Sunday, October 18, 2009

The Impossible Scheme - Hong Kong Court Finds Share Splitting Manipulative

Winston Churchill once said that (North) America and Britain were "two nations divided by a common language." I thought of this recently reading the Hong Kong Court of Appeal decision in Re: PCCW Limited.

One thing that has always struck me as peculiar is that some of what we in Canada and the US call "plans" (pension plans, plans of arrangement, etc.) the rest of the common-law world calls "schemes." This gives it a slightly sinister undertone. The PCCW case is about, well, a scheme to ensure a scheme of arrangement got implemented.

The scheme of arrangement in question was a privatisation in which minority shareholders would be cashed out at a premium to market. Despite this, many shareholders complained that they were being taken out at a time when the market price for the shares was at a nine-year low and they would miss an opportunity to profit from a market rise. Proxy advisors unanimously recommended that shareholders not approve the arrangement. The offerors behind the scheme (who would own and control the company if approved) had more than a majority of the shares. However, under the Hong Kong Companies Ordinance a double super-majority (75% of shares and 75% of shareholders) is required to approve an arrangement. At a preliminary meeting, a motion to adjourn was defeated on an initial show of hands.

In order to ensure the approval of the arrangement, some people connected with the offerors devised a plan to induce employees of their firms and friends to buy small amounts of shares. They were also given proxies to vote in favour of the arrangement. One of the persons bought 500 board lots and gave them away to 494 employees as a "bonus." Of the 1404 shareholders who voted in favour of the arrangement, 940 became shareholders after the preliminary meeting.

Under Hong Kong law (as in Canada) an arrangement must also be approved by a court. The arguments raised by PCCW and the offerors were:

(1) The court should not overturn a valid vote of the shareholders (it was conceded by all parties that the new shareholders were registered shareholders entitled to vote);
(2) Shareholders are entitled to vote the way they please; and
(3) So-called "share splitting" is a normal and accepted practice in these situations.

The court dismissed the first argument out of hand, stating that it made the requirement for court approval superfluous. The court had an obligation to review the arrangement regardless of the shareholder vote and ensure it is fair. In particular, the double majority requirements were adopted precisely to ensure the protection of minority shareholders.

The court then examined the other arguments. While shareholders have a right to vote as they wish, it was clear that they were being told to vote in favour in order to ensure a quick profit. The court found it unusual that the proxy forms were not obtained from PCCW but from the deputy chairman of the company instigating the privatisation. As for the argument that share-splitting was an acceptable practice, the court said:

"I do not consider that any right thinking member of society could condone a situation where the law required that a vote should be taken so as to balance the fairness between the holders of shares in different proportions and deliberate steps had been taken to distort that vote; in this case, it may be said, at minimal cost to those responsible. Vote manipulation is nothing less than a form of dishonesty. The court cannot sanction dishonesty."

Thus, attempts to manipulate voting in corporate transactions are unlawful in Hong Kong.

Sunday, September 6, 2009

L'Affaire Madoff I: A Night to Remember

Late in the evening of April 14, 1912, everything that could possibly go wrong did and 1,517 people lost their lives. The story is well known: the RMS Titanic was on its maiden voyage across the Atlantic. It was a dark, moonless night, and the crew in the crow’s nest didn’t have binoculars (in an oversight, they hadn’t been loaded on the ship). An iceberg in the ship's path wasn't spotted in time. The ship turned to avoid it, but scraped against it, causing the iceberg to slice through several of the ship's water-tight compartments that supposedly made it unsinkable. If the ship had been going more slowly, it could have made the turn without hitting the iceberg. If it had been going more quickly, it would have hit the iceberg dead on. While still suffering damage, it likely would have remained afloat.

Error piled on top of error. The ship didn't have enough lifeboats to evacuate all of the passengers and crew. Many of those that were launched were not full because passengers refused to believe the ship could sink. The nearly Californian ignored Morse Code, signal lamp and rocket flare distress calls.

I was thinking of this as I read the SEC Inspector General's report on the agency's investigations of Bernard Madoff. (Full disclosure: I was on a panel with Madoff at a conference at Baruch College in 2001. That's the only time I met the man. Honest.) The full report runs 477 pages (I confess, I just read the executive summary. It was enough).

Although the Inspector General finds no SEC personnel had directly attempted to influence the investigations, the SEC did not perform a thorough and competent investigation. This was despite receiving six substantive complaints and the SEC's awareness of articles in "reputable publications" that questioned Madoff's investment returns.

The report states that the most of the evidence appears to support a conclusion that Madoff had been operating a Ponzi scheme since at least 1992, and the SEC had an opportunity to detect it as far back as then. There were a number of factors listed as to why the investigation was botched for so long.

  • Most of the investigative staff was very junior with limited training and experience. Often they were litigators with little experience with equity and derivative trading. The first complaint from Harry Makropolos (who eventually testified before Congress of his attempts to get the SEC to investigate Madoff) was not acted on because the Boston District Office's Assistant District Administrator didn't understand the information he presented. Madoff frequently gave evasive and inconsistent answers to questions that were not followed up.

  • Madoff would try to intimidate the examiners. He would let them know that he knew senior people at the SEC. He told them Christopher Cox would be appointed SEC Chairman several weeks in advance of the appointment, and said that he (Madoff) had been on the short list for the position.

  • Although complaints specifically raised the possibility that Madoff was operating a Ponzi scheme, the SEC never focussed on that, even after it learned that the "Madoff's well-known market-making business would be losing money without the secretive hedge fund business." One was focussed on front-running because "that was the area of expertise for [the investigation] crew." Another focussed on whether Madoff should be required to register his hedge fund with the SEC and whether his disclosures to investors were adequate (they weren't, of course, but they appeared to be).

  • Little effort was made to obtain third-party verification of the hedge fund's holdings and trading. When the few that were made uncovered more red flags, they were ignored. After the fraud was exposed, it took only a few days to confirm that Madoff had not used any of the investors' funds to make trades.

  • One investigation was terminated before it was completed. This often occurs as enforcement priorities shift.

  • There seems to be a serious problem of silos at the agency. The Office of Compliance Inspections and Examinations' broker-dealer group (who were in charge of the investigation) did not request assistance from the investment adviser group. At one point, the OCIE and the SEC's Northeast Regional Office were conducting separate investigations unbeknownst to each other. After they discovered the overlap (due to Madoff telling one team he had already given the SEC the information they were requesting), there was little effort to compare notes. The investigators asked the SEC's Office of Economic Analysis for assistance in reviewing Madoff's trading, but did not provide copies of the detailed complaints about that trading. After 2 1/2 months, an OEA expert on options trading concluded that Madoff's purported "split-strike" trading strategy would not be expected to "earn significant returns in excess of the market." This analysis was never passed on to Enforcement staff.

  • Madoff used the fact that he had been examined by the SEC as a marketing tool to convince reluctant new investors they should invest with him.

One bright spot of the Titanic tragedy was that the various inquiries, coupled with public outrage, brought changes that made travelling by ship much safer. We can only hope that the SEC will learn the lessons of the OIG report and we won't see someone outdo Madoff.

Some Weekend Reading

There were two interesting articles in today's New York Times. On the front page was "Wall Street Pursues Profit in Bundles of Life Insurance" by Jenny Anderson, reporting on new products Wall Street is creating that sound a lot like the old products that got us into this mess. Interestingly, some of the firms have approached DBRS for a rating. DBRS was the only firm that would rate asset-backed commercial paper with so-called Canadian-style market disruption clauses (which provided that a liquidity guarantee was only provided if commercial paper could not be issued at any price by any issuer). The freezing of the ABCP market in 2007 was Canada's equivalent to the subprime fiasco in the U.S. Although DBRS subsequently stopped rating the paper, the Canadian Securities Administrators are considering whether greater oversight of credit rating agencies is required.

The second, in the magazine, is "How Did Economists Get It So Wrong?" by Paul Krugman. It details the internecine fights among schools of economists (the "saltwater" and "freshwater" economists) and concludes that a belief that markets are always efficient and will always find the correct balance are mistaken.

Sunday, August 30, 2009

Quebec Appeal Court Cuts Norbourg Fraudster’s Jail Time

On August 21, the Quebec Court of Appeal released its decision in L'Autorité des marchés financiers c. Lacroix, 2009 QCCA 1559 (CanLII) reducing the total jail time to be served by the architect of the Norbourg Asset Management collapse to 5 years less a day. (The decision is only available in French). The AMF is considering whether to appeal the decision.


In December, 2007, Vincent Lacroix, the ex-CEO of Norbourg, was convicted under 50 counts of violating the Quebec Securities Act. 27 of the convictions were for violations of section 195.2 of the Act, which prohibits “influencing or attempting to influence the market price or the value of securities by means of unfair, improper or fraudulent practices.” 8 of the convictions were for making misrepresentations in documents filed with the AMF contrary to subsection 197(4) of the Act, and the remainder concerned misrepresentations in records kept contrary to subsection 197(5).

In addition to fines, the trial judge sentenced Lacroix to 5 years less a day for each of the convictions under section 195.2, to be served concurrently. Lacroix was sentenced to 42 months for each of the violations of subsections 197(4) and (5). The sentences for each subsection were to be served concurrently, but the 42 months for the subsection 197(4) violations was to begin after the sentence for the 195.2 violations had been served and the 42 months for the subsection 197(5) violations was to begin after the sentence for the 197(4) violations had been served. Thus, Lacroix was sentenced to a total of 12 years less a day in prison.

Lacroix appealed to the Superior Court. The Court ruled that all of the sentences for the section 197 violations were to be served concurrently, but following the sentence for the section 195.2 violations, reducing total time served to 8 ½ years. Both Lacroix and the AMF appealed to the Court of Appeal.

Issue 1: Could Lacroix raise the issue of the consecutive sentences on appeal?

In his appeal, Lacroix argued that the court did not have the ability to impose consecutive sentences under the Quebec Code of Penal Procedure. This argument had not been previously made. The Court of Appeal noted that at his trial, he was not represented by counsel. At the Superior Court, his counsel did not object to the consecutive sentences, but rather that his sentences were in each case the maximum allowable, and the result was a penalty that was disproportionate.

The Court ruled that it could entertain a new argument on appeal if it would be unjust not to do so. It also noted that the only issue raised was one of the correct interpretation of the Code, which did not require new facts to be proven.

Issue 2: Could consecutive sentences be imposed?

The Court reviewed the text of the Code. Section 239 provides that “a term of imprisonment is executory upon sentence.” Section 241 states that “subject to articles 350 and 351, where the defendant is already in detention, the judge, in sentencing him to a new term of imprisonment, may order that the terms be served consecutively.”

The Court did a review of the case law and noted that sections 350 and 351 dealt with mandatory consecutive sentences for defaulting on payments while imprisoned. It also reviewed the Code’s predecessor statutes. It interpreted the language of section 241 as meaning where the defendant is already in detention on an unrelated matter. For related matters, a court may only impose consecutive sentences if the legislation specifically allows it.

The Court’s reasoning can be questioned. Section 241 does not specifically require the detention to be for an unrelated matter. The 2 sections referred to (350 and 351) impose mandatory consecutive sentences. In other words, they take away the judge’s discretion to impose concurrent sentences. Given that “[m]ore than 9,000 investors were defrauded of a total of $115 million when Lacroix made a series of illegal transactions” through Norbourg, it’s the Court of Appeal decision that seems to impose a “disproportionate” sentence.

Wednesday, August 26, 2009

You Know We're Really in a Recession...

I was looking at the Securities and Exchange Commission website last week when I came across an item stating that the SEC had suspended trading in the securities of a company called Tasty Fries, Inc. for failure to file required reports. This is normally a sign that a company is in serious financial difficulty, if not out of business entirely. I thought we really must be in a recession if a company with a name like "Tasty Fries" can't make a go of it.

I thought I should dig deeper. It turns out that Tasty Fries hadn't made any filings for the previous four years. Four years! Cease trading delinquent filers is something Canadian securities commissions do much faster (i.e. the day after a filing deadline is missed), so scratch one up for our side. I did a Google search and came across an article stating that the Delaware Chancery Court determined it was little more than a "sham meant to defraud investors." In 2007, the SEC filed settled charges against the company, its CEO and two other officers "unlawfully issued Tasty Fries stock without proper authorization, issued and filed with the Commission false and misleading financial statements and made false and misleading statements in press releases and Commission filings." As is the practice for settlements in the United States, the defendants neither admitted nor denied the charges.

I was disillusioned. As Maxwell Smart, Agent 86, might say, "if only they had used their knowledge for goodness and deliciousness instead of greediness and rottenness." At least I had no personal experience with their product, unlike Chipwich, Inc., which was the subject of SEC administrative proceedings for accounting jiggery-pokery and went bankrupt in 1992. Cbipwiches were probably my favourite ice-cream snack. The company either came out of bankruptcy or sold the rights to make Chipwiches as I have seen them since, but rarely. If anyone knows where they are sold in the Toronto area, please e-mail me.

Monday, August 24, 2009

U.S. Senator Calls for "Comprehensive" Market Structure Review

It's always disheartening when politicians wade into market structure issues. Their motivation is, naturally, political, and they assume they know more than the regulators with day-to-day experience. The recent tirades against short selling are an example. I have not seen one study suggesting that short sales in any way contributed to the economic meltdown, yet regulators were threatened with a legislative response if they didn't "do something" (which they inevitably do). Senator Ted Kaufman (D, Delaware) has sent a letter to SEC Chairman Mary Schapiro calling on the SEC to mount a comprehensive, independent review of "questionable market structure issues" before "piecemeal changes to the current market structure make things worse."

Senator Kaufman is concerned that advances in electronic trading have created an unlevel playing field where "questionable practices threaten to further erode investor confidence in our financial markets." There is certainly an unlevel playing field, but it would be difficult if not impossible to level it without creating a highly inefficient market.

He raises concerns about the latent disparities in the market. In particular, high volume traders often co-locate their servers with a marketplace's in order to cut the latency in receiving and delivering order and trade information to a minimum. Their trading strategies depend on low latency, so they know immediately if an order has been filled.

Latency also raises other issues: is the national best bid and offer accurate in reflecting quotes from various venues? The short answer is no. No two users (be they traders, dealers or market data vendors) will get the same datum at exactly the same nanosecond. It will always take a bit longer to get to some parties.

This is not a new issue. Back in the days of trading floors, order and trade information was always more complete and up-to-date in the trading square than it was on the data feeds.

I will tackle some of the particular issues he raises in later posts (and I agree some need to be looked at) but want to make one general comment. His motivation, like many other politicians, is that retail investors are being disadvantaged. But are they? The high-speed traders are interested in shaving pennies as they buy and sell in different markets to take advantage of the market. An investor with a longer-term outlook shouldn't care about slight price variations. They know their price and it they get it, they are happy. Retail investors who take aggressive short-term positions and try to time the market are competing directly with the professionals and they simply don't have the information or computer algorithms to do it successfully. To level the playing field would mean that the markets are so inefficient and slow the professionals move on to something else.

Monday, July 27, 2009

It Was a Dark and Stormy Night....

The 2009 winners of the Bulwer-Lytton fiction contest have been announced. As most of you probably know, contestants strive to write the worst opening sentence they can think of. The contest was inspired by Edward Bulwer-Lytton's Victorian novel Paul Clifford, which begins:

"It was a dark and stormy night; the rain fell in torrents, except at occasional intervals, when it was checked by a violent gust of wind which swept up the streets (for it is in London that our scene lies), rattling along the house-tops, and fiercely agitating the scanty flame of the lamps that struggled against the darkness."

This year's winner is David McKenzie with this less-than-deathless prose:

"Folks say that if you listen real close at the height of the full moon, when the wind is blowin' off Nantucket Sound from the nor' east and the dogs are howlin' for no earthly reason, you can hear the awful screams of the crew of the "Ellie May," a sturdy whaler Captained by John McTavish; for it was on just such a night when the rum was flowin' and, Davey Jones be damned, big John brought his men on deck for the first of several screaming contests."

The successful (?) contestants have a tendency to cram as much extraneous information into a sentence as possible, such as Eric Rice’s winning entry for detective fiction:

"She walked into my office on legs as long as one of those long-legged birds that you see in Florida - the pink ones, not the white ones - except that she was standing on both of them, not just one of them, like those birds, the pink ones, and she wasn't wearing pink, but I knew right away that she was trouble, which those birds usually aren't." Reading these got me thinking that a lot of legal writing could be competitive in this contest. Lawyers love dense prose and infinite subclauses. Unfortunately, the reader tends to get lost, and misses the point the writer is trying to make.

I am a big fan of plain legal writing. It is not only more understandable, but more persuasive.

Rather than go on at length about using the active voice and excising unnecessary words, I thought I would simply point you to some good resources. Unfortunately, I haven't been able to find the first on-line. It's an article by (now) Mr. Justice Paul Perell of the Ontario Superior Court of Justice titled Written Advocacy. It was published in the Law Society of Upper Canada Gazette Vol. 27, No. 1 (March 1993). I have kept it lo these many years and periodically re-read it.

The United States Securities Exchange Commission has published an excellent Plain English Handbook. It not only covers writing style but also addresses document organization and set-up (including use of fonts and justification) and presentation of graphics, with the goal of making the document more reader-friendly. Given that Canadian commission also require plain English in filings such as prospectuses, it is a useful read for lawyers north of the border as well.

One of my favourite before-and-after examples from the SEC Handbook is the following:


Drakecorp has filed with the Internal Revenue Service a tax ruling request concerning, among other things, the tax consequences of the Distribution to the United States holders of Drakecorp Stock. It is expected that the Distribution of Beco Common Stock to the shareholders of Drakecorp will be tax-free to such shareholders for federal income tax purposes, except to the extent that cash is received for fractional share interests.


While we expect that this transaction will be tax free for U.S. shareholders at the federal level (except for any cash paid for fractional shares), we have asked the Internal Revenue Service to rule that it is.

There are a number of other good style guides out there. I like The Economist's.

Thursday, July 23, 2009

Insider Twitting

Bruce Carton’s Enforcement Action blog on Compliance Week is always interesting and informative. This week, he questioned whether someone who traded in securities based on information leaked through Twitter would be engaging in insider trading. He had three scenarios and analysed each (although he confessed it was “way tougher than I thought it would be”).

I thought it would be interesting to look at this from a Canadian perspective, given that our insider trading prohibition is more black and white, and got Mr. Carton’s consent to use his examples. But as the existing rules and guidelines were written well before the advent of social networking sites like Facebook and Twitter, I realized it was, well, way tougher than I thought it would be. As I thought it through, it occurred to me: this would make an excellent exam problem. And, as I have been watching the old Paper Chase TV series recently, I imagined a Socratic inquiry into the issue. You have to assume that Professor Charles Kingsfield teaches securities law in addition to contracts and that he teaches at the University of Toronto (where the movie version of The Paper Chase was filmed) and not Harvard (where it was set).

The biggest difference between Canadian and American law is that Canadian law is a blanket prohibition on trading on undisclosed material information, while American law requires a breach of a fiduciary duty, such that the person is misusing a confidence. In the recent SEC v. Cuban case,(1) six law professors filed an amici curiae brief (surprisingly short, given law professors wrote it!) arguing that the charges against Cuban should be dismissed. The SEC action alleged that Cuban breached Rule 10b-5 of the Securities Exchange Act of 1934 by selling shares of a company after he learned it was planning to issue shares at a discount to market, despite an agreement with the company that he would keep the information confidential. The professors argued (persuasively it seems, as the case was dismissed with leave for the SEC to refile) that breach of confidentiality alone is not sufficient. There must be some sort of family or other relationship that is betrayed when the confidential information is misused by the person receiving it. For example, someone giving confidential information to their spouse normally does so on the basis that the spouse will maintain the confidentiality and not trade on or otherwise unfairly profit from the information. In the Cuban case, there was no such relationship and no duty to refrain from trading absent an explicit agreement not to do so.

So are the Canadian rules clearer? Yes and no. Let’s see.

KINGSFIELD: Mr. Baikie, will you please give us the facts of Ontario Securities Commission v. Twaddle?

BAIKIE: Mr. Twaddle was a senior vice-president at ABC Corp. He knew that the company was in negotiations to be taken-over by XYZ Inc. at a premium to the current market price, and that they expected to come to final terms shortly. He made a posting on Twitter that said “I’m about to become a rich man. My company, ABC Corp., will be acquired next week at a 50% premium to the current stock price. Shhh!!!!” Several of his followers bought ABC stock on the Toronto Stock Exchange prior to the announcement of the merger, and the stock price jumped from $20 to $30 when the merger was announced. The OSC brought an enforcement action against Twaddle for violation of section 76 of the Ontario Securities Act.

KINGSFIELD: So, do you think Twaddle’s Twitter tweet was a violation?

BAIKIE: Clearly, sir. Subsection 76(2) of the Act prohibits any person or company in a special relationship with a reporting issuer from informing, or “tipping” any other person about a material fact or material change concerning the reporting issuer that has not been generally disclosed, or, in common parlance, “inside information.” As an insider, Mr. Twaddle was in a special relationship by virtue of the definition of “person in a special relationship” in subsection 76(5).

KINGSFIELD: Does it matter that Mr. Twaddle didn’t himself trade?

BAIKIE: No. Tipping is a violation in and of itself.

KINGSFIELD: Could Mr. Twaddle have argued that by tweeting the information he was “generally disclosing” it?

BAIKIE: I don’t think so. Both the Canadian Securities Administrators’ National Policy 51-201 Disclosure Standards and the TSX’s Timely Disclosure Policy (2) require broader dissemination than a tweet. The TSX policy requires the company to issue a news release with the broadest dissemination possible. NP 51-201 states that a conference call or press conference may be adequate if interested members of the public can attend or listen in and are given sufficient advance notice so they can decide whether to attend. NP 51-201 and the TSX’s Electronic Communications Disclosure Guidelines both state that posting information on a company’s website does not constitute general disclosure. If posting the information on ABC’s website would not be sufficient, it’s hard to see how posting it to a limited number of followers on Twitter would be.

KINGSFIELD: And what about Twaddle’s followers who bought the stock. Did they violate the Act?

BAIKIE: The OSC charged them separately, so this case doesn’t say what happened to them.

KINGSFIELD: I know, but I expect you to be able to analyse every aspect of the case. Come now, Mr. Baikie, we’re waiting. Fill this room with your intelligence!

BAIKIE: Any tippee, that is a person who receives inside information, violates subsection 76(1) of the Act if they trade in the subject security. The OSC does not have to prove that they used the information in their trading decision. Given that Mr. Twaddle’s tweet states “my company” and “Shhh,” I think it’s clear he was giving them inside information they could improperly use to their benefit. Furthermore, subsection 76(2), which I mentioned earlier, prohibits them from passing the inside information along to others.

KINGSFIELD: And that’s the end of the analysis?

BAIKIE: Yes, sir.

KINGSFIELD: I think not. Mr. Gagarian, could you enlighten us, please?

GAGARIAN: Sir, the answer to whether they violated the Act has to be “it depends.”

KINGSFIELD: And it depends on what?

GAGARIAN: Subsection 76(4) provides a defence if the person trading reasonably believed that the information had been generally disclosed. The key word is reasonable, and that depends on the circumstances.

Suppose Twaddle’s postings were extremely boring and his only followers were 5 family members and close friends. It is unlikely that the followers would believe that he was doing anything other than giving them inside information.

Now suppose he has 2,000 followers. An argument could be made that a follower could assume that the information had been generally disclosed. Although tweeting clearly doesn’t satisfy the requirements of NP 51-201, the inquiry doesn’t end there. First off, NP 51-201 is a policy, which by definition isn’t a binding rule. It notes that the Act doesn’t define what constitutes “generally disseminated,” but cites some insider trading cases as precedent. It was written when the Internet was in its infancy and social networking sites like Twitter and Facebook weren’t even contemplated. The precedents are even older.

One of Twaddle’s many followers might have a reasonable belief it wasn’t confidential because he had never posted confidential information before and because it would be read by so many other people. This is negated somewhat by the fact that he did say “Shhh,” and by the fact that if the information had been disclosed it should have already been reflected in the stock price, but I think there’s an argument there. If there was nothing in the tweet suggesting the information was confidential, they would have a much stronger argument.

Now what if he had only 5 followers, all of whom were strangers? They could construct an argument that they didn’t believe he was giving them confidential information because he had absolutely no motive to tip off people he didn’t know, but I think they are in a weaker position than the 2,000 followers.

KINGSFIELD: Are you suggesting that Mr. Baikie was incorrect when he stated that the tweet did not constitute general disclosure?

GAGARIAN: No, sir. Although “generally disseminated” isn’t defined, the Act clearly contemplates widespread awareness of the information before someone can trade. That would be thwarted if someone could “disclose” the information by posting it on the internet such that only a few people will become aware of it. And it would be unworkable if the test were a certain minimum number of people being aware, as the person posting would have no way of knowing how many people actually read it.

I’m suggesting that even though tweeting would not constitute “generally disclosing” the information, in certain circumstances, someone reading the tweet would reasonably conclude that it had been generally disclosed. Maybe 2,000 followers isn’t enough, but what if Ashton Kutcher told his 2.9 million followers (3)about the take-over?

KINGSFIELD: But aren’t you ignoring the fact that a tweet isn’t considered “general disclosure”?

GAGARIAN: This is a defence to an insider trading charge. The test isn’t whether the information was in fact generally disclosed. If the information had been, there wouldn’t have been a violation in the first place. The test is whether the tippee reasonably believed it had been. I think the standard should be the reasonable Twitter follower, not the reasonable securities lawyer who should be expected to know it hadn’t.

KINGSFIELD: Excellent, Mr. Gagarian. Now, did ABC breach the Act? Ms . . . . Logan?

LOGAN: Although subsection 75(1) of the Act requires prompt disclosure of a material change in a reporting issuer, which a take-over bid certainly is, subsection 75(3) allows a company to delay disclosure if premature disclosure would be unduly detrimental. If so, the company can make a confidential filing with the OSC. In this case, ABC could reasonably argue that disclosing details of the pending merger before all the terms were finalized could cause XYZ to walk away, which would be to the detriment of ABC’s shareholders.

However, subsection 75(5)requires ABC to make immediate disclosure of the information if it becomes aware that people are trading on the information. So if ABC knew about the tweet, or if there were unusual buying interest in the stock suggesting that the information had leaked, they would have to issue a news release.

KINGSFIELD: Thank you, Ms. Logan. I see we are out of time. Class dismissed.

KINGSFIELD gathers up his books and seating chart and leaves quickly by the back of the room.

(1) I was directed to this by Jim Hamilton’s World of Securities Regulation, another excellent blog.
(2) The timely disclosure policies of the other Canadian exchanges are virtually identical.
(3) Actually, it’s 2,895,067 followers as of July 23.

Wednesday, January 28, 2009

OSC requires shareholder approval of acquisition

On January 23, the Ontario Securities Commission ordered HudBay Minerals Inc. to obtain shareholder approval prior to closing its proposed acquisition of Lundin Mining Corporation. The decision overturned an earlier decision by the Toronto Stock Exchange (TSX) to allow the transaction without requiring a shareholder vote.

Last year, HudBay and Lundin announced that HudBay had agreed to acquire all of the outstanding common shares of Lundin on the basis of 0.3919 HudBay common shares for each Lundin common share. The total number of shares to be issued to Lundin shareholders under the proposal was slightly more than the total number of HudBay shares outstanding at the time. The market did not look kindly on the proposal; HudBay’s share price dropped 40% on the announcement.

The rules
Section 611 of the TSX Company Manual provides that shareholder approval will normally be required if a proposed acquisition would result in a listed company issuing over 25% of the number of outstanding shares on a non-diluted basis. Section 611(d) of the Manual gives an exemption where the company being acquired is a reporting issuer with 50 or more beneficial shareholders.

However, section 603 of the Manual provides that the TSX has discretion to accept notice of a proposed transaction and can impose conditions such as shareholder approval. Section 604 provides that shareholder approval will generally be required if a transaction will result in a change of control of the issuer.

Challenging the Proposal
Jaguar Financial Corporation, a HudBay shareholder, filed an application with the OSC to review the TSX’s decision. The application cited the following grounds for OSC review:

1. The exemption in section 611(d) is out of step with current regulatory best practices. Virtually every other exchange would require shareholder approval in this circumstance and the TSX itself has requested comment on whether the provision should be amended.
2. The sheer size of the proposal and the effect on shareholders justify a review.
3. Shareholders are opposed to the proposal. This is demonstrated by the negative market reaction.
4. The proposal would result in a material change of control of HudBay, where 5 of 9 directors of the amalgamated company would be former Lundin directors.
5. HudBay’s special board committee reviewing the proposal did not do adequate due diligence.

The OSC normally defers to the judgment of the TSX, particularly in areas of the TSX’s expertise. There are limited circumstances in which it will intervene. The fact that it would have reached a different decision is not one of them.

The OSC hearing panel found the TSX’s determination that the proposal would not result in a change of control of HudBay to be within a range of reasonableness.
The panel then reviewed Section 603 of the TSX Manual, which requires the TSX in exercising its discretion to consider the effect that a proposed transaction would have on the quality of the TSX marketplace. The minutes of the TSX Listing Committee simply stated that “in this circumstance the rules would not require the transaction to be approved by HudBay shareholders,” and that it would “not be appropriate” to exercise discretion to require a shareholder vote. The TSX did not provide the panel with any affidavit evidence.

The panel concluded it had no basis upon which to determine whether the TSX’s conclusion not to require HudBay shareholder approval was within a range of reasonableness and, consequently, whether it should defer to the TSX’s judgment. The panel limited itself to interpreting and applying the existing Section 603, and explicitly stated it was not changing the rule. The fact that the TSX proposed amending the rule was not a consideration.

The panel interpreted “quality of the marketplace” to include the impact on market participants. More or less following the grounds set out in Jaguar’s application, the panel found a number of factors that it believed would have a negative effect on HudBay’s shareholders if the proposal were allowed without shareholder approval.

The TSX appears to have taken a restricted view of the basis on which it could impose shareholder approval. It seems to interpret “quality of the marketplace” to mean that a proposed transaction will result in shareholders having a less liquid and efficient market in their securities. In this case, the fact that a large number of shares would be issued should, if anything, increase liquidity.

The OSC has taken a more expansive view, interpreting “quality of the marketplace” to include upholding shareholders’ reasonable expectations of what the exchange would require.

This decision is not a hard-and-fast rule that issuers must obtain shareholder approval for acquisitions of other listed companies. However, it is a shot over the bow that the TSX’s existing practices must change. The TSX will likely respond (and quickly, no doubt) by removing section 611(d) of the Manual and requiring shareholder approval anytime an acquisition will result in more than 25% of the outstanding shares being issued. Approaching this on a case-by-case basis will leave the TSX open to criticism no matter what its decision and no matter how thoroughly it analyzed whether to exercise its discretion.

Monday, January 19, 2009

A federal securities commission on the horizon?

On Tuesday, the federal government’s Expert Panel issued its recommendations on securities law reform. It is the umpteenth panel since the 1930s to study this issue. Unlike its predecessors, it has a very good chance of seeing its recommendations implemented.

While imperfect, establishing one national securities regulator will make regulation and capital raising more efficient and effective. All capital market participants should support the implementation of the Panel’s recommendations as quickly as possible.

The recommendation
The Panel’s report recommends that the federal government establish a national securities commission. It trots out the usual reasons for a national securities commission, such as the slow pace of policy making because of the need for consensus among the various provincial regulators and the need for a strong voice on international bodies.

It recommends a model in which provinces would opt in, that is, amend their securities legislation to mirror the federal legislation and defer to the federal commission. Predictably, some provinces are resisting this. The Panel recommends that public companies and registrants in non-participating jurisdictions also be able opt in and be governed by the federal regime rather than their provinces’. Few, if any, companies or registrants would fail to avail themselves of this option, which is why we are likely to see a federal commission in the not-too-distant future.

The legislation
The draft legislation accompanying the Panel’s report is based on the Alberta Securities Act, which is the most up-to-date in the country. While this is no worse than what is in place today, it is unfortunate that the Panel didn’t take this opportunity to improve it.

For example, the Panel supports principles-based regulation, where the legislation specifies the desired outcome but not the means of achieving it. The draft legislation is very rules- and process-based. The draft legislation also carries forward the current incoherent approach to self regulation, where stock exchanges must obtain recognition from the Commission while other entities may be recognized. Parliament should fix these and other problems before anything is finalized.

What does this mean to me?
If you are a public company or a registrant, you should pay close attention to developments in Ottawa. Creating a national regulator is clearly a priority of the current government. The Liberals have indicated their agreement in principle, but not necessarily with the Panel’s specific recommendations. In particular, they may not support the recommendation that companies and registrants have the ability to opt into the federal regime.

If Parliament enacts the Panel’s recommendations, public companies and registrants in jurisdictions that do not opt in (at least Alberta, Manitoba and Quebec) will need to decide whether to opt in to federal regulation.

While imperfect, establishing one national securities regulator will make regulation and capital raising more efficient and effective. All capital market participants should support the implementation of the Panel’s recommendations as quickly as possible.