to settle any resulting trade unless the Participant through which the order is to be entered on a marketplace is satisfied, after reasonable inquiry, that the reason for any prior failed trade was not as a result of any intentional or negligent act of the client or non-client. IIROC confirms that “administrative error” or “delay” (such as delayed processing times by a transfer agent or custodian) would not be considered an intentional or negligent act of the client or non-client.

If a Participant or Access Person has filed previously at any time a report of an Extended Failed Trade in respect of a principal trade by that Participant or Access Person in a particular security, the Participant or Access Person would not be able to enter an order that on execution would be a short sale without having made arrangements to borrow the securities necessary to settle any resulting trade unless IIROC has consented to the entry of the principal order that is a short sale of that particular security.  In providing the consent, IIROC will be able to review with the Participant or Access Person the circumstances surrounding the previous Extended Failed Trade and the reasons why the Participant or Access Person believes that future short sales of that particular security are unlikely to fail to settle. 

Under the Amendments, a Participant or Access Person who enters an order that would, on execution, be a short sale of a security that IIROC has designated as a “Pre-Borrow Security” would be required to have made arrangements to borrow the securities necessary for settlement of any trade prior to the entry of the order on a marketplace.

As a result of the Amendments, each Participant and Access Person will have to ensure that they have adequate policies and procedures to regulate the entry of short sales in circumstances when the Participant or Access Person has previously executed an “Extended Failed Trade”21 or IIROC has designated a security as a “Pre-Borrow Security”.

1. Repeal of the “Short Exempt” Designation

Prior to the Amendments being implemented, the “short exempt” order designation will be used to identify an order for the short sale of a security which is not subject to the tick test.  Upon the tick test being repealed on September 1, 2012, the use of the “short exempt” order designation will no longer be required and provisions for its use are also repealed.

1.  Introduction of the “Short-Marking Exempt” Designation

Under the Amendments, a new order designation will be introduced to indicate that an order is being entered by an account that is exempt from marking an order as “short” (i.e. “short-marking exempt”).  Under this provision, orders from particular accounts for the purchase or sale of a security would be designated as “short-marking exempt” upon entry on a marketplace.  More specifically, orders would be marked as “short-marking exempt” if the order is from an account that is:

• an arbitrage account which makes a usual practice of buying and selling securities in different markets to take advantage of differences in prices;
• the account of a person with Marketplace Trading Obligations22 in respect of a security for which that person has obligations;
• a client, non-client or principal account:

• for which order generation and entry is fully-automated, and
• which, in the ordinary course, does not have at the end of each trading day more than a nominal position, whether short or long, in a particular security; or

• a principal account that has acquired during a trading day a position in a particular security in a transaction with a client that is unwound during the balance of the trading day such that, in the ordinary course, the account does not have, at the end of each trading day, more than a nominal position, whether short or long, in a particular security.

Concurrent with the issuance of this Rules Notice, IIROC has issued for public comment revised draft guidance on the use of the “short sale” and “short-marking exempt” order designations.  IIROC would intend to issue the guidance in final form prior to the Amendments becoming effective.23 

1. Consequential Amendments

1. Definition of “Pre-Borrow Security”

The Amendments require a Participant or Access Person to have made arrangements to borrow securities prior to the entry of an order that would, on execution, be a short sale of a security that IIROC has designated as a “Pre-Borrow Security”.  The Amendments add a definition of “Pre-Borrow Security” to Rule 1.1 and set out the considerations which IIROC would take into account in making such a designation in an addition to Policy 1.1.  In determining whether to make such a designation, IIROC would have to consider whether:

• based on information known to IIROC, there has been an increase in the number, value or volume of failed trades in the particular security by more than one Participant or Access Person;
• the number or pattern of failed trades is related to short selling; and
• the designation helps to maintain  a fair and orderly market.

1. Example of “Manipulative or Deceptive Method, Act or Practice”

With the repeal of the price restrictions on the price at which a short sale may be made, clause (d) of Part 1 of Policy 2.2 which precludes the practice of purchasing a security at a price below the last sale price with the intention of making a short sale at that new lower price has become spent and, as such, the Amendments repeal the provision.

3. Changes from the Proposed Amendments

The Amendments as approved vary from the Proposed Amendments in a number of areas including:

• changes to the definition of “short-marking exempt order” to permit any client, non-client or principal account (and not just an account of an institutional customer as set out in the Proposed Amendments) to qualify and to simplify the criteria to require that:
  • order generation and entry is fully-automated, and
  • in the ordinary course, trading activity is “non-directional”;
• extending the definition of “short-marking exempt order” to include certain principal “facilitation” accounts which are “non-directional”; and
• simplifying the ability of a Participant to relieve a client or non-client of the need to “pre-borrow” a security subject to a short sale if the Participant is satisfied that any previous failure was not as a result of any intentional or negligent act of the client or non-client (which simplification also eliminated the need for IIROC to have the ability to consent to such order entry).

4. Summary of the Impact of the Amendments

The following is a summary of the most significant impacts of the adoption of the Amendments:

• Participants and Access Persons are relieved of the obligation to ensure that short sales comply with the “tick test”;
• marketplaces, which have elected to system-enforce the “tick test” for Participants and Access Persons, are able to remove this functionality from their trading systems;
• each Participant and Access Person will have to ensure that they have policies and procedures that will adequately regulate the entry of short sales in circumstances where the security has been designated a “Pre-Borrow Security” or the Participant or Access Person has previously executed an Extended Failed Trade;
• Participants and Access Persons will need to have made arrangements to borrow securities when undertaking a short sale of:
  • a security that has been designated as a “Pre-Borrow Security”,
  • any listed security on behalf of a client or non-client that previously had an Extended Failed Trade in any listed security, or
  • a particular security by the Participant or Access Person acting as principal if the Participant or Access Person has had an Extended Failed Trade in respect of that particular security;
• each Participant will have to ensure that it has adequate policies and procedures to properly identify orders that should be designated as either “short sale” or “short-marking exempt”; and
• each marketplace will have to ensure that its trading systems correctly handle orders designated as “short sale” or “short-marking exempt”.

5. Technological Implications and Implementation Plan

The technological implications of the Amendments on Participants, marketplaces or service providers are as follows:

• their systems have to be able to differentiate between an order designated as “short sale” and “short-marking exempt” (since, under the Amendments, the designations are mutually exclusive);
• their systems have to be able to accept the “short-marking exempt” designation on both purchase and sell orders; and
• their system enforcement of the tick test should be disabled for orders marked as a “short sale”.

The Amendments will become effective on September 1, 2012.  IIROC has initiated meetings with marketplaces and service providers to deal with the technological implications of the Amendments and, in particular, to co-ordinate the introduction of the “short-marking exempt” designation.

Appendices

Appendix A – Text of Provisions Respecting Regulation of Short Sales and Failed Trades

Appendix B – Comments Received

Appendix C – IIROC Initiatives on Short Sales and Failed Trades

• 3In particular, reference should be made to IIROC Notice 11-0077 – Rules Notice – Technical – UMIR – Price Movement and Short Sale Activity:  The Case of the TSX Venture Exchange (February 25, 2011).
• 4While Rule 10.10 of UMIR requires Participants and Access Persons to file short position reports, the CSPR is produced for securities listed on the TSX and TSXV by the TSX which makes certain of the information publicly available and provides the full CSPR on a subscription basis.  A separate CSPR is produced by CNSX for securities listed on that exchange.  See IIROC Notice 11-0075, op. cit.
• 5IIROC Notice 12-0076 - Rules Notice – Request for Comments – UMIR – Canadian Securities Administrators / Investment Industry Regulatory Organization of Canada Joint Notice 23-312 – Transparency of Short Selling and Failed Trades (March 2, 2012).
• 6See SEC Release 34-6159 – Regulation SHO (February 26, 2010) and SEC Release 34-63247 – Regulation SHO (November 4, 2010).
• 7IIROC Notice 12-0077 - Rules Notice – Technical – UMIR – Effects of Short Sale Circuit Breakers in the United States on the Trading of Inter-listed Securities in Canada (March 2, 2012).  The Short Sale Circuit Breaker Study considered the 112 instances between February 28, 2011 and April 29, 2011 when a short sale circuit breaker was triggered in the U.S. for an inter-listed security.
• 8See IIROC Notice 12-0040 – Rules Notice – Guidance Note – UMIR – Guidance Respecting the Implementation of Single-Stock Circuit Breakers (February 2, 2012).  See IIROC Notice 10-0331 - Rules Notice – Request for Comments – UMIR – Proposed Guidance on Regulatory Intervention for the Variation or Cancellation of Trades (December 15, 2010).
• 9See Appendix “C” – Reconciliation of UMIR and Proposed Amendments to the IOSCO Recommendations on Regulation of Short Sales of IIROC Notice 11-0075, op. cit.
• 10See IIROC Notice 12-0077, op. cit.
• 11Reference should be made to IIROC Notice 11-0077 - Rules Notice – Technical – Price Movement and Short Sale Activity:  The Case of the TSX Venture Exchange (February 25, 2011).
• 12Reference should be made to IIROC Notice 11-0078 - Rules Notice – Technical – Trends in Trading Activity, Short Sales and Failed Trades (February 25, 2011).
• 13Reference should be made to IIROC Notice 09-0037 - Administrative Notice – General – Recent Trends in Trading Activity, Short Sales and Failed Trades (February 4, 2009).
• 14Reference should be made to IIROC Notice 09-0038 - Administrative Notice – General – Impact of the Prohibition on the Short Sale of Inter-listed Financial Sector Issuers (February 9, 2009).
• 15For a more detailed discussion of the Failed Trade Study and its results, see Market Policy Notice 2007-003 – General – Results of the Statistical Study of Failed Trades on Canadian Marketplaces (April 13, 2007).
• 16See IIROC Notice 10-0331, op cit.   IIROC expects to republish the draft guidance in the near future for further public comment.
• 17See IIROC Notice 12-0044, op. cit.
• 18See IIROC Notice 11-0080 - Rules Notice – Guidance Note – UMIR – Implementation Date for the Reporting of Extended Failed Trades (February 25, 2011).
• 19There is no universally accepted definition of “naked short selling”.  The most common usage is in connection with a short sale when the seller has not made arrangements to borrow any securities that may be required to settle the resulting trade.  Some commentators use a more restrictive interpretation that describes any short sale when the seller has not pre-borrowed the securities necessary for settlement.
• 20A “non-client” is a person who is a partner, director, officer or employee of a Participant or a related entity of a Participant that holds an approval from an exchange or self-regulatory entity.
• 21IIROC Notice 11-0080, op. cit.  A report of an Extended Failed Trade is required on and after June 1, 2011 for trades settling through the CNS facilities of CDS.  A report for failures of trades settling through the Trade-for-Trade settlement facility of CDS will become effective at a later date once IIROC has completed the development and testing of system that would permit IIROC to receive the information directly from CDS.
• 22See IIROC Notice 11-0251 – Rules Notice – Notice of Approval – UMIR – Provisions Respecting Market Maker, Odd Lot and Other Marketplace Trading Obligations (August 26, 2011).
• 23See IIROC Notice 12-0079 - Rules Notice – Request for Comments – UMIR – Proposed Guidance on “Short Sale” and “Short-Marking Exempt” Order Designations (March 2, 2012).