Recent enforcement cases offer a reminder of risks when short selling prior to an offering
Two recent enforcement actions relating to the short selling of securities in advance of a securities offering provide important lessons for market participants. First, the Ontario Securities Commission (OSC) commenced an enforcement proceeding against an investment dealer, its head of equity capital markets and their client alleging that “illegal and abusive short selling” occurred “in anticipation of a private placement”.[1] Second, the Securities and Exchange Commission (SEC) recently settled an enforcement proceeding relating to the short selling of securities in advance of a public offering.[2]
The Canadian landscape
Existing securities legislation in Canada[3] includes an express prohibition against misleading or manipulative trading, and the Criminal Code includes an offence for fraudulent manipulation of stock exchange transactions.[4] In addition, existing securities legislation in Canada confers wide discretion on securities regulatory tribunals to sanction anyone that, in the opinion of the tribunal, has engaged in conduct that offends the public interest.[5] A tribunal can sanction a person or company for offending the public interest even in the absence of any breach of securities laws. Securities legislation does not define “public interest” and Canadian courts have shown themselves to be especially reluctant to interfere with securities regulatory tribunals’ exercise of their sweeping discretionary public interest powers.
In addition, about a year ago, the Ontario Government’s Capital Markets Modernization Taskforce recommended the creation of an express prohibition of short selling in advance of prospectus offerings and private placements. If that proposal becomes law, market participants would be prohibited from acquiring securities in an offering if they have a short position of a security of the same type as that being offered (or interchangeable with such securities, such as warrants). Shortly thereafter, the OSC issued guidance concerning “abusive” short selling in advance of an equity offering, noting:[6]
Market manipulation may include actions that improperly affect a stock’s price or volume. This may include short selling an issuer’s securities to negatively impact the price in advance of a public offering or private placement of that issuer’s securities. Short selling involves the sale of securities that the seller does not own but has borrowed. Abusive short sellers may seek to manipulate the price of a security lower into an offering so as to profit from the resulting price discrepancy between the short sale price and the offering price. If you are an Ontario small-cap or micro-cap issuer seeing misconduct in short selling ahead of public offerings or private placements, the OSC and IIROC encourage you to report such abusive activity.
The OSC’s allegations in Cormark Securities et al.
In a pending enforcement proceeding before the OSC,[7] Staff alleges that an investment dealer, its head of equity capital markets and an investor client together devised a series of connected transactions that would allow them to profit “virtually risk-free” from an anticipated increase in demand for the shares of an issuer client of the dealer that was contemplating a ~$25 million non-brokered private placement.
Among other things, the OSC alleges that the dealer’s investor client sold short shares of the issuer client (a cannabis company) in the secondary market, purchased an equal number of that company’s shares in a subsequent private placement, swapped the private placement shares for free-trading shares under a securities lending agreement entered into with one of the issuer’s directors, and then used the free-trading shares to settle the short sales. According to the OSC, this arrangement effectively guaranteed the investor client, having invested no money whatsoever, a nine per cent gain because the private placement price had been previously set at a nine per cent discount to the company’s previous closing price.
The OSC alleges that, in the result, the investor’s profit was over $1.27 million, the investment dealer earned $362,500 for its services and the issuer’s director received $875,000 as a securities lending fee, which amounts represent in the aggregate, 9%, equating to approximately the same percentage discount used to price the private placement.
The OSC has made a novel allegation that an illegal distribution occurred when the cannabis company’s shares from the private placement were distributed by the dealer’s investor client to the public through a “backdoor underwriting”. The OSC has also alleged a breach of the dealer’s obligation to deal fairly, honestly and in good faith because it did not provide accurate information to its company client about the transactions it facilitated with its investor client. Finally, the OSC has also alleged that the conduct alleged amounts to a breach of the public interest because it undermined: the timely and efficient disclosure of information, investor protection provided by hold periods, and efficient pricing in the secondary market.
The OSC Staff’s allegations remain unproven.
The SEC proceeding in Weiss Asset Management
In a different proceeding south of the border, the SEC recently settled with Weiss Asset Management LP (“Weiss”) allegations that Weiss bought offering shares from an underwriter or broker-dealer participating in a follow-on or secondary public offering seven times, despite having sold short the same security during the restricted period. In total, Weiss’ trading resulted in gains of $6,508,792.81.
The SEC found that such conduct breached Rule 105 of Regulation M of the Securities Exchange Act.[8] Rule 105 makes it unlawful for a person to purchase equity securities from an underwriter, broker, or dealer participating in a public offering if that person sold short the security that is the subject of the offering during the restricted period defined in the rule, absent an exception.[9] The Commission adopted Rule 105 “to foster secondary and follow-on offering prices that are determined by independent market dynamics and not by potentially manipulative activity.”[10] Rule 105 has been enforced by the SEC on a number of previous occasions.[11]
As part of its settlement, Weiss disgorged its gains along with prejudgment interest and paid a civil penalty to the SEC.
Key Takeaways
Market participants should periodically and carefully review their internal policies and procedures concerning short selling securities while participating in an offering. Given recent regulatory expectations, engaging in or facilitating transactions like those engaged in by Weiss and those alleged in Cormark is fraught with risk. Canadian securities regulators have stated publicly that they consider short selling prior to a public offering or private placement when the short seller is aware of the impending offering and participates in the offering to be “abusive” and contrary to securities law. They have actively solicited whistleblowers to identify such conduct. [12]
In recent years, Canadian securities regulators have increasingly expanded their reach under the public interest jurisdiction to impose standards of behaviour that are not specifically required by the legislative scheme and to sanction conduct that, even where it does not contravene any specific requirement of securities law, nonetheless offends the securities regulators’ conception of the public interest. The OSC allegations against Cormark and the other respondents appear to be a continuation of this trend. Moreover, depending on the of any given case, an enforcement proceeding could also be grounded in alleged breaches of prohibitions against:
- Insider trading: on the theory that an investor sold short the issuer’s securities while in a special relationship with the issuer and with knowledge of material non-public information; and
- Market manipulation: on the theory that the investor, investment dealer and (even possibly) an insider who is part to a securities lending agreement may have, directly or indirectly, engaged or participated in, or attempted to engage or participate in, acts, practices or courses of conduct relating to securities that they knew, or reasonably ought to have known, resulted in or contributed to a misleading appearance of trading activity in, or an artificial price for, the securities.
[1]In the Matter of Cormark Securities Inc., William Jeffrey Kennedy, Marc Judah Bistricer and Saline Investments Ltd.
[2] In the Matter of Weiss Asset Management LP, File No. 3-20899, Release No. 95099 / June 14, 2022 (U.S. S.E.C.).
[3] For example, section 126.1 of the Securities Act (Ontario).
[4] See section 382 of the Criminal Code (Canada).
[5] For example, section 127 of the Securities Act (Ontario).
[6] Joint OSC/IIROC Whistleblower Guidance, <https://www.osc.ca/sites/default/files/2021-02/joint-osc-iiroc-whistleblower-guidance.pdf>. (emphasis added)
[7] In the Matter of Cormark Securities Inc., William Jeffrey Kennedy, Marc Judah Bistricer and Saline Investments Ltd.
[8] In the Matter of Weiss Asset Management LP, File No. 3-20899, Release No. 95099 / June 14, 2022 (U.S. S.E.C.).
[9] 17 C.F.R. § 242.105; Short Selling in Connection with a Public Offering, Rel. No. 34-56206, 72 Fed. Reg. 45094 (Aug. 10, 2007) (effective Oct. 9, 2007).
[10] 17 C.F.R. § 242.105; see Short Selling in Connection with a Public Offering, Rel. No. 34-56206, 72 Fed. Reg. 45094 (Aug. 10, 2007) (effective Oct. 9, 2007)
[11] E.g. In the Matter of Helikon Investments Ltd., File No. 3-20587, Release No. 93091 / September 21, 2021 (U.S. S.E.C.); In the Matter of Millenium Management LLC, File No. 3-18272, Release No. 81989 / October 31, 2017 (U.S. S.E.C.); In the Matter of Carlson Capital L.P., File No. 3-14066, Release No. 62982 / September 23, 2010 (U.S. S.E.C.).
[12] Joint OSC/IIROC Whistleblower Guidance, <https://www.osc.ca/sites/default/files/2021-02/joint-osc-iiroc-whistleblower-guidance.pdf>. (emphasis added)