Thursday, November 25, 2010

Big Changes Proposed to Ontario Securities Act

You wouldn't know it from the title, but Schedule 18 of the Helping Ontario Families and Managing Responsibly Act, 2010 (Bill 135) contains some far reaching amendments to Ontario securities law. Most notably, it contains a legislative framework for regulating derivatives that is missing from both the Securities Act and the Commodity Futures Act.

In addition to numerous clean-up amendments, Bill 135
  • allows the OSC to designate credit rating agencies for the purposes of Ontario securities law but not to regulate the content of ratings or the agency's methodologies;

  • allows the OSC to designate trade repositories, which are entities that collect and maintain reports of completed trades by other entities;

  • provides a legislative framework for trading derivatives; and

  • extends the insider trading prohibition and related civil liabilities to TSX Venture Exchange listed companies with a "real and substantial connection" to Ontario.
Credit Rating Agencies

In an earlier post, I described the CSA initiative to create a framework for regulation of credit agencies. Bill 135 allows the OSC to require the agencies to have a code of conduct applicable to directors, officers and employees and to have policies and procedures to manage conflicts of interest between the agency and client companies.

Trade Repositories

The OSC would be able to designate trade repositories in what appears to be a similar process to that of recognition of exchanges, quotation and trade reporting systems and SROs.


Before the bill was even tabled, the proposed derivative regulation was a matter of speculation, at least in the Globe and Mail. The actual contents of the bill are not as bold as perhaps what was anticipated.

"Derivative" is defined as an option, swap, futures contract, forward contract or other financial or commodity contract or instrument whose market price, value, delivery obligations, payment obligations or settlement obligations are derived from, referenced to or based on an underlying interest (including a value, price, rate, variable, index, event, probability or thing), excluding
  • a commodity futures contract as defined in subsection 1 (1) of the Commodity Futures Act,
  • a commodity futures option as defined in subsection 1 (1) of the Commodity Futures Act, and
  • a contract or instrument that, by the regulations or Commission order is not a derivative.
The bill makes a number of linguistic changes to the Act to accommodate derivatives, such as changing references to "stock exchanges" to "exchanges" and replacing the term "security" (for the most part, but not in all cases) to "security or derivative." To the extent that a particular instrument fits the current definition of "security," there won't be any practical change. However, there are some contracts that might be exempt from the definition before that could now be caught. For example, it is arguable that forward contracts are not "securities" under the current definition unless they could be characterized as "investment contracts."

One problem with the bill is that the definition of "security" in the act has not been amended, which means that many contracts will be both "securities" and "derivatives." It would be preferable for the definitions to be exclusive, that is "security" does not include a "derivative." The bill in fact, gives the OSC the authority to rule that certain classes of derivatives are securities.

It would have been even better if the derivatives provisions were incorporated into the Commodity Futures Act, making it a comprehensive body of rules governing exchange-traded and over-the-counter derivatives, similar to what Quebec has done.

In terms of substantive changes, there isn't much in the bill. It allows for registration to trade derivatives. While this is unlikely to affect investment dealers (who are currently permitted to trade them), it would allow for a tailored registration regime for derivative-only firms.

Derivatives are exempt from the prospectus requirements if a disclosure document is prepared and accepted by the Commission. While the content of the disclosure document is not specified, this appears to be a codification of the current prospectus exemption for exchange-traded derivatives provided a risk disclosure statement is first given to the client. This also reflects the reality that each trade in a derivative results in the issuance of a new security because the clearing house becomes a counterparty to each side of the trade.

Insider Trading

The prohibition on trading on the basis of undisclosed material information (and the resulting civil liability for violations) has been extended to TSX Venture Exchange listed issuers that have a real and substantial connection to Ontario. Currently, the prohibition only extends to Ontario reporting issuers.

It isn't clear why this provision is needed, given that section 18 of TSX VE Policy 3.1 requires issuers with a "substantial connection" to Ontario to make a bona fide application to the OSC to become a reporting issuer within six months of it becoming aware that it has a significant connection. The concern might be that these issuers are traded on alternative trading systems in Ontario; previously the trading would have been done on the Venture Exchange and the BCSC and ASC would have jurisdiction. The Ontario government might be concerned that the very people who are responsible for having the company apply to be an Ontario reporting issuer might improperly delay the application to trade with knowledge of inside information. Even so, it is difficult to see why the provisions weren't extended to all TSX VE listed companies (as the gap continues to exist for those that do not have a real and substantial connection to Ontario) or, like section 57.2 of the British Columbia Securities Act, extended to all public companies regardless of reporting issuer status.

“Real and substantial connection” is not defined, and it could prove unworkable if the OSC adopts a different definition from that in the TSX VE’s rules.

There are a number of more minor problems with the bill. It continues the Ontario government’s insistence on putting provisions in the legislation that in other provinces are left to commission rules. In this case, some provision of National Instrument 21-101 Marketplace Operation are brought into the Act. In addition, the current power given to the OSC to suspend trading on a stock exchange in the event of a market disruption is unclear as to whether it extends to quotation and trade reporting systems and alternative trading systems. Although the provision will be amended to allow suspension of trading in securities and derivatives, the ambiguity remains.

This is legislation, not a commission rule, so there is no notice and comment period. However, it is hoped that some of the concerns with the act (which in my case go more to form than substance) can be remedied by the Legislature's deliberations.

Friday, November 19, 2010

CSA/IIROC Position Paper on Dark Markets Released

Following on the heels of studies by the SEC, IOSCO, and the Australian Securities and Investments Commission, the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada have released a joint position paper on dark liquidity in Canadian markets.

The paper lists those issues the regulator feeds need to be addressed immediately, and it contemplates amendments to National Instrument 21-101 and the Universal Market Integrity Rules.

The paper defines "dark order" as an order that is entered on a marketplace without being visible to other market participants, and "dark pool" as a marketplace with no pre-trade transparency for any orders. Partially undisclosed orders, such as iceberg orders, are not considered dark orders as they contribute to price discovery.

The main risks dark orders and dark pools pose to capital markets are making price discovery less efficient and reducing liquidity available to all market participants by diverting order flow that otherwise would have gone to visible, public markets. On the other hand, orders are dark because full disclosure of trading intentions may have an impact on the market price, leading to a worse fill. Dark pools offer an alternative to the upstairs market where institutional block orders were traditionally traded. Dark orders also offer potential liquidity to smaller orders that are sent to a dark pool first in search of a better price than that available on visible markets.

The paper sets out the regulators' positions on three issues:
  1. Orders under a certain size should be required to be publicly displayed. The rationale for allowing dark orders not to be shown weakens if the order could be displayed with no market impact. Once entered, the order's size could not be reduced below the threshold (unless the reduction is due to a partial execution). The report suggests that the current threshold of 50 board lots in UMIR is an acceptable threshold, and invites specific feedback.
  2. Two dark orders of at least the minimum size should be allowed to execute at or between the national best bid and offer (at or between (i) the highest price for a buy order on any market and (ii) the lowest price for a sell order on any market). All other trades involving a dark order should provide meaningful price improvement over the NBBO (at least a penny for all stocks trading over 50 cents, or a half-penny if the NBBO spread is one cent).
  3. Within a market, visible orders at a price should have priority of execution over dark orders unless two dark orders exceeding the minimum size can execute. The regulators believe that this will enhance liquidity for larger orders, while requiring immediate post-trade dissemination of the trade details assists in price discovery.

The paper does not address other concerns. One is that the dark pool may try to attract order flow by offering a smart order router using data that is not available to other marketplace participants. This will be addressed in proposed amendments to NI 21-101 that are expected to be published in early 2011. The second issue is the practice of broker preferencing, which allows offsetting orders from the same firm to execute ahead of other orders at the price, even if those orders have established time priority. A request for information to allow the brokers to better evaluate the impact of preferencing will be published in the near future.

The deadline for comments is January 10, 2011.

Wednesday, November 3, 2010

Share Structure Concerns in IPOs

The Canadian Securities Administrators recently issued Staff Notice 41-305 concerning share structure issues in initial public offerings.

The purpose of the notice is to put issuers and insiders on notice of the issues that the various commissions will consider when deciding whether issuing a receipt for a prospectus is in the public interest. The primary concern is companies that have issued large amounts of shares for nominal cash consideration (or as payment for assets or services where the value cannot be easily or objectively determined). This is particularly true if the issuer has a limited history of operations and thus is difficult to value and the number of cheap shares issued is large compared to the number of shares to be issued in the IPO.

These issues persist despite the fact that both the TSX Venture Exchange and the Canadian National Stock Exchange have policies that address some of these issues and the CSA itself has an escrow policy that acts to lock up cheap shares issued prior to an IPO.

The notice states that the commissions will consider a number of factors when determining whether a share structure is objectionable. The main consideration is whether public shareholders are getting a disproportionately small ownership stake in the company relative to the amount of money raised in the IPO. On the other hand, staff recognize that management and insiders may have spent considerable time and resources in building the business, and they will consider factors such as whether the value of the shares issued to the insiders can be corroborated by factors such as arm's length pre-IPO financings.

The takeaway is that persons acting for companies that have a lot of cheap or free stock outstanding should have a discussion with commission as well as exchange staff early on in the IPO process.